Now that the House Financial Services Committee has wrapped up its debate over the proposed Consumer Financial Protection Agency, it will continue its important work on financial regulatory reform by turning its attention to policies to address systemic risk posed by the nation's largest financial institutions.
To prevent another calamitous government bailout of the financial industry, Congress must establish a regulatory framework that achieves two basic goals. First, it must subject all financial institutions, regardless of size, to meaningful market discipline. Second, it must enable large complex institutions to be resolved in an orderly manner and at no cost to taxpayers.
After last year's collapse of the capital markets, the Federal Reserve and the Treasury Department concluded that the only way to prevent a potential financial and economic meltdown was to inject a colossal amount of government funding directly into the nation's mega-institutions. Through regulator-assisted and/or encouraged mergers, they became even larger. The validation of "too big to fail" was an unfortunate side effect of their actions. It was not good for markets, since it has exacerbated moral hazard, and it was not good for smaller institutions, since they are put at a competitive disadvantage.
We place a tremendous responsibility upon the executive management and directors of financial services firms to operate their institutions wisely and in a way that serves the public interest. We place tremendous responsibility on their regulators to properly oversee them. However, some institutions have grown so large that they may not just be "too big to fail," but perhaps also too big for their executive officers to properly manage their risks; too big for their directors to understand and properly oversee their risks; too big for their regulators to comprehensively supervise their risks; and too politically influential to be good for the financial system as a whole.
If we fail to learn from this experience and to enact real reforms, we will have done nothing to restore a good balance and protect the system from a future collapse.
A viable system of financial supervision cannot reward financial firms that operate in an unsafe and unsound manner and become insolvent. Such institutions must be allowed to fail, regardless of their size or complexity.
Under the president's proposal, a resolution regime would be created with the ability to establish conservatorship or receivership of a failing firm. Although the proposal contains many useful elements, it also contemplates giving the Treasury almost unlimited authority to stabilize a failing institution by providing loans to it, purchasing assets from it, guaranteeing its liabilities or making equity investments in it. In short, the proposal leaves open the possibility that a firm could be propped up to continue doing business as usual.
If we hope to avoid future calamities that leave taxpayers on the hook for billions of dollars, Congress must not allow this. The resolution process must be orderly, but it also must involve losses to shareholders and long-term creditors and the removal of directors and management.
Another component of the administration's proposal is the creation of a Financial Services Oversight Council. The council's mission would be to facilitate information sharing and coordination among regulatory bodies, identify emerging risks, advise on the identification of systemic institutions and provide a forum for resolving jurisdictional disputes.
These are valuable functions. However, given the council's broad mission, the omission of state financial regulators will seriously curtail the council's view of the financial system and emerging risks. States supervise 73% of the insured depository institutions in the nation, including three of the top 10. States also oversee financial service providers not affiliated with a depository institution, such as insurance companies, securities firms, mortgage providers, money-services businesses and consumer finance companies. Because of our proximity to and knowledge of the entities we regulate, local economic conditions and consumers in our states, my fellow state regulators and I are often the first to identify emerging trends, practices or products that threaten the financial system. That was certainly true leading up to the mortgage crisis. The involvement of state regulators is vital for the council to fulfill its mission.
I support the Treasury Department's Sept. 3 announcement of core principles for regulatory capital standards. Higher capital standards, especially for systemically significant firms, will enhance the stability of the financial system. I also support many of the ideas for improving the regulation and supervision of large financial institutions laid out recently by Federal Reserve and FDIC officials. There is much work that needs to be done, both domestically and in coordination with supervisors in other countries, to raise safety and soundness standards and to facilitate the unwinding of large, internationally active firms. Much of this can be done without legislation. Yet it is up to Congress to learn from the mistakes of the past and establish the foundation. We cannot allow "too big to fail" banks to run roughshod over the principles that made the American financial system successful.