>> that is incremental in the sense the vice chairman stipulated could decide amongst the relatively small number of small institutions who is or not in the category. the supervision, the enforcement -- the regulation of the behavior of the institutions it seems to me naturally would be more appropriately placed in an agency for whom that is the primary priority. an agency such as the fdic. the third concern that i have is a question of the -- really the leadership of the federal reserve. historically, this is -- the chairmanship of the board of the governors of the federal reserve is an extremely high profile appointment. it's an individual who tends to be close to and to need the confidence of the financial markets and there is a real question as to whether there is any record in the history of the federal reserve of effective response to systemic risk in advance of crisis. this was not the case benjamin

strong in the 1920s. the leading figure at the time, although not the chairman of the board. it was not the case of the alan greenspan in the run-up of the test crisis. we had a doctrine which, in effect, denied that systemic risk that could bring down that system. it was articulated at the peak of the federal reserve and it seems to me we had a test of that proposition and it came up wanting. itoes seem to me that there are reasons to be worried about vesting the authority for systemic risk in the federal reserve. thank you very much. >> i thank you for your testimony and dr. burner, you're recognized for five minutes. >> thank you, mr. chairman, ranking member paul and other members of the committee. thanks for inviting me to this hearing to address this important question, the role of the federal reserve and systemic risk regulation. i think the broader question here is, how shall we address the significant weaknesses in our financial system and our financial regulatory structure that the current financial

crisis has exposed. among market participants and i talked to many of them -- i think there are two policy changes that are needed, that are well recognized. first, strength in our regulatory infrastructure. and second, adopt appropriate regulation oversight to mitigate those systemic system-wide risks across financial market instruments, markets, and institutions. in addition, i believe that macroeconomic policy should lean against asset and credit booms which create financial instability. in my view, the federal rerve is best equipped to take the lead on systemic risk regulation and oversight. like others, i think this function is an essential of the fed's monetary policy role and of its responsibities as lender of last resort. there are three factors that support that claim. first be the fed is the ultimate guardian of our financial markets and so it should be the agency that ensures the safety and soundness of the most important financial institutions operating in those markets. second, the process of

intermediation through traditional traditional lenders and the capital markets has become increasingly complex. supervision of the institutions involved will enhance the fed's ability to make the right monetary policy decisions. and finally, the fed's expertise in financial markets and institutions mes it the natural choice for this role. the fed's leadership in the supervisory capital assessment program demonstrated that expertise. in short, good monetary policy and financial stability in my view are complementary. asset booms and busts have destalled the market and systemic regulation and oversight and an policy tools required for each overlap substantially. that may explain why the other countries that separate such responsibilities from the traditional role of the central bank have fared no better than we did in this crisis. the u.k. is a good example.

while the bank of england and the financial services authority have collaborated in the recent crisis their separation of powers did not help manage the current crisis more successfully than u.s. regulators. however, naming the fed to this role won't solve all of our problems that i just enumerated. i outlined some related remedies. in my view our regulatory system has three major shortcomings wi supervised institutions rath than financial activities which allow some firms to take on risky activities within adequate oversight. a focus on systemic risk is one remedy for that problem. designating the fed to take will limit the financial activities and it will promote supervisory accountability. our regulatory safety net is excessively prone to moral hazard encouraging inappropriate risk taking concentration as you've all alluded to in this hearing in our financial

services industry has created institutions that are too big to fail. remedies needed should include more extensive oversight and supervisor of large, complex financial institutions. an i can policit regulatory charge to help us offset the moral hazard and a strong resolutionramework that is understood by all before a crisis hits. an ad hoc approach creates uncertainty and reduces the credibility of policy. the third problem with procyclicalality. our regular infrastructure encourages excessive leverage which magnifies excessive market volatility. three remedies needed here are first we need a stronger system of capital regulation. that should improve financial stability and help monetary policy lean against the wind of asset booms. we mus resolve the tension between accountants who want to limit reserves and regulators who want to build them in favor of the regulators. second, securities must be more transparent and homogenous and less reliant on credit ratings

and third to reduce settlement and payment system risk we need greater use of less counter-parties of derivatives. i want to answer your four questions. are there conflicts with the fed's traditional role here? yes, there can . in a crisis decisions about particular firms likely would involve the fed and inherently political considerations. and the use of taxpayer funds that could compromise its independence. we should insulate the fed's independence with two firewalls. first the resolution of troubled financial institutions shoul fall to the fdic. and second, and globally, we must change institutions now big to fail and being too strong to fail. remedies will include many of the options i just discussed. both firewalls should strengthen the firewall by reducing moral hazard especially by reducing the chance that we will keep nonviable institutions alive, a concern you've experienced. what are the policy pros and cons here?

in my view the pros outweigh the cons. interconnectedness means supervision must look horizonally across regions reason vertical silos. the fed has the most expertise and reach to provide that. the fed is best positioned to prescribe and enforce remedies to procyclicalality and build shock absorbers. the fed isn't perfect. as the guardian of our financial system the fed in the past have come ushort in a snub number of ways. i only say while we consider making the fed the lead systemic regulator the fed and we must examine how it can improve its functioning to take on these new duties. what about the arguments against? while ensuring financial stability may be too big a job for just one regulator even if the fed takes the lead, coordination with other regulators will be essential for success. coordination with regulators and central banks abroad may be more critical than in sync regulators

at home. our regulation is largely local. i like the president's recommendations for the financial services oversight council and international cooperation and coordination especially. last, what about rssigning other responsibilities. regulators should do what they do best. and, for example, as others have said, consumer protection and promotion of financial literacy could go to another agency. but i think theed may still play a useful role in supporting these areas. mr. chairman, let me add that these views are mine and not necessarily those of my employer, morgan staey or its staff. i want to thank you for your attention and i'm happy to answer your questions. >> thank you for your testimony. dr. taylor, you're recognized fofive minutes. >> thank you, mr. chairman. ranking member, paul, the other recommends, members of this committee for inviting me to testify on this important

subject. in my view the administration's plan would grant to the fed significan new powers. more powers tha it has ever had before. these powers would include determining whether a financial firm ia threat to financial stability. these designated firms by the fed would then be put in a special group called tier 1 fhcs. the fed would have the power to surprise and regulate this newly defined group and the firms in this group would be subject to this new resolution regime, chosen bit fed subject to the new regime. taken as a whole, these powers mean that the fed would be a systemic risk regulator. though, that term is not defined in the cuments. i take it as a definition these new powers. in my view, these new power

will negatively affecthe fed's role as an independent monetary authority. i have four main concerns. first, it seems to me that the additional powers and responsibilities would dilute the key mission of the feder reserve, which is to maintain overall economic and price stability by controlling the growth of the money supply and thereby influencing the overall level of interest rates in the economy. my experience in government, including the u.s. treasury, and elsewhere, is that institutions work best when they focus on a limited set of understandable goals and are held accountable tn the public for achieving these goals. as the number of goals and the lack of clarity increases, the effectiveness and the performance generally decline. my second concern is at responsibility for these new tier 1 financial holding

companies would reduce credibility of the federal reserve by involving it directly in potentially ctroversial decisions. in fact, it seems to me the experience over the last few months illustrates this problem the fed's credibility is an extraordinarily valuable asset and it would be terrible to lose that asset. my third concern is that the plan would create a conflict of interest. indeed, this has been discussed widely already at this hearing with the vice chairman and others. firms in the tier 1 financial holding company would be perceived as too big to fail and perhaps too big to resolve to go through that complicated process that's being proposed. in my view there will, therefore, be a temptation to adjust the instruments of monetary policy, the money supply or the interest rates, to help protect these institutions. it's a natural evolution. lower interest rates, whenhat i have not appropriate, will be harmful to the economy and a

larger fed's balance sheet when not appropriate would be harmful to the economy. my fourth concern is that by giving so much new power to the federal reserve that the plan would actually threaten the fed's monetary policy. why would this be the case? in my view, sooner or later, the increased power will resultn checks and limits on it. perhaps through micromanaged political interference or perhaps through legislative changes. it would be impossible, as some have suggested, in practice to prevent such interference from spreading from the new regulatory powers and supervisy powers to the traditional monetary function of the fed. after all, they are in the same institution and they're run by the same ceo. i think this loss of federal reservendependence is a serious issue, especially, at this time of rapid growing

federal debt and greatly expanded federal reserve balance sheet. actually, i could not do any better than to quote a former secretary of the treasury also former secreta of state or secretary of labor and director of thebudget, secretary george schultz, who after studying carefully the events over the last few months came up with the following statement. ani quote secretary schultz, observing this process, the question comes forcefully at you. has the accord gone down the drain. the second is referring to the '51 accord where the fed regained its independence from the treasury, which had had lost in world war ii and was committed to pegging interest rates. and he went on to say, remember how difficult it was the f to disentangle itself from the treasury in the post-world war ii period.

so these are very serious concerns, my four concerns, and i'd be happy to answer any questions you have about them. thank you. >> dr. meltzer, you're recognized for five minutes. [inaudible] >> thank you forhe opportunity to present my appraisal of the administration's proposal for regulatory changes. i will confine most of my comments to the role of the federal reserve as a systemic regulator. and i'll offer an alternative proposal much closer to the republican proposal. i share the belief that change is needed and long-delayed but appropriate change must protect the public not the bankers. during much of the past 15 years, i have written three volumes entitled a history of the federal reserve. working with two assistants we have read virtually all of the minutes of the board of governors, the federal open market committee and the

directors of the federal reserve bank. we have also read many of the staff papers and the internal memos supporting decisions. i speak from that perspective. two findings are very relevant for the role of the federal reserve. first, i do not know of any single clear example in which the federal reservected in advance to head off a crisis or a series of banking and financial failures. we a know of several where it failed to act in advance. congress members should ask themselves this question. can you expect the federal reserve or anyone else of systemic regulators to close fannie and freddie after congress has stated that it declined to act. what kind of conflict is that going to be posed and how is that going to be resolved? second, in it's 96-year history the federal reserve has never nounced a lender of last

resort. it's discussed internally the content of such a policy several times but it rarely announced what it would do. and the announcements that it made as in 1987 were limited to the circumstces of that time. announcing and following the policy from the financial institutions to the fed's expected action it is might reduce pressures on congress to aid failing entities. following the rule in a crisis, the lender of last resort in a crisis would change bankers' incentives and reduce moral hazard. a crisis policy rule is long overdue. the administration proposal recognizes the need but doesn't propose the rule. experiences in the past from the history suggests three main lessons. first, we cannot avoid banking failures but we can keep them from spreading crises. second, neither the federal rerve nor anyther agency has succeeded in predicting crises by anticipating systemic failure.

it is hard to do in part because systemic risk is not well defined. reasonable people will differ and since much is often at stake, some will fight hard to deny that there's a systemic risk. one of the main reasons that congress in 1991 passed the improvement act was to prevent the federal reserve from delaying closure of failing banks, increasing losses and weakening the fdic fund. the federal reserve and the fdic have not used this against large banks in this crisis. that should change. the third lesson is, that a successfu policy will alter bankers' incentives and avoid moral hazard. bankers must know that risk-taking brings both rewards and costs including failure. loss of managerl position inequity followed by sales of operations. several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers.

members of congress should ask themselves and each other, is the banker or the regulatorore likely to know about the risks on the bank's balance sheet? of course, it is the banker and especially so if the banker is taking large risks that he wants to hide. to me, that means the reform should start by increasing the bankers' responsibility for losses. the administration proposal does the opposite. by making the federal reserve responsible for systemic risk. systemic risk is a term of art. i doubt that it can be defined in a way that satisfies the many parties involved in regulation. members of congress will properly urge that any large company in their district is systemic. administrations and regulators will have other objectives without a clear definition, the proposal will bring frequent controversy and without a clear definition, the proposal is incomplete. resolving the conflicting interest is unlikely to protect

the general must be more like regulators claim they will provoke the public by protecting the banks. i think that's wrong. i believe there are better alternatives than the administration's proposal. first step, end too big to fail. require all financial institutions to increase capital more than in proportional to increasing the size of tir assets. too big to fail is perverse. it allows banks to fail. second step, require the federal reserve to announce a rule for lender of last resort. congress should adopt the rule that they are willing to sustain. the rules should give banks an incentive to hold collateral to be used in a crisis period. the rule from the 19th century bank of england is a great place to srt. third step, recognize that regulation is an ineffective way to change behavior.

my first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation. the bassil accord is an example. they put the assets off the balance sheet. after the fact they had to take them back but that was after the fact. fourth step, recognize that regulators do not allow for the incentives induced by their regulations. in the tiunanimousic financial markets, it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating. fifth step, either extend it to include holding companies or subject financial holding companies to bankruptcies law. make the holding company subject to early intervention either under it or bankruptcy law. that not only reduces or eliminates taxpayers losses but

it also includes prudential behavior. other important changes should be made. congress should close fannie mae and freddie mac and put any subsidy on the housing on the budget. and the same should be done to other credit market subsidies. the budget is a proper place for suidy. three priiples should be bourne in mind. unanticipated large changes can and will cause failures. our problem is to minimize the cost of failures to society. second, remember, that capitalism without failure is like religion without sin. it removes incentives for prudent behavior. third, those who rely on regulation to reduce risk should recall that this is the age of madoff. the fed, too, lacks a record of success in managing large risk to a financial system. the economy and the public. incentives for fraud, evasion

and scircumvention. thank you. >> i thank the gentleman for his extension statement. [laughter] >> i'm going to recognize the members for questions and i'll just reserve my questions last because we have to be out at 5:00. there's another meeting. and i recognize the gentleman from texas, mr. paul. thank you, mr. chairman. and i welcome the paul and especially it's nice to say dr. medical zer here. -- meltzer here. i would like to start a question with mr. dr. meltzer and talk about the latin american crisis where the federaleserve went to the imf and instructed the imf to pay interest to those banks that were exposed. and, of course, that was without congressional permission and i think it makes a point -- one of the points that i've been trying

to me and that is transparency of the federal reserve. now, it sounded to me like the majority here is for independence, which is a code word for secrecy and in opposition to transparency. and it's always used for the public interest. of cour, i think the public interest is served by exposure and knowing what's going on and whose interests are being served and that's why i would like to see a lot more transparen. the question i have for dr. meltzer, since he's aware of this, he's published this, is this a good reason for us to know a lot more about the agreements that the federal reserve makes because they can make agreements with international banking institutions and we have no right -- we may have a right under the constitution that we should but we don't -- we've given up that right and we've given up that privilege.

would this be a good example of why we need to know more what exactly the federal reserve is doing. >> yes. let me begin by saying independence to me, and i believe to many of the members of the panel, does not mean lack of transparency. it means protection -- the reason we have independent central banks is so they don't expand under pressure from congress from the administration, from the banking community and from others. we want them to be independent to make their judgments without -- because they are obligated by law to maintain high employment and low inflation. now, that law doesn't work very well, at least in my opinion, but that's why we want independence. so transparency, how can you be against transparency? but i believe the congress would be more effective in its oversight of the federal reserve if it concentrated much more on

outcomes and much less on process. t them make their decisions the way they want to make them. monitor the process. they are not living up to the mandate to maintain full employment or high employment and low inflation and that's what we should be concerned about. >> i thank you. and i'm going to hurry along because our five minutes runs out rather quickly. but i wanted to ask dr. galbraith a question because he's worked here and he knows the system so i've been rather shocked at what you presented here. you actually talked about the constitution. didn't you find out that we're not supposed to dohat around here? we don't have that much concern -- i was delighted from my viewpoint that you brought this up and remind us of henry's royce's concern of the constitutionally of the fmoc. of course, i agree with that. but i wanted to see if there's a little bit more that you might

agree with because there are some who believe that we shouldn't be doing anything unless it's explicitly it's authorized and, of course, the central bank is not authorized. it's been ordained by the courts and the congress but it was never explicitly authorized. and -- but the point -- the more practical point that i might be able to get you to comment on is the concept of the budget. i mean, the fed is a government unto itself. you know, they hire and make their wages and it doesn't go through the ordinary process. the constitution says it should all go through the constitutional process. and also maybe you could comment on these foreign agreements. these are like treaties. the federal reserve goes and makes these agreements and they pass out money. does this strike you as maybe that too might be challenged if you happen to come at this from a constitutional viewpoint. >> the congress has ever right for whatever information it seeks from the federal reserve.

and if the congress were to decide to change the way the federal reserve is funded, it would also have the right to do that. it seems to me it would be an appropriate decision for congress to make. >> they would then have the right -- so my proposal that we find out more, you would say that would be right and proper to find out what type of agreements they had with other governments, other central banks, other banking organization >> my own view that as a member of congress you'r entitled to that information. that would be theosition i would have understood to be the case when i was working here 30 years ago. >> thank you. >> the time of the gentleman has expired. the gentleman from delaware, mr. castle, is recognized for five minutes. >> thank you very much, mr. chairman. let me just say i thought this was a very good panel. i thought you had some good ideas whether one agrees or not with the concept we would go, i would hope staff and all of of you would take note of what you

stated here today i think it makes a difference. i might ask -- start with you, doctor. you basically indicated that in going to systemic risk regulation, it wouldn't be a great change as far as the fed is concerned. i don't mean to put words in your mouth but that's the impression you stated. and if that's the case and others have indicated that the fed did not anticipate particularly well the problems which have arisen in the banking industry in the last year or two -- but if that's the case is it arguable that the fed had some of this power and did not succeed in carrying out the responsibility of dealing with systemic risk to the limits they had before and, therefore, we should question whether they should expand or not? >> okay. so first let me say what i said before and i agree with voice chairman cohen here that what

the treasury proposal does is very incremental and not degree dramatic and not a vast expansion of powers. basically asking what the fed to be doing as holding bank company supervisor and extending that reach to a modest degree over financial institutions, systemically important financial institutions that don't have a bank. now, i think it's clear that the federal reserve didn't distinguish itself in its carrying out its responsibilities as supervisor and regulator of banks and bank holding companies. this is an extraordinary period. it's the worst financial crisis since the great depression. and i don't believe any other financial supervisor or regulator carried out its responbilities to protect the safety and soundness of the banks' institutions under their control in this circumstance