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From Securities Regulation Daily, May 21, 2013

Senators Press Secretary Lew on TBTF, LIBOR, IRS

By Mark S. Nelson, J.D.

Members of the Senate Banking Committee today pressed Treasury Secretary Jacob J. Lew to explain the status of Treasury’s and the Financial Stability Oversight Council’s (FSOC’s) efforts to implement the Dodd-Frank Act. Questions focused on too-big-to-fail (TBTF), LIBOR manipulation, and cross-border issues. Senators also asked Mr. Lew about allegations that the Internal Revenue Service (IRS) unfairly targeted charitable groups based on those groups’ political views.

IRS probe. Although Senate Banking Committee Chairman Tim Johnson (D-SD) said in his opening remarks that the IRS is outside the committee’s jurisdiction, the urgency of the matter spurred many questions. Sen. Johnson even asked Mr. Lew for an opening statement on the emerging IRS scandal.

Mr. Lew said that although the Treasury Inspector General report found no evidence of political motive, the alleged IRS conduct is “inexcusable.” Mr. Lew noted that he had quickly asked for and received the acting IRS commissioner’s resignation. Going forward, Mr. Lew said a new acting commissioner would start tomorrow and his directive is to ensure accountability, fix any failures in the IRS system, and conduct a forward-looking review of IRS systemic problems. Said Mr. Lew, “[we need to] make sure nothing like this ever happens again.”

Responding to questions from Ranking Member Mike Crapo (R-Idaho), Mr. Lew said he learned of the IRS audit on March 15, 2013 and he was not involved in formulating the allegedly planted question about IRS conduct asked at an American Bar Association conference.

Sen. Crapo asked Mr. Lew what steps can be taken to boost public trust in the IRS. Mr. Lew said the IRS and tax matters “should be beyond politics.” In reply to questions from many other senators, Mr. Lew repeatedly emphasized that Treasury policy is not to interfere with an inspector general. He also said that the IRS has much discretion to enforce tax laws and that Treasury would not “cross the line into administration of the tax system.”

TBTF. Chairman Johnson led off questions on FSOC’s 2013 Annual Report by asking Mr. Lew if Dodd-Frank did enough to end TBTF. Mr. Lew said that Dodd-Frank contains “powerful tools” and that “too-big-to-fail is unacceptable policy.” Mr. Lew also emphasized that he sees a need for an “ongoing look at the system” in addition to Dodd-Frank implementation.

Sen. Bob Corker (R-Tenn) noted that he had sent a letter to the FSOC asking if a healthy bank could be broken up just because it is too big. Mr. Lew said he had not yet seen the letter, but he would review it.

Sen. Sherrod Brown (D-Ohio), following questions by Sen. Corker about community banks, said that the recently introduced Brown-Vitter bill would address community bank issues and pull the U.S. out of Basel III. Sen. Brown noted that so-called megabanks still have a funding advantage and get favorable credit ratings due to their TBTF status. Sen. Brown asked Mr. Lew why FSOC has not recommended that the six largest U.S. banks maintain higher capital levels.

Mr. Lew said regulators have not finished the capital rules. He also said he is worried that Basel III is a floor, even though this new standard has helped to pull many companies up because of the standard’s aspirations. Mr. Lew reiterated that administration policy is to ensure that TBTF is over, but that it is difficult to show progress here because the marketplace still implies a federal subsidy.

Sen. Brown then urged Mr. Lew to do more to eradicate the market’s persistent TBTF expectations. Mr. Lew replied that Treasury will seek to ensure that financial institutions have a “thick enough layer of capital” in order to avoid a scenario in which markets expect a political judgment about whether to save a failing bank.

Sen. Elizabeth Warren (D-Mass), recalled that the Brown-Kaufman Amendment, which would have provided for the break-up of large banks, had bipartisan support but never made it into the Dodd-Frank Act allegedly because of Treasury’s opposition. She noted that the four largest banks in 2008 are now 30 percent bigger. Sen. Warren asked Mr. Lew if Treasury is still opposed to capping banks’ size.

In reply, Mr. Lew said that administration policy is to end TBTF. Although Mr. Lew said he could not speak to Treasury’s pre-Dodd-Frank policy, Treasury’s and FSOC’s job now is to implement Dodd-Frank and then look for any additional reform options.

Sen. Warren then asked Mr. Lew how much bigger banks must get before the break-up option is viable. Mr. Lew said that banks now are better capitalized and that their derivatives trades are more transparent. He also observed that “size is not the only factor” and that some of the largest banks’ recent growth could be due to their acquisition of failing institutions during the financial crisis.

Cross-border rules. Chairman Johnson asked what Treasury and FSOC had done to improve international cooperation on cross-border financial regulations. Mr. Lew said that global cooperation on these rules had improved because of the G20’s efforts to coordinate with central bankers and finance ministers. Mr. Lew suggested that U.S. policy seeks to balance U.S. competitiveness and taxpayer protection against concerns that cross-border issues may lead to a race to the bottom instead of the race to the top sought by the U.S.

Ranking member Crapo asked Mr. Lew about a letter from nine foreign ministers challenging U.S. cross-border initiatives. Mr. Lew said the letter was “ill-informed” but that Treasury was working with its global counterparts to resolve cross-border issues.

LIBOR alternative. Sen. Jack Reed (D-RI) observed that recent scandals called into question the continued viability of LIBOR, which is written into most contracts that involve interest rates. Specifically, Sen. Reed asked if LIBOR should be replaced. Mr. Lew said there is a need to replace LIBOR, but there is no “ready replacement” because LIBOR is a self-designated rate that involves contractual rights. When a replacement is found, Mr. Lew said, there should be a period of transition to the alternative rate.

Sen. Reed also asked if U.K. regulators had done enough to police LIBOR. Mr. Lew acknowledged that prior regulations were “unacceptable” and challenges persist because of uncertainty about LIBOR rates, which are now being set during an era in which overnight bank lending has declined.

MMMFs and tri-party repos. Sen. Reed noted that broker-dealers’ reliance on tri-party repos was problematic. Mr. Lew agreed that tri-party repos present a “serious systemic concern” regarding wholesale funding. In both his testimony and prepared remarks, Mr. Lew noted that both money market mutual funds (MMMFs) and the tri-party repo markets present similar risk for runs in times of economic crisis. Mr. Lew said some progress has been made on tri-party repos, but that MMMF reforms still loomed. He noted that FSOC issued its MMMF proposed recommendations last November.

Enforcement. Sen. Jeff Merkley (D-Ore) reminded Mr. Lew of his earlier reply to a question about the IRS in which he said that no one is above the law. The senator asked Mr. Lew if that principle applied to financial institutions and their executives. Specifically, Sen. Merkley noted that despite mounting evidence that HSBC had engaged in money laundering, no one at the bank had been prosecuted.

Mr. Lew replied that although neither HSBC nor its executives were criminally prosecuted, the bank did pay civil penalties. Mr. Lew reiterated that, regardless of context, no one is above the law. He also noted that decisions to pursue criminal charges are outside of Treasury’s responsibilities. Sen. Merkley then urged Mr. Lew to “weigh in” on criminal matters.

Sen. Joe Manchin III (D-WVa) later remarked that during the 1980s savings and loan crisis, the federal government investigated bank executives and senators. He asked Mr. Lew why the government had not taken similar action following the 2008 financial crisis. Mr. Lew reiterated his prior testimony that no one is above the law.

Additionally, Sen. Mark Kirk (R-Ill) offered a chart showing how efforts to curb Iran’s ability to finance its nuclear and other programs were achieving significant results. Sen. Kirk also noted that a logical “next step” is to go after Iran’s Euro-denominated accounts. Specifically, Sen. Kirk cited a Dutch effort to rein in Iran’s currency.

Mr. Lew agreed with Sen. Kirk regarding the success of U.S. sanctions on Iran. Mr. Lew also said he has discussed Iran with his European counterparts but European administrative issues remain a barrier to further progress. Mr. Lew said he was unfamiliar with the Dutch plan cited by Sen. Kirk.

Housing and GSEs. Sen. Kay Hagan (D-NC) asked Mr. Lew how FSOC planned to get more capital into the housing market. Mr. Lew said the administration has developed general principles for doing this, but that FSOC did not have a specific plan. Mr. Lew also said that the GSE conservatorships will take time to wind up and that Treasury will try to get back as much taxpayer money as possible. Mr. Lew also said that there is an overdependence on government-guaranteed mortgages and that he understands the need to bring more private capital into the housing market.

Mr. Lew also noted that opposition to Dodd-Frank has receded a bit as compared to the Act’s first two years. Now, said Mr. Lew, there is a “desire for things to settle down.” He suggested that there is increased acceptance of Dodd-Frank as the law of the land since last November’s national election.

Dodd-Frank time frame. Mr. Lew noted in his opening statement that Dodd-Frank implementation is “much closer to the end of the process than to the beginning.” With respect to the overall economic recovery, Mr. Lew said “we need to keep our foot on the accelerator” and take other steps, including “sensible deficit reduction measures” to promote growth.

In reply to many senators’ questions, Mr. Lew declined to give a specific time frame to complete Dodd-Frank implementation. Mr. Lew told Chairman Johnson that he wanted Dodd-Frank efforts to shift into a higher gear so that implementation can be measured in weeks or months instead of months or years.

Cybersecurity. Chairman Johnson closed the hearing with a question to Mr. Lew about what FSOC can do to help maintain U.S. vigilance against cyber attacks. Mr. Lew replied that FSOC cannot merely take action and declare the issue resolved because cyber threats are ongoing. Mr. Lew suggested that FSOC could coordinate efforts between private industry and government regulators.

But FSOC can do little more than adhere to President Barack Obama’s recent cybersecurity executive order without new legislation. Mr. Lew also observed that big firms can do the most on their own to combat cyber threats, but cybersecurity risks also impact less well-equipped smaller firms outside the circle of money center banks.

MainStory: TopStory BrokerDealers Derivatives DoddFrankAct Enforcement InvestmentCompanies Swaps

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