Senate Committee on Homeland Security and Governmental Affairs

Where Were the Watchdogs? Systemic Risk and the Breakdown of Financial Governance

Mr. Chairman, Senator Collins, and other members of this Committee: Thank you for asking me to testify today on what could not be a more important issue facing the country in the wake of the current financial and economic crisis -- how our policies and institutions can do a better job in the future of reducing systemic risk in the financial system.

Specifically, I will address and answer the questions posed in your invitation:

  • Do we need a systemic risk regulator (SRR)? Yes.
  • Can the monitoring and response to systemic risks be accomplished within our existing regulatory structure, specifically by the Federal Reserve, or by some new entity? Ideally, I would like to see all federal financial regulatory activities consolidated in two agencies, a financial solvency regulator and a federal consumer protection regulator, with systemic risk responsibilities being assigned to the solvency regulator. As a second-best option, I would give clear systemic risk oversight authority to the Fed, an option which is better than either creating a new agency just for systemic risk or regulating through a “college” of existing financial regulators.
  • If a systemic risk regulator is to be authorized, what should be its mandate? The SRR should have oversight of all systemically important financial institutions (SIFIs), although the nature and details of this oversight should take account of the differences in types of such institutions (banks, large insurers, hedge funds, private equity funds, and financial conglomerates). The SRR (or existing financial regulators should no systemic risk regulator be designated) should also regularly analyze and report to Congress on the systemic risks confronting the financial system.
  • There are legitimate challenges associated with assigning any agency the awesome responsibility for reducing systemic risk. But after surveying the alternatives, I have concluded that policy makers have no other choice. As long as there are financial institutions whose failure could lead to calamitous financial and economic consequences, and thus invite all-but-certain federal rescue efforts if the threat of failure is real, then we must have some arm of the federal government oversee systemic risk and do the best we can to make that oversight work.
  • Finally, while the United States should continue to cooperate with governments of other countries, notably through the G-20 process, in reforming financial systems, we should not wait for international agreements to be in place before we get our own financial house in order.
In reaching these conclusions, I draw on several recent reports I have prepared over the past year with colleagues at the Brookings Institution, and which are available on the Brookings website, and on highly useful conversations with my colleagues and grantees of the Kauffman Foundation and with other financial policy experts.

I advance the views I express here with humility. Although I have spent most of my professional career studying the financial industry, the magnitude of recent events is so far beyond anything I could have imagined several years ago that I – and I believe all of us, if we are honest – cannot be fully confident that the “fixes”, both in the short and long run, that we discuss and that the Congress and our regulators eventually adopt will be ideal and immutable. We should all be open to making mid-course corrections, as events continue to unfold, as we learn more, and reflect on what we have learned.

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