1 UNITED STATES OF AMERICA 2 FINANCIAL CRISIS INQUIRY COMMISSION 3 Official Transcript 4 5 Hearing on 6 "Too Big to Fail: Expectations and Impact of Extraordinary 7 Government Intervention and The Role of Systemic Risk in the 8 Financial Crisis." 9 Thursday, September 2, 2010, 9:00a.m. 10 Dirksen Senate Office Building, Room 538 11 Washington, D.C. 12 COMMISSIONERS 13 PHIL ANGELIDES, Chairman 14 HON. BILL THOMAS, Vice Chairman 15 BROOKSLEY BORN, Commissioner 16 BYRON S. GEORGIOU, Commissioner 17 SENATOR ROBERT GRAHAM, Commissioner 18 KEITH HENNESSEY, Commissioner 19 DOUGLAS HOLTZ-EAKIN, Commissioner 20 HEATHER MURREN, COMMISSIONER 21 JOHN W. THOMPSON, COMMISSIONER 22 PETER J. WALLISON, Commissioner 1 Reported by: JANE W. BEACH, Hearing Reporter 2 PAGES 1 - 195 1 SESSION I: THE FEDERAL RESERVE: 2 BEN S. BERNANKE, Chairman 3 Board of Governors of the Federal Reserve System 4 5 SESSION II: FEDERAL DEPOSIT INSURANCE CORPORATION: 6 SHEILA C. BAIR, Chairman 7 U.S. Federal Deposit Insurance Corporation 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 2 1 P R O C E E D I N G S 2 (9:00 a.m.) 3 CHAIRMAN ANGELIDES: Good morning. Welcome to 4 the public hearing of the Financial Crisis Inquiry 5 Commission. This is our second day examining the issue of 6 financial institutions that have become too big, too 7 important, too systemic to fail. 8 Yesterday we looked at two case studies, Wachovia 9 Corporation and Lehman Brothers, and this morning we will be 10 hearing from the Chairman of the Federal Reserve, Mr. Ben 11 Bernanke, as well as the Chair of the FDIC, Ms. Sheila Bair. 12 Welcome, Mr. Chairman. Thank you for joining us 13 here today. I might note that this is the second time you 14 have come before this Commission, first in our offices for a 15 private session when we were first convened as we began our 16 work, I believe almost a year ago. And today, in what will 17 be our final hearing in Washington, D.C., although after 18 today we will head across the country to a number of 19 communities in California, in Nevada, and in Florida, to 20 hold hearings in communities that are still gripped by high 21 unemployment, high foreclosure rates, and we're going to be 22 going to those communities to see how the seeds of this 23 crisis were sown on the ground and what the consequences are 24 today. 25 Mr. Chairman, as we have done with all witnesses, 3 1 we will now ask you to do, I would now like to ask you to 2 stand so I can swear you as a witness. And if you would 3 stand and raise your right hand: 4 Do you solemnly swear or affirm under penalty of 5 perjury that the testimony you are about to provide the 6 Commission will be the truth, the whole truth, and nothing 7 but the truth, to the best of your knowledge? 8 CHAIRMAN BERNANKE: I do. 9 (Chairman Bernanke sworn.) 10 CHAIRMAN ANGELIDES: Thank you very much, Mr. 11 Chairman. 12 Thank you very much for your extensive written 13 testimony. And this morning we would like to ask you to 14 speak to us orally and take up to ten minutes this morning 15 to give your opening remarks, at which point, upon 16 conclusion of your opening remarks, we will move to 17 questions from Commissioners. 18 So, Mr. Chairman, the floor is yours. 19 WITNESS BERNANKE: Thank you, Mr. Chairman. I 20 won't take a full ten minutes, and I would like to say that 21 we will be submitting additional answers to your questions 22 very shortly. 23 Chairman Angelides, Vice Chairman Thomas, and 24 other members of the Commission: 25 Your charge to examine the causes of the recent 4 1 financial and economic crisis are indeed important. Only by 2 understanding the factors that led to and amplified the 3 crisis can we hope to guard against a repetition. 4 So-called too big to fail financial institutions 5 were both a source--though by no means the only source--of 6 the crisis, and among the primary impediments to 7 policymakers' efforts to contain it. 8 In my view, the too big to fail issue can only be 9 understood in the broader context of the financial crisis 10 itself. In my full written testimony I provide an overview 11 of the factors underlying the crisis, as well as some of the 12 problems that complicated public officials' management of 13 the crisis. 14 In understanding the causes of the crisis, it is 15 essential to distinguish between triggers: the particular 16 events or factors that touched off the crisis, and 17 vulnerabilities: the structural weaknesses in the financial 18 system and in regulation and supervision that propagated and 19 greatly amplified the initial shocks. 20 Although a number of developments helped to 21 trigger the crisis, the most prominent was the prospect of 22 significant losses on subprime mortgage loans that became 23 apparently shortly after house prices began to decline. 24 While potential subprime losses were large in 25 absolute terms, judged in relation to global financial 5 1 markets they were not large enough to account for the 2 magnitude of the crisis on their own. Instead, the system's 3 preexisting vulnerabilities, together with gaps in the 4 government's crisis response toolkit, are the primary 5 explanation of why the crisis has such devastating effects 6 on the global financial system and the broader economy. 7 Let me give an illustration of how 8 vulnerabilities in the financial system greatly increased 9 the effects of the triggers of the crisis. 10 In the years before the crisis, a system of so- 11 called "shadow banks," financial entities other than 12 regulated depository institutions, had come to play a major 13 role in global finance. 14 As it grew, the shadow banking system, including 15 certain types of special-purpose vehicles such as those 16 financed by asset-backed commercial paper, and some 17 investment banks had become dependent on short-term 18 wholesale funding. 19 Such reliance on short-term uninsured funds made 20 shadow banks subject to runs, much like commercial banks had 21 been prior to the creation of Deposit Insurance. 22 When problems in the subprime mortgage market and 23 other credit markets became known, the providers of short- 24 term funding ran from the shadow banks, disrupting short- 25 term money markets. Thus, the vulnerability--in this 6 1 case, the excessive dependence of many financial 2 institutions on unstable short-term funding--greatly 3 amplified the effects of the trigger, in this case the 4 prospective losses of subprime mortgages. 5 Among the consequences of this instability were 6 sharp declines in high volatility in asset prices, 7 widespread hoarding of liquidity by financial institutions, 8 and associated reductions in the availability of credit to 9 support economic activity. 10 Many of the key vulnerabilities of the financial 11 system were the product of private sector arrangements, 12 including, as just noted, over dependence of many financial 13 institutions on an unstable short-term funding, poor risk 14 management, excessive leverage of some households and firms, 15 misuse of certain types of derivative instruments, 16 mismanagement of the mortgage securitization process, and 17 other problems. 18 But important vulnerabilities also existed in the 19 public sector, both in the United States and in other 20 countries. These vulnerabilities included both gaps in the 21 statutory framework, and flaws in the performance of 22 regulators and supervisors. 23 Important examples of statutory gaps were the 24 absence of effective authority to regulate and supervise 25 some important types of shadow banks such as special-purpose 7 1 vehicles, and broker-dealer holding companies, the lack of 2 authority or responsibility to take actions to limit 3 systemic risks, and the absence of a legal framework under 4 which failing systemically critical nonbank financial firms 5 could be resolved in an orderly way. 6 Where appropriate authorities existed, financial 7 regulators and supervisors--both in the United States and 8 abroad--did not always use them effectively. For example, 9 bank supervisors in many cases did not do enough to force 10 financial institutions to strengthen their internal risk 11 management systems and to curtail risky practices; and bank 12 capital and liquidity standards were insufficiently 13 stringent. 14 The recent financial reform legislation addresses 15 many of the statutory gaps I have mentioned, and the Federal 16 Reserve and other agencies are taking strong steps to 17 tighten the regulation of financial institutions, to give 18 regulation and supervision a more systemic and multi- 19 disciplinary orientation, and to make supervision more 20 effective. 21 Many of the vulnerabilities underlying the crisis 22 were linked to the existence of so-called too-big-to-fail 23 firms, those whose size, complexity, interconnectedness, and 24 critical functions were such that their unexpected failure 25 was likely to severely damage the financial system and the 8 1 economy. 2 Because of the grave risks presented should a 3 too-big-to-fail firm file for bankruptcy protection, in the 4 short run governments have strong incentives to prevent such 5 events from occurring; hence, too big to fail. 6 However, in the longer term, the existence of 7 too-big-to-fail firms create severe moral hazard problems 8 which can lead to the buildup of risk and future financial 9 instability, while complicating the resolution of financial 10 crises.