Bernanke Asks Congress to Reform SEC's Consolidated Supervised Entity Regime for Investment Banks

Legislation is needed to authorize strong holding company oversight of large investment banks currently regulated under the SEC’s consolidated supervised entity regime, said Federal Reserve Board Chair Ben Bernanke in testimony before the House Financial Services Committee. He also urged Congress to provide new tools for ensuring the orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy. The Fed official also said that Congress should give the Board statutory authority for payment and settlement of derivatives and other securities similar to what global central banks enjoy.

Under its consolidated supervised entity (CSE) program, the SEC supervises global securities firms on a group-wide basis. For such firms, the Commission oversees not only the U.S-registered broker-dealer, but also the consolidated entity, which may include foreign-registered broker-dealers, banks, and the holding company itself.

Currently, noted the Fed chair, the SEC’s oversight of the holding companies of the major investment banks is based on a voluntary agreement between the SEC and those firms. While the recent SEC-Fed Memorandum of Understanding signals near-term cooperation between the Fed and the SEC, he noted, it is taking place within the existing statutory framework. In the longer term, he emphasized, legislation will be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers.

In the Fed chair’s view, Congress must empower a regulator to set standards for capital, liquidity holdings, and risk management. Bank-affiliated primary dealers are already subject to mandatory consolidated supervision, he noted, but the focus of that supervision has been on limiting risks to the banks and other insured depository institutions within the holding company. Regulators must be authorized to assess and limit risks to all functionally regulated entities, including securities subsidiaries. At the same time, he cautioned that legislative reforms must recognize the distinctive features of investment banking and take care to neither inhibit innovation nor induce an offshore migration of risk-taking activities.

The potential vulnerability of the financial system to the collapse of Bear Stearns was exacerbated by weaknesses in the infrastructure of financial markets, said the chair, notably in the markets for over-the-counter derivatives. More generally, he explained, the stability of the broader financial system requires key payment and settlement systems to operate smoothly under stress and to effectively manage counterparty risk. While the Federal Reserve, together with other regulators and the private sector, is currently engaged in a broad effort to strengthen the financial infrastructure by, for example, improving the clearing and settling of credit default swaps and other OTC derivatives, statutory authority must be the ultimate answer.

Currently, said the Fed chief, the Federal Reserve relies on a patchwork of authorities and moral suasion to ensure that the various payment and settlement systems have the necessary procedures and controls in place to manage the risks they face. By contrast, major central banks around the world have an explicit statutory basis for their oversight of payment and settlement systems. Noting that robust payment and settlement systems are vital for financial stability, the Fed chief asked Congress to give the Board express oversight of the payment and settlement systems.

Finally, in light of the Bear Stearns episode, he urged Congress to provide new tools to ensure an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, he reasoned, the Treasury should have a leading role in any such process, in consultation with the SEC.

He suggested that the model for the liquidation of a large securities firm should be the process for dealing with insolvent commercial banks under the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which authorizes the FDIC to act as a receiver for an insolvent bank and to set up a bridge bank to facilitate an orderly liquidation of the firm. FDICIA also requires that failing banks be resolved in a way that imposes the least cost to the government, except when the authorities, through a well-defined procedure, determine that following the least-cost route would entail significant systemic risk.