WASHINGTON -- Federal banking and securities regulators told the House Banking Committee yesterday that they do not need additional legislative authority to regulate the derivatives markets, but members of the panel remained skeptical.
Rep. Jim Leach, R-Iowa, said that none of the federal banking and securities regulatory agencies has authority over insurance companies such as American International Group Inc., whose derivatives products subsidiary is one of the largest players in the municipal and taxable swap markets.
AIG's top officials recently staged a covert investigation of their derivatives group after becoming worried that Howard Sosin, the ex-Drexel Burnham Lambert official they had hired to head the operation, was taking huge risks. Sosin and AIG have since parted ways.
Federal agency officials at the hearing conceded that insurance companies are regulated by state commissions.
"Congress might want to address this issue," Leach said.
Leach suggested that perhaps the entire approach to regulating derivatives should be reoriented toward different derivatives activities, rather than the institutions that participate in the derivatives markets.
The responsibility for regulation of derivatives currently is divided among: the Securities and Exchange Commission, which regulates broker-dealers dealers; the Federal Reserve Board, which oversees bank holding companies and some state banks; the Office of the Comptroller of the Currency, which regulates national banks; the Federal Deposit Insurance Corp. which governs state banks that are not members of the Federal Reserve System; and the Commodity Futures Trading Corp., which regulates futures and options.
Both Leach and Rep. Joseph P. Kennedy, D-Mass., were skeptical whether federal capital requirements for banks and securities firms adequately cover the risks associated with derivatives.
"I'm not convinced anybody has a good handle on how much capital should be set aside for these risks,' Leach told the regulators.
"I'm not certain you really are on top of what those risks are," Kennedy said.
Susan Phillips, a Federal Reserve Board governor, told Kennedy that the current bank capital requirements assess some of the derivatives-related risks for banks.
But when Kennedy asked Phillips if she were willing to say the requirements are sufficient to prevent a derivatives-related crisis, she said, "I'm not sure one can ever be fully assured we have a fail-safe environment. Banking does entail some risk. I can't give you assurance that nothing is ever going to happen."
Rep. Marge Roukema, R-N.J., asked the federal officials if higher capital standards are needed for banks.
"That is certainly a very relevant concern, but it is being addressed and I don't think we need additional powers to do it," said Eugene A. Ludwig, Comptroller of the Currency.
The bank regulatory agencies have united to propose rules to modify their capital requirements to take into account the interest rate risk as well as credit risk of a bank's derivatives activities. The rules, which are currently subject to public comment, would take affect next year if issued in final form.
J. Carter Beese, an SEC commissioner, in written testimony said the SEC is considering whether its net capital rule needs to be modified to better cover the derivatives activities of broker-dealers and their affiliates.
The SEC's net capital rule is aimed at ensuring broker-dealers maintain enough liquid assets to satisfy their obligations to customers and other broker-dealers. But the rule was developed prior to the growth of the over-the-counter derivatives market, Beese said.
The SEC's capital requirement has led broker-dealers, in some cases, to engage in derivatives through unregistered entities here and abroad for through separately capitalized derivatives product companies, Beese said.
One approach the SEC could take to address this problem is to devise capital requirements that encourage firms to conduct derivatives activities through registered broker-dealers "without what they often regard as undue capital constraints," Beese said.
Another approach would be for the SEC to devise separate capital requirements for the separately capitalized derivatives product companies, he said.
The SEC could also simply maintain its net capital rule, Beese said.
Meanwhile, Rep. Richard Baker, R-La., worried that the Office of the Comptroller of the Currency went too far this week in issuing guidelines that require banks to ensure their derivative products are appropriate for their customers. Under the requirements, if a product is inappropriate, the bank must inform customer. If the customer insists on the investment, the bank is supposed to document its recommendation against it.
Baker said he feared the requirement would lead banks' customers to sue them for any losses from derivatives.
But Ludwig said the requirement is important to ensure that banks do not sell risky derivatives products to other, less sophisticated banks.
The comptroller's office's guidelines also require banks involved in derivatives to: set up independent units to assess the risks of their derivatives activities; ensure senior management understands and is able to control the risks associated with these products; continuously monitor appropriate capital levels; and submit to periodic reviews of systems and personnel by management and the comptroller's office.
Leach suggested that the bank regulatory agencies make clear that bank managers will be responsible for any derivatives-related "major hits" on their capital that require draws from federal insurance funds.