This morning witnesses from federal bank regulatory agencies and from academia will take questions from the Senate Banking Committee on ways to regulate "too big to fail" institutions. Committee members have recently expressed wariness over the Federal Reserve's ability to handle a job as a systemic risk monitor, and today's hearing should further illuminate the committee's intentions to address the regulation of systemically important firms.

Witnesses will appear in two panels. The first will include Federal Deposit Insurance Corp. Chariman Sheila Bair and Federal Reserve Bank of Minneapolis President Gary Stern. The second panel will include The American Enterprise Institute´s Peter Wallison; The Brookings Institution´s Martin Baily; and University of Chicago Finance Professor Raghuram G. Rajan.

Right now the witnesses are giving their opening statements. BankThink will start its live feed when the questions begin.

9:22am: Sen. Chris Dodd, D-Conn., is starting off with the idea of a resolution authority for systemically important firms. He's asking Stern if the FDIC can handle the job.

Stern: "I've given more thought rather than to who, to how. It's important that the resolution regime be established in a way that losses can be put onto uninsured creditors without damaging spillovers."

9:24am: Bair is saying Congress needs to set out a claims priority that stipulates which creditors take losses and when. "The direction should be to resolve the institution quickly, not keep it going." She mentions Glenn Hubbard's WSJ op-ed today.

9:26am: Dodd is now asking Bair about the structure for a systemic risk regulator: How about a council idea rather than a single institution?

Bair: "We make a distinction between prudential oversight of systemic institutions and the broader need" to be looking at the system. "For the latter need a council is more equipped...The President's Working Group could be transitioned into something like that." Something that could write rules about capital reserves.

Stern: A systemic risk regulator would have to have a clear mandate and would have to understand "the interconnections" between large firms and various markets. Who would do that, "I don't have a firm conviction about who would do that."

9:30am: Sen. Michael Johanns, R-Neb., is addressing the witnesses now. "I never thought I'd live long enough to see the day that somebody walked into the White House, a CEO of a private company, and left without their job."

He's asking Bair who can do the systemic resolution duties.

She says the FDIC, the SEC, and consolidated banking regulators.

"The FDIC seems to work very well," Johanns replies.

9:33am: Resolving a bank is "a painful process," Bair is saying. "All the talent that's out there now to deal with resolving troubled institutions, we have that."

9:34am: Now Johanns is asking whether just having the systemically important resolution authority is enough.

Stern says "we need to reduce the size of bailouts going forward." And in "tranquil times" there has to be a greater effort to organize creditors.

"We have to try to put ourselves in a position so that even if you do have to bail somebody out...you want to make sure that the next steps you take reduce the probability that you have to do it again."

9:36am: Sen. Michael Bennet, D-Colo., is point out that the problem with systemically important institutions isn't simply one of size; the biggest firms are also very complicated and interconnected. Will a regulatory regime ever be strong enough to keep up? And how would it keep up without stifling innovation?

Stern: "I am not trying to curtail appropriate innovation," but risk pricing will improve and that will take care of some of the problems by itself. "When we see a very complex structure of an organization, ask about the economic rational for that structure...we could ask for streamlining of that kind of structure."

Stern: "Too big to fail is a big, challening problem. We need to improve incentives where we can, we should also improve capital where we can...We really need to address this on a number of fronts."

9:38am: Bennet is asking Bair how to "stay ahead of the curve."

Bair: "Greater market discipline." Investors have to look at companies' balance sheets more carefully.

Risk-based insurance premiums are the first step, she adds.

9:40am: Now Bennet is asking Bair about New Fronteir Bank in Greeley, Colo. It recently failed.

Bair: We're trying to find banks to purchase the bank's loans and to find other banks in the area for the Greeley residents to use.

9:42am: Sen. Jim Bunning, R-Ky., is ridiculing ratings agencies. Now he's asking if some products or interconnections should be "limited or banned."

Stern: "If we identified some interconnections or exposures that" looked threatening, "then it's an opportunity...to push to reduce those exposures and or to figure out how you're going to deal with the spillover effects should problems arise."

9:45am: Bunning wants to know what should be changed in the bankruptcy laws.

Bair: How derivatives contracts are treated, for one. That should change. Also the ability to create a bridge bank.

Bunning: But the Fed has said that we shouldn't involve ourselves in overseeing derivatives.

Bair: "You've never heard me say that." We need greater oversight of those markets and we should revise the Commodity Futures Modernization Act. We should also prevent derivatives counterparties from grabbing back their collateral.

Bunning: When should we end the TLGP, if ever?

Bair: "We very much want to end it Oct. 31 and all institutions should operate as if that will happen."

9:47am: Stern is adding, on derivatives: Central clearing platforms are "a very important step...I am cautiously optimistic" that that step will help.

Bunning is giving him a hard time about the Fed's previous dismissal of moves to regulate derivatives.

Stern: "All I can say is, it's been a difficult lesson."

"And an expensive one!" Bunning interjects.

9:49am: Sen. Mark Warner, D-Va., is asking about the stress tests.

Bair: "All these institutions exceed regulatory standards for being well-capitalized." The stress tests were more rigorous than the current standards. We did them to anticipate a worse situation.

9:50am: Bair thinks the stress test results "will be a confidence-inducting announcement."

Bair: This is an inter-agency process and it's a holding company process. There are judgement calls...some people will say we were too tough; others will say not enough...hopefully in the middle.

Stern: Declines to comment.

Warner: "What guidance advice would you have" to give us on the subject of a systemic risk regulatory council? How could we prevent it from becoming simply "a debating society?" How would we give it force?

Bair: "Accountability will be key. The statute needs to put accountability for systemic risk with this authority...and it needs to be given the authority to write rules."

Not for the first time, Bair is looking good. She's fielding questions with more openness than Stern is, and she seems less wary. Reassuring to the committee members.

9:54am: Stern is saying that "for systemic supervision to be effective, this group would have to have the ability, under the right circumstances, to intervene if they felt the consolidated supervisor wasn't doing an adequate job."

Bair agrees.

9:55am: Dodd: That's a very important point. It's like the corporate model. Does the council just advise, or can they intervene? We haven't settled that.

9:56am: Sen. Bob Corker, R-Tenn., is calling Bair's testimony, which he likes, "a stunning rejection of the policies put in place by our Treasury Secretary." He's saying Bair has embraced the free market while Secretary Timothy Geithner is asking for the authority to "spend taxpayer money" on too-big-to-fail institutions.

Bair is chuckling.

Corker: "Timing:" We're not rushing, but the systemic resolution authority is important. Can it be done separately? And how quickly should it be done?

Bair: The authority to resolve bank holding companies and thrift holding companies "would be a huge contribution to the tools that we have" and it could be broken off from other regulatory restructuring efforts.

Bair's chuckling again now as Corker asks her to advise the committee.

9:59am: If we let banks repay their Tarp money, should we force them to stop using the TLGP at the same time?

Bair: Well, the TLGP has been a money-maker for us and is helping us replentish the deposit insurance fund. We'd still like to have it end on Oct. 31.

If we can't exit it on Oct. 31, we're at least going to raise fees and possibly lower the percentage of the guarantee.

Corker: So if we end the program on Oct. 31, would we need to put that resolution authority in place before that date? Because I don't think some of the institutions out there can survive without the TLGP.

Bair: "It would be helpful." But of course we hope we'd never have to use it. Just the threat of it might help make some smaller institutions shape up, though.

10:02am: Corker ends his questioning with a fond shout-out to Bair and to their "phone conversations." Sweet. He adds that he wants to know what it's like when she talks on the phone with Geithner, who is, in Corker's view, the anti-free market nemesis of the glorious Bair.

10:03am: Sen. Robert Menendez, D-N.J. is also sweet-talking Bair, and points out that she's not supporting free market policies with total abandon, is she?

Bair admits she's not.

Menendez: You pointed out that economies of scale are exhausted well below the size a firm can reach at which it poses systemic risk. How can we prevent firms from getting too big to fail?

Bair: Risk-based premium assessments work. You could build up a fund so that if a large, complex organization got into trouble you would put it into resolution and use the insurance fund money to absorb the losses.

Bair: Banning products doesn't really work. We need economic disincentives for excessive risk-taking.

10:06am: Menendez: How about counter-cylclical capital requirements?

Bair: Yes.

10:07am: What about prompt corrective action limits and off balance sheet assets and conduits?

Bair: The off-balance sheet exposures for which banks didn't have to maintain capital reserves came back onto the balance sheets really quickly, and that was bad.

Menendez: How quickly will the FDIC be able to stabilize or lower the fees it's charging smaller institutions once we sign the bill the Senate discussed yesterday?

Bair: Really quickly

10:09am: Sen. Richard Shelby, R-Ala. is here now. He's asking Bair to define too big to fail.

Bair: A firm whose failure would hurt other firms.

Stern: "I think of it in terms of an institution" that would impose spillover effects on other firms if it failed.

Shelby: "Could a hands-on regulator prevent this?"

Stern: "It would take a re-orientation of traditional regulation." You'd broaden your perspective from the old safety and soundness concerns. "But even if you did that I would be concerned that that by itself wouldn't be sufficient." You'd also have to diminish the potential for spillovers.

10:11am: Shelby: Mr. Stern, you need a system that give capital-raising tools to firms when they need it the most--how would we do that?

Stern: "Contingent capital:" A debt instrument which would have as the firm's capital diminished the mechanism to convert to equity.

Shelby asks Stern: In your tenure at the Fed, have you ever seen a well-regulated, well-run bank fail?

Stern: Ha ha.

Stern: Smaller banks are more straightforward to regulate. Larger banks are more complex and confusing, and it's hard to take the correct action in time.

10:14am: Shelby: "Is there any substitute for capital, real capital?"

Bair: "We recognize the importance of capital and we need more capital." But market discipline is also important.

Dodd: I agree.

10:15am: Sen. Jack Reed, D-R.I., is asking Bair whether we should return to Basel I capital standards.

Bair: We could build on Basel I to make it "more nuanced, more granular."

Reed: Why not go back to Basel I rather than invent a totally new approach.

Bair: Yes, that would be faster.

Stern: Basel II needs a "very thorough review," but I think the too big to fail problem is challenging enough that capital won't solve it.

10:18am: Reed has asked Stern whether the Fed currently has the authority to get firms to change their risky behavior.

Stern: In good times, when it looks like things are going smoothly, it's hard to justify divestiture from risky positions.

10:19am: Reed: So, how do we deal with the interconnectedness in terms of lending to firms with lots of counterparty exposure?

Bair: We need to apply leverage constraints across the board.

Reed: And should the systemic regulatory council have an analytical staff to anticipate issues?

Bair: We do that internally at the FDIC, but it only extends to insured depository institutions.

10:21am: Dodd: I agree that that's important. And what about products in the system? They can be a source of systemic risk. We need an analytical staff to look at products.

10:22am: Sen. Jeff Merkley, D-Ore. is asking Stern about the shifting landscape of capital requirements.

Stern: We need to address market discipline as well as capital requirements, because "this is a difficult issue to address, its consequences are potentially very serious."

10:24am: Merkley: Mr. Stern, can the Fed really balance all of its commitments properly and be a systemic risk regulator?

Stern: I never said the Fed should be a systemic risk regulator. We're just the institution with the most experience and we're the ultimate liquidity source, so we should have some sort of role. But I don't know what it should be.

Merkley: Also, how do we convince uninsured creditors that they will be taking losses if the institution falters?

Stern: Shareholders have already lost a lot of money, first of all. The uninsured creditors do need to take some losses going forward (not during the crisis, though). The legislation on it should contain a systemic risk exception.

So Stern is saying that creditors should take losses except when doing so would pose systemic risk.

Bair: I agree.

10:28am: Dodd is announcing a break due to a schedule change on the floor of the Senate. Warner is going to take over chairing the committee temporarily.

10:29am: Now Sen. Robert Bennett, R-Utah, is asking about the "essential" clerical functions that big firms like Citigroup peform in the markets worldwide. "If Citi were allowed to fail as a bank, it would be unable to perfom these services that it performs for the system as a whole." How does that impact our judgment about what to do with Citi?

10:31am: Bennett also asks how to reconcile the fact that Citi is making lots of money on some things while the government is pumping cash into its failing businesses.

Bair: "I never comment on open operating institutions."

Bair: Bridge banks would help this kind of thing seem less absurd. The profitable businesses would continue while the failing business would be retained in receivership. "This is why bankruptcy doesn't work, because you don't have that bridge bank process."

Stern: That has been a difficult issue to address. [Tells the story of an incident, 15 years ago, in which a computer glitch resulted in a multi-billion dollar loan from the New York Fed.]

10:34am: To laughter from the witnesses, Bennett asks something about taxes. The witnesses decline to address it.

Stern: But in terms of accounting, overstating potential problems is better than understating them.

Bair: Brings up the failure of Silverton bank and its correspondent accounts with other banks. The bridge bank was essential, she said, in that situation. She didn't want to talk about accounting or taxes.

10:37am: Warner has the floor again. He's asking Stern whether the Fed would be reluctant to turn over bank holding company resolution authority to the FDIC if there were early warning signs about the health of a company. He also wants to know whether, if the legislative action were separated from other regulatory restructuring initiatives, it would be worth the rush.

Stern: It might reduce the urgency of taking other steps that would be necessary as well, and I would be concerned that we might think that the resolution authority would have addressed the problem. So I think it would be better to focus on comprehensive regulatory restructuring.

Bair: But getting the bank and thrift holding company resolution would be a nice start.

10:40am: Warner is dismissing Bair and Stern as witnesses. The second panel is assembling. Follow BankThink to a new post for the second panel.