Thank you Steve, for that kind introduction. I appreciate the opportunity to talk to you today.
I want to start by giving you an overview of the President's comprehensive plan for regulatory reform and focus in particular on the problem that has come to be known as "too big to fail."
Just over a year ago, the collapses of Washington Mutual, Wachovia, and Lehman Brothers, and the extraordinary interventions in AIG, severely tested our collective ability to respond to a financial crisis. In the panic that followed, our financial system nearly ground to a halt.
A swift response prevented a truly catastrophic collapse. But last September's events revealed deep weaknesses in our financial system.
It did not take long for the financial contagion to infect the real economy. When President Obama took office, America's growth rate had hit negative 6.3 percent, and monthly job losses had reached 741,000 - the worst in decades.
There are indications that we have moved back from the financial brink and are headed toward economic recovery. Important parts of the financial system are back to functioning on their own. Some of the damage to people's savings has been repaired. We have taken the first steps towards both reducing the government's direct involvement in the financial system and reducing the risks that taxpayers are bearing.
But we cannot ignore the urgent need for action: our regulatory system is outdated and ineffective, and the weaknesses that contributed to the financial crisis persist. Our citizens are paying the price everyday for the failures in our financial system. The progress of recovery must not distract us from the project of reform.
The Administration has put forward comprehensive reforms and we are working closely with Congress to enact legislation by the end of this year. I'll spend most of our time today taking questions from you, but first let me briefly outline the Obama Administration's approach to financial regulatory reform, and in particular to explain the way that our plan addresses the challenge of those firms whose failure could threaten the stability of the financial system
Our goals are simple: to give responsible consumers and investors the basic protections they deserve; to lay the foundation for a safer, more stable financial system, less prone to panic and crisis; and to safeguard American taxpayers from bearing risks that ought to be borne by shareholders and creditors.
Right now we are working closely with the House and Senate to establish a federal insurance office within Treasury to gather information, develop expertise, monitor for systemic risks to and from the sector, negotiate international prudential agreements, and coordinate federal policy in the insurance sector. Insurance is a major component of the financial system. In 2008, the insurance industry had $5.7 trillion in assets, compared with $15.8 trillion in the banking sector. This office will be a significant step forward for the development of expertise at the Federal level and to give insurance appropriate focus within the development of federal policy for financial institutions and financial markets. [Such an office would have played a critical role in the events of last year, and not just with AIG but also with the issues the crises brought to bear on some life insurers].
For the immediate term, and critically in the international arena, creating a federal office within Treasury will enable the U.S. to speak with one voice in the International Association of Insurance Supervisors (IAIS) and to better represent American interests in negotiations with other countries, and enter into prudential agreements that will promote the ability of American insurers to operate effectively abroad.
Although many of the problems at AIG were created outside of its traditional insurance businesses, the example illustrates how large, leveraged and interconnected firms can develop in any business model – and that our regulatory approach must be flexible enough and tough enough to address risks wherever they may arise.
In recent decades, we've seen the significant growth of large, highly leveraged, and substantially interconnected financial firms. These firms benefited from the perception that the government could not afford to let them fail. This perception was an advantage in the market place. Creditors and investors believed that large firms could grow larger, take on more leverage, engage in riskier activity – and avoid paying the consequences should those risks turn bad. It is a classic moral hazard problem.
Of course, during the financial crisis, the federal government did stand behind almost all of these firms. That action was necessary, but there is no question that, unless we enact meaningful reforms, the fact that the federal government intervened this past year will have made the problem worse. We take this moral hazard challenge very seriously. Our proposals for reform address it head on. We must end the perception that any firm is too big to fail.
First, the biggest, most interconnected financial firms must be subject to serious, accountable, comprehensive oversight and supervision. The idea that investment banks like Bear or Lehman or other large firms like AIG could escape meaningful consolidated federal supervision should be considered unthinkable from now on.
For the largest, most interconnected financial firms – for any firm whose failure might threaten the stability of the financial system – there must be clear, inescapable, single-point regulatory accountability. The scope of that accountability must include both the parent company and all subsidiaries.
In our view, the Federal Reserve is the agency best equipped for the task of supervising the largest, most complex firms. The Fed already supervises all major U.S. commercial banking organizations on a firm-wide basis. After the changes in corporate structure over the past year, the Fed now supervises all major investment banks as well. It is the only agency with broad and deep knowledge of financial institutions and the capital markets necessary to do the job effectively.
So the first part of our approach to the moral hazard problem is clear, accountable, comprehensive oversight and supervision.
The second part is tougher standards. The regulatory and supervisory costs for firms that could pose a risk to the financial system must be increased. The firms must not feel like there is a benefit to being so large and interconnected that their failure could pose a risk to the system.
Those prudential requirements should be set with a view to offsetting any perception that size alone carries implicit benefits or subsidies. Capital and liquidity requirements must be higher for major firms, and they should be set at levels that compel firms to internalize the cost of the risks they impose on the financial system.
We will explicitly empower the Federal Reserve to require systemic firms to sell assets or terminate activities if necessary to ensure the safety and soundness of the firm or to protect financial stability.
We will impose higher capital requirements on riskier activities, including in particular proprietary trading and sponsorship of off-balance sheet vehicles.
Our proposal requires the Federal Reserve to review large acquisitions by systemic firms to ensure that the acquisition does not impair financial stability.
We will strengthen the firewalls between insured depository institutions and their affiliates (including affiliated investment funds and trading firms).
We have required bank holding companies that have elected to be financial holding companies and engage in a broad range of financial activities (such as merchant banking or underwriting and dealing in securities) to meet substantially higher capital requirements.
Through tougher prudential regulation, we aim to give these firms a positive incentive to shrink, to reduce their leverage, their complexity, and their interconnectedness. And we aim to ensure that they have a far greater capacity to absorb losses when they make mistakes.
As part of our proposal, we've called for the major financial firms to prepare what some have called "living wills." We would require these firms to prepare and regularly update a credible plan for their rapid resolution in the event of distress. Supervisors will make this a key component of regulatory oversight, both domestically and internationally as has been agreed in the G20. This requirement will leave us better prepared to deal with a firm's failure – and will provide another incentive for firms to simplify their organizational structures and improve risk management.
The third key element of our response to the moral hazard problem is to emphasize that being among the largest, most interconnected firms does not come with any guarantee of support in times of stress. Indeed, the presumption should be the opposite: shareholders and creditors should expect to bear the costs of failure.
That presumption needs to have real weight. That means the financial system must be able to handle the failure of any firm. In this last crisis, it clearly was not.
Leading up to the recent crisis, the shock absorbers that are critical to preserving the stability of the financial system – capital, margin, and liquidity cushions in particular – were inadequate to withstand the force of the global recession.
While the largest firms should face higher prudential requirements than other firms, standards need to be increased system-wide. We've proposed to raise capital and liquidity requirements for all banking firms and to raise capital charges on exposures between financial firms.
We've also laid out principles that we believe should guide regulators in setting capital requirements in the future. The core principle is that capital and other regulatory requirements must be designed to ensure the stability of the financial system as a whole, not just the solvency of individual institutions.
Beyond that, we've called for a greater focus on the quality of capital. We've called for capital requirements that are more forward-looking and reduce pro-cyclicality. We've called for explicit liquidity requirements. And we've called for better rules to measure risk in banks' portfolios.
We've also called for measures to strengthen financial markets and the financial market infrastructure. For example, we've proposed to strengthen supervision and regulation of critical payment, clearing, and settlement systems and to regulate comprehensively the derivatives markets.
Our plan would require standardized derivatives to be centrally cleared and traded on an exchange or trade execution facility – substantially reducing the build-up of bilateral counterparty credit risk between our major financial firms. We would require all customized OTC derivatives to be reported to a trade repository, making the market far more transparent. We would provide for strong and consistent prudential regulation of all OTC dealers and all other major players in the OTC markets, including robust capital and initial margin requirements for derivative transactions that are not centrally cleared.
We should never again face a situation – so devastating in the case of AIG – where the potential failure of a virtually unregulated major player in the derivatives market can impose risks on the entire system.
Taken together, the significance of these reforms should be clear: by building up capital and liquidity buffers throughout the system, and by increasing transparency in key markets, our plan will make it easier for the system to absorb the failure of any given financial institution. The stronger the system, therefore, the clearer it will be that there is no such thing as an implicit government guarantee.
In most circumstances, these precautions will be enough. More comprehensive oversight, combined with stronger capital and liquidity standards and the other measures we've proposed, will minimize the risk that the largest financial institutions will face failure. Moreover, in the event that they do fail, we believe that these actions will minimize the risk that any individual firm's failure will pose a danger to broad financial stability, which is why bankruptcy proceedings will remain the dominant option for handling the failure of non-bank financial institutions.
The last two years, however, have shown that the U.S. government simply does not have the tools to respond effectively when failure could threaten financial stability. That is why our plan permits the government, in very limited circumstances, to resolve the largest and most interconnected financial companies outside of the traditional bankruptcy regime and consistent with the approach long taken for bank failures.
This is the final step in addressing the problem of moral hazard. To make sure that we have the capacity – as we do now for banks and thrifts – to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system.
The purpose of the special resolution regime would be to unwind, dismantle, restructure, or liquidate the firm in an orderly way at the least cost to taxpayers and the financial system. All holders of tier 1 and tier 2 regulatory capital would be forced to absorb losses, and management responsible for the failure would be fired. If there are any losses to the government in connection with the resolution regime, these will be recouped by the financial industry in proportion to firms size.
Our proposals represent a comprehensive, coordinated answer to the moral hazard challenge posed by our largest, most interconnected financial institutions: strong, accountable supervision; the imposition of costs, both to deter excessive risk and to force firms to better protect themselves against failure; a strong, resilient, well-regulated financial system that can better absorb failure, and a flexible resolution regime to enable the government to unwind major financial firms in a financial crisis in an orderly manner that protects financial stability. The plan protects taxpayers and enables shareholders and creditors to take losses.
Together, these proposals give us a clear and credible argument that, as the President said two weeks ago in New York, "Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall."