FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member Kanjorski, members of the Subcommittee, I appreciate the opportunity to appear before you today on behalf of the President's Working Group on Financial Markets. I would like to thank the members of this Subcommittee for your leadership in efforts to mitigate systemic risk by implementing recommendations that the President's Working Group on Financial Markets (the Working Group) set forth in its April 1999 report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.

Today, I would like to focus my comments on two broad areas:

• First, I will briefly address the developments in systemic risk mitigation since the Working Group issued its report, including progress in the implementation of the Working Group's specific recommendations;
• Second, I will focus on the importance of market discipline and enhanced transparency and disclosure, and the ways in which H.R. 2924, the bill you will be addressing today, introduced by Chairman Baker, Ranking Member Kanjorski and others, would help to promote enhanced transparency in our financial system.

As you recall, in the immediate aftermath of the near-collapse of LTCM in September 1998, then-Secretary Rubin called on the Working Group to prepare a study of the potential implications of the operations of firms such as LTCM and their relationships with their creditors and counterparties. The Working Group report concluded that the near collapse of LTCM highlighted the possibility that problems at one financial institution - (i.e. a hedge fund or other highly leveraged institution) - could be transmitted to other institutions and potentially pose risks to the financial system, and, that excessive leverage in such institutions can increase the likelihood of a general breakdown in the functioning of financial markets. Thus, the principal public policy issue arising out of the events surrounding the near-collapse of LTCM was how to constrain excessive leverage more effectively.

To this end, the Working Group set forth a series of recommendations designed to help constrain excessive leverage and thereby help to reduce the likelihood that future failures of individual institutions could pose a threat to our financial markets more broadly. Three broad themes united these recommendations:

• The first is that our market economy relies primarily on market discipline to constrain excesses - particularly excessive leverage;
• The second is that that market discipline must be built upon sound risk management practices by all market participants; and
• Finally, in order for markets, generally, to impose that discipline, there must be sufficient transparency and information available to allow individual participants, including creditors, counterparties, and investors to make more informed investment and credit decisions.

Let me briefly update you on the progress that has been made to date on the implementation of the recommendations from the report that promote these themes and, more generally, on the mitigation of systemic risk:

• First, our call for regulators to encourage improvements in the risk management systems of regulated entities was answered last year when the Federal Reserve Board and the Office of the Comptroller of the Currency issued new guidelines urging improvements in such systems. The guidelines were designed to address weaknesses in banks' existing credit risk management tools and the risk management of financial derivatives and to help banks adapt their basic risk management policies, procedures, and internal controls to new products and counterparties in increasingly global and interrelated markets.
• Second, the provisions recommended by the Working Group to improve the netting regime for certain financial contracts in bankruptcy and bank insolvency situations are currently a subject for the conference committee on the bankruptcy bill. We urge Congress to adopt these financial contract netting provisions.
• Third, the private sector has responded to the Working Group's calls for improvements in their risk management practices with groups such as the Counterparty Risk Management Policy Group (CRMPG) and a group of the largest hedge funds publishing reports outlining detailed recommendations for improved risk management standards. These reports have also helped to advance the dialogue between the public and private sectors concerning public disclosure.
• Fourth, internationally, groups such as the Highly Leveraged Institutions (HLI) Working Group of the Financial Stability Forum are taking a hard look at highly leveraged institutions and their effect upon market dynamics worldwide. The HLI Working Group report will be released in a few weeks, and we expect it to broadly support the thrust of the proposals of the President's Working Group, including the legislation being discussed today. Additionally, the International Swaps & Derivatives Association (ISDA), the Emerging Markets Traders' Association (EMTA), the Bond Market Association and the Financial Markets Lawyers Group have joined together, with others, to create the Global Documentation Steering Committee to help reduce systemic risk by "improving the plumbing" through efforts to ensure that industry documentation initiatives will be harmonized.

While this progress is encouraging, there is still more work to be done. Tomorrow, Secretary Summers will elaborate on some of these issues in a speech that he will give at the Futures Industry Association conference.

Let me now turn to H.R. 2924 and the issues of transparency and disclosure. The premise of the Working Group's recommendations is that, in our market economy, the primary mechanism that should and does regulate risk-taking is the market discipline provided by creditors, counterparties, and investors. This discipline can serve to constrain excessive leverage and thereby reduce the associated risks. But its effectiveness is contingent upon counterparties and investors having the information necessary to impose such discipline. The government cannot impose market discipline, but can help to enhance the effectiveness of market discipline by creating an environment of greater transparency and disclosure. Indeed, the long history of public disclosure and transparency in our financial markets has been a source of great strength, and a leading factor in establishing and maintaining the high degree of confidence the world has in the integrity of the U.S. financial markets. This confidence, in turn, increases investment in our markets, lowering the cost of capital for American businesses and individuals, and thereby helping to strengthen the U.S. economy.

Several of the Working Group's recommendations were designed to enhance transparency, and important efforts are already underway to enact some of these recommendations:

• The Commodity Futures Trading Commission (CFTC) has been drafting proposed regulations that would require more relevant and more frequent information from large commodity pool operators regarding the funds they operate and would make this information public. These regulations will be similar to the provisions contained in H.R. 2924 as amended and, should H.R. 2924 become law, it would be important that those reporting to the CFTC and those reporting to the Federal Reserve Board report the same sort of information; and
• The Securities and Exchange Commission (SEC) has been studying ways to implement the disclosure recommendation for public companies and has indicated that they will introduce a draft for public comment in the near future.

H.R. 2924 would contribute to these efforts to enhance transparency by implementing the Working Group's recommendations regarding public disclosure of more frequent and meaningful information on the largest hedge funds. If the manager's amendment is adopted, the bill would require that the largest unregulated hedge funds provide basic non-proprietary financial information and meaningful and comprehensive measures of risk to the Federal Reserve Board of Governors. The Federal Reserve would then share that information with other members of the President's Working Group and disclose the information publicly, allowing market participants to make more informed investment decisions.

One of the primary areas of concern expressed by the private sector has been the challenge of balancing the disclosure necessary to enhance market discipline with the need for protection of proprietary information essential to the firms' ability to engage in business transactions. The Working Group is sensitive to this concern. We believe that H.R. 2924, with the manager's amendment, strikes the appropriate balance by providing the Federal Reserve, in consultation with the other members of the Working Group, with the flexibility to determine what information is both relevant and useful without compromising the firms' ability to engage in business transactions.

H.R. 2924 does not call for direct regulation of hedge funds. It is our view that investors in highly leveraged institutions are generally high net worth individuals or institutional investors, and the usual investor protection grounds for such regulation are not relevant. Moreover, a direct regulatory regime could create a form of moral hazard in which investors and counterparties, knowing that a highly leveraged institution is regulated and supervised for systemic reasons, might reduce their normal due diligence and relax their risk management standards. Thus, rather than imposing regulation, H.R. 2924 would provide for enhanced public disclosure only by those hedge funds that are large enough such that if any one of them were to fail, such failure could potentially pose risk to the financial system more broadly.

We recognize that enhancing transparency and disclosure and providing information to market participants does not guarantee that those participants will process or use the information effectively. However, it is equally true that if the information is not made available to market participants, it cannot be processed or used at all. Thus, the Working Group is seeking to provide the market with one of the key ingredients to making informed credit and investment decisions and thereby collectively promoting greater market discipline.

In this way, H.R. 2924, combined with the Working Group's other recommendations, would take an important step in helping to mitigate systemic risk.

Finally, I would like to thank you, Mr. Chairman, Mr. Kanjorski, and other sponsors of H.R. 2924 for the spirit of cooperation with which you have approached this bill. Members of the Working Group have been working closely with Committee staff and representatives of the private sector to help ensure that this legislation is as effective as possible in accomplishing our collective goals while remaining sensitive to private sector concerns. We are pleased with the results of this cooperation and the steps this bill, as amended by the manager's amendment, takes in promoting our efforts to create an environment conducive to enhanced market discipline.

The Working Group appreciates this Subcommittee's ongoing interest in and efforts regarding the Working Group's recommendations.

I would be happy to answer any questions that you may have.