UPDATE: “Perspectives on Systemic Risk” Hearing Wraps Up - Collective Summary Notes of Hearing

March 5, 2009

The House Financial Services Committee, Subcommittee on Capital Markets, just wrapped up at 2 p.m. its hearing entitled “Perspectives on Systemic Risk.” The following provides: (1) an executive summary; (2) summary of issues raised in opening statements; (3) summary of issues raised in Q+A; and (4) the witness list.

I. Executive Summary

Key issues raised at the hearing included the problem of defining “systemic risk,” the potential role of Federal Reserve as potential systemic risk regulator, regulation of insurance industry (including whether federal charter is appropriate), credit default swaps, mark to market accounting, AIG bailout and whether to divest insurance arm from other more risky arms, hedge fund taxation, government picking winners and losers, global convergence, among numerous other issues further discussed below.

Notably, today’s hearing comes as Congress works to draft legislation for a systemic risk regulator, a role the Federal Reserve may be delegated, in the coming weeks ahead of the G20 conference on April 2, 2009. Subcommittee Chairman Kanjorski asked at the conclusion of the hearing whether Congress should rush to create a systemic risk regulator in such a short time frame before the April 2, 2009 G20 meeting. Witnesses including Mr. Bartlett, SIFMA and Ms. Williams, GAO, agreed that there is urgency to creating a systemic risk regulator but also noted the need for the working in creating such a regulator to be undertaken consistently and methodically.

II. Recap of Issues Raised in Opening Statements

Issues raised in the opening statements included: (1) defining systemic risk (2) role of the Federal Reserve; (3) insurance industry; (4) regulatory gaps, too big to fail, and GSEs; (5) government picking winners and losers; and (6) credit rating agencies.

(1) Defining Systemic Risk. Chairman Kanjorski (D-PA) spoke about need to define what systemic risk is, how to go about regulating, and impact on insurance, securities, and capital markets. Similarly, Rep. Sherman (D- CA) said that everyone knows that we need a systemic risk regulator, but no one knows what systemic risk is; he raised concern about taxpayer money being transferred to foreign entities and to Wall Street. Further, Rep. Castle (R-DE) said he cannot define “systemic risk either,” and does not know whether this should be given to Fed or other entity; the bottom line is that someone needs to look at the new innovations in the economy.

(2) Role of Federal Reserve. Rep. Garrett (R-NJ) expressed concern over the Federal Reserve’s ability to take on added responsibility of systemic risk regulator in addition to monetary policy and other existing roles.

(3) Insurance Industry. Rep. Royce – (R-CA) spoke about need for world class regulatory alternative to the fragmented 50 state system overseeing the insurance market. Further, Chairman Kanjorski (D-PA) referenced the need to examine regulation of insurance in addition to regulation of securities and the capital markets.

(4) Regulatory Gaps, Too Big to Fail, GSEs. Rep. Royce – (R-CA) The fact that institutions have become too big to fail; noted role of GSEs in building up bubble in housing sector; raised concern in regulatory gaps.

(5) Government Picking Winners and Losers. Rep. Price (R-GA) - the idea of a systemic risk regulator raises concerns – if an institution is noted as systemically significant classification – it gives that company an unfair advantage that government will not let it fail. In effect government will be picking winners and losers, and a whole new set of Fannie and Freddies.

(6) Credit Rating Agencies. Rep. Ackerman (D-NY) spoke about the problems raised by credit rating agencies in the financial crisis.

III. Recap of Issues Raised in Q+A

Issues raised in Q+A included: (1) defining systemic risk; (2) auto industry; (3) mark to market accounting; (4) credit derivatives/GAO report; (5) federal regulator for insurance companies; (6) role of Federal Reserve and creating “super regulator”; (7) unregulated entities; (8) too big to fail; (9) AIG bailout and foreign entities benefiting from bailout money; (10) credit default swaps; (11) AIG: Whether to Separate Insurance Arm from Credit Default Arm. (12) GAO report on credit default swaps; (13) hedge fund tax policy; (14) insurance and federal charter; (15) systemic risk regulator; (16) credit default swaps. (17) global harmonization; and (18) private equity funds.

(1) Defining Systemic Risk. Chairman Kanjorski (D-PA) said he is disturbed trying to get his arms around the idea of what is “systemic risk.”

(2) Auto Industry. Chairman Kanjorski (D-PA) said he met with auto dealers that met with him to say they pose systemic risk – and he asked whether this is what we are talking about in defining “systemic risk.”

(3) Mark to Market Accounting - Rep. Ackerman (D-NY) asked where there is no market, how do you expect companies to use mark to market accounting? Mr. Bartlett, Financial Services Roundtable, [or was it Baker] responded that efficient market function only comes with accurate disclosure of values; there will be a very difficult decision to be made in coming context of government-owned assets. Dr. Vaughan, National Association of Insurance Commissioners, raised the problem of confidence in the market, and noted that to force companies that are planning on holding on assets to write down these assets is sending the wrong signal to the market place and to consumers about the capital that is in these companies and how strong these companies are. Rep. Ackerman (D-NY) noted possibility of reinstating the uptick rule.

(4) Credit Derivatives / GAO Report. Ranking Member Bachus (R-AL) noted that he had requested a GAO study on credit derivatives, and that this report was filed today.

(5) Federal Regulator for Insurance. Ranking Member Bachus (R-AL) said he saw no evidence that insurance markets had failed and questioned need for federal regulator as others had claimed; he noted that insurance market is among strongest in financial system now. He distinguished AIG from other insurers, noting that AIG had an alternative investment vehicle that operated in London with 300 people which had no insurance regulator because it was not an insurance business. Rep. Bachus said that he could find thousands of instances of failure of bank regulators, but found few with insurance. He said that state insurance regulators have done a better job than almost everyone else. Dr. Vaughan, National Association of Insurance Commissioners, noted that the regulators will make mistakes and that when you build a regulatory system you need to ensure that there are multiple sets of eyes on the problem; and that the state regulation of insurance companies should not be taken away or preempted.

(6) Role of Federal Reserve and Creating “Super-Regulator” - Ranking Member Bachus (R-AL) questioned whether Federal Reserve should be systemic risk regulator. Mr. Baker, MFA, emphasized need for a systemic risk regulator but side-stepped responding whether the Federal Reserve should be the entity to take on this role. Rep. Castle (R-DE) further raised concerns about the Federal Reserve taking on role of systemic risk regulator, and asked if witnesses shared his concern. Mr. DiMuccio, Amica Mutual Group, raised strong support for the Federal Reserve being put in the position of systemic risk regulator.

(7) Unregulated Entities. Ranking Member Bachus (R-AL) noted that it was the unregulated entities that failed, rather than those companies that were regulate. Mr. Ryan, SIFMA, spoke about the “shadow banking system” and that we need someone to look forward over the horizon to look at unregulated entities.

(8) Too Big to Fail. Rep. Sherman (D-CA) said why not have instead of “too big to fail,” why not prohibit “too big to fail” – e.g. that any financial institution over a quarter million in size and split them off. Ranking Member Bachus (R-AL) also raised rhetorical question of alternatives to taxpayers bailing out companies that are too big to fail, including: orderly liquidation; or not allowing companies to become a systemic risk.

(9) AIG Bailout and Foreign Entities Benefiting from Bailout Money. Rep. Sherman (D-CA) asked what portion of counterparties to AIG would be foreign entities; should taxpayers assume that a substantial portion of the taxpayer money is going to foreign counterparties? Dr. Vaughan, National Association of Insurance Commissioners, said she did not have an answer to that question.

(10) Credit Default Swaps. Rep. Sherman (D-CA) noted that while credit default swaps are not technically insurance, they serve the role of insurance; if they are regulated as insurance, which state would regulate them and would this create a race to the bottom? He said that he was not sure that state insurance regulators could handle regulation of insurance of financial products. Dr. Vaughan, National Association of Insurance Commissioners, said she shared concern that there are some differences between credit default swaps and other types of insurance; she noted that credit default swaps are so pervasive and said that this would be a challenge for state regulators to oversee credit default swaps.

(11) AIG: Whether to Separate Insurance Arm from Credit Default Arm. Rep. Castle (R-DE) raised concern about demise of AIG, and asked whether there should be a separation of insurance industry from financial arms. Dr. Vaughan, National Association of Insurance Commissioners, responded that AIG was not an insurance company, but rather a large global financial institution; she noted that insurance arms were solvent; and she said a lot of the problem was unregulated activities. Rep. Castle (R-DE) said this seemed to be an argument in favor of a systemic risk regulator. Further, Rep. Bean asked whether the insurance subsidiaries of AIG were solvent, and whether the $30 billion in aid was necessary for the insurance companies. Dr. Vaughan, National Association of Insurance Commissioners, responded that the insurance companies were solvent. Rep. Maloney (D-NY) noted that the insurance arm of AIG is solvent, but cautioned that insurance be tied to such other risky arms, and suggested possibility of separating the risky arm of AIG from the insurance arm.

(12) GAO Report on Credit Default Swaps. Rep. Scott (D-GA) asked the GAO witness about the report on credit default swaps, and how to best regulate credit default swaps. Ms. Williams, GAO, said that she would start by how “credit default swap” is defined; she noted the dynamic of holding company regulators and holding companies; how if the holding company regulator is not going in to the subsidiaries it is difficult to identify problems with the subsidiaries.

(13) Hedge Fund Tax Policy. Rep. Scott (D-GA) asked why the hedge fund managers should be taxed not at capital gains rate. Mr. Baker, MFA, said that at previous hearing that hedge fund managers had hoped that outcome of any tax proposal would not be prejudicial to the hedge fund industry, although managers expected a change in capital gains treatment. Rep. Scott (D-GA) noted that there is confusion about who is a “hedge fund operator.” Mr. Baker, MFA, said that there is a bit of lack of clarity of what constitutes a hedge fund in the marketplace.

(14) Insurance and Federal Charter – Rep. Royce (R-CA) asked what we might learn from foreign counterparts in regulation of insurance? He noted that European foreign entities are frustrated with the 50 state regulations. Mr. Bartlett, the Financial Services Roundtable, noted that the 50 state insurance industries without a federal charter is a high trade barrier; he said if you keep the current system you can have another AIG type problem. Further, a question was asked whether insurance of financial products with no nexus in any state should have some federal regulator – should that regulator be separate or part of a larger systemic regulator. Mr. Bartlett responded that the systemic regulator, the Fed for example, should take a look at these products and then work with prudential regulator; Mr. Bartlett said that for a large company to have an optional federal charter for a national insurance regulator (as opposed to systemic risk regulator); Mr. DiMuccio, Amica Mutual Group, and Dr. Vaughan, National Association of Insurance Commissioners, together cautioned against disturbing an insurance system that is working adequately; Dr. Vaughan further said she would like a system where she works with insurance.

(15) Systemic Risk Regulator. Rep. Perlmutter (D-CO) asked whether we should be taking some degree of separation between regulation of insurance, banking, and the stock markets in forming systemic risk regulator. Bartlett, the Financial Services Roundtable, said his proposal is to have the Federal Reserve collect information on the total financial services industry, and noted that financial services is interrelated; that separating regulation of insurance, banking and stock market regulation would be harmful. He emphasized the need for a systemic risk regulator working through a prudential supervisor plus creation of a national insurance regulator. By contrast, Dr. Vaughan, National Association of Insurance Commissioners, said that Congress should keep what is working now. Rep. Maloney (D-NY) raised issue of whether the financial crisis, unlike the 9/11 crisis, could have been avoided in the first place if there were a systemic risk regulator.

(16) Credit Default Swaps. Rep. Kilroy (D-OH) asked who appropriate regulator would be for credit default swaps. Mr. Baker said regulation of credit default swaps could come under regulation of systemic risk regulator, or the prudential risk regulator of the counterparty. Rep. Biggert (R-IL) asked how to analyze credit default swaps. Mr. Baker, MFA, noted going to the capital adequacy of company holding the obligation using a reasonable man standard. However, Mr. Baker also noted the benefits of credit default swaps, but also noted that any instrument inappropriately used can lead to a financial dislocation. He said that the systemic risk office should look at areas where people are over-concentrating.

(17) Global Harmonization. Rep. Foster (D-IL) raised the issue of global harmonization in the context of prior G30 reports and initiatives to develop further global harmonization. Mr. Ryan, SIFMA, noted work with the London arm of SIFMA being done on global harmonization, and said that Congress needs to get this right because markets are totally globally interconnected. Mr. Ryan said that SIFMA is firmly behind a regulator that has power and information of a systemic risk regulator.

(18) Private Equity Funds. A question was raised regarding Mr. Ryan’s inclusion of private equity in context of systemic risk regulation. Mr. Ryan, SIFMA, responded that he included discussion of private equity in broader discussion, and that his testimony was intended to urge Congress to look broadly at who should be included, but seemed to indicate that he had not intended to single out private equity.

IV. Witness List

Ms. Orice Williams, Director, Financial Markets and Community Investment, Government Accountability Office
The Honorable Richard H. Baker, President and Chief Executive Officer, Managed Funds Association
The Honorable Steve Bartlett, President and Chief Executive Officer, The Financial Services Roundtable
Dr. Therese Vaughan, Chief Executive Officer, National Association of Insurance Commissioners
Mr. Robert A. DiMuccio, President and Chief Executive Officer, Amica Mutual Group
Mr. T. Timothy Ryan, Jr., President and Chief Executive Officer, Securities Industry and Financial Markets Association

Written by Kirsten Wegner