THOMAS HOENIG'S STATEMENT ON BASEL III AND FINANCIAL STABILITY

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 
Statement by Thomas Hoenig: Basel III Capital Interim Final Rule and Notice of Proposed Rulemaking

I wish to thank the many individuals from the U.S. and international communities involved in the Basel process for their efforts to improve the capital standard: its definition, measures of risk, and levels of protection. I am particularly aware that our FDIC staff shared a heavy burden in the work, and they deserve our thanks.

Despite this impressive effort, I am able to support only one of the two proposals before us today.

It is often suggested that Basel III provides more and better capital than earlier versions of the Basel standards. However, this is not a worthy standard of comparison given Basel II's contribution to the last crisis. To compare nearly any standard to Basel II will show improvement.

I support more and better capital; however, the Basel III standard without a binding leverage constraint remains inadequate to the task of assuring the American public, who paid a high price for the financial crisis, that our capital standards are adequate to contribute to financial stability. A capital standard, to be useful, must be understandable and enforceable and must be sufficient to absorb unexpected loss. Unfortunately, the Basel III interim final rule, as proposed, fails to fully meet these criteria.

The interim final rule continues the disparity in capital requirements between and among banks, and affects operational and competitive positions within the financial industry. This disparity has been confirmed as recently as last week in a study released by the Basel Committee.

While Basel III strengthens the definition of capital, its primary reliance on a risk-weighted asset standard employs the same techniques as Basel II with ratios that remain unduly complex, difficult to compute and requiring a vast number of calculations just begging to be gamed. This result is well illustrated when considering that the percentage of risk-weighted assets to total assets for the world's largest banks has systematically declined almost since the introduction of the Basel standards. The result has been confusion instead of clarity among the public and among bank directors who have a responsibility to oversee these firms.

The supervisory world has been made aware through a growing body of research that risk-weighted capital measures correlate poorly with actual future losses, reflecting the reality that complexity does not assure predictability nor enable individuals to know in advance how risks will shift among assets. Despite these flaws, the interim final rule continues to rely on risk-based measures, ignoring the usefulness of the leverage ratio to constrain excess risk taking for the largest, most complex institutions.

To that point, Basel III provides for a 3 percent supplemental leverage ratio applicable to advanced approach firms. This ratio measures capital against total assets and a portion of off-balance sheet exposures. It is important to know that just prior to the crisis these firms held tangible capital averaging just under 3 percent of assets, an amount that proved woefully inadequate. That a 3 percent leverage ratio is too low was appropriately noted by the Board of Governors during its July 2 discussions of this topic.

Also, a wide variety of studies and data accumulated during the comment period provide further evidence of the significant contribution that a stronger leverage ratio would bring to these firms' balance sheets. Thus, failure to include an adequate leverage ratio in the interim final rule leaves a gaping hole in the Basel III standard that has been pointed out to policymakers for months.

Moreover, nothing is accomplished by acting now and failing to wait an extra 60 or 90 days to receive comment and then implement a complete rule with a stronger leverage ratio. All of the largest, most complex U.S. firms currently meet the requirements of the interim final rule. It does nothing in the interim to strengthen the balance sheets of U.S. banks. Thus, by separating the implementation of Basel III from the supplemental leverage ratio proposal, we gain little and risk a stronger leverage ratio being delayed, or worse, not being adopted.

In summary, I support the FDIC's leadership in proposing to raise the supplemental leverage ratio for the eight largest financial holding companies in the U.S. to 6 percent for the banks and 5 percent for the holding company. I also would encourage comment on whether these capital levels are sufficient. I cannot support the interim final rule because without a binding leverage ratio, it is incomplete and inadequate. You cannot have a strong capital standard without an adequate leverage ratio, and it should be part of any rule we adopt, even on an interim basis.

Finally, I have voiced my concerns with the inadequacies of Basel III and have advocated for a stronger leverage ratio over the past year in hopes of creating a capital program that serves the broader economy. My divided vote today signals my continued concern for what is left undone. I remain fully committed to engaging with my colleagues to strengthen U.S. capital standards and to ensure that promised improvements are realized.

FDIC CHAIRMAN GRUENBERG GIVES STATEMENT ON MITIGATING SYSTEMIC RISK THROUGH REFORM

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 

Statement Of Martin J. Gruenberg, Chairman, Federal Deposit Insurance Corporation on Mitigating Systemic Risk Through Wall Street Reform before the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate; 538 Dirksen Senate Office Building

July 11, 2013 

Chairman Johnson, Ranking Member Crapo and members of the Committee, thank you for the opportunity to testify today on the Federal Deposit Insurance Corporation's (FDIC) actions to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

With the three-year anniversary of the Dodd-Frank Act approaching, the FDIC has made significant progress in implementing the new authorities granted by the Act, 1 particularly with regard to the authorities to address the issues presented by institutions that pose a risk to the financial system. We also have moved forward in our efforts to strengthen the Deposit Insurance Fund and to improve the resiliency of the capital framework for the banking industry.

My written testimony will address three key areas. First, I will provide a brief overview of the current state of the banking industry and the federal deposit insurance system. Second, I will provide an update on our progress in implementing the new authority provided to the FDIC to address the issues posed by systemically important financial institutions. Finally, I will discuss the Act’s impact on our supervision of community banks.

Overview of the Banking Industry

The financial condition of the banking industry in the United States has experienced three consecutive years of gradual but steady improvement. Industry balance sheets have been strengthened and capital and liquidity ratios have been greatly improved.

Industry net income has now increased on a year-over-year basis for 15 consecutive quarters. FDIC-insured commercial banks and savings institutions reported aggregate net income of $40.3 billion in the first quarter of 2013, a $5.5 billion (15.8 percent) increase from the $34.8 billion in profits that the industry reported in the first quarter of 2012. Half of the 7,019 FDIC-insured institutions reporting financial results had year-over-year increases in their earnings. The proportion of banks that were unprofitable fell to 8.4 percent, down from 10.6 percent a year earlier.

Credit quality for the industry also has improved for 12 consecutive quarters. Delinquent loans and charge-offs have been steadily declining for over two years. Importantly, loan balances for the industry as a whole have now grown for six out of the last eight quarters. These positive trends have been broadly shared across the industry, among large institutions, mid-size institutions, and community banks.

The internal indicators for the FDIC also have been moving in a positive direction over this period. The number of banks on the FDIC's "Problem List" – institutions that had our lowest supervisory CAMELS ratings of 4 or 5 – peaked in March of 2011 at 888 institutions. By the end of last year, the number of problem banks stood at 651 institutions, dropping further to 612 institutions at the end of the first quarter 2013. In addition, the number of failed banks has been steadily declining. Bank failures peaked at 157 in 2010, followed by 92 in 2011, and 51 in 2012. To date in 2013, there have been 16 bank failures compared to 31 through the same period in 2012.

Despite these positive trends, the banking industry still faces a number of challenges. For example, although credit quality has been improving, delinquent loans and charge-offs remain at historically high levels. In addition, tighter net interest margins and relatively modest loan growth have created incentives for institutions to reach for yield in their loan and investment portfolios, heightening their vulnerability to interest rate risk and credit risk. Rising rates could heighten pressure on earnings at financial institutions that are not actively managing these risks. The federal banking agencies have reiterated their expectation that banks manage their interest rate risk in a prudent manner, and supervisors continue to actively monitor this risk.

Condition of the FDIC Deposit Insurance Fund

As the industry has recovered over the past three years, the Deposit Insurance Fund (DIF) also has moved into a stronger financial position.

Restoring the DIF

The Dodd-Frank Act raised the minimum reserve ratio for the DIF (the DIF balance as a percent of estimated insured deposits) from 1.15 percent to 1.35 percent, and required that the reserve ratio reach 1.35 percent by September 30, 2020. The FDIC is currently operating under a DIF Restoration Plan that is designed to meet this deadline, and the DIF reserve ratio is recovering at a pace that remains on track under the Plan. As of March 31, 2013, the DIF reserve ratio stood at 0.59 percent of estimated insured deposits, up from 0.44 percent at year-end 2012 and 0.22 percent at March 31 of last year. Most of the first quarter 2013 increase in the reserve ratio can be attributed to the expiration of temporary unlimited deposit insurance coverage for noninterest-bearing transaction accounts under the Act on December 31, 2012

The fund balance has grown for thirteen consecutive quarters and stood at $35.7 billion at March 31, 2013. This is in contrast to the negative $21 billion fund balance at its low point at the end of 2009. Assessment revenue and fewer anticipated bank failures have been the primary drivers of the growth in the DIF balance.

Prepaid Assessments

At the end of 2009, banks prepaid to the FDIC more than three years of estimated deposit insurance assessments, totaling $45.7 billion. The prepaid assessments were successful in ensuring that the DIF had adequate liquidity to handle a high volume of bank failures without having to borrow from the Treasury. In accordance with the regulation implementing the prepaid assessment, the FDIC refunded almost $6 billion in remaining unused balances of prepaid assessments to approximately 6,000 insured institutions at the end of June.

Improving Financial Stability and Mitigating Systemic Risk

Capital Requirements

On July 9, the FDIC Board acted on two important regulatory capital rulemakings. First, the FDIC issued an interim final rule that significantly revises and strengthens risk-based capital regulations through implementation of Basel III. This rule consolidates the proposals issued in the three separate notices of proposed rulemakings (NPRs) that the agencies issued last year and includes significant changes from the original proposals to address concerns raised by community banks. Second, the FDIC issued a joint interagency NPR to strengthen the leverage requirements for systemically important banking organizations.

Interim Final Rule on Basel III

The interim final rule on Basel III would strengthen both the quality and quantity of risk-based capital for all banks by placing greater emphasis on Tier 1 common equity capital. Tier 1 common equity capital is widely recognized as the most loss-absorbing form of capital. The interim final rule adopts with revisions the three notices of proposed rulemakings or NPRs that the banking agencies proposed last year. These are the Basel III NPR, the Basel III advanced approaches NPR, and the so-called Standardized Approach NPR. These changes will create a stronger, more resilient industry better able to withstand environments of economic stress in the future.

This interim final rule is identical in substance to the final rules issued by the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC) and allows the FDIC to proceed with the implementation of these revised capital regulations in concert with our fellow regulators. Issuing the interim final rule also allows us to seek comment on the interactions between the revised risk-based capital regulations and the proposed strengthening of the leverage requirements for the largest and most systemically important banking organizations which is described in more detail below.

During the comment period on these proposals, we received a large number of comments, particularly from community banks, expressing concerns with some of the provisions of the NPRs. The interim final rule makes significant changes to aspects of the NPRs to address a number of these community bank comments. Specifically, unlike the NPR, the rule does not make any changes to the current risk-weighting approach for residential mortgages. It allows for an opt-out from the regulatory capital recognition of accumulated other comprehensive income, or AOCI, except for large banking organizations that are subject to the advanced approaches requirements. Further, the rule reflects that the Federal Reserve has adopted the grandfathering provisions of section 171 of the Dodd Frank Act for Trust Preferred Securities issued by smaller bank holding companies. Comments received on all these matters were extremely helpful to the agencies in reaching decisions on the proposals.

The interim final rule includes requirements for large banking organizations subject to the advanced approaches requirements that do not apply to community banks. For example, these advanced approach large institutions would be required to recognize AOCI in regulatory capital and also would face strengthened capital requirements for over-the-counter derivatives.

Consistent with the Basel III international agreement, the interim final rule includes a three percent supplementary leverage ratio that applies only to the 16 large banking organizations subject to the advanced approaches requirements. This supplementary leverage ratio is more stringent than the existing U.S. leverage ratio as it would include certain off-balance sheet exposures in its denominator. Given the extensive off-balance sheet activities of many advanced approaches organizations, the supplementary leverage ratio will play an important role. Finally, the rule maintains the existing U.S. leverage requirements for all insured banks, with the minimum leverage requirements continuing to set a floor for the leverage requirements of advanced approaches banking organizations.

Although the new requirements are higher and more stringent than the old requirements, the vast majority of banks meet the requirements of the interim final rule. Going forward, the rule would have the effect of preserving and maintaining the gains in capital strength the industry has achieved in recent years. As a result, banks should be better positioned to withstand periods of economic stress and serve as a source of credit to local communities.

While much contained in these rules does not apply to community banks, we want to be certain that community banks fully understand the changes in the capital rules that do apply to them. To that end, the FDIC is planning an extensive outreach program to assist community banks in understanding the interim final rule and the changes it makes to the existing capital requirements. We will provide technical assistance in a variety of forms, targeted specifically at community banks, including community bank guides on compliance with the rule, a video that will be available on the FDIC website, a series of regional outreach meetings, and subject matter experts at each of our regional offices whom banks can contact directly with questions.

Interagency NPR on the Supplementary Leverage Ratio

The FDIC joined the Federal Reserve and the OCC in issuing an NPR which would strengthen the supplementary leverage requirements encompassed in the interim final rule for certain large institutions and their insured banks. Using the NPR’s proposed definitions of $700 billion in total consolidated assets or $10 trillion in assets under custody to identify large systemically significant firms, the new requirements would currently apply to eight U.S. bank holding companies and to their insured banks.

As the NPR points out, maintenance of a strong base of capital at the largest, most systemically important institutions is particularly important because capital shortfalls at these institutions can contribute to systemic distress and can have material adverse economy effects. Analysis by the agencies suggests that a three percent minimum supplementary leverage ratio would not have appreciably mitigated the growth in leverage among these organizations in the years preceding the recent crisis. Higher capital standards for these institutions would place additional private capital at risk before calling upon the DIF and the Federal government’s resolution mechanisms.

The NPR would require these insured banks to satisfy a six percent supplementary leverage ratio to be considered well capitalized for prompt corrective action (PCA) purposes. Based on current supervisory estimates of the off-balance sheet exposures of these banks, this would correspond to roughly an 8.6 percent U.S. leverage requirement. For the eight affected banks, this would currently represent $89 billion in additional capital for an insured bank to be considered well-capitalized.

Bank Holding Companies (BHCs) covered by the NPR would need to maintain supplementary leverage ratios of a three percent minimum plus a two percent buffer for a five percent requirement in order to avoid conservation buffer restrictions on capital distributions and executive compensation. This corresponds to roughly a 7.2 percent U.S. leverage ratio, which would currently require $63 billion in additional capital.

An important consideration in calibrating the proposal was the idea that the increase in stringency of the leverage requirements and the risk-based requirements should be balanced. Leverage capital requirements and risk-based capital requirements are complementary, with each type of requirement offsetting potential weaknesses of the other. Balancing the increase in stringency of the two types of capital requirement should make for a stronger and sounder capital base for the U.S. banking system.

Resolution of Systemically Important Financial Institutions

In addition to these capital proposals, the FDIC has made progress on policies and strategies to build a more effective resolution framework for large, complex financial institutions. One of the most important aspects of the Dodd-Frank Act is the establishment of new authorities for regulators to use in the event of the failure of a systemically important financial institution (SIFI).

Resolution Plans – “Living Wills”

Under the framework of the Dodd-Frank Act, bankruptcy is the preferred option in the event of the failure of a SIFI. To make this objective achievable, Title I of the Dodd-Frank Act requires that all bank holding companies with total consolidated assets of $50 billion or more, and nonbank financial companies that the Financial Stability Oversight Council (FSOC) determines could pose a threat to the financial stability of the United States, prepare resolution plans, or “living wills,” to demonstrate how the company could be resolved in a rapid and orderly manner under the Bankruptcy Code in the event of the company’s financial distress or failure. The living will process is an important new tool to enhance the resolvability of large financial institutions through the bankruptcy process.

The FDIC and the Federal Reserve Board issued a joint rule to implement Section 165(d) requirements for resolution plans (the 165(d) rule) in November 2011. The FDIC also issued a separate rule which requires all insured depository institutions (IDIs) with greater than $50 billion in assets to submit resolution plans to the FDIC for their orderly resolution through the FDIC’s traditional resolution powers under the Federal Deposit Insurance Act (FDI Act). The 165(d) rule and the IDI resolution plan rule are designed to work in tandem by covering the full range of business lines, legal entities and capital-structure combinations within a large financial firm.

The FDIC and the Federal Reserve review the 165(d) plans and may jointly find that a plan is not credible or would not facilitate an orderly resolution under the Bankruptcy Code. If a plan is found to be deficient and adequate revisions are not made, the FDIC and the Federal Reserve may jointly impose more stringent capital, leverage, or liquidity requirements, or restrictions on growth, activities, or operations of the company, including its subsidiaries. If compliance is not achieved within two years, the FDIC and the Federal Reserve, in consultation with the FSOC, can order the company to divest assets or operations to facilitate an orderly resolution under bankruptcy in the event of failure. A SIFI’s plan for resolution under bankruptcy also will support the FDIC’s planning for the exercise of its Title II resolution powers by providing the FDIC with a better understanding of each SIFI’s structure, complexity, and processes.

2013 Guidance on Living Wills

Eleven large, complex financial companies submitted initial 165(d) plans in 2012. Following the review of the initial resolution plans, the agencies developed Guidance for the firms to detail what information should be included in their 2013 resolution plan submissions. The agencies identified an initial set of significant obstacles to rapid and orderly resolution which covered companies are expected to address in the plans, including the actions or steps the company has taken or proposes to take to remediate or otherwise mitigate each obstacle and a timeline for any proposed actions. The agencies extended the filing date to October 1, 2013, to give the firms additional time to develop resolution plan submissions that address the instructions in the Guidance.

Resolution plans submitted in 2013 will be subject to informational completeness reviews and reviews for resolvability under the Bankruptcy Code. The agencies will be looking at how each resolution plan addresses a set of benchmarks outlined in the Guidance which pose the key impediments to an orderly resolution. The benchmarks are as follows:

Multiple Competing Insolvencies: Multiple jurisdictions, with the possibility of different insolvency frameworks, raise the risk of discontinuity of critical operations and uncertain outcomes.
Global Cooperation: The risk that lack of cooperation could lead to ring-fencing of assets or other outcomes that could exacerbate financial instability in the United States and/or loss of franchise value, as well as uncertainty in the markets.
Operations and Interconnectedness. The risk that services provided by an affiliate or third party might be interrupted, or access to payment and clearing capabilities might be lost;
Counterparty Actions. The risk that counterparty actions may create operational challenges for the company, leading to systemic market disruption or financial instability in the United States; and
Funding and Liquidity. The risk of insufficient liquidity to maintain critical operations arising from increased margin requirements, acceleration, termination, inability to roll over short term borrowings, default interest rate obligations, loss of access to alternative sources of credit, and/or additional expenses of restructuring.
As reflected in the Dodd-Frank Act and discussed above, the preferred option for resolution of a large failed financial firm is for the firm to file for bankruptcy just as any failed private company would. In certain circumstances, however, resolution under the Bankruptcy Code may result in serious adverse effects on financial stability in the United States. In such cases, the Orderly Liquidation Authority set out in Title II of the Dodd-Frank Act serves as the last resort alternative and could be invoked pursuant to the statutorily prescribed recommendation, determination and expedited judicial review process.

Orderly Liquidation Authority

Prior to the recent crisis, the FDIC’s receivership authorities were limited to federally insured banks and thrift institutions. The lack of authority to place the holding company or affiliates of an insured depository institution or any other non-bank financial company into an FDIC receivership to avoid systemic consequences severely constrained the ability to resolve a SIFI. Orderly Liquidation Authority provided under Title II of the Dodd-Frank Act gives the FDIC the powers necessary to resolve a failing systemic non-bank financial company in an orderly manner that imposes accountability on shareholders, creditors and management of the failed company while mitigating systemic risk and imposing no cost on taxpayers.

The FDIC has largely completed the core rulemakings necessary to carry out its systemic resolution responsibilities under Title II of the Dodd-Frank Act. For example, the FDIC approved a final rule implementing the Orderly Liquidation Authority that addressed, among other things, the priority of claims and the treatment of similarly situated creditors.

Under the Dodd-Frank Act, key findings and recommendations must be made before the Orderly Liquidation Authority can be considered as an option. These include a determination that the financial company is in default or danger of default, that failure of the financial company and its resolution under applicable Federal or State law, including bankruptcy, would have serious adverse effects on financial stability in the United States and that no viable private sector alternative is available to prevent the default of the financial company.

To implement its authority under Title II of the Dodd-Frank Act, the FDIC has developed a strategic approach to resolving a SIFI which is referred to as Single Point-of-Entry. In a Single Point-of-Entry resolution, the FDIC would be appointed as receiver of the top-tier parent holding company of the financial group following the company’s failure and the completion of the recommendation, determination and expedited judicial review process set forth in Title II of the Act. Shareholders would be wiped out, unsecured debt holders would have their claims written down to reflect any losses that shareholders cannot cover, and culpable senior management would be replaced. Under the Act, officers and directors responsible for the failure cannot be retained.

During the resolution process, restructuring measures would be taken to address the problems that led to the company’s failure. These could include shrinking businesses, breaking them into smaller entities, and/or liquidating certain assets or closing certain operations. The FDIC also would likely require the restructuring of the firm into one or more smaller non-systemic firms that could be resolved under bankruptcy.

The FDIC would organize a bridge financial company into which the FDIC would transfer assets from the receivership estate, including the failed holding company’s investments in and loans to subsidiaries. Equity, subordinated debt, and senior unsecured debt of the failed company would likely remain in the receivership and be converted into claims. Losses would be apportioned to the claims of former equity holders and unsecured creditors according to their order of statutory priority. Remaining claims would be converted, in part, into equity that will serve to capitalize the new operations, or into new debt instruments. This newly formed bridge financial company would continue to operate the systemically important functions of the failed financial company, thereby minimizing disruptions to the financial system and the risk of spillover effects to counterparties.

The healthy subsidiaries of the financial company would remain open and operating, allowing them to continue business and avoid the disruption that would likely accompany their closings. Critical operations for the financial system would be maintained. However, creditors at the subsidiary level should not assume that they avoid risk of loss. For example, if the losses at the financial company are so large that the holding company’s shareholders and creditors cannot absorb them, then the subsidiaries with the greatest losses would have to be placed into resolution, thus exposing those subsidiary creditors to loss.

The FDIC expects the well-capitalized bridge financial company and its subsidiaries to borrow in the private markets and from customary sources of liquidity. The new resolution authority under the Dodd- Frank Act provides a back-up source for liquidity support, the Orderly Liquidation Fund (OLF). If it is needed at all, the FDIC anticipates that this liquidity facility would only be required during the initial stage of the resolution process, until private funding sources can be arranged or accessed. The law expressly prohibits taxpayer losses from the use of Title II authority.

In our view, the Single Point-of-Entry strategy holds the best promise of achieving Title II’s goals of holding shareholders, creditors and management of the failed firm accountable for the company’s losses and maintaining financial stability at no cost to taxpayers.

Statement of Policy

Informing capital markets, financial institutions, and the public on what to expect if the Orderly Liquidation Authority were to be invoked is an ongoing effort. While the FDIC has already been highly transparent in our planning efforts, we also are currently working on a Statement of Policy which would provide more clarity on the resolution process. We anticipate the release of a proposal for public comment before the end of the year.

In addition, the Federal Reserve, in consultation with the FDIC, is considering the merits of a regulatory requirement that the largest, most complex U.S. banking firms maintain a minimum amount of unsecured debt at the holding company level. Such a requirement would ensure that there are creditors at the holding company level to absorb losses at the failed firm. Questions surrounding a debt requirement are complex and include issues on the amount, seniority structure, and its relation to equity capital.

Cross-border Issues

Advance planning and cross border coordination for the resolution of globally active, systemically important financial institutions (G-SIFIs) will be critical to minimizing disruptions to global financial markets. Recognizing that G-SIFIs create complex international legal and operational concerns, the FDIC is actively reaching out to foreign host regulators to establish frameworks for effective cross-border cooperation and the basis for confidential information-sharing, among other initiatives.

As part of our bilateral efforts, the FDIC and the Bank of England, in conjunction with the prudential regulators in our respective jurisdictions, have been working to develop contingency plans for the failure of G-SIFIs that have operations in both the U.S. and the U.K. Of the 28 G-SIFIs designated by the Financial Stability Board (FSB) of the G-20 countries, four are headquartered in the U.K, and another eight are headquartered in the U.S. Moreover, approximately 70 percent of the reported foreign activities of the eight U.S. G-SIFIs emanates from the U.K. The magnitude of these financial relationships makes the U.S.-U.K. bilateral relationship by far the most significant with regard to the resolution of G-SIFIs. As a result, our two countries have a strong mutual interest in ensuring that, if such an institution should fail, it can be resolved at no cost to taxpayers and without placing the financial system at risk. The FDIC and U.K authorities released a joint paper on resolution strategies in December 2012, reflecting the close working relationship between the two authorities. This joint paper focuses on the application of “top-down” resolution strategies for a U.S. or a U.K. financial group in a cross-border context and addresses several common considerations to these resolution strategies.

In addition to the close working relationship with the U.K., the FDIC is coordinating with representatives from other European regulatory bodies to discuss issues of mutual interest including the resolution of European G-SIFIs. The FDIC and the European Commission (E.C.) have established a joint Working Group comprised of senior executives from the FDIC and the E.C. The Working Group convenes formally twice a year -- once in Washington, once in Brussels -- with on-going collaboration continuing in between the formal sessions. The first of these formal meetings took place in February 2013. Among the topics discussed at this meeting was the E.C.’s proposed Recovery and Resolution Directive, which would establish a framework for dealing with failed and failing financial institutions. The overall authorities outlined in that document have a number of parallels to the SIFI resolution authorities provided here in the U.S. under the Dodd-Frank Act. The next meeting of the Working Group will take place in Brussels later this year.

The FDIC also is engaging with Switzerland, Germany, Japan, and Canada on a bilateral basis. Among other things, the FDIC has further developed its understanding of the Swiss resolution regime for G-SIFIs, including an in-depth examination of the two Swiss-based G-SIFIs with significant operations in the U.S. During the past year, we also have participated in several productive workshops with the Federal Financial Supervisory Authority (BaFin), the German resolution authority. The FDIC anticipates a principals-level meeting with Japan later this year.

To place these working relationships in perspective, the U.S., the U.K., the European Union, Switzerland and Japan account for the home jurisdictions of 27 of the 28 G-SIFIs designated by the Financial Stability Board (FSB) of the G-20 in November 2012. Progress in these cross-border relationships is thus critical to addressing the international dimension of SIFI resolutions.

The Volcker Rule

The Dodd-Frank Act requires the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), and the federal banking agencies to adopt regulations generally prohibiting proprietary trading and certain acquisitions of interest in hedge funds or private equity funds. The FDIC, jointly with the FRB, OCC, and SEC, published an NPR requesting public comment on a proposed regulation implementing the prohibition against proprietary trading. The CFTC separately approved the issuance of its NPR to implement the Volcker Rule, with a substantially identical proposed rule text.

The proposed rule also requires banking entities with significant covered trading activities to furnish periodic reports with quantitative measurements designed to help differentiate permitted market-making-related activities from prohibited proprietary trading. Under the proposed rule, these requirements contain important exclusions for banking organizations with trading assets and liabilities less than $1 billion, and reduced reporting requirements for organizations with trading assets and liabilities of less than $5 billion. These thresholds are designed to reduce the burden on smaller, less complex banking entities, which generally engage in limited market-making and other trading activities.

The agencies are evaluating a large body of comments on whether the proposed rule represents a balanced and effective approach or whether alternative approaches exist that would provide greater benefits or implement the statutory requirements with fewer costs. The FDIC is committed to developing a final rule that meets the objectives of the statute while preserving the ability of banking entities to perform important underwriting and market-making functions, including the ability to effectively carry out these functions in less-liquid markets. Most community banks do not engage in activities that would be impacted by the proposed rule.

The Dodd-Frank Act and Community Banks

While the Dodd-Frank Act has changed the regulatory framework for the financial services industry, many of the Act’s reforms are geared toward larger institutions, as discussed above. At the same time, the Act included a number of provisions that impacted community banks. Of particular relevance to the FDIC, the Act made changes to the deposit insurance system that have specific consequences for community banks.

In the aftermath of the crisis, the Dodd-Frank Act made permanent the increase in the coverage limit to $250,000, a provision generally viewed by community banks as a helpful means to attract deposits.

The FDIC also implemented the Dodd-Frank Act requirement to redefine the base used for deposit insurance assessments as average consolidated total assets minus average tangible equity. As Congress intended, the change in the assessment base shifted some of the overall assessment burden from community banks to the largest institutions, which rely less on domestic deposits for their funding than do smaller institutions. The result was a sharing of the assessment burden that better reflects each group's share of industry assets. Aggregate premiums paid by institutions with less than $10 billion in assets declined by approximately one-third in the second quarter of 2011, primarily due to the assessment base change.

In the aftermath of the financial crisis and recession, as well as the enactment of the Dodd-Frank Act, many community banks had concerns about their continued viability in the U.S. financial system. Prompted by that concern, the FDIC initiated a comprehensive review of the U.S. community banking sector covering 27 years of data and released the FDIC Community Banking Study in December 2012.

Our research confirms the crucial role that community banks play in the U.S. financial system. As defined by the Study, community banks represented 95 percent of all U.S. banking organizations in 2011. These institutions accounted for just 14 percent of the U.S. banking assets, but held 46 percent of all the small loans to businesses and farms made by FDIC-insured institutions. While their share of total deposits has declined over time, community banks still hold the majority of bank deposits in rural and micropolitan counties. 2 The Study showed that in 629 U.S. counties (or almost one-fifth of all U.S. counties), the only banking offices operated by FDIC-insured institutions at year-end 2011 were those operated by community banks. Without community banks, many rural areas, small towns and urban neighborhoods would have little or no physical access to mainstream banking services.

The Study found that community banks that grew prudently and that maintained diversified portfolios or otherwise stuck to their core lending competencies funded by stable core deposits during the Study period exhibited relatively strong and stable performance over time. Institutions that departed from the traditional community bank business model generally underperformed over the long run. These institutions pursued higher-growth strategies – frequently through commercial real estate or construction and development lending – financed by volatile funding sources. This group encountered severe problems during real estate downturns and characterized the community banks that failed during the aftermath of the crisis.

As the primary federal regulator for the majority of smaller institutions (those with less than $1 billion in total assets), the FDIC is keenly aware of the challenges facing community banks. The FDIC has tailored its supervisory approach to consider the size, complexity, and risk profile of the institutions it oversees. For example, large institutions (those with $10 billion or more in total assets) are generally subject to continuous supervision (targeted reviews throughout the year), while smaller banks are examined periodically (every 12 to 18 months) based on their size and condition. Additionally, the frequency of our examinations of compliance with the Community Reinvestment Act can be extended for smaller, well-managed institutions. Moreover, in Financial Institution Letters issued to the industry to explain regulations and guidance, the FDIC includes a Statement of Applicability to institutions with less than $1 billion in total assets.

In addition to the changes in the Dodd-Frank Act affecting community banks, the FDIC also reviewed its examination, rulemaking, and guidance processes during 2012 as part of our broader review of community banking challenges, with a goal of identifying ways to make the supervisory process more efficient, consistent, and transparent, while maintaining safe and sound banking practices. Based on the review, the FDIC has implemented a number of enhancements to our supervisory and rulemaking processes. First, the FDIC has restructured the pre-exam process to better scope examinations, define expectations, and improve efficiency. Second, the FDIC is taking steps to improve communication with banks under our supervision through the use of web-based tools, regional meetings and outreach. Finally, the FDIC has instituted a number of outreach and technical assistance efforts, including increased direct communication between examinations, increased opportunities to attend training workshops and symposiums, and conference calls and training videos on complex topics of interest to community bankers. The FDIC plans to continue its review of examination and rulemaking processes, and continues to explore new initiatives to provide technical assistance to community banks.

Conclusion

Thank you for the opportunity to share with the Committee the work that the FDIC has been doing to address systemic risk in the aftermath of the financial crisis. I would be glad to respond to your questions. (Attachment)

1 A summary of the FDIC’s progress implementing the provisions of the Dodd-Frank Act is attached to this testimony.

2 The 3,238 U.S. counties in 2010 included 694 micropolitan counties centered on an urban core with populations between 10,000 and 50,000 people, and 1,376 rural counties with populations less than 10,000 people.

SHELIA BAIR SPEAKES

The following is an excerpt from the FDIC web site:

"Remarks by FDIC Chairman Sheila C. Bair to the ICBA National Convention, San Diego, CA
March 22, 2011

It is always a pleasure to address the annual meeting of the ICBA. I have addressed your meeting every year of my five year term at the FDIC, and I've always had an affinity for this group. You are fiercely independent in your core mission of defending the interests of the nation's community bankers.

As you know, I am also tenacious in defending the interests of the FDIC as it pursues its vital public mission of depositor protection and financial stability. Like me, you are frequently direct and pointed in your communications. You pride yourselves in your professionalism, and you influence opinion through reasoned public debate. Like me, you stay focused on your objectives. And you are never confused about who you represent. That has been a key to your considerable effectiveness in Washington.

You may not be aware of this, but my experience with community banking extends back into my early childhood. In fact one of those experiences helped prepare me for the Chairmanship of the FDIC. When I was in grade school, I loved accompanying my father to Citizens Bank in Independence Kansas each Friday afternoon when he would deposit the week's earnings from his medical practice. As I would stand with him in the teller line waiting for our turn at the window, I would always stare in fascination at the big, shiny steel door of the bank's vault. It had a huge, round metal handle with prongs like the steering wheel of a ship. I imagined that behind that door stood tall stacks of crisp green bills and piles of gleaming coins.

One Friday afternoon, as we entered the bank, I noticed that the vault door was open a crack. My heart raced. Someone had forgotten to close the door! Now was my chance to sneak a peak at the treasures within. As my father was pre-occupied in conversation with a friend, I slipped away from him and edged furtively to the vault door in rapt anticipation. But when I reached the vault and peeked expectantly into the small slit of an opening, I had the surprise of my life -- no crisp greenbacks, no bags of shiny coins -- just rows and rows of little metal drawers with numbers on them. "There's no money in the bank, there's no money in the bank" I shouted, racing back to my father to forewarn him that someone had been absconding with his and other bank depositors' hard-earned cash.

As you might imagine, this created quite a stir among the long line of customers waiting to deposit their week's earnings. The bank's President came rushing out of his office to find out what was causing all the commotion. After giving me a few somewhat forceful pats on the head, he assured me that everyone's money was quite safe. He then invited me and my father into his office for a quick tutorial on reserve banking. I didn't understand much of it, except for the idea that most of the depositors' money was loaned out to others to help them buy things like cars and homes, which I thought was nice.

So this was my first introduction to the community banking model, as well as the importance of depositor confidence. Ironic that a six-year-old who nearly instigated a bank run that day would later become Chairman of the Federal Deposit Insurance Corporation.

We have had quite a ride over these past five years. When I first came to the FDIC in June of 2006, I thought that my main challenges would be dealing with the Wal-Mart ILC application and implementing our new authorities under the Federal Deposit Insurance Reform Act to begin assessing risk based premiums on all banks.

To be honest, back then, I didn't really know where I stood on the issue of commercial ownership of banks. But I came quickly to understand that the Wal-Mart application, if approved, had the potential to radically transform the structure of the banking industry. This was a step that needed to be decided by Congress, not by the FDIC. This application risked embroiling the FDIC in a never-ending controversy which would divert it from its core public mission.

So we imposed a moratorium on ILC applications to give Congress time to act, and Wal-Mart eventually withdrew its application, making the issue somewhat moot. Dodd-Frank has now closed the so-called ILC loophole to bank holding company rules. So I am glad we imposed the moratorium, and I think that the end result was the right one.

Though community banks were obviously pleased by our early decision on the Wal-Mart application, you were a bit more mixed on our decision to move ahead with a new risk-based pricing system that would begin charging all banks something for their deposit insurance.

As most of you will recall, prior to 2006, the FDIC was essentially prohibited from charging CAMELS 1 or 2 banks for deposit insurance so long as the reserve ratio stayed above 1.25. This was a nice deal for the more than 95 percent of the industry which had the requisite high CAMELS rating. The downside, however, was that a number of new banks had been chartered which never had to pay anything for deposit insurance, an inherently unfair situation for older banks which had paid dearly to cover losses from the last bank and thrift crisis.

Another significant downside was that if the fund were to dip below 1.25, everyone would be whacked with a 23 basis-point assessment. When the deposit insurance reform law said we could start charging a premium to every institution, it also gave us the ability to manage the fund within a range. This would allow us to build reserves in the good times and provide a cushion against the need for pro-cyclical premium hikes during downturns. In addition, the law gave older banks a credit in recognition of past assessments, so the brunt of the initial assessment would fall on so-called "free riders."

I remember well the strongly-worded comment letters and tense meetings with newer banks, many of whom followed non-traditional strategies through internet deposits or affiliations with investment banks. They were not happy with us, and I recall many saying we had no need to build the fund because of the health of the industry and lack of bank failures.

Yes, they assumed, the good times would go on forever, so why in the world did we need more money? The rest, as they say, is history. We went ahead with the new assessment rate schedule, which was my first major rulemaking just two weeks into my tenure.

But as it turned out, it was too little, too late. As the crisis hit, bank failures mounted, and so did losses to the Deposit Insurance Fund. The low point was the fourth quarter of 2009, when the fund dipped to a negative balance of $20.8 billion. But the fund, like the banking industry, is healing, and I anticipate that it will achieve a positive balance before the end of the year.

So where are we now? Community banks' return on assets in 2010 was 0.33 percent, and 4 out of every 5 community banks operated at a profit. Noncurrent loans stood at 3.5 percent, with a net charge-off rate of 1.27 percent. This is a major improvement from the fourth quarter of 2009, when ROA was a negative 0.65 percent, and more than one in three community banks were unprofitable.

However, the current situation still pales in comparison to the robust earnings enjoyed by most banks during the so-called "golden age of banking" prior to the crisis. Now, as the industry is beginning to recover from the setbacks of the past few years, you are moving forward to a future which holds much promise but also considerable uncertainty.

As with previous crises, there has been significant consolidation over the past few years, and nearly 300 community banks have failed. As I've discused with you many times before, we at the FDIC have a keen appreciation for the unique role community banks play, not only in their local markets but also through the contributions they make to the national economy.

Quarter after quarter, throughout the crisis and ensuing recession, we saw you maintain and even modestly grow your loan balances as the largest institutions were pulling back dramatically. Small businesses, in particular, come to you for credit because you understand the local economy and you understand their particular credit needs. In the wake of the most severe recession since the 1930s, we need a thriving community banking sector to support the credit needs of local households and businesses.

I know that you have many concerns about the future of community banking and how it will be affected by the changes that are taking place as regulators implement Dodd-Frank. Yours is already one of the most heavily regulated industries in America. Congress just passed a 2,000 page bill mandating scores of new regulations. You are understandably wary of how the new law will be implemented, and even if you are not the target of its many reforms, you are concerned that there could be collateral damage to your industry.

I am not going to claim that we have always seen things the same way on every issue. We have not, and we should not. Our respective jobs are quite different. But I will say this: We at the FDIC are committed to a future regulatory structure that will support a vibrant, competitive community banking sector, that will assure a level playing field between large and small banks, and most importantly, that will put an end to the pernicious doctrine of too big to fail.

Throughout this crisis, we have consciously pursued policies to protect community banks and their customers from the fall out of the financial crisis—a crisis that was not of your making, to mute the impact of deposit insurance fund losses while maintaining the integrity of industy funding, to preserve continuation of community banking services in areas impacted by failing institutions, and to assure that financial reform measures take into account the potential impact on smaller banks.

We were early and strong advocates for interagency guidance addressing high-risk mortgages. We were among the first to see the dangers of these unaffordable mortgages to the broader banking sector -- indeed to the entire economy. We supported strong guidance in 2006 to tighten standards on so-called pick-a-pay loans, and successfully pushed for extending those standards to subprime hybrid loans in early 2007.

While commercial real estate lending was not the cause of the crisis, we could see in 2006 that poorly managed commercial real estate concentrations were becoming a growing threat to the deposit insurance fund. So we also supported heightened supervisory standards for CRE concentrations.

I know we disagreed on that guidance, but looking back it is clear that weak banks with high levels of CRE concentrations – especially construction and development concentrations – represent the lion's share of small bank failures. So this was not a case of overzealous regulation.

At the same time, going forward, I believe that supervisory policies need to reflect the reality that most community banks are specialty CRE lenders and that examiners need to focus on assuring quality underwriting standards and effective management of those concentrations. Though hundreds of small banks have become troubled or failed because of CRE concentrations, thousands more have successfully managed those portfolios. We need to learn from the success stories and promote broader adoption of proven risk-management tools for banks concentrated in CRE.

As the crisis unfolded, we worked with our fellow regulators and the Treasury Department to promote public confidence and system stability. Foreseeing the risk of increased failures from growing problems in the housing sector, we launched in 2008 an intensive public education campaign about deposit insurance. We used the occassion of our 75th anniversary to re-acquaint the general public about the FDIC's strong record in protecting insured bank deposits. Here again, our objective was to assure the stabiliy of insured deposits, the lifeblood of community banks, and in that we were successful.

However, as conditions deteriorated in the summer and fall of 2008, we witnessed growing volatility in uninsured deposits and a troubling trend of business accounts "fleeing" community banks for larger institutions perceived as too big to fail. For this reason, when we were asked by the Treasury Department and the Federal Reserve Board to develop a debt guarantee program which would have primarily benefited larger institutions, we also proposed an unlimited temporary guarantee for non-interest bearing transaction accounts. This program proved enormously successful in stabilizing these accounts and averting liquidity stress or failures in otherwise healthy community banks.

Throughout the crisis, we were determined not to turn to taxpayer borrowing but rather to manage our losses and liqudity needs through our industry-funded resources. In retrospect, given the understandable public backlash to TARP and the taxpayer bailouts, I am more convinced than ever that this was the right decision. At the same time, we used strategies to soften the impact of additional assessments on a distressed banking sector.

We worked with you to bolster public confidence in our resources by convincing Congress to substantially raise our borrowing line, ameliorating the need for a large special assessment. We also successfully secured legislation to make clear that any losses on the FDIC's debt guarantee program would be assessed on those holding companies availing themseves of that program, not insured banks.

We required prepayment of three years worth of premiums to make sure that our cash resources were adequate to cover bank failures, while allowing you to expense those premiums gradually over time.

And finally, we deployed resolution strategies to sell failing banks to other insured depositories, while providing credit support on futures losses from failed banks' troubled loans. This strategy has saved us $40 billion over losses we would have incurred if we had liquidated those banks. But perhaps more importantly, this strategy provided continuation of banking services in local areas served by the failed banks, frequently through the acquisition of a failed communty bank by a healthy one. Now, the system is on the mend. Bank failures peaked last year at 157. Profitability is returning, loan quality is improving, and borrower demand is starting to pick up somewhat with an improving economy.

Unfortunately, many of the obvious problems that led to this crisis -- excess leverage, unregulated credit derivatives, skewed incentives from securitization, too big to fail -- have yet to be fixed. And increasingly, regulators are being called to task for doing too much too fast, just as a few years go we were being pilloried for being asleep at the switch.

Do not misunderstand. Accountability and oversight are a good thing for the regulatory process. As a market-oriented Republican, I wholeheartedly concur that our regulations should be tightly focused on fixing what went wrong. But we must not lose sight of the fact that A lot went wrong and it does need to be fixed. Which brings me back to Dodd-Frank.

Dodd-Frank is not a perfect law. There are many things in it that I would like to change. But, on balance, it is a good law and one which I think will strengthen, not weaken, communtiy banks. Let's start with the basics.

If Dodd-Frank had not been enacted, deposit insurance limits would have reverted to $100,000. The transaction account guarantee would have expired. The too big to fail doctrine would have remained intact. A public still uncertain about the strength of smaller banks would have pulled their newly uninsured deposits and fled to the large, too big to fail institutions. This would have led to more small bank failures and higher costs for the deposit insurance fund.

So you would have lost large deposit accounts, and it is likely that your deposit insurance premiums would have gone up. But none of that happened.

Dodd-Frank made permanent the $250,000 deposit insurance limit and provided a two-year extension of the transaction account guarantee. It attacked the doctrine of too big to fail by extending the FDIC's resolution process to large, systemically-important financial institutions. It subjected all financial institutions, large and small, bank and non-bank, to our resolution process, which imposes losses where they belong -- on shareholders and creditors -- not on taxpayers.

It also required that large financial entities have capital cushions at least as strong as those that apply to community banks. And it changed the assessment base so that instead of your premiums going up, they will be reduced by about 30 percent later this year. Why did this happen? You.

Instead of stridently opposing even the most modest of reforms, the ICBA stayed engaged. You maintained a constructive dialogue with the key sponsors of the legislation. You gave voice to the views of community banks, and Congress listened. Most of the other financial trade groups tried to stop reform. It didn't matter. A bill was going to pass. The ICBA realized the inevitability of the process. You kept a seat at the table, and you had an impact on the outcome.

I know you have many concerns about this legislation. I understand your concerns. It is a massive law, and you would be foolish not to take an active interest in the new regulations as they are developed. We are proceeding to implement the provisions of Dodd-Frank as transparently and expeditiously as possible.

We are going beyond the normal steps that we use in the rulemaking process. We are holding roundtables to discuss issues, and documenting meetings between senior FDIC officials and outside parties that are related to Dodd-Frank implementation. In addition, we continue to discuss issues related to Dodd-Frank during the visits by the state banking delegations to the FDIC and at meetings of our Advisory Committee on Community Banking.

So you will continue to have many venues to provide feedback to us as implementation moves forward. And I want you to know that we're paying close attention to the potential impact of the law on community banks.

On March 10, we sent a letter to Federal Reserve Chairman Bernanke commenting on the proposed rule on debit-card interchange fees. We are extremely concerned that community banks may not actually receive the benefit of the interchange fee limit exemption explicitly provided by Congress. In the comment letter, we urged the Board to use its authority under the Electronic Fund Transfer Act to address the practical implications of the proposal. The proposed rule assumes the creation of a two-tiered interchange structure, and failure to maintain a two-tiered structure could result in a loss of income for community banks, and higher banking costs for your customers.

We also urged the Board to expand its survey methodology to gain information on the costs incurred by issuers of all asset sizes; to include costs associated with anti-fraud protection; and to revise its fee cap proposal as appropriate.

Your concerns about the potential impact of the interchange fee provision are well-founded, and we are working hard to assure that you receive the protection promised by the law. At the same time, I would ask you to maintain an open-mind about the potential positive benefits of the new consumer protection agency. Many of the fears I have heard expressed about this new agency are not well-founded.

On the contrary, I believe that this agency holds the promise of doing tremendous good by simplifying consumer rules and disclosures, reducing compliance costs for you and making products easier to understand for your customers. I also think this agency can help level your competitive playing field by applying much-needed regulation and enforcement to non-bank mortgage originators and other providers of consumer credit.

Banking has come a long way since the days when I used to accompany my father to Citizen's Bank every Friday afternoon. We have just come through the worst financial crisis and most severe recession since the 1930s. I know these are uncertain times for you, when the economic environment remains difficult, and the regulatory outlook seems unclear.

I ask you to continue our dialogue, and to work with us to get the details right on the regulatory reforms now underway. It is my hope and belief that public dissatisfaction with impersonal, model-driven banking will bring more customers back to those institutions which bank the old-fashioned way – to banks who know their customers and tend to their individual banking needs – to banks run by hands-on executives willing to take some time to explain to a six-year-old why all the depositors' money isn't sitting in the vault.

Community banking is the foundation of our economy. The future belongs to you, and it depends on you. That is why I am asking you to support the reforms that are needed to restore financial stability and lay the foundation for a stronger U.S. economy in the years ahead. Thank you."

FDIC CHAIRMAN CALLS FOR ACCOUNTABILITY

Although the FDIC (Federal Deposit Insurance Corporation) is theoretically geared more to the banking system than the SEC (Security and Exchange Commission) the businesses of banking and securitization has been merged within many institutions over the last couple of decades. In short, what affects the securities industry affects the banking industry and vice verse. The following excerpt from the FDIC web page are remarks given by FDIC Chairman Sheila Bair to the Boston Club:



"Remarks by FDIC Chairman Sheila C. Bair to The Boston Club, Boston, MA
December 2, 2010
Thank you for that kind introduction. It is wonderful to be back in Massachusetts and an honor to talk to this distinguished group.

The past few years have been the most eventful for U.S. economic policy since the 1930s. And that, of course, is because our nation has suffered its most serious economic setback since the Great Depression. We knew that the crisis posed a grave threat to the U.S. economy. Our response has been historic in scope, and it has sparked a sorely needed debate over the appropriate roles for government and business in regulating and leading the economy.

What I would like to do this morning is outline the rationale for the new reforms, and explain how they intersect with the fundamental need for much greater responsibility and accountability on the part of government and corporate leaders. The following are remarks given by

Warren Buffett has said: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.”

What we need are leaders who are willing to do things differently; leaders who are willing to do the hard work necessary to move our country forward. Leaders who aren’t interested in promoting their short term personal gains, but rather want to build their organizations for the long term for the benefit of this and future generations.

Accountability and responsibility

The financial crisis has revealed critical flaws in how our financial system operated and was regulated, as well as in our leadership culture. If there is an overarching theme of this crisis, it is a lack of accountability by managers, by regulators, by lenders, by borrowers -- by everyone. We see that at the failed banks – both large ones that the government bailed-out and smaller ones the FDIC has had to resolve.

We’ve seen disengaged managers; managers who were not hands-on, who would not take responsibility or find out what was going on inside of their organization. We’ve seen managers who didn’t look beyond their next quarter’s financial statements and who rewarded short term profit generation through high risk activities which sowed the seeds of their ultimate demise. They didn't do their homework, they didn't understand the risks their companies were taking, and they didn't work hard enough. Some were arrogant.

It's an important lesson for investors, shareholders and, of course boards, who ultimately are responsible for hiring the CEO, and making sure that the CEO and other senior managers are up to the job, and doing their job. At larger institutions, some managers assumed that their size protected them from regulatory or market sanctions – that they were so systemically important and interconnected that they were Too Big To Fail. And some of them proved to be right. Especially at the height of the financial crisis, we saw these large, systemically important institutions exempted from the type of supervisory sanctions that community banks face every day.

That is one of the reasons why we fought so hard to end Too Big To Fail. We now have a resolution process that will impose discipline on large institutions as well as the smaller ones. If they get into trouble, there will be accountability. There will be consequences for management, for corporate boards, for investors, and for creditors.

Too Big To Fail & Resolution Authority

The new Dodd-Frank financial reform act establishes a credible resolution authority for giant banks and non-bank financial institutions. It gives the FDIC, for the first time, a set of receivership powers to close and liquidate systemically-important financial firms that are failing. These new powers are similar to the existing FDIC receivership process for insured banks and thrifts.

Let me briefly describe the practical significance of these new powers. In the old world of Too Big To Fail, risk taking was subsidized. Systemically-important companies took on too much risk because the gains were private while the losses were socialized. Market discipline failed to rein in the excesses at these institutions because equity and debt holders -- who should rightly be at risk if things go wrong -- enjoyed an implicit government backstop.

This skewing of financial incentives inevitably led to a misallocation of capital and credit flows, which ultimately was harmful to the broader public good, as we have seen with the recent devastating losses of livelihoods, homes, and life savings. It was these poor incentives in place under Too Big To Fail that helped push risk out into the so-called shadow banking system, where regulation was the lightest. That’s where you saw most of the excesses in subprime and nontraditional mortgage lending, as well as holdings of mortgage-related derivative instruments.

So implementing the new resolution authority and ending Too Big To Fail is a game changer. It corrects the economic incentives, and protects the broader public good:


Market discipline will be restored,
Financial incentives will be better aligned,
Capital and credit will be allocated more efficiently, and
Taxpayers will no longer be on the hook when financial companies get it wrong.

Executive compensation

Another example of lack of accountability can be found in the misaligned compensation incentives, which were among the root causes of the financial crisis. Compensation was too-often based on deal volume or current earnings, and not enough attention was paid to risks that eventually caused problems down the road.

It is not appropriate for regulators to set or limit compensation. But it is very appropriate to undertake regulatory initiatives that encourage companies to structure compensation so that excessive risk taking is discouraged, long term profitability is rewarded, and most importantly, that meaningful financial penalties are imposed on employees whose risk taking ends up causing losses later on.

Fiscal responsibility

In Washington, we also need more accountability for our increasingly dire fiscal situation. We must mend our ways if we are to preserve financial stability in the years ahead. Excessive government borrowing poses a clear danger to our long-term financial stability, and assuaging it requires fiscal responsibility and leadership. Total U.S. public debt has doubled in just the past seven years to almost $14 trillion, or more than $100,000 for every U.S. household.

This explosive growth in federal borrowing is not only the result of the financial crisis, but also the unwillingness of our government over many years to make the hard choices necessary to rein in our long-term structural deficit. If it is not checked soon, this borrowing will at some point directly threaten financial stability by undermining the confidence that investors have in U.S. government obligations.

Actually fixing these problems will require a bipartisan national commitment to a comprehensive package of spending cuts and tax increases over many years. The plan released yesterday by the National Commission on Fiscal Responsibility and Reform offers such a plan. It proposes a combination of spending cuts, revenue-enhancing tax reforms, and cost containment in health care and entitlement programs that would produce nearly $4 trillion in deficit reduction over the next ten years.

While opinions differ as to exactly what combination of spending cuts and revenue increase will be necessary we can be sure that most of the needed changes will be unpopular, and will likely affect every interest group in some way or another. We will want to phase in these changes over time as the economy continues to recover from the effects of the financial crisis.

But only with a comprehensive package can we truly achieve the long-term budget discipline needed to preserve our nation’s credibility in global financial markets, and maintain a stable banking system to support the real economy. We must look beyond our narrow partisan interests, and show the world that we are prepared to act boldly to secure our economic future.

Leadership

I am very proud of the stability that the FDIC has provided throughout the crisis. No one lost a penny of insured deposits. And in fact, no one has ever lost a penny of insured deposits in the 77 years since the FDIC was created in 1933. As the crisis unfolded and other financial sectors were destabilizing, insured deposits remained stable and there were no disruptions.

As the leader of an organization, I always try to keep a focus on mission. Protecting insured deposits is a very important, tangible mission. It's one that the public understands and appreciates.

If you look at other organizations – whether private or public -- that have high morale, they have a clearly defined mission. The leadership at those organizations has to ensure that people stay focused on the mission and help them understand how their individual jobs relate to the mission. You need accountability. You need responsibility. You need people to take ownership of their jobs and connect that to the organization’s broader mission.

One challenge I have is to tell our people how good they are. That their judgment is as good as that of the banks they are examining, and that it is their job to speak up about any concerns they have. That they have the right and the obligation to question and tell a bank’s management about those concerns, whether they're not reserving enough against their loans, or that they're moving into a new line of business or a new geographic area in which they are unfamiliar.

Conclusion

We all know there are no easy shortcuts to rebuilding our financial infrastructure and reining in our long-term structural deficit. And it is always appealing to try to go back to old and familiar ways. But in American finance, those are the practices that pushed our economy to the brink of ruin.

Instead, we must move forward, make the tough choices, and accept that preserving stability is a prerequisite to making the financial system more efficient and more profitable. In the end, leadership means showing the resolve to identify emerging risks and taking concerted action to head them off.

In concluding, I don’t want to leave you with the impression that all leadership in the financial sector should be faulted. There are several examples of senior management at financial institutions, large and small, who avoided the excessive risk taking that led to the crisis. So let us celebrate those who led their organizations effectively and resolve to foster a culture which rewards managers who are willing to forego short term profits in favor of long term stability and prosperity.

And as part of building that culture, let’s hope that we see a lot more women in the upper echelons of financial institution management, including – at long last – at the very top.

Thank you."

The FDIC believes there has to be reform in order to improve our overall economy. With reforms supported by the FDIC along with legal sanctions taken by the SEC perhaps we might have a light at the end of this long dark tunnel our economy in which our economy has been stuck. We can only hope someone sprays for poisonous spiders before financial oversight authorities signal that it is O.K. to move through the tunnel to the light.