Congressional Testimony

S. HRG. 111–772 FEDERAL RESERVE’S FIRST MONETARY POLICY REPORT FOR 2010 HEARING BEFORETHE COMMITTEE ON BANKING, HOUSING, ANDURBANAFFAIRS UNITED STATES SENATE ONE HUNDRED ELEVENTH CONGRESS SECOND SESSION ON RECEIVING THE FEDERAL RESERVE’S SEMI-ANNUAL MONETARY RE- PORT TO THE CONGRESS AND DISCUSSING MONETARY POLICY AND THE ECONOMIC OUTLOOK FEBRUARY 25, 2010 Printed for the use of the Committee on Banking, Housing, and Urban Affairs ( Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html U.S. GOVERNMENT PRINTING OFFICE 61–513 PDF WASHINGTON : 2010 For sale by the Superintendent of Documents, U.S. Government Printing Office, http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202–512–1800, or 866–512–1800 (toll-free). E-mail, gpo@custhelp.com. COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS CHRISTOPHER J. DODD, Connecticut, Chairman TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama JACK REED, Rhode Island ROBERT F. BENNETT, Utah CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky EVAN BAYH, Indiana MIKE CRAPO, Idaho ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee DANIEL K. AKAKA, Hawaii JIM DEMINT, South Carolina SHERROD BROWN, Ohio DAVID VITTER, Louisiana JON TESTER, Montana MIKE JOHANNS, Nebraska HERB KOHL, Wisconsin KAY BAILEY HUTCHISON, Texas MARK R. WARNER, Virginia JUDD GREGG, New Hampshire JEFF MERKLEY, Oregon MICHAEL F. BENNET, Colorado EDWARD SILVERMAN, Staff Director WILLIAM D. DUHNKE, Republican Staff Director and Counsel MARC JARSULIC, Chief Economist DREW COLBERT, Legislative Assistant MISHA MINTZ-ROTH, Legislative Assistant LISA FRUMIN, Legislative Assistant MARK OESTERLE, Republican Chief Counsel JEFF WRASE, Republican Chief Economist ANDREW OLMEM, Republican Senior Counsel CHAD DAVIS, Republican Professional Staff Member RHYSE NANCE, Republican Professional Staff Member LAURA SWANSON, Professional Staff Member KARA STEIN, Professional Staff Member DAWN RATLIFF, Chief Clerk LEVON BAGRAMIAN, Hearing Clerk SHELVIN SIMMONS, IT Director JIM CROWELL, Editor (II) C O N T E N T S THURSDAY, FEBRUARY 25, 2010 Page Opening statement of Chairman Dodd .................................................................. 1 Opening statements, comments, or prepared statement of: Senator Shelby .................................................................................................. 3 WITNESSES Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System ................................................................................................................... 4 Prepared statement .......................................................................................... 50 Response to written questions of: Senator Shelby ........................................................................................... 109 Senator Brown ........................................................................................... 117 Senator Merkley ........................................................................................ 122 Senator Bunning ....................................................................................... 125 (III) FEDERAL RESERVE’S FIRST MONETARY POLICY REPORT FOR 2010 THURSDAY, FEBRUARY 25, 2010 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 9:08 a.m. in room SD–538, Dirksen Sen- ate Office Building, Senator Christopher J. Dodd, Chairman of the Committee, presiding. OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD Chairman DODD. The Committee will come to order. Let me welcome all who are here this morning for the Committee hearing, the hearing on the semiannual monetary report to Con- gress by the Chairman of the Federal Reserve, and we welcome you once again, Mr. Chairman, to the Banking Committee. I will make a brief opening statement, turn to Senator Shelby for any com- ments he may make, and then we will turn right to you for your opening comments and get to some questioning. But we thank you once again for joining us here this morning. Today, as you testify before us, Mr. Chairman, it is worth taking a moment to recognize that our economy is showing signs of emerg- ing from this recession. During the last two quarters, GDP has shown positive growth, as has gross private domestic investment, and financial markets have stabilized enough to allow the Fed to wind down nearly all the liquidity facilities it established in re- sponse to this crisis. But that does not mean, of course, that our economy is out of the woods, as we all know. And more importantly, it does not mean that the situation of working families has improved dramatically either. Households and small businesses dependent on banks for fi- nancing continue to have trouble getting the loans that they need. Commercial real estate losses continue to mount, and combined with losses on home mortgages, they are making the credit crunch even worse. Outside of securities guaranteed by the Federal Government, the residential and commercial markets for mortgage-backed securities are practically non-existent. Foreclosures continue to plague our communities at greater and greater rates, and the large inventory of foreclosed homes continues to suppress the housing market and discouraging new construction. And worst of all, Mr. Chairman, the job market continues to suf- fer from the losses incurred during the recession. We have lost 8.4 million jobs since December of 2007. The unemployment rate (1) 2 stands at 9.7 percent, although many of us would argue here that that number is actually vastly in excess of that in many areas of the country. And it is widely expected that it will remain high for several years to come. An astonishing 6.3 million American work- ers have been out of a job for a half a year or more, and that is a record in our Nation. The state of our economy as a whole may be improving, but if we are talking about the situation of ordinary American families, I think I can sum up this recovery in three words: Not good enough. I think most would agree. The longer we go without resolving these problems, the worse off, of course, we all will be. Unemployed Americans will continue to lose their health insurance and their homes. Their skills will begin to deteriorate, leaving us less competitive in the global economy. Those who do have jobs will see their wages stagnate. Our country will suffer as a result. This Congress has a role to play in putting people back to work, and we have a responsibility to put protections in place to make sure that a crisis like this never threatens our financial system again. Our Committee has made important progress toward that end, and my hope is that we will have a financial reform bill ready in the coming days. Mr. Chairman, you also have a role to play in all of this, as you know, and I have been impressed by your leadership, keeping the American economy from falling into the abyss, and you deserve a great deal of credit, in my view, for having contributed so signifi- cantly to that result. But now it is time as well, as I am sure you will agree, for you to show the same kind of leadership in helping us and American families along with those of us on this side of the dais to achieve the same fate, to come out of this abyss and get back on our feet again. So I look forward to working with you in the coming days—I know all of my colleagues will—work on your ideas and how mone- tary policy can help our constituents emerge from this recession. Now, as many of my colleagues know, having filled in the seat for Ted Kennedy as Chairman of the Health, Education, and Labor Committee, I have another place to be this morning—at the White House—to sit there and resolve health care, which I am confident we are going to do this morning, I would say to my colleagues. I do not see any smiles around the table on hearing that prediction. And so I am going to be leaving shortly, but I want to take—I am going to abuse my chairmanship for a minute. I am going to ask you a question because I will not get a chance in the normal proc- ess. In light of what is happening in Greece, Mr. Chairman, I wanted to raise an issue because matters have arisen, and I will raise this and you can either respond quickly to it and I will go right to Sen- ator Shelby. But if I indulge my colleagues by doing this—I have not done this before, but given that I have got the problems this morning where I have to be. The debt crisis, Mr. Chairman, in Greece is shedding light on the role of derivatives in the financial markets. According to news re- ports this morning and over the last several days, banks and hedge funds are using credit default swaps to bet that Greece will default 3 on its debt. The rising price of these contracts contributes to an at- mosphere of crisis, making it even more difficult for the Greek Gov- ernment, in my opinion, to borrow. Since there is no requirement that purchasers of credit default swaps actually own any of the un- derlying debt, we have a situation in which major financial institu- tions are amplifying a public crisis for what would appear to be pri- vate gain. I want to ask you here whether or not you think there ought to be limits on the use of credit default swaps to prevent the inten- tional creation of runs against governments. Do you have any quick comments on that? Mr. BERNANKE. Yes, Senator. I just want to say first of all that we are looking into a number of questions related to Goldman Sachs and other companies and their derivatives arrangements with Greece and on this issue as well. As you know, credit default swaps are properly used as hedging instruments. Chairman DODD. I agree. Mr. BERNANKE. The SEC, of course, has been interested in this issue. Obviously, using these instruments in a way that inten- tionally destabilizes a company or a country is counterproductive, and I am sure the SEC will be looking into that. We will certainly be evaluating what we can learn from the activities of the holding companies that we supervise here in the United States. Chairman DODD. Well, let me just make the request of you here, and we will make the similar request to the SEC. I am sure all of us on this Committee would like to hear very quickly what the re- sponse is going to be, if any, either from your or recommendations you would make as well as from the SEC. I will make that formal request this morning. I think it is a critical issue for all of us. Senator Shelby. STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you. Thank you, Chairman Dodd. Wel- come to the Committee, Chairman Bernanke, again. As our financial markets began to show signs of improvement, many of the Fed’s temporary lending facilities have been allowed to expire, and monetary policy has begun to normalize. And while use of the temporary lending facilities wane, expanded purchases by the Fed of Federal agency debt, mortgage-backed securities, and longer-term Treasury securities have kept the size of the Fed’s bal- ance sheet unusually large. As of last week, it is my understanding that the banks had over $1.2 trillion in reserve balances at Federal Reserve banks. That is more than 100 times the average level of such balances in 2006. This morning I am interested in hearing, Mr. Chairman, plans for reducing the size of the Fed’s balance sheet, withdrawing ex- traordinary liquidity support from the banking system, and con- tinuing the normalization of monetary policy. In addition, I believe, Mr. Chairman, you should tell us how the Fed plans to use interest on reserves as a monetary policy tool and how you intend to use reverse repurchase agreements to address reserves in the banking system. Finally, the Committee, I believe, should gain a better under- standing of how the Fed and the Treasury Department intend to 4 manage the Fed’s balance sheet, and I think this is especially rel- evant given Tuesday’s announcement by the Treasury that it an- ticipates selling securities and injecting around $200 billion into the Department’s supplemental financing account at the Fed over the next 2 months. Mr. Chairman, while there are signs of improvement in the econ- omy, conditions remain weak, especially in labor markets. Too many Americans are unemployed or underemployed. Because cred- ible plans for fiscal balance and monetary policy are essential for economic recovery, we need to have transparency and clarity about the Federal Reserve’s plans. My hope this morning, Mr. Chairman, is that you will provide that clarity. Thank you. Chairman DODD. Mr. Chairman, the floor is yours. STATEMENT OF BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Thank you. Chairman Dodd, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress. I will begin today with some comments on the out- look for the economy and for monetary policy and then touch brief- ly on several important issues. Although the recession officially began more than 2 years ago, U.S. economic activity contracted particularly sharply following the intensification of the global financial crisis in the fall of 2008. Con- certed efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, to- gether with highly stimulative monetary and fiscal policies, helped arrest the decline and are supporting a nascent economic recovery. Indeed, the U.S. economy expanded at about a 4-percent annual rate during the second half of last year. A significant portion of that growth, however, can be attributed to the progress that firms made in working down unwanted inventories of unsold goods, which left them more willing to increase production. As the impe- tus provided by the inventory cycle is temporary, and as the fiscal support for economic growth likely will diminish later this year, a sustained recovery will depend on continued growth in private sec- tor final demand for goods and services. Private final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial condi- tions. In particular, consumer spending has recently picked up, re- flecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business in- vestment in equipment and software has risen significantly. And international trade—supported by a recovery in the economies of many of our trading partners—is rebounding from its deep contrac- tion of a year ago. However, starts of single-family homes, which rose noticeably this past spring, have recently been roughly flat, and commercial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been especially hard hit by the recession, as employers reacted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 5 2009. Some recent indicators suggest that the deterioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have contin- ued to trend lower, and the temporary services industry, often con- sidered a bellwether for the employment outlook, has been expand- ing steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern, be- cause of its long-term implications for workers’ skills and wages, is the increasing incidence of long-term unemployment; indeed, more than 40 percent of the unemployed have been out of work for 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flat- tened out over recent months, and most indicators suggest that in- flation will likely remain subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers’ unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, re- flecting high vacancy rates. In addition, according to most meas- ures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Conditions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be ham- pered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak de- mand for credit amid uncertain economic prospects. In conjunction with the January meeting of the FOMC, Board members and Reserve Bank presidents prepared projections for economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these fore- casts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 31⁄ 2 per- cent in 2010 and 31⁄ 2 to 41⁄ 2 percent in 2011. Consistent with mod- erate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 61⁄ 2 to 71⁄ 2 percent by the end of 2012, still well above their estimate of the long-run sus- tainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 per- cent in 2010 through 2012. In the longer term, inflation is expected to be between 13⁄ 4 and 2 percent, the range that most FOMC par- ticipants judge to be consistent with the Federal Reserve’s dual mandate of price stability and maximum employment. Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price sta- bility. The target for the Federal funds rate has been maintained at a historically low range of 0 to 1⁄ 4 percent since December 2008. The FOMC continues to anticipate that economic conditions—in- cluding low rates of resource utilization, subdued inflation trends, 6 and stable inflation expectations—are likely to warrant exception- ally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial mar- kets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities it created during the crisis. On February 1, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary li- quidity swap lines with foreign central banks, were all allowed to expire. The only remaining lending program for multiple borrowers cre- ated under the Federal Reserve’s emergency authorities, is the Term Asset-Backed Securities Loan Facility, or TALF, and it is scheduled to close on March 31 for loans backed by all types of col- lateral except for newly issued commercial mortgage-backed securi- ties, and it will close on June 30 for loans backed by newly issued CMBS. In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of discount window funds to depositories through the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking system, will occur on March 8. Last week, we announced the maximum term of discount window loans, which was increased to as much as 90 days during the crisis, would be returned to overnight for most banks, as it was before the crisis erupted in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the out- look for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary condi- tions to prevent the development of inflationary pressures. Not- withstanding the substantial increase in the size of its balance 7 sheet associated with its purchases of Treasury and agency securi- ties, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time. Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks’ holdings of reserve balances at Federal Reserve banks. By increasing the in- terest rate on reserves, the Federal Reserve will be able to put sig- nificant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be re- flected in turn in longer-term interest rates and in financial condi- tions more generally. The Federal Reserve has also been developing a number of addi- tional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve’s control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse re- purchase agreements, a tool that the Federal Reserve has histori- cally used to absorb reserves from the banking system, is being ex- panded so that such transactions can be used to absorb large quan- tities of reserves. The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of de- pository institutions’ holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements. In addition, the FOMC has the option of redeeming or selling secu- rities as a means of reducing outstanding bank reserves and apply- ing monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on eco- nomic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony. The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. In- deed, on matters related to the conduct of monetary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular, extensive reports to the Congress and the public; and we have worked closely with the GAO, the SIGTARP, the Congress, and private sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were impor- tant tools for implementing monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the in- tegrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve’s management of all facilities created under emergency authorities. In particular, we would sup- port legislation authorizing the GAO to audit the operational integ- rity, collateral policies, use of third-party contractors, accounting, financial reporting, and internal controls of these special liquidity and credit facilities. The Federal Reserve will, of course, cooperate 8 fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appropriate delay. It is important that the release occur after a lag that is suffi- ciently long that investors will not view an institution’s use of one of these facilities as a possible indication of ongoing financial prob- lems, thereby undermining market confidence in the institution or discouraging use of any future facility that might become necessary to protect the U.S. economy. An appropriate delay would also allow firms adequate time to inform investors through annual reports and other public documents of their use of Federal Reserve facili- ties. Looking ahead, we will continue to work with the Congress in identifying approaches for enhancing the Federal Reserve’s trans- parency that are consistent with our statutory objectives of fos- tering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the Amer- ican people. Moreover, the confidentiality of discount window lend- ing to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to pro- vide liquidity to depository institutions under circumstances where other sources of funding are not available. The Federal Reserve’s ability to inject liquidity into the financial system is critical for pre- serving financial stability and for supporting depositories’ key role in meeting the ongoing credit needs of firms and households. Strengthening our financial regulatory system is essential for the long-term economic stability of the Nation. Among the lessons of the crisis are the crucial importance of macroprudential regulation that is, regulation and supervision aimed at addressing risks to the financial system as a whole—and the need for effective consoli- dated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress’ ongoing ef- forts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Reserve’s oversight of banking organiza- tions, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms, and we have been taking the lead in en- suring that compensation structures at banking organizations pro- vide appropriate incentives without encouraging excessive risk tak- ing. The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to im- prove the effectiveness of consolidated supervision and to incor- porate a macroprudential perspective that goes beyond the tradi- tional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to im- prove coordination within our own supervisory staff and with other 9 supervisory agencies and to facilitate more integrated assessments of risks within each holding company and across groups of compa- nies. Last spring the Federal Reserve led the successful Supervisory Capital Assessment Program, popularly known as the bank stress tests. An important lesson of that program was that combining on- site bank examinations with a suite of quantitative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the process of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory informa- tion will be combined with firm-level, market-based indicators and aggregate economic data to provide a more complete picture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve’s unparalleled breadth of exper- tise, this program will apply a multidisciplinary approach that in- volves economists, specialists in particular financial markets, pay- ments systems experts, and other professionals, as well as bank su- pervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Reserve’s effectiveness in carrying out its responsibilities as a central bank, including the making of mon- etary policy and the management of the discount window. But most important, as the crisis has once again demonstrated, the Federal Reserve’s ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the reg- ulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Develop- ment to assess how we might further increase transparency in the mortgage process. We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaning- ful opportunities to avoid overdraft fees. In addition, the Federal Reserve has implemented an expanded consumer compliance super- vision program for nonbank subsidiaries of bank holding companies and foreign banking organizations. More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again dev- astated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. Thank you. Senator JOHNSON. [Presiding.] Thank you, Mr. Chairman. Is there an agreement that 5 minutes should be enough on the clock? I do not want to be overly rigid, but so be it. Chairman Bernanke, the weather has been unusually harsh across the country in the past month. This has disrupted business 10 and Government activity and is likely to have an impact on em- ployment. Do you think the effects will be strong enough to show up in the next month’s employment statistics? Mr. BERNANKE. Senator, first I would say that the harsh weather will not have permanent effects on the—— Senator BUNNING. Turn on your microphone. Mr. BERNANKE. Pardon me. Senator, I would like to say first that the harsh weather is unlikely to have any permanent effects on the economy, simply a temporary effect. But it does seem likely that there will be some impact on the employment statistics for Janu- ary. It is very hard to know exactly how much, but the snowstorms were during the week in which the information is gathered about payrolls. It may also affect unemployment insurance claims and some other kinds of information. So we will have to be particularly careful about not overinterpreting the data that we receive for Jan- uary. Senator JOHNSON. As Congress grapples with the need for job creation and the need to reduce our mounting deficits and national debt, can you talk about the impact unemployment and the budget imbalance could have on inflation? Mr. BERNANKE. Well, currently Senator, inflation looks to be sub- dued. We are not expecting inflation to rise significantly in the near or medium term. On the one hand, the unemployment and the low use, utilization, the low rate of utilization of labor has been a force keeping wage gains very lower, which, of course, from a worker’ perspective is a problem. From the perspective of employers, they are seeing both very slow wage growth and because of all the cuts and cost-cutting measures, they are also seeing very strong increases in produc- tivity, which are quite remarkable. So the combination of slow wage growth and high productivity gains means that the unit labor costs, the costs of production are, if anything, falling for most firms. So that, together with very weak demand in many indus- tries, means that firms have very little ability or incentive to raise prices, which would, of course, tend to moderate inflation. On the deficit, the impact on inflation in the near term I think is limited. Of course, it is important that Congress, the Administra- tion, find solutions to our longer-term debt problems. Otherwise, it is conceivable—and I am not anticipating anything in the near term, but it is conceivable that it could lead to a loss of confidence in aspects of the U.S. economy. It could affect interest rates. It could affect the value of the dollar. And those things could directly or indirectly affect the state of the economy, the recovery, and, of course, the rate of inflation. Senator JOHNSON. As the Federal Reserve begins to wind down purchases of mortgage-backed securities, what steps, if any, are needed to ensure stability in the housing market during this tran- sition? Mr. BERNANKE. Well, as you know, Senator, we are at this point planning to end our purchases at the end of this first quarter. A question is to what extent will mortgage rates be affected by the end of our purchases. Of course, even though we have stopped pur- chases, we still retain on our balance sheet $1.25 trillion of mort- gage-backed securities, and we believe that the holding of all those 11 securities off the market in itself will tend to keep mortgage rates down. We do not know for sure how much mortgage rates will respond to our leaving the market. So far, there is little evidence of much change in mortgage rates, but obviously, we have to keep moni- toring that. If there is a response which seems to threaten the broader economic recovery, we certainly would be prepared to re- view that decision. But, again, at the moment it does not seem to be that a large change in mortgage rates or any effect on housing is evident. Senator JOHNSON. Although the minutes of the January 26–27, 2010 Federal Open Market Committee meeting indicate that core measures of inflation have been stable, they also indicate that headline inflation with swings in energy prices and core inflation may have been held down by unusually slow increases in the price index for shelter due to the housing crisis. Do you think that poten- tially higher future energy and housing costs pose an inflationary threat in the medium run? Mr. BERNANKE. Well, we believe that the underlying trend of in- flation, given stable expectations, given a very weak economy, looks to be subdued. Of course, we monitor energy and commodity prices very closely and they can vary substantially depending, for exam- ple, on the strength of the global recovery. Recently, energy prices have been roughly stable and futures prices don’t indicate an ex- pectation of sharp increases in the near term. So, again, we will continue to monitor energy prices, but currently, at least, they are not presenting a major inflationary threat. The very high vacancy rates in rental properties are keeping rents down, as well as vacancies in homes, as well, and our antici- pation is that shelter costs are going to remain quite subdued for some time. Senator JOHNSON. Senator Shelby. Senator SHELBY. Thank you. Chairman Bernanke, this Committee continues, as you well know, to wrestle with financial reform and the role of the Fed has been a significant part of that debate, as you are well aware. Chairman Dodd has previously proposed stripping the Fed of its regulatory authority, allowing you and your colleagues to focus on your monetary policy, lender of last resort, and payment systems functions and so forth. On the other hand, some on the Committee have argued in favor of allowing the Fed to retain some type of reg- ulatory authority over the largest institutions, perhaps some of the others. What do you see—how do you see such an approach, as a net positive or a net negative here, and what would you do as Chair- man of the Board of Governors of the Fed if the will of the Con- gress was to give the Fed another opportunity to be a regulator? What would you change, considering all the problems that were had in the last 7 years in the regulatory process? Mr. BERNANKE. Thank you, Senator. As you know, I think that stripping the Federal Reserve of its supervisory authorities in the light of the recent crisis would be a grave mistake for several rea- sons. 12 First, we have learned from the crisis that large, complex finan- cial firms that pose a threat to the stability of the financial system need strong consolidated supervision. That means they need to be seen and overseen as a complete company, reflecting the develop- ments not only in their banks, but also in their securities dealers and all the various aspects of their operations. A bank supervisor which focuses on looking at credit files is not prepared to look at the wide range of activities of a complex inter- national financial firm. The Federal Reserve, in contrast, by virtue of its efforts in monetary policy, has substantial knowledge of fi- nancial markets, payment systems, economics, and a wide range of areas other than just bank supervision, and in our stress test, we demonstrated that we can use that whole range of multidisci- plinary skills to do a better job of consolidated oversight. By the same token, we need to look at systemic risks. Systemic risks themselves also involve risks that can span across companies and into various markets. There again, you need an institution that has a breadth of skills. It is hard for me to understand why in the face of a crisis that was so complex and covers so many mar- kets and institutions you would want to take out of the regulatory system the one institution that has the full breadth and range of those skills to address those issues. Let me mention your second point, and I think your point is very well taken. As I discussed in my testimony, we have taken very, very seriously both changes in our performance, changes in the way we go about doing supervision, but also changes in the struc- ture of supervision, and we have made very substantial changes in order to increase the quality of our supervision, to increase our ability to look for systemic risks, and to use a multidisciplinary cross-expertise platform to look at these different issues. So we are very committed, and I would be happy to discuss with you through a letter or individually more details. I guess I would also like, if I might just have one more second, the Federal Reserve, of course, made errors and made mistakes in the supervisory function, but we were hardly alone in that respect and there were—— Senator SHELBY. But what have you learned? I guess that is the question. Mr. BERNANKE. Well, my—— Senator SHELBY. You and the Board of Governors. What have you learned? Mr. BERNANKE. We have learned several things. We have learned, first, that regulations need to be tougher, and we have led the effort to strengthen capital requirements, to strengthen liquid- ity requirements, to put more controls, risk controls into these com- panies. We have learned that we need to have a more risk and sys- temic-oriented approach and we have changed our approach to do that. So we have gone at this very extensively. Senator SHELBY. Mr. Chairman, I want to briefly get into the Volcker Rule and size limits. The Administration recently proposed, as you well know, that limitations be imposed on banks and bank holding companies with respect to trading activities, including pro- prietary trading, the so-called Volcker Rule. The Administration also proposed placing limitations on what was referred to as, quote, 13 ‘‘excessive growth’’ of the shares of liabilities at the largest finan- cial firms. What are your views on the Volcker Rule proposal, and sepa- rately, on the proposal to limit excessive growth in the firms’ liabil- ities? And do the regulators right now have the power, as some people have suggested, to invoke the Volcker Rule, or would you need legislation if the Congress so thought it was necessary? Mr. BERNANKE. Senator, first, I think we would all agree that we don’t want companies taking excessive risks when they are pro- tected by the government safety net, so that is very important. There are obviously multiple ways to address those risks and they include capital requirements, and we have increased capital re- quirements, as well as, for example, restrictions on executive com- pensation, which affect willingness to take risks. If you go about imposing the Volcker Rule, I think it would be difficult to do on a purely legislative basis because of the potential for having unintended consequences. So while on the one hand you may want to restrict purely proprietary trading, you also want to distinguish that from, say, appropriate hedging behavior—— Senator SHELBY. You have to be careful, don’t you? Mr. BERNANKE. You have to be careful of unintended con- sequences. Hedging, market making, customer activities can in- volve ownership of securities for a period of time. I do think if you want to go in that direction, you should at least allow some role for the supervisors to make determinations about individual activi- ties. I think it would not be inappropriate if a supervisor deter- mines that a company doesn’t have the managerial or risk capacity to appropriately manage a particular activity, for the supervisor to be able to restrict that activity. I would argue that we have that authority to some extent now, but if Congress wants to reinforce that, of course, it couldn’t hurt. Senator SHELBY. Thank you, Mr. Chairman. Senator JOHNSON. Senator Reed? Senator REED. Thank you very much, Mr. Chairman, and wel- come, Chairman Bernanke. A follow-up on the Volcker Rule. How would you implement it if you were to do it through your regulatory process? Mr. BERNANKE. We would do it as part of our overall risk man- agement assessment. We would look at the range of activities that the company engages in. There might be some activities that would be explicitly prohibited by legislation, say perhaps owning a hedge fund, for example. But if there are other activities, such as pur- chasing of, say, credit default swaps, I think it would be appro- priate for the supervisor to, first of all, ascertain that the use of credit default swaps is primarily intended to hedge other positions and therefore is overall a net reduction in risk for the company as opposed to an increase or a speculative increase in risk. Second, even if the purposes of the program are in some sense legitimate, there is still the question of whether the company has adequate managerial risk management resources to properly man- age those risks, and what we saw in the previous crisis, and I think this is one of the things we really learned, is that many large, complex companies didn’t really understand the full range of risks that they were facing and as a result they found themselves 14 exposed in ways they didn’t anticipate. So if a company didn’t have strong risk management controls and a strong culture of system— enterprise-wide risk management, I think that would be also grounds for the supervisor requesting either substantial strength- ening in those controls or eliminating those activities. Senator REED. Just an observation. Those controls are much more rigorous today, but they tend to erode over time, particularly as these unpleasant crises fade. And also, the capacity of the regu- lators, the Federal Reserve and other regulators, to make very nuanced judgments about management, et cetera, there is really a question of regulatory capacity as well as managerial capacity that at least the last several months suggests that it won’t be handled by simply sort of letting you do what you inherently can do now. Mr. BERNANKE. Well, certainly Congress could provide guidance about what they would like to see shut down or make specific stat- utory recommendations or statutory laws. But another—I am sorry. I lost my train of thought. Oh, yes, sorry. I just recalled. I think another part of the reform package that is very important is the resolution authority and measures taken to address the too-big-to-fail problem. If you can address the too-big-to-fail problem and get market discipline affect- ing firms so that investors will have an incentive to try to evaluate the risk taking of those firms, that will be an additional—not a panacea, but it will be an additional factor helping the regulators and the firm itself make good decisions. Senator REED. Underlying this discussion of the Volcker Rule is a more general principle, I think. That is, what risks should tax- payers support? I think there is a consensus that traditional com- mercial banking, which everything has a risk, has historically been supported and should be supported. But the ability to access your credit facilities and your authority under 13(3) by large financial institutions whose primary activity is not commercial banking but either proprietary trading, which is inherently riskier, I mean, there is a real question here of whether they should have that ac- cess and I think that is at the heart of the Volcker Rule. To your point about too big to fail, I mean, the size has not been indicative of the sort of capacity to fail, so again, I just—there are real questions that we have to wrestle with with respect to, as a policy that you will implement, whether we are going to, with tax- payers’ money, support very profitable risk-taking activities when they work and catastrophic activities to taxpayers when they don’t work. Mr. BERNANKE. Well, Senator, as an example, consider the sav- ings and loans, which basically were killed by interest rate risk. Today, they would either be able to securitize the loans that they made or they would be able to hedge that interest rate risk. So I am not disagreeing with you at all. I think we all agree that we don’t want excessive risk taking, particularly on a ‘‘tails, I win, heads, you lose’’ basis, certainly. But there are some legitimate purposes for using securities and we just want to make sure not to increase the risk—— Senator REED. No, I recognize the difficulty of sorting out a pro- prietary trade. You don’t have the staff, frankly, to do that, to keep up with every trading platform and every trading floor in the coun- 15 try. So that is why I think there has to be perhaps a simpler ap- proach, since these organizations are so large in terms of their trading versus the commercial banks, they might not qualify for the same type of support. Thank you. Senator JOHNSON. Senator Bunning? Senator BUNNING. Thank you, Mr. Chairman. Thank you for being here. On the discount rate increase, how much lending is currently outstanding at the discount window? I don’t want to know the peo- ple, I just want to know the amounts. Mr. BERNANKE. I believe it is in the order of $17 to $20 billion. Senator BUNNING. OK. If that is the case, since there is so little discount window borrowing going on, the increase in the discount rate seems to be more for show than for substance. On top of that, you and the Fed have gone out of your way to downplay the impor- tance of that move. Why should anyone take that move as a sign that you are serious about taking away the punch bowl at this time? Mr. BERNANKE. Well, Senator, what we have been trying to do is to eliminate the extraordinary support that we have provided fi- nancial markets, and we had a wide range of programs that try to address the dysfunction in the commercial paper market, money market mutual funds, interbank markets, repo markets, and a va- riety of others. And as I mentioned in my testimony, on February 1, we shut down most of those programs. By June, we will have no more of these 13(3) programs—— Senator BUNNING. Except—except what Senator Shelby brought up. On Tuesday, the Treasury announced that they were starting up a supplemental financing program again. It is $200 billion-plus. Under that program, Treasury issues debts and deposits the cash with the Fed. That is the effective same thing as the Fed issuing its own debt, which you know is not legal. Mr. BERNANKE. What it does—— Senator BUNNING. There are—well, let me finish with the ques- tion and you can answer. What are the legal grounds that the Fed and Treasury used to justify that program? And did anyone in the Fed or Treasury object when the program was created? Mr. BERNANKE. Well, legally, we are the fiscal agent of the Treasury and we hold Treasury balances that they—for all kinds of purposes, so there is no—— Senator BUNNING. But they are not allowed to issue debt, Treas- ury. Mr. BERNANKE. Treasury is allowed to issue debt. Senator BUNNING. On its own? Mr. BERNANKE. I don’t—they issue bills and other kinds of debt all the time. Senator BUNNING. Oh, yes, Treasury notes, Treasury bills, Treas- ury 2-years, 5-years, 10-years. But you are buying—you buying their debt. Mr. BERNANKE. We are just paying them interest on their depos- its on our balance sheet. Senator BUNNING. OK. That isn’t the answer that I wanted. 16 Given what you learned during the AIG crisis and the bailout, do you think Congress should be doing something to address insur- ance regulation or the commercial paper markets? Mr. BERNANKE. Well, Senator, I think AIG is the poster child for, first, consolidated supervision. It did not have a strong consolidated supervisor that was paying attention to its derivatives activities, for example. That is very important to do. Second—— Senator BUNNING. Were those the ones in England? Mr. BERNANKE. No, those were the ones, the CDS—the credit de- fault swaps that the Financial Products Division was exposed—— Senator BUNNING. Weren’t they located in London? Mr. BERNANKE. Well, they were in any case accessible to U.S. regulators. Senator BUNNING. I didn’t ask that question. I said, but didn’t AIG have an office in London that did those things? Mr. BERNANKE. It had some foreign offices, but I believe that the Financial Products Division is headquartered in Connecticut. Senator BUNNING. OK. Go right ahead. Mr. BERNANKE. So again, to address AIG issues, you need a strong consolidated supervisor that can identify those kinds of risks to the company and you also need some methodology, and I think you would agree that we don’t want to have too-big-to-fail firms. We don’t want the Fed involved in these bailouts. So you need an alternative legal structure. We have supported a resolution regime. I know this Committee is considering alternatives that would allow the government, excluding the Fed, to wind down a firm like this in a crisis in a way that would not bring down the overall financial system. I think that is a very important direction. Senator BUNNING. Does any other Fed Governor have their own staff? Mr. BERNANKE. The staff of the Federal Reserve works for all the Governors. There is no—— Senator BUNNING. That is not my question. Mr. BERNANKE. The staff—no, not dedicated, except for cler- ical—— Senator BUNNING. OK. Do you think they should? Mr. BERNANKE. No. I think we all work collectively and we all get the support from the entire staff. Senator BUNNING. Do Fed Governors have access to the Board’s staff recommendations or do they only get to see the recommenda- tions you approve of? Mr. BERNANKE. They see the staff recommendations. Senator BUNNING. They do? Mr. BERNANKE. Yes. Senator BUNNING. Have you ever tried to change or influence staff recommendations before they were presented to the Board? Mr. BERNANKE. Not final recommendations, no. Senator BUNNING. Your e-mails tell us differently. Mr. BERNANKE. You are referring to an e-mail where a prelimi- nary draft by a couple of economists—— Senator BUNNING. It was the Fed staff. That is what the—— Mr. BERNANKE. It was Fed staff, but it wasn’t the Fed staff’s rec- ommendation because it was a draft done by several people in the division, not by the leadership of the staff. And it was, in any case, 17 a recommendation that was outdated because of changes in cir- cumstances. Senator BUNNING. That was in your opinion. Mr. BERNANKE. Yes, sir. Senator BUNNING. I have more, but I am past my time. Senator JOHNSON. Senator Akaka? Senator AKAKA. Thank you very much, Mr. Chairman. I want to welcome Chairman Bernanke back to the Committee and also to congratulate and welcome him and wish him well in his continued tenure as Chairman of the Board of Governors of the Federal Reserve System. We both share a commitment to improv- ing the lives of working families by better educating, protecting, and empowering consumers. Chairman Bernanke, Chairman Dodd and other Members of this Committee helped develop and enact meaningful card reform legis- lation. I am proud that the law includes provisions from my Credit Card Minimum Payment Warning Act which will provide con- sumers with detailed personalized information on their billing statements and access to reputable credit counseling services. Con- sumers will learn the true costs of making the minimum payments and how long it will take for them to pay off their balance if they only make minimum payments. Consumers are also provided with the amount that they need to pay to eliminate their outstanding balance within 36 months, which is the typical length of a debt management plan. This useful information recently started appear- ing on statements, and I looked at it and was happy to see it. My question to you is, how will the personalized credit card min- imum payment information influence the behavior of consumers, and also what additional personalized disclosures pertaining to other financial service products would enable consumers to make better informed choices? Mr. BERNANKE. Well, Senator, I congratulate you on those con- tributions. As you know, the Federal Reserve developed extensive disclosures for credit cards as well as some rules which were very extensively incorporated in the Congressional bill that passed and was signed by the President. Obviously, as you point out, the more information you can pro- vide consumers, the better decisions they can make and the kinds of information about minimum balances, time to pay off, the cost of the card, the penalties they might face, those are the kinds of things people need to shop. If they can shop, the market becomes more competitive and you get a market that better serves con- sumers. We have been very focused on good disclosures, good information. We have in our disclosure reform that we did earlier, we—I don’t see Senator Schumer here yet today, but there is the so-called Schumer Box, which has—— Senator BUNNING. He is at the White House. Mr. BERNANKE.——has a list of key features of the account. We have done a lot of work on that to make it easier to read and more understandable to consumers. One of the innovations pioneered by the Federal Reserve has been to use consumer testing. We have gone out and instead of having some lawyers just sort of figure out what should be in the 18 disclosure, we have actually gone out to shopping malls and had people look at the disclosures and then we have tested them to see how much they understand and retain. And by doing that, we think we are improving considerably the ability of folks to under- stand what they are buying and encouraging them to shop around to get a better deal. So again, I congratulate you on your contributions to this and on your longstanding support for financial literacy and for clear disclo- sures. Senator AKAKA. Mr. Chairman, unfortunately, investment banks, credit card issuers, and predatory lenders through their excessive bonuses and unfair treatment of consumers are giving the term ‘‘bank’’ an even greater negative connotation. I am afraid that abused or angry consumers may continue to underutilize main- stream financial institutions. After having grown up in an unbanked home, I personally know the challenges that confront the unbanked. Many community banks and credit unions provide vital financial services to working families by providing opportunities for savings, borrowing, and low-cost remittances. The question is, why is it essential that we attempt to encourage the unbanked and the underbanked to utilize mainstream financial institutions more? Mr. BERNANKE. Well, Senator, as you well know, for various rea- sons, lack of information, cultural reasons, and so on, many minor- ity or immigrant communities don’t make much use of the regular banking system. The cost of that is they may find themselves pay- ing much more for check cashing or for short-term borrowing or for other services that they need. In most cases, they would be better off in a mainstream financial institution. We have encouraged banks, credit unions, and other financial in- stitutions to reach out to minority neighborhoods by, for example, having people on staff who speak the language, through advertising and through other activities, through the CRA, the Reinvestment Act. By doing that, you attract people from these communities and give them access to the broader financial network. It helps them not only to get better deals on their financial services, to pay less for check cashing, for example, but it also helps them begin to learn how to save or learn how to borrow for a home and do other things that you need to have access to the broad mainstream finan- cial system in order to achieve. So I think it is very important that mainstream financial institu- tions continue to reach out to people in their communities, includ- ing minorities and immigrants, to attract them to use of main- stream financial services. Senator AKAKA. Thank you. Thank you very much, Mr. Chair- man. Senator JOHNSON. Senator Johanns? Senator JOHANNS. Thank you, Mr. Chairman. Mr. Chairman, good to see you again. Mr. Chairman, let me start out and say that I think we have done some good work as we have tried to move through regulatory reform. I think everybody, quite honestly, has learned from the mistakes of the last years, no doubt about that. But I must admit, I have a concern about something that I think is shared by prob- 19 ably everybody here. It may be a little sensitive, but I want to ask about it, and that is Fannie and Freddie. We have spent a lot of time talking about too big to fail and look- ing at private companies and how gigantic they had gotten and how that really put us in a box. In the end, the taxpayers got put on the hook for that. Isn’t Fannie and Freddie the government version of that too big to fail? And how do you get out of that box? Mr. BERNANKE. Well, Senator, first, as I am sure you know, the Federal Reserve has a long record of warning about the dangers of the structure of Fannie and Freddie. There are numerous dan- gerous, including conflicts of private and public interest, and most notably, insufficient capital to support the very large portfolios that they held. And, in fact, it turned out they didn’t have enough cap- ital and now the U.S. Government, the taxpayer, is subject to sub- stantial cost. Right now, we are kind of in no man’s land. Fannie and Freddie are in conservatorship. They are part of the government’s efforts to maintain the housing market because there really is no other source of mortgages at this point, or mortgage securitization. But certainly, this is not a sustainable situation and I think it is very important that we move toward clarifying the longer-term status. There are numerous ways to go. I have talked about some in a speech. But to give two examples, one would be a privatization ap- proach, which might allow the privatized firms that securitize mortgages to purchase insurance from the government for the mortgages that they package and sell. Another possibility would be just to acknowledge that these are government utilities and incorporate them with Ginnie and FHA and other government agencies. So those are two very different ap- proaches, but both of them have the advantage of eliminating this platypus kind of, you know, neither fish nor fowl status that those firms have now. Senator JOHANNS. Neither approach will eliminate the exposure that the taxpayer faces. Would you agree with me there? Mr. BERNANKE. Well, for example, if you had a situation where privatized firms were not allowed to hold large portfolios, which is a major source of the risk, first; and, second, that they paid actu- arially fair premiums to the Government as opposed to the implicit support they had before, there would still be risks to the taxpayer, but at least there would be some compensation, some premium is being collected. Senator JOHANNS. In effect, it sounds to me like a Government liquidation, and I do not know that I would want to personally buy into that. But I guess as a taxpayer we would all end up buying into that. But it is a huge number, isn’t it? It is probably $1 trillion plus of exposure. Mr. BERNANKE. Well, it depends how you count exposure. Of course, the mortgage-backed securities outstanding are in the tril- lions. Senator JOHANNS. Yes. Mr. BERNANKE. The Government’s commitment at this point is a couple hundred billion to those institutions. Senator JOHANNS. Let me also draw your attention to something, and I am running out of time here, but I was just catching up on 20 some things, and I noticed today that first-time unemployment fil- ings have increased. That was not expected. Durable goods orders have fallen the most since August. That is not a good sign. And that excludes, I think, transportation. The market has responded by dropping at least at this point by 160, and I appreciate the market can have up days and down days. I am starting to read more and more articles about the national debt interfering with economic recovery. And yet I do not see an effort to slow that down here. In fact, if we were just to stand down and say, OK, we will adopt the President’s plan, there are trillion dollar deficits over the next decade. I cannot imagine how that turns out for—you know, I will be 70 years old the next decade. I am not going to live long enough to pay that off. That means my children and grandchildren are going to have to deal with that. I am beginning to wonder, Mr. Chairman—and I do not want this to sound overly pessimistic, but I am beginning to wonder whether low interest rates really have any possibility of spurring this economy. And I will tell you what I am thinking about, and you may not even have enough time to respond. Unless there is de- mand, unless we can get consumers back into it, it just seems very unlikely to me that you are going to see much growth. I talked to people who handle the freight—the railroads, the trucking companies. They are not seeing much improvement. All these signs point to a situation where, quite honestly, this economy is still enormously flat. And I am not sure that offering somebody an interest rate at 2 percent versus 4 percent is going to get us on the other side of this, and I would just like your thought on that. Mr. BERNANKE. Well, first, I agree that the economy is still very weak and very disappointing in that respect. I think low interest rates do tend to help, and I will give you a couple of examples. One, you mentioned the durable goods. Notwithstanding—I have not had a chance to get into those numbers in detail this morning, but investment, actually equipment investment, equipment and software investment has been something of a bright spot and has been growing. And part of the reason for that is that larger firms at least have pretty good access to credit at reasonable rates in the corporate bond market, for example, and that has supported the in- vestment rebound, which is a big part of what we are seeing in the recovery. Another example is that the Fed’s actions, interest rate actions and our purchases of mortgage-backed securities, have helped bring down mortgage rates. That has helped to some extent to stabilize demand for housing and helped—as you may know, house prices seem to have flattened out and begun to rise a bit, which is very important for consumers in terms of their wealth, in terms of the risk of foreclosure, and in terms of, you know, restarting activity in the residential construction sector. So those are two examples where we see growth. We did have 4- percent growth in the second half of 2009. I think the issue we face is will the growth be fast enough to materially reduce the unem- ployment rate at a pace that we would like to see, and that is a big uncertainty right now. But we are getting some output growth at this point. 21 Senator JOHANNS. Mr. Chairman, thank you. Senator JOHNSON. Senator Brown. Senator BROWN. Thank you, Mr. Chairman. Mr. Chairman, nice to see you. We all know for most of our Nation’s history—I am going to go in a bit different direction. For most of our Nation’s history, manu- facturing and agriculture and transportation drove our economy, whether it is steel in Youngstown or agriculture around places like Lexington, Ohio, or the Port of Cleveland shipping raw materials and finished goods all over the Midwest. As an expert on—as an economic historian, as you are, and an expert on the Great Depression, you are aware, obviously, of the role of manufacturing, especially a historic role, in pulling our Na- tion out of recession. As many Ohioans can tell you, can painfully tell you, manufac- turing steadily declined over the last three decades. At the same time, we know that the financial industry has rapidly expanded. As recently as the 1980s, manufacturing made up 25 percent of GDP; financial services made up less than half of that, in the vicin- ity of 11 or 12 percent. Those numbers crossed in the 1990s. Now it is almost a direct flip. Manufacturing, 12 percent; financial serv- ices, 20 or 21 percent. Wall Street’s output, put another way, was equal to all the Farm Belt States and the Industrial Belt States combined. In 2004, 44 percent of all corporate profits in the United States came from the financial sector compared with 10 percent from manufacturing. And I say that as a preface to my question for this reason: Kevin Phillips, the writer, has noted sort of the history of great nations in the last 400 years. Habsburg Spain, the United Provinces of Netherlands, and Imperial England, all three saw their economies go from manufacturing, shipping, agriculture—depending on which of each of the three—and energy into more and more emphasis on financial services. And the financialization in that sense is what probably cost those empires their empire. They were countries that never really recovered in the wealth creation. It really is the fact that banking is not an independent source of wealth. It does not cause our prosperity. The success of banking is created by our suc- cess and our ability to create wealth. Then I hear people, when I talk about manufacturing policy, I hear your predecessors say this, I hear advisers in the White House, regardless of party, say we cannot have a manufacturing policy, we cannot pick winners and losers. Well, it is pretty clear in the 1980s that this country, this Government, your predecessors, and the Treasury Department picked winners and losers. They de- cided that financialization, the financial services sector should be the winner as we got rid of usury laws, as we changed rules and deregulated and all those things. So we put ourselves in a position where, as Kevin Phillips said, finance is the chosen sector of the U.S. economy. So my question is this: As your role, your statutory role, a man- dated target of 4-percent unemployment, it is at least twice, maybe three times that right now. When I look at a building on the Oberlin College campus 20 miles from my house, fully powered by solar energy, the largest solar-powered building on any college 22 campus in America, about 8 years it was built. All the panels were built in Germany, a country that had an industrial policy that stimulated demand and supply and have built clean energy jobs way better than we have. You read the articles in the paper about what China is about to way outcompete us on alternative energy, solar and wind turbines. We know all that. We still sit with no manufacturing policy. So my question is this: As the economic historian that you are, are you troubled by the fact that the financial sector is now twice the size of the manufacturing sector? And I put parentheses around the next part of that, that no country that I can see in economic history has done well when that happened. Are you troubled by that? And if you are troubled by that fact that the financial indus- try is twice the size of manufacturing, flipping what it was, what should we do about it and what are you doing about it? Mr. BERNANKE. Well, financial services obviously has a place to play in a modern economy, and it is a productive industry in the sense that it helps allocate capital more effectively and share risk and do important things like that. I think we would all agree that over the past decade or so, financial services, residential construc- tion, and some other sectors may have become too big relative to other sectors, and we are now seeing the painful unwinding of that process. I think the right way to address the size of financial services is to make sure that it is being productive and constructive, and that means having a good regulatory regime that directs—that provides a context in which financial services will do productive, construc- tive things for the economy. So good financial regulatory reform should lead the financial services industry to adjust to an appro- priate size that is right for the economy. On manufacturing, it is really a mixed picture in the United States. We still are probably the biggest or one of the biggest man- ufacturers in the world. We are the most productive. We have had extraordinary increases in productivity, in manufacturing recently. That, in fact, is part of the reason why the employment share of manufacturing keeps going down, is that we need fewer workers to produce a car or an airplane than we used to. Senator BROWN. That is true, Mr. Chairman, but look at the profits of the financial services—the chasm between financial serv- ices and manufacturing is—the chasm is big in terms of the per- centage of GDP. It is even larger in terms of profits in the last 5 years. Keep that in mind. Mr. BERNANKE. So in terms of the financial industry, you know, I think markets should be allowed to work, but they should be al- lowed to work in an environment where regulation is appropriate and where there is an appropriate level playing field. So you would, I suppose, agree that financial services were not appropriately reg- ulated or appropriately supervised. If we strengthen that regula- tion and allow appropriate changes to take place, that ought to bring down the size of the financial services industry to a size which is more appropriate for our economy. Manufacturing is another issue. I think there are lots of things that mostly Congress—I do not think the Federal Reserve has a lot of direct influence on any particular sector. But there are a lot of 23 things that Congress can do. There is tax policy, there is immigra- tion policy, trade policy. There is the issue of picking winners and losers. I think that is difficult to do. But you gave the example of solar panels. Solar pan- els are a viable industry with Government support if the Congress determines that, for example, for global warming purposes that carbon-reducing technologies or capital is socially desirable and, therefore, supports that activity, then that will—the private sector will, therefore, come out and produce that. So that is a determina- tion of Congress whether it needs a public subsidy. I do not think that many of those alternative energy sources would survive by themselves in a marketplace because whatever value they have in reducing carbon, for example, is not captured in their price in the market. So I guess what I am saying is that we need, first of all, better regulation in finance to bring finance down to an appropriate size and an appropriate set of functions. And there are a set of things that Congress can do to try to improve our trade balance, for exam- ple, to improve the tax policy. I think, frankly—and this is a topic that I never could get much traction on. I think that our immigration policy which restricts se- verely the number of highly trained, skilled immigrants is a prob- lem because bringing those sorts of folks in helps our high-tech in- dustries develop more competitive—become more competitive. So there are things I think you can do to strengthen manufacturing. I would also just note that while it has been a very severe reces- sion in the manufacturing sector, manufacturing is, in fact, leading this recovery, as you pointed out. Industrial production has been very strong, and we are seeing, in fact, growth in manufacturing employment. So it has been important in that respect. Senator BROWN. One real quick closing statement. If manufac- turing were even close to the same percentage of GDP as it was, think how much stronger—how much quicker we would come out of this recession in terms of recovery, just as a point of reference perhaps. Thank you, Mr. Chairman. Senator JOHNSON. Senator Vitter. Senator VITTER. Thank you, Mr. Chairman. Thank you, Mr. Chairman, for being here and for your work. Thank you for your monetary report. Mr. Chairman, when I go around my State and have town hall meetings and other things, obviously folks are real concerned about jobs and the recession. But I get just as many questions and ex- pressions of concern about what they consider the next looming cri- sis caused by spending and debt. Now, obviously, you gave us a monetary report focused on things you can control. Federal spending and debt is not something you can directly control. What is your general projection and outlook, once we are out of this current recession, for the impact on the current levels of what are, in my view, unsustainable Federal spending and debt and the impact on the economy? Mr. BERNANKE. Well, Senator as you point out, at the moment we are in a deep recession. Revenues are down to 15 percent of 24 GDP. We have a lot of costs arising from the recession, and so defi- cits are extremely high. The really interesting question is: What is the structural me- dium-term deficit? If you look at the range of estimates provided by the OMB and the CBO over different scenarios and so on, most of them suggest that the deficit after we come out of recession, say 2013 or so and the rest of that decade, should be somewhere be- tween—will be somewhere between 4 and 7 percent of GDP. That is not a sustainable number. A rule of thumb is that in order to keep the ratio of outstanding Government debt to our GDP more or less constant—I mean, it would be better even to reduce it, but just to keep it constant, you need to have deficits more in the area of 21⁄ 2 to 3 percent. So I think it is important—so 4 to 7 percent is not sustainable. If it were actually to happen, what we would see is increasing in- terest costs, and eventually the markets would just entirely lose confidence in our fiscal policy, and interest rates would spike. So it is very important for Congress—even though we are now still in a very deep recession or in a very weak economy, it is im- portant for Congress to try to clarify how we are going to exit from our fiscal position and try to provide a credible blueprint for how our Federal deficit will be controlled over the next 10 years and 20 years. Senator VITTER. And just to follow up on that, let us say in the future we reach a point that we are truly out of this recession in a meaningful way and those deficits are where they are projected, 4 to 7 percent, versus 21⁄ 2 . How quickly would that become a major problem in terms of the economy? Mr. BERNANKE. Well, it could become a problem tomorrow if bond markets are not persuaded that Congress is serious about bringing down the deficit over time. But in any case, certainly if you look at the CBO numbers, you know, by 2025, 2030, under existing poli- cies we are going to be seeing the curve very sharply rising and—— Senator VITTER. But surely way before that it would be an issue and a problem in terms of interest rates, et cetera. Mr. BERNANKE. Absolutely. Absolutely. And you would be seeing debt-to-GDP ratios rising; you would be seeing crowding out of in- vestments and other problems. Yes, absolutely. Senator VITTER. So is it fair to say, you know, we are perhaps not seeing those immediate threats because we are in a serious re- cession? Once we come out of that, those immediate threats, the chances of their having a real negative impact elevate enormously. Mr. BERNANKE. That is right. And we are not completely sure we will not have negative effects even sooner than that. Senator VITTER. Before that. Mr. BERNANKE. Depending on how interest rates respond. Senator VITTER. Right. Mr. Chairman, I want to Fannie Mae and Freddie Mac. On June 18, the Treasury Secretary said before us, ‘‘Fannie and Freddie were a core part of what went wrong in our system.’’ I assume you agree with that. Mr. BERNANKE. Yes, sir. Senator VITTER. We are discussing regulatory reform. In terms of the draft bills we are discussing, there is no title on Fannie and 25 Freddie. When should we be addressing that? Sooner rather than later, or when? Mr. BERNANKE. Well, I think for no other reason than just trying to reduce uncertainty in the markets, the sooner that you can come to some clarity on the future of Fannie and Freddie, the better. Of course, I understand that you are dealing with a lot of complex issues in financial reform and health care and in other areas right now. But it would be, obviously, helpful to try to get some clarity on that. That does not mean necessarily that you can get to that new sit- uation quickly. It is going to take some time to move from the cur- rent situation to a more stable long-run situation. But certainly I hope Congress is looking at this issue now and thinking about where you want to go. Senator VITTER. OK. We are really not looking at the issue now, at least in a meaningful way. And the schedule, as I understand it, particularly from Treasury, is not until 2011. Is there any good reason, in your opinion, to essentially put that off to 2011? Mr. BERNANKE. Well, I think their concern is just that the agen- da is so full and is there time, you know, for everyone to focus on that. And that is not my judgment to make, but I think that is their concern. I think they would agree that an earlier resolution would be better, certainly. Senator VITTER. OK. Mr. Chairman, I want to go to resolution authority and 13(3) type authority, and we have talked about this before, but it is really important so I want to have the discussion quickly again. If in our regulatory reform package we come up with a reason- able, workable wind-down mechanism to resolve large failed insti- tutions in an orderly way, to take them down, to break them up in an orderly way, if we do that, would you support our also end- ing, taking away 13(3) and other similar authority from the Fed and others to put taxpayer dollars in large quantities into indi- vidual firms? Mr. BERNANKE. In short, yes, I would support that—13(3) has been used two ways. It has been used in what you would call bail- outs, and it has been used in developing these broad-based lending facilities to help individual markets, like the ones we just closed down on February 1st. I think the latter is a valuable thing to have in case of a future crisis, but we would be happy to give up any involvement in the wind-down of failing, systemically critical firms. Senator VITTER. And just to make clear, I am talking about the former not the latter, so I think we are on the same page. Mr. BERNANKE. We are on the same page. Senator VITTER. As I understand the Treasury’s position, they say they support a resolution authority, but they essentially also want to keep that other authority as ‘‘foam on the runway,’’ as sort of a backup plan, however you want to term it. Do you think that is necessary or a good idea? Mr. BERNANKE. It depends on exactly how the resolution author- ity is structured. It might be that you want the Fed to be available to provide liquidity as part of the resolution process, for example. But, generally speaking, I prefer that you develop a process that leaves the Fed to do only its standard discount window lending 26 against collateral as it always has done, without use of the emer- gency authority. Senator VITTER. So if we get the resolution authority right, you do not see any need for that other authority with regard to indi- vidual firms continuing to exist? Mr. BERNANKE. We would be very happy if you could find a solu- tion that allows us to give up that authority. Senator VITTER. OK. Senator JOHNSON. Could you gentlemen wrap it up? Senator VITTER. OK. I have one more question, which is about audits and transparency of the Fed. I welcomed your recent written comments about that as certainly movement in the right direction from my point of view. One thing you underscored was some delay in terms of disclosing certain action so as not to disrupt the mar- kets in terms of an immediate disclosure of certain activity. What is your reaction to the idea of having the same disclosure with a lag for all loans and collateral used to secure loans made by the Fed—in other words, the normal discount window activity? Mr. BERNANKE. Including the names of the borrowers? Senator VITTER. Correct. Mr. BERNANKE. That is a concern that we have, and the problem is that if banks think they are going to be—that their names are going to be publicized, then they will not come even if they are under attack by the market, even if there is a panic or a run on the firm. So it is a very delicate issue. I think we will have further discussions, I am sure, but we are quite nervous about essentially shutting down the viability of this critical tool, which proved to be very valuable during the crisis. So that is something that we are concerned about, even, you know, with a delay. Senator VITTER. So even with a delay. Mr. BERNANKE. You know, I am sure we will have further discus- sions about this, but, you know, again, if a company is under at- tack by people who do not believe that it is stable and they know that if they go to the window, their name is going to be published even with some delay, they may feel that they have no option, that they will just have to fail, because if they go to the window and that is revealed, then the market will then believe that they, in fact, are not stable, and the whole purpose of the discount window loan will not be served. So that is a particularly sensitive one for us, even though that is a relatively small part of our lending. Senator VITTER. OK. Thank you. Senator JOHNSON. Senator Warner. Senator WARNER. Thank you, Mr. Chairman. I appreciate getting my time. Thank you, Chairman Bernanke, for being here. I do share one concern that Senator Vitter mentioned about the deficit, and, gosh, I wish we would have supported Senator Gregg’s proposal when we had a chance. I think it was still the best, perhaps last best pro- posal to actually force this Congress to take an up-or-down vote on a plan that would put us back into fiscal sanity. I want to come back on the question of financial regulation. Mr. Chairman, you make, I think, a strong case about the need to have sophisticated, strong supervision for bank holding companies and 27 that this supervision has to take a look at not just individual su- pervision but systemic risk in a macro level. I still think we are weighing where that role should be, and I am not sure, at least from my standpoint, while you make a strong case that you have fully made the case that it absolutely has to be deposited within the Federal Reserve, that it could perhaps be deposited elsewhere. You know, one of the comments you have made—and we are now 18 months after the crisis, and you have said that you have looked at the Fed within supervision of the bank holding companies, stronger capital, stronger risk supervision. You know, we have had a lot of discussion over the last 18 months about size. We have talked a little bit earlier—Senator Reed raised questions about the Volcker Rule, and I share some of your concerns about how you draw those lines. Chairman Dodd raised the question about use of some of the instruments out there in terms of derivatives. Could you tell us a little bit in this last 18 months, with this in- creased focus on the large sophisticated bank holding companies that you currently supervise, you know, what steps that has taken to strengthen that supervision in a little more specific way than you did in your—— Mr. BERNANKE. Well, it would take me quite a long time. Senator WARNER. Perhaps you could give that for the record. I would like to see—— Mr. BERNANKE. OK. So just very briefly, there has been a lot on the regulatory side. We are working with our colleagues in Basel and elsewhere to substantially strengthen and modernize the cap- ital requirements, liquidity requirements, executive compensation requirements, risk management requirements, and a whole raft of things just to give a tougher, stronger regime. So that is an impor- tant part. In terms of supervision, we are restructuring our internal organi- zation, and we think a landmark event, a watershed event was the stress tests last spring, which were incredibly successful, which the Federal Reserve led. And I think the Federal Reserve’s input to that was to supplement the standard bank examiner going in look- ing at the credit file with a lot of analytical statistical information which helped improve comparability across banks, which helped to determine the factors underlying possible risks to banks, which in- tegrated the macroscenarios so we could do stress tests and those sorts of things. So in our internal structure, we are, first of all, creating a new group which will bring together not just the bank supervisors but people from other dividends—and I mentioned the economists, the payment system people, the financial people, and so on—to manage the supervisory effort for the system as a whole, and they will be looking at a portfolio of firms, and so it will not be a firm-by-firm operation where this teams looks at Citigroup and this team looks at JP Morgan. Instead, they will be looking collectively at groups of firms doing horizontal comparisons and taking a more systemic type approach. On top of that, we will also have a quantitative evaluation team which increases something we have already done, which is cur- rently for small banks, we do not go in every year or every 6 months. What we tend to do is we look at a bunch of data, a bunch 28 of call report information, for example, and use statistical models to try and evaluate whether there are problems that we should go back and look. Well, expanding that idea in a much more sophisticated way, we can give these quantitative folks the license to look at a range of activities in the firms and look at them across firms and try to use their offsite type analysis to supplement and support the on-side analysis. Senator WARNER. Because I want to be absolutely sensitive to my colleagues’ times who have been waiting here for a long time, I want to just get one more point out. Mr. BERNANKE. Sure. Senator WARNER. I have got a lot of other questions, but I will take them at another time. Specifically in terms of, I believe, within safety and soundness you can look at proprietary trading, hedge fund activities, and pri- vate equity, whether you have ramped up on that, and one of the issues that one of the panels raised with us a little bit earlier that I thought was quite good was the whole question of interconnected- ness, and I will close with that. But I would love to get your quick comments on that, recognizing other folks have been waiting a long time. Mr. BERNANKE. So we have not tried to apply the Volcker rules. We have not forbidden some activities. But we have—— Senator WARNER. Heightened. Mr. BERNANKE. Yes, we have heightened our activities, particu- larly with respect to risk management. We find that was the big Achilles heel in the whole situation, that firms did not really have a sufficient understanding of the broad-based exposure across all their business lines to certain kinds of risks. And we have been working very hard on that part. Senator WARNER. Interconnectedness. Mr. BERNANKE. On interconnectedness, this is a place, I think, where the Federal Reserve really has a comparative advantage. We have, for example, been working very hard on strengthening the operations of the credit default swap market, the tri-party repo market, et cetera. And in doing that, we are looking at how the— it is critical to us—you know, JP Morgan plays a critical role in the tri-party repo market. DTCC plays a critical role in the securities clearing markets and so on. So we are integrating those with our analysis of the firms, and that is extremely important. We are paying a lot of attention to that. Senator WARNER. Thank you, Mr. Chairman. Senator JOHNSON. Senator Gregg? Senator GREGG. Were you here earlier than I was, Jim? Senator JOHNSON. Senator DeMint? Senator GREGG. I think Senator DeMint was here. He left. I do believe he is—go ahead. Senator DeMint. Thank you, Mr. Chairman. Thank you, Mr. Bernanke, for enduring us again here. I really appreciate you being here. I apologize for missing some of the ques- tions, but I did hear your testimony. 29 I would just like to get a broad perspective. I know we are talk- ing about a lot of the details of financial monetary systems, but just maybe a larger concern. As I look at what we are doing here in Washington overall and a lot of the debate about specifics, it does seem that the underlying debate is more about are we going to have a free market economy or more of a centrally planned, gov- ernment-directed economy. And there are very different views on monetary policy depending really on what our paradigm is, I be- lieve. My concern is as I look at where we are even versus 5 years ago, that the Federal Government owns two of our largest auto compa- nies, our largest insurance company, our largest mortgage com- pany. We are heavy in debate about expanding government control of health care. We pretty much control the energy sector, where we drill, all of those kinds of things. We are considering now a new financial reform package that would supercede State control, go all the way down to payday lenders and pawn shops. And in the proc- ess of moving in this direction, we have created huge debts, unsustainable, and 10-year projections are more than a trillion dol- lars a year additional debt. My concern is that in your testimony, that you didn’t mention any of this. Not until we questioned the debt was it a concern. I mean, I know it is a concern. I am not suggesting it is not. But I would think that given the fact that the uniqueness of the Amer- ican economic system has a lot to do with more of the Adam Smith invisible hand, bottom up, that the Chairman of our Federal Re- serve would express some concern about the expansion of govern- ment ownership and controls of large sections of the private sector economy, knowing that there is a tipping point at some point where we no longer function as a free market economy. I am not sure if we have gone past that or not, but my concern and alarm is that you had not expressed any concern or alarm of the need for Congress to look at ways to devolve and divest of these things, to try to move things back in that direction. Is that not a concern, or is your focus just not—your focus is what you have to do with what you have got to work with and that is just not your area? Mr. BERNANKE. Well, Senator, first, I have, obviously, a lot of things to talk about, so I can’t cover everything of concern. Senator DeMint. Sure. Mr. BERNANKE. Let me talk about the financial sector, and I think there, that returning to a more market-oriented financial sec- tor is a top priority and we are, in fact, doing that. For example, all the big banks have now paid back their TARP money and we are trying as quickly as we can to get those banks financed by pri- vate capital, which they have raised a great deal of private capital and it is very important. AIG, of course, is very problematic, but they are selling off assets in order to pay us back and they are making progress on that, and our objective there, of course, is to put them back in the private sector. We talked earlier about Fannie and Freddie, and I do think that we have to get away from this neither fish nor fowl situation where they are part public, part private. I think one solution would be to 30 privatize those firms, and I think that is an interesting direction to go. If I might, I think perhaps the most important thing, as a num- ber of people have discussed, this Committee is looking at too big to fail, looking at resolution authorities and so on. If you were able to get a strong resolution authority, you would do more to bring back a level competitive playing field, market discipline into the fi- nancial sector than anything else that you can do, because with a true resolution authority where creditors know they will lose money, shareholders know they will lose money if the firm fails, then they have the incentive after that to evaluate the firm’s cred- it, quality, and their risk taking and so on, and that would, again, bring back competition, bring back market discipline. So I am very much in favor of bringing back the market in all these areas, recognizing that the financial sector does need appro- priate regulation, but market forces and competition ought to play a substantial role, and I am all in favor of doing that and will work with you on that. Senator DeMint. Well, I appreciate that and I suspect we have very much the same philosophies about economies. But I think the country and the world needs to know that and I just would appre- ciate as you look at where we are that there is a need to back away from where we are. A lot has happened in a short period of time that has expanded the government scope in a lot of areas, and there is a big difference in central planning concepts, as you know more than I do, than free market accountabilities, and I think you are talking about and believe in. So I appreciate that and I thank the Chairman for allowing me to ask a question. I yield back. Senator JOHANNS. Senator Bayh? Senator BAYH. Thank you, Mr. Chairman. It is good to see you again. First, just a comment. I count myself as one who believes the Fed should retain a robust role in the supervisory area. The reason for that is that any new entity would have to get up to speed. There would be a learning curve there that I think would present some difficulties. Second, my strong impression is that you and your team have learned from the recent past about what can go wrong and that can inform your decisionmaking going forward. And third, my impression is that you gain some important in- sights by the oversight at the micro level informing your judgment about setting monetary policy and making macro decisions. So that is kind of my take on how we ought to view this going forward. Just a couple of questions. First, as you mentioned, the last quar- ter GDP figures were pretty good, but a big chunk of that was in- ventory rebuilding and that sort of thing. So we are all worried about the sustainability of the recovery, the risk of a double-dip, that sort of thing. You mentioned the key to this, to have it become self-sustaining, is final private demand. I don’t want you to wade into the political thickets, but there is a debate in Congress about what measures we might take to augment final private demand. Do you have any sense about what steps would be prudent to take at this time to 31 put some wind at the back of the recovery and ensure that it is sustainable? Mr. BERNANKE. Well, as you know, Senator, I don’t like to inject myself in debates on fiscal policies—— Senator BAYH. But as an economist, do you care to offer any? Mr. BERNANKE. Well, no. I don’t think I can separate my role that easily. My sense is, I mean, just as an observer, it seems that the Congress is debating a number of potential fiscal actions, but none of them are—I think no one is proposing anything of the scale we saw last year, as far as I know—— Senator BAYH. Well, let me put it another way. The Senate voted the other day on a $15 billion package. I voted for it. There are some good things in there. Some of my colleagues disagreed, took a different approach. Just in terms of scale, I mean, most people would say, even myself, some good things, I voted for it, but that is unlikely to be of a magnitude that is going to materially add to final private demand, to use your words. Do you have any sense about the scale that would be needed to have a material impact on final private demand? Mr. BERNANKE. Well, if these smaller programs are well de- signed, they can be very beneficial, and so we don’t want to deni- grate those at all. But—— Senator BAYH. I didn’t mean to, and I wasn’t asking you to—— Mr. BERNANKE. But my sense is—— Senator BAYH. I am just trying to get a sense of, what can we do to try and ensure the economy gets the legs under it that it needs? Mr. BERNANKE. You know, this is going to sound like a dodge, but I think that if you are going to do more fiscal policy in the near term, it would be very constructive to combine that with more at- tention to the exit strategy 5 years down the line, because I think there is a risk that financial markets may begin to become con- cerned about the sustainability of U.S. Fiscal policy, and the more you can assure them of ultimate—— Senator BAYH. It is actually not a dodge. It leads to my second question. You were asked by Senator Dodd about the use of deriva- tives and the problems they are having in Greece. Senator Vitter touched upon the deficit. I would like to raise the question of Greece again. At what level—you know, our debt-to-GDP ratio is now going to be going up. Some of that is unavoidable because of the recession we are experiencing. But you are asking us to focus on the intermediate term, which I think is exactly right, and that is why I was a strong supporter of the Gregg-Conrad Commission and other steps. Do you have a sense, at what ratio of debt-to-GDP do we begin to approach the tipping point and really run into a risk of currency problems, interest rate spikes, the kinds of things that Greece is now experiencing? Do you have any judgment about that? Mr. BERNANKE. It is, of course, very hard to know, and we are very different from Greece in terms of the type of our economy, the size of our economy, the fact that we have our own currency and all those sorts of issues. Just to give you one number, Ken Rogoff and Carmen Reinhart’s book about financial crisis has been discussed in many quarters, 32 mentioned a 90 percent debt-to-GDP ratio as a level at which growth becomes impacted after that. Now, saying that, we have got a wide variety of experience among industrial countries, ranging up to very high levels in Japan and in other countries. But our historic levels, we were down to the 30s in terms of debt-to-GDP and I think heading toward a 100 percent debt-to-GDP ratio would be very undesirable, particularly given the aging of our society and those obligations we are facing longer term. Senator BAYH. And we are estimated to get up close to, what, 65, 70 percent here over the next five to 10 years, something like that? Mr. BERNANKE. Yes. Senator BAYH. My last question. My time is about to expire. And we also finance our debt. Japan is mostly internal, isn’t it? We have a lot of external, which makes it a little bit different. Are you at all concerned about Japan’s recent steps to constrain demand there? What impact might—their economy is obviously growing very robustly. Does that present any risks to the global economy, the fact that they are moving in that direction? Mr. BERNANKE. Do you mean China? Senator BAYH. I am sorry. I misspoke. China. Yes, I did mean China. Mr. BERNANKE. No, I am not concerned about it. I think they have to make appropriate decisions about not overheating their economy. They are obviously growing very quickly. From our per- spective, we would like to see more flexibility in their exchange rate as being part of the process for reducing overheating risks. But I think it is important that they achieve an appropriate bal- ance between very rapid growth and the risks of overheating, the risks that their extensive credit extension becomes troubled. So, no, I am not particularly concerned about that right now. Senator BAYH. Thank you for your service, Mr. Chairman. Thank you. Senator JOHNSON. Senator Gregg. Senator GREGG. Thank you, Mr. Chairman. I want to associate myself with Senator Bayh’s comments rel- ative to your regulatory authority and the range of regulatory au- thority that you should retain. I do think it is important that you be a major player in the regulatory atmosphere, and I do believe that although there are obviously errors that have occurred across the regulatory regimes, that yours are no more grievous than any- body else’s, and in fact, I think in many ways, less grievous. To get into this issue, however, which Senator Bayh has touched on, Senator Vitter has touched on, which is when is the tipping point, you have basically alluded to the fact that it may be sooner rather than later if the markets lose confidence in us, the inter- national markets especially. And we have had a budget presented to us which puts us on a path, as you described, of unsustainability because deficits will run at five to 7 percent, debt will triple, and the public debt-to-GDP will hit 80 percent by 2015, 2016, and we will hit 60 percent this year, actually. So the question becomes, what do we need as a government to do to give the markets confidence that we are actually taking some action, real action in trying to control the out-year event, not the immediate issue of getting out of this recession, but the fact that 33 in the out years, we have an unsustainable situation which could lead to a significant financial issue for us as a nation and the re- duction in our lifestyle and the quality of life and the standard of living of our children? Mr. BERNANKE. Well, the earlier question was about the debt-to- GDP ratio, which was the tipping point. Another way to look at this is what does the trajectory look like? If the trajectory is such that you have an unstable dynamic where interest payments get larger and larger, that in turn increases the deficit, that in turn leads to higher interest payments and it explodes, essentially, then that is a situation where markets will become very concerned. So I think this is as much a political question as an economic question. The question is, can the Congress—and I recognize these are very, very hard problems. I don’t want to in any way downplay the difficulty that it is for Congress to address these hard prob- lems. But it would be extraordinarily helpful if there was persua- sive evidence that Congress had the political will to achieve over a number of years a stabilization of the debt-to-GDP ratio or of the fiscal trajectory, and that could be done either through whatever mechanisms you choose to undertake or it may be through specific plans, or maybe even through actions that you could take now that would affect expenditures and deficits in the out years. Senator GREGG. But something should be done. Mr. BERNANKE. It would be very—again, the point I would like to make is that there really is some—it is not just a question of paying today for a benefit tomorrow. There is benefit today if, in fact, you can increase the confidence of the markets that we will, in fact, address this issue. It gives you more scope and probably lower interest rates today. Senator GREGG. And arguably, the markets aren’t going to have that confidence unless there is an event which gives them con- fidence, which means the Congress has to address the gap between spending and revenues with the fact that that gap is primarily driven by spending, in my view. That is a rhetorical question. So where are we in the perception of the world relative to this country? Does the world have confidence that we can get our house back in order, in your opinion? Mr. BERNANKE. Well, the markets seem to have confidence. I mean, we can sell 20- and 30-year debt at relatively low interest rates and I think that is a vote of endorsement for the long-term ability of this country to respond to these challenges. But we have to make good that trust. We have to follow through. Senator GREGG. And if we look at the issue of how you get the money out of the market, you have put $2 trillion, basically, into the economy. Is that about right? Mr. BERNANKE. The Federal Reserve? Senator GREGG. Right. Mr. BERNANKE. Our balance sheet is $2.3 trillion. It was $900 billion before we started, so we have expanded our balance sheet by about $1.4 trillion. Senator GREGG. So you have got to get that money back out at some point, right? Mr. BERNANKE. That is right. 34 Senator GREGG. And I notice you listed a few things here that you have got as mechanisms. There is one, however, that I wasn’t that familiar with. I am not familiar with it at all, to be honest with you. You said, the Federal Reserve is currently refining plans for a term deposit facility that can convert a portion of depository institution holdings of reserves balances into deposits that are less liquid. Does that mean you are basically going to require bigger re- serves? Mr. BERNANKE. No. It means that instead of having reserves held at the Federal Reserve only on an overnight basis, we are going to offer a slightly higher interest rate so that banks will be willing to hold reserves with us for an extended period, and that would take those reserves out of the overnight money markets and give us more control over the Federal funds rate. Senator GREGG. So you are not raising the reserves. You are just going to say—— Mr. BERNANKE. No—— Senator GREGG.——you are going to encourage people to put more money in because you are going to pay them interest on it. That is part of your new authority? Mr. BERNANKE. That is part of the authority Congress gave us, to pay interest on reserves. Senator GREGG. OK. Thank you. Senator JOHANNS. Senator Bennet. Senator BENNET. Thank you, Mr. Chairman. I was going to go in a different direction, but just because the last part of this was so useful, I wanted to say we just heard the Fed Chairman talk about the political will in Congress to be able to address this issue, and I just—it is breathtaking to me as some- body new here that 2 weeks ago, we had the chance, because of Senator Gregg’s leadership and Senator Conrad’s leadership, to vote for a bipartisan commission—that is all it was—to take a look over a period of time and give us recommendations for an up or down vote, and we didn’t have the political will as an institution even to support that. So I want to thank Senator Gregg for his leadership and I hope we will try again, because we need to demonstrate the political will that you are talking about if we are not going to leave our kids a completely diminished set of opportunities. But I will come back to that. I wanted to ask you a question a little bit along the lines of what Senator Brown was asking, but different. In Colorado, if you look at the last period of economic growth in the country before we went into this terrible recession, that period of economic growth resulted in an $800 decrease in median family income in our State. So the economy grew, but middle-class family income fell, as it did across the country. For our middle-class families, I would argue, we have got two recessions that we are trying to recover from, this one and the last period of economic growth that didn’t drive their income. And at the same time, in our State, the cost of health insurance over that period went up by 97 percent. The cost of higher edu- cation went up by 50 percent. So you have got an economy that is driving costs of things that are important to move families ahead, but income is going down. And my understanding is it is the first 35 time our economy has grown in our history and median family in- come went down. I just wonder if you have some thoughts about that, because it just feels to me like there are some structural things going on in our economy that we need to be worried about, we need to concern ourselves with. Mr. BERNANKE. You are correct that median family income hasn’t kept up with average GDP or productivity, and there are a couple of arithmetic—— Senator BENNET. Let me just say, because you made that point earlier, as well, and at the same time, because of the increases in productivity you were talking about, it is not apparent where the jobs are going to come from to be able to help ameliorate the issues that I was just talking about. I will stop there. Sorry. Mr. BERNANKE. So just in terms of the median income, you men- tioned one factor, which is the higher costs of benefits and medical care, those things which have lowered wage growth as opposed to total compensation growth. But more importantly is the increased inequality. So you can have a growing economy, but if there is more going to the top, then the median guy could still be coming down and that is an issue, and I have given some speeches on this and tried to address this to some extent. I mean, it is a very vexed issue. The one thing I think everybody agrees about is that income in- equality is to some extent tied to educational skills and equality. We live in a society where technology is advancing, where we are competing with other countries that have very large pools of un- skilled labor, and therefore, as Senator Brown was saying, union jobs in manufacturing are no longer a normal—or a predominate form of employment. So for all those reasons, in order to get more people to enjoy the benefits of productivity and higher economic growth, the training, skills, education is a critical part of that. One of the advantages of the United States in general is that we do have a very flexible system. You know a lot about education. But besides K to 12, we have community colleges, junior colleges, on-the-job training, and all kinds of other ways for people to get skills. One of the things I would just say to this Committee as you think about our unemployment problem, one of the lasting scars of this recession is very likely to be a generation of people who have been unemployed for a year or 2 years and will find it difficult to come back and get a decent job because their loss of skills, because they will have to explain why they were out of work for 2 years. So that retraining, those aspects are very important. Senator BENNET. I think I am already out of time, but let me just observe that I agree on the importance of education, and it is one of the sad facts of the legacy of the last decade that in addition to the economic issues we were just talking about, we started the dec- ade, as I understand it, roughly first in college degrees, and 10 years later, we are roughly 15th in the world. So I wouldn’t say that our track record there over the last 10 years has been particu- larly good, either, and it just is a reminder of the urgency that we face. 36 This is working itself out in the daily lives of Americans. I think there is enormous anxiety that we are at risk of being the first gen- eration of Americans to leave less opportunity to our kids and our grandkids. It goes to the deficit and the debt issue we were talking about earlier and also these fundamental economic issues. I appreciate your being here today. Thank you. Mr. BERNANKE. Thank you. Senator JOHANNS. Senator Bennett. Senator BENNETT. Thank you very much, Mr. Chairman, and Chairman Bernanke, I appreciate your being here. Picking up on what Senator Gregg was talking about, simply an observation so that everybody understands exactly what we are talking about. When we say political will, cut spending, two-thirds of the Federal budget is in mandatory spending, and that is a com- bination of the entitlements, Social Security, Medicare, Medicaid, farm subsidies, interest on the national debt. I am an appropriator. None of those items come before the Appropriations Committee. All of them are on autopilot to be spent by virtue of commitments that have been made. I once had a very wealthy man say to me, ‘‘Explain to me why the Federal Government sends me a check every month for,’’ I have forgotten the number, $250 or whatever it is. He says, ‘‘I don’t need it.’’ And I said, but Sam, you are entitled to it, and by law, we are going to give it to you whether we have got it or not. And let us make it very clear that when we are talking about spending, we are talking about fiscal policy, these are terms we hide behind when we talk to our constituents and give speeches about Congress has got to get tough on spending. The real fact is that we have got to have the courage to attack the most popular programs in American history. We have got to level with our con- stituents and tell them we are talking about the programs you value the most and you insist are off limits. If the entitlements are off limits for any kind of discussion here on fiscal policy, we are going to hit 10 percent of GDP within 24 months unless we have the courage to deal with. It is 65 to 67 percent of the budget now. We are on autopilot to see 75 percent of the budget within 10 years and the other 25 percent includes defense. So if you take defense out of the remaining 25 percent, you have got about 10 percent of the budget that you have to get tough on in order to solve this problem. All right. I have finished my soapbox, but I think anybody who is paying attention to these hearings ought to hear that and under- stand that because that is the reality. Let me get to a question relating to the debt. We had our experi- ences, you and I and all the rest of us, a little over a year ago with respect to TARP. One of the things you said to us at the time, and we banked on as we voted for TARP, was that this was not a bail- out. This was money that would come back to the Treasury, would come back to the Federal Reserve, wherever it came from. And, in fact, you were right. The money is coming back, has come back. A lot of the major players of TARP have paid it back. Now, the Treasury is recycling that money. Senator Gregg and I have been very firm about we were in the room when the con- versation was made as to what would happen to that money when 37 it came back, and we thought, naively, that we wrote into the law the requirement that when it came back, it would be used to pay down the national debt. But we have been informed by the Treas- ury lawyers that that is not what we did. I would like your reaction. My opinion is, TARP solved its prob- lems. TARP did, indeed, avoid a worldwide depression—a world- wide collapse. We maybe are in a worldwide depression, but TARP did, indeed, avoid a worldwide collapse in that very difficult week- end in September when you came here and said, ‘‘I have run out of tools,’’ a very chilling kind of comment. One of my colleagues said, ‘‘I feel like I am in a James Bond movie,’’ listening to the Chairman of the Federal Reserve say we have run out of tools. I think TARP worked. My position, and I would like your reac- tion, is that having worked, it is now time to end it so that the Treasury does not recycle it and that when the money does come back from those people who benefited from TARP, it goes to pay down the national debt. I would like your reaction to that. Mr. BERNANKE. Well, first let me just say on the first part of your comments that this is why I think it is so very difficult to ad- dress these deficit problems, because those are very popular pro- grams. I agree with you that the TARP, unpopular as it is, achieved its basic objective of stabilizing the banking system. It did not do as much as we would have liked to create more credit. It is now com- ing back. The financial firms—I would put aside the autos and the mortgages. Senator BENNETT. Right. Mr. BERNANKE. Just talking about the financial firms, including AIG, putting them all together it looks like a pretty good chance we are going to break even on that, which would be a remarkable— in the long run, which would be a remarkable achievement. You have put me in a very difficult position. I do not know how to adjudicate the legal debate. I think basically Congress—— Senator BENNETT. Forget the law. Just give me your opinion of whether or not you think TARP should be terminated. Mr. BERNANKE. It boils down—well, I do not think—I think Treasury was right not to terminate it unconditionally at this point because there is still some risk out there that we may have further financial problems. I think it is small. But to have some flexibility in case some new crisis were to arise, I think at least for a short period, is not unreasonable. I am afraid I am going to have to defer to Congress on whether or not you think the other programs that are being proposed, like support for small business lending and those things, are within the spirit of the TARP or good programs in themselves. I do not know how to help you on that one. Senator BENNETT. All right. Well, this Member of Congress thinks they are not. Thank you, Mr. Chairman. Senator JOHNSON. Senator Merkley. Senator MERKLEY. Thank you very much, Mr. Chair. And thank you, Chair Bernanke, for your testimony. I first wanted to note that when Senator Vitter asked the ques- tion on whether there is a need to limit the Fed’s ability to use Sec- 38 tion 13(3) Federal Reserve Act emergency lending power funds to support individual firms, I just wanted to note that in Chair Dodd’s draft that action—that is, emergency lending to individual firms— is prohibited. And so a point I was asked to put forward and clar- ify. I wanted to turn to the issue of recapitalizing our community banks. This is something I hear about back home all the time, the challenge of these banks to be able to put out new loans given their leverage limitations and their capital challenges. And I had sup- ported an effort to recapitalize community banks, and the Adminis- tration has now put forward a very similar plan. I was just won- dering if you could give us any insights on your perceptions on how the role of community banks in supporting lending to small busi- ness might be a factor in the recovery of our economy. Mr. BERNANKE. Well, I think it is very important, and I guess on the subject of regulation, I guess I would like to remind the Committee that the Federal Reserve, although we have been very focused on large institutions over the last couple years because of the crisis, we also supervise a large number of community banks, State member banks, and they provide us very important informa- tion about the economy. We can learn from them what is hap- pening at the grass-roots level, what is happening to lending. And, you know, to get to your question, that kind of information is very valuable for us as we try to understand what is going on in the economy. As you point out, the community banks have in many cases, when they are able, when they are strong enough, have been able to step up and provide lending. They are very important lenders to small businesses, for example. And as you say—and this was the issue that Senator Bennett was raising—one of the proposals that the Treasury has made is to create a fund that would capitalize small banks that demonstrate that they can increase their lending to small businesses. So in the spirit of my previous conversation with Senator Ben- nett, I am not going to endorse or not endorse that approach. There are other approaches also for addressing small businesses. But I would say that if you go do that, one suggestion the Treasury makes, which is to separate it from the TARP, maybe to pass it— this would address Senator Bennett’s question—to pass it sepa- rately so that it is not stigmatized or otherwise associated with the restrictions with the TARP, which increase the chance that that would be a successful program. But we certainly do value the small banks for what they are able to do, and if we are going to get this economy going again and get employment growing again, then small banks, small businesses are going to be critical for that. Senator MERKLEY. Thank you very much, and I want to turn to another issue, which is that I was meeting with a group of Mem- bers of Parliament from Canada two nights ago, and when I asked them about the economic meltdown and the impact on Canada, they smiled and said: Well, you know, we kept the risk out of our banking system, and now there is a huge economic movement in which we are going down, Canadians are going down and buying up the foreclosed real estate in the United States. 39 And certainly in your role, there is the chance to look at and learn how different models interacted around the world. And would you just take a second to comment on the Canada structure, how they managed risk, whether there are any insights for us here in our efforts to provide regulatory reform? Mr. BERNANKE. I will start with one point, which is that Can- ada’s monetary policy was very similar to that of the United States, and they had very different outcomes. So those who blame this on monetary policy should address that issue. I think the differences between Canada and the United States had to do with their regu- latory structure, and there were two primary advantages that they had. First, they simply had a much more conservative bank super- visory structure in terms of what they allowed banks to do, in terms of the amount of capital that banks had. You know, in the go-go days, they would be considered staid and unexciting. But, of course, that turned out to be the right way to go, and they are looked at as models around the world as we look at banks super- vision. The other thing that they did, which we did not avoid, was they avoided the deterioration in underwriting standards in mortgages and the proliferation of very low downpayments and bad under- writing and other problems that came back to bite us in the crisis. So they took a very conservative approach, and it really paid off for them, although given that they are the biggest trading partner of the United States, they still have had a significant recession, of course. Senator MERKLEY. Well, if I can follow up on your point about the underwriting standards, some have argued that the reason that Canada proceeded to maintain solid underwriting standards was that they had an independent consumer financial protection agency and that that vision of defending consumers from tricks and traps in lending was never subverted, if you will, to other goals, be they safety and soundness, monetary policy, and so forth. Any insights on the role that institution plays in Canada? Mr. BERNANKE. I do not know the facts on that, but I would agree with you that it is very important to have strong consumer protection laws. Senator MERKLEY. I think I am over my time now, so I will stop there. But thank you very much. Senator REED. [Presiding.] Senator Shelby, a second round. Senator SHELBY. Thank you, Mr. Chairman. Chairman Bernanke, the Chinese have made a number of com- ments about their massive U.S. Treasury holdings. Last year, they publicly ‘‘worried’’ about whether their investments were safe. Re- cently, they have expressed the belief that they should respond to some of the Obama Administration decisions by selling billions of Treasury holdings. While China does not have a financial interest in rapidly—I do not believe they do—dumping its U.S. dollar assets, it may have other competing political interests. Do you believe that there is a risk to stability of the financial system associated with risk to the value of the dollar stemming or 40 coming from international relations between China and the United States? Second, do you believe that China’s large dollar reserve holdings pose a threat to the stability of the global financial system given the leverage those holdings provide to China to enable it to pursue a policy of pegging its currency at an artificially low value? I know that is a mouthful, but I think these are important ques- tions. Mr. BERNANKE. Well, let me try to address that. First is just the factual question. I do not think there has been any significant change in China’s holding of dollar reserves. Senator SHELBY. OK. Mr. BERNANKE. They have continued to acquire reserves. They have done that when the dollar was falling. They did that when the dollar was rising. Senator SHELBY. Do you think that is a good thing, a bad thing, or are you indifferent about it? Mr. BERNANKE. I think it arises from a couple of problems. Senator SHELBY. OK. Mr. BERNANKE. One problem is their foreign exchange policy to keep the currency pegged, and in order to do that, they have no al- ternative but to buy treasuries. The other reason is the global im- balances, the fact that they run this very large—which is related, of course, to foreign exchange policy, which is that they run a very large current account surplus while we run a current account def- icit. And it was one of the objectives discussed by the G–20 leaders in the recent financial summits that we should all work to try to get a more balanced trade and capital flow situation. So I think it would be a healthier situation if China saved less and we saved more and as a result they were not accumulating dollar assets so quickly and we had a more balanced financial picture. I do think that those large capital flows and the potential insta- bility of those flows can be a risk to our financial system, and, you know, I think we need to try to get those imbalances rectified. Senator SHELBY. Picking up—and it has already been mentioned a couple of times by Senator Vitter and others—about the GSEs, at this point, as has been said here, there is no indication that any GSE reform will take place in the near term. In fact, just yesterday Secretary Geithner indicated and I think you alluded to this—that the Administration is unlikely to provide a plan for reforming these institutions prior to 2011 at the earliest. I know it is difficult and I know it is costly, but while imple- menting reform will take time, could you describe to the Committee here some of the risks that we face should we not start the process of reform as soon as possible? In other words, if we kick the can down the road, we could cause difficult problems, could we not? Mr. BERNANKE. Yes, sir. First of all, I think you and I have a lot in common on this particular issue. Senator SHELBY. We have worked together on it. Mr. BERNANKE. We have worked together on it. The Federal Re- serve has had concerns for a long time, and you were a supporter of very good, strong regulatory oversight of Fannie and Freddie. And unfortunately, you know, we know how it turned out, that they did not have enough capital. 41 You know, I think the current situation is worrisome. It obvi- ously is a costly situation. And it also generates a certain amount of uncertainty in markets as people try to anticipate, you know, what the U.S. housing financial situation is going to be in the fu- ture. Housing policy is a very big part of our financial policy in this country, and the lack of clarity about that is an issue. Now, again, let me just say I sympathize with Secretary Geithner in that there is an awful lot going on and financial reform is complex. But I do hope we will be thinking about where we want to take Fannie and Freddie soon so that we can at least provide some clarity to the markets and to the public about, you know, where we think this ought to be. Senator SHELBY. Thank you, Mr. Chairman. Senator REED. Senator Menendez. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman Bernanke, welcome and congratulations on your con- firmation. Mr. BERNANKE. Thank you. Senator MENENDEZ. I was pleased to support you. Let me ask you, over the next few years, there is going to be more than $1 trillion in short-term commercial real estate loans that will reach maturity, and the ongoing credit crunch will make it very difficult for owners of viable commercial real estate to se- cure long-term financing. In 2007, at this Committee hearing with others, I said we were going to have a tsunami of foreclosures in the housing market. I was told that was an exaggeration. I wish they had been right and I had been wrong. And I see this as the next looming crisis. You know, it seems to me that the Federal Government failed to act on the warning signs about the home foreclosure crisis, and I am very concerned that we are not acting on increasingly clear warning signs about this commercial mortgage market. So I am wondering, first, do you believe that this is a very seri- ous issue facing us down the road and might this emerge as our next economic crisis? And regardless of how you might characterize it, which I will wait to hear what you have to say, what do you think we can do? For example, I have been told that this is one in which commu- nity banks will face a fair challenge across the spectrum. Is, for ex- ample, allowing those banks to amortize losses over 10 years an op- tion so that we do not completely dry up lending and at the same time maybe have a lot of these institutions close as a result of it? I am looking to get ahead of the curve, but that curve is com- ing—that tidal wave is coming really soon, and so I would like to hear your views on it. Mr. BERNANKE. Senator, I share your concerns about this. This is yet another place where the Federal Reserve’s oversight of small and regional banks has been very informative for us. We have been able to follow the situation closely and to look at its implications for the broader economy and for the financial system. It seems likely that small and regional banks will be facing a lot of challenges from losses on commercial real estate, and the bank regulators are watching this very carefully because it is going to put a lot of pressure on some banks. Chairman Bair, I think the 42 other day, put out a list of problem banks, which has been obvi- ously increased, and one of the key reasons for that is the commer- cial real estate issues that a lot of small banks are facing. It has the implication not only of putting pressure on the banks, but if a small bank has lost capital because of its losses in commercial real estate, then it does not have the funds to make loans to small busi- nesses, for example, so it can permeate, it can affect the broader economy as well. Just a few comments. As I said, we are very alert to this. We are concerned about it. We and the other bank regulators have tried to address it. We have put out commercial real estate guidance to the banks which attempts to address the question you raised about how to deal with debts that are coming due. And that guidance, one of the main purposes is, first of all, to avoid unnecessary writedowns. So one of the guidances we give is that a commercial real state project that is able to make the payments but whose col- lateral value has declined should not necessarily be written down for that purpose, for example. Our guidance also gives specific examples and helps banks see how they can restructure loans, just like we restructure residential mortgages, in ways that will keep the loan current without having a major writedown for the bank. So we have been doing that; as bank regulators, we have been trying to find solution. I also want to mention the TALF again, which is still open for commercial mortgage-backed securities. We have had a bit of suc- cess in bringing down commercial mortgage-backed security spreads and in starting up some activity, including activity outside of the Fed in creating new CMBS securities. So we are very focused on those issues, and we have addressed it in a number of different ways. I want to end with just a little bit of—I would not say good news, but lately the evidence on commercial real estate is that there seems to be some improvement in some places, that the fundamen- tals are a little better than we had feared in some cases as the economy has done a bit better. And as we said, we have seen some more progress in the CMBS market and in banks’ ability to re- structure loans. I do not disagree with your initial characterization that this is a very, very serious problem that we have to continue to monitor, but I would put forward just a sliver of optimism recently in terms of some improvement in the outlook for that category. Senator MENENDEZ. If I may briefly follow up, Mr. Chairman? Chairman, I appreciate your answer, and I appreciate the guidance that the regulators have given. That is somewhat helpful. I am just concerned—and I am happy to hear that there is a sliver of a silver lining here about some improvement in certain sectors. But my sense is that that is not going to meet the challenge be- fore us, and I hope that we are thinking prospectively about what else we need to do or be ready to do, because it seems to me that if the worst-case scenario happens—and I have to be honest with you. I have heard from a wide sector of community banks, and I have heard from a wide sector of those who are in the commercial real estate market, who tell me that there is not a market out there for the renewal of these mortgages. And as such, it could be 43 a body blow to this economy at a time that we are seeing recovery take place. And that would be hugely unfortunate as well as con- sequential in a very real way to our overall economy. So I would love to continue to engage with you on figuring out how we are going to continue from all different levels—not just the Federal Reserve, but we have also talked to the Treasury about this. We need to figure out how do we best meet this challenge, be- cause it is a challenge that is coming. And while, you know, those who maybe were irresponsible beyond a certain degree will have to face the possibility of closure, the breadth and scope of this is something that I am afraid of the consequences of what it means to our overall economy. Mr. BERNANKE. Thank you. We are very focused on it and we would like to work with you on it. Senator MENENDEZ. All right. Thank you, Mr. Chairman. Senator REED. Senator Bennett? Senator BENNETT. Thank you, Mr. Chairman. The one thing that I hear most often and I think my colleagues hear most often as they talk about where we are right now, a con- stant, constant complaint that banks aren’t lending. And when I talk to the banks, they say, well, we are better than we were. Year over year, we are better in 2010 than we were in 2009, so the vol- ume has gone up and we are doing our best, but we can’t find cred- itworthy borrowers. We are ready to loan, but we can’t find credit- worthy borrowers. And then when I drill down a little more, I find the real chal- lenge comes from regulators who come in with a definition of cred- itworthy borrowers that say to the bank, OK, you used to make auto loans at this number on your credit report and now, if that isn’t this higher number, you can’t make the auto loans. I have had business people with whom I have been involved personally, now divested myself, say we go to our bank with whom we have had a 30-year relationship, say we want to make this acquisition, and can we get a loan to fund it, and instead of saying yes, as the bank has always said before, we like your business plan, we like your track record, you are solid people, you know exactly what you are doing, they say, we will give you this loan if you can demonstrate that you can pay out of your current cash stream. Well, if I could pay out of my current cash stream, I wouldn’t be coming for the loan to try to make the acquisition. And so additional jobs or addi- tional productivity that would come from what we would normally think of as very ordinary kind of transactions is simply not there. And inevitably, it always comes back to the regulators won’t let us do this. The regulators have tightened their requirements of what is considered creditworthy. You are the primary regulator. You see this, I am sure, every day, or at least your staff does. I would like your reaction to that because that is what I hear after the rhetoric is all over and the screaming is all over in a political way. That is what I hear from the business people. The banks are not supporting true entrepre- neurial activity in this country, and until they do, we won’t get the jobs back, we won’t get the economic recovery going, and they are saying it is primarily because of tightened standards on the part of the regulators. 44 Mr. BERNANKE. Well, it is a difficult problem and one we are very focused on, as well. First of all, there is a tradeoff. Probably credit terms were too easy before the crisis. They have tightened up some. Lately, banks seem to have leveled out. They are not tightening any further, at least. But there is a tradeoff between making sure that you are really making good loans versus making sure that creditworthy borrowers are not denied. Now, our focus at the Federal Reserve has been to achieve an ap- propriate balance. We want to make sure that creditworthy bor- rowers who are creditworthy can obtain credit, and we have been very aggressive in trying to do that. We started with, again, these guidances, but these are instructions to our examiners as well as to the banks which say, first of all, that we strongly encourage banks to make creditworthy loans because it is good for the bank, it is good for the borrower, it is good for the economy. We have trained our examiners to take that approach. We have most recently put out yet another guidance on small business which actually says, you know, you should not be denying credit based on what business you are in, whether you are res- taurant or whatever, or what geographic location you are in. Again, this issue about your collateral value. If that has declined, that should not be a reason not to make the loan. We are encouraging so-called Second Look Committees who look, again, at loans that have been turned down just to make sure that there is not a way to make that loan. So our guidances, our regulatory philosophy, our training of our examiners has been very focused on getting that appropriate bal- ance. Now, I have said this in previous testimonies. People say, well, I am not convinced. What is your evidence? So since then, we have been really trying to do outreach and try to get information directly back from banks, small businesses. We have, for example, put questions in the NFIB’s Survey of Small Businesses to get more in- formation about their credit experience. We are requiring banks to provide us more information on small business loans. We have a series of meetings and programs at the Reserve Banks which bring together small banks, small businesses, community development organizations, and so on. We are doing our best to go out there and find out what is really happening, because in some cases, I mean, I think you would agree, in some cases, the regulator is a good scapegoat and—— Senator BENNETT. Yes. I understand that. Mr. BERNANKE.——and gets the credit for the problem. But the Federal Reserve, because we have interest, of course, in safety and soundness, but we also have interest in a healthy economy, and that insight that we get and that balance is very important. I real- ize it doesn’t filter down to every bank and every situation, but we are making enormous efforts to get that balance. When you do talk to your business acquaintances, first, ask them who the regulator is who is causing the problem, because it is not always the Federal Reserve—— Senator BENNETT. I think that is fair. 45 Mr. BERNANKE. But if you are hearing stories related to the Fed- eral Reserve, I would be more than happy to talk to you about it and hear more details. Senator BENNETT. Well, if I could just quickly, Mr. Chairman, one other aspect of this that I have discovered as I have talked to the people in the venture capital community, they say, we are not in the venture capital business anymore. To the degree we are in- vesting any money, we are doubling down on previous bets, because the pattern used to be the venture capital would come in, fund the startup. Once the startup proved its viability, it would then go to a bank and get the money that it needed to get to the point where it could then make an IPO and go public. And, they said, we are now discovering that the start-ups that we funded in that first wave can’t get the bank funding, so to keep the organization alive and protect our first investment, we double- down on our bet and we are now in a position we have never, ever been in before. We are providing what the banks used to provide, and as a consequence, there is no VC money available for new start-ups and new activities. So I am delighted to hear your focus on this. I think you are ex- actly right with the kinds of things you need to do and I simply encourage you to keep doing it. Mr. BERNANKE. We are hearing the same things on venture cap- ital that you are hearing. Senator BENNETT. Thank you, Mr. Chairman. Senator REED. Thank you, Senator Bennett. Mr. Chairman, again, thank you for your testimony and for your leadership. You, in response to several questions, pointed out how central the housing sector is to our economy, and one of the areas of great concern to all of us is the mortgage foreclosure situation. Frankly, we have not effectively responded to that yet. It is a grow- ing phenomenon. In my State, one out of ten homes are either in foreclosure or 90-days delinquent, and that saps not only the en- ergy from the economy, but with the uncertainty in the employ- ment market, with the fear of losing your home, particularly for people at mid-life, their sense of the American dream is evaporating. Part of what we have to do is not only get the econ- omy right, we have to get the confidence of the American people restored, and their trust. So specifically, I am wondering what you can do as the Federal Reserve to compel institutions to do more to modify mortgages. I get complaints constantly, I am sure my colleagues do, that there is a help line number. You call it and, oh, yes, sure, and then we don’t get back to it. I know there are a lot of press releases about everything that is being done, but until I think you make it clear that this is an important objective, we will get a lot of motion and not a lot of results. And I would assume, for example, I would hope that as within your powers of supervising the management could insist that at least there is a calculation done for each mortgage, whether a refi- nancing would be better than a foreclosure, or something like that which would be an open process, a quick process, and encourage in- stitutions that you regulate—if you can’t order them, then encour- age them, and you have many tools to encourage them—to do more. 46 Mr. BERNANKE. We are doing so. I guess I would first mention that our mortgage-backed security purchases—— Senator REED. Yes. Mr. BERNANKE.——lowered the mortgage rate and allowed for some millions of refinances, which I am sure has been helpful. As you know, the leadership in terms of actual programs is the Treas- ury’s program, the HAMP program, and there are a few others, the Help for Homeowners and those, and we felt that our best way of contributing is to be supportive of those things and to strongly en- courage both banks and, in our case, as consolidated supervisors, we also have supervisory responsibilities for non-bank subsidiaries, whether it is some servicers or mortgage companies or whatever, to participate and to be effective in those programs. And we have for some time now been both looking for solutions to barriers, legal or accounting barriers, and we have been doing research to try to support these programs. For example, we have long felt that the problem of being underwater, the principal issue, is a serious one, and so that was why we were supportive of some of these efforts, like the Hope for Homeowners, that involves a principal reduction. Unfortunately, that program apparently has not been successful in bringing in a lot of participation, but we con- tinue to look at different approaches to get restructuring. I think it is encouraging. The Treasury, I know, is not only try- ing to do their best to ramp up the HAMP program, and I think we will see more permanent modifications coming in since they have a pretty big pipeline at this point, but they are also doing some pilot programs that involve alternative approaches. For example, one problem that their approach doesn’t deal with is the problem of somebody who is unemployed, can’t even make a reduced payment. So what is needed there is not a permanent modification but some temporary assistance. Another issue has to do with principal reduction. So in some of their pilot programs, I think they are looking to try to take some of these different ap- proaches. We have worked with them, our economists worked with their economists, and we have been very engaged in trying to figure out what is the best approach. It is a very hard problem. Unfortu- nately, many foreclosures are just hard to avoid for a wide variety of reasons. But where there is a preventable foreclosure, it is not only in the interest of the borrower, but in the interest of the bank and of the whole economy to try to avoid it. Senator REED. I will concede, it is a difficult problem, but some- times you have got to send a very strong message. For example, you know, could you set a goal, maybe institution by institution of modifications as a condition to access your credit facilities? These institutions are borrowing money at virtually zero percent and then they are turning around saying, we can’t modify a loan because of the interest, or we will do, from 8 percent, we will cut it 50 basis points, when essentially many of these people, when they pay their taxes, they are giving them zero percent loans. Mr. BERNANKE. Well, I don’t think we have to use that threat. I think we could use our supervisory authority, and we went back—in November of 2008, we made very clear in our guidance 47 that we expected full compliance and full cooperation on this issue and we have had many conversations with the banks and—— Senator REED. Expecting it and getting it are two different things, and I think we have reached the point we have got to get it, Mr. Chairman. I know you agree conceptually, but we have just got to move on this issue. Senator Menendez sort of previewed an- other potential problem with commercial, but we are in the midst of this great residential and it goes right to the core of economic confidence and ultimately consumer demand and everything else that we have to do. Let me switch quickly, and you have been very kind to take these questions, but at this juncture and going forward, are you using multiple tests for the adequate capital of institutions and the adequate sort of resources, i.e., leverage, indexes, liquidity meas- ures, tangible capital as well as risk-based capital, or are you still essentially and formally simply relying upon the Basel capital re- quirements? Mr. BERNANKE. No, we have gone beyond that. We have a gen- eral principle that there are regulatory minima and then above that, you know, we reserve the right to push banks to do more, de- pending on the risks they take and so on. So to give two examples, one, we have actually worked with international colleagues to de- velop new liquidity principles. That was one of the, I think, real big shortcomings that was made evident in the crisis, that they didn’t have enough liquidity, and we have pushed banks to expand their liquidity and we have been pretty successful in doing that. The other example I would give is that another thing that was illustrated by the crisis was that a lot of the capital, quote-unquote, was not really very high quality. It wasn’t of much use when the crisis came. And so, for example, as we have worked with banks in the stress tests or as we work with banks who want to repay TARP, we have put very heavy emphasis on raising new common equity as the highest quality form of capital. So yes, and every bank is required to do an internal capital as- sessment that we work with them on to make sure that not only are they meeting all the regulatory minima, but they are prepared for serious stresses that might come down the road. Senator REED. Can I presume that you would not object to statu- tory language requiring multiple tests that are readily made and disclosed? Mr. BERNANKE. Well, I would like to talk to you about exactly what those tests would be. We already have capital and leverage requirements—— Senator REED. No, I would presume they would be the measures which you would agree and your colleagues would agree were ap- propriate, but they would not be simply one standard. Again, I think some of the problems with the Basel II, particularly, were the ability to rely exclusively on credit ratings for securitized prod- ucts, many of which the banks were sort of structuring and then buying because they couldn’t sell them, but they were AAA-rated, so that was a very low charge on their risk-based capital but inher- ently very, very risky, as we found out, so—— 48 Mr. BERNANKE. We have been working on the charges and they have been substantially increased. We are currently testing out the implications of that. On the particular issue of these off-balance sheet vehicles, as you know, the new accounting standards will force banks to consolidate most of those onto their own balance sheet and so they will have to have a full capital charge against them. Senator REED. And one final question, Mr. Chairman, and that is we have talked a lot about derivatives. We all do recognize there is a long-term value to derivatives. My recollection is the Chicago Board in 1848 started trading agricultural futures. In fact, I think I recall a story where General Grant and General Sherman showed up to congratulate one of the architects for helping them win the Civil War because of being able to guarantee supply. So that is the question of the utility in that sense, and other senses, is not at stake here. But there also is the growing perception, and I am coming to a conviction, that many times these devices are used to avoid regu- latory constraints. In the case of Greece, it might have been strictly legal, but clearly the intent was to avoid the budget limitations and the budget restrictions of joining the European Community. With respect to many other derivatives, for example, even com- mercial derivatives, because they are not typically recorded as lending, or in some cases not even on the books, it is borrowing that is not in violation of covenance with other lenders. It is bor- rowing that allows additional leverage. And one of the problems we are trying to recognize now is over-leverage. So to the extent that we have to deal with these derivatives, any thoughts our guidance about how we prevent them from being used not for economic hedging but for clearly and very deliberately— maybe legally, maybe not—avoiding your capital requirements, the lending covenants of a bank, and many other examples. Mr. BERNANKE. Yes. There are two related issues here. One has to do with circumventing accounting rules, which maybe is what Greece is about. After Enron, that turned out to be—a lot of finan- cial arrangements essentially were structured to avoid accounting requirements and we, at that time, the Federal Reserve—not me personally, but the Federal Reserve—came down pretty hard, pro- viding sets of rules and guidances to banks to assure that they were not creating special structures or in order to—— Senator REED. And yet they did. Mr. BERNANKE.——in order to avoid accounting rules. The Greek thing is from before that period, as far as we know. Senator REED. Yes. Mr. BERNANKE. We are looking into that, but as far as we know, that was about 10 years ago that those were done. So that is one set of issues. The other set of issues has to do with whether hedging, which is in principle a good thing, is actually true hedging or not, and the poster child for that would be the capital hedges that banks took out with AIG which allowed them to reduce their capital standards because they were, quote, protected by the credit default swaps with AIG. And there, the challenge is to make sure that when the 49 hedge takes place, that it is a true hedge and that it doesn’t induce other risks, like counterparty risks, for example, or liquidity risks. So it is a difficult technical problem, but you are absolutely right that derivatives have a legitimate role for hedging risks, but if they are used to distort accounting results or regulatory ratios, then that needs to be addressed. We are working on that as part of the broad reforms that Basel is undertaking. Senator REED. Thank you very much, Mr. Chairman. Mr. BERNANKE. Thank you. Senator REED. Seeing no other members, the hearing is ad- journed. Mr. BERNANKE. Thank you. [Whereupon, at 11:49 a.m., the hearing was adjourned.] [Prepared statements and responses to written questions sup- plied for the record follow:] 50 PREPARED STATEMENT OF BEN S. BERNANKE CHAIRMAN, BOARDOFGOVERNORSOFTHEFEDERALRESERVESYSTEM FEBRUARY25, 2010 Chairman Dodd, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress. I will begin today with some comments on the outlook for the econ- omy and for monetary policy, then touch briefly on several other important issues. The Economic Outlook Although the recession officially began more than 2 years ago, U.S. economic ac- tivity contracted particularly sharply following the intensification of the global fi- nancial crisis in the fall of 2008. Concerted efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, together with highly stimulative monetary and fiscal policies, helped arrest the de- cline and are supporting a nascent economic recovery. Indeed, the U.S. economy ex- panded at about a 4 percent annual rate during the second half of last year. A sig- nificant portion of that growth, however, can be attributed to the progress firms made in working down unwanted inventories of unsold goods, which left them more willing to increase production. As the impetus provided by the inventory cycle is temporary, and as the fiscal support for economic growth likely will diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services. Private final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial conditions. In particular, consumer spending has recently picked up, reflecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business investment in equipment and software has risen significantly. And international trade—sup- ported by a recovery in the economies of many of our trading partners—is rebound- ing from its deep contraction of a year ago. However, starts of single-family homes, which rose noticeably this past spring, have recently been roughly flat, and commer- cial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been hit especially hard by the recession, as employers re- acted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 2009. Some recent indicators suggest the dete- rioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have continued to trend lower, and the tem- porary services industry, often considered a bellwether for the employment outlook, has been expanding steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern, because of its long-term implications for workers’ skills and wages, is the increasing incidence of long-term unemploy- ment; indeed, more than 40 percent of the unemployed have been out of work 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most mar- kets, and sharp increases in productivity have further reduced producers’ unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Condi- tions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be hampered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit amid uncertain economic prospects. In conjunction with the January meeting of the Federal Open Market Committee (FOMC), Board members and Reserve Bank presidents prepared projections for eco- nomic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these forecasts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a mod- erate pace of economic recovery, with economic growth of roughly 3 to 31⁄2 percent in 2010 and 31⁄2to 41⁄2percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of 51 roughly 61⁄2 to 71⁄2 percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain sub- dued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 13⁄4and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Re- serve’s dual mandate of price stability and maximum employment. Monetary Policy Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price stability. The target for the Federal funds rate has been maintained at a historically low range of 0 to 1⁄4 percent since December 2008. The FOMC continues to anticipate that economic conditions—in- cluding low rates of resource utilization, subdued inflation trends, and stable infla- tion expectations—are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve over- all conditions in private credit markets, the Federal Reserve is in the process of pur- chasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its pur- chases of securities in light of the evolving economic outlook and conditions in finan- cial markets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities it cre- ated during the crisis. On February 1, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary liquidity swap lines with foreign central banks, were allowed to expire.1 The only remaining lending program for multiple borrowers created under the Federal Reserve’s emer- gency authorities, the Term Asset-Backed Securities Loan Facility, is scheduled to close on March 31 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and on June 30 for loans backed by newly issued CMBS. In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of dis- count-window funds to depositories through the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking sys- tem, will occur on March 8. Last week we announced that the maximum term of discount window loans, which was increased to as much as 90 days during the cri- sis, would be returned to overnight for most banks, as it was before the crisis erupt- ed in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and busi- nesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an ex- tended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of infla- tionary pressures. Notwithstanding the substantial increase in the size of its bal- ance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.2 Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks’ holdings of reserve balances at Federal 1Primary dealers are broker-dealers that act as counterparties to the Federal Reserve Bank of New York in its conduct of open market operations. 2For further details on these tools and the Federal Reserve’s exit strategy, see Ben S. Bernanke (2010), ‘‘Federal Reserve’s Exit Strategy,’’ statement before the Committee on Finan- cial Services, U.S. House of Representatives, February 10, www.federalreserve.gov/newsevents/ testimony/bernanke20100210a.htm. 52 Reserve Banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally. The Federal Reserve has also been developing a number of additional tools to re- duce the large quantity of reserves held by the banking system, which will improve the Federal Reserve’s control of financial conditions by leading to a tighter relation- ship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves.3 The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions’ holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements.4 In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative pol- icy stance will depend on economic and financial developments. I provided more dis- cussion of these options and possible sequencing in a recent testimony.5 Federal Reserve Transparency The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. Indeed, on matters related to the conduct of mone- tary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular, extensive reports to the Congress and the public; and we have worked closely with the Government Accountability Office (GAO), the Office of the Special Inspector General for the Troubled Asset Relief Program, the Congress, and private- sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were important tools for imple- menting monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the integrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve’s management of all facilities created under emergency authorities.6 In particular, we would support legislation authorizing the GAO to audit the operational integrity, collateral policies, use of third-party contractors, ac- counting, financial reporting, and internal controls of these special credit and liquid- ity facilities. The Federal Reserve will, of course, cooperate fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appro- priate delay. It is important that the release occur after a lag that is sufficiently long that investors will not view an institution’s use of one of the facilities as a pos- sible indication of ongoing financial problems, thereby undermining market con- 3The Federal Reserve has recently developed the ability to engage in reverse repurchase agreements in the triparty market for repurchase agreements, with primary dealers as counter- parties and using Treasury and agency debt securities as collateral, and it is developing the ca- pacity to carry out these transactions with a wider set of counterparties (such as money market mutual funds and the mortgage-related government-sponsored enterprises) and using agency mortgage-backed securities as collateral. 4In December the Federal Reserve published a proposal describing a term deposit facility in the Federal Register (see Board of Governors of the Federal Reserve System (2009), ‘‘Federal Reserve Board Proposes Amendments to Regulation D That Would Enable the Establishment of a Term Deposit Facility,’’ press release, December 28, www.federalreserve.gov/newsevents/ press/monetary/20091228a.htm) We are now in the process of analyzing the public comments that have been received. A revised proposal will be reviewed by the Federal Reserve Board, and test transactions could commence during the second quarter. 5See Bernanke, ‘‘Federal Reserve’s Exit Strategy,’’ in note 2. 6Last month the Federal Reserve said that it would welcome a full review by the GAO of all aspects of the Federal Reserve’s involvement in the extension of credit to the American Inter- national Group, Inc. (see Ben S. Bernanke (2010), letter to Gene L. Dodaro, January 19, www.federalreserve.gov/monetarypolicy/files/letterlaigl20100119.pdf). The Federal Reserve would support legislation authorizing a review by the GAO of the Federal Reserve’s operations of its facilities created under emergency authorities: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Primary Dealer Credit Facility, the Term Asset-Backed Securities Loan Facility, and the Term Securities Lending Facility. 53 fidence in the institution or discouraging use of any future facility that might be- come necessary to protect the U.S. economy. An appropriate delay would also allow firms adequate time to inform investors through annual reports and other public documents of their use of Federal Reserve facilities. Looking ahead, we will continue to work with the Congress in identifying ap- proaches for enhancing the Federal Reserve’s transparency that are consistent with our statutory objectives of fostering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people. Moreover, the confiden- tiality of discount window lending to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to provide liquidity to depository institutions under circumstances where other sources of fund- ing are not available. The Federal Reserve’s ability to inject liquidity into the finan- cial system is critical for preserving financial stability and for supporting deposi- tories’ key role in meeting the ongoing credit needs of firms and households. Regulatory Reform Strengthening our financial regulatory system is essential for the long-term eco- nomic stability of the nation. Among the lessons of the crisis are the crucial impor- tance of macroprudential regulation—that is, regulation and supervision aimed at addressing risks to the financial system as a whole—and the need for effective con- solidated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress’s ongoing efforts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Re- serve’s oversight of banking organizations, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity require- ments for financial institutions, particularly systemically critical firms, and we have been taking the lead in ensuring that compensation structures at banking organiza- tions provide appropriate incentives without encouraging excessive risk-taking.7 The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to improve the effectiveness of consoli- dated supervision and to incorporate a macroprudential perspective that goes be- yond the traditional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to improve coordination within our own supervisory staff and with other supervisory agencies and to facili- tate more-integrated assessments of risks within each holding company and across groups of companies. Last spring the Federal Reserve led the successful Supervisory Capital Assess- ment Program, popularly known as the bank stress tests. An important lesson of that program was that combining onsite bank examinations with a suite of quan- titative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the proc- ess of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory information will be combined with firm-level, mar- ket-based indicators and aggregate economic data to provide a more complete pic- ture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve’s unparalleled breadth of expertise, this program will apply a multidisciplinary approach that involves economists, specialists in par- ticular financial markets, payments systems experts, and other professionals, as well as bank supervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Re- serve’s effectiveness in carrying out its responsibilities as a central bank, including the making of monetary policy and the management of the discount window. Most important, as the crisis has once again demonstrated, the Federal Reserve’s ability to identify and address diverse and hard-to-predict threats to financial stability de- pends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous 7For further information, see Board of Governors of the Federal Reserve System (2009), ‘‘Fed- eral Reserve Issues Proposed Guidance on Incentive Compensation,’’ press release, October 22, www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm. 54 Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the regulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Development to assess how we might further increase transparency in the mortgage process.8 We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaningful opportunities to avoid overdraft fees.9 In addition, the Federal Reserve has implemented an expanded consumer compliance supervision program for nonbank subsidiaries of bank holding companies and foreign banking organiza- tions.10 More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again devastated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. 8For further information, see Board of Governors of the Federal Reserve System (2009), ‘‘Fed- eral Reserve Proposes Significant Changes to Regulation Z (Truth in Lending) Intended to Im- prove the Disclosures Consumers Receive in Connection with Closed-End Mortgages and Home- Equity Lines of Credit,’’ press release, July 23, www.federalreserve.gov/newsevents/press/bcreg/ 20090723a.htm. 9For more information, see Board of Governors of the Federal Reserve System (2009), ‘‘Fed- eral Reserve Approves Final Amendments to Regulation Z That Revise Disclosure Requirements for Private Education Loans,’’ press release, July 30, www.federalreserve.gov/newsevents/press/ bcreg/20090730a.htm; Board of Governors of the Federal Reserve System (2009), ‘‘Federal Re- serve Announces Final Rules Prohibiting Institutions from Charging Fees for Overdrafts on ATM and One-Time Debit Card Transactions,’’ press release, November 12, www.federalreserve.gov/newsevents/press/bcreg/20091112a.htm; and Board of Governors of the Federal Reserve System (2010), ‘‘Federal Reserve Approves Final Rules to Protect Credit Card Users from a Number of Costly Practices,’’ press release, January 12, www.federalreserve.gov/ newsevents/press/bcreg/20100112a.htm. 10For further information, see Board of Governors of the Federal Reserve System (2009), ‘‘Federal Reserve to Implement Consumer Compliance Supervision Program of Nonbank Sub- sidiaries of Bank Holding Companies and Foreign Banking Organizations,’’ press release, Sep- tember 15, www.federalreserve.gov/newsevents/press/bcreg/20090915a.htm. 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKE Emergency Lending Under Section 13(3) Q.1.a. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech his belief that the Fed’s emergency 13(3) lending authority should be either eliminated or severely curtailed (‘‘The Federal Reserve System: Balancing Inde- pendence and Accountability,’’ presented February 17, 2010 by President Plosser to the World Affairs Council of Philadelphia). He stated: I believe that the Fed’s 13(3) lending authority should be either eliminated or severely curtailed. Such lending should be done by the fiscal authorities only in emergencies and, if the Fed is involved, only upon the written re- quest of the Treasury. Any non-Treasury securities or collateral acquired by the Fed under such lending should be promptly swapped for Treasury secu- rities so that it is clear that the responsibility and accountability for such lending rests explicitly with the fiscal authorities, not the Federal Reserve. To codify this arrangement, I believe we should establish a new Fed-Treas- ury Accord. This would eliminate the ability of the Fed to engage in ‘bail- outs’ of individual firms or sectors and place such responsibility with the Treasury and Congress, squarely where it belongs. Do you agree with President Plosser? A.1.a Since the fall of 2008, I have advocated that Congress estab- lish a statutory resolution regime that provides a workable alter- native to Government bailouts and disorderly bankruptcies. With enactment of a workable resolution regime for systemically impor- tant firms, I have also called for removal of the Federal Reserve’s authority under section 13(3) to extend credit to troubled non- banking entities. However, I believe that it would be appropriate for the Federal Reserve to retain the authority to lend to establish broad market- based credit facilities in unusual and exigent circumstances. In ex- ceptional circumstances the preservation of financial stability may require that the Federal Reserve have the authority to provide li- quidity to restart or encourage markets to operate, thereby pro- viding liquidity needed to allow households, small businesses, de- positors and others access to working liquid markets. The need for such authority was fully evident during the financial crisis, when preventing a financial catastrophe required that the Federal Re- serve provide liquidity to money market mutual funds, primary dealers, the commercial paper market, and the market for student loans, credit card loans, small business loans and the commercial real estate market. Q.1.b. Do you believe that modifications to Section 13(3) of the Federal Reserve Act would be useful in clarifying emergency re- sponses of various branches of government to financial crises? If so, what modifications do you believe would be most useful? A.1.b. Apart from a possible elimination of the authority to lend to single firms (as discussed above), I do not believe that significant modifications to section 13(3) are necessary or appropriate. The Federal Reserve has historically been extremely cautious in using the section 13(3) authority. Prior to the recent financial crisis, the Federal Reserve had au- thorized the extension of credit under section 13(3) in only one cir- 110 cumstance since the Great Depression and had not in fact extended credit under this section since the 1930s. During this financial crisis, the Federal Reserve worked closely with the Department of the Treasury before exercising authority under section 13(3). We believe this consultation is important and appropriate and would not object to a statutory provision requiring consultation with or approval by the Secretary of the Treasury prior to authorizing an extension of credit under section 13(3). Q.1.c. Do you favor the establishment of a new Fed-Treasury Ac- cord to provide greater distinction between fiscal policy actions and lender-of-last resort actions taken by the Federal Reserve in an emergency? A.1.c. The Federal Reserve and the Treasury have an accord that sets forth the principles applied by each in addressing the current crisis. We would favor a legislative provision allowing the Federal Reserve to transfer to the Treasury obligations that, while acquired in the course of Federal Reserve action as the lender of last resort, become fiscal obligations more appropriately managed by the Treasury Department. We would be happy to work with you on de- veloping this type of approach. Interest on Reserves Q.2. Congress provided the authority to pay interest on reserves to the Board of Governors of the Federal Reserve, and not the Federal Open Market Committee (FOMC). Similarly, the Board of Gov- ernors, and not the FOMC, has authority over setting the discount rate and reserve requirements. According to minutes of the Janu- ary 26–27, 2010, FOMC meeting, the interest rate paid on excess reserve balances (the IOER rate) is one of the tools available to support a gradual return to a more normal monetary policy stance. Quoting from the minutes: Participants expressed a range of views about the tools and strategy for re- moving policy accommodation when that step becomes appropriate. All agreed that raising the IOER rate and the target for the Federal funds rate would be a key element of a move to less accommodative monetary policy. • Are there any possible future conflicts or difficulties that you could imagine might arise from having the Federal Reserve’s target for the Federal funds rate determined by the FOMC while the IOER and discount rate are determined by the Board of Governors? • As it moves toward a more normal monetary policy stance, the Federal Reserve may use the IOER rate to help manage re- serve balances. If the IOER rate, rather than a target for a market rate, becomes an indicator of the stance of monetary policy for a time, will the balance of power over monetary pol- icy between the FOMC and the Federal Reserve Board change? A.2. As you know, the Congress has assigned to the Board the re- sponsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other impor- tant terms that are relevant for the conduct of monetary policy— for example, the Board ‘‘reviews and determines’’ the discount rates 111 that are established by the Federal Reserve Banks; the Federal Open Market Committee has no statutory role in setting the dis- count rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the Federal Open Market Committee has no statutory role in setting reserve require- ments. For many years, the Board and the FOMC have worked colle- gially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work co- operatively in the future in adjusting all of the instruments of mon- etary policy. Monetary Policy and Fiscal Policy Distinction Q.3.a. Several regional Federal Reserve bank presidents have ex- pressed concern that actions taken by the Fed, many under Section 13(3) authority, were actions to channel credit to specific firms or specific segments of financial markets and the economy. The con- cern is that some actions amounted to fiscal, and not lender of last resort, policies. Moreover, in a March 23, 2009 joint press release, the Fed and the Treasury stated the following: The Federal Reserve to avoid credit risk and credit allocation The Federal Reserve’s lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Re- serve Bank. Actions taken by the Federal Reserve should also aim to im- prove financial or credit conditions broadly, not to allocate credit to nar- rowly defined sectors or classes of borrowers. Government decisions to influ- ence the allocation of credit are the province of the fiscal authorities. In accord with the joint statement, should the Fed’s stock of agency debt and mortgage-backed securities along with its Maiden Lane holdings be swapped for Treasury securities, thereby trans- parently placing the channeling of credit support to the housing sector firmly in the hands of fiscal authorities? A.3.a. The Federal Reserve’s purchases of agency debt and mort- gage-backed securities, and the credit it has extended to the Maid- en Lane entities, arose for different reasons and deserve different treatment. The primary purpose of the Federal Reserve’s purchases of secu- rities issued or guaranteed by Federal agencies was a monetary policy response intended to support the overall economy by pro- viding support to the mortgage and housing sectors. The Federal Reserve believes that in routine circumstances the modes of gov- ernment support for the housing sector should be determined by the Congress and carried out through agencies other than the Fed- eral Reserve. For that reason, the Federal Reserve in recent decades mini- mized its participation in the agency securities markets. However, the highly strained financial market conditions of the past few years prevented the Federal Reserve’s monetary policy actions to lower interest rates from being fully transmitted to housing mar- kets, as would have happened in more normal times, and the Fed- eral Reserve’s ability to lower short-term interest rates further was constrained after short-term rates were lowered to essentially zero. 112 In the circumstances, the Federal Reserve initiated a program to purchase agency debt and mortgage-backed securities. The credit extensions to AIG and the Maiden Lane entities rep- resent exercise of the Federal Reserve’s authority as lender of last resort. The Treasury Department is better suited to make the pol- icy and management decisions that attend the longer term relation- ship with a nonbanking firm that requires government assistance. Accordingly, the Federal Reserve would support a transfer to the Treasury of its AIG and Maiden Lane credits. The issues regarding a possible swap of agency debt and MBS securities for Treasury se- curities are somewhat more complex and would require careful study. Q.3.b. The Fed has purchased over $1 trillion of agency mortgage- backed-securities and intends to complete purchases of $1.25 tril- lion of those securities by the end of March. To help finance those purchases, the Fed uses supplemental borrowing from the Treasury and issues interest-bearing reserve balances. In effect, the Fed is borrowing from the public, including banks, with promises to repay the borrowed sums plus interest. The Fed will continue that bor- rowing in order to hold on to its mortgage-backed securities until those assets gradually decline as they mature or are prepaid or sold. When the Fed effectively finances an enormous portfolio hold- ing of a specific class of assets using interest bearing debt issued to the public, how is that not a fiscal policy exercise? A.3.b. Monetary policy and fiscal policy are different tools that both can be used to stimulate the economy. The purpose of the Federal Reserve’s large-scale asset purchases was primarily to apply macro- economic stimulus by lowering longer-term interest rates and by improving financial market functioning; fiscal policy applies stim- ulus by adjusting overall government spending or revenues. Be- cause the Federal Reserve’s large-scale asset purchases involved changes in the central bank’s balance sheet—and, in particular, the creation of a large volume of reserves, it is clear that the purchases were a monetary policy action. Moreover, the Federal Reserve’s de- cision to purchase a large volume of longer-term assets in the crisis was consistent with its statutory mandate to promote maximum employment and price stability, and it was clearly supported by its statutory authorities. These transactions can and will be unwound in a manner consistent with these same mandates. Systemic Risk Regulation Q.4.a. Your February 25, 2010, testimony identifies that the Fed is making fundamental changes in its supervision of bank holding companies to, in your words, ‘‘incorporate a macroprudential per- spective that goes beyond the traditional focus on safety and sound- ness of individual institutions.’’ Could you precisely define what you mean by a ‘‘macroprudential perspective,’’ and what metrics guide that perspective? A.4.a. Our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. As was evident in the financial crisis, complex, global financial firms can be pro- foundly interconnected in ways that can threaten the viability of individual firms, the functioning of key financial markets, and the 113 stability of the broader economy. A macroprudential perspective re- quires a more system-wide approach to the supervision of system- ically critical firms that considers the interdependencies among firms and markets that have the potential to undermine the sta- bility of the financial system. To that end, we have supported the creation of a council of regulators that would gather information from across the financial system, identify and assess potential risks to the financial system, and work with member agencies to address those risks. In our own supervisory efforts, we are reorienting our approach to some of the largest holding companies to better anticipate and mitigate systemic risks. For example, we expect to increase the use of horizontal reviews, which focus on particular risks or activities across a group of banking organizations. In doing so, we have drawn on our experience with the Supervisory Capital Assessment Program (SCAP), in which the Federal Reserve led a coordinated effort by the bank supervisors to evaluate on a consistent basis the capital needs of the largest banking institutions in an adverse eco- nomic scenario. Because the SCAP involved the simultaneous eval- uation of potential credit exposures across all of the included firms, we were better able to consider the systemic implications of finan- cial stress under an adverse economic scenario, in addition to the impact of an adverse scenario on individual firms. The SCAP also showed the benefits of drawing on the work of a wide range of staff—including supervisors, economists, and market and payments system experts—to comprehensively evaluate the risks facing financial firms. Going forward, the Federal Reserve is instituting a data-driven, quantitative surveillance mechanism that will draw on a similar range of staff expertise to provide an inde- pendent view of the risks facing large banking firms. As part of that effort, we are developing quantitative tools to help identify vulnerabilities at both the firm level and for the aggregate finan- cial sector. We anticipate that these tools will incorporate macro- economic forecasts, including spillover and feedback effects. We also expect to develop indicators of interconnectedness, which could encompass common credit, market, and funding exposures. The de- velopment of specific metrics will also depend, in part, on the avail- ability of timely and comparable data from systemically important firms. Q.4.b. Does the Fed intend to redefine what regulators should re- gard as ‘‘safety and soundness?’’ A.4.b. Ensuring the safety and soundness of institutions has been a cornerstone of the Federal Reserve’s supervision program. The re- cent crisis has shown that large, interconnected firms can be buf- feted by a market-driven crisis, magnifying weaknesses in risk management practices, and revealing capital and liquidity buffers calibrated to withstand institution-specific stress events to be in- sufficient. For this reason, leading supervisors in the United States and abroad are reviewing the prudential standards needed to en- sure safety and soundness for individual firms and the financial system as a whole. The Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher quality capital, improve their 114 risk-management practices, have more robust liquidity manage- ment, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with con- sumers. We are working with our domestic and international counter- parts to develop capital and prudential requirements that take ac- count of the systemic importance of large, complex firms whose fail- ure would pose a significant threat to overall financial stability. Options under consideration include assessing a capital surcharge on these institutions or requiring that a greater share of their cap- ital be in the form of common equity. For additional protection, sys- temically important institutions could be required to issue contin- gent capital, such as debt-like securities that convert to common equity in times of macroeconomic stress or when losses erode the institution’s capital base. U.S. supervisory agencies have already increased capital requirements for trading activities and securitization exposures, two of the areas in which losses were es- pecially high. Liquidity requirements should also be strengthened for system- ically critical firms, as even solvent financial institutions can be brought down by liquidity problems. The bank regulatory agencies are implementing strengthened guidance on liquidity risk manage- ment and weighing proposals for quantitatively based require- ments. In addition to insufficient capital and inadequate liquidity risk management, flawed compensation practices at financial insti- tutions also contributed to the crisis. Compensation should appro- priately link pay to performance and provide sound incentives. The Federal Reserve has issued proposed guidance that would require banking organizations to review their compensation practices to en- sure they do not encourage excessive risk-taking, are subject to ef- fective controls and risk management, and are supported by strong corporate governance including board-level oversight. Federal Reserve’s Asset Holdings Q.5. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech that . . . the Fed could help preserve its independence by limiting the scope of its ability to engage in activities that blur the boundary lines between mon- etary and fiscal policy. Thus, as the economic recovery gains strength and monetary policy begins to normalize, I would favor our beginning to sell some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets. Doing so would help extri- cate the Fed from the realm of fiscal policy and housing finance. Do you agree with President Plosser? A.5. I provided my views on asset sales in my March 25, 2010, tes- timony before the House Committee on Financial Services. The rel- evant passage is reproduced below. When these tools [reverse repurchase agreements and term de- posits] are used to drain reserves from the banking system, they do so by replacing bank reserves with other liabilities; the asset side and the overall of the Federal Reserve’s balance sheet remain unchanged. If necessary, as a means of applying monetary re- straint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have 115 the effect of reducing the size of the Federal Reserve’s balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combina- tion of tools that the Federal Reserve uses as it exits from its cur- rently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve’s dual mandate of maximum employ- ment and price stability. Treasury Financing Account at the Fed Q.6. On February 23, 2010, the Treasury announced, rather sud- denly and surprisingly, and without much explanation, that it an- ticipates increasing its Supplementary Financing Account at the Fed by around $200 billion over the next 2 months. This means, essentially, that the Treasury will borrow on behalf of the Fed and simply hold the funds in the Treasury’s account at the Fed. I un- derstand that the Treasury’s Supplementary Financing Program helps the Fed absorb reserves from the banking system and man- age its balance sheet. I wonder, however, about the lack of informa- tion concerning why the Treasury suddenly decided to increase its balance at the Fed. • Was the Treasury’s February 23 announcement planned in ad- vance and coordinated with the Fed, or was it a surprise to the Fed? • What are the future plans for the size of the Treasury’s Sup- plemental Financing Account? • Who will decide what will be the future balances in the Sup- plemental Financing Account? A.6. The Treasury and the Federal Reserve consulted closely on the Treasury’s February 23 announcement regarding the Supple- mentary Financing Program. However, the Treasury makes all de- cisions on balances to be held in the Supplementary Financing Ac- count. Efforts to Toughen Capital and Liquidity Requirements Q.7.a. Your testimony on February 25, 2010 identifies that . . . the Federal Reserve has been playing a key international role in international efforts to toughen capital and liquidity requirements for finan- cial institutions, particularly systemically critical firms . . . Could you describe what those efforts have been? A.7.a. The Federal Reserve has an active leadership role within the Finance Stability Board, the Basel Committee for Banking Super- vision, and various other international supervisory fora. Through these fora, especially the Basel Committee, the Federal Reserve has worked diligently with supervisors from around the world to develop a comprehensive series of reforms to address the lessons that we have learned from the recent global financial crisis. The goal of the Basel Committee’s reform package is to improve the international banking sector’s ability to deal with future economic and financial stress, thus reducing the contagion risk from the fi- nancial sector to the real economy. 116 The Federal Reserve co-chairs three Basel Committee working groups that are focusing on reforms especially pertinent to system- ically important institutions. These groups are developing: a) revi- sions to the capital regulations for trading book activities, designed to enhance risk measurement and to significantly increase the cap- ital requirement associated with various financial instruments that contributed to losses at systemically important institutions during the crisis; b) enhanced and higher capital charges for counterparty credit risk, including a new charge for credit valuation allowances (CVA), which were a significant source of loss during the crisis; and c) new liquidity standards, which directly address a major chal- lenge during the global turmoil. With regard to the latter, the pro- posed standards draw heavily from conceptual design work contrib- uted by Federal Reserve staff. In addition, Federal Reserve staff made significant contributions to the Basel Committee’s Principles for Sound Liquidity Risk Management and supervision issued in September 2008. In many cases, the international principles articu- lated drew heavily from established Federal Reserve guidance. Moreover, Federal Reserve economists and supervisors have been heavily involved in work conducted by the Basel Committee and by the Committee of Global Financial Stability to develop forward- looking measures of systemic liquidity risks and in assessing the current state of funding and liquidity risk management at inter- nationally active financial institutions. Federal Reserve staff also are key players in the Basel Commit- tee’s working groups developing a new international leverage ratio standard, which is largely inspired by the U.S. leverage standard, and a new definition of regulatory capital for banking organiza- tions, which is an area where the Federal Reserve provides insight- ful experience since almost all banking capital issuance in the U.S. is executed at the bank holding company level.1 Moreover, the Fed- eral Reserve has also played an active role in the Basel Commit- tee’s working group that recently issued recommendations to strengthen the resolution of systemically significant cross-border banks.2 Q.7.b. Could you define a ‘‘systemically critical’’ firm and identify how many such firms currently operate in the United States? A.7.b. A ‘‘systemically critical’’ firm is one whose failure would have significant adverse effects on financial markets or the econ- omy. At any point in time, the systemic importance of an individual firm depends on a wide range of factors including whether the firm has extensive on- and off-balance sheet activities, whether the firm is interconnected—either receiving funding from, or providing fund- ing to other systemically important firms—whether the firm plays a major role in key financial markets, and/or whether the firm pro- vides crucial services to its customers that cannot easily or quickly be provided by other financial institutions. That said, the identi- fication of systemic importance requires considerable judgment be- cause each stress event is different, because market structure, business practices, financial products, technologies, supervisory 1See ‘‘Strengthening the resilience of the banking sector-consultative document’’ (December 2009), available at www.bis.org/publ/bcbs164.htm. 2See ‘‘Report and recommendations of the Cross-border Bank Resolution Group-final paper’’ (March 2009), available at www.bis.org/publ/bcbs169.htm. 117 practices and regulatory environments evolve over time. This evo- lution, of course, changes the interconnections between firms, their relative sizes, their functions and services, and the extent to which services can be obtained from other firms or in financial markets. As a practical matter, it is likely that the number of firms that are considered systemically critical will be less than 50. For example, only about 35 U.S. financial firms, with publicly traded stock out- standing, have total assets over $100 billion as of 2008:Q4. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BROWN FROM BEN S. BERNANKE Bank Lending Q.1. I have heard from Ohio banks that banking regulators are preventing them from expanding commercial lending by requiring them to maintain greater capital reserves. I agree that we need to ensure that our banks are well capitalized, but at some point we’ve got to get lending going again, particularly to businesses that will use their money to hire workers. How can banks strike a balance between being well capitalized and still lending like they are supposed to? A.1. The loss absorbing characteristics of capital provide the eco- nomic bedrock that supports prudent bank lending and, as such, it is not inconsistent for banks to remain well capitalized and con- comitantly engage in healthy lending practices. However, during the financial crisis, many banks recorded significant financial losses that eroded their capital base and as a result, some banks may be operating with reduced capital bases to support lending ac- tivities. In other instances, well capitalized banks may be reluctant to lend if their outlook on economic conditions lead them to believe that additional losses are likely in the near term, which would fur- ther erode their current capital position. The Federal Reserve be- lieves that, in cases where banks are concerned about potential ad- ditional losses, a prudent response would be for those banks to in- crease their capital position in order to address this concern and to take advantage of any demand in commercial lending. Likewise, we believe that an improving economic outlook should help banks to bolster their capital levels and contribute to increased willing- ness of banks to lend. Q.2. Have you considered taking any specific steps, like lowering the Fed’s interest payments on excess bank reserves, or perhaps even imposing a penalty on hoarding money, to promote greater lending? A.2. The Federal Reserve’s payment of interest on excess reserves is unlikely to be a significant factor in banks’ current reluctance to lend. The Federal Reserve is currently paying interest at a rate of only one quarter of 1 percent on banks’ reserve balances. By con- trast, the prime rate is currently at 31⁄ 4 percent, and many bank lending rates are considerably higher than the prime rate. Given the large difference between the interest rate paid on excess re- serves and the interest rates on banks, the ability to earn interest on excess reserves is unlikely to be an important reason for the tightening of banks’ lending standards and terms over the past few 118 years. Indeed, survey results suggest that the major reason that banks have tightened lending terms and standards over the past 2 years or so was their concern about the economic outlook. As you know, the Federal Reserve has acted aggressively from the outset of the financial crisis to stabilize financial market conditions and promote sustainable economic growth. An improving economic out- look should contribute to increased willingness of banks to lend. Bank Concentration Q.3. Banks are borrowing at record low interest rates—particularly those banks that are viewed as ‘‘too big to fail.’’ According to the Center for Economic and Policy Research, the 18 biggest banks are getting what amounts to a $34.1 billion a year subsidy because of their implicit government guarantee. More recent data from the FDIC shows that big banks are turning a profit, but small banks are not. Data from 1999 shows that large banks’ fees for overdrafts are 41 percent higher than at small banks and bounced check fees are 43 percent higher. Now borrowers are having their lines of credit slashed and their bank fees are still increasing. So it appears that consumers and small banks are suffering, while the big banks thrive. And the market is only getting more concentrated: 319 banks were forced to merge or fail in 2009. What steps are the Fed taking to ensure that there is not exces- sive concentration in the banking industry, and that consumers are being well served through meaningful competition? A.3. The Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 provides prudential protection against exces- sive concentration in the banking industry by prohibiting the Fed- eral Reserve from approving a bank acquisition that would result in a bank holding company exceeding a nationwide deposit con- centration limitation of more than 10 percent of the total amount of deposits of insured depository institutions in the United States. Notwithstanding that protection, there are many other potential methods to address the subsidies that may arise because of percep- tions that large financial firms are ‘‘too-big-to-fail.’’ For example, firms that might reasonably be considered ‘‘too-big-to-fail’’ may be subject to higher capital (and liquidity) requirements, more highly tailored resolution mechanisms, tighter deposit share caps, re- quired issuance of contingent capital instruments and/or subordi- nated debt instruments, limitations on, or a ban of, certain activi- ties (e.g., hedge funds or private equity funds), and taxes on non- deposit balance-sheet liabilities. As the financial crisis winds down, many of these types of proposals to reduce the subsidies that arise from implicit guarantees are under consideration in the United States and abroad. In fact, Federal Reserve staff are participating on many international working groups that are considering the po- tential effects, including unintended consequences, that may arise from implementing such proposals either singularly, or in combina- tion. A key factor in such analyses is the impact on competition here in the United States and internationally across borders. Research on whether consumers benefit from ‘‘too-big-to-fail’’ sub- sidies is scant. It is plausible that large financial institutions might pass along some of their subsidies to consumers to fuel their own 119 growth at the expense of smaller peers. Some evidence, however, suggests otherwise. For example, Passmore, Burgess, Hancock, Lehnert, and Sherlund (in a presentation at the Federal Reserve Bank of Chicago Bank Structure Conference, May 18, 2006) esti- mate that just 5 percent of the Fannie Mae and Freddie Mac’s bor- rowing advantage flowed through to mortgage rates, resulting in just a few basis points reduction in conforming mortgage loan rates. Even if financial firms do not pass along their ‘‘too-big-to- fail’’ subsidies to consumers, it does not necessarily imply that they cannot pass along the higher costs that would result from the re- duction of such subsidies. Indeed, larger firms may set the market prices for some financial products because of other cost advantages associated with their size. In such circumstances, consumers may end up paying higher prices when ‘‘too-big-to-fail’’ subsidies are re- duced (or eliminated) even though they did not previously much benefit from such subsidies. That said, all consumers benefit from a more stable financial system with less systemic risk and this is the goal of reducing or eliminating ‘‘too-big-to-fail’’ subsidies. Resolution of Failed Banks Q.4. You have previously said that you favor ‘‘establishing a proc- ess that would allow a failing, systemically important non-bank fi- nancial institution to be wound down in any orderly fashion, with- out jeopardizing financial stability.’’ There’s been a lot of talk about whether this job should be done by banking regulators or a bank- ruptcy court. Do you have an opinion about this, particularly whether the FDIC is doing a good job with its resolution authority? A.4. In most cases, the Federal bankruptcy laws provide an appro- priate framework for the resolution of nonbank financial institu- tions. However, the bankruptcy code does not sufficiently protect the public’s strong interest in ensuring the orderly resolution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. A new resolution regime for systemically important nonbank fi- nancial firms, analogous to the regime currently used by the Fed- eral Deposit Insurance Corporation for banks, would provide the government the tools to restructure or wind down such a firm in a way that mitigates the risks to financial stability and the econ- omy and thus protects the public interest. It also would provide the government a mechanism for imposing losses on the shareholders and creditors of the firm. Establishing credible processes for impos- ing such losses is essential to restoring a meaningful degree of market discipline and addressing the ‘‘too-big-to-fail’’ problem. It would be appropriate to establish a high standard for invoca- tion of this new resolution regime and to create checks and bal- ances on its potential use, similar to the provisions governing use of the systemic risk exception to least-cost resolution in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve’s participa- tion in this decisionmaking process would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large bank- ing organizations. The Federal Reserve, however, is not well suited, 120 nor do we seek, to serve as the resolution agency for systemically important institutions under a new framework. Because the suit- ability of an entity to serve as the resolution agency for any par- ticular firm may depend on the firm’s structure and activities, the Treasury Department should be given flexibility to appoint a re- ceiver that has the requisite expertise to address the issues pre- sented by a wind down of that firm. Banks Trading Commodities Futures Derivatives Q.5. You gave an address at Harvard in 2008 in which you talked about out-of-control crude oil prices. You said that ‘‘demand growth and constrained supplies’’ were responsible for ‘‘intense pressure on [gas] prices.’’ Senator Carl Levin investigated the crude oil market and found that speculation ‘‘appears to have altered the historical relationship between [crude oil] price and inventory.’’ In 2003, at the request of Citigroup and UBS, the Fed authorized bank holding companies to trade energy futures, both on exchanges and over-the- counter. Given that commodity prices affect the Consumer Price Index, which affects inflation, have you investigated what effect the rule change, and the resulting investments in commodities futures and other commodities-related derivatives, have had on oil prices? Q.6. If not, how can you conclude that rises in gasoline prices are due solely to simple changes in supply and demand? Q.7. If presented with evidence that energy speculation was driving up prices or affecting inflation, would you consider revoking the banks’ authority to trade energy futures? A5.–7. The broad movements in oil and other commodity prices have been in line with developments in the global economy. They rose when global growth was strong and supply was constrained. and they collapsed with the onset of the global recession. As the global economy began to recover and financial conditions began to normalize, commodity prices rebounded. Nonetheless, the extreme price swings, particularly in the case of oil, have been surprising. Some have argued that speculative activi- ties on the part of financial investors have been responsible for these outsized price movements. Notwithstanding considerable study, however, conclusive evidence of the role of speculators and financial investors remains elusive. The fundamentals of supply and demand, along with expectations for how these fundamentals will evolve in the future, remain the best explanation for the move- ments in commodity prices. That said, we must remain open to other possibilities, and if conclusive evidence emerged that com- modity markets were not performing their price discovery and allocative role effectively, then changes in regulatory policies may be appropriate. Fed Purchases of Foreign Currency Derivatives Q.8. In the wake of the Greek debt crisis, I’m concerned about gov- ernments’ use of foreign currency exchanges—that other govern- ments might be using foreign currency swaps to mask their debt, or for other purposes. We know that the Federal Reserve entered into swaps with Foreign Central Banks and then those Foreign 121 Central Banks bailed out their own banking systems. For example, the Federal Reserve worked with the Swiss central bank on the rescue effort for UBS, securing dollars through a swap agreement for francs. As of December 31, 2008, the United States had entered into $550 billion in liquidity swaps with foreign central banks. How are these arrangements between the Federal Reserve and the other central banks structured? A.8. The dollar liquidity swap arrangements that the Federal Re- serve entered into with foreign central banks were fundamentally different from the currency swaps that have been discussed in the Greek context. According to reports, the Greek cross-currency swaps were highly structured arrangements initiated 8 or 9 years ago between the government of Greece and a private sector finan- cial institution. These swaps apparently entailed payment obliga- tions over a period of 15 to 20 years with large balloon payments at maturity, and they allowed the Greek government to exchange into euros the proceeds of borrowing it had done in Japanese yen and U.S. dollars at off-market rates of exchange. The dollar liquidity swaps, the volume of which is now zero fol- lowing the termination of the arrangements in February, were more straightforward, shorter-term arrangements with foreign cen- tral banks of the highest credit standing. In each dollar liquidity swap transaction, the Federal Reserve provided U.S. dollars to a foreign central bank in exchange for an equivalent amount of funds in the currency of the foreign central bank, based on the market exchange rate at the time of the transaction. The parties agreed to swap back these quantities of their two currencies at a specified date in the future, which was at most 3 months ahead, using the same exchange rate as in the initial exchange. The Federal Reserve also received interest corresponding to the maturity of the swap drawing. Because the terms of each swap transaction were set in advance, fluctuations in exchange rates following the initial exchange did not alter the eventual payments. Accordingly, these swap oper- ations carried no exchange rate or other market risks. In addition, we judged our swap line exposures to be of the highest quality and safety. The foreign currency held by the Federal Reserve during the term of the swap provided an important safeguard. Further- more, our exposures were not to the institutions ultimately receiv- ing the dollar liquidity in the foreign countries but to the foreign central banks. We have had long and close relationships with these central banks, many of which hold substantial quantities of U.S. dollar reserves in accounts at the Federal Reserve Bank ofNew York, and these dealings provided a track record that justified a high degree of trust and cooperation. The short tenor of the swaps, which ranged from overnight to 3 months at most, also offered some protection, in that positions could be wound down relatively quickly were it judged appropriate to do so. Q.9. Are these swaps being used in any way to mask U.S. Govern- ment debt? A.9. No. These swaps were limited to the exchange of U.S. dollar liquidity for foreign-currency liquidity and were not used in any way to mask U.S. Government debt. 122 Q.10. Does the Federal Reserve keep track of which foreign banks ultimately receive U.S. money from foreign central banks? If so, what banks have gotten U.S. money, and how much has each got- ten? A.10. The Federal Reserve’s contractual relationships were with the foreign central banks and not with the financial institutions ul- timately obtaining the dollar funding provided by these operations. Accordingly, the Federal Reserve did not track the names of the in- stitutions receiving the dollar liquidity from the foreign central banks but instead left to the foreign central banks the responsi- bility for managing the distribution of the dollar funding. This re- sponsibility included determining the eligibility of institutions that could participate in the dollar lending operations, assessing the ac- ceptability of the collateral offered, and bearing any residual credit risk that might have arisen as a result of the lending operations. Q.11. Is the U.S. Treasury issuing Treasury bonds which the Fed is then buying through the U.K. or other foreign governments? A.11. No. RESPONSE TO WRITTEN QUESTIONS OF SENATOR MERKLEY FROM BEN S. BERNANKE Q.1. The homeownership rate in Canada is almost identical to that of the United States. Yet the percentage of U.S. mortgages in ar- rears is fast approaching 10 percent while the percentage of Cana- dian mortgages in arrears has been relatively stable for the past two decades at less than 1 percent. What characteristics of the mortgage market in Canada do you believe have helped that coun- try avoid a similar foreclosure crisis? A.1. A number of characteristics of the Canadian mortgage market helped Canada avoid a foreclosure crisis. Canadian homeowners typically maintain greater equity in their homes, in part because mortgage insurance, which is required when loan-to-value ratios exceed 80 percent, is more costly than in the United States. More- over, Canadian mortgages are subject to substantial pre-payment penalties, reducing the incentives of households to regularly refi- nance their mortgages. While in general this limits households’ ability to take advantage of falling interest rates, it also reduces the number of ‘‘cash out’’ refinancings, increasing the average eq- uity held by households. In addition, a greater fraction of Canadian mortgages are prime mortgages, which default at lower rates than sub-prime mortgages. One reason the sub-prime market was slower to grow in Canada is because of the incentives, noted above, for borrowers to make higher down payments. Another reason is that a smaller fraction of mortgages in Canada are securitized, because even mortgages that have been securitized and resold carry a capital charge, giving Canadian banks less incentive to securitize mortgages. A mortgage lender that plans to hold a mortgage to maturity likely employs higher underwriting standards than a mortgage lender that plans to securitize the loan. Finally, Canada has experienced a comparatively milder labor- market downturn than the United States and only a modest de- 123 cline in house prices. These factors, too, have helped reduce the in- cidence of default. Q.2. All of the six major banks in Canada own investment banking and insurance subsidiaries. All five of the major banks in Canada would probably be considered ‘‘too-big-to-fail.’’ However, the Cana- dian banking regulators have prudently enforced more stringent capital requirements including a 7 percent minimum of Tier 1 cap- ital and 10 percent minimum of total capital. Additionally, there is an Assets-to-Capital Multiple maximum of 20 (or leverage ratio). What lessons have you learned from observing the actions that Canadian regulators have taken regarding the use of more strin- gent capital requirements than those required under Basel II? A.2. At present, the U.S. regulatory capital rules result in a re- quirement for banking organizations to hold capital at levels that are equal to, or exceed, Canadian peers; notwithstanding that the stated required minimum Tier 1 risk-based capital ratio is 6 per- cent for ‘‘well capitalized’’ banks under PCA.1 Because of statu- torily required responses to the breeching of a PCA capital thresh- old, market forces generally necessitate banks and bank holding companies to hold substantially more capital than the ‘‘well capital- ized’’ ratio requirements to ensure that significant losses can be ab- sorbed before a ‘‘well capitalized’’ ratio is breached. The following table outlines the Tier I, Total and Leverage ratios of the top six U.S. bank holding companies and provides our estimate of their re- spective Assets-to-Capital Multiple as computed under the Cana- dian regulatory capital regime. As shown below, each of the top six U.S. bank holding companies would easily exceed the Canadian standards outlined above. Selected Capital Ratios Six Largest U.S. Bank Holding Companies (as of December 31, 2009) B T a i s e e r d 1 C R a i p s i k t - a l Ba T s o e ta d l C R a is p k it - a l Ti a e g r e 1 R L a e t v i e o r - A U s . ( S 1 s I M n . e R v C t u L s e a a l e - r t t p v s i t i p o o e e it ) l - r a e a T o l i g f e e r C ( D A a C s e p a s f i t i t n e i n a p t a i s l l t d e - i M i o t a o n u n - ) l - Bank of America............................................. 10.41% 14.67% 6.91% 14.5 11.6 JP Morgan Chase............................................ 11.10% 14.78% 6.88% 14.5 13.7 Citigroup ......................................................... 11.67% 15.25% 6.89% 14.5 12.7 Wells Fargo ..................................................... 9.25% 13.26% 7.87% 12.7 9.6 Goldman Sachs............................................... 14.97% 18.17% 7.55% 13.2 12.3 Morgan Stanley............................................... 15.30% 16.38% 5.80% 17.2 17.1 The Federal Reserve believes that, going forward, capital re- quirements will need to be recalibrated to directly address the in- appropriate incentives that were the underlying causes of the fi- nancial crisis. We are engaged in a significant effort both here in the United States and abroad to achieve this objective. Q.3. Canada has an independent consumer protection agency, called the Consumer Financial Agency of Canada. Do you believe 1To be considered ‘‘well capitalized’’ under the U.S. Prompt Corrective Action (PCA) require- ments, a bank must have a Tier 1 Leverage ratio of no less than 5 percent, a Tier I risk-based capital ratio of no less than 6 percent, a Total risk-based capital ratio of no less than 10 percent. 124 that this agency’s mission and independence has helped the Cana- dian financial markets remain stable and well capitalized, even under the current economic conditions? A.3. Consumer protection laws are very important for maintaining a well-functioning financial system. The Financial Consumer Agen- cy of Canada (FCAC) is responsible for ensuring compliance with consumer protection laws and regulations; monitoring financial in- stitutions’ compliance with voluntary codes of conduct; and inform- ing consumers of their rights and responsibilities as well as pro- viding general information on financial products. Ensuring compliance with consumer protection laws is an impor- tant defense against future financial problems, and informed con- sumers are undoubtedly less likely to enter unfavorable mortgage agreements. It is difficult to gauge, however, the extent to which the quality of consumer information and extent of consumer protec- tion help explain why Canada had relatively few of the exotic, hard-to-understand sub-prime mortgages that have had such high default rates in the United States. As noted in the answer to the preceding question, other factors—the structure of the mortgage market and bank capital regulation in Canada—appear to rep- resent more tangible reasons why the sub-prime market was slow to develop in Canada. Q.4. Throughout the past year, many witnesses before the Senate Banking Committee have argued that the widespread practice of securitizing mortgages helped propagate bad underwriting prac- tices and contributed to the toxic nature of many, if not all, invest- ments in subprime mortgages. The Canadian mortgage market only has approximately 5 percent of outstanding mortgages cat- egorized as ‘‘subprime.’’ Additionally, according to the Bank of Can- ada, 68 percent of mortgages remain on the balance sheet of the lender and most residential mortgage financing is funded through deposits. Do you think that banks who keep major portions of their residential real estate lending ‘‘on the books’’ are less likely to en- gage in the financing of, ‘‘subprime’’ mortgage lending? A.4. It is unlikely that a requirement to keep mortgage exposures on balance sheet would make banking organizations less likely to underwrite ‘‘subprime’’ exposures. For instance, prior to the finan- cial crisis, many banking organizations entered into ‘‘subprime’’ mortgage securitizations and retained the ‘‘first loss’’ positions ‘‘on the books,’’ reflecting a high risk tolerance for exposure to the ‘‘subprime’’ mortgage market. Additionally, many other banking or- ganizations provided recourse on ‘‘subprime’’ mortgage exposures that they sold to securitization structures; again, a reflections of a high risk tolerance ‘‘subprime’’ mortgage exposures. If banking or- ganizations were no longer allowed to place ‘‘subprime’’ mortgages into securitization vehicles, it could be reasonably posited that banking organizations would continue to underwrite ‘‘subprime’’ mortgages given the higher yield earned from these exposures and the fact that the current risk-based capital framework levies an identical capital requirement for a ‘‘subprime’’ exposure as it does for a ‘‘prime’’ exposure. There are several distinct differences between the U.S. and Ca- nadian mortgage markets that raise difficulty in using the Cana- 125 dian experience as a comparator. For example, the Canada Mort- gage and Housing Corporation (CMHC), which serves a similar function as Freddie and Fannie, is guaranteed by the full faith and credit of Canada, in the same manner as GNMA is guaranteed by the United States. As a result, banking organizations that invest in securitization structures through the CMHC are required to hold no regulatory capital against their investment (0 percent risk- weight exposure), versus in the United States where banking orga- nizations must risk-weight exposures to Freddie or Fannie at 20 percent. In addition, Canadian banking organizations are required to obtain private mortgage insurance (PMI) for all mortgages with a loan-to-value ratio over 80 percent and they must maintain the PMI for the life of the loan, regardless of any subsequent reduction in a mortgage’s LTV that may result from loan repayment or house appreciation. However, banks that rely on private mortgage insur- ers receive a government guarantee against losses that exceed 10 percent of the original mortgage in the event of an insurer failure. As a result, Canadian banking organizations are required to hold relatively little capital against mortgage exposures that are held on balance sheet—either through on-balance sheet mortgage portfolios or through investments in CMHC securitizations. The market for ‘‘subprime’’ mortgages was all but ended for Ca- nadian banking organizations in 2008 when the CMHC decided to no longer insure ‘‘subprime’’ mortgages. This provided a significant regulatory capital disincentive for Canadian banking organizations to underwrite ‘‘subprime’’ mortgages. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKE Q.1. Treasury recently announced they were starting up the Sup- plemental Financing Program again. Under that Program, Treas- ury issues debt and deposits the cash with the Fed. That is effec- tively the same thing as the Fed issuing its own debt, which is not allowed. What are the legal grounds the Fed and Treasury use to justify that program? And did anyone in the Fed or Treasury raise objections when the program was created? A.1. Section 15 of the Federal Reserve Act requires the Federal Re- serve to act as fiscal agent for the United States and authorizes the Treasury to deposit money held in the general fund of the Treasury in the Federal Reserve Banks. Balances held by the Reserve Banks in the Treasury’s Supplementary Financing Account (SFA) are de- posited and held under this authority. Although the Treasury and the Federal Reserve have consulted closely on matters regarding the Supplemental Financing Program (SFP), the Treasury makes all decisions on balances to be held in the SFA. I am not aware of any staff member or policymaker raising legal objections to the creation of the SFP. However, at least one Federal Reserve policymaker has publicly expressed policy concerns with the SFP. See Real Time Economics, WSJ Blogs, ‘‘Q&A: Philly Fed’s Plosser Takes on ‘Extended Period’ Language,’’ March 1, 2010. Q.2. Given what you learned during the AIG crisis and bailout, do you think Congress should be doing something to address insur- ance regulation or the commercial paper market? 126 A.2. The financial crisis has made clear that all financial institu- tions that are so large and interconnected their failure could threaten the stability of the financial system and the economy must be subject to consolidated supervision. Lack of strong consoli- dated supervision of systemically critical firms not organized as bank holding companies, such as AIG, proved to be a serious regu- latory gap. The Federal Reserve strongly supports ongoing efforts in the Congress to reform financial regulation and close existing gaps in the regulatory framework. An effective framework for financial supervision and regulation also must address macroprudential risks—that is, risks to the fi- nancial system as a whole. The disruptions in the commercial paper market following the failure of Lehman Brothers on Sep- tember 15, 2008 and the breaking of the buck by a large money fund the following day are examples of such macroprudential risks. Legislative proposals in both the House and Senate would also improve the exchange of information and the cross-fertilization of ideas by creating an oversight council composed of representatives of the agencies and departments involved in the oversight of the fi- nancial sector that would be responsible for monitoring and identi- fying emerging systemic risks across the full range of financial in- stitutions and markets. The council would have the ability to co- ordinate responses by member agencies to mitigate identified threats to financial stability and, importantly, would have the au- thority to recommend that its member agencies, either individually or collectively, adopt heightened prudential standards for the firms under the agencies’ supervision in order to mitigate potential sys- temic risks. Q.3.a. When did you know that AIG’s swaps partners were going to be paid off at effectively par value in the Maiden Lane 3 trans- action? Q.3.b. Did you or the Board approve the payments? A.3.a.–b. I was not directly involved in the negotiations with the counterparties that sold multi-sector collateralized debt obligations (‘‘CDOs’’) to Maiden Lane III LLC (‘‘ML III’’) in return for termi- nation of credit default swaps AIG had written on those CDOs. These negotiations were handled by the staff of the Federal Re- serve Bank of New York (‘‘FRBNY’’). I participated in and support the final action of the Board to authorize lending by the FRBNY to ML III for the purpose of purchasing the CDOs in order to re- move an enormous obstacle to AIG’s financial stability and thereby help prevent a disorderly failure of AIG during troubled economic times. As explained in the testimony of Thomas Baxter, Executive Vice President and General Counsel, FRBNY, before the Committee on Oversight and Government Reform on January 27, 2010, the Fed- eral Reserve loan to ML III was used by ML III to purchase the multi-sector CDOs underlying AIG’s CDS at their current market value (approximately $29 billion), which represented a significant discount to their par value ($62 billion). Collateral already posted by AIG (not ML III) under the terms of the CDS contracts was also relinquished by AIG in return for tearing-up the contracts and free- ing AIG of further obligations under the CDS contracts. Before 127 agreeing to the transaction, the Federal Reserve consulted inde- pendent financial advisors to assess the value of the underlying CDOs and the expectation that the value of the CDOs would be re- covered. The advisors believed that the cash flow and returns on the CDOs would be sufficient, even under highly stressed condi- tions, to fully repay the Federal Reserve’s loan to ML III. Under the terms of the agreement negotiated with AIG, the Federal Re- serve will also receive two-thirds of any profits received on the CDOs after the Federal Reserve’s loan and AIG’s subordinated eq- uity position are repaid in full. Q.3.c. When did you find out about the cover-up of the amount of the payments? Q.3.d. Did you approve of the efforts to cover up the amount of the payments? Q.3.e. If you did not approve of the cover-up at the time, do you believe that it was the right decision? A.3.c.–e. The amount of the payments to the CDS counterparties was fully disclosed by AIG. Moreover, the Federal Reserve fully dis- closed the amount of its loan to ML III and the fair value of the assets that serve as collateral for that loan in both the weekly bal- ance sheet of the Federal Reserve (available on the Board’s website) and in the Board’s reports to Congress as required by law. AIG was at all times responsible for complying with the disclo- sure requirements of the various securities laws. I was not involved in the discussions between the Federal Reserve and AIG related to AIG’s securities law filings. I fully supported AIG’s decision to re- lease publicly in March 2009 the identities of these counterparties. Q.4. The Fed has been out in the press talking about how they are going to make money on their AIG loans, making it sound like a good deal for the taxpayers. However, that is not the whole story because Treasury has committed some $70 billion to the AIG bail- out. So the taxpayers are still exposed to AIG, and in fact are likely to take losses. Do you agree that the Fed’s exposure to AIG is not the whole story and the taxpayers are likely to face losses from the AIG bailout? A.4. As you know, the Federal Reserve provided liquidity to AIG through direct line of credit and through loans provided to two Maiden Lane facilities that funded certain assets of AIG. Extensive information about each of these credits is available on the Board’s website and in reports and testimony provided by the Federal Re- serve to Congress. Based on analysis of the collateral supporting these loans by experienced third-party advisors and the FRBNY, the Federal Reserve expects to be fully repaid on each of these credits, with no loss to the taxpayers. The Treasury Department has provided equity to AIG. Like the liquidity provided by the Federal Reserve, this equity was provided in order to prevent the disorderly collapse of AIG during a period of extreme financial stress that could have caused significant eco- nomic distress for policy holders, municipalities, and small and large businesses, and led to even greater financial chaos and a far deeper economic slump than the very severe one we have experi- enced. 128 Q.5. Did you or the Board approve of then New York, Fed Presi- dent Geithner staying on at the New York Fed while working for the Obama transition team? If yes, why did you think that was a good idea? A.5. Timothy Geithner was appointed President of the Federal Re- serve Bank of New York for a 5-year term that extended until Feb- ruary 28, 2011. When President Geithner was asked by the Presi- dent-elect of the United States to serve as Secretary of the Treas- ury, President Geithner withdrew from the Bank’s day-to-day man- agement pending his confirmation by the Senate. He also relin- quished his Federal Open Market Committee (FOMC) responsibil- ities which were assumed by Christine Cumming, the Reserve Bank’s alternate representative elected in accordance with the Fed- eral Reserve Act. President Geithner did not attend the December 2008 FOMC meeting. Ms. Cumming served as a voting member of the FOMC until President Geithner’s successor took office. It was expected that President Geithner would continue to serve as Presi- dent of the Reserve Bank at least through the end of his term if he did not become Secretary of the Treasury. Q.6. Is the Fed now, or has the Fed in recent years, purchased Greek Government or bank debt? A.6. The Federal Reserve has not purchased debt of the govern- ment of Greece nor has the Federal Reserve purchased the debt of any Greek financial institution. Detailed information on the Fed- eral Reserve’s foreign exchange holdings, both currency and invest- ments, is available in the quarterly Treasury and Federal Reserve Foreign Exchange Operations report published by the Federal Re- serve Bank of New York. See http://www.newyorkfed.org/mar- kets/quarlreports.html. Q.7. Unemployment numbers continue to bounce up and down every week. As this year goes on, the Census is going to be hiring 700,000 to 800,000 workers on a temporary basis. Are you worried those numbers will distort the true jobs picture, and that economic forecasts that use those jobs numbers will be wrong? A.7. As you suggest, hiring of temporary workers by the U.S. Bu- reau of the Census in support of the decennial census will elevate the total payroll employment counts reported by the Bureau of Labor Statistics (BLS) each month because these temporary work- ers are included in Federal Government employment in the Cur- rent Employment Statistics (CES) survey. However, I do not think that Census hiring will make it much more difficult than usual to interpret the monthly employment reports. The BLS is publishing information each month on the number of temporary census work- ers in the CES data, and thus it will be straightforward to adjust the data to calculate the monthly changes in payroll employment excluding the effects of Census hiring; moreover, Census hiring will not distort the BLS estimates of employment change in the private sector. In addition, the Bureau of the Census has made available its hiring plans for coming months, which economic forecasters can use in making their projections of employment changes for the re- mainder of this year. Although these plans are subject to change, based on this information, the Department of Commerce expects the effect on the level of payroll employment reported by the BLS 129 to peak at about 635,000 jobs in May 2010 and to fall back to roughly 25,000 jobs by September. The extent to which Census hir- ing reduces the measured unemployment rate is more difficult to estimate because that effect depends on the prior labor force status of the temporary Census workers. However, based on the employ- ment estimates, the peak effect on the unemployment rate in May would probably be between 1⁄ 4 and 1⁄ 2 percentage point. Q.8. Please explain how term deposits and reverse repo trans- actions are not the economic equivalent of the Fed issuing debt. A.8. There are a number of similarities and differences between term deposits, reverse repurchase agreements and agency debt obli- gations. In principle, each could be used to drain reserves from the financial system in order to reduce the potential for inflation and thereby maintain price stability. Indeed, various central banks use instruments similar to these to help manage interest rates and maintain price stability. In the United States, Congress has specifically authorized the Federal Reserve to accept deposits from depository institutions. (See 12 USC 342). Congress has also specifically authorized the Federal Open Market Committee to direct Reserve Banks to pur- chase and sell in the open market obligations of, or obligations guaranteed as to principal and interest by, the United States or its agencies. (See 12 USC 263 and 355). Reverse repurchase agree- ments represent the sale and purchase of obligations of, or obliga- tions guaranteed as to principal and interest by, the United States or its agencies. Congress has not specifically authorized the Federal Reserve to issue its own agency debt obligations. Unlike deposits and reverse repurchase agreements, agency obli- gations are freely transferable. Term deposits may only be accepted from depository institutions and are not transferable. Reverse re- purchase agreements also are not transferable and occur only with counterparties that are interested in purchasing qualifying govern- ment or agency securities. Q.9. Given that you have signaled that the Fed will be using the interest on reserves rate as a policy tool in the near future, do you believe that rate should be set by the Federal Open Market Com- mittee rather than the Board of Governors? A.9. As you know, the Congress has assigned to the Board the re- sponsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other impor- tant terms that are relevant for the conduct of monetary policy— for example, the Board ‘‘reviews and determines’’ the discount rates that are established by the Federal Reserve Banks; the FOMC has no statutory role in setting the discount rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the FOMC has no statutory role in setting reserve requirements. For many years, the Board and the FOMC have worked colle- gially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work co- 130 operatively in the future in adjusting all of the instruments of mon- etary policy.

Ben S. Bernanke (2010, February 24). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20100225_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_20100225_chair_federal_reserves_first_monetary_policy,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2010},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20100225_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}