The House Financial Services Committee met Thursday to hear expert testimony on systemic risk in the financial system and the potential role of resolution authority in unwinding troubled firms.

A key witness at the meeting, former chairman of the Board of Governors of the Federal Reserve System Paul Volcker, urged the registration of hedge funds and private equity funds and suggested the Federal Reserve should oversee the overall financial system.

Committee chairman Barney Frank (D-Mass.) reiterated a "universal dislike" of too-big-to-fail institutions, noting there is no apparent single solution and any legislation adopted by the House would implement a series of steps to prevent these systemic presences in the market. Additionally, the legislation should adopt a resolution authority or "death panel" that would "put an institution to death" when it becomes clear it can no longer function, Frank added in his opening remarks.

Rep. Spencer Bachus (R-Ala.), on the other hand, maintained his opposition of much of the Administration's proposed regulatory reforms. He brought the issue of firms considered "too small to save," indicating the existence of uneven treatment of financial firms. Bachus called to considered resolution authority a "permanent TARP" (or Troubled Asset Relief Program).

He noted Treasury Department secretary Tim Geithner at the hearing Wednesday would not rule out the possibility of future bailouts of systemic firms. Bachus noted a contrasting  support by House Republicans supports bankruptcy proceedins for failed non-bank institutions. He said firms "can and should fail as their bad decisions render them insolvent."

Volcker instead supported placing insolvent non-bank firms into the proposed resolution authority. He indicated he is "more than somewhat resistant" to the Administration's proposal. A majority of systemic institutions are commercial banks, he noted, adding that a safety net already exists for those banks, which are subject to deposit insurance and other means of support. Banking and insurance companies are most systemic, he said, and an extension of regulation beyond these firms would increase moral hazard issues.

But private equity firms and hedge funds are not outside the realm of supervision and should register and report to supervising agencies, Volcker said. Private equity, hedge funds, credit default swaps (CDs) and collateralized debt obligations (CDOs) are different businesses from commercial banking, however, he said. The economy needs strong capital markets; it's a different business — an impersonal, useful trading business, Volcker added.

"As a matter of broad policy, an assumption that those non-bank institutions would come into the framework of the Federal safety net should be discouraged," Volcker said in prepared remarks. "The credibility of that approach will need to be supported by legislation."

Volcker added: "A designated regulatory agency will need to be provided authority to set rules for capital, leverage, and liquidity for those few institutions that may be large enough to pose systemic risk."

But any legislation eventually passed should prohibit banks and their bank holding companies (BHCs)  from sponsoring hedge funds and should keep the businesses distinct, Volcker said. Strict supervision enforced by capital requirements on proprietary trading, securities and derivatives should be included, he noted. Additionally, these systemic non-banks should be resolved through the resolution authority, if necessary.

Volcker noted the need to "rejigger" regulation authority, as identified by the Treasury Department's proposal for a council of regulators to survey the overall financial system and identify risks. Such a council would prove ineffective, he noted, adding these supervisory authorities fall within the Fed's jurisdiction.

"This is the natural function for the Federal Reserve," he said.

Write to Diana Golobay.

The House Financial Services Committee wrapped up a long day of hearings on the Administration's proposed financial regulatory reform as regulators weighed in late Wednesday.

After hearing solely from Treasury Department secretary Tim Geithner, who spoke on the Administration's proposals for sweeping reform early Wednesday, Committee members heard an emerging consensus that merging major regulators into one entity would be ineffective to exercising authority in areas that require different forms of regulation.

Committee members seemed to agree on the need for some form of overhaul in the financial system. Rep. David Scott (D-Ga.), for example, noted unemployment and foreclosures climb at a time when banks are not lending to small businesses, which create the jobs.

"There seems to be a freezing of the arteries within the banking system," Scott said.

But unfreezing the banking system requires a convergence of the Administration and lawmakers on moving reform legislation through.

Rep. Scott Garrett (R-NJ), for example, noted Committee chairman Barney Frank's (D-Mass.) recent suggestions to narrow the proposed Consumer Financial Protection Agency (CFPA) seem to contrast the Administration's move to apply reform on a much broader basis, to areas of the system that did not cause the fundamental problems at hand.

Federal Deposit Insurance Corp. chairman Sheila Bair, the first witness at the hearing, indicated the FDIC supports the CFPA. She also urged a new resolution regime to resolve financial institutions similar to the way the FDIC steps in and resolves banks.

She called for larger capital buffers at financial institutions but warned against removing consumer protection examination and supervision from other supervisory efforts — like safety and soundness supervision — which she said could undermine the effectiveness of both efforts.

"A strong case can be made for creating incentives that reduce the size and complexity of financial institutions," Bair said in prepared remarks. "A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet on the performance of those banks and that regulator. "

Office of the Comptroller of the Currency (OCC) John Dugan said the OCC supports a council of financial regulators in the Administration's proposal, as well as some consolidation of regulation to be applied to all systemic financial institutions, including securities and insurance firms.

The OCC, he added, supports the goals of the CFPA, but said rule writing would not be uniform at the new agencies, as the proposal indicates states can adopt different rules. Dugan said the CFPA ought to provide for federal banking agencies' input for uniformity in rule-making.

The final two witnesses to present opening remarks at the Committee hearing shared comments that a consolidation of major regulators into a single entity — similar to proposals formed by Sen. Christopher Dodd (D-Conn.) — would fail to address the key issues of financial regulatory reform.

Office of Thrift Supervision acting director John Bowman said Congress will not solve the "problems of tomorrow" by merging regulatory agencies. This move for blanket regulation would be inappropriate for all financial firms, Bowman said. Focusing the same regulation on community banks and large financial institutions with different needs, for example, would prove costly and inefficient.

The North Carolina Commissioner of Banks Joseph Smith Jr., on behalf of the Conference of State Bank Supervisors, indicated some concern over a consolidated financial industry that consumes the attention of regulators and is "unmoved" by the needs of consumers and communities. He added it is a misconception that a consolidated, "monolithic" regulatory system will lead to stronger financial system.

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[Update 1 adds statement from Federal Reserve Bank of New York.]

The Federal Open Market Committee (FOMC) wrapped up its monetary policy meeting Wednesday, keeping — as expected — the federal funds rate at a 0 to 0.25% target range as inflation risk remains subdued.

The FOMC, in its statement late Wednesday, indicated positive developments since its August meeting, although it plans to extend certain securities- and debt-purchasing programs into 2010.

"Conditions in financial markets have improved further [since August], and activity in the housing sector has increased," FOMC members wrote. "Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit."

But the Federal Reserve intends to continue its role in providing credit to the securities market.

The FOMC confirmed the Fed is on track to buy a total $1.25trn of agency mortgage-backed securities (MBS) from Fannie Mae (FNM: 0.00 N/A), Freddie Mac (FRE: 0.00 N/A) and Ginnie Mae. The Fed will gradually slow the pace of the purchases in anticipation of a full execution of the program by the end of Q110 — which ends in March 2010.

It marks an extension of the MBS-purchasing program past the previously anticipated year-end date of December 2009. The slowing of purchases is intended to "promote a smooth transition in markets" as the government ends its participation in the agency MBS market.

To implement the gradual slowing of agency MBS purchases, agents acting on behalf of the Federal Reserve Bank of New York's open market trading desk plan to reduce the average weekly purchase amounts beginning with the reporting week that starts September 24, according to a NY Fed statement.

The Fed will also purchase up to $200bn of agency debt with a projected execution date also in March 2010. The Fed's purchases of $300bn of Treasury securities will complete by the end of October 2009.

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As the Federal Open Market Committee (FOMC) meets today to wrap up a session largely expected to result in no change to the low federal funds rate — the overnight rate at which banks lend to each other — the House Financial Services Committee heard testimony on the Administration's plans for sweeping financial regulatory reform.

Committee chairman Barney Frank (D-Mass.) said in opening statements there should be a mechanism for putting non-bank financial institutions "out of everyone's misery," adding "there will be a death panel" enforced by the legislation eventually adopted.

Rep. Spencer Bachus (R-Ala.) took a less aggressive tone, stressing the need for smarter — not more — regulation. He said reform legislation should seek greater enforcement of existing regulations, rather than a new layer of regulation.

Bachus cited his "deep-seated" reservations on the Administration's proposal, pointing toward "misguided" government intervention in bailing out large financial institutions. He said failed non-banks should be moved through bankruptcy proceedings, in which shareholders and investors would absorb losses, rather than government regulators and — ultimately — taxpayers.

Bachus also indicated his reservations over the proposed Consumer Financial Protection Agency (CFPA), saying consumers will ultimately pay for it at a time when other regulatory entities fail to enforce their share of consumer protection. The CFPA would not solve the key issues at hand, he said, calling instead for an effort to streamline existing bank regulators into a unified entity.

Rep. Scott Garrett (R-N.J.) seemed to oppose such a mega-regulator, citing Sen. Christopher Dodd's (D-Conn.) recent proposal to combine the Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) into a single financial regulator.

Dodd's intentions to create a single large regulator threw a "wrench into the works" at a time when congressional attempts to create financial regulatory reform legislation have already delayed, Garrett said. He suggested pushing the timeline for completed legislation into 2010, to allow both the Senate and House of Representatives to arrive at mutual agreements.

In the mean time, two key challenges remain: finding balance between consumer protection and competition among financial firms, and dealing with firms considered too big to fail, according to Treasury Department secretary Tim Geithner.

Geithner, the Committee's sole witness in the morning's hearing and the first in an "ambitious" series of hearings scheduled in weeks to come, said addressing these challenges requires regulatory overhaul without limiting consumer choice of financial products or stifling competition.

The Administration's proposals focus on achieving three goals, including provide new protection for consumers and investors, creating a more stable, safer financial system that is less prone to crisis and safeguarding taxpayers from bearing costs of battling future crises, Geithner said in prepared remarks.

The proposed legislation seeks to merge the OCC and OTS into a new National Bank Supervisor. It also would require hedge funds to register, set rules for derivatives markets, constrain leverage and require financial firms to hold higher capital and liquidity buffers.

Following Geithner's opening remarks, Bachus drew his attention to suggested changes by Frank to the proposed CFPA. Frank called specifically to drop the requirement that CFPA enforces the marketing and sale of "plain vanilla" financial products, according to Bachus.

The provision aims to prevent complex debt products and confusing mortgage terms but faces criticism for government regulation of financial products.

Geithner seemed to indicate the Administration is generally supportive of the changes proposed by Frank. He seemed to push greater disclosure of product terms over regulated products, emphasizing "smarter regulation" of disclosures currently in place.

Consumers ought to have the right to choose a more simple, understandable product and the way to do that is to "get disclosure right," Geithner said.

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