fee would be paid by large bank holding companies that engage in risky activities beyond traditional banking

TO BE NOTED: From the NY Times:

‘Too Big to Fail’ Policy Must End, F.D.I.C. Chief Says

Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation, is adding to the debate over what may be the largest overhaul of the nation’s financial rules in decades.

In an interview on CNBC Friday morning, Ms. Bair said a main priority was ending the “too-big-to-fail doctrine” — the idea that a financial institution can become so large and interconnected that it must be propped up at all costs — and called the Obama administration’s proposed regulatory changes an “opening in the process” toward that goal.

She said she wanted a seat at the table in redrafting banking rules and reiterated her support for higher insurance fees for large banks that take big risks, an issue that has been a sore spot between her and John C. Dugan, the comptroller of the currency.

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As the insurer of $6 trillion in bank deposits, the F.D.I.C. should be included in the decision-making process, Ms. Bair said Friday, especially when it comes to dealing with risks to the entire financial system.

“We would obviously like a seat at the table in decision making on systemic risk,” she said. “The F.D.I.C. has tremendous exposure to the system.”

Ms. Bair is seeking to create a separate insurance pool, similar to, but separate from, the deposit insurance premiums the F.D.I.C. currently collects from banks, which would be designed to curb systemic risk. The fee would be paid by large bank holding companies that engage in risky activities beyond traditional banking. Ms. Bair mentioned proprietary trading and over-the-counter derivative trading as two examples of activities that could warrant the payment of the new insurance fee.

Ms. Bair said the fees would create economic disincentives for banks to take on more risk and grow to a size that would make them too big to fail, thereby posing a risk to the whole financial system.

She also said that she is not likely to continue in her role at the F.D.I.C. past her five-year term, which ends in 2011.

“I am very much looking forward to getting back to more sane hours and more time with my family,” Ms. Bair.

– Cyrus Sanati"

You stabilize the banks to support the economy. But you don’t stabilize the banks for the sake of stabilizing the banks.

TO BE NOTED: From Bloomberg:

"Bair Attacks Too-Big-to-Fail as Enforcer Geithner Must Trust

By Alison Vekshin

May 29 (Bloomberg) -- Sheila Bair, chairman of the Federal Deposit Insurance Corp. and a lifelong Republican, boarded Air Force One for the first time in February. Neither President George H.W. Bush nor his son, President George W. Bush, had invited her on the world’s most famous jet in the five years she worked for them. It was a Democratic president, Barack Obama, who asked her to fly to Washington after the two had unveiled his administration’s foreclosure relief plan in Mesa, Arizona.

“Sheila, come on back. I want to talk to you,” Obama told Bair, who was seated in the plane’s conference room. He then escorted her into his airborne Oval Office for their first private meeting, where they discussed the government’s role in alleviating the worst financial crisis since the 1930s.

“It was great,” Bair says of her meeting with the president. “He’s got an agenda which we share. Banks are a means to an end. You stabilize the banks to support the economy. But you don’t stabilize the banks for the sake of stabilizing the banks.”

After being left out of big decisions by Bush administration officials, such as the push last year for the $700 billion bank bailout, Bair, 55, has become one of the most powerful policy makers in Washington. Driven by a combination of circumstances and her own candor, Bair has presided over the biggest expansion of the FDIC’s authority since its founding in 1933 to insure bank deposits.

‘Bites Like Jaws’

“She looks like Bambi and she bites like Jaws,” says Wade Henderson, president of the Washington-based Leadership Conference on Civil Rights, who has known her for 27 years. “There’s a quiet intensity about her. She’s idealistic in spite of her 30 years in Washington.”

Under Bair, the normally invisible agency was the prime mover behind Obama’s $75 billion program to curb foreclosures. Last year, the FDIC became the go-to agency to insure hundreds of billions in bank debt to boost liquidity, and it’s currently spearheading half of the initiative to encourage investors to buy up to $1 trillion in troubled assets.

The FDIC head isn’t done expanding her influence over Wall Street. An opponent of the “too-big-to-fail” policy for firms like Citigroup Inc., Bair is lobbying Congress to give the FDIC authority to wind down bank and thrift holding companies -- a move she says is necessary to protect taxpayers. And she wants lawmakers to include the agency in a systemic risk council to prevent future financial shocks.

Populist

As Bair builds her power, soaring bank failures are jeopardizing her agency’s deposit insurance fund, which had dwindled to $13 billion in the first quarter, the lowest amount since 1993 following the savings-and-loan crisis. She requested more funding from Congress, which on May 19 more than tripled the FDIC’s borrowing authority from the Treasury Department to $100 billion. Lawmakers also approved a temporary boost of the credit line to $500 billion.

A self-described “populist,” Bair has won allies in the Democratic Party, such as Representative Barney Frank of Massachusetts, in muscling the FDIC into prominence. She has also fought battles with the Independent Community Bankers of America, representing 5,000 banks, and the Bush administration.

In 2008, Bair says, her struggle with midlevel Treasury Department officials turned tense as they stonewalled her proposal to use federal funding to prevent foreclosures. And she tussled with Timothy Geithner, then the president of the Federal Reserve Bank of New York, over the request last year that the FDIC guarantee all debt issued by lenders -- a move she rejected because it would expose her agency to big losses.

Geithner’s Respect

“I’m from Kansas; I’m not from New York,” Bair says. “I’m a lot of things that are different. So maybe that does give me some more independence of thought and daring to not care who I offend.”

Following Obama’s election in November, Geithner tried to have her ousted for not being a team player, according to people familiar with the matter. Through a spokesman, Geithner declined to say whether he sought to remove Bair from office.

“I have great respect for her,” Geithner told Bloomberg TV on May 21. “She’s a strong advocate for her agency and a strong advocate for her points of view.”

In May, after the FDIC assisted the Federal Reserve in stress testing 19 lenders, Bair put their executives on notice. She said some of them could lose their jobs in the next few months after the companies submit capital-raising plans to the government, according to an interview with Bloomberg TV and a statement from the FDIC on May 15. Bair didn’t say that the government would oust the chief executive officers of the banks.

$4.8 Trillion in Deposits

Bair says she’s seeking more authority over banks because her agency has so much at stake -- $4.8 trillion in insured deposits.

“There is some perception we want these programs, we want all this power,” Bair says. “That is not the case. We want a cleanup. This agency was born of a crisis and made for a crisis.”

Congress created the FDIC in 1933 at the depths of the Great Depression during President Franklin D. Roosevelt’s first term. As thousands of customers rushed their lenders to withdraw funds, toppling about 4,000 banks that year, Congress gave the new agency the powers to insure deposits and liquidate failed lenders.

Set up as an independent authority like the Federal Reserve, with a chairman serving a five-year term, the FDIC has been quiescent during most of its history. Then, in the 1990s, the agency expanded its staff to liquidate banks during the S&L crisis, when 124 insured institutions went down in 1991 alone.

1,000 Bank Failures

Now facing the largest number of bank failures since the S&L debacle, Bair has been fighting with bankers to protect the solvency of her deposit insurance fund. As many as 1,000 banks will go down from 2009 to 2012, says Gerard Cassidy, managing director of bank equity research at RBC Capital Markets in Portland, Maine.

The FDIC’s insurance fund, which covers deposits up to $250,000 after Congress temporarily boosted the amount from $100,000, is financed by banks. Most of them pay an annual fee of 12 cents to 16 cents per $100 in deposits. In February, Bair proposed an additional, emergency one-time charge of 20 cents per $100 in deposits, which ignited a firestorm of criticism from small banks.

Camden Fine, president of the Independent Community Bankers of America in Washington, sent a letter to more than 35,000 bankers in early March.

Hiking Bank Fees

“Shake the walls of the FDIC and Congress until they reverse this and other misguided policies,” Fine wrote. Bankers barraged the agency with letters complaining that the levy would wipe out profits.

After Congress agreed to boost the FDIC’s credit line to backstop the insurance fund, Bair moved to reach a compromise with the banks. On May 22, the FDIC approved a one-time fee on banks of 5 cents per $100 in assets, minus Tier 1 capital. By basing the fee on assets rather than deposits, the FDIC is putting more of the onus on larger institutions.

As the FDIC gains more regulatory clout, Republican lawmakers say the agency is stretching itself too thin in veering from its main job of insuring deposits.

“I’m very concerned ultimately about the core function of the FDIC, which is the cornerstone of our financial system, which is the safety and soundness of the insurance fund,” says Representative Jeb Hensarling, a Texas Republican.

ABA Opposition

The American Bankers Association, which represents banks of all sizes, is lobbying to stop the FDIC from gaining more turf. Bair’s proposal to give her agency the power to dismantle huge financial companies would have included government-controlled American International Group Inc. before the government took control of it, according to the Washington-based ABA. It says Congress shouldn’t give the wind-down authority to the FDIC because the financial burden of liquidating the large companies would likely fall on fee-paying banks.

“We think it would be a calamity for the country because the FDIC insurance of bank deposits has been so important,” says Edward Yingling, president of the trade group. “Why should a community bank in the middle of Iowa be paying for AIG? We pay insurance premiums to cover insurance on banks, not on everybody.”

As Bair’s stature rises, so does the number of hostile e- mails she receives from depositors who have suffered losses because their amount of money at failed banks exceeded the insurance limit. For the first time, starting in early 2009, the FDIC assigned a security detail to its chief. After speeches, Bair is often swarmed by crowds of reporters and citizens who sometimes jostle her 5-foot-4-inch (1.6-meter) frame.

Independence, Kansas

“She’s a very recognizable face now,” says Fine of the banking trade group. “All it takes is one disgruntled banker or depositor and bad things can happen.”

Bair’s populist politics were shaped in Independence, Kansas, a rural town of about 10,000 people where she grew up. Her mother, Clara, a nurse, and her father, Albert, a doctor, were children during the Great Depression and swayed her views about the importance of being thrifty.

“The culture out there is one of being in touch with the people and grassroots,” says Fine, who’s from Jefferson City, Missouri.

A classic overachiever, Bair graduated from Independence High School a year early and earned a degree in philosophy in three and a half years from the University of Kansas in Lawrence in 1975.

“I like to get things done quickly,” she says.

Robert Dole

Hoping to work in public service, she entered a law program at the same school and graduated three years later. Bair interviewed at several law firms that in the 1970s were mostly hiring men.

“They couldn’t compete with men for jobs in the law firms,” says Fred Lovitch, a professor at the law school who taught Bair in a securities regulation course. “She did what our best women students did then, which was to get as good a job as they could in the federal government and work their way up from there.”

The Department of Health, Education and Welfare in Kansas City hired Bair as a civil-rights lawyer. In 1981, she began her ascent in Washington, landing a job in the office of Robert Dole, a Republican senator from her home state. Dole, 85, says one of the reasons he hired Bair was because he knew her father, a political supporter. In seven years with the senator as a research director and counsel, she worked on civil rights, including legislation making Martin Luther King Jr.’s birthday a federal holiday and extending the Voting Rights Act; judicial nominations; and Dole’s presidential bid in 1988.

Runs for Congress

“She’s a hard worker, one of these people who if you say, ‘Sheila, would you do A, B, C or all three?’ then you didn’t have to worry about it every day,” Dole says.

Eager to make some money, Bair left Dole’s office in 1988 after his failed campaign for the White House and joined the New York Stock Exchange as its legislative counsel in Washington.

In 1990, at Dole’s urging, Bair returned to Kansas to run in the Republican primary in the 5th District for a House seat. The only pro-choice candidate among six contenders, she called for a balanced budget and the revitalization of economically depressed southeast Kansas. She rode around in rural communities on a bicycle with a yellow flag saying “Bair for Congress” before losing by 760 votes.

“She should have gotten married before the race,” Dole says. “At that time in Kansas, I think there were a lot of people, seniors and others, who would like to see young people married before they go to some public office.”

CFTC Commissioner

A year later, in 1991, the first President Bush nominated Bair to be commissioner of the Commodity Futures Trading Commission, an agency that fell under the jurisdiction of the Senate Agriculture Committee that Dole had served on. During her tenure at the CFTC, Enron Corp., the energy-trading company that would blow up in 2001, lobbied the commission to exempt over- the-counter energy derivatives from the agency’s rules banning fraud, says Susan Milligan, a senior vice president at the Chicago-based Options Clearing Corp. who worked for Bair at the CFTC.

Bair was the only commissioner of the three-member panel who dissented on the proposed exemption; she lost the battle.

“There was a lot of pressure to vote for the exemption from the OTC derivatives community,” Milligan says. “Sheila said, ‘Absolutely not. No responsible regulator exempts anyone from their anti-fraud authority.’”

NYSE

Bair returned to the NYSE in 1995, where she ran its Washington lobbying office for six years during the Internet- fueled stock market boom and bust. At the stock exchange, Bair maintained her consumer protection bent, leading the successful effort to include limits in the 1999 Gramm-Leach-Bliley Act to prevent OTC derivatives dealers from offering equity swaps to retail investors. The law repealed part of the Glass-Steagall Act of 1933, which banned companies from acting as both a commercial and an investment bank.

“We didn’t want retail investors to be in a situation where they didn’t understand the product and had losses,” says Milligan, who followed Bair to the NYSE.

In June 2001, as the Standard & Poor’s 500 Index was on course for a 13 percent drop for the year, the second President Bush nominated Bair to the post of assistant secretary for financial institutions at Treasury. After her confirmation in July, she helped create an office to improve the financial knowledge of Americans. The office encouraged banks to open student-run branches in high schools.

University of Massachusetts

Bair departed Washington about 12 months later for a quieter life at the Isenberg School of Management at the University of Massachusetts in Amherst. She raised two children -- Preston, 16, and Colleen, 9 -- with her husband, Scott Cooper, vice president of government relations at the Washington-based American National Standards Institute, a nonprofit group that helps coordinate standards for U.S. products.

“Students were always impressed with how well prepared she was,” says Thomas O’Brien, a finance professor who taught a course with Bair in 2005. “Sheila wasn’t a showoff at all. She does her own homework, and she calls things the way she sees them.”

At the university, some of her research focused on improving financial services for low-income people. In one paper on Latin American immigrants, she recommended that banks provide bilingual documents and staff, open more branches in Latino neighborhoods and offer money transfers along with check cashing.

President Bush

In 2006, Bair published the first of two children’s books, Rock, Brock, and the Savings Shock. It’s a tale about twin brothers -- a spender and a saver -- and how saving makes one brother rich. The second, Isabel’s Car Wash, about investing, tells of a girl with a plan to take $5 from her friends to start a car wash and pay them back with interest.

Bair says she wasn’t seeking a government post when Bush’s personnel director called her in 2006 about replacing Donald Powell, the FDIC head who had left to oversee the Hurricane Katrina reconstruction program. While she enjoyed the freedom at the university to express her own views, Bair couldn’t resist a return to public service. The Senate confirmed her in June 2006 as banks were reporting record earnings and no lender had failed in two years.

Early the following year, Bair became one of the first policy makers to speak out about the coming housing crisis that would plunge the economy into recession. The FDIC chief saw that a rash of subprime mortgages issued at low teaser interest rates a few years earlier were about to adjust to higher rates, boosting monthly payments by more than 30 percent and threatening to spur a wave of defaults.

Early Warnings

Bair wanted lenders to change mortgage terms to reduce monthly payments and help borrowers stay in their homes. But she had no regulatory control over major mortgage servicing companies. So Bair resorted to a series of private meetings and congressional appearances to try to persuade the mortgage industry to voluntarily prevent foreclosures.

In April 2007, Bair organized a summit of lenders and regulators at the seven-story FDIC headquarters in Washington. Representatives from Countrywide Financial Corp., Morgan Stanley Bank and Wells Fargo Home Mortgage were among the about 40 people who attended the eight-hour meeting. During the gathering, the representatives vowed that they would begin modifying loans, Bair says.

“Everybody said they knew these loans were going to be resetting and unaffordable and the loans would be restructured because it was in everyone’s interest to keep people in the house,” she says.

Pressuring Investors

The Bush appointee also collaborated closely with Democratic leaders in Congress. On April 17, the day after her summit, Bair urged servicers to adjust the terms of loans when she testified before the House Financial Services Committee, chaired by Frank. She also said investors in mortgage-backed securities whose returns were guaranteed in contracts would have to take losses too.

“I thing we should hold the servicers’ and the investors’ feet to the fire on this,” she said. “It was clear to investors that these were high risk. So I think everybody needs to share the pain now.”

The following day, she attended another closed-door meeting with lenders convened by Christopher Dodd of Connecticut, the Senate Banking Committee chairman.

Her testimony -- coming three months before two Bear Stearns Cos. hedge funds collapsed under the weight of investments in subprime debt -- made Bair the darling of Democrats and immunized her from criticism by lawmakers who chastised other regulators for their lax oversight of banks.

Admired by Frank

“I admire the fact that she wouldn’t let people shut her up,” Frank says. “The people who’d appointed her were unhappy she was speaking out, and she was right.”

In the months following her summit, Bair was reminded of the limits of her own power: Loan servicers hadn’t begun reducing payments for homeowners because of resistance by investors.

“I was frustrated because everybody was privately singing this song to us, but there was no execution,” Bair says. “A lot of the pushback was coming from the investor community. And you still see it with the investor community.”

As the bankruptcy of Lehman Brothers Holdings Inc. in September 2008 froze credit markets and threatened to take down even bigger securities firms, Treasury Secretary Henry Paulson and Fed Chairman Ben S. Bernanke rushed to Congress to win approval of an emergency rescue plan.

TARP

Just before they went to lawmakers to set up the $700 billion Troubled Asset Relief Program, or TARP, Bair says, she got a perfunctory call from Paulson telling her of their plans and asking her if she wanted anything added to the bill.

“They made the decision to go to the Hill to start this program,” Bair says. “We were never part of any of that.” Paulson, who left office in January, didn’t respond to requests for an interview.

Paulson told Congress that TARP funds would be used to buy troubled bank assets. Bair says the administration included a mortgage modification provision in the bill to try to win votes from the Black and Hispanic caucuses and other Democrats. The provision said that Treasury would set up a program to help struggling homeowners if the department used TARP money to buy mortgages or related securities.

Bair says that although Paulson changed course, opting to use the money to buy preferred bank shares, he still seemed to support the use of some TARP funding to modify mortgages. So the FDIC developed a $24.4 billion plan that soon died because mid- level Treasury staffers didn’t want to use taxpayer money to bail out homeowners, Bair says.

‘Robust Discussions’

“Then it got nasty,” she says. “People started leaking our plan with derogatory comments, so we went public with ours. It was just a kind of classic Washington unpleasant process.”

William Isaac, who served as FDIC chairman under President Ronald Reagan from 1981 to 1985, says Bush officials objected to Bair’s push to modify loans.

“They thought she was way out in left field,” Isaac, 65, says. “I think she was right. Too many foreclosures were driving down real estate values, and if we didn’t address that issue, then the banking and economic problems would only get worse.”

As banks struggled to raise money, Paulson and Bernanke turned to Bair to start the Temporary Liquidity Guarantee Program to insure debt issued by banks -- a sweeping escalation of the FDIC’s role. Bair says she and Geithner had “robust discussions” about how much debt the FDIC would insure under the program.

“There were early discussions about us guaranteeing all bank liabilities, and we weren’t going to do that,” Bair says.

Insuring Debt

If the FDIC suffered losses, they would have to be recouped by charging fees to already battered banks. Bair did agree to temporarily insure new senior unsecured debt, such as commercial paper. And she insisted the agency charge banks that use the program a fee for the guarantee.

The program, which started in November, allows banks to issue debt with a top, AAA credit rating. Bair has said she doesn’t want to extend the program, which had insured $342.7 billion in debt and raised $8 billion in fees without incurring any losses as of mid-May, beyond its scheduled end on Oct. 31.

Lou Crandall, chief economist at research firm Wrightson ICAP LLC in Jersey City, New Jersey, says the program has been one of the government’s most successful responses to the financial crisis.

“It’s contributed to the funding stability of a large number of issuers and eased immediate concerns about their access to cash,” Crandall says.

President Obama

After the November election, Geithner, then Obama’s nominee for Treasury secretary, sought to push Bair out of office, according to people familiar with his thinking. Geithner said Bair was too focused on protecting the solvency of her deposit insurance fund rather than the financial system as a whole, the people said.

“He’s never indicated to me in any way that he had any problem with working with me or anything else,” Bair says. “President Obama has made clear he wants people to work together.”

As the head of an independent agency whose term overlapped two administrations, Bair could have kept her job without being reappointed by Obama. Bair says she would have stepped down if the president had requested it. Instead, Obama sent signals that he wanted her to stay.

Troubled Assets

Bair says the transition team, co-chaired by John Podesta, whom she’s known for years, reached out to her to discuss mortgage modifications. Dodd and Frank also wrote a letter to Obama in December asking him to keep Bair, stressing her willingness to buck the Bush administration.

“I wasn’t sure whether there would be a carryover of the friction with the Bush people, so that’s why I wrote that letter,” Frank says. Bair’s flight on Air Force One in February suggested to her that the new president wanted her to continue leading the agency. “With the new administration, the president has been very inclusive, and that’s helped us,” Bair says.

Early this year, as public hostility over Wall Street bailouts and bonuses reached a fever pitch, Bair says she played a significant role with Geithner and Bernanke in devising the Public-Private Investment Program to buy illiquid mortgage- backed assets from banks. Paulson’s decision in 2008 not to use TARP funds to buy these assets hurt the prices the FDIC was getting when it liquidated failed banks. Congress wasn’t about to hand the Treasury more money to acquire bad debt while unemployment soared, reaching 8.9 percent in April.

Buffett’s Idea

So Bair says the trio decided to create incentives for private investors -- an idea that billionaire investor Warren Buffett had proposed to Paulson in 2008 -- since they were better suited to establish market prices for the debt. The Treasury and Fed told her that the FDIC would have to provide financing to get the loan program for banks off the ground.

“They basically said, ‘If you want it, you’ll have to ante up too,’” says Bair, who agreed. Bair told the Treasury that her agency should operate the auction of assets since it had experience selling off failed banks. “Treasury was fine with that,” Bair says. “They are not really equipped to run a program like this.”

Under the PPIP, which was announced in March and will use up to $100 billion of TARP funds, the FDIC will oversee the sale of distressed loans. The Treasury will provide half of the equity to buy a pool of loans from banks, with private investors putting up the other half. The FDIC will offer debt guarantees to investors of up to six times the capital provided.

Reluctant Banks

“The debt guarantee by the FDIC is a huge sweetener,” says Mark Tenhundfeld, senior vice president at the ABA.

While investors have expressed a lot of interest in buying the assets, banks are reluctant to sell them.

“The troubled assets are still there, and the need is still there to clean that up,” Bair told Bloomberg TV on May 15. “Some need to be told that they need to deal with their troubled assets.”

Most banks may decide to keep the assets and take writedowns rather than sell them at a steep discount, says Christopher Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ Ltd. in New York.

“I’d be surprised if you’re going to get many banks who feel their assets are worth 90 cents on the dollar right now selling at 60 cents to a hedge fund,” Rupkey says.

Dwindling Insurance Fund

At a May 27 news conference, Bair pointed to additional obstacles to getting banks and investors to participate. She said they may be hesitant because of concerns that Congress could change the rules governing the program. She cited an amendment lawmakers approved this month that requires the Treasury to write rules guarding against conflicts of interest in the PPIP, a process that could delay a test run of the program that had been scheduled for June. Banks also have been able to raise capital and may have less incentive to sell assets, Bair said.

With bank failures rising -- 36 have folded this year -- Bair is struggling to keep the deposit insurance fund solvent. In the first quarter, bank collapses had reduced the fund to $13 billion from $17.3 billion in the previous period.

The FDIC classified 305 banks as “problem” institutions in the first quarter, the highest total in 15 years and an increase from the 252 on the agency’s list in the fourth quarter. Banks are rated on measures including asset quality, earnings and liquidity.

“The banking industry still faces tremendous challenges,” Bair said on May 27. “Going forward, asset quality remains a major concern.”

Emergency Fee

Last September, Bair was still bullish about the fund. “Despite the recent drawdown to cover losses, the insurance fund is in a strong financial position to weather a significant increase in bank failures,” Bair told the Florida Bankers Association in Sarasota, Florida.

In moving to replenish the pool, Bair made a major misstep, says Fine of the community banking group. Her emergency fee proposal on Feb. 27 of 20 cents per $100 in deposits was immediately met with outrage from bankers. They deluged her office with protests, saying it would take a large chunk out of their 2009 profits at a time when they could least afford it.

The assessment would cost Citizens Bank of Ada more than 10 percent of its net earnings, Kassie Cothran, the Oklahoma-based bank’s senior vice president, wrote the agency.

Battle With Bankers

“Without these assessments, the deposit insurance fund could become insolvent this year,” Bair wrote in a letter to bank CEOs on March 2. That didn’t quell the brouhaha. The next day in his letter to bankers, Fine likened the proposal to “Japan’s sneak attack on Pearl Harbor.”

A day later, Bair called Fine on his cell phone to make peace while he was dining with two bankers. “You’re going to have to call the dogs off,” Fine says Bair told him. “You’ve got to tone down the rhetoric. We’re just getting bombarded.”

When Bair asked if sharply reducing the fee would help, Fine said it was a step in the right direction. On March 5, she turned to Congress for funding, sending a letter to Dodd urging lawmakers to expand the agency’s credit as a contingency and so the FDIC could reduce the bank fee. Two months later, Congress overwhelmingly approved the massive increase, including a $500 billion credit boost through 2010, and the president signed the measure on May 20.

Dismantling Giants

The FDIC has tapped this credit only once in its history, when the S&L crisis left the fund insolvent by $7 billion in 1991. The agency repaid the loan with interest two years later using industry fees.

Fine says the protests from bankers caught Bair flat-footed and taught her a lesson. “I believe if she had it to do over again, she would have explored alternatives and laid some groundwork before,” he says. “She, to her credit, adjusted very rapidly.”

The FDIC boss doesn’t think she misplayed her hand by proposing the fee.

“I don’t know if it was a mistake,” she says. “The 20 basis points -- we thought about that very carefully. I don’t think I had any choice.”

As financial behemoths such as Citigroup live off bailouts -- it’s received $45 billion in taxpayer funding -- Bair is asking Congress to give her agency the power to dismantle large bank holding companies. Currently, the FDIC can only unwind thrifts and banks such as Citibank, a division of Citigroup that operates retail outlets. The agency can’t disassemble the entire Citigroup, which also has trading and investment banking units.( NB DON )

Risk Council

“Done correctly, the effect of the resolution authority will be to increase market discipline and protect taxpayers,” Bair told the Senate Banking Committee on May 6.

While lawmakers begin the biggest regulatory overhaul since FDR, they’re split on who should get the power to contain systemic financial risk. Last year, Frank and Paulson pushed for the Fed to gain the authority to prevent shocks such as the one caused by the collapse of Lehman Brothers. In March, after the public outcry over government-funded AIG’s payout of $165 million in bonuses, lawmakers blamed the Fed because the New York Fed is the insurer’s main overseer while under government control. Following that flap, Bair told lawmakers on May 6 that they should divide the super-cop job among the FDIC, the Fed, the Treasury and the Securities and Exchange Commission.

While SEC Chairman Mary Schapiro backs Bair’s proposal to prevent concentration of power with a single regulator, Geithner opposes it.

Congress’s Priority

“Geithner believes that we need a single independent regulator with responsibility for systemically important firms,” Treasury spokesman Andrew Williams said in a May 8 e- mail. “He does see a role, however, for a council to coordinate among the various regulators.”

Ronald Glancz, chairman of the financial services group at Venable LLP, a Washington law firm, says Congress won’t let the debate over who gets authority prevent the creation of a super regulator.

“It is going to happen,” Glancz says. “This is the No. 1 priority in Congress for dealing with future financial crises.”

After trying to rescue struggling homeowners for almost two years, Bair says she felt vindicated standing with Obama in February as he announced his foreclosure plan in Arizona. It uses $75 billion to coax banks to make payments affordable for up to 4 million borrowers. The government will share in the cost of reducing the borrowers’ monthly payments to 31 percent of their monthly income.

JFK Award

The program hasn’t permanently altered any loans yet. Fourteen participating loan-servicing companies had extended trial modification offers to more than 55,000 homeowners, according to a May 14 Treasury release. At least 10,000 borrowers are making lower payments as part of a three-month trial, a requirement before borrowers can have their loans permanently modified, the Treasury said.

On May 18, Bair accepted the John F. Kennedy Profile in Courage Award at his presidential library in Boston for “sounding early warnings” about the subprime lending crisis. She shared the honor with Brooksley Born, former chairman of the CFTC, who in the late 1990s fought to regulate OTC derivatives in a losing battle against Robert Rubin, a former Treasury secretary and Citigroup executive committee chairman.

Bair says she’s not seeking the Treasury secretary post or any other higher position in Washington.

“I have no aspirations other than to return to academia after this job is over and have more time with my family again,” she says from her office, located a block away from the White House.

Bair’s legacy will mostly ride on the effectiveness of her new initiatives, from foreclosure relief to asset sales. As results are tallied, Bair’s friends and critics can then judge whether the idealistic populist from Kansas who ventured to Washington three decades ago has helped put America’s banks back on stable ground.

To contact the reporter on this story: Alison Vekshin in Washington at avekshin@bloomberg.net."

After all – if the government could wipe you out why would you ever invest in low risk margin debt?

TO BE NOTED: From Bronte Capital:

"Do you or did you ever have friends in the FDIC?

"Here in my hand is a list of 205 communists in the blogosphere and the mainstream media."

Well – no actually – but I have a long list of people who – on the record – supported the confiscation of Washington Mutual.

Washington Mutual – by far the biggest bank confiscation in US history – happened during the AIG/Lehman week. It was confiscated despite being liquid and adequately capitalised at the time. Sheila Bair – the head of the Federal Deposit Insurance Corp (FDIC) did the deed – and in my opinion it was not her finest hour.

Washington Mutual was given to JP Morgan who did not need to honour all of WaMu’s debts. Debt holders – who would normally have expected to recover most or all of their investment were wiped out.

After this – and until very recently – no major US bank could raise any debt without a government guarantee. After all – if the government could wipe you out why would you ever invest in low risk margin debt?

The confiscation of Washington Mutual thus forced the entire system onto the government guarantee tit. The cost to taxpayers is thus potentially enormous.

Now at the time the confiscation looked justified to many because they assumed that Washington Mutual was insolvent no matter what their accounts said. JP Morgan – the acquirer – obliged this view by writing down the value of WaMu’s assets by about 20 billion. This write-down also justified the action by Sheila Bair. I said at the time that Sheila Bair was acting improperly despite this – and I said later that JPM was lying.

However if JPM was telling the truth – and Sheila Bair had a decent basis for believing them – then this was not arbitrary confiscation – though it was confiscation without appeal. It would be costly for the system – and it might have been justified.

Alas the facts have a neat way of outing the incompetence of Sheila Bair. JPMorgan is now confessing that almost all of the charges taken when Washington Mutual was confiscated will be reversed through their P&L. Washington Mutual was never insolvent and should never have been confiscated. [Hat tip – Felix Salmon.]

Sheila Bair – a Republican appointee no less – confiscated without compensation and without right of appeal valuable private property. I have argued repeatedly that she should resign – but now my basic thesis is proven her position is totally untenable.

A huge number of people supported her at the time. These are people who supported the confiscation of private property without appeal. Usually such people are called communists. The alternative explanation is that these people are just dopes.

Actually I know a lot of these people and they are not dopes. [Using McCarthyist logic therefore they must be communists.]

But they are not Communists either. Instead they were dopes on this occasion. Panics – be them financial or political do that. They turn thinking – even iconoclastic people like high profile bloggers – into dopes.

Now Washington Mutual was in fact very easy to add up. It was obviously solvent if you ran the numbers properly – but people find it quite difficult to run the numbers on banks. This applies to senior government officials too. And that explains why financial crises happen. People thought there was no risk in financial assets that were obviously risky during 2005 and 2006 and even into 2007. Thereafter they thought that financial assets that were most likely safe were (near) worthless. Government officials seemingly arbitrarily confiscating assets into the height of the crisis just added to that fear. A preferred stock is worthless if the government steals the underlying collateral (as I found out to my cost in the WaMu case).

After the confiscation of WaMu we needed not only to judge the solvency of banks (something which I think I am capable of doing) but also to judge the behaviour of individual officials in crisis (which I am not capable of doing).

The irrational fear in markets was not unlike the irrational fear that other manias (eg Joe McCarthy) engendered. That doesn’t make the fear less real or less destructive.

I thought at the time that Sheila Bair’s resignation would heal that wound– and would be the single best thing that the government could do to ease the financial crisis. Her resignation would break the nexus between fear in the market and the fear of seemingly arbitrary confiscation by government officials.

That nexus is broken now through repeated and consistent subsidy at huge potential cost to the taxpayers. The government – through repeated capital injections and guarantees – has managed to convince most people that American banks are safe.

It would have been cheaper for Sheila Bair just to resign.

However – the immediate and pressing need for Sheila Bair to resign as a matter of policy has past. The market is no longer outright afraid of arbitrary government confiscation of financial assets though they might have some fear about government intervening in Detroit’s bankruptcy.

But whilst the time for Sheila Bair’s resignation as a matter of national priority is past, the time for her resignation for proven incompetence has just begun.

John

Posted by John Hempton

The fact is, banks do benefit from implicit and explicit government safety nets.

TO BE FILED: From the FDIC:

Speeches & Testimony

---

Remarks By Sheila Bair Chairman, U.S. Federal Deposit Insurance Corporation; 2007 Risk Management and Allocation Conference, Paris, France
June 25, 2007

FOR IMMEDIATE RELEASE

Press Contact: Andrew Gray (angray@fdic.gov)
Ph: (202) 898-7192

Good morning, and thank you. According to the conference program, I'm to speak on "The Dream of a Single Global Standard." When they wrote that, I think someone must have had a sense of humor.

Or perhaps the question the conference sponsors really wanted to ask was: "When Will the Americans Finish the Rule?" Sorry to let you down. I'm not here to answer that question. But we are working on it. We want a consensus on appropriate safeguards that will allow our banks to implement Basel II.

Today, I would like to share my concerns about the advanced approaches. And then give you my sense of where we are in the process.

Eight years in the making

When I became FDIC Chairman last June, Basel II had been in the making since at least 1999, when the first consultative paper was published. Eight years is a long time for developing any regulation.

But the length of the process reflects the difficulty of building consensus on such an extraordinary and very complicated undertaking. Eight years of intensive technical consultation with large banks continues to this day.

There's also been significant evolution in the policy arena. The 1999 Basel Committee paper I mentioned, said there would be no reduction in capital requirements. That statement has since been modified, of course, to allow for some reduction in capital requirements to provide incentives to adopt the advanced approaches.

U.S. regulators have assured Congress that our intention was not to produce substantial reductions in capital requirements for the large banks adopting the advanced approaches. And my opinion on this has always been that we don't want capital reductions to be a tool of international competition. That is a game with no winners.

When I became Chairman, the Basel II process was already steeped in controversy in the U.S., and had been for some time.

As the new head of the U.S. deposit insurer, it was obviously my obligation to find out what the controversy was all about. So I learned as much as I could as quickly as I could. Frankly, the more I learned, the more uncomfortable I became. But given the long history of the process … I wanted to find a way to move forward. And the many safeguards that had already been built into the proposed rule helped give me comfort that we were moving ahead in a controlled and responsible manner. That is why I scheduled a meeting and voted to publish the Notice of Proposed Rulemaking just a few months after I became Chairman.

Protecting the capital cushion

The rulemaking included safeguards against unconstrained reductions in risk-based capital requirements. My support for the proposed rule was contingent on these safeguards.

The importance of the safeguards is not a personal point of view, but an institutional one. While all bank regulators are responsible for safety and soundness, the FDIC explicitly insures over $4.2 trillion in deposits. We also have a statutory mandate to promote public confidence in the U.S. banking system.

A critical point that everyone must keep in mind is that the Basel II framework was developed and debated during a very benign period of economic growth and strong bank profitability.

The recent trouble in U.S. sub-prime mortgages is a clear reminder of how fast and decisively market conditions can change. It points to the danger of thinking that banks will have enough lead-time to ramp up their capital as economic conditions deteriorate.

Some fear we may be approaching a more general turning point in the credit cycle. As regulators, we want to ensure that banks have a strong enough capital cushion to withstand a downturn.

For the last two decades, the Basel Committee keeps coming back to the same basic question: How much bank capital is enough?

The Four Risks

I don't think you can answer that question unless you consider four significant risks in connection with Basel II's advanced approaches.

Risk number one: The advanced approaches come uncomfortably close to letting banks set their own capital requirements. That would be like a football match where each player has his own set of rules. There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent.

The fact is, banks do benefit from implicit and explicit government safety nets.

Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure.

History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s.

The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.

Risk number two: The jury is still out on whether the Basel II advanced approaches can tie capital requirements to risk, as intended.

Why? Because the key risk inputs that drive the advanced approaches are subjective … unreliable and unproven.

Let me hasten to say that some large banks have internal risk-rating systems that do a good job of grading relative risks within their portfolios. But in the advanced approaches, if Bank A has a small capital requirement, and Bank B has a large capital requirement, we are supposed to assume that Bank A has a safer portfolio.

Unfortunately, in the advanced approaches, these two banks could simply be measuring identical risks in different ways. Regulators have taken appropriate care not to micro-manage internal ratings systems. But the resulting wide latitude in capital requirements could lead to inconsistency across banks. And it could lead regulators to accept capital requirements that are too low.

Risk number three: Even if banks and supervisors could somehow work together to average out the subjective and divergent risk inputs, the advanced framework may still deliver insufficient capital.

Let me use the U.S. residential mortgage market as an example, which all of you know is having problems. In our QIS-4 exercise, we looked at the potential capital impact of the advanced approaches. For all residential mortgages, the median reduction in capital requirements was 64 percent … and for home equity loans, it was 77 percent. More than a few of our 26 banks reported that their minimum risk-based capital requirement for mortgages went down by 90 percent or more.

To me, one of the most troubling aspects of Basel II is that a purely historic look at mortgage data might have justified such numbers. We also saw the same kind of aggressive reductions in capital requirements under the advanced approaches for most commercial real estate loans … and for many commercial and industrial loans … with median reductions exceeding 50 percent.

These kinds of results are simply unacceptable. Redefining capital requirements sharply downward in this way under the advanced approaches, risks increasing the fragility of the global banking system.

In response to such criticisms, many argue that supervisory diligence under Pillar 2 will somehow protect against inadequate capital under Pillar 1. More specifically, they say required stress-testing by banks will take care of any capital shortages under Pillar 1.

This brings me to the final risk on my list.

Risk number four: Despite the best of intentions … banks and supervisors may be ill-equipped to mitigate deficiencies in the advanced approaches. If the basic capital standards are unreliable, how can we have confidence that supervisory add-ons will be sufficient or consistent?

To put this in terms of the advanced approaches, neither banks nor regulators know how much stress to build into the capital calculations. This is far more than a technical problem for future research. There are real limitations on our ability to identify important changes in market practices as they are occurring and to think concretely about the implications.

Consider the U.S. sub-prime mortgage market that is having trouble. This market has some uniquely American characteristics, but it's a case study that all nations can learn from. Over the last few years, sub-prime mortgage lending grew dramatically as a percentage of the overall mortgage market. Most of us saw this as a very positive trend. It gave unprecedented access to home ownership and wealth, especially for low-income earners.

What we couldn't see until late in the game was how pervasive … and how quickly … risky lending practices had become. Borrowers with weak credit were offered loans with initial teaser rates that are now resetting at unaffordable higher rates, leaving these borrowers with mortgage obligations as high as 60 percent to 70 percent of income.

Loans were frequently made based on "stated income," without documentation. Many of these loans, some 2 million this year and next, will reset with the potential for widespread foreclosures.

I don't know of anyone in the regulatory community or the ratings agencies who really "connected the dots" on this problem until late last year. Certainly, we all knew sub-prime lending was a growing asset class. We all understood that borrowers were exposed to rising interest rates. And we all knew that home prices would not rise at double-digit rates forever. But it took a long time to see the problem, and now we're scrambling to fix it.

What's the lesson in all this?

If the regulators were behind the curve in discerning the risks in these widely-used and simple mortgage products, how can we expect to fully understand the risks in more complex and dynamic products, such as Collateralized Debt Obligations (CDOs), credit derivatives, and leveraged lending and hedge funds?

I believe the lesson here is that these products and markets pose risks and stresses that may be impossible to quantify. It's easy to assume that banks and supervisors will set a principles-based approach to build an appropriate level of stress into the advanced capital calculations. But I fear that in reality, the lag in identifying and understanding changes in market practices will make this very difficult.

To complicate matters, other incentives could emerge for some banks to boost return on equity, capture business and the like … which could drive stress-calculations the wrong way. The risk, of course, is that if we have an inadequate Pillar 1 capital requirement, supplemented by inadequate consideration of potential stress under Pillar 2, we will end up with inadequately capitalized banks.

Where are we?

So, where does that leave us? Wither Basel II? To be honest and frank, we don't yet know whether Basel II's advanced approaches will work. We don't know whether, or when, the risk inputs will become reliable. We don't know whether the level of minimum capital requirements will be sufficient. And nobody knows how to build enough stress into the capital calculations to address the non-transparent and ever-changing risks that banks are taking.

Given this uncertainty, regulators must proceed with caution. We're public servants, and that's our job. Safeguards against precipitous and open-ended declines in risk-based capital requirements should be removed only when the global framework has proved its capital sufficiency and reliability.

At this time we are still working through these issues in the United States, including whether to allow the standardized approach for all U.S. banks.

Conclusion

We've been at this a long time. But the stakes for our global banking system are very high. Today, our banks are strong and profitable. They are engines for job creation and economic growth. And I'm hopeful that we'll be able to resolve these four risks and move forward with Basel II in a way that assures the future health and stability of the global financial system.

Let there be no doubt. I support moving ahead with the Basel II framework and doing so expeditiously. No one wants this issue resolved more than I do. But I do not see how the FDIC can responsibly agree to remove important safeguards before we have evidence that the advanced approaches will work. That would be akin to trying to put the toothpaste back into the tube.

Thank you."

F.D.I.C. currently has the power to seize depository banks, but does not have similar authority for non-banks, including bank holding companies

TO BE NOTED:

"F.D.I.C. Seeks New Power Over Bank Holding Companies

The Federal Deposit Insurance Corporation is talking with lawmakers about speedy legislation giving it power to wind down troubled bank holding companies, but not a broader range of financial firms, Reuters reported.

The Federal Reserve and U.S. Treasury Department have some disagreement with the F.D.I.C. about exactly what new powers the agency should gain, Reuters said, citing a source speaking anonymously because the meetings have been private.

The F.D.I.C. has been meeting in recent days with lawmakers’ staff, at the request of Congress, about so-called “resolution authority.”

“I think just giving us authority over bank holding companies would be easier… than tackling the larger non-bank systemic institutions,” FDIC Chairman Sheila Bair said after speaking to a National Association of Realtors’ meeting in Washington.

Of her agency’s talks with lawmakers she said: “It’s their call. They seem interested and we’re responding to their questions.”

The F.D.I.C. currently has the power to seize depository banks, but does not have similar authority for non-banks, including bank holding companies such as Citigroup and GMAC, which have both received billions of dollars in government aid.

Treasury Secretary Geithner told Reuters on Friday the government would likely have to provide “substantial” additional capital to GMAC.

The Treasury in March drafted a legislative proposal that names the F.D.I.C. as the resolution authority for a broad range of financial firms, but some members of the administration and bank industry groups have opposed such a plan, saying the F.D.I.C. is not properly equipped for such a large task.

The White House is expected in the next couple weeks to give Congress a plan for comprehensive financial regulatory reform. That proposal is likely to call for the Fed to play a central role in regulating systemic risk in the economy, sources said last week.

The F.D.I.C. is seeking quick passage of a separate piece of legislation for resolution authority, as the broad reform legislation will likely not get passed until close to the end of the year, Reuters said, citing the source.

The more narrow definition of resolution authority would also likely increase the chances the legislation could get passed quickly, as it would calm some concerns the Reuters said, citing the source does not have enough experience to handle complicated companies such as insurer American International Group.

But some lawmakers and administration officials want the resolution authority provision as part of the larger reform legislative package because they believe the systemic risk regulator proposal should dovetail with the authority to wind down large financial firms.

Ms. Bair told a Senate Banking Committee hearing last week that the ability to resolve bank holding companies would give the Reuters said, citing the source “a vital tool.”

She also said the lack of that tool has driven the administration’s policy decisions when dealing with large troubled financial firms.

Another source familiar with the F.D.I.C.’s plans told Reuters on Tuesday that the agency was considering seeking to create a new fund to help deal with any resolution of systemically important financial institutions. ( NB DON )

The source, who asked to remain anonymous because the fund is in the planning stages, told the news service that institutions with over $100 billion in assets could be required to pay into the fund on a regular basis.

The administration has shifted its focus in recent days to financial regulation reform, after the government released last week the results of stress tests on the 19 largest U.S. banks.

The government is driving to tighten regulation of banks and markets to prevent another financial crisis like the one that is currently ravaging economies worldwide.

National Economic Council Director Lawrence Summers, a senior adviser to President Barack Obama, is leading the effort on regulatory restructuring.

The administration hopes the House Financial Services Committee can approve the broad legislative package by July 4, with the goal of final passage by the end of the year."

Sheila Bair confiscated a solvent bank encouraged by lying bankers

TO BE NOTED: From Bronte Capital:

"JP Morgan lied to regulators

I purchased preferred shares in Washington Mutual when it was in distress and lost money when it was confiscated by Sheila Bair. I have argued that it was the most extraordinary action made by government during this crisis and that an essentially solvent bank was confiscated.

In anger I posted my response to the WaMu takeover the day after it happened. I also purchased adwords on Google so that when you google Sheila Bair’s name you will get an advert linking to my blog and explaining why she should resign. It is no secret I dislike Sheila Bair.

Moreover there are law suits (whose basic premise I agree with) that JP Morgan whilst doing due diligence on Washington Mutual was also badmouthing them in the press and encouraging the regulator to take them over. [It is easier to sue JPM than the Federal Government.]

That said – we have a fairly comprehensive proof that JP Morgan did lie to regulators. The only issue is did they lie to regulators when encouraging them to confiscate Washington Mutual or did they lie when they were conducting the stress test? If they lied to Sheila Bair to get them to confiscate WaMu and she believed them then she must resign. But the alternatives I see are worse.

Detailing the JP Morgan lies

First you need to look at the document that JPM released when it took over WaMu.

Here is – with what they think the losses will be in the various stress scenarios.

JP Morgan is predicting $36 billion in losses in WaMu's book in their base case and $54 billion in the "severe recession" case.

These losses are measured since December 31 2007. The losses as estimated in the stress test are from the end of 2008 – and to get the numbers consistent you need to take about 8 billion dollars off these numbers as about 8 billion in losses were realised during 2007.

It already looks like we are in the severe recession. Unemployment is well over 8 percent. On these numbers – numbers that were presented by JP Morgan to the market and to regulators – JPM has to take a further $46 billion in losses on the Washington Mutual book alone. (46=54-8).

Almost all of these losses come from mortgages. Indeed in the presentation JP Morgan made when it merged with Washington Mutual all the losses except about a billion dollars came from the mortgage book.

The only problem is that the losses estimated on mortgages by the regulators (including Sheila Bair) in the stress test include only $39 billion in losses – being 12 percent of the entire mortgage book. Here are the results of the stress test on JPMorgan.

The implication is that there are negative losses in the rest of JP Morgans very large book. This is unlikely.

So we are left with two possibilities both of which involve JP Morgan telling porkys:

1. The losses as estimated by the JP Morgan and told to regulators when they were manipulating Sheila Bair into confiscating Washington Mutual were lies – indeed were so grotesquely over-estimated as to be absurd criminal lies or
   
2. The losses as estimated by JP Morgan and the regulators in the stress test are grotesque under-estimates – which – in order to be that grotesquely wrong had to involve major misrepresentations of their book by JP Morgan.
   

It is possible that both sets of losses were grotesquely mis-estimated - though the differences here are so stark that a simple and honest "bit of both" is not possible.

I prefer the first choice. The losses at WaMu as suggested by JPM never made any sense – and I prefer the idea that – encouraged by JPM’s lying – Sheila Bair confiscated a solvent bank.

The second choice suggests the stress tests were totally phoney and allowed JP Morgan to lie at will. If that is correct the regulators have a duty to confiscate JPMorgan as its embedded losses (using similar ratios as they used in arguing for the Washington Mutual takeover) leave it desperately and diabolically insolvent.

The idea that Sheila Bair confiscated a solvent bank encouraged by lying bankers should not surprise anyone familiar with big-bank lobbying prowess. Most the bears in the blogosphere would prefer believe the stress test was phoney without any real assessemnt of likely losses.

John

Technical accounting note the losses in the stress test page were before 20 billion in purchasing adjustments. Those purchasing adjustments were JPMorgan over-estimating the losses at WaMu so - as the loans come in a little better than expected JPM shows better-than-real earnings.

POST SCRIPTS: The first response I got to this suggests a third possibility - that JP Morgan (and presumably all the other banks) were ASKED to give the regulators the information that they wanted to hear for the stress test - that they were asked to lie. That I suspect stretches reality. It is hard to keep things like that quiet - and also some banks (notably Wells Fargo) are very unhappy.

Posted by John Hempton "

they had assumed Lehman was too big too fail and its creditors would garner government support

TO BE NOTED: From the FDIC:

"Statement of Sheila C. Bair Chairman, Federal Deposit Insurance Corporation on Regulating and Resolving Institutions Considered "Too Big To Fail"; before the Committee on Banking, Housing and Urban Affairs, U.S. Senate; Room 538, Dirksen Senate Office Building
May 6, 2009

Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the need to address the issue of systemic risk and the existence of financial firms that are deemed "too big to fail."

It has been a difficult 18 months since the financial crisis began, but despite some long weekends and tense moments, government and industry have worked together to take extraordinary measures to maintain the stability of our financial system. The FDIC has been working with other federal agencies, Congress, and the White House to protect insured depositors and preserve the stability of our banking system. We have sought input from the public and the financial industry about our programs and how to structure them to produce the best results to turn this crisis around. There are indications that progress is being made in the availability of credit and the profitability of financial institutions. As we move beyond the liquidity crisis of last year, we must examine how we can improve our financial system for the future.

The financial crisis has taught us that many financial organizations have grown in both size and complexity to the point that, should one of them become distressed, it may pose systemic risk to the broader financial system. The managers, directors and supervisors of these firms ultimately placed too much reliance in risk management systems that proved flawed in their operations and assumptions. Meanwhile, the markets have funded these organizations at rates that implied they were simply too big to fail. In addition, the difficulty in supervising these firms was compounded by the lack of an effective mechanism to resolve them when they became troubled in a way that controlled the potential damage their failure could bring to the broader financial system.

In a properly functioning market economy there will be winners and losers, and some firms will become insolvent and should fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market's incentive to monitor the actions of similarly situated firms. Unfortunately, the actions taken during the past crisis have reinforced the idea that some financial organizations are too big to fail. The most important challenge now is to find ways to impose greater market discipline on systemically important financial organizations.

My testimony will examine whether large institutions posing systemic risk are necessary for the efficient functioning of our financial system -- that is, whether they promote or hinder competition and innovation among financial firms. I also will focus on some specific changes that should be undertaken to limit the potential for excessive risk in the system, including identifying systemically important institutions, creating incentives to reduce the size of systemically important firms and ensuring that all portions of the financial system are under some baseline standards to constrain excessive risk taking.

In addition, I will explain why an independent, special failure resolution authority is needed for financial firms that pose systemic risk and describe the essential features of such an authority. Finally, independent of the systemic risk issue, I will discuss the benefits of providing the FDIC with a statutory structure under which we would have authority to resolve a non-systemic failing or failed bank or thrift holding company, and how this authority would improve the ability to effect a least cost resolution for the depository institution or institutions it controls.

Do We Need Financial Firms That Are Too Big to Fail?

Before policymakers can address the issue of "too big to fail", it is important to analyze the fundamental issue of whether there are economic benefits to having institutions that are so large and complex that their failure can result in systemic issues for the economy. Because of their concentration of economic power and interconnections through the financial system, the management and supervision of institutions that are large and complex has proven to be problematic. Unless there are clear benefits to the financial system that offset the risks created by systemically important institutions, taxpayers have a right to question how extensive their exposure should be to such entities.

Over the past two decades, a number of arguments have been advanced about why financial organizations should be allowed to become larger and more complex. These reasons include being able to take advantage of economies of scale and scope, diversifying risk across a broad range of markets and products, and gaining access to global capital markets. It was alleged that the increased size and complexity of these organizations could be effectively managed using new innovations in quantitative risk management techniques. Not only did institutions claim that they could manage these new risks, they also argued that often the combination of diversification and advanced risk management practices would allow them to operate with markedly lower capital buffers than were necessary in smaller, less-sophisticated institutions.

Indeed many of these concepts were inherent in the Basel II Advanced Approaches, resulting in reduced capital requirements. In hindsight, it is now clear that the international regulatory community over-estimated the risk mitigation benefits of diversification and risk management when they set minimum regulatory capital requirements for large, complex financial institutions.

Notwithstanding expectations and industry projections for gains in financial efficiency, the academic evidence suggests that benefits from economies of scale are exhausted at levels far below the size of today's largest financial institutions. Also, efforts designed to realize economies of scope have not lived up to their promise. In some instances, the complex institutional combinations permitted by the Gramm-Leach-Bliley (GLB) Act were unwound because they failed to realize anticipated economies of scope. Studies that assess the benefits produced by increased scale and scope find that most banks could improve their cost efficiency more by concentrating their efforts on improving core operational efficiency.

There also are practical limits on an institution's ability to diversify risk using securitization, structured financial products and derivatives. Over-reliance on financial engineering and model-based hedging strategies increases an institution's exposure to operational, model and counterparty risks.

Clearly, there are benefits to diversification for smaller and less complex institutions, but the ability to diversify risk is diminished as market concentration rises and institutions become larger and more complex. When a financial system includes a small number of very large, complex organizations, the system cannot be well-diversified. As institutions grow in size and importance, they not only take on a risk profile that mirrors the risk of the market and general economic conditions, but they also concentrate risk as they become the only important counterparties to many transactions that facilitate financial intermediation in the economy. These flaws in the diversification argument become apparent in the midst of financial crisis when large, complex financial organizations -- because they are so interconnected -- reveal themselves as a source of risk to the system.

Creating a Safer Financial System

A strong case can be made for creating incentives that reduce the size and complexity of financial institutions as being bigger is not necessarily better. A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions at the right time.

Reliance solely on the supervision of these institutions is not enough. We also need a "fail-safe" system where if any one large institution fails, the system carries on without breaking down. Financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system. In addition, restrictions on leverage and the imposition of risk-based premiums on institutions and their activities would act as disincentives to growth and complexity that raise systemic concerns.

In contrast to the standards implied in the Basel II Accord, systemically important firms should face additional capital charges based on both their size and complexity. To address pro-cyclicality, the capital standards should provide for higher capital buffers that increase during expansions and are drawn down during contractions. In addition, these firms should be subject to higher Prompt Corrective Action (PCA) limits under U.S. laws. Regulators also should take into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet.

One existing example of statutory limitations placed on institutions is the 10 percent nationwide cap on domestic deposits imposed in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. While this regulatory limitation has been somewhat effective in preventing concentration in the U.S. system, the Riegle-Neal constraints have some significant limitations. First, these limits only apply to interstate bank mergers. Also, deposits in savings and loan institutions generally are not counted against legal limits. In addition, the law restricts only domestic deposit concentration and is silent on asset concentration, risk concentration or product concentration. The four largest banking organizations have slightly less than 35 percent of the domestic deposit market, but have over 45 percent of total industry assets.¹ As we have seen, even with these deposit limits, banking organizations have become so large and interconnected that the failure of even one can threaten the financial system.

In addition to establishing disincentives to unchecked growth and increased complexity of institutions, two additional fundamental approaches could reduce the likelihood that an institution will be too big to fail. One action is to create or designate a supervisory framework for regulating systemic risk. Another critical aspect to ending too big to fail is to establish a comprehensive resolution authority for systemically significant financial companies that makes the failure of any systemically important institution both credible and feasible. A realistic resolution regime would send a message that no institution is really too big to ultimately fail.

Regulating Systemic Risk

Our current system has clearly failed in many instances to manage risk properly and to provide stability. While U.S. regulators have broad powers to supervise financial institutions and markets and to limit many of the activities that undermined our financial system, there are significant gaps that led to the current crisis. First, there were gaps in the regulation of specific financial institutions that posed significant systemic risk -- most notably very large insurance companies, private equity and hedge funds, and differences in regulatory leverage standards for commercial and investment banks. Second, there were gaps in the oversight of certain types of risk that cut across many different financial institutions. A prime example of this was the credit default swap (CDS) market which was used to both hedge and leverage risk in the structured mortgage finance market. Both of these aspects of oversight and regulation need to be addressed.

A distinction should be drawn between the direct supervision of systemically-significant financial firms and the macro-prudential oversight of developing risks that may pose systemic risks to the U.S. financial system. The former appropriately calls for a single regulator for the largest, most systemically-significant firms, including large bank holding companies. The macro-prudential oversight of system-wide risks requires the integration of insights from a number of different regulatory perspectives -- banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. As a result, for this latter role, the FDIC would suggest creation of a systemic risk council (SRC) to provide analytical support, develop needed prudential policies, and have the power to mitigate developing risks.

Systemic Risk Regulator

With regard to the regulation of systemically important entities, a systemic risk regulator (SRR) should be responsible for monitoring and regulating their activities. Centralizing the responsibility for supervising institutions that are deemed to be systemically important would bring clarity and focus to the efforts needed to identify and mitigate the buildup of risk at individual institutions. The SRR could focus on the adequacy of complex institutions' risk measurement and management capabilities, including the mathematical models that drive risk management decisions. With a few additions to their existing holding company authority, the Federal Reserve would seem well positioned for this important role.

While the creation of a SRR would be a significant improvement over the current system, risks that resulted in the current crisis grew across the financial system and supervisors were slow to identify them and limited in our ability to address these issues. This underscores the weakness of monitoring systemic risk through the lens of individual financial institutions, and argues for the need to assess emerging risks using a system-wide perspective.

Systemic Risk Council

One way to organize a system-wide regulatory monitoring effort is through the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system. Based on the key roles that they currently play in determining and addressing systemic risk, positions on this council should be held by the U.S. Treasury, the FDIC, the Federal Reserve Board and the Securities and Exchange Commission. It may be appropriate to add other prudential supervisors as well.

The SRC would be responsible for identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards. The standards would be designed to provide incentives to reduce or eliminate potential systemic risks created by the size or complexity of individual entities, concentrations of risk or market practices, and other interconnections between entities and markets.

The SRC could take a more macro perspective and have the authority to overrule or force actions on behalf of other regulatory entities. In order to monitor risk in the financial system, the SRC should also have the authority to demand better information from systemically important entities and to ensure that information is shared more readily.

The creation of a comprehensive systemic risk regulatory regime will not be a panacea. Regulation can only accomplish so much. Once the government formally establishes a systemic risk regulatory regime, market participants may assume that the likelihood of systemic events will be diminished. Market participants may incorrectly discount the possibility of sector-wide disturbances and avoid expending private resources to safeguard their capital positions. They also may arrive at distorted valuations in part because they assume (correctly or incorrectly) that the regulatory regime will reduce the probability of sector-wide losses or other extreme events.

To truly address the risks posed by systemically important institutions, it will be necessary to utilize mechanisms that once again impose market discipline on these institutions and their activities. For this reason, improvements in the supervision of systemically important entities must be coupled with disincentives for growth and complexity, as well as a credible and efficient structure that permits the resolution of these entities if they fail while protecting taxpayers from exposure.

Resolution Authority

The most important challenge in addressing the issue of too big to fail is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible. Creating a resolution regime that applies to any financial institution that becomes a source of systemic risk should be an urgent priority.

The ad-hoc response to the current banking crisis was inevitable because no playbook existed for taking over an entire complex financial organization.( NB DON ) There were important differences in the subsequent outcomes of the Bear Stearns and Lehman Brothers cases, and these difference are due, in part, to issues that arise when large complex financial institutions are subjected to the bankruptcy process. Bankruptcy is a very messy process for financial organizations and, as was demonstrated in the Lehman Brothers case, markets can react badly. Following the Lehman Brothers filing, the commercial paper market stopped functioning and the resulting decrease in liquidity threatened other financial institutions.

One explanation for the freeze in markets was that the Lehman failure shocked investors because, following Bear Stearns, they had assumed Lehman was too big too fail and its creditors would garner government support.( NB DON ) In addition, many feel that the bankruptcy process itself had a destabilizing effect on markets and investor confidence. While the underlying causes of the market disruption that followed the Lehman failure will likely be debated for years to come, both explanations point to the need for a new resolutions scheme for systemically important non-bank financial institutions which will provide clear, consistent rules for all systemically important financial institutions, as well as a mechanism to maintain key systemic functions during an orderly wind down of those institutions.

Under the first explanation, investors found it incredible that the government would allow Lehman, or firms similar to Lehman, to declare bankruptcy. Because the protracted proceedings of a Chapter 11 bankruptcy were not viewed as credible prior to the bankruptcy filing, investors were willing to make "moral hazard" investments in the high-yielding commercial paper of large systemic institutions. Had a credible resolution mechanism been in place prior to the Lehman bankruptcy, investors would not have made these bets, and markets would not have reacted so negatively to the shock of a bankruptcy filing.

Under the second explanation, the legal features of a bankruptcy filing itself triggered asset fire sales and destroyed the liquidity of a large share of claims against Lehman. In this explanation, the liquidity and asset fire sale shock from the Lehman bankruptcy caused a market-wide liquidity shortage.

Under both explanations, we are left with the same conclusion -- that we need to develop a new credible and efficient means for resolving a distressed large complex non-bank institution. When the public interest is at stake, as in the case of systemically important entities, the resolution process should support an orderly unwinding of the institution in a way that protects the broader economic and taxpayer interests, not just private financial interests, and imposes losses on stakeholders in the institution.

Unlike the clearly defined and proven statutory powers that exist for resolving insured depository institutions, the current bankruptcy framework available to resolve large, complex non-bank financial entities and financial holding companies was not designed to protect the stability of the financial system. This is important because, in the current crisis, bank holding companies and large non-bank entities have come to depend on the banks within their organizations as a source of strength. Where previously the holding company may have served as a source of strength to the insured institution, these entities now often rely on a subsidiary depository institution for funding and liquidity, but carry on many systemically important activities outside of the bank that are managed at a holding company level or non-bank affiliate level.

In the case of a bank holding company, whether systemically significant or not, the FDIC has the authority to take control of only the failing bank subsidiary, thereby protecting the insured depositors. However, in some cases, many of the essential services for the bank's operations lie in other portions of the holding company and are left outside of the FDIC's control, making it difficult to operate and resolve the bank. When the bank fails, the holding company and its subsidiaries typically find themselves too operationally and financially unbalanced to continue to fund ongoing commitments. In such a situation, where the holding company structure includes many bank and non-bank subsidiaries, taking control of just the bank is not a practical solution.

While the depository institution could be resolved under existing authorities, the resolution would likely cause the holding company to fail and its activities would then be unwound through the normal corporate bankruptcy process. Putting the holding company through the normal corporate bankruptcy process may create additional instability as claims outside the depository institution become completely illiquid under the current system. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of a large, complex financial institution includes the risk that it will become a systemically important event.

If a bank holding company or non-bank financial holding company is forced into, or chooses to enter, bankruptcy for any reason, the following is likely to occur. In a Chapter 11 bankruptcy, there is an automatic stay on most creditor claims -- with the exception of specified financial contracts (futures and options contracts and certain types of derivatives) that are subject to immediate termination and netting provisions. The automatic stay renders illiquid the entire balance of outstanding creditor claims. There are no alternative funding mechanisms, other than debtor-in-possession financing, available to remedy this problem. On the other hand, the bankrupt's financial market contracts are subject to immediate termination -- and cannot be transferred to another existing institution or a temporary institution, such as a bridge bank. In bankruptcy, without a bridge bank or similar type of option, there is really no practical way to provide continuity for the holding company's or its subsidiaries' operations. Those operations are based principally on financial agreements dependent on market confidence and require continuity through a bridge bank mechanism to allow the type of quick, flexible action needed. The automatic stay and the uncertainties inherent in the judicially-based bankruptcy proceedings further impair the ability to maintain these key functions.. As a result, the current bankruptcy resolution options available -- taking control of the banking subsidiary or a bankruptcy filing of the parent organization -- make the effective resolution of a large, systemically important financial institution, such as a bank holding company, virtually impossible. This has forced the government to improvise actions to address individual situations, making it difficult to address systemic problems in a coordinated manner and raising serious issues of fairness.

Addressing Risks Posed By the Derivatives Markets

One of the major risks demonstrated in the current crisis is the tremendous expansion in the size, concentration, and complexity of the derivatives markets. While these markets perform important risk mitigation functions( NB DON ), financial firms that rely on market funding can see it dry up overnight. If the market decides the firm is weakening, other market participants can demand more and more collateral ( NB DON )to protect their claims. At some point, the firm cannot meet these additional demands and it collapses. In bankruptcy, current law allows market participants to terminate and net out derivatives and sell any pledged collateral to pay off the resulting net claim. During periods of market instability -- such as during the fall of 2008 -- the exercise of these netting and collateral rights can increase systemic risks. At such times, the resulting fire sale of collateral can depress prices, freeze market liquidity as investors pull back, and create risks of collapse for many other firms.

In effect, financial firms are more prone to sudden market runs because of the cycle of increasing collateral demands( NB DON ) before a firm fails and collateral dumping after it fails. Their counterparties have every interest to demand more collateral and sell it as quickly as possible before market prices decline. This can become a self-fulfilling prophecy -- and mimics the depositor runs of the past.( NB DON )

One way to reduce these risks while retaining market discipline is to make derivative counterparties keep some "skin in the game" throughout the cycle. The policy argument for such an approach is even stronger if the firm's failure would expose the taxpayer or a resolution fund to losses. One approach to addressing these risks would be to haircut up to 20 percent of the secured claim for companies with derivatives claims against the failed firm if the taxpayer or a resolution fund is expected to suffer losses. This would ensure that market participants always have an interest in monitoring the financial health of their counterparties. It also would limit the sudden demand for more collateral because the protection could be capped and also help to protect the taxpayer and the resolution fund from losses.

Powers

The new resolution entity should be independent of the institutional regulator. In creating a new resolution regime, we must clearly define roles and responsibilities and guard against creating new conflicts of interest. No single entity should be able to make the determination to resolve a systemically important institution. The resolution entity should be able to initiate action, but the final decision should involve other affected regulators. For example, the current statute requires that decisions to exercise the systemic risk authorities for banks must have the concurrence of several parties. Yet, Congress also gave the FDIC backup supervisory authority, recognizing there might be conflicts between a primary regulator's prudential responsibilities and its willingness to recognize when an institution it supervises needs to be closed. Once the decision to resolve a systemically important institution is made, the resolution entity must have the flexibility to implement this decision in the way that protects the public interest and limits costs.

This new resolution authority should also be designed to limit subsidies to private investors by assisting a troubled institution. If financial assistance outside of the resolution process is granted to systemically important firms, the process should be open, transparent and subject to a system of checks and balances that are similar to the systemic-risk exception to the least-cost test that applies to insured depository institutions. No single government entity should be able to unilaterally trigger a resolution strategy outside the defined parameters of the established resolution process.

Clear guidelines for this process are needed and must be adhered to in order to gain investor confidence and protect public and private interests. First, there should be a clearly defined priority structure for settling claims, depending on the type of firm. Any resolution should be subject to a cost test to minimize any public loss and impose losses according to the established claims priority. Second, the process must allow continuation of any systemically significant operations. Third, the rules that govern the process, and set priorities for the imposition of losses on shareholders and creditors should be clearly articulated and closely adhered to so that the markets can understand the resolution process with predicable outcomes.

The FDIC's authority to act as receiver and to establish a bridge bank to maintain key functions and sell assets offers a good model. A temporary bridge bank allows the government to prevent a disorderly collapse by preserving systemically significant functions. The FDIC has the power to transfer needed contracts to the bridge bank, including the financial market contracts, known as QFCs, which can be crucial to stemming contagion. It enables losses to be imposed on market players who should appropriately bear the risk. It also creates the possibility of multiple bidders for the bank and its assets, which can reduce losses to the receivership.

The FDIC has the authority to terminate contracts upon an insured depository institution's failure, including contracts with senior management whose services are no longer required. Through its repudiation powers, as well as enforcement powers, termination of such management contracts can often be accomplished at little cost to the FDIC. Moreover, when the FDIC establishes a bridge institution, it is able to contract with individuals to serve in senior management positions at the bridge institution subject to the oversight of the FDIC. The new resolution entity should be granted similar statutory authority as in the current resolution of financial institutions.

These additional powers would enable the resolution authority to employ what many have referred to as a "good bank -- bad bank" model in resolving failed systemically significant institutions. Under this scenario, the resolution authority would take over the troubled firm, imposing losses on stockholders and unsecured creditors. Viable portions of the firm would be placed in the good bank, using a structure similar to the FDIC's bridge bank authority. The nonviable or troubled portions of the firms would remain behind in a bad bank and would be unwound or sold over time. Even in the case of creditor claims transferred to the bad bank, these claims could be made partially liquid very quickly using a system of "haircuts" tied to FDIC estimates of potential losses on the disposition of assets.

Who Should Resolve Systemically Significant Entities?

As the only government entity regularly involved in the resolution of financial institutions, the FDIC can testify to what a difficult and contentious business it is. Resolution work involves making hard choices between competing interests with very few good options. It can be delicate work and requires special expertise.

In deciding whether to create a new government entity to resolve systemically important institutions, Congress should recognize that it would be difficult to maintain an expert and motivated workforce when there could be decades between systemic events. The FDIC experienced a similar challenge in the period before the recent crisis when very few banks failed during the years prior to the current crisis. While no existing government agency, including the FDIC, has experience with resolving systemically important entities, probably no agency other than the FDIC currently has the kinds of skill sets necessary to perform resolution activities of this nature.

In determining how to resolve systemically important institutions, Congress should only designate one entity to perform this role. Assigning resolution responsibilities to multiple regulators creates the potential for inconsistent resolution results and arbitrage. While the resolution entity should draw from the expertise and consult closely with other primary regulators, spreading the responsibility beyond a single entity would create inefficiencies in the resolution process. In addition, establishing multiple resolution entities would create significant practical difficulties in the effective administration of an industry funded resolution fund designed to protect taxpayers.

Funding

Obviously, many details of a special resolution authority for systemically significant financial firms would have to be worked out. To be truly credible, a new systemic resolution regime should be funded by fees or assessments charged to systemically important firms. Fees imposed on these firms could be imposed either before failures, to pre-fund a resolution fund, or fees could be assessed after a systemic resolution.

The FDIC would recommend pre-funding the special resolution authority. One approach to doing this would be to establish assessments on systemically significant financial companies that would be placed in a "Financial Companies Resolution Fund" (FCRF). A FCRF would not be funded to provide a guarantee to the creditors of systemically important institutions, but rather to cover the administrative costs of the resolution and the costs of any debtor-in-possession lending that would be necessary to ensure an orderly unwinding of a financial company's affairs. Any administrative costs and/or debtor-in-possession lending that could not be recovered from the estate of the resolved firm would be covered by the FCRF.

The FDIC's experience strongly suggests that there are significant benefits to an industry funded resolution fund. First, and foremost, such a fund reduces taxpayer exposure for the failure of systemically important institutions. The ability to draw on the accumulated reserves of the fund also ensures adequate resources and the credibility of the resolution structure. The taxpayer confidence in the Deposit Insurance Fund (DIF) with regard to the resolution of banks is a direct result of the respect engendered by its funding structure and conservative management.

The FCRF would be funded by financial companies whose size, complexity or interconnections potentially could pose a systemic risk to the financial system at some point in time (perhaps the beginning of each year). Those systemically important firms that have an insured depository subsidiary or other financial entity whose claimants are insured through a federal or state guarantee fund could receive a credit for the amount of their assessment to cover those institutions.

It is anticipated that the number of companies covered by the FCRF would be fluid, changing periodically depending upon the activities of the company and the market's ability to develop mechanisms to ameliorate systemic risk. Theoretically, as companies fall below the threshold for being potentially systemically important, they would no longer be assessed for coverage by the FCRF. Similarly, as companies undertake activities or provide products/services that make them potentially more systemically important, they would fall under the purview of the FCRF and be subject to assessment.

Assessing institutions based on the risk they pose to the financial systems serves two important purposes. A strong resolution fund ensures that resolving systemically important institutions is a credible option which enhances market discipline. At the same time, risk-based assessments are an important tool to affect the behavior of these institutions. Assessments could be imposed on a sliding scale based on the increasing level of systemic risk posed by an entity's size or complexity.

Resolution of Non-Systemic Holding Companies

Separate and apart from establishing a resolution structure to handle systemically important institutions, the ability to resolve non-systemic bank failures would be greatly enhanced if Congress provided the FDIC the authority to resolve bank and thrift holding companies affiliated with a failed institution. The corporate structure of bank and thrift holding companies, with their insured depositories and other subsidiaries, has become increasingly complex and inter-reliant. The insured depository is likely to be dependent on affiliates that are subsidiaries of its holding company for critical services, such as loan and deposit processing, loan servicing, auditing, risk management and wealth management. Moreover, in many cases the non-bank affiliates themselves are dependent on the bank for their continued viability. It is not unusual for many business lines of these corporate enterprises to be conducted in both insured and non-insured affiliates without regard to the confines of a particular entity. Examples of such multi-entity operations often include retail and mortgage banking and capital markets.

Atop this network of corporate relationships, the holding company exercises critical control of its subsidiaries and their mutually dependent business activities. The bank may be so dependent on its holding company that it literally cannot operate without holding company cooperation. The most egregious example of this problem emerged with the failure of NextBank in northern California in 2002. When the bank was closed, the FDIC ascertained that virtually the entire infrastructure of the bank was controlled by the holding company. All of the bank personnel were holding company employees and all of the premises used by the bank were owned by the holding company. Moreover, NextBank was heavily involved in credit card securitizations and the holding company threatened to file for bankruptcy, a strategy that would have significantly impaired the value of the bank and the securitizations. To avert this adverse impact on the DIF, the FDIC was forced to expend significant funds to avoid the bankruptcy filing.

As long as the threats exists that a bank or thrift holding company can file for bankruptcy, as well as affect the business relationships between its bank and other subsidiaries, the FDIC faces great difficulty in effectuating a resolution strategy that preserves the franchise value of the failed bank and so protects the DIF. Bankruptcy proceedings, involving the parent or affiliate of a bank, are time-consuming, unwieldy, and expensive. The FDIC as receiver or conservator occupies a position no better than any other creditor and so lacks the ability to protect the receivership estate and the DIF. The threat of bankruptcy by the BHC or its affiliates is such that the Corporation may be forced to expend considerable sums propping up the holding company or entering into disadvantageous transactions with the holding company or its subsidiaries in order to proceed with a bank's resolution. The difficulties are particularly egregious where the Corporation has established a bridge bank to preserve franchise value, protect creditors (including uninsured depositors), and facilitate disposition of the failed institution's assets and liabilities. By giving the FDIC authority to resolve a failing or failed bank's holding company, Congress would provide the FDIC with a vital tool to deal with the increasingly complicated and highly symbiotic business structures in which banks operate in order to develop an efficient and economical resolution.

The purpose of the authority to resolve non-systemic holding companies would be to achieve the least cost resolution of a failed insured depository institution. It would be used to reduce costs to the DIF through a more orderly and comprehensive resolution of the entire financial entity. If the current bifurcated resolution structure involving resolution of the insured institution by the FDIC and bankruptcy for the holding company would produce the least costly resolution, the FDIC should retain the ability to use that structure as well. Enhanced authorities that allow the FDIC to efficiently resolve failed depository institutions that are part of a complex holding company structure will provide immediate efficiencies in bank resolutions result in reduced losses to the DIF and not require any additional funding.

Conclusion

The current financial crisis demonstrates the need for changes in the supervision and resolution of financial institutions, especially changes relative to large, complex organizations that are systemically important to the financial system. The choices facing Congress in this task are complex, made more so by the fact that we are trying to address problems while dealing with one of the greatest economic challenges we've seen in decades. While the need for some reforms is obvious, such as a legal framework for resolving systemically important institutions, others are less clear and we would encourage a thoughtful, deliberative approach. The FDIC stands ready to work with Congress to ensure that the appropriate steps are taken to strengthen our supervision and regulation of all financial institutions -- especially those that pose a systemic risk to the financial system.

I would be pleased to answer any questions from the Committee."