Executive Summary

Federal Reserve Chairman Ben Bernanke appeared before the Senate Banking Committee for the second day of hearings on the Fed's semi-annual monetary policy report. The Committee explored the same issues that were discussed yesterday in the House. Separately, the Committee voted, on a unanimous roll call, to report favorably the pending nominations to the Fed and CEA.  Of note, both ranking members of the Committee warned Chairman Bernanke not to proceed with the Basel II bank capital accord unless it is neutral regarding overall levels of capital in the industry. 

Highlights of the hearing appear below:

Interest rate outlook

Chairman Richard Shelby (R-AL) discussed the possible implications of a persistent inverted yield curve for the long-term economic outlook. Bernanke repeated his remarks from yesterday that under conditions of low interest rate and low returns, he is not concerned about the implications. He assured Sen. Jim Bunning (R-KY) that the entire FOMC would be involved in setting the FFR.

GSEs

Sen. John Sununu (R-NH) spoke of the systemic risk of the mortgage portfolios held by the GSEs, and he questioned whether holding such large portfolios is consistent with their mission. He introduced a letter from Chairman Greenspan dated January. Sen. Elizabeth Dole (R-NC) said she agreed with Sununu's remarks. Sen. Tom Carper (D-DE) stated his intention to ask questions about the GSE issue but did not do so. There was no further discussion of GSEs.

ILCs

Sen. Robert Bennett (R-UT) stated that a House Member had told him the issue came up yesterday and it was said that there had been failures of ILCs. Bernanke responded that there had been no mention of failures. Bennett said ILCs are back in the news because of Wal-Mart's application; that since Target has an ILC, as do several auto makers there is no reason for Wall-Mart not to have one; and that Wall-Mart is not trying to go into banking, in fact has signed agreements with independent banks, but it wants to save $30m in interchange fees, and there is nothing wrong with this. The Fed is saying the FDIC isn't capable of regulating ILCs, and the Fed seems to be on a "crusade" either to shut ILCs down or to take over their regulation.

Bernanke responded that the FDIC is going to hold a hearing, that the Fed's concerns are interstate branching, mixing banking and commerce, and potentially extending the federal safety net. He argued that there should be parallel regulation of banks, and he added that he did not think the Fed was trying to lobby for additional jurisdiction. Sen. Bennett rejoined that Bernanke will learn from his staff that this is the case. He referred to a 1997 statement by Greenspan that the case for umbrella regulation is weak if the bank component is small, although he acknowledged Greenspan later changed his position. Bernanke insisted that the Fed is not looking for new regulatory domains, and he stated that the Leach bill would mitigate the Fed's concerns. Sen. Sarbanes took issue with all of Sen. Bennett's remarks, and he said Target should not be allowed to have an ILC, and the loophole should be closed, as the thrift holding company loophole was closed in GLBA. He referred to a GAO report that found ILC regulation inadequate.

Basel II

Sens. Shelby and Sarbanes both urged Bernanke not to implement Basel II in such a way as to reduce the capital in the banking system. Bernanke assured the senators that QIS-IV was experimental, that banks need to develop their data and models to serve a full interest rate cycle, and that various devices, including capital floors, the leverage ratio, pillar two, and multipliers, would be used to adjust Basel II as it is implemented.

Comment:  Mega dittos to Sen. Sarbanes, who questioned whether banks have a conflict of interest in developing their own internal risk assessment models because they would gain a competitive advantage through lower capital levels. We have long believed that a Basel II proposal which relies on non-public data and models for determining capital adequacy is a non-starter.  Ironic that it takes a liberal Democrat like Sarbanes to point out the obvious to bank regulators.  In our view, the only way that Basel II can be salvaged in the US is for the Fed and other regulators to re-group around a set of public data proxies for the credit risk metrics in the original proposal.

Bernanke assured the Committed that the Fed does not want to see a less stable financial system, and that it will work with the banks and with Congress. Sen. Sarbanes warned that if the Fed goes ahead with its present plan, responding only to its international partners, "Congress will put a stop to it."

Foreigners Holding Dollars

Bernanke took issue with the premise of a question by Sen. Sarbanes that the large foreign holdings of U.S. securities represent almost solely official decisions. He said that whether government or private investors would buy and hold U.S. assets depends on their sensitivity to interest rates. Several senators cautioned that political considerations could cause central banks to act in ways that would not be in their economic interest.

Regulatory Relief

Sen. Michael Crapo (R-ID) stated that he plans to hold a markup in weeks, not months, and he asked the Fed to submit its views.

AML Enforcement

Sen. Sarbanes referred to DOJ investigations of several banks, and he questioned whether this indicated that the banking regulators have fallen behind.

Derivatives

Sen. Crapo stated that he is concerned about the potential adverse effects of several legislative proposals to regulate the industry.

Mortgage charge-offs

Sen. Shelby said 40% of senior loan officers have responded that the charge-off picture for non-traditional mortgage products is deteriorating. He said he hopes that there will be a soft landing from any cooling in the housing market, and he also hopes the regulators have been timely with their guidance to banks on this subject. Bernanke responded that the guidance addresses the main issues - underwriting, disclosure, and safety and soundness.

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