1 Thomas R. Sullivan Commissioner, Connecticut Insurance Department 2 BIG 2 Fail Thursday, December 3, 2009

2 How did we get here?

3 HOW DID WE GET HERE Excessive money creation Negative household savings Huge US trade deficit Dollar volatility Public deficits Inflation Easy credit conditions US monetary policy contributed to imbalances

4 HOW DID WE GET HERE Under Government pressure, Fannie Mae and Freddie Mac expanded their riskier lending Subprime mortgages spiked to nearly 20% in In April 2004, the SEC relaxed the net capital rule Investment banks increased their leverage and expanded issuance of mortgage backed securities Sub-prime mortgage delinquency rates increased to 25% in early 2008 from their historical 10-15% range

5 HOW DID WE GET HERE Gramm-Leach-Bliley Act –Gramm-Leach-Bliley Act repealed part of the Glass-Steagall Act of 1933, and reduced the separation between commercial banks (which traditionally had a conservative culture) and investment banks (which had a more risk-taking culture) Net capital rule –The SEC relaxed the net capital rule, which enabled investment banks to increase their debt, fueling the growth in mortgage-backed securities supporting subprime mortgages Inadequate regulation of investment banks and hedge funds –Investment banks and hedge funds were not subject to the same regulation as depository banks, allowing them to assume additional debt relative to their capital base Inadequate Regulation

6 HOW DID WE GET HERE Off-balance sheet accounting –Banks were allowed to move significant assets and liabilities off- balance sheet into complex legal entities, masking the degree of leverage or risk taken, increasing uncertainty Unregulated derivatives market –Self-regulation of the OTC derivatives market came with the Commodity Futures Modernization Act of Derivatives such as credit default swaps (CDS) increased 100-fold from 1998 to 2008 Inadequate Regulation

7 Now what?

8 NOW WHAT There are weaknesses in our regulatory structure –The current structure is designed to evaluate individual institutions and no regulator has a mandate to evaluate risk to the entire system –Some institutions that potentially pose systemic risk are either not regulated at all or are inadequately regulated –The government does not have a resolution mechanism for major non-bank financial institutions –Regulation of consumer lending is spread across many agencies, and no agency has consumer financial protection as its central mandate

9 NOW WHAT ProvisionSenate BillHouse Bill Systemic Risk Creates a new Agency for Financial Stability, composed of: –federal bank regulators and –two independent councilors appointed by the President. The council will make decisions regarding systemically risky firms. A systemic risk council, composed of: –the federal bank regulators, will make decisions, to be carried out by the Federal Reserve. The Fed would be empowered to conduct “on site” examinations of any systemically risky firm. Consolidated Regulators Consolidates all existing federal bank regulators into one super- regulator, the Financial Institutions Regulatory Authority (FIRA). Removes bank supervisory powers from the Federal Reserve and the FDIC. Merges the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), leaves other regulators in place. Policy Response

10 NOW WHAT ProvisionSenate BillHouse Bill Breaking up risky firms. Gives federal regulators the authority to break up systemically risky firms on a case-by-case basis. Resolution Authority Includes resolution authority, funded by an after-the-fact assessment on institutions with more than $10 billion in assets. Institutions must draw up a “living will,” to be used in the event they must be unwound. Includes resolution authority, pre- funded by an assessment on institutions with more than $50 billion assets. Institutions must draw up a “living will,” to be used in the event they must be unwound. Consumer Financial Protection Agency (CFPA) Includes a CFPA with rule-writing authority, with no federal preemption of state law. All financial institutions are subject to examination by the CFPA. Includes a CFPA with rule-writing authority, and bank regulators can preempt state law on a case-by- case basis. Financial institutions with less than $50 billion in assets are not subject to CFPA examinations. Policy Response

11 Analysis and Reflections Who said, “We won’t have a real market based financial system until it is safe to let a financial firm fail” ??? Concerns: Broad Scope – Extends to more than just banks and financial institutions. The discretion provided the federal authorities is seemingly unlimited. No Punishment – Bad bets are not in anyway discouraged, and therefore excessive risk will continue if company executives have security in knowing such risk is socialized to other institutions or US tax payers. No Threat of Extinction – No provision for firms to be wound down or liquidated. Creditors/bond holders have implicit guarantee if there is no risk of default.

12 Thank You