they want to be part of the united states. in the case of albania, it is not likely. but one that might have happened was newfoundland, which was kind of separate from canada and they wanted to be part of america, and we probably could have worked bad deal out. but the united states at that time did not want to add in newfoundland as a state. texas was off for a nation that became part of america, -- was a foreign nation that became part of america, hawaii the same thing. host: "lost states" is the name appreciate your time this morning. at a lot of fun, a lot of interesting history there. thank you. >> guest: thank you very much. i am a big fan of c-span. >> now the financial crisis inquiry commission. this government appointed committees investigating the causes behind the recent economic crisis. in this part of today's hearing members question former securities and exchange commission officials who were responsible for regulating equities markets. this is just under three hours. >> a meeting of the financial crisis inquiry commission will come back into order. we are now on our third session of the day. it is the regulation of investment banks by commission. thank you very much for being here today gentlemen. as we do with all witnesses we are going to swear you before your testimony so would like to ask all of you to stand up and raise your right hand and be sworn. do you solemnly swear or affirm under the penalty of perjury that the testimony you are about to provide the commission will be the truth, the whole truth and nothing but the truth to the best of your knowledge? thank you. thank you. gentlemen, thank you for being here. we appreciate you having submitted written testimony to us. we also would now like to give you the opportunity to provide for both testimony of no more than five minutes and so with that, we are going to start with you and we will go from my left to my right, so if you would please begin. thank you. >> thank you for the opportunity to testify today before this commission on the subject of the imitation of the securities and exchange commission consolidated supervised entity program and the adequacy of the oversight of bear stearns another cse program participants. i appreciate the interest of the ftc and the office of inspector general. my testament today i'm representing the office of the secretary-general and the views expressed are those of mine alone and do not reflect the views of the commission or any commission or. the office of inspector general's mission is to the critical programs and operations of the sec. this mission has become increasingly important in light of the current economic crisis facing our nation. are audit unit has issued numerous reports involving batters critical to the sec operations in the investing public. of the most significant audit reports we we are prepared today was a comprehensive report issued september 2008 analyzing the commission's oversight of the sec cse program. we initiated this out of based on congressional requests received on april 22008 from charles grassley ranking member of the united states senate committee on finance. senator grassley requested review of the division of trading and marketing oversight of the cse firms with a special emphasis on bear stearns announced announced that we analyze how the cse program was run and the adequacy of the commission's monitoring of air stearns. the audit was not intended to be a complete assessment of the multitude of events that led to bear stearns's collapse and accordingly did not purport to demonstrate any direct connection between the failure of the program's oversight of bear stearns and air stearns's collapse. given the complexity of the subject matter he retained an expert to provide assistance with the other. professor kyle is a faculty member is a renowned expert on the aspect of caddell bull markets on numerous finance remitted manner. this cse program or to improvement. to allow the commission to monitor for an act quickly and responsibly to financial operational weakness in the cse golding company or its unregulated affiliates that my place regulated entities including foreign registered banks and broker-dealers were the broader financial system had risk. are audit found the cse program failed to carry out its mission in his oversight of bear stearns because under the commission's cse program watch air stearns suffered financial weaknesses in the federal reserve bank of new york needed to intervene during the week of march 102008 to prevent significant harm to the broader financial system. overall are audit found there were significant questions about the adequacy of a number of cse program requirements given bear stearns was compliant with several other requirements but nonetheless collapse. and additionally i found prior to bear stearns collapse the assisi became where potential red flags regarding bear stearns concentration of mortgage securities high leveraged shortcomings of risk management and mortgage based securities and the lack of compliance in the spirit of international spirit but did not take action to limit these factors. the audit found certain procedures and processes were not always strictly follow. for example the commission issued an order that approves bear stearns to become a cse prior to the completion of the inspection process. the sec authorize the cse audit staff to perform critical audit work involving risk management systems instead of its working for performed by the external auditor. further are audit found the division of corporation finance did not review bear stearns 10-k filing in a timely manner. the audit identified 26 recommendations intended to improve the commission's oversight of the cse firm. the recommendations included a reassessment of guidelines and rules regarding the cse like what do you programmer crime complaint to the existing rules that required external auditors to review the firm's risk management control systems developing and automated process to ensure they are adequately resolved, improving collaboration efforts among the divisions of trading and market corporation finance and the office of compliance inspection and evaluation and the office of risk assessment. and tracking and monitoring compliance with its internal guidelines and the creation of a task force led by the office of risk assessment with staff and trading of markets division management to perform analysis of certain large firms. on september 26, 2008 a day after we issued a report on the oversight of bear stearns and related entities former sec chairman christopher cox announced they would end the program. notwithstanding the closer the program the sec has made efforts to implement the recommendations contained in our report and to improve its operations accordingly. as of march 31, 2002 management completed 23 of the 26 recommendations contained in our audit report. in conclusion we appreciate the commission's interest in the sec in our office and in particular are audit report. i believe the commission's analysis of these matters is beneficial to strengthening the accountability and effectiveness of the sec. >> thank you or go mr. donaldson. >> turn your mic on please mr. donaldson. there should be a button and one thing i should ask of the witnesses is if the light will go to yellow, when there is one minute remaining on your time, and then a red when the time is up. >> thanks for inviting me to testify today. i particularly appreciate the opportunity to offer my views on the shadow banking system. is my long-standing interest to strengthen oversight of unregulated and opaque sectors of our financial market including during my tenure as chairman of the securities and exchange commission from february 2003 until june 2005. you have asked me to discuss the origins of approval and structure of the sec consolidated supervised entity cse program and the impact of that program and the leverage of participants. we have also asked by comment on several additional issues. these issues include my understanding of the term shadow banking and second the ability of regulators to oversee the shadow banking system entered the sec's ability to oversee systemic risk and the wool over-the-counter derivatives played in the financial crisis. my remarks today i will summarize my views on these topics included in my written testimony. before discussed the topics i want to remind you that the views i express on my own and not necessarily the views of the sec in any current or former commissioners were commission staff. first i would like to discuss the cse program. public report mistakenly suggested that this step was the regulatory in nature, just the opposite is the case. the program in fact extended sec oversight into new areas namely the activities of unregulated holding companies and other affiliations of u.s. broker-dealers. the sec does not have the legal authority to impose mandatory capital requirements on holding companies or large security firms. before 2004 the sec had required regulatory capital computations only for broker-dealer subsidiaries of such holding companies. the cse program established for the first time and sec history the framework for consolidated oversight of the capital liquidity and risk parameters of this holding company. the global activity carried out by those holding companies do their non-sec registered affiliates were of concern to regulators including regulators and certain non-us jurisdictions are going to thousand four during my tenure as chairman of the sec the commission adopted the cse program by unanimous vote. under the cse program the holding company was hard to compete on a monthly basis risk-based consolidated holding company capital. the holding company was required to provide the sec with information concerning its activities and risk exposures on a consolidated basis and submit its nonregulated affiliates two examinations. the cse program relied on the existing authority over broker-dealer affiliates as the basis of an posing examination and driven story requirements on a parent holding company. the basel standard was generated through the efforts of bank regulators and financial markets and services of financial institutions. would use their internal mathematical models to calculate the net capital requirements to the market risk of certain positions. which is how commercial banks and in market basis for their trading position since 1997. the commission recognized that utilizing these models might result in lower capital requirements that otherwise would be required under the net capital rule accordingly the commission decided to include a requirement that cse participants provided early morning to the commission that their net capital before utilizing the models total $5 billion. they also modified the rules to require cse companies to hold liquid assets. the rules did not contrary to the suggestions and some published reports eliminate leverage ratio restrictions on broker-dealers. large broker-dealers had not been subject to leverage ratio requirements under the capital standards in place since 1970 or over the net capital never constrain leverage edna broker-dealer holding company or other regulated affiliate. as a result the many-- risky activities such as otc trading real estate loans were conducted outside the sec registered broker-dealer. additionally either the holding company level so simplistic and harrison of the leverage ratio to leverage ratio of banks is misleading. the product mix of securities differ significantly from that of banks. in particular security-- extensive holding of highly liquid assets and market books and limited exposure to off-balance vehicles. gse program represent a forward-looking effort to improve oversight of the unregulated affiliate of u.s. broker-dealers. it also requires--. >> how are you doing mr. donaldson? >> i'm going to start right now. >> i'm sorry. >> i was going to go want to talk about shadow banking and a couple of other questions u.s. which i will be a glad to do at the end of the session. >> thank you very much. we have got many hard-working commissioners here. mr. cox. >> thank you very much. thank you for this opportunity to offer my views today. you asked me to overview the shadow crisis as well as the sec's experience for a program to regulate one portion of that system. the shadow banking system most often refers to borrowing and lending using nonmonetary instruments as well as money outside of the traditional banking system. includes money market mutual funds, insurance companies, securitization vehicles, hedge funds, and most significantly the gse's fannie mae and freddie mac which was roughly $12 million. live in the commercial banks have been large elements in the shadow banking system are off-balance sheet entities and also through the investment banking subsidiaries. in the run-up to the financial crisis the abrupt devaluation of mortgage-backed securities and other credit risk transfer instruments led to many parts of the shadow banking system including investment banks facing a run on the bank. that said and evaluation of mortgage-backed securities was itself the result of an asset bubble, bubble in the housing market inflated with high risk mortgage products such as the notorious liar loans and that no money down financing. it is abundantly clear as the sec's former chief accountant lynn turner has testified that it's honest lending practices have been followed much of this crisis quite simply would not have occurred. most of this of course took place within the traditional banking system at the shadow banking system helped spread the contagion to every sector. the failures of the bailout of so many regulated commercial banks as well as investment banks and non-banks highlighted the inadequacy of the capital of liquidity standards in both sectors. one might expect to see these problems in the unregulated part of the system but what about the failures to out the system. to answer this question the starting point is the capital standards for commercial banks which didn't provide an adequate early warning system. the standards which are still in place today assign a risk waste of bank assets to treat mortgages and in particular the securities of fannie mae and freddie mac as far less risky. even without the benefit of hindsight, commercial bank regulators have wrecked nice the problems with the basel standard they encourage people to put risk off-balance-sheet. that led to the basel ii standards which the sec incorporated into its voluntary program that chairman mcdonald described in 2004. the program is voluntary as he mentioned because the commission lacked the statutory authority over almost all of the businesses within the investment bank holding company. this program a, the gse program is built on the sec's jurisdiction over the regulated broker-dealer of the investment bank holding company that bear stearns demonstrated this reliance on the internationally accepted waffles-- basel standards was a fundamental flaw. if the firms were even coming close to the 10% capital ratio of that the fed uses to determine a well-capitalized bank. yet at all times even during the weekend of the sale to jpmorgan chase dare stearns had a basel capital capital cushion well above that. that is why in march of 2008 i formally requested the basel committee to address the inadequacy of the standards in light of these experiences. since all of the world's major banking regulators rely on the basel standards this remained a matter of the utmost urgency. while the sec and the fed and the treasury were surprised by the speed affairs run on the bank the decisions that week that bear stearns was too big to fail was even more surprising. the sec throughout its history had seen investment banks failed or be required to save themselves. e.f. hutton, salomon brothers and more involved a voluntary gse program and to give early warning of investment bank failures it was not capable of preventing them because no government regulation could do that. an important lesson from this is that the concept of too big to fail must be eliminated. along with regulatory and market uncertainty that follows from it and the freedom to fail which is the cornerstone of risk-taking has to be restored. i would add to this that transparency is a powerful antidote for much of what happens in the financial crisis and that is nowhere more true than in the otc derivatives market. mr. chairman and the commission, thank you for your questions. >> thank you mr. cox. >> thank you for the invitation to testify at the sec regulation of investment banks in the shadow banking system. i am a professor of finance at bassman college in wellesley massachusetts. from september 2006 until april 2000 i was the director of the division of trading and market of the u.s. securities and exchange commission. the sec regulation of broker-dealer finances aims to ensure that in the event of a firm's failure, customers obtain the return their cash and securities held at the firm. some broker-dealers are subsidiaries of investment bank holding companies, complex firms with hundreds or even thousands of subsidiaries. the vast majorities of the subsidiaries as well as the holding companies of the entire investment bank lacks statutory regulation under the regulatory regime laid out in the 1999 graham bleak graham-- of commercial bank holding companies but not for holding companies to investment banks. thus the u.s. regulatory system currently contains no statutory provision providing for substantive regulation of the investment bank holding companies including the setting of capital requirements. nor does the statute provide any regulator the authority to impose liquidity standards or other requirements intended to guard the financial or operational condition of the holding company. finally the law does not provide a consolidated supervisor that is knowledgeable in the course-- for security business of these firms and has the authority to impose requirements it would be recognized for this purpose by international regulators. following the demise in 1990 the sec realize they failure of the holding company for a nun broker-dealer subsidiary could cause problems for the regulated broker-dealer. one of the measures taken by the sec to address the serious regulatory gap was a consolidated supervisory for u.s. investment banks in march of 2004. the program construct an alternative best capital regime for the broker-dealer subsidiary was carried as a condition the affiliated holding companies consent to groupwide supervision by the commission. this was a significant regulatory extrapolation that the commission believed in 2004 was necessary to fulfill a significant regulatory gap. with the five cse firms the commission oversaw not only the broker-dealer but also supervise holding companies and affiliates on a consolidated basis. the cse program is tailored to reflect to fundamental differences between investment banks and commercial bank holding companies. first the cse regime reflected the resilience of securities firms relying on security firms of daily mark-to-market accounting is a critical risk in and governance control. second, the design of the regime reflected the critical importance of maintaining adequate liquidity for holding companies that did not have access to an external liquidity provider. it is important to note that the cse program was not the only oversight regime applicable to these firms. the broker-dealers within the holding companies were regulated and supervised by additional personnel and by a broker-dealer self-regulatory organization with extensive examination and enforcing staff and there were no regulators of other subsidiaries including foreign broker-dealers, insurance companies. the sec required to not