[Joint House and Senate Hearing, 111 Congress]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-117

                  TOO BIG TO FAIL OR TOO BIG TO SAVE?:
                EXAMINING THE SYSTEMIC THREATS OF LARGE
                         FINANCIAL INSTITUTIONS

=======================================================================

                                HEARING

                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                             APRIL 21, 2009

                               __________

          Printed for the use of the Joint Economic Committee










                  U.S. GOVERNMENT PRINTING OFFICE
52-189                    WASHINGTON : 2009
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing 
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC 
area (202) 512-1800 Fax: (202) 512-2104  Mail: Stop IDCC, Washington, DC 
20402-0001






                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES             SENATE
Carolyn B. Maloney, New York, Chair  Charles E. Schumer, New York, Vice 
Maurice D. Hinchey, New York             Chairman
Baron P. Hill, Indiana               Edward M. Kennedy, Massachusetts
Loretta Sanchez, California          Jeff Bingaman, New Mexico
Elijah E. Cummings, Maryland         Amy Klobuchar, Minnesota
Vic Snyder, Arkansas                 Robert P. Casey, Jr., Pennsylvania
Kevin Brady, Texas                   Jim Webb, Virginia
Ron Paul, Texas                      Sam Brownback, Kansas, Ranking 
Michael Burgess, M.D., Texas             Minority
John Campbell, California            Jim DeMint, South Carolina
                                     James E. Risch, Idaho
                                     Robert F. Bennett, Utah

                     Nan Gibson, Executive Director
               Jeff Schlagenhauf, Minority Staff Director
          Christopher Frenze, House Republican Staff Director














                            C O N T E N T S

                              ----------                              

                     Opening Statements of Members

Hon. Carolyn B. Maloney, Chair, a U.S. Representative from New 
  York...........................................................     1
Hon. Sam Brownback, Ranking Minority, a U.S. Senator from Kansas.     2
Hon. Michael Burgess, M.D., a U.S. Representative from Texas.....     3
Hon. Elijah E. Cummings, a U.S. Representative from Maryland.....     5
Hon. Brad Miller, a U.S. Representative from North Carolina......    38

                               Witnesses

Statement of Dr. Joseph E. Stiglitz, Nobel Laureate, Professor, 
  Columbia University, Former Chairman, Council of Economic 
  Advisers, New York, NY.........................................     7
Statement of Simon Johnson, Ronald A. Kurtz Professor of 
  Entrepreneurship, MIT's Sloan School of Management; Senior 
  Fellow, Peterson Institute; Former Economic Counselor, 
  International Monetary Fund, Cambridge, MA.....................    10
Statement of Thomas M. Hoenig, President, Federal Reserve Bank of 
    Kansas City, Kansas City, MO                                     12

                       Submissions for the Record

Prepared statement of Representative Carolyn B. Maloney..........    50
Prepared statement of Senator Sam Brownback......................    50
Prepared statement of Representative Michael Burgess.............    51
    Editorial entitled ``Probe Yourselves''......................    52
Prepared statement of Dr. Joseph E. Stiglitz.....................    53
Prepared statement of Dr. Simon Johnson..........................    59
Prepared statement of Thomas M. Hoenig...........................    66

 
                  TOO BIG TO FAIL OR TOO BIG TO SAVE?:
                     EXAMINING THE SYSTEMIC THREATS
                    OF LARGE FINANCIAL INSTITUTIONS

                              ----------                              


                        TUESDAY, APRIL 21, 2009

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The committee met at 9:36 a.m., in Room 210 of the Cannon 
House Office Building, the Hon. Carolyn B. Maloney (Chair), 
presiding.
    Senators present: Klobuchar and Brownback.
    Representatives present: Maloney, Cummings, Burgess, and 
Miller.
    Staff present: Gail Cohen, Nan Gibson, Colleen Healy, Marc 
Jarsulic, Barry Nolan, Lydia Mashburn, Jeff Schlagenhauf, Jeff 
Wrase, Chris Frenze, and Robert O'Quinn.

  OPENING STATEMENT OF HON. CAROLYN B. MALONEY, CHAIR, A U.S. 
                  REPRESENTATIVE FROM NEW YORK

    Chair Maloney. The meeting will come to order. Good 
morning. I want to welcome our extraordinary panel of witnesses 
and thank you all in advance for your testimony today.
    This hearing is timely because Congress expects soon to 
take up legislation being prepared by the administration to 
address the Federal Government's inability to wind down nonbank 
financial institutions in an orderly way. The current financial 
crisis has made clear that we need additional tools to handle 
financial institutions that are too big to fail. The disorderly 
failure of large financial institutions can pose a significant 
threat to the stability of the financial system both in the 
United States and globally.
    The panic after Lehman Brothers declared bankruptcy last 
September and the unprecedented drop in jobs during the months 
since then is evidence enough that under our present regulatory 
structure, allowing large financial firms to fail can seriously 
damage our economy. Another failure could have created even 
worse economic consequences with even deeper effects on 
employment, incomes and growth.
    On the other hand, unconditional support for large failing 
firms can be just as dangerous. Implicit guarantees give firms 
incentives to take bigger risks. Allowing firms to escape the 
consequences of bad business decisions could prompt even 
riskier behavior. Our financial regulators presently lack the 
means to steer between these two unacceptable alternatives.
    Chairman Bernanke and Treasury Secretary Geithner recently 
testified before the House Financial Services Committee that 
without new legislation they lacked the authority to conduct an 
orderly unwinding of large financial institutions such as AIG.
    The FDIC has mechanisms in place to allow resolution of 
failed depository institutions. For the other subsidiaries, the 
bank holding companies, and for investment banks, insurance 
companies, and other large financial firms, the only option 
seems to be bankruptcy.
    Fixing our financial system is of the utmost importance. We 
are therefore fortunate to have with us this morning three 
outstanding experts on the topic of restoring confidence in our 
financial system while minimizing both the cost to taxpayers 
and the incentives for institutions to take excessive risks in 
the future. I am confident that we in Congress can work with 
the administration to solve this crisis and give regulators 
better options and tools to prevent, as well as cope with, 
future financial crises.
    [The prepared statement of Representative Maloney appears 
in the Submissions for the Record on page 50.]
    Chair Maloney. And I am delighted to recognize the Ranking 
Member for 5 minutes and every other member for 5 minutes.

 OPENING STATEMENT OF HON. SAM BROWNBACK, RANKING MINORITY, A 
                    U.S. SENATOR FROM KANSAS

    Senator Brownback. Thank you very much, Madam Chairman. I 
appreciate that. Welcome, panelists, Dr. Stiglitz, Dr. Johnson, 
Mr. Hoenig. I am delighted to have you here. The Chairman and I 
talked about doing a panel like this sometime in the past. I am 
very appreciative that you have put this together and you have 
got such an excellent set of witnesses.
    My hope is that there will be other members and groups 
looking in and tuning in to this, because we have got a huge 
problem and I don't think we are yet headed in the right 
direction to fix it. I have reviewed and what some of the 
panelists have said; I think you have got some quite useful 
ideas for us to be able to consider. So it is my hope that this 
will be a very important hearing as we look back on the history 
of the mess that we are in and that we start figuring a real 
road out.
    Mr. Hoenig, I read your recent speech last night. I have 
been circulating an earlier speech that you gave about too-big-
to-fail has failed, that the overall policy has failed. And I 
have thought that and it just, I guess, really resonated with 
me and has with a number of my constituents, that what we have 
done has made the matter worse, and we have taken a strategy 
that hasn't produced an end, and we continue to pour money into 
a leaky ship that it is still listing.
    And at the same time, I saw the Wall Street Journal 
yesterday showing that big-bank lending is continuing to 
decrease, bank lending keeps dropping. Now, this is going the 
exact opposite direction of what we had hoped at this point in 
time.
    I just finished a 2-week break, as we all did in Congress. 
I am traveling around home, and everybody is saying that banks 
are still not lending. And the way out of this is to get the 
banks operating and working again. And I go to the homebuilders 
and the construction builders, who say the bank is not lending. 
The banks say, we can't because the regulators won't let us 
lend. Regulators say, we are not doing anything any different.
    But, clearly, at the end of the day, the thing that 
exacerbates the current situation that we are in is that credit 
continues not to flow, and this is a key thing for us to watch. 
And it also, I think, points out that the idea of what we have 
pursued, that too-big-to-fail has failed. And we have got to 
get to a system that can get us right-sized and get going 
again.
    I am deeply concerned that the government's response to 
date has served to increase confusion in the marketplace rather 
than to restore order. And that is a very big issue, because 
until that confidence returns to the marketplace, you are going 
to continue to see bank lending drop and you are going to 
continue to have people wait and see what the Federal 
Government is going to do to resolve this before anything real 
happens.
    I appreciate very much the panelists being here. I look 
forward to the questions and the comments that you have about a 
different way to go to get us into some sort of resolution that 
can restore public confidence, that the public can know which 
way the government is going, and that we can get banks back to 
lending again in some sort of stable system. And what I hope we 
can do from this hearing is pass your information on to many 
others for people to look at another way, a way that can get us 
out of this crisis.
    Madam Chairman, I would like to put my full statement in 
the record, as presented, and I look forward to the question-
and-answer session.
    Chair Maloney. Without objection.
    [The prepared statement of Senator Brownback appears in the 
Submissions for the Record on page 50.]

    OPENING STATEMENT OF HON. MICHAEL BURGESS, M.D., A U.S. 
                   REPRESENTATIVE FROM TEXAS

    Representative Burgess. And I too am pleased to be joining 
with the Chair and Senator Brownback in welcoming this 
distinguished panel of witnesses testifying before us this 
morning.
    We are, of course, very concerned and continue to be 
concerned about the state of the economy and the concept before 
us this morning. The concept of too-big-to-fail and its effect 
on the economy is one that has troubled many of us for some 
time.
    The roots of the current crisis are to be found in 
government policies that encouraged risky mortgage lending 
practices as well as a breakdown of lending standards in the 
private sector. Many banks and other financial institutions 
made investment decisions that resulted in huge losses that now 
have to be written down.
    Some think the financial situation is improving. The fact 
remains that loan defaults continue to trend upward and 
probably will for some time to come. The administration has 
responded with a plan, announced on February 10, based on 
public and private partnerships to purchase the toxic assets of 
banks. Many economists have raised concerns about whether this 
plan is adequate, given the magnitude of the problem of the 
banking sector.
    Estimates of the amount of toxic assets in the United 
States banking system now range up to $2 trillion. The 
administration plan relies heavily on providing generous 
subsidies to private-sector participants who would enjoy half 
of any private-sector profits. However, if the partnership 
fails, the taxpayers would shoulder over 90 percent of the 
losses. The prospect of trillions of dollars of taxpayer money 
at risk in this plan is indeed very troubling.
    I am also disturbed by the lack of transparency and 
accountability in the administration plan. The Treasury seems 
to have designed the plan specifically to evade the 
congressional appropriation process. Trillions of taxpayer 
dollars are at risk. But congressional approval is not needed 
for the plan to proceed. On its face, this is a violation of 
the democratic process.
    Perhaps some of the witnesses today can--perhaps Dr. 
Stiglitz said it best when he characterized the recent Treasury 
proposal as ``robbery of the taxpayers.'' There is even 
speculation that the firms receiving the bailouts could also 
directly or indirectly participate and enjoy the subsidies 
offered in the Treasury plan. I remain concerned that the cost 
of the plan will be exorbitant, and it will not work 
effectively to solve the financial crisis.
    Putting the future impact of the Department of Treasury's 
plan aside for a moment, I also want to spend just a minute and 
talk about something that I hear every time that I go back 
home. And that relates to the beginnings of this crisis, 
whether it be in 2007 or 2008, or indeed if it began with the 
failure of Lehman Brothers in September of 2008. But why has 
there been no concerted congressional investigation as to what 
went wrong and who was accountable? The old ``what did they 
know and when did they know it?''
    We had a commission to investigate the 9/11 failings. And 
while there were good things and bad things that came out of 
that, they did their job and they produced a report that all of 
us now refer to. And in fact several legislative proposals have 
come out of that report.
    The Iraq Study Group in the fall of 2006 produced a report, 
some of which I disagreed with, but nevertheless they produced 
a report. And, arguably, it was the basis of that report which 
ultimately led to the successes we saw on the ground in Iraq.
    So while I am not a big fan of commissions and I am not a 
big fan of Congress giving up any of its authority, I think 
this is the situation that cries out for that, and indeed 
congressional credibility is on the line. And I am not alone in 
this. I am going to be introducing a bill later on this week 
with Congressman Brady to authorize just such a commission. But 
Friday's Investors Business Daily, in its lead editorial 
appropriately called ``Probe Yourselves,'' talks about Speaker 
Nancy Pelosi calling for a commission to do just such an 
investigation and hold people accountable. The lead quote is, 
``House Speaker Nancy Pelosi wants a broad probe of Wall Street 
much like that in 1932 that led to sweeping bank reforms.'' 
Good idea. Let the probing begin.
    Now the editorial writing said, let it begin with Pelosi's 
Congress. But nevertheless let's do the investigation, let's 
find out where the fault lies and let's not go through this 
again anytime soon.
    So, Madam Chairwoman, I thank you for the indulgence for 
the time to talk about this. I will be introducing it later on 
this week with Congressman Brady, and I certainly look forward 
to the testimony of our witnesses today. I would ask unanimous 
consent to insert the Investors Business Daily, the total of 
the editorial, for the record.
    [The prepared statement of Representative Burgess appears 
in the Submissions for the Record on page 51.]
    [The editorial entitled ``Probe Yourselves'' appears in the 
Submissions for the Record on page 52.]
    Chair Maloney. The Chair recognizes Mr. Cummings.

     OPENING STATEMENT OF HON. ELIJAH E. CUMMINGS, A U.S. 
                  REPRESENTATIVE FROM MARYLAND

    Representative Cummings. Thank you very much, Madam 
Chairlady. I wanted to thank you for calling today's hearing to 
enable us to assess the nature of the systemic risk posed by 
large financial institutions and the legal and regulatory 
measures that should be put in place going forward to ensure 
that no financial firm's actions can ever again put our entire 
economy at risk.
    These issues are of central importance at this time, and 
perhaps the example of AIG best illustrates what the concept of 
too-big-to-fail has really come to mean to United States 
taxpayers. By varying estimates, AIG has received between $170 
billion and $180 billion in taxpayer aid. The TARP aid being 
provided to this firm is provided under a category called 
``systemically significant failing institutions,'' a name that 
frankly says it all.
    The question that should have been understood and answered 
long ago was, one: Under what circumstances should a firm be 
allowed to become systemically significant? And two: How can we 
ensure such a firm is fully subject to the consequences of 
failure?
    Given, however, that we failed to address either of these 
issues adequately, our Nation is now essentially held hostage 
to a vicious cycle in which the mere threat of the downgrade of 
AIG's credit rating could trigger massive financial obligations 
that would have consequences unacceptable to our economy. To 
prevent this scenario from playing out, we appear forced to pay 
whatever it takes to prevent what would normally be the 
consequence of failure, which is bankruptcy, if not 
liquidation.
    Bankruptcy and liquidation are precisely what have happened 
to so many firms that have obviously been deemed ``small enough 
to fail.'' And those employees are suffering the consequences 
as they join the ranks of the unemployed by the hundreds of 
thousands each month. But because AIG and other financial firms 
are being too big to fail, they have said they have essentially 
become or been made immune to the full consequences of their 
actions.
    Since the emergence of the financial crisis, the witnesses 
who appear before us today have commented with blistering 
clarity on the assumptions, such as the assumption that our 
modern financial system could and would effectively manage 
risks that led to the creation of firms too big to fail, and 
that have now tied us in knots.
    In particular, they have described the evolution of a 
shared mind-set among Wall Street employees and government 
regulators that appears to have inhibited critical examination 
of the growing risks being created by stunningly complex 
financial transactions.
    They have also argued that the responses to the current 
crisis have simply perpetuated some of the most questionable 
assumptions by isolating the failed firms--which is precisely 
what they are--in an artificial cocoon of taxpayer aid, which 
apparently not even the most basic consequences of failure 
appear to apply. Thus, AIG and other bailed out firms have 
continued to operate as if they have every right to expect 
taxpayers not only to clean up all the binding obligations they 
have created and that now binds us, but also to fund their 
parties and their private jets.
    Bailed-out firms and their employees have also continued to 
demand outrageous bonuses and other perks. AIG has spoken with 
a straight face of how critical it is to pay bonuses to 
employees who unwinding and stunningly complex transactions 
created by the financial products division, precisely because 
they are the only ones who could understand them, and thus are 
so indispensable their departures would cause the situation to 
worsen, costing us all the more. Such situations in which firms 
are essentially able to hold guns to the government's 
collective head and then repeatedly threaten to pull the 
trigger are simply absurd, and yet this is what we have allowed 
the term ``too big to fail'' to mean to us. Particularly as 
Special Inspector General for TARP, Neil Barofsky, has just 
issued a report that warns of extending old assumptions to 
additional aspects of the bailout.
    I look forward to the testimony of today's witnesses and I 
look forward to hearing their frank assessments of how to 
identify and control systemic risks.
    And with that, Madam Chairlady, I yield back.
    Chair Maloney. Thank you very much for your testimony.
    Now I would like to introduce our distinguished panelists. 
Professor Joseph Stiglitz is a university professor at Columbia 
University in New York and chair of Columbia University's 
Committee on Global Thought. He is also the cofounder and 
executive director for the Initiative for Policy Dialogue at 
Columbia. In 2001 he was awarded the Nobel Prize in economics. 
He had previously received the John Bates Clark medal in 1979. 
Dr. Stiglitz was a member of the President's Council of 
Economic Advisors from 1993 to 1995, during the Clinton 
administration, and served as CEA chairman from 1995 to 1997. 
He then became chief economist and senior vice president of the 
World Bank from 1997 to 2000. Dr. Stiglitz graduated from 
Amherst College and received his Ph.D. from MIT in 1967.
    Dr. Simon Johnson is the Ronald A. Kurtz professor of 
entrepreneurship at MIT's Sloan School of Management. He is 
also a senior fellow at the Peterson Institute for 
International Economics in Washington. He is also a member of 
the Congressional Budget Office's Panel of Economic Advisors. 
In 2007 and 2008 Professor Johnson was the International 
Monetary Fund's economic counselor and chief economist and 
director of its research department. He holds a Ph.D. in 
economics from MIT and an MA from the University of Manchester 
and a BA from the University of Oxford.
    Dr. Thomas Hoenig is the president of the Federal Reserve 
Bank of Kansas City, a position he has held since 1991. He 
currently serves as an alternate voting member of the Federal 
Open Market Committee. Dr. Hoenig joined the Federal Reserve 
Bank of Kansas City in 1973 as an economist in the banking 
supervision area. He was named vice president in 1981 and a 
senior vice president in 1986. He earned a BA in economics and 
mathematics from Benedictine College in Kansas and MA and Ph.D. 
degrees in economics from Iowa State University.
    I want to thank all of you very, very much for coming.
    Chair Maloney. And Dr. Stiglitz, will you please proceed 
with your opening testimony. We are asking each of you to 
testify and summarize your remarks in 5 minutes so that there 
is more time for questions. Thank you.

     STATEMENT OF HON. JOSEPH E. STIGLITZ, NOBEL LAUREATE, 
  PROFESSOR, COLUMBIA UNIVERSITY, FORMER CHAIRMAN, COUNCIL OF 
                ECONOMIC ADVISERS, NEW YORK, NY

    Dr. Stiglitz. Thank you very much for allowing me to speak 
and for holding these hearings. I think some of the 
introductory remarks have already drawn attention to some of 
the issues I wanted to discuss.
    Too little attention has been given to the question of what 
kind of a financial system we want to have as we emerge from 
this crisis. The decisions we make today on how to rescue our 
financial system inevitably will shape the financial system of 
tomorrow.
    As we think about what kind of financial system we would 
like, we should begin by recognizing the failures of our 
existing system. We have a financial system which created risk 
and misallocated capital, but with high transaction costs.
    While our banks have not been at the center of our 
economy's dynamic growth, they have been at the center of this 
tempest. They have created risk for our country, without any 
offsetting rewards for our society; though, to be sure, those 
in the industry have been rewarded well.
    Our financial system discovered that there was money at the 
bottom of the pyramid and made a concerted effort to make sure 
that it did not remain there. They engaged in predatory 
lending. It is ironic that they were hoisted by their own 
petard in the subprime mortgage market.
    As an aside, preventing banks from being too big to fail 
and intense regulation of these too-big-to-fail institutions is 
not the only thing that is needed. We need a financial products 
safety commission to assess which financial products are safe 
for use by consumers and for what purposes. This commission 
will help in addressing the problems of the too-big-to-fail 
banks as well, and it will take risk out of the system. These 
banks won't be able to buy up big packages of financial 
products that have a high risk of nonpayment.
    We need strong regulation at the bottom of the pyramid to 
complement the strong relation at the top that I describe 
below. In some developing countries modern banking services 
have been extended to even the poor and sometimes remote 
villages. The poor in our inner cities still use check-cashing 
services, which charge exorbitant fees. Modern technology 
should have resulted in the low-cost electronic payment 
mechanism.
    Our system entails exploitive fees to both businesses and 
consumers. Thus, as we go about repairing or bailing out our 
financial system, we must keep in mind the kind of system we 
want to have going forward. We should not want to go back to 
the world we had before the crisis, nor can we. We had too big 
of a financial sector. In the post-crisis era, the financial 
sector as a whole will shrink. There is no good case for making 
the smaller competitive community-oriented institutions, which 
have provided the majority of lending to small- and medium-
sized enterprises, take the brunt of the downsizing. One of the 
key problems comes from allowing certain institutions to become 
too big to fail, or at the very least very expensive to save.
    Yet the response to the crisis has led to the consolidation 
of the big banks, increasing the risk of the surviving banks 
becoming too-big-to-fail. Some of the too-large-to-fail banks 
have been the recipients of huge subsidies under TARP and the 
other bailouts and guarantee programs sponsored by Treasury, 
the Fed and FDIC.
    To date we have not had any systemic and systematic 
comprehensive accounting. Congress should demand this both from 
the agencies and from the CBO. Our bailouts run the risk of 
transferring large amounts of money to those banks that did the 
worst job in risk management--hardly principles on which normal 
market economics is based--and to their shareholders and to the 
bondholders. Among these are some of the too-big-to-fail banks. 
In effect, the government is tilting the playing field towards 
the losers.
    Much of the discussion of regulatory reform has skirted the 
main issues. There is talk about the need for comprehensive 
oversight of hedge funds. Remember, the core problems were not 
with the hedge funds, but with the regulations and regulatory 
enforcement for big commercial investment banks. It is that 
which has to be fixed. Being too big to fail creates perverse 
incentives for excessive risk-taking, and it also distorts the 
marketplace in another way: There are hidden subsidies which 
have increased in the current crisis. We could have reduced the 
extent of moral hazard that we created in the subsequent 
bailouts had we made an obvious distinction between bailing out 
the banks and bailing out the bankers, their shareholders, and 
their bondholders.
    We have similarly confused too big to fail with too big to 
be financially restructured. Moreover, it is usually far 
cheaper to target money where it is needed than to rely on 
trickle-down economics. The decisions of both the Obama and 
Bush administrations to extend unnecessarily the corporate 
safety net has meant that incentives are more distorted, the 
costs to our economy are greater, and our national debt will be 
massively larger than it otherwise would have been.
    It is not too late to change this policy. With the bailout 
of AIG, we have officially announced that any institution which 
is systemically significant will be bailed out. I think it is 
imperative that Congress narrow the breadth of this new 
corporate welfare state. It is people that we should be 
protecting, not corporations.
    There are but two solutions, breaking up the institutions 
or regulating them heavily. We need to do both. The only 
justification for allowing these huge institutions to continue 
is that there are significant economies of scale and scope that 
otherwise would be lost. I have seen no evidence to that 
effect. Because we know that there will be pressures over time 
to soften any regulatory regime, and because any regulatory 
regime itself is imperfect, it is I think imperative that we 
break up these too-big-to-fail institutions and strongly 
restrict the activities in which they can be engaged.
    But we know that our efforts to limit the development of 
too-big-to-fail institutions will not be perfectly successful 
in the best of circumstances. Hence, our regulatory structure 
must prepare to deal with any financial institutions that are 
too big to fail.
    In previous testimony I have laid out what is required in 
terms of a comprehensive regulatory framework, including strong 
restrictions on incentive structures, corporate governance, 
risk-taking, leverage, derivatives and so forth. We have to be 
aware that there will be attempts at cosmetic reforms, not real 
reform. Too-big-to-fail banks should be forced to conduct the 
boring business of doing conventional banking, leaving the task 
of risk-taking to others. There are plenty of other 
institutions, not depository institutions and not too big to 
fail--not so big that their failure would bring the entire 
economy down--that are able to take on the task of risk 
management. Such a reform would increase the efficiency of the 
economy.
    The restrictions on their activities may yield low returns, 
but that is as it should be. High returns that were earned in 
the past were the result of risk-taking taken at the expense of 
American taxpayers. A basic law in economics is that there is 
no free lunch. Higher-than-normal returns come with risk, and 
these too-big-to-fail institutions are not the ones that should 
be undertaking this risk.
    What I am arguing for is a variant of what is sometimes 
called the Public Utility Model: in return for the implicit or 
explicit guarantees associated with these too-big-to-fail 
institutions we should demand the highest standards of 
corporate governance. The too-big-to-fail banks should also be 
required to provide banking services to underserved communities 
at prices and terms that are competitive, reflecting actual 
cost.
    The too-big-to-fail banks should be put at the center of a 
new electronic payment system that will use modern technology 
to provide a 21st century payment system at a low cost for 
America. They should not be allowed to engage in the predatory 
credit card practices that have become commonplace. We should 
have a 21st century efficient and fair credit system to 
correspond to our 21st century electronic payment mechanism.
    Being too big to fail gives these banks a distinct 
advantage over stand-alone institutions. It is neither 
equitable nor efficient to force those banks that have been 
doing the job of real banking to pay for the losses of the too-
big-to-fail banks.
    One of the disturbing aspects of the recent bailouts is the 
absence of a clear set of criteria and a seeming inconsistency 
in practice that was referred to earlier. Before a crisis every 
financial institution will claim that it does not pose systemic 
risk. In a crisis almost all will make such claims. Recognizing 
this, we must take a precautionary approach. A systemically 
significant firm is any whose failure alone or in conjunction 
with other firms following similar investment strategy leads to 
a cascade of effects, significant enough to justify government 
intervention. If those in the financial market continue to 
insist, as they have been, that allowing any major bank to go 
under or allowing bondholders to take significant reductions in 
value would lead to a cascade of effects simply because of 
fears that it might induce among bondholders, then the reach of 
institutions that fall within the rubric of too big to fail and 
needs to be greatly broadened.
    One cannot have it both ways: claim that we only need to 
regulate tightly the largest institutions who are too big to 
fail and claim, at the same time, that a bankruptcy of any 
large institution would lead to cascade effects through market 
expectations. The taxpayer is told he must pony up billions 
because it is too risky to allow bondholders' interest or even 
shareholders' interest to be diminished. As it should under 
normal rules of a market economy, the net of strong regulation 
has to be correspondingly wide.
    There will be those who argue that the regime I have 
proposed will stifle innovation. A disproportionate part of the 
innovations in our financial system were aimed at tax, 
regulatory, and accounting arbitrage. They did not produce 
innovations which would have helped our economy manage some 
critical risk better, like the risk of home ownership. In fact, 
their innovations made things worse.
    I believe that a well-designed system along the lines I 
have described will be more competitive and more innovative, 
with more of the innovative effort directed at innovations 
which will enhance the productivity of our firms and the 
economic security and general well-being of our citizens. Thank 
you.
    Chair Maloney. Thank you.
    [The prepared statement of Joseph E. Stiglitz appears in 
the Submissions for the Record on page 53.]
    Chair Maloney. Dr. Johnson.

   STATEMENT OF SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF 
  ENTREPRENEURSHIP, MIT'S SLOAN SCHOOL OF MANAGEMENT; SENIOR 
    FELLOW, PETERSON INSTITUTE; FORMER ECONOMIC COUNSELOR, 
           INTERNATIONAL MONETARY FUND, CAMBRIDGE, MA

    Dr. Johnson. Thank you very much. I would like to underline 
the seriousness of the current situation and the dangers 
inherent in our system with two numbers in the beginning. The 
first is, as you may have heard, is that the IMF's new estimate 
released this morning of global financial losses, $4.1 
trillion. Now, those are not all, obviously, in the United 
States but they are primarily due to the behavior of large 
banks in the United States and in Western Europe. This is an 
extraordinary problem. It is a global problem. We are very far 
from being out of it.
    The second number is my own purely personal estimate of the 
increase in privately held government debt that will result 
from this enormous financial fiasco. As you know, when we 
started the crisis the CBO placed this measure of government 
debt around 40 percent--41 percent to be precise--of GDP. I 
think that when we are done with the various bailouts and the 
fiscal responses that are, in my opinion, appropriately called 
for, we will be much closer to 80 percent of GDP. We cannot 
afford to have another crisis of this magnitude anytime in the 
next 5 years or 10 years or maybe even 20 years. It is simply 
too expensive to the taxpayer.
    And I would completely endorse many of the proposals, 
probably all the proposals, put forward by Professor Stiglitz 
in this regard. But I would go further. I think the danger of 
the situation, the danger to the taxpayer, is so large and so 
imminent that we should consider seriously applying our 
existing antitrust laws to breaking up the country's largest 
banks. I realize that this is a departure from standard 
practice. I understand that it is a step not to be taken 
lightly, particularly in an economic downturn of this nature, 
nor do I think that it is a measure that you adopt tomorrow or 
try to implement in the next 3 months.
    But I think as a complementary set of actions to Professor 
Stiglitz's proposed Public Utility Model for banking, 
considering these banks to be too large to fail, so large that 
they endanger the interests of consumers, of taxpayers, very 
much in the same way that an industrial monopoly can endanger 
the interest. In fact, if you consider the amount of damage 
that has actually been done by this banking system and by the 
institutions that are too large to fail, because they felt 
immune from damage because they believed--correctly, as it 
turns out--they were too big to fail, this far exceeds any of 
the damages done by any of our industrial monopolies or 
potential monopolies at least since the end of the 19th 
century.
    You have to go back I think to the end of the antitrust 
movement and to the concerns that were expressed then by Teddy 
Roosevelt, and other leaders of that thinking, in terms of the 
source of the power, the source of the political influence and 
the economic damage that could be done by very large interests. 
In those days it was industrial. Now it is financial. And I 
would emphasize that while I don't at all subscribe to view 
this as any kind of conspiracy at work here, I do think since 
1980--and I laid this out in my written testimony and in other 
work--since 1980 we have really shifted in this country away 
from having a financial sector that was important and a central 
part of the functioning of the economic and political system 
towards something that was much larger, much bigger in 
political terms as well as in economic terms.
    And we have also constructed it to be, quite honest, a 
system of belief both in industry and in our political life and 
absolutely in academia in which we thought that what was good 
for Wall Street and what was good for big finance on Wall 
Street was good for the economy. That was a mistake. That was a 
very big conceptual error. And I think Mr. Cummings alluded to 
this in his opening remarks.
    And Dr. Burgess, I would stress that not only--I would 
agree with you on the mortgage practices source, of course. But 
I would suggest that we put that in a broader framework and ask 
how did we get a financial sector that was so powerful that it 
could lobby for--and I understand they were not unassisted in 
this matter but for sure they wanted less regulation of 
derivatives, of mortgage lending that the capital flows that we 
worry about around the world, the so-called issue of global 
imbalances, clearly--and there are many claims out there that 
this played also a role in lowering interest rates and making 
credit conditions easier. All of these conditions were very 
much parts of a system that was incredibly favorable to big 
finance.
    Now, I am not suggesting that we can dismantle this 
immediately. I think that we have encountered a situation very 
much like how you would feel after a serious problem at a 
nuclear power plant. I don't think you can uninvent nuclear 
power. I don't think you want to close down all of your nuclear 
power stations immediately. I think you need to move nuclear 
power--in this case financial services--toward the Public 
Utility Model, so nicely articulated by Professor Stiglitz. But 
in addition, to make sure that as, for example, the 
administration applies the resolution authority, which they are 
currently seeking from Congress and which I believe you will 
feel the need to--and you should feel the need to grant them--
as they apply that, I think the use of antitrust to break up 
the largest banks will be essential.
    There will be a lot of resolution. There is already a run 
in the credit market on some of our country's largest financial 
institutions. We can discuss that further if you like, 
particularly perhaps more in private. This is a very serious 
imminent danger. It needs to be addressed. It needs to be 
addressed partly through the Public Utility Model. But I think 
also partly through--and absolutely through the regulation of 
behavior, which Professor Stiglitz has articulated, but also 
through a much more aggressive and innovative application of 
our existing antitrust laws. Thank you very much.
    Chair Maloney. Thank you.
    [The prepared statement of Simon Johnson appears in the 
Submissions for the Record on page 59.]
    Chair Maloney. Mr. Hoenig.

STATEMENT OF THOMAS M. HOENIG, PRESIDENT, FEDERAL RESERVE BANK 
                OF KANSAS CITY, KANSAS CITY, MO

    Mr. Hoenig. Madam Chair Maloney and Ranking Member 
Brownback and the other members of the committee, I want to 
thank you for the opportunity to testify at this hearing here 
this morning.
    Certainly the United States currently faces economic 
turmoil related directly to the loss of confidence in our 
largest financial institutions because policymakers accepted 
the idea that some firms are just too big to fail. I do not. 
Despite record levels of expenditures we have not seen the 
return of confidence or transparency to financial markets, 
leaving lenders and investors weary of making new commitments. 
Until confidence is restored, a full economic recovery cannot 
be achieved.
    When the crisis began to unfold last year and its full 
depth was not yet clear, substantial liquidity was provided to 
the financial system. With the crisis continuing and hundreds 
of thousands of Americans losing their jobs every month, it 
remains tempting to pour additional funds into large firms in 
hopes of a turnaround. However, actions that strive to protect 
our largest institutions from failure risk prolonging the 
crisis and increasing its cost.
    A particular concern to me is the fact that financial 
support provided to firms considered too big to fail provides 
them a competitive advantage over other firms and subsidizes 
their growth and profit with taxpayer funds. Yes, these 
institutions are systemically important. But we all know that 
in a market system, insolvent firms must be allowed to fail, 
regardless of their size, market position or the complexity of 
operations.
    In the rush to find stability, no clear process was used to 
allocate TARP funds among the largest firms. This created, in 
the end, further uncertainty and is impeding the recovery. We 
have options that could provide more successful outcome, but 
there are several hard steps that have to be taken. Here are 
two:
    First, we must, in a sense, triage systemically important 
financial firms based on their current condition. For those 
that are well capitalized, we move on. Those that are viable 
but need more capital either raise it privately or seek 
government assistance, with the taxpayer put in the senior 
position and the government determining the circumstances of 
the senior managers and directors.
    Second, nonviable institutions must be allowed to fail and 
could be put into a negotiated conservatorship, even today, as 
was done in 1984 with the holding company Continental Illinois, 
and reprivatized as quickly as possible. Such actions serve to 
ensure that when public funds are used, and they may well be 
needed, management and shareholders bear the full cost of their 
actions before taxpayer funds are committed. It would give the 
public confidence in the process and mitigate the need for the 
government to then micromanage the institution. Such a 
resolution process is equitable across funds, has worked in the 
past and favors the taxpayer.
    Past experience also suggests this approach is much less 
costly than the alternative of not recognizing losses and 
allowing forbearance, as Japan initially did with its problem 
banks during its lost decade, and as the United States 
initially did with thrifts in the 1980s.
    As we look to the future, of course, we will turn to the 
matter of regulatory reform as a way to address this. It is 
critical that we correctly diagnose the cause of this crisis. 
The structure of our regulatory system is neither the cause nor 
the solution. These too-big-to-fail institutions are not only 
too big, they are too complex and too politically influential 
to supervise on a sustained basis without a clear set of rules 
constraining their actions.
    When the recession ends, old habits, I assure you, will 
reemerge. Thus we should focus on defining the supervisory 
framework and operational rules that over the decades have 
provided the best outcomes, no matter the complexities and 
dynamics of the market. For example, history has shown that 
strong limits on ratio levels work.
    Finally, I do want to mention that the structure of the 
Federal Reserve System is also not the problem, as has recently 
been suggested. It would be a sad irony if the outcome of a 
crisis initiated on Wall Street was to result in Wall Street 
gaining power at the expense of other parts of the country.
    The twelve regional Federal Reserve banks that make up the 
Federal Reserve System were established by Congress 
specifically to address the populist outcry against 
concentrated power on Wall Street in the past. Its structure 
reflects a system of checks and balances that serves us well at 
all levels of government and is the reason I am here today, 
able to express an alternative view.
    I look forward to your questions, Madam.
    Chair Maloney. Thank you very much for your testimony.
    [The prepared statement of Thomas M. Hoenig appears in the 
Submissions for the Record on page 66.]
    Chair Maloney. I would like to ask all of the panelists, 
beginning with Dr. Stiglitz and going down the line, if anyone 
else would like to comment, or I hope you do comment. Would you 
say that we have a double standard in place right now in our 
banking system? Smaller banks that do not pose a risk to the 
financial system are shut down, while larger systemically 
important ones are allowed to continue with little penalty to 
creditors or counterparties.
    And specifically to your testimony, Dr. Stiglitz, you 
testified that you don't see any economics of a scale or scope 
with large financial institutions. If the United States returns 
to a banking system that is narrower and more functionally 
regulated and smaller, do we run the risk of losing our 
financial edge in the global economy?
    Some argue that the large Universal Bank Model is needed in 
order to compete in the world and global economy.
    Thank you very much for being here. It is a great honor for 
me and, I am sure, the other members of Congress to have you 
here today. Thank you.
    Dr. Stiglitz. Thank you. First, I agree very much that we 
have in effect a double standard. It is absolutely clear that 
we have a double standard. The only question is, is there 
justification for that double standard? The only justification 
would be that there was some necessary economic advantage from 
these too-big-to-fail institutions. This could be, for example, 
strong evidence that economies of scale by larger banks are 
more efficient, or that economies of scope bringing all these 
activities into one institution, are so great to overcome the 
disadvantages of the risk of being too big to manage that are 
imposed on the taxpayers. It has become very clear that a lot 
of the banks can't manage themselves.
    Looking at the evidence, it seems overwhelmingly clear that 
the disadvantages outweigh the advantages. If you look at that 
financial system as a whole for the United States, we have some 
really strong institutions. There are venture capital firms 
that finance our dynamic parts, not only in Silicon Valley, but 
also in various parts of our country. However, the strong 
institutions aren't the too-big-to-fail institutions; they are 
the small institutions such as local and community banks that 
are providing credit to new enterprises and providing capital 
to small- and medium-sized enterprises. It worries me that 
beginning with the reforms back in the nineties, like the 
repeal of Glass-Steagall, we are moving away from a financial 
system that provides these basic services on which the dynamics 
of American capitalism depends and moving into a system where 
all the resources are going into a financial system that is 
dysfunctional. That financial system, the big banks and those 
other parts, led al Qaeda to capital in the way that it should 
not have gone and didn't make our economy more productive. They 
really demonstrated a lack of ability to allocate capital and 
manage risk.
    And so I would strongly endorse Dr. Johnson's perspective 
that we need to take even a stronger view on antitrust. The 
presumption should be that they should be broken up unless a 
compelling case can be made not to do that. I can say I see no 
evidence against breaking them up. I think that this kind of 
threat that is constantly put forward, that if we do so, we 
won't be able to compete on a global level, is just nonsense.
    You have to ask the question, so what if we lost a little 
bit in these too-big-to-fail institutions? What we would gain 
is enormous. From the point of view of taxpayers, the price we 
have paid for those institutions, illustrated by the numbers 
that Dr. Johnson gave, make it clear that our society did not 
gain anything commensurate with the benefits that these larger 
institutions gained.
    Chair Maloney. Dr. Johnson and Mr. Hoenig would you like to 
comment?
    Dr. Johnson. If I could just add two points. I agree 
completely with what Professor Stiglitz said. There are no 
compelling advantages to size. That is quite evident. And the 
disadvantages are dramatic.
    Let me make two supporting points. First is in Europe. They 
have tried--they have gone much further than we have in terms 
of too big to fail. The Royal Bank of Scotland, for example, in 
the U.K. had a balance sheet, at its peak, of two times U.K. 
GDP, not 20 percent, 200 percent and that is not an exception.
    If you look at Deutsche Bank in Germany, you look at UBS in 
Switzerland, you see a similar kind of phenomenon. That is 
obviously crazy. Now, perhaps they will survive. They are 
willing to nationalize. It is a huge fiscal cost they are 
taking on, by the way. Does this give them any kind of 
competitive advantage in the global economy right now? No, it 
doesn't. Extricating themselves from that is the major reason 
why Europe, I think, is going to struggle to recover and they 
will recover slower than the United States in my estimation.
    The second point is just to back up Professor Stiglitz on 
this risk-taking which is a key part of the U.S. economy. I am 
a professor of entrepreneurship at MIT. I spend most of my time 
interacting with entrepreneurs, would-be entrepreneurs, venture 
capitalists. And these people are absolutely livid at the way 
large banks have been run. Their point is that they, the risk-
takers, are being hampered and they are going to face much 
bigger tax bills because of the incompetence, mismanagement and 
hubris of big finance.
    I think that the one piece I would emphasize that you need 
is securities firms that are able to take companies public, but 
there the key should be a return to an older model in which 
firms put their own capital at stake, preferably their 
partner's capital. So it is your money on the line. And if you 
back an issue and it is a bad issue, you lose your money, not 
someone else's money--not, you know, some grandma and widows' 
and orphans' money--your own personal capital. And we can do 
that.
    And venture capital is exactly the perfect model for how to 
do this. Equity finance, the partners have got money in, long-
term investors put money in and individuals' reputations are on 
the line. That is what we should go for as the risk-taking part 
of our economy. And the financial transactions part should be 
run along the public utility lines that Professor Stiglitz has 
outlined earlier.
    Chair Maloney. Mr. Hoenig.
    Mr. Hoenig. Thank you. On the question of double standard, 
there is no question that there is a double standard, that you 
have in institutions of smaller size--I will give two examples 
in our region. One had a liquidity crisis, still had some 
capital but could not fund itself. It was taken over. It was 
closed in the sense of all the stockholders lost their money. 
There were some assets sold and we went on.
    In another instance they could not find a buyer. The FDIC 
took it over to systemically liquidate it in an orderly 
fashion. That is not being done with the other institutions. 
And what I have suggested is there is a way even under current 
circumstances, although cumbersome, that we, in fact, do take 
it over in terms of the negotiated transaction where you can, 
against losses that have occurred or would occur, wipe out the 
stockholders and then continue to run and then reprivatize 
those institutions. That would make the outcomes equitable for 
all, which they are not now.
    On the question of this competitive issue, I would note 
that when we eliminated Glass-Steagall, I and others raised 
concern that it would provide a mechanism under the idea that 
we had to be more competitive globally, that these institutions 
would grow in size and would, in fact, despite all the 
protestations, become too big to fail. And that is exactly what 
they have done. We have tried that model and that model has not 
worked. So it doesn't give us a competitive edge. It puts us in 
jeopardy, and I think that is where we need to focus our 
attention.
    Chair Maloney. Thank you very much. And Ranking Member, 
Senator Brownback.
    Senator Brownback. Thank you very much, Ms. Chairman. And 
thank you for this panel. Again, I really appreciated the 
comments people have made.
    Dr. Hoenig, you have basically said we need to allow a 
means for allowing big institutions to fail and a system where 
you could do that. I read in your speech you gave recently that 
if the four largest bank holding companies each had more than 
$1 trillion in assets and they account for half of the banking 
industry's assets--I mean just huge concentration for now--of 
those four, basically then you are talking about, I guess, 
probably at least two of them would be dismembered and moving 
out. I don't know the inside numbers on these things. I hope 
somebody around the government does. But is that--is that what 
I am hearing you say specifically?
    Mr. Hoenig. Well, I won't say how many of the four. But I 
do say that if any of the four are unable to have sufficient 
capital to manage their circumstance, and if they do need more 
capital to make sure that they remain solvent, then the 
government should take a senior position; and that any losses 
that have occurred, or would still occur, should be taken 
against the stockholders so they feel the loss before any of 
the taxpayers' money is used.
    Senator Brownback. Basically, I mean, you are saying we 
should treat them the same way we do banks across the rest of 
the country. And we have a system and we have done it before in 
Continental Illinois, which had a similar very large position 
in the overall financial sector at a different time.
    Mr. Hoenig. Yes. I am saying they should be treated the 
same for the benefit of the economy. I mean, an economy works 
when it is allowed to run efficiently; and that is, 
institutions that do not manage well fail, may be broken up by 
just the fact of the market working. And then we move on, and 
the economy is healthier as a result.
    Senator Brownback. And you have been a bank regulator. You 
have been through all of this. You have seen this happen now a 
couple of cycles in your professional career, whether it was 
through the thrifts or the Continental Illinois or much of the 
crisis we had in the Midwest in the eighties. This is not an 
unknown cycle.
    Mr. Hoenig. This is not--this is not a cycle that is--this 
is a cycle that has been experienced before, only now the sizes 
are greater because of the growth in these largest 
institutions.
    Senator Brownback. The rub for me--I am sorry to cut you 
off, but time is limited--the rub is, people say that will take 
the economy on down further, and that you would get into a spot 
where you cannot recover in any near-term time frame, if you do 
that with one of these four entities that have a trillion in 
assets or more.
    Mr. Hoenig. I don't buy that for the following reason: that 
if you address these issues and deal with them, then I think 
the economy--it takes a certain degree of the uncertainty out 
of the economy, so people know where things stand.
    One of the things that happened in this lost decade of 
Japan that people talk about is they didn't step up to the 
problem and deal with it, and it went on. People didn't know 
where the problems were. They didn't deal with the banks, and 
things spiraled down. That is what we risk here unless we take 
on and address these issues and allow ourselves clarity, and 
then the economy can move forward.
    Senator Brownback. Dr. Johnson, do you agree with Dr. 
Hoenig on this?
    Dr. Johnson. I absolutely agree. And I think the example of 
Japan is the right one. There is, I think, sometimes a human 
instinct to draw back from dramatic actions. That is the 
dangerous, expensive thing, but that is not the case for all 
our--all the things we encounter in life. And it is certainly 
not the case with banking. And I think Japan in the 1990s is 
fascinating because----
    Senator Brownback. I am going to cut you off because I am 
going to get cut off. Dr. Stiglitz, do you agree with Dr. 
Hoenig?
    Dr. Stiglitz. Yes, absolutely. There are risks with any 
strategy, but you have to balance those risks.
    Senator Brownback. You don't believe this will tank further 
the United States economy at this point in time?
    Dr. Stiglitz. Absolutely not.
    Senator Brownback. Do you believe it is the route out for 
the U.S. economy at this point in time?
    Dr. Stiglitz. That is right. Absolutely. The point is, 
there is complete confusion between too-big-to-fail and too big 
to be financially restructured. The issues of conservatorship 
that Mr. Hoenig mentioned are a form of financial 
restructureship, it has been done in other countries, such as 
Sweden.
    Senator Brownback. And we can do this and the ATM still 
works when people step up to the ATM, or the credit card still 
functions across the society?
    Dr. Stiglitz. They are likely to work better than under our 
current system. I will share a joke. One of my friends said 
that when he went into one of the big banks and put in his ATM 
card and it said insufficient funds. He didn't know whether it 
was his account or the bank. I think that is the kind of 
uncertainty that we have right now.
    Senator Brownback. Let me back up to Dr. Hoenig. Thank you, 
Chairman, for giving me more time.
    What if it is two of the four that we have to go through 
this with and the government has to go in and basically do what 
we do with any other bank, which is you take it over, you clean 
it up, you peel off assets, you try to sell it. Or if you can't 
sell it, you sell pieces. Or if you can't do that, it is 
closed. I mean, you are talking about now $2 trillion in assets 
that is going to be being run through a system that is normally 
used to dealing with banks a hundredth that size.
    Mr. Hoenig. Senator, if the loss is there, the loss is 
there. What I am suggesting is you take it into a 
conservatorship and much of the--many, most of the employees 
would continue to work there with oversight from the FDIC, or 
the party, and with the new management perhaps, and probably 
new directors, that then adds the capital because the losses 
are there. You have to address that. So what I am saying is, 
here is a systematic way to do that.
    Chair Maloney. Will the gentleman yield?
    Senator Brownback. Yes.
    Chair Maloney. How long would you see them in a 
conservatorship? Would you see it for 5 days, 2 weeks, a year? 
How long would you see it?
    Mr. Hoenig. It probably would be years, as Continental was 
when it was taken over. It was managed. They broke it into a 
bad bank so they could liquidate the assets, left the 
franchise, the good bank, what they called, where it had a 
franchise to build up, and then that allowed them--because it 
takes a different kind of mentality to liquidate an institution 
than to build it up. So they had it separated--with oversight 
from the FDIC. And they ran it for some years. And then they 
reprivatized it and made--actually sold it above the stock 
cost.
    Chair Maloney. I yield back.
    Senator Brownback. Thank you very much. And thank you for 
the sudden--I just want to make sure that we are on this point, 
that this isn't further disruption in a weakened economy that 
we already have. And you believe, and all of you believe and 
know that this it actually the route out. And I believe you 
even cite to the Swedish example and the lost decade in Japan 
as the way not to go with this.
    A final quick question if I--I thought I had 28--all right. 
I thought I had 27 seconds here. This is--do you support the 
commission idea that Dr. Burgess put forward, Dr. Stiglitz? Do 
you think it is a good idea? Just a real yes or no.
    Dr. Stiglitz. Yes. I think we need to have a comprehensive 
review of the economic----
    Senator Brownback. Dr. Johnson, do you----
    Dr. Stiglitz [continuing]. Politics that led to it.
    Dr. Johnson. I think it is essential.
    Senator Brownback. Sorry. Thank you for your forbearance.
    Chair Maloney. Thank you so much. These are critical issues 
and we have very important panelists. We are going to be very 
lenient on time so we can get a cross-section of all the 
panelists' responses to the issues. Mr. Cummings is recognized.
    Representative Cummings. Thank you very much. Gentlemen, I 
want to thank you for your outstanding testimony. And the thing 
that I guess I am concerned about is we are putting all this 
money in these banks and where the rubber meets the road is on 
my street. And a lot of people can't get loans. And one of the 
things that also concerns me is that when we do these 
measuring--we use these measuring tools as to whether the 
economy is going in the right direction, it seems like we base 
it upon what is happening on Wall Street. And that is all well 
and good, but the people on my block, they are concerned about 
the foreclosure rate, they are concerned about the job losses, 
they are concerned about consumer confidence. And sometimes I 
wonder whether gearing so much towards the investor class puts 
aside the pain and the hurt that is going on in the 
neighborhoods. And so recent reports indicate that even the 
largest recipients of TARP aid have not increased and in some 
instances have decreased their lending. Should more be done to 
require that banks increase lending and it is also interesting 
that even these banks that just showed enormous profit use 
every excuse under the sun to say that it is really not profit, 
that it is something else, while people are losing their houses 
and credit cards are becoming more expensive to use and things 
of that nature.
    I just want your comments on that. Dr. Stiglitz?
    Dr. Stiglitz. First, going back to the conservatorship 
model, one of the key points is that with new management and 
new incentives, we could try to induce financial institutions 
to work in ways that are more consistent with the national 
objective. You are absolutely right that what is good for Wall 
Street may not be good for the rest of the country. They are 
focusing on very narrow objectives: the survival of the bank, 
the maximization of bonuses, and the maximization of their 
dividends and the share price.
    Representative Cummings. And these are people that have 
already been paid and people who lost money and took my 
constituents' savings that they will never get back.
    Dr. Stiglitz. Exactly. Now, one of the important questions 
is, do we want to throw good money after bad, down the drain, 
which is what we have been doing, or do we want to have the 
money that the public is spending going forward? Part of going 
forward is to say, okay, there may be some risks associated 
with new business lending, because we don't know how long this 
economic downturn is going to last. We could come up with 
creative ways of sharing the risk of lending in order to make 
sure that there are incentives for good lending practices and 
that the banks understand the loans are not their 
responsibility but the government's responsibility, if we have 
a recession that lasts for 3 years. We can do a better job of 
risk sharing that will enable the banks to be comfortable about 
restarting lending. Right now it is perfectly understandable 
why the banks aren't doing that, because what they see is a 
recession going as long as the eye can see, with nothing 
effective being done to deal with the underlying problems of 
our financial system. Why would you want to lend? We haven't 
even done what the U.K. did when they took over their banks. 
Admittedly, they have a much worse problem, because they let 
their banks grow even more too big to fail. However, when the 
U.K. gave money to their banks, they insisted on having more 
control, and they tried to create frameworks that would provide 
organizational structures to induce more lending. Now, even 
with these steps it has been very difficult, but the point is 
they were very aware of the need to get more lending, and it 
wasn't just lecturing the banks. They actually tried to create 
institutional structures to motivate that greater lending.
    We have said we don't want to have any control, that we are 
going to give banks money and don't even want to trace where 
the money has gone. We said, we just trust you. If you want to 
spend those dollars that we are giving you as dividends and 
bonuses, we trust that you are going to use the money the right 
way. We know now that is the wrong answer.
    Representative Cummings. Dr. Johnson.
    Dr. Johnson. We almost have the worst of all worlds. As Dr. 
Hoenig said, there is massive uncertainty about the future and 
the banks are very uncertain about what is essential 
investment. As Professor Stiglitz said, these banks have got 
distorted incentives. And putting more money in this top 
fashion does nothing to address those problems. That is why I 
think all three of us are calling for a more comprehensive 
systemwide approach, do it now, do it in a somewhat more 
dramatic fashion but get beyond this.
    And then I think--and also I would emphasize breaking up 
the banks. If you had smaller, more competitive banks, they are 
going to be looking for people to lend to where the lending 
makes sense. I would add, though, two provisos to this. First 
of all, I think your issues around housing are absolutely 
critical and need to be addressed. And one of the problems we 
are going to see more and more, as people lose their jobs, even 
if the Fed is able to bring down mortgage rates, people will 
not be able refinance because they won't qualify for the 
refinancing. So they are going to be hammered because they lost 
their job and they are going to be stuck with this high 
interest rate, so they will lose the house as well as losing 
the job. That is a disaster. But that has to be addressed 
through housing policy, and I think some of the 
administration's moves in this direction are good. I would 
actually support doing more in that direction so people who 
have been----
    Representative Cummings. Like what? Like what? You said 
more in that direction. Did you have any----
    Dr. Johnson. I think you have to facilitate refinancing of 
mortgages. People who have lost their homes are not going to 
qualify for new mortgages under existing rules. But that is 
part of what is going to drive them into bankruptcy and they 
are going to lose their homes. So we have to look at the ways 
in which those--refinancing is possible based on your income 
stream and the probability you are going to get rehired.
    It is a complicated issue. It is an issue of support for 
Main Street versus Wall Street, which I think is your other 
point. And in addition, I would stress there is going to be 
deleveraging. We became very highly indebted as a society. And 
we know there was excessive credit creation because of the 
incentives of the banks to take on these massive risks. So if 
we could move to a system I think the three of us would more 
broadly support, that is likely to be a system with less 
lending and less credit. Let us be honest, that would also come 
with some pain. That is part of the adjustment process and 
unfortunately it is coming out of the system we have created.
    Representative Cummings. Thank you, Madam Chair. I see I 
have run out of time.
    Chair Maloney. Thank you. Congressman Burgess.
    Representative Burgess. Thank you. Dr. Johnson, just 
briefly, I want to stay on that last point on the mortgage 
lending HOPE for Homeowners was passed last fall. It apparently 
was misnamed. It should have been singular homeowner, because I 
don't think we have helped very many people. So it just seems 
that when we at this end try to get into that business we don't 
really do anyone any favors. I am concerned, having lived 
through the S&L meltdown in the late 1980s in the State of 
Texas, that as it seemed like we were beginning to get past 
that, it was almost impossible to get credit. And I am thinking 
back in terms of running a practice and being a small 
businessman. Many of our banks were taken over by the--I think 
it was the North Carolina National Bank that had the 
unfortunate initials that also read ``no cash for nobody.'' And 
we just couldn't get loans.
    So looking forward, as we emerge from this, how do you keep 
that credit from being so tight in an environment where 
everyone is worried, the borrower and the lender both?
    Dr. Johnson. It is obviously going to be a problem. We are 
clearly facing a credit contraction. There is a big recession 
and we have not yet turned the corner. I am not trying to sugar 
coat it for you at all. But I think if you had a more 
competitive banking system, it is the smaller players--for 
example, North Carolina, South Carolina has some very strong, 
smaller banks, regional banks, or I guess you can call them 
local banks, community banks. The diversity of size in the 
American bank system is at this point an advantage. I am not 
saying those banks are without their own risks. They do have 
exposure to commercial real estate, for example, and I don't 
think we have necessarily turned the corner there. But I think 
one big advantage of breaking up the larger players is that it 
is going to even the playing field. And If you talk to the 
community bankers, they complain a lot and with good reason 
about the behavior of the biggest banks.
    Representative Burgess. A lot. We will stipulate a lot.
    Dr. Johnson. I think much of it is with good reason. And 
looking back, I think you can see that they were right in some 
points that previously were--maybe we just thought were 
contentious. So moving towards a more competitive banking 
system is going to help address exactly your issue. If there 
are good loans to be made--and this also addresses Professor 
Stiglitz's utility model--that we are not looking for the bank 
system to take on outrageous risks. We are looking for them to 
look at credit scores, to make a sensible assessment of your 
income prospects and to land on that basis, make banking 
boring. Boring banks would lend to the kinds of small 
businesses that you are talking about.
    Mr. Hoenig. Can I just add one comment? I want to emphasize 
for both that it is important--we are in a recession and people 
are going to pull back, both the largest lender who is trying 
to conserve capital, but I would also remind you there are over 
7,000 community and regional banks across the United States. 
And they are, I would say, willing to make loans, but they are 
also looking at this recession and being more cautious.
    The other part of this, for the consumer, the person on the 
block, one of the things we found in our working with our 
different communities around our region is that there is a real 
absence of knowledge on that consumer's part. And one of the 
biggest steps I have seen is some of the work that these 
counseling, HOPE Now and so forth, have done to educate and 
then to work with them to get them through this. That is 
proving as helpful as anything else we have done, and I think 
the banking system, the community banking system across the 
country then will be in a position when confidence begins to be 
restored and we begin to address these issues around too big to 
fails and other to provide loans across this country. That is 
this country's big advantage and that is having banks 
throughout all these communities able and willing to make 
loans. That will come back too, I am confident.
    Representative Burgess. I would obviously just echo that in 
the conference calls that I have with my community bankers and 
credit unions back home. That is exactly the sentiment that I 
am hearing.
    Let me just--I want to go back to what Senator Brownback 
was talking about and the concept of--that doing some of these 
things that we are talking about, the antitrust and the 
breakups of large institutions and not cause further disruption 
of a weakened economy, just temporarily go--let us go back 6 
months, and I did not support the TARP legislation when it came 
through either time in the House of Representatives but--and I 
wasn't privy to any of the conversations that went on in the 
White House, but I can just imagine being faced with the 
staggering losses that they were looking at. Was this an 
unreasonable assumption that they made, that the TARP funding 
was necessary to put in place to keep the system from entirely 
collapsing? Or should, in fact, we have just let these 
institutions fail and continue to fail and things would have 
worked themselves out? Was the TARP decision an unreasonable 
decision that was made at the time? I did not vote for it, but 
looking back at it I have to wonder if it wasn't the right 
decision at that time.
    Dr. Stiglitz. Let me say that there were a lot of problems 
with the structure of TARP, and I will come to that in a 
second. I think that at least some of the people that were 
pushing TARP originally were absorbed in a fiction. They 
thought that if you just announced that you were giving a lot 
of money, confidence would stabilize, prices would be restored, 
and we wouldn't actually have to spend the money. I thought 
that was a total fiction. We had a bubble, and many of us saw 
the bubble coming. The bubble had broken, the losses were 
there, and the question was who was going to bear the losses 
and how do we restructure our financial system. That is where I 
thought our intentions should be.
    Representative Burgess. I don't mean to interrupt. Let me 
ask you, then, so at that point would it have been better to 
let those banks fail and go through the process that was gone 
through with the savings and loan melt down in the 1980s?
    Dr. Stiglitz. Yes. When I say fail, remember what I said in 
my testimony which is we have to distinguish between too big to 
fail and too big to restructure. They should have been 
restructured in the kind of conservatorship that Mr. Hoenig 
talked about. That is where we should have allocated money, 
because with TARP it will likely be necessary to put in more 
money. If the burden had been placed on the bondholders, the 
amount that the Federal Government would have needed to put in 
could have been much less, and therefore the Federal 
Government's balance sheet in 10 years time would be much 
better.
    Representative Burgess. If some incorrect assumptions were 
made last fall, are we at risk now of institutionalizing those 
incorrect assumptions as we go forward and continue to put 
money into this system without allowing those banks to actually 
seek their new level?
    Dr. Stiglitz. I think we are continuing to lose more and 
more money. We are distorting the structure, and we are not 
taking this opportunity to begin to think about what kind of a 
financial system we want to create. That was the beginning of 
my testimony. I think that is absolutely right, that we really 
now ought to draw the line in saying where do we want to go 
from here and are we reinforcing a failed system, rather than 
creating a new system at very great cost to our future.
    Representative Burgess. So it is not too late to draw that 
line?
    Dr. Stiglitz. No, I made that very clear. It is not too 
late to draw the line, although it would have been better if we 
had done it earlier.
    Chair Maloney. The gentleman's time has expired. Senator 
Risch.
    Senator Risch. Mr. Johnson, the takeaway I had from your 
testimony is compared to the European banks we are actually 
doing pretty good here as far as the size of the banks. Your 
comments?
    Dr. Johnson. We are doing badly, but we are doing better 
than the Europeans. That is exactly my assessment.
    Senator Risch. I would like to hear the answer from Mr. 
Johnson and Mr. Hoenig to the Congressman's last question about 
the TARP. Was it a good idea or a bad idea in summary? Dr. 
Johnson?
    Dr. Johnson. I think you had to come in to support the bank 
system. What we should have done is something much closer to 
what Dr. Hoenig is now proposing, with recapitalization, with 
conservatorship where appropriate with additional private 
capital where that could be raised, and we would now be 6 
months further through the process of turning the economy 
around. Actually, I think we should have used the same measures 
that Dr. Hoenig was talking about back when Bear Stearns 
failed. Then we would be a year through the process. And it is 
now a matter of public record that the International Monetary 
Fund, when I was working there, did make those suggestions to 
the U.S. Treasury. The U.S. Treasury, of course, saw fit to 
proceed otherwise.
    Senator Risch. Of course when Bear Stearns failed, things 
were not bad enough that politically anybody could have gotten 
away with what you are suggesting.
    Dr. Johnson. But that is exactly--perhaps that is true and 
that is the line being taken by former Treasury officials. I 
recognize that. But on the other hand, that was the perfect 
time in which to do this kind of restructuring and 
reorganization. I think there was a persistent 
misunderstanding, as Dr. Stiglitz has emphasized, that the 
Treasury kept saying it is just a liquidity problem, we will be 
able to get through it through liquidity measures. It is not a 
liquidity problem. It has been recognized by outsiders at the 
G-10 level of international officials--I can tell you, many 
people were telling the United States you are not looking at--
for 2 years, my personal experience is they were telling the 
United States at the highest level, this is not a liquidity 
problem you are facing, it is a solvency problem. Solvency 
problems are addressed very differently. They are addressed 
using the kind of approach that Dr. Hoenig has laid out for 
you.
    Senator Risch. I understand what you are saying, but of 
course none of those people have to go out and get elected 
either.
    Mr. Hoenig, your comments, please.
    Mr. Hoenig. I would agree that on Bear Stearns in 
hindsight--but that passed. But I think with the TARP and the 
amount of money that was being discussed and eventually passed, 
my comment was at that point, you think about how you are going 
to create a system or a process or a structure around that so 
that you allocate those funds most effectively. That was the 
opportunity to do that. And I think it is an opportunity that 
we should not pass by again.
    Senator Risch. I appreciate your comments, but don't we 
have to give just a little bit of slack to those guys in the 
fact that they had a real gun to their head at the time they 
were trying to structure this mammoth $700 billion we were 
talking about? Is that a fair statement?
    Mr. Hoenig. I think that that is correct. I think it was 
very, very stressful and we had a lot at risk. But at the same 
time, think of the amount of money that we had--we were talking 
about. We need--whenever you are going to do something like 
that, you need to have the--and it wasn't like we didn't have 
experiences like Continental, like the Swedish model. That is 
all I am saying. I don't dispute the fact that you had to 
have--that losses were there and you had to address those 
losses. But you wanted to do it in a systematic fashion and 
also as you work through it a way that would allow you to have 
these largest institutions in effect fail in terms of the 
stockholders taking the loss as part of the process.
    Senator Risch. Thank you. Thank you, Madam Chair.
    Chair Maloney. Thank you very much. Thank you. I would like 
to ask all of the panelists, in regulating large financial 
institutions, should we have a list of systemically significant 
institutions, a systemic regulator or should we have rules that 
apply to all institutions that get tougher with more intense 
oversight as institutions get bigger and more interconnected? 
And related to this, where should responsibility for regulation 
lie? Many think with the Fed. Could all of you comment on this? 
We will go down the line, beginning with Dr. Stiglitz.
    Dr. Stiglitz. I think it is very clear the second approach 
is what is required. The fact is we can't tell ex ante who is 
going to be systemically significant. No one would have 
classified AIG as such until afterwards. However, if we have a 
comprehensive framework that includes all institutions, with 
more intensive oversight of those that are clearly systemically 
significant while also having oversight and regulation of 
everything, including in all of the areas that I talked about 
in my testimony, including incentive structures and leverage, 
then we are in a much better position to see what is going on 
and to deal with the problems before it is too late.
    One of the problems is, in a dynamic economy, somebody who 
is not systemically significant can within a year or 2 become 
systemically significant. AIG was not systemically significant 
4 or 5 years ago. The operations of one row group in London 
made it systemically significant. So you have to have 
comprehensive regulations. In terms of who should do it, I know 
Mr. Hoenig may disagree with me on this, but I don't think the 
Fed did a wonderful job in the run-up to this crisis. I think 
it failed to use the regulatory powers that it had. I put major 
responsibility on the investment banks, for excessive risk 
taking in the securities markets, but the Fed had an oversight 
role that it didn't perform. The conclusion that I reach from 
this is that we need to have an array of institutions. One of 
them is the Financial Products Safety Commission, which should 
not be in the Fed. It needs to be an independent organization 
with a greater focus on the concerns of those who might lose 
money if things go badly, as opposed to those who are making 
money when things are going well. I think that is a basic 
principle. We also need to have a financial stability 
commission with oversight of the system as a whole, in terms of 
the stability of the whole economic system, and I think that 
needs to be independent of the Fed. The Fed is focused on the 
banking system, and our modern financial system includes a lot 
of things that are outside the banking system explicitly, such 
as insurance and so forth.
    Chair Maloney. Dr. Johnson and Mr. Hoenig, in other words, 
you do not believe that a systemic regulator is enough, you 
should regulate everything across the board?
    Dr. Stiglitz. That is right. The Fed is an important 
component focusing on the banking system. They all need to talk 
to each other. It is absolutely essential to have a framework 
in which there is coordination. You can't have double 
standards: regulation should be according to what they do, not 
what they call themselves. That is an important principle. But 
there are advantages of knowing about banking, which is what 
the Fed does, and advantages of knowing about insurance, for 
which we need an insurance regulator. You need to have 
something that comprehensively includes everything.
    A couple of countries have tried to have this approach, 
combining both comprehensiveness and specialization.
    Chair Maloney. Any other comments from the panelists?
    Mr. Hoenig. Let me just say a couple of things. To answer 
your first kind of in reverse order, no one did a particularly 
stellar job in supervising these institutions. And that is the 
Comptroller, the FDIC, SEC or the Federal Reserve. And part of 
that is, if you think about it, we changed--we had an 
environment where deregulation was the watchword. And you went 
forward with that. You had these very large institutions, and 
we in a sense allowed ourselves to think that sophisticated 
methods of financial transaction was a substitute for 
fundamental principles. And so that is I think one of the areas 
we need to focus on.
    As far as financial stability regulator, the Federal 
Reserve in one sense is, if we have the financial stability, we 
have responsibility for macro policy, the financial industry 
and so forth. I am less enamored with the idea of a financial 
stability regulator for the very reason that these institutions 
got too big. They couldn't manage the breadth of all these 
activities. I don't see where you are going to get the 
expertise, that one institution is going to be able to tie all 
this together. It is based upon having people understand the 
business lines that they are involved with. As to how you 
regulate, I think whether you are the largest or the smallest, 
there are fundamental principles that we need to--if we do a 
commission--need to look at and reestablish this standard. One 
is what is the leverage that you should have. If you have an 
institution that has a 30 to 1 leverage ratio, assets to 
equity, it is going to have more risk and be more subject to 
failure than the one that has 10. So that is where you spend 
your resources. If you have underwriting standards that allow 
for loan to value ratios to be over 100 percent, that is where 
you ought to be spending your attention and they should be 
paying more for--they should have more capital and they should 
be required to have more capital.
    We need to establish very clear standards, financial 
standards, for these firms so that we do not see this repeated. 
And in the good times, which will return, we don't start 
shaving those back as we try and leverage up and make more 
income.
    And finally, the process should be look at the financial 
strength and then there needs to be a clear resolution process 
so that if they do fail, they are resolved.
    Chair Maloney. Thank you. My time has expired. Senator 
Brownback.
    Senator Brownback. Thank you very much, Chairwoman. I won't 
be so long.
    Dr. Johnson, do we still have a solvency problem as a 
nation? I think I know the obvious answer to that, but I want 
to hear yours?
    Dr. Johnson. You are asking about consumers or the 
government level or the banking----
    Senator Brownback. I am talking about the total debt 
structure of the United States. You said--we were telling you--
we were saying to the international bodies that we just have a 
liquidity problem and the international bodies were saying to 
us, no, you have a solvency problem. And I want to know your 
thoughts, whether we still have that solvency problem from the 
statements and the factual setting that they were originally 
said.
    Dr. Johnson. Those statements were specifically about the 
banking system having suffered losses. So they had bad loans 
rather--and the loans needed to be written down, so they had 
assets that were below the value of their liabilities. That is 
a solvency problem for the banking system, not a liquidity 
problem, which was the position----
    Senator Brownback. Do you believe we still have a solvency 
problem today?
    Dr. Johnson. Yes, absolutely. And that is what the 
numbers--the IMF numbers which were produced by a different 
team than the one I directed when I was at the IMF have been 
very reliable throughout this situation. You take the numbers 
released today and apply them to the United States. It is 
available in their detailed breakdown. And you compare that 
with the amount of capital that has been raised. We are in 
better shape than the Europeans, it is true, but we are not in 
good shape. There is still a solvency problem in the U.S. 
banking system, particularly presumably among the larger banks. 
And this is where Mr. Hoenig's suggestions I think line up 
absolutely with what the IMF would suggest to the United 
States.
    Senator Brownback. And this is even with all the money that 
the Federal Government has put into these big banks, we still 
have a solvency problem?
    Dr. Johnson. Yes, that is correct. That money has addressed 
part of the problem, but there is still a solvency gap that 
these banks are facing. And I think the government strategy is 
one of forbearance. They are hoping that the economy will 
recover, that the banks will make sufficient money to close 
that gap. And it did work in very different circumstances in 
the early 1980s for some banks. I don't think it is appropriate 
for today's circumstances. I don't think it is working, and I 
don't think it is going to work.
    Senator Brownback. Dr. Hoenig, you are a President of the 
Federal Reserve, a man in good standing. You have done that for 
a number of years. You must talk to your colleagues at other 
Federal Reserve banks. Do they agree with your prescription 
here?
    Mr. Hoenig. Some do and some are, I think, more of less, 
trying to bear through this. So it varies. I think that is the 
advantage of having 12, you get different opinions to come 
forward to the solution. But not unanimous.
    Senator Brownback. Thank you. Thank you, Madam Chair.
    Chair Maloney. Congressman Cummings.
    Representative Cummings. Yes. Dr. Stiglitz, you have 
written about the shortcomings of TARP and you also commented 
that a particular mindset among Treasury officials led to the 
choice of this policy. Do you think that we as a nation have 
simply been unable to change our fundamental paradigms of the 
market and therefore are infusing funds rather than requiring 
fundamental changes or compelling shareholders to accept losses 
they would have had to incur had the government not intervened 
in the way they have?
    Dr. Stiglitz. I think unfortunately it is because so much 
of this was controlled by people who did not approach it from a 
mindset of the every part of financial markets, because the 
financial markets are more comprehensive. Community banks are 
also part of the financial markets. A very narrow part of the 
financial markets were the big banks, and they tried to shape 
the view that there is no alternative other than giving them 
massive amounts of money, because it would be too risky to go 
the conservatorship approach. Politically, had either the Bush 
administration or the Obama administration come to the American 
people and said, here is a model that has worked in Sweden, and 
in America over and over again, which is actually the less 
risky model because it is tried and true, I think Americans 
would have supported that more than they have the TARP, which 
had a lot more political risk and hasn't worked very well.
    Representative Cummings. I want you all to comment on this 
question. Dr. Stiglitz, you are were reported as commenting in 
recent days that this new public-private partnership plan will 
enrich investors while requiring taxpayers to bear losses. You 
previously have said this is tantamount to robbery of the 
American people.
    Can you elaborate on your comments and explain what level 
of losses you think taxpayers will bear from the implementation 
of the public-private partnership program? And I am sure you 
may be familiar with the IG's opinion that came out at midnight 
last night, Mr. Barofsky, where he commented on--he had some 
criticism of the plan. But would you all comment, please? We 
will start with you and then go.
    Dr. Stiglitz. Let me try to be fairly brief. It is a very 
badly designed program. It was mentioned in the introductory 
remarks that this is a very peculiar partnership where the 
private sector puts up 8 percent of the money and yet can walk 
off with 50 percent of the profits, and the taxpayer puts in 92 
percent of the money and takes the brunt of the losses. 
Moreover, because we bear the losses, it leads to perverse 
incentives that actually may make it more difficult to resolve, 
for instance, some of the bad mortgages. There is an incentive 
to delay resolution of mortgages because if there is a chance 
that things might get better, which hopes, then the banks get 
to keep the gains. If in the more likely outcome things get 
worse, the FDIC and the government bear the brunt of the 
losses. So it actually impedes the resolution of some of the 
underlying problems in the mortgage market.
    Representative Cummings. Dr. Johnson.
    Dr. Johnson. I agree completely, but I also think it won't 
work. I think that both--the banks are already indicating they 
won't participate because they think it will come with 
restrictions. They want their bonuses back and they want that 
compensation right back the way they were before. And I think 
the government is rightly going to balk at that and so there is 
a problem there. And the hedge funds and other entities who are 
supposed to come in and buy even though it is potentially for 
them a fantastic deal, as Dr. Stiglitz has outlined, again they 
are not going to want the potential of sensible legitimate 
restrictions on various things they may and can do down the 
road.
    So I think the scheme is not going to work, in addition to 
being a bad idea.
    Representative Cummings. Mr. Hoenig.
    Mr. Hoenig. Yes, I have talked to different parties that 
would be considering this and there are concerns from both 
sides. First from the bank side, this assumes that the losses 
have been taken because if you have toxic assets you have to 
write them down. If you think somebody is going to buy them at 
more than they are worth, you are wrong. So you have to take 
the losses. If that is the case, then the gain to the other 
side is pretty significant, subsidized by the government. And 
they are very reluctant because they know if they make 
substantial gains, we have very strong backlash to that. So it 
does have issues that I think still have to be worked through 
if they are going to go forward with this.
    Representative Cummings. Thank you, Madam Chair.
    Chair Maloney. Congressman Burgess.
    Representative Burgess. Thank you. Dr. Stiglitz, you have 
talked about or written about the revolving door that exists 
between Treasury and Wall Street. Does that continue to be a 
problem? Is that something that should continue to trouble us 
here in Congress?
    Dr. Stiglitz. Yes, very much so. Let me emphasize, it is 
not just the question of whether there are explicit promises. 
It is a question of mindset. If you have spent 20 years in one 
of these big banks, then spend 4 years in Washington and go 
back and spend another 10 years in one of the big banks, what 
is your mindset, how is the way you think about the world 
shaped? We have different people that see the world in 
different ways, but they see things in this very peculiar, very 
insulated way. We have seen some outstanding examples of that 
in this crisis.
    There is another problem, which is that it undermines 
public confidence. When the public sees somebody who has been 
in one of the big banks join the government and rewrite a law 
or do these other things, you hope it reflects his best 
judgment. However, if it comes out to benefit the private party 
at the cost of the government, there is an undermining of 
confidence in our democratic political processes. It is made 
all the worse when there are these magnitudes of, quote, 
investments, public contributions and campaign contributions. 
The inference is these guys know how to manage their 
investments: they invested in government, and they got a high 
return.
    Representative Burgess. Let me ask you a question because 
on the previous line of questioning, we were talking about, you 
know, is it too late to draw the line and you said it was not. 
And to move into a newer system. Do you think the current team 
that is in place is capable of doing that, of reversing course, 
drawing that line, and moving into the new regulatory system 
that you described?
    Dr. Stiglitz. I think reform is possible for anybody, but 
the question is, is it likely. I don't want to make a judgment 
about that.
    Representative Burgess. I guess I don't either. So let me 
move to Mr. Hoenig and ask you a question. I was really taken 
with your testimony because again I lived this in the late 
1980s in Texas. The savings and loans imploded. Energy prices 
plummeted. Real estate prices went away all overnight and left 
all of us in pretty terrible shape. I don't know if it was that 
way all over the country, but it sure seemed--my world 
collapsed and collapsed around me. I didn't think the sun would 
ever shine again. And by doing the right things or what 
appeared to be the right things at the time, and it was very 
painful and cost many of us some aspects of our savings and our 
business, but as a consequence we got through it and then the 
number of years of prosperity that followed were that was a 
sustained period of growth that really I never would have 
expected we can emerge from that crisis and see that type of 
growth. Now, one of the--I know one of the techniques that was 
described to us by the former Chairman of the Federal Deposit 
Insurance Corporation, Bill Isaacs, when he came and talked to 
our policy committee last fall and he talked about things like 
the mark-to-market and the net worth certificate and the things 
that they had done back in the 1980s at the FDIC to get through 
this, were those tools, were they applicable to the situation 
last fall or was the problem just simply too large to be 
handled by that type of activity?
    Mr. Hoenig. Let me just start by saying what you described 
was around the country and our region between 1982 and 1992 I 
was involved in almost 350 bank failures, each a strategy. All 
hurt the community. We did get through it. Many of those banks 
were closed or sold with the shareholders losing all. And in 
those larger institutions, in that crisis, and the methods that 
Bill Isaac described to you, they could--they can still work 
today. And Continental is the best example, where you have--now 
it is a negotiated transaction, when you know you have an 
institution that is in dire trouble as Continental was, but it 
did work. And those things can work today. Yes, the scale is 
larger, but the process and the techniques I think are 
applicable.
    Representative Burgess. And again my recollection at that 
time was painful, but then things got better and they got a lot 
better and they got a lot better for a sustained period of 
time.
    Mr. Hoenig. Correct.
    Representative Burgess. I worry about whether or not we are 
setting the stage for a suppression of that growth that 
otherwise might follow from this period of deleveraging or 
recession.
    Mr. Hoenig. We have to address the issue so that we can 
begin the healing process and then begin to grow again.
    Chair Maloney. Thank you. Senator Klobuchar.
    Senator Klobuchar. Thank you very much, Madam Chair. I have 
to get used to these things on the House side. There we go. I 
am sorry I missed your testimony. I have this single Senator 
thing going in Minnesota. There are a lot of things to do. But 
I just want to let you know I appreciate this. Sounds like a 
very interesting discussion, even coming in at the tail end 
here. My focus is on just a few things.
    One is that we have a number of healthy banks in Minnesota, 
our community banks. U.S. Bank has been doing well. Wells Fargo 
has a big presence. We have the biggest bank that is returning 
their TARP money, Twin City Federal. And I wrote a piece for 
the Washington Post about this, how they were all affected when 
the stress test announcement first got made in terms of--I 
likened them to standing in the heartland with their feet 
firmly planted in the ground with their sensible midwestern 
brief cases with credit default swaps swirling around them like 
a cyclone saying Toto, we are not in Kansas anymore. So I 
appreciate the understanding that there will be differences 
with the banks.
    The second focus I have is on the regulatory piece of this, 
which is the--how we best go forward in terms of regulating. 
And I know the administration is really interested in this. And 
one of the questions I would--just with the different types of 
regulation we have now with the SEC being a disclosure based 
system, the Federal Reserve placing a premium on 
confidentiality, what is the best way to try to regulate these 
financial institutions when you have the regulations set up to 
be separate lanes and they are all crossing back and forth like 
a superhighway?
    Anyone can take it if you would like.
    Mr. Hoenig. Let me start because it is an area I am 
familiar with. In my testimony, Senator, I said let us diagnose 
this correctly and the issue of the Comptroller of the Currency 
or the SEC with its mission and so forth, and starting with 
that is having been broken is not the place to start. The place 
to start is what should be the standards of behavior in terms 
of financial principles and rules that we are going to hold the 
institution accountable for adhering to and hold the regulatory 
authority for enforcing. So that we--if we have leverage 
standards in the good times, we don't say well we don't need 
those anymore, they are firm, they are going to go through. If 
we have underwriting standards and we expect you to have loan-
to-value ratios that make sense, we expect when we see this 
material that there is a cash flow that actually services this 
loan, that we would hold you accountable for having that and 
hold the regulator accountable for enforcing that and if it is 
a disclosure issue, then that is the purview of the SEC, that 
in fact they do disclose appropriately. That where we need to 
really I think focus going forward to reestablish those--you 
know, it is interesting, those fundamental principle, we talk 
about the new world we are in, but those fundamental principles 
are as applicable in the 21st century as they were in the 19th. 
They involve prudence and standards that we have to abide by, 
diversification and so forth. And that is what happens.
    Senator Klobuchar. Dr. Johnson.
    Dr. Johnson. I have been arguing I think exactly the point 
that you made at the beginning, which is it is a good thing 
Minnesota didn't have just a few of these massive banks running 
the banking system. Having a more diverse system, having a more 
competitive system is absolutely essential. I am in favor of 
better regulation of behavior, as Dr. Hoenig laid out, but I am 
afraid that we have seen time and again, all our regulators, 
particularly around big finance, get captured. Not in any 
corrupt type of way, but in a mindset way. They come to believe 
that these clever innovations, the new derivatives or the way 
mortgage lending is being handled is somehow better and 
different. And if you think what we have in this country is 
bad, go look at Europe where they have big integrated 
regulators full of sophisticated, smart people who completely 
fell for this in a much bigger scale.
    So I think having a super regulator is fine, but you have 
to break up the big banks. And I am not naive. I, of course, 
understand that the community banks can get together and 
subvert a regulator. Okay? You have to be aware of this problem 
always. But having four or six or eight titans of finance is 
really asking for trouble. And assuming that the regulator will 
be able to control their behavior I think really doesn't fit 
with the historical record in this country or elsewhere.
    Senator Klobuchar. Dr. Stiglitz.
    Dr. Stiglitz. I agree with everything that has been said so 
far, but I would like to add a few other things. First, 
transparency disclosure is absolutely essential, but it is not 
enough. You have to go well beyond that.
    Secondly, any regulatory approach has to be comprehensive, 
because otherwise bad behaviors will always result from holes 
in the system. You need to have detailed institutional 
knowledge, and that is why you need to have somebody who knows 
securities markets and banking systems. Our financial system is 
very clever, and it will find the hole, the weakest part of 
that system. You have to have both a comprehensive approach, 
and very institutionally based approaches.
    Thirdly, you have to include not only restrictions on 
behavior, like excess leverage where there ought to be 
cyclically adjusted standards, but you also have to affect 
incentives. You can't allow core banking institutions to have 
people with incentives to have excessively short sighted 
behavior and excessive risk taking. We have seen what 
economists would have predicted come about. You know, I was 
actually worried for a while that things were not as bad as 
they should have been, but now economic theory has been 
validated.
    The issue of regulatory capture is absolutely essential, 
and we have seen it over and over again. In our regulatory 
structures we have to be sensitive to it. For instance, one of 
the important innovations that we ought to be thinking about is 
the Financial Products Safety Commission where you have 
somebody looking at the financial products to see if they are 
safe, in what dosage, and for whom, but outside of a framework 
which can be influenced by the investment community. It has to 
be related to those who will lose if you make a mistake, such 
as the union or the workers who are more likely to suffer. You 
have to move it away from Washington or from New York. You need 
to think about how our system has failed and try to recognize 
that.
    Senator Klobuchar. Because you would argue that some of the 
failure is consumers just not being protected from these 
products or not understanding what they are or what their risks 
are?
    Dr. Stiglitz. Exactly. Now, some other countries have done 
a far better job than we have, and we ought to learn from that. 
For instance, when one central banker in another country was 
approached by American financial institutions saying we want to 
sell our derivatives (we put a lot of pressure on some of these 
countries) the central banker asked, can you explain what these 
things are and what they are going to do? The reply was no, we 
can't really explain it. The banker said, you can't sell it in 
our markets if you can't explain it.
    Senator Klobuchar. That is a simple test. All right. Thank 
you very much.
    Chair Maloney. The gentlelady's time has expired.
    Dr. Johnson and Dr. Hoenig, do you likewise support the 
Financial Products Safety Commission idea?
    Mr. Hoenig. I think it is an interesting idea in terms of 
consumer protection, yeah. I think it is worth exploring.
    Chair Maloney. Then Dr. Johnson.
    Dr. Johnson. I think it is very sensible, and I 
particularly like the point about locating this commission away 
from New York, away from the big financial centers, and away 
from Washington. That works for me, too.
    Chair Maloney. I think a lot of financial products should 
be in New York City since I represent it. But I would like to 
note that my distinguished colleague, Brad Miller, is sitting 
here in the front row and he has introduced the Financial 
Products Safety Commission legislation, and I welcome him to 
the hearing and invite you to join the dais if you would like, 
Brad.
    I would like to go back to the Treasury, to the idea of how 
we handle these complex financial institutions that are 
systemically important but are on the verge of being insolvent. 
And Treasury has submitted proposed legislation that would give 
the FDIC authority to unwind these institutions similar to the 
authority FDIC has for depository institutions. I would like to 
ask the panelists, if you have reviewed this legislation, do 
you have comments on it either now or later in writing for the 
committee members? And do you think it is more complicated and 
more difficult than what we have with the authority now with 
the FDIC? And could you just comment on it?
    And likewise, Dr. Stiglitz, you have mentioned Sweden 
several times and often it comes up in conversation as we are 
discussing this in the Financial Services Committee and other 
committees, and they say that Sweden is different, it is not as 
large a country as ours, their financial institutions are not 
as universal or as complex as those in the United States and 
that the comparison is not a good one, that we can't really 
compare the financial institutions of the U.S. with Sweden 
because of the complexity of our financial institutions and the 
universal institutions that we have.
    So I invite all of the panelists, Dr. Johnson, Mr. Hoenig 
and Dr. Stiglitz to comment.
    Dr. Stiglitz. First, on the issue of the Swedish parallel, 
let me say that financial restructuring conservatorship has 
been done in the United States. As well as the example that Mr. 
Hoenig has referred to several times, Continental Illinois, 
there have been other examples in other countries around the 
world, so one shouldn't just focus on the Swedish model. They 
have all been basically very similar, that you put the banks in 
a conservatorship or you do financial restructuring. This is a 
model that has worked in many circumstances. I was just talking 
yesterday to a person from Sweden who was very much involved at 
the time this was done on exactly this issue, about whether 
Sweden is different. The answer is, had they failed, it would 
have been as devastating for Sweden as our system failing would 
have been for America. The analogy I think is relevant, and the 
impact on their economy of their failure would have been just 
as significant.
    Scale makes it a little more difficult. The point, which 
Mr. Hoenig has made before, is that you are going to keep most 
of the bankers. The government is not going to be running this 
in the way that some fearmongers have described. The point is 
you have changed the management and the incentive structures, 
and having people who are hard working with better management 
and better incentive structures will work better both for the 
institution and for our economy.
    The attempt to dismiss the relevance of those repeated 
restructurings is simply an attempt to mislead America about 
how successful restructurings can be and that they are what 
economic theory would have predicted would work.
    I have not looked at the details of the legislation, but 
the notion that we need to have a mechanism for an orderly 
restructuring of these large institutions seems absolutely 
apparent. It should have been done earlier, after Bear Stearns, 
when it was clear that the government at that point did not 
feel that it had adequate mechanisms and had to go into what 
you might call novel approaches. That is when they should have 
introduced the legislation, and I am glad that they are finally 
getting around to doing it.
    Chair Maloney. Dr. Johnson and Mr. Hoenig, would you 
comment on Treasury's proposed legislation that would give the 
option of resolving the complex companies the way it does with 
depository institutions? Do you support it? Again I invite your 
comments either in writing or now on the proposed legislation.
    Dr. Johnson. Yes. I have looked at the proposed legislation 
and we follow this closely. I think it is a sensible step. I 
also don't understand why it wasn't taken either a year ago or 
6 months ago when the need was apparent. I would also stress 
that I think there needs to be some modifications. I think some 
of the protections, for example, for workers that are standard 
in bankruptcy proceedings should also be included under the 
resolutional authority and that is quite important. I don't see 
why workers should get particularly hammered when you have to 
handle these kinds of bankholding companies versus what would 
happen for a General Motors type situation were they to go into 
bankruptcy. But I think the basic idea is a good one. I would 
stress, though, that it is not a panacea. And I think what is 
going to happen and what is already happening is there is a run 
on the resolutional authority of the government. So as the 
system begins to stabilize, we are seeing the credit default 
swap spreads on some of the largest banks actually widen. And 
that I think is the market betting that some of the largest 
banks will or can be forced into being resolved in this way and 
having debt for equity swaps.
    So there will be a debt default for those big banks. In 
some sense you should be aware that they may further encourage 
these kind of speculative attacks in the credit market and the 
government has to be able to act. They have to have enough 
money and enough clarity of vision to make sure it is not a 
one-way bet for speculators. Because if they have the sense 
they can attack a company, force it into being resolved in this 
way, they will then move on and attack the next credit.
    So we are still in a very dangerous situation.
    Chair Maloney. My time has expired. Mr. Cummings.
    Representative Cummings. Thank you very much. I just want 
you all to comment on what is the appropriate way for the 
United States to exercise shareholder rights regarding the 
firms like AIG, regarding banks that the government converts 
preferred shares to common stock. And it is very interesting 
what is happening here in the AIG situation where we own 79 
percent of the company and decisions are being made and it is 
questionable how much power we have and how much power we 
exercise with regard to those companies, and I mean, I know you 
all would have preferred to see something different. But now 
that we are there with the AIG and some of these other 
companies and we have got these folks who are moving from the 
preferred to the common stock, I just want to know do you--
first of all, do you--how do you see us--should we have a role, 
a significant role in what happens to those companies and, if 
so, can the role that we have in those companies alter things 
in a way to take us in another--in a direction where the 
taxpayer will be better off?
    Mr. Hoenig.
    Mr. Hoenig. Yes. Let me answer that in a sense--also answer 
Madam Chair's question, and that is with that particular 
instance, that could be structured in many ways is similar to 
the Continental where you negotiated with the ownership, with 
the directors as you provided this outside capital and these 
amounts of money. So it is I think perfectly legitimate and 
should be structured, since it is government funds that have 
been sought and provided, that it should be structured in a way 
that protects the taxpayer first, takes all losses against the 
stockholders first and then can be risk structured and later 
reprivatized.
    So I think that is very important. But it also begs the 
question, back to the question in terms of the FDIC proposal, 
yeah, we should have a much more I think refined resolution 
process as being proposed in this legislation. We need to take 
a careful look at this legislation because as it involves the 
FDIC we have to be careful who is going to fund it because 
right now that is dependent upon insurance fees across all 
banks and I think it is very important that we know where the 
funds are going to come from in the future. But as to these 
institutions we should have a systematic approach, whether it 
is AIG or any other institution, to--if the government is 
turned to for a salvaging situation, it should be put in the 
position of control that would allow it to be managed and then 
reprivatized as quickly as possible.
    Representative Cummings. Dr. Johnson.
    Dr. Johnson. In my opinion, when the government becomes a 
significant shareholder in the kind of situation we already 
have with Citigroup, for example, there should be a change--we 
have the same rights as other shareholders. We should exercise 
them and there should be a change in the boards of directors 
and the boards of directors where appropriate should change the 
management. I thought it was extraordinary that the Treasury 
said at the moment when they converted from preferred to common 
back in February, that they were reaffirming--they said this on 
background to the New York Times, they were reaffirming Mr. 
Pandit as the CEO of Citigroup. That is an extraordinary 
statement for the U.S. Government to be making. That is a 
decision for the board of directors to take. And I think there 
is a real danger that I would emphasize of political control 
here. We often think of political control of a credit in many 
places, in many countries, in many situations as being 
dangerous, meaning politicians trying to tell the banks what to 
do. I think the political control here is coming from the--I am 
quite serious--the power of the insiders in these banks, the 
bank executives, the people who run these banks are incredibly 
influential characters and they are I think capturing, if you 
can believe this, the very process through which the government 
is coming in and trying to rescue them.
    So you are absolutely getting a bad deal on all sides 
there, and that the only way to do it is to bring in new people 
to the board of directors and have them assess which CEOs 
should stay and which should go.
    Representative Cummings. Dr. Stiglitz.
    Dr. Stiglitz. Yes. First, there is enormous risk of a 
separation of ownership and control. This has been talked about 
in economic literature for a long time, and that in effect is 
what we have been doing. We have been putting money into 
Citibank and into AIG and not exercising the control of an 
owner, to make sure that these institutions operate, at the 
very least, in the interest of the major shareholder, which is 
the U.S. taxpayer. That should be the basic principle. I agree 
very much that we know how to set up governing structures to 
make sure that banks are more insulated from direct political 
pressure, such as having a board of directors. This has been 
done over and over again.
    There is one other thing that I want to emphasize, which is 
that as an owner, I think we should insist on the highest 
standards of corporate governance and behavior. I don't want as 
a taxpayer to feel like I am the owner of a company that has 
become a slumlord or that is engaged in exploitation through 
exploitive credit card fees or other kinds of exploitive 
practices. For instance, in the case of AIG, it has written a 
large number of insurance policies against our troops in Iraq, 
and it is refusing to pay on those insurance policies. That is 
outrageous. It is through some technical exclusionary 
provisions: they got the premium and now do not want to pay. It 
seems to me that as an owner, we should follow basic commercial 
principles, but we also ought to be a good owner. We want the 
company to act as a good, responsible business person would.
    Chair Maloney. The gentleman's time has expired. But I 
would like to share with my colleagues that the Financial 
Services Committee will be acting on some of these abuses. We 
will be marking up this week on Thursday the credit card 
holders' bill of rights that will ban many of these abusive 
practices. We are marking it up tomorrow.
    Senator Klobuchar.
    Senator Klobuchar. Thank you very much.
    The Senate, Madam Chair, is debating this week The 
Bipartisan Fraud Enforcement and Recovery Act, which is going 
to, I think, help greatly. As a former prosecutor, when you 
have these Ponzi schemes and the Madoff case and things that 
result from these loose and ineffectual regulations from the 
past, so we could at least beef up some of the law 
enforcement's efforts in this area. I think that is going to be 
a necessary part of this as well.
    My question though is, I just came out of the trip I took 
with Senator McCain and Senator Graham to Asia, and just seeing 
firsthand, in Vietnam and China and Japan, they are 
experiencing many of the things that we are but also thinking 
and asking questions of their leadership about the regulatory 
structure. And I know this came up at the G-20 meeting with 
Sarkozy and the whole issue of how these countries work 
together. But I just have a general question of how we best 
protect our financial markets in terms of working with other 
countries when what they do, obviously, we have seen from 
everything that happened with the London loophole and the Dubai 
loophole and all these things, how what they do affects what we 
do, and how we do this? We cannot do this in a cocoon.
    Dr. Stiglitz.
    Dr. Stiglitz. The first thing is that regulation has to be 
not only comprehensive within our country; it has to also be 
comprehensive globally, even having what is sometimes described 
as uncooperative jurisdictions----
    Senator Klobuchar. That sounds nice.
    Dr. Stiglitz. There are regulatory loopholes. The Cayman 
Islands has not become a major financial center because the 
weather is particularly conducive to banking. It is because the 
regulatory environment, including looking the other way in 
terms of tax evasion, accounting and regulatory evasion, is the 
basis of their success. We should make it very clear that our 
banks cannot deal with financial institutions and banks from 
these jurisdictions that don't comply with the highest 
standards of regulation. We would shut them down overnight if 
we did not allow our financial institutions to deal with them; 
they would not be able to survive. They only survive because we 
tolerate them. There is now a very big move in a number of 
European jurisdictions to shut them down.
    Senator Klobuchar. Dr. Johnson, with your IMF experience, 
how would you answer this?
    Dr. Johnson. I think seeking comprehensive global 
regulation is the right goal. And, of course, Dr. Stiglitz is 
right; there are these loopholes and places with which you can 
refuse to do business. But honestly, the problem is that the 
Europeans really don't get this at all. They have massive 
banks. Their banks have completely captured their regulators. 
This is a terrible danger to us and to themselves. And the G-20 
process which I have, you know, a fair amount of admiration on 
some dimensions has to my mind completely failed on the 
regulatory side. It is going nowhere. The Europeans are using 
it as a smokescreen for their own regulation failure. They let 
their big banks plow into the most crazy products in the United 
States. It is true we let our banks sell them, but both parties 
were very happy with this deal.
    Senator Klobuchar. How do you solve it? You have your new 
blog, right, called ``The Hearing,'' and yesterday, you talked 
about, your question was, what politically feasible exit 
strategy makes the most sense in terms of protecting taxpayers 
and facilitating an economic recovery? So I would ask you that 
in the context of this international problem.
    Dr. Johnson. I think you have to take care of your own 
national regulations first and foremost, and you have to break 
up the biggest banks, and then you have to tightly control what 
other banks coming from other jurisdictions about which you are 
suspicious, and I am afraid I would include France as well as 
other European jurisdictions, what they are allowed to do in 
your country, the kind of interactions.
    So Dr. Stiglitz said the Cayman Islands. We can all agree 
on these small places. But very big countries, there are very 
big countries that are totally fine trading partners. We get on 
very well with them diplomatically and other ways. But they 
don't run their banks in a responsible way. We have to be very 
clear about that, and we have to be much blunter, I am afraid, 
than is standard practice at, say, a G-20 framework.
    Senator Klobuchar. Mr. Hoenig, final word.
    Mr. Hoenig. Very quickly. I agree. We have to first start 
with ourselves, make sure we have a strong regulatory system. 
We will need to look at that and strengthen it, as I have said 
before. We have to do that first.
    There are mechanisms. There is a Bank For International 
Settlements and a Financial Stability Institute where the 
central banks get together, negotiate, talk about these things. 
I think we do have to assure ourselves and work with these 
other countries that they, too, would implement improved 
regulatory standards. I don't think we just walk away from 
this. I think we have to come together, and I think we can do 
that over time.
    Senator Klobuchar. Okay. Thank you.
    Chair Maloney. Thank you.
    And Congressman Miller.

 OPENING STATEMENT OF HON. BRAD MILLER, A U.S. REPRESENTATIVE 
                      FROM NORTH CAROLINA

    Representative Miller. I will take Senator Klobuchar's 
seat.
    Thank you, Madam Chair, for your kindness. I know that I am 
officious intermeddler here, and I didn't object to sitting 
with the hoi polloi, but you do hear better up here.
    One question that I have, both Dr. Stiglitz and Dr. Johnson 
have helped me understand the problem with zombie banks. When 
you use the term ``zombie banks,'' it sounds so bad, you almost 
don't need to explain why it is bad. There are core reasons; 
one is they don't make normal profitable loans that would put 
their capital at risk for getting a normal return.
    But on the other hand, as Dr. Stiglitz I think wrote in The 
Nation recently, they make kind of crazy risks because there is 
no point in not; you know, if you are going to go bankrupt 
anyway, you might as well try. The comparison to a basketball 
team down 8 points with 2 minutes to play, you know, you jack 
up shots quickly; you foul; who cares if you lose by 14 instead 
of by 8, if the object is to try to stay alive.
    Dr. Johnson, in a recent op-ed and in your testimony just a 
minute ago, you said that leaving the incumbent management in 
place is also a big problem as well because they have been 
cooking the books, and you are not going to figure out what the 
status of the bank is and what they have been doing until they 
are out of there and you have got fresh eyes in there.
    But I want to pursue the kind of crazy risk scenario. And 
Dr. Stiglitz, you pointed out in that Nation article that one 
of the reasons the banks aren't modifying mortgages is the only 
way they can survive is if the mortgages actually prove to 
perform, even though there is every reason to think that they 
won't.
    The Congressional Oversight Panel in the last week or so 
has criticized the banks receiving TARP funds for jacking up 
every other kind of consumer fee, for overdraft fees, for 
credit card interest. I heard an estimate yesterday that banks 
think that overdraft fees will be $40 billion this year, which 
is more than twice what it has been in the past. Is that also 
an indication of a zombie bank trying to get back in the game?
    Dr. Stiglitz. It is as much evidence that there is a lack 
of effective competition in our financial system. It really is 
a reinforcement of what Dr. Johnson has repeatedly said about 
the need for more competition. The concentration in the credit 
card industry is particularly severe, a real area of anti-
competitive practice. You wouldn't be able in a normal 
competitive market to get away with that kind of increase.
    I don't think in this particular aspect that they are 
gambling on what I call resurrection, where you take big risks 
in order to survive. You might say there is a political risk of 
a backlash, which is really the risk that they are taking. 
However they seem to be amazingly insensitive to those kinds of 
risks. In terms of their ability to exploit and get people to 
do that, it is very clear that they know that they can probably 
get away with it, especially when they all do it together.
    Representative Miller. Okay.
    Dr. Johnson.
    Dr. Johnson. Two points, first of all, what you just stated 
in terms of overdraft fees is an indication of excessive market 
power and potential collusion. It should be referred directly 
to the Department of Justice, and there should be a serious 
investigation of this. I think, within the framework of our 
existing antitrust laws, they can tackle exactly that kind of 
behavior.
    Secondly, in terms of the kinds of behavior you get from 
zombie banks, there is strong what I would call anecdotal 
evidence, and I can't prove this, but this story comes very 
strongly from various parts of the market that one thing that 
our largest banks that now regard themselves as invisible are 
doing is using their extensive credit from the Federal 
Government to essentially take very big short positions in the 
credit of other financial institutions, including some of the 
other big banks, their rivals potentially, and also in some of 
the more vulnerable emerging market countries.
    Now this is incredible, right. If true, it says that we, 
the taxpayers, directly through TARP and through the Federal 
Reserve, are financing proprietary traders in some of our 
largest banks, engaging speculative attacks that will 
potentially lead to further taxpayer losses as they--this is 
how you run on the resolution authority; you use your line of 
credit from the Fed in order to do it. These are anecdotes. 
These are not proven. But if something like this does come out 
to be true, then we are going to feel ourselves even more 
foolish if we allow the system to continue as we currently do.
    Representative Miller. One of the arguments we will hear 
against Mrs. Maloney's credit card bill and overdraft bill and 
other consumer protections, including Dr. Stiglitz, the 
Consumer Product Safety Commission, is that this is not the 
time to do anything that will restrict credit.
    Given the abuses and given the conduct of banks trying to--
not really being subject to any market limitation, not being 
subject in the limitation based on moral compass either, that 
this is as good a time as any to rein in those practices rather 
than have it go to banks that are trying to stay afloat.
    Dr. Stiglitz. I think it is really a good time to rein it 
in, partly because one of the things that is restricting 
individuals from purchasing goods is the recognition that they 
have to pay excessive fees. It is like a price increase. They 
look at the cost of credit, which is going up now, and they 
know that the banks have treated them abusively in the past. 
They are more anxious about it. If they felt more comfortable 
that the financial system in its lending practices is more 
under control, they will be more willing to take out credit. So 
I view that as an absolutely essential part of our recovery 
efforts.
    Dr. Johnson. There will never be a good time according to 
the bankers to do this, right? And this is exactly--or they 
will say the recovery is too fragile; we need more time.
    I think now is the right time for the reasons Dr. Stiglitz 
said. People more broadly understand there have been predatory 
practices, and I think there have been violations of our 
antitrust laws. And I think that you have to address those. 
There is going to be deleveraging. There is going to be 
difficulty in the credit market. What you want is to have a 
banking system within 18 months, 2 years, that is functioning 
properly, soundly and competitively; that is in a position to 
provide sensible amounts of credit as the recovery really moves 
forward.
    Mr. Hoenig. As far as I would tell you is, if you provide 
better information to the consumer so that they are making good 
credit choices, you are actually going to improve things much 
greater for the future. I think part of the problem is, people 
have not been well informed and have made bad credit choices. 
And that is part of what the downside of this is. So I think it 
is all upside.
    Chair Maloney. Thank you very much for your comments and 
building support for a bill we will be marking up literally 
tomorrow.
    And as we speak, there are so-called stress tests going on 
in 19 of our largest institutions. And I would like to ask you, 
how confident are you that the stress test will tell us which 
banks to bring back to life and which banks to shut down? We 
have not been given the information about or the public has not 
been given the information about how these stress tests will be 
conducted. So I would like to ask you, how would you design a 
system or stress test to determine which institutions are 
solvent and which are not? And can you be specific about how 
you would design such a system, and then, of course, do you 
think this system will be sufficient to lead us forward?
    Thank you, and I open it to anyone.
    Please, Dr. Johnson.
    Dr. Johnson. I think the notion of a comprehensive stress 
test is a good one. The question is the scenarios that you use. 
We know what the results are going to be. It is mystifying to 
see how long it has taken to produce the results because it is 
all about the macroeconomic scenarios, the downside scenario, 
so the stress scenario, and the stress scenario that the 
government assumed for this exercise is really quite a mild 
one.
    To answer your question directly, this particular version 
of the stress test, the way it has been implemented will tell 
us very little about the underlying solvency issues of these 
banks under duress. The point of the stress is to examine, 
under duress, how much capital will they need, and to make a 
plan for raising that capital either privately or through some 
government support or through some kind of restructuring, some 
kind of conservatorship. I think, unfortunately, these stress 
tests are not going to be informative.
    Chair Maloney. Dr. Stiglitz, can you give specifics about 
how you believe the design of such a system should work?
    Dr. Stiglitz. Let me first make a prefatory remark. The 
banking system was supposed to be performing stress tests on 
their own banks prior to the crisis. That was the whole notion 
of self-regulation that was proposed. They went through those 
stress tests, and they said, well, we are fine. We were 
managing their risk. We know the stress tests by themselves 
don't tell you anything.
    It all depends on the models and scenarios you put in. The 
models include all kinds of things, not only the macroeconomic 
assumptions but also very detailed assumptions about the 
correlations between various risks and the probabilities of 
small-probability events occurring. A large number of 
particular assumptions go into it.
    The most important of those assumptions have to deal with 
the macroeconomic issues, like what will be the magnitude of 
the fall in the prices of real estate, including commercial 
real estate? What will be the level of unemployment? What will 
be the likely level of bad commercial and consumer loans? If 
you put in very mild assumptions, then, as Dr. Johnson said, we 
know they will pass the stress test. Unfortunately, the few 
assumptions that they have announced do not give us very much 
confidence. Even if they pass this test, they are using models 
that didn't work well before, so we won't have much confidence 
in the outcome or be able to say that these financial 
institutions will really be able to survive over the next 2 
years with a high degree of confidence. I don't think they are 
going to succeed in convincing us that it is going to work.
    One of the other things I just want to add is about the 
reform; the changes in the accounting practices have made it 
more difficult for us to tell what is going on. I think that is 
something that we should be very concerned about.
    Chair Maloney. Well, thank you for your statement.
    And many people have argued that we need more flexibility 
in the mark to market and therefore FASB came forward with 
their new flexible rule. And do you support this flexible rule? 
It should allow the banks to maybe be--or at least appear to be 
more solvent on paper.
    Dr. Stiglitz. You used the key word: appear. We want to 
know what their real state is, and we want to make a 
distinction between how we use the information and the 
information that we have. As ordinary investors, we can't look 
at the banks' books; we have to rely on their accounting. If we 
are told that the banks have the discretion not to write down a 
mortgage or a security that is impaired because they are going 
to hold it until maturity, that is deteriorating the quality of 
the information. We know less and less about the state of the 
banks, and that is contributing to the uncertainty, making it 
more difficult for our economy to resolve the problems that it 
needs to resolve. We want the best information, and then the 
regulators need to make a decision about how to use that 
information. This move to less transparency is a real big 
disappointment.
    Mr. Hoenig. Can I just say one thing on that, Madam?
    I think that the rationale for the change in the accounting 
rule was that these are--some of these are fire sale values, 
and they are not the intrinsic. If you can show where the value 
is, that is the bank can show where the value is actually 
there, you can put these on the books appropriately. I think 
that is a legitimate approach, but I would say that it requires 
then that the supervisory authority with very clear guidelines 
go in and check those numbers so that you don't game the 
system, so that you don't get an abuse out of it.
    Chair Maloney. Thank you very much. My time has expired.
    Mr. Cummings.
    Representative Cummings. Dr. Johnson, you--and I think all 
of you have alluded to this that a part of resolving this 
financial problem that we have, part of it is confidence, 
people feeling comfortable to spend, to invest and whatever. 
And one of the things that is so interesting is that I believe 
that the President is doing everything he can to turn this 
situation around. But I also believe that it is important that 
the public feel comfortable that their money is being spent 
effectively and efficiently and that there is some benefit that 
is going to come back to them.
    And one of the things that seems to be so controlling in a 
lot of these ways we got into this problem, it seems we have 
got into this problem, and that is these salaries, these 
bonuses. I mean, I don't think the American people have any 
problem with people getting bonuses. It is just that they have 
a problem with people getting bonuses who have failed their 
companies and failed them while they sit there with no job, no 
savings, no anything.
    So is there some kind of way that we can--do you think 
there should be some restructuring of this salary system, any 
of you, so that people are adequately compensated for all that 
they do, but at the same time, it is not driving--it seems like 
you are getting rewarded for doing things quickly and quantity 
as opposed to quality? And I think that is kind of what kind 
of--that is part of what caused the problems that we have here. 
And I was just wondering about you all's thoughts on that.
    Dr. Johnson. I think this is a central issue. I think it 
has to be addressed. I think these very large payments to 
insiders, these bonuses you are talking about, are a reflection 
of the market power of these players. And I think you should 
address that both through regulation of what is acceptable 
compensation, schemes--remember, it is also encouraging them to 
take a lot of risk and hope that bad things wouldn't happen 
within the same bonus period so you get to cash out first. That 
is not acceptable for anything that has any kind of systemic 
impact.
    I think corporate governance needs to be much stronger, and 
we have allowed a system to develop with these very big players 
basically run by the management of the banks; the owners are 
not involved in effectively controlling compensation. And I 
think that they come back to the key point which is really the 
way to change the nature of the bank system is to make it more 
competitive. I think a vibrant financial services industry is 
essential to the prosperity of New York and to the prosperity 
of this country. But having it dominated by four or five or six 
massive players is not good for the country, and I don't think 
it is terribly good for New York City either. That is where I 
stand on it.
    Representative Cummings. Dr. Stiglitz.
    Dr. Stiglitz. First, I think we want to distinguish between 
the structure and the level of the incentives. The structure of 
the incentive system as it is officially described encourages 
short-sighted behavior and excessive risk-taking, and this 
played a role in bringing on these problems and should clearly 
not be allowed within the core financial systems and in these 
too-big-to-fail institutions.
    The second thing, on which I very strongly agree with Dr. 
Johnson is that there are real problems in corporate 
governance. How did the banks allow their executives to get 
paid in ways that the shareholders have lost? Everybody has 
lost. The American people have lost. The only people who have 
gained have been the executives of these companies. We really 
need changes in corporate governance. One clear part of that is 
transparency of the payments to executives. A lot of them get 
paid by stock options, which are not expensed, not shown 
clearly to even the shareholders and, in many cases, are 
interestingly described as incentive schemes. We now know that 
they are not incentive schemes: The salary is high when things 
are good and high when things are bad. When things are good, 
they are called bonuses. When things are bad, they are called 
retention payments, so they don't leave. However, we know that 
this is all a charade.
    One of the things that ought to be done as part of 
corporate governance is to require transparency about total 
compensation and the relationship between performance, not just 
the announced relationship but the actual relationship between 
pay and performance. If you did that, I think there would be a 
shareholder uprising. They would say, you have been swindling 
us and calling this incentive pay, but it is not. It doesn't 
work that way. You get paid whether things are good or bad.
    Mr. Hoenig. Let me just add quickly, I wouldn't have the 
problem with pay and bonuses if we didn't have too big to fail 
because it would fall on the shareholder. And they would 
develop things that have fallback provisions to bring these 
bonuses back over time. When you don't have the ability to 
fail, then I think these bonuses need to be restructured and 
probably will end up being regulated. So we really have to 
address the fundamental problem here today, and that is to 
address too big to fail.
    Representative Cummings. Thank you.
    Chair Maloney. Brad Miller.
    Representative Miller. Dr. Stiglitz, I am sure you have 
read Dr. Johnson's piece in the Atlantic in the last couple of 
weeks. He makes the point that if the United States were any 
other country in the world and came to the IMF, the IMF would 
say, you have to do two things: First of all you need to reboot 
your financial system, your banking system; but second of all, 
you have got an oligarchy that is controlling your economy and 
controlling your political system, your government, and until 
you end the power of the oligarchy you are not going to get the 
reforms that you need to fix your economy. Do you agree with 
that analysis?
    Dr. Stiglitz. Very much so. I have often actually given the 
same kind of analogy, as chief economist of the World Bank. If 
I had come and visited the United States, we would have cut off 
all aid to the United States. It would have not passed muster. 
As an example, if you looked at the Public-Private Partnership 
Program as it has been announced, we would have said, this 
looks like a scam. One of the reasons that I am very sensitive 
about this issue is probably the same reason Dr. Johnson is, 
that we have seen in the midst of crises in so many developing 
countries massive redistributions from the ordinary taxpayers 
to the financial sector.
    What we are seeing in the United States is a pattern that 
happens over and over again. We are not even original. We are a 
little bit clever in some of the ways we are doing it, but it 
is a pattern that one sees over and over again.
    Representative Miller. How do we--I assume, Dr. Johnson, 
you agree with your own article.
    How do we do that? I mean, is it enough to take banks into 
receiverships and therefore displace the incumbent management, 
the banks that are insolvent or so thinly capitalized that they 
should be in a receivership, creating smaller banks? What more 
needs to be done to limit the power of those who are now 
controlling our economy and our government?
    Dr. Johnson. If that question is to me, I think what--I 
could live with various schemes, at least the schemes put 
forward by my colleagues this morning. I think what Dr. Hoenig 
is telling you from his vast experience coming from within the 
Federal Reserve System is that this is totally doable, and the 
only thing I think I am adding on top of that or perhaps I am 
emphasizing antitrust can be used as a mechanism to make sure 
people don't become too big to fail. I think that is an 
application within Dr. Hoenig's framework. And I think this is 
an issue on which right, left, and center can completely agree.
    The difference I think is not the standard differences 
across the political spectrum. It is very much, there is a 
group of people who think big finance, that you have got to 
stick with big finance; they brought you here, and they are the 
only people who are can get you out.
    And there are people from across the political spectrum 
like us today with very different, I am sure, opinions on other 
points, but we are agreeing on this. We are agreeing that big 
finance is too big, and it can be dealt with within our 
existing framework. And that is a matter of pressing national 
priority.
    Mr. Hoenig. So long as you have too big to fail, you will 
have oligarchies. You have to have mechanisms that allow for 
failure, or I think you will encourage that outcome.
    Representative Miller. A couple of you have mentioned the 
need for reform of corporate governance. One proposal that Carl 
Icahn has proposed allowing a shareholder vote on the State of 
incorporation rather than letting management choose a State of 
incorporation and always choosing the State that is most 
indulgent of management, Delaware; there would be a pressure on 
management if they knew they could lose that vote. And I think 
Icahn said Delaware--I am sorry. Iowa. Is that a useful 
proposal? And what are the proposals for how to reform 
corporate governance?
    Dr. Stiglitz. There are a number. I think that is a very 
interesting one. It is important to just let shareholders know 
what the compensation is. Right now through our accounting 
system, we don't typically force them to expense stock options. 
They don't realize the magnitude of the delusion of shareholder 
value. I agree with the initiative of allowing shareholders, 
who are, after all, the owners, to vote on the compensation; 
what I find shocking is the resistance to even a nonmandatory 
vote, which there is now. There are a whole set of specific 
reforms in shareholder control. A variety of mechanisms have 
been developed so you rotate the board very slowly so that no 
one can take over the board. It will take 5 years before you 
can change the board after you are the owner. There are many 
things that have been put in the way to get more discipline in 
the market for corporations through shareholders.
    Chair Maloney. The gentleman's time has expired.
    Gentlemen, is stock price a good indicator of a successful 
program for bringing zombie banks back to life?
    Dr. Stiglitz. That is a great question, partly because too 
often when a proposal is put forward, for instance, for a bank 
restructuring, they say the market loves it because stock 
prices have gone up. In a sense, stock prices going up can be a 
sign of a very bad proposal. One way of getting stock prices up 
is writing a big blank check to the banks. Yes, the owners of 
the banks will love that, but the taxpayers' shares which we 
don't actually see, have gone down, and our national debt has 
increased, by even more than the shareholder value has gone up. 
Shareholder value is a very bad signal of what is a good 
program for the American economy. It doesn't tell you about 
lending or the net cost to our society.
    Chair Maloney. And also in this debate, some have suggested 
that the taxpayer is not at risk for the guarantees provided by 
the FDIC since it is obligated to be self-sustaining. Does this 
mean that we should not be concerned about potential losses?
    Dr. Stiglitz.
    Dr. Stiglitz. There are two issues here. One is that, the 
losses can be so large that even though the FDIC is supposed to 
be self-sustaining, the sense will be that they cannot fill it 
and will come back to Treasury. Even if they don't, the 
question is, who is going to pay? The way the FDIC generates 
revenue is by a tax on depositors, so we are asking depositors, 
including depositors at good banks and community banks, to pay 
for the losses.
    In my testimony, I talk about the principle, in 
environmental economics that the polluter pays; that is, those 
who pollute the environment ought to pay for the cleanup. The 
big banks have polluted our economy with toxic mortgages. In 
effect, they are asking other people to pick up the cost. I 
think that any system which forces others to pick up the cost 
is neither fair nor efficient. This is the problem that we have 
been talking about, of shifting the cost to others, both short-
run and long-run distortionary costs to our economy.
    Chair Maloney. Can you tell us, Dr. Stiglitz, your opinion 
about the government taking preferred stock initially with the 
TARP money but now taking common stock warrants? This happened, 
I believe, over the weekend. Can you address the trade-offs for 
the taxpayers as well as the ability of the company that is 
bailed out to attract outside capital?
    Dr. Stiglitz. The first effect is very clear that we now 
bear more risk. The nature of a preferred share relative to a 
common share is that there is more risk in a common share.
    The second point is that, as a common share, we should have 
much more voice in the actions. We are now an ordinary 
shareholder. However, my understanding is that we won't be 
exercising that voice and that vote.
    The critical issue is, what are the prices? We know from 
the Congressional Oversight Panel that we got cheated in the 
initial share issues. The real question is, and I haven't seen 
the details, what were the prices as they converted preferred 
shares to common shares, and did we get cheated once again? If 
the suspicion is that we did, I think there should be a real 
outrage over what has happened.
    Chair Maloney. Dr. Johnson and Mr. Hoenig, would you like 
to comment on this?
    Dr. Johnson. I agree and wholeheartedly second what Dr. 
Stiglitz just stated.
    Chair Maloney. Mr. Hoenig.
    Mr. Hoenig. It depends on what the prices are and what the 
striking prices are in the warrants. So it depends. But having 
taken it--if we take a common stock position, then we should 
have more control and more voice in it, no question.
    Chair Maloney. Speaker Pelosi is supporting a review of 
what brought us to this crisis. Over the weekend, Jamie Diamond 
from JPMorgan Chase gave a speech about some of the causes. And 
in it, he mentioned the high cost of the war that was not 
really apparent to the public. And I cite your book, Dr. 
Stiglitz, the $3 trillion war. Many of you in your writings 
have cited other reasons, the high leverage and so forth. Would 
you like to comment on what you believe brought us to this 
situation for the record?
    And you can submit your further thoughts in writing for the 
official record. All of your testimony has been tremendously 
insightful, deeply appreciated. We will be circulating it to 
our colleagues on both sides of the aisle and certainly to the 
general public. I thank you very much. But we would like to 
hear your ideas for the Speaker on what brought us to this 
situation, Dr. Stiglitz.
    Dr. Stiglitz. Well, it is clear that the low cost of 
finance was a contributing factor. One of the reasons that 
interest rates were lower than they would otherwise have been 
was the fact that we had to keep our economy going even though 
we were spending hundreds of billions of dollars to import oil 
from the Middle East and to offset that and other weaknesses in 
the economy.
    If we had had a financial system that functioned, having 
low cost of capital would have been an advantage. Most 
societies like the idea of having a low cost of capital. It 
could have been allocated by a well-functioning system to a 
burst of investment in our economy, and a whole set of issues 
could have been addressed.
    The bottom line of the failure is our financial sector. Our 
regulators didn't stop them, but that is like a thief saying, I 
stole it, but the cop didn't stop me. The fact was, it was the 
financial sector that didn't do its job. The energy was there 
from the low interest rates. It could have been used in a 
better way, but the regulators didn't stop them.
    Dr. Johnson. The big banks in this country became much more 
powerful in economic terms and political terms with 
deregulation in the 1980s, the arrival of new technologies 
particularly derivatives in the 1990s. And they plowed this 
political influence back into further deregulation, further 
tilting the field playing field in their favor, and this 
allowed them to build compensation systems that were extremely 
favorable for the insiders that enriched people at the very top 
of these organizations. But it also loaded them up with risk. 
And this created massive system risk that has now come back to 
haunt us on a colossal scale.
    Unless and until we address the underlying fundamental 
problem, excessive economic power and political power of big 
finance, we will not really resolve the situation.
    Chair Maloney. Mr. Hoenig.
    Mr. Hoenig. I think that, importantly, we saw the end of 
clear strong underwriting standards, and we allowed our 
institutions to leverage up far beyond what they should have. 
Thank you.
    Chair Maloney. Well, I would like to thank our 
distinguished panel of witnesses for your testimony today. 
Stabilizing our financial system is critical to the recovery of 
our economy. All of your testimony has helped policymakers make 
more informed decisions. I look forward to your written 
comments.
    The record will be open for 5 days for additional questions 
that may be put in writing or statements that other members may 
want to put into the record. I am deeply grateful for your 
testimony today. Thank you so much for coming.
    [Whereupon, at 12:12 p.m., the committee was adjourned.]
                       SUBMISSIONS FOR THE RECORD

     Prepared Statement of Representative Carolyn B. Maloney, Chair
    Good morning. I want to welcome our extraordinary panel of 
witnesses and thank you all in advance for your testimony today.
    This hearing is timely because Congress expects to take up 
legislation being prepared by the Administration that would expand the 
federal government's ability to unwind large financial institutions.
    The current financial crisis has made clear that we need additional 
tools to handle financial institutions that are ``too big to fail.''
    The disorderly failure of large financial institutions can pose a 
significant threat to the stability of the financial system, both in 
the United States and globally.
    The panic after Lehman Brothers declared bankruptcy last September 
is evidence enough that, under our present regulatory structure, 
allowing large financial firms to fail can seriously damage our 
economy.
    Another failure could have created even worse economic 
consequences, with even deeper effects on employment, incomes, and 
growth.
    On the other hand, unconditional support for large failing firms 
can be just as dangerous. Implicit guarantees give firms incentives to 
take bigger risks. Allowing firms to escape the consequences of bad 
business decisions could prompt even riskier behavior.
    Our financial regulators presently lack the means to steer between 
these two unacceptable alternatives. Chairman Bernanke and Treasury 
Secretary Geithner recently testified before the House Financial 
Services Committee that without new legislation, they lack the 
authority to conduct an orderly unwinding of large financial 
institutions such as AIG.
    The FDIC has mechanisms in place to allow resolution of failed 
depository institutions. For the other subsidiaries of bank holding 
companies, and for investment banks, insurance companies and other 
large financial firms, the only option seems to be bankruptcy.
    Fixing our financial system is of the utmost importance. We are 
therefore fortunate to have with us this morning three outstanding 
experts as we discuss the topic of restoring confidence in our 
financial system while minimizing both the cost to taxpayers and the 
incentives for institutions to take excessive risks in the future.
    I am confident that we in Congress can work with the administration 
to solve this crisis and give regulators better options and tools to 
prevent as well as cope with future financial crises.
                               __________
     Prepared Statement of Senator Sam Brownback, Ranking Minority
    Thank you Chairwoman Maloney for arranging today's hearing on the 
issue of institutions deemed ``too big to fail.'' I look forward to the 
testimony of our distinguished panel. I am especially pleased to see 
before me my friend, President Thomas Hoenig of the Federal Reserve 
Bank of Kansas City.
    I have found President Hoenig's recent remarks about the issue of 
``too big to fail'' useful and find his proposals to deal with the 
issue very constructive. In his words, ``too big to fail has failed.''
    It's hard to pick one word to describe fully the feelings of the 
constituents I talk with in Kansas. The emotions run the spectrum from 
bewildered and confused over how this happened to anger over being 
forced to use their hard-earned tax payments to fund risky, speculative 
bets of large institutions and bad decisions of highly sophisticated 
titans of finance. The argument that these institutions pose a 
``systemic risk'' and threaten to bring down the entire system if they 
are allowed to fail is not easy to digest. My constituents want to know 
how a set of large speculative institutions ended up threatening the 
entire financial system and economy. They also want to know what we can 
do to make those responsible pay the price with as little cost to the 
taxpayer as possible and what we can do to insure that no institution 
is ever allowed again to threaten the stability of the financial system 
and the American economy.
    When an institution grows to be deemed too big to fail, it ends up 
having too much leverage over the entire financial system and economy. 
With expectations that regulators and others with oversight would not 
allow such large institutions to fail in the event that their large 
speculative bets turn out bad, there is little incentive for the too 
big to fail institutions not to make those reckless bets. The incentive 
structure for a too big to fail institution, articulated often and by 
many commentators is simply this: heads we win; tails the taxpayer 
loses. The large institutions are effectively allowed to place one-
sided bets with taxpayer backing.
    My constituents and, indeed, most Americans, find this situation 
intolerable. We need to firmly address the too big to fail issue and 
provide some constructive mechanisms to deal with the issue. And, while 
it is important that we achieve success from the bailouts to Fannie 
Mae, Freddie Mac, Bear Stearns, AIG, auto companies, and more, it is 
also important to note that failure to address the too big to fail 
problem can ensure future instability. Having repeatedly sent the 
message that if you get big enough, we will use taxpayer funds to bail 
you out, there is little reason to believe that, in the absence of 
dealing with the too big to fail problem, large institutions in the 
future will not simply expect more of the same. We can expect that, in 
the absence of action, the problems of ``moral hazard'' will recur.
    While the words ``too big to fail'' have been part of the public 
debate over financial policy for decades, until a little more than a 
year ago, the term ``systemic risk'' was a term rarely heard in 
hearings or debate on the floor of the House or Senate. In the public's 
mind, ``too big to fail'' was often viewed as a sign of an 
institution's strength rather than a designation given to institutions 
that would potentially cost taxpayers hundreds of billions, even 
trillions, of dollars.
    We need a mechanism to identify when an institution is becoming so 
big that it may begin to impose threats to the stability of the overall 
financial system and economy. We need an operational framework that can 
identify growing threats to stability and when to intercede. We need 
market discipline and systemic oversight.
    We already have processes that have proven effective. For example, 
the FDIC oversees insured banks, supervises them, identifies troubled 
institutions in early phases of difficulties, and resolves the 
difficulties using various processes like conservatorship and 
receivership. Our current difficulties stem from the fact that 
institutions, whose creditors were not insured by something like the 
FDIC, were not effectively supervised, and often operated in what has 
been called the ``shadow financial system.'' They grew so large, 
complex, and intertwined with others that they threatened and brought 
down the stability of the entire financial system.
    We need to construct ways to get large speculative bettors out of 
the shadow system and under supervision if those bettors begin to 
threaten systemic stability. And, we need to insure that supervision, 
oversight, and regulation is dynamic and keeps pace with the ever-
evolving shapes and forms of institutions and financial products.
    I understand that there are difficulties and challenges in 
constructing the oversight and regulatory mechanisms needed to address 
the too big to fail problem. Fortunately, we have some of the best and 
brightest minds on our panel today to help us make progress in 
understanding and addressing the problem. I know that President Hoenig 
has thought carefully about the problem and has identified what seem to 
me to be key elements of a strategy for resolving the too big to fail 
problem, and I particularly look forward to his thoughts.
    I hope we can get to several key issues during today's hearing. 
First, are these institutions truly ``too big to fail?'' or is there an 
orderly process under which they can be liquidated with minimal cost to 
the taxpayer and the financial system? Second, what approaches should 
we take in the future to prevent a repeat of this disaster? Is there 
any way to impose a different set of regulations on ``systemically 
important'' institutions that does not create gross distortions in the 
market for financial services? Rather than trying to reduce the risk 
associated with these institutions through regulations, should we 
consider simply not permitting an institution to become ``too big to 
fail'' and restructuring those who are? We must also be extremely 
cautious in listening to these financial institutions' arguments 
regarding the need to impose significant new restrictions on the over-
the-counter market for non-financial product derivatives. Those 
arguments are about market power, not about the soundness and safety of 
the financial system.
    I am deeply concerned that the government's response to date has 
served to increase confusion in the market rather than restore order. 
It seems as though we move from ad hoc response to ad hoc response, 
with each iteration in the process costing the taxpayers billions more. 
It is time to reach a resolution. If we do not adequately address the 
problem, too big to fail will return in the future. Taxpayers do not 
want to have to pay higher taxes, nor have their children pay higher 
taxes, to cover the reckless bets of institutions that have grown too 
big to fail.
                               __________
       Prepared Statement of Representative Michael Burgess, M.D.
    I am pleased to join in welcoming the members of the panel 
testifying before us this morning. We are all very concerned about the 
financial crisis and its impact on the economy.
    The roots of the financial crisis are to be found in government 
policies that encouraged risky mortgage lending practices as well as a 
breakdown of lending standards in the private sector. Many banks and 
other financial institutions made terrible investment decisions that 
resulted in huge losses that now have to be written down. While some 
seem to think the financial situation is improving, the fact remains 
that loan defaults continue to trend upward, and probably will for some 
time to come.
    The Obama administration has responded with a plan announced on 
February 10th based on public and private partnerships to purchase the 
toxic assets of the banks. Many economists have raised concerns about 
whether this plan is adequate given the magnitude of the problems in 
the banking sector. Estimates of the amount of toxic assets in the U.S. 
banking system now range up to $2 trillion.
    The Administration plan relies heavily on providing generous 
subsidies to private sector participants who would enjoy half of any 
partnership profits. However, if the partnership fails, the taxpayers 
would shoulder over 90 percent of the losses. The prospect of trillions 
of dollars of taxpayer money at risk in this plan is very troubling.
    I am even more disturbed at the lack of transparency and 
accountability in the Administration plan. The Treasury seems to have 
designed the plan specifically to evade the Congressional 
appropriations process. Trillions of taxpayers' dollars are at risk, 
but Congressional approval is not needed for the plan to proceed. This 
is a violation of the democratic process.
    Perhaps Dr. Stiglitz said it best when he characterized the recent 
Treasury proposal as robbery of the taxpayers. There is even 
speculation that firms receiving bailouts could also directly or 
indirectly participate and enjoy the rich subsidies offered in the 
Treasury plan. I remain concerned that the costs of this plan will be 
exorbitant, and that it will not work effectively to solve the 
financial crisis.
    Putting the future impact of the Department of Treasury's plan 
aside for a moment, I want to take this opportunity to announce a plan 
to address the past. Today I am introducing a bill to create a 
Congressional Commission on Financial Accountability and Preparedness. 
I have put together this bill, along with the support of Ranking Member 
Brady, to address something that my constituents bring to my attention 
all the time--the fact that we don't really know what and who caused 
this financial breakdown, and also the fact that no one has been held 
publicly accountable for the path that got us to this point today. 
People in Texas want answers and they want to see that their government 
is willing to seek the truth without politics getting in the way, 
especially before we put a new regulator or regulations in place. This 
temporary and bipartisan commission can accomplish that goal. I hope 
the other members of this Committee will join me and Ranking Member 
Brady and support this legislation.
    Thank you Madam Chairwoman, and with that I yield back.
                               __________

     [Editorial From the Investor's Business Daily, April 16, 2009]

                            Probe Yourselves

Finance: House Speaker Nancy Pelosi wants a broad ``probe'' of Wall 
Street, much like the 1932 Pecora Commission that led to sweeping bank 
reforms. Good idea. Let the probing begin--with Pelosi's Congress.

    Named for its chief counsel, Ferdinand Pecora, the 1932 
congressional commission dragged influential bankers and stockbrokers 
before its members for rough questioning--both of their business 
practices and private lives.
    The Pecora Commission led directly to the Securities Act of 1933, 
the Securities Exchange Act of 1934 and the creation of the Securities 
Exchange Commission in 1935 to oversee Wall Street.
    Now Pelosi's calling for an encore. ``People are very unhappy with 
these bailouts,'' she noted, especially the bonuses that went to 
executives. ``Seventy five percent of the American people, at least, 
want an investigation of what happened on Wall Street.''
    No doubt, that's true. The problem is, what ``happened on Wall 
Street'' was a direct result of what happened on Capitol Hill and we're 
not the only ones who believe that, by the way.
    ``Government policies, especially the Community Reinvestment Act, 
and the affordable housing mission that Fannie Mae and Freddie Mac were 
charged with fulfilling, are to blame for the financial crisis,'' wrote 
economist Peter Wallison, a fellow at the American Enterprise 
Institute, recently.
    ``Regulators also deserve blame for lowering lending standards that 
then contributed to riskier homeownership and the housing bubble.'' 
Exactly correct.
    As such, Pelosi's proposed Pecora-style commission will be little 
more than a fig leaf to cover Congress' own multitude of sins--letting 
its members, the true creators of this financial mess, bash business 
leaders as they pose as populist saviors of Main Street from Wall 
Street predators.
    Why do this now? Pelosi and her Democrat colleagues are feeling the 
heat from Tea Party demonstrations and growing voter anger over the 
massive waste entailed in the $4 trillion (and rising) stimulus-bailout 
bonanza. Again, the Democrats created all this spending. Now, as it 
proves unpopular, they just walk away from it.
    On NPR Thursday, a reporter confronted Rep. Barney Frank, chairman 
of the Financial Services Committee, with the fact that his $300 
billion ``Hope for Homeowners'' program, passed with much fanfare last 
fall, had so far helped just one homeowner. One.
    Frank's response: It was the fault of the ``right.'' And Bush.
    Truth is, Frank's party has been in charge since 2006. And during 
that time, Democrats have presided over one of the most disgraceful and 
least accomplished Congresses in history. This financial mess began on 
their watch, yet they pretend otherwise.
    What better way to take the heat off yourself than by pointing 
accusing fingers at those most unlikable of people--Wall Street 
bankers? That's what the Pelosi-Pecora Commission will do.
    It won't get to the bottom of our financial crisis; it will 
carefully select scapegoats to be ritually shamed by the liberal media, 
stripped of their wealth, and exiled. Then new rules will be imposed 
that will no doubt make things worse. And the cycle will begin again.
    We're not saying Wall Street has no blame for the financial 
meltdown. But Wall Street didn't create the subprime mess. Congress, 
through repeated interventions in healthy markets, did. And when the 
whole thing failed, it was Congress' fault.
    We'd be happy to support a 9/11-style commission to look into the 
causes of the financial meltdown. But only if Congress agrees to put 
itself in the dock. Anything less would be a sham.
                               __________
              Prepared Statement of Dr. Joseph E. Stiglitz
    Let me first thank you for inviting me to speak to you on this 
critical topic. Too little attention has been given to the question of 
what kind of a financial system we want to have as we emerge from this 
crisis. The decisions we make today on how to rescue it inevitably will 
shape the financial system of tomorrow.
    As we think about what kind of financial system we would like, we 
should begin by recognizing the failures of our existing system.
    A good financial system manages risk and allocates capital, with 
the intent of increasing the overall efficiency of the economy; it does 
this with low transaction costs. However, we have a financial system 
which created risk and misallocated capital, with high transaction 
costs. While capital was being misallocated to homes beyond people's 
ability to pay and in places where homes were not needed, too little 
capital was being deployed to new start-ups, to create and expand small 
and medium size enterprises, which are the bases of a dynamic economy.
    A small part of our financial system, the venture capital firms, is 
responsible for a large part of our economy's economic growth. While 
our big banks have not been at the center of this dynamic growth, they 
have been at the center of this tempest; they have created risk to our 
country, without any offsetting rewards--though to be sure those in the 
industry have been rewarded well.
    Other parts of our financial system have done a good job--community 
banks, credit unions and local banks--in supplying consumers, small and 
medium sized enterprises with the finance they need.
    But we should also be aware of the inadequacies of our financial 
system--beyond the failures in risk management and capital allocation 
that led to this crisis. Our financial system discovered that there was 
money at the bottom of the pyramid and made a concerted effort to make 
sure that they money did not remain there. They engaged in predatory 
lending; it is ironic that they were hoisted by their own petard in the 
sub-prime mortgages. (As an aside, preventing banks from becoming too 
big to fail, and intense regulation of these too big to fail 
institutions, is not the only thing that is needed. We need a Financial 
Product Safety Commission to assess which financial products are safe 
for use by consumers--and for what purposes. But this Commission will 
help in addressing the problems of the too big to fail banks as well. 
It will take risk out of the system; these banks will not be able to 
buy up big packages of financial products that have a high risk of non-
payment. We need strong regulation at the bottom of the pyramid to 
complement the strong regulation at the top that I describe below.)
    In some developing countries, modern banking services have been 
extended to even the poor in remote villages; by contrast, the poor in 
our inner cities are still using check cashing services which charge 
exorbitant fees. Modern technology should have resulted in a low-cost 
electronic payments system. Our system entails exploitive fees.
    Thus, as we go about repairing--and bailing out--our financial 
system, we must keep in mind the kind of system we want to have going 
forward. We should not want to go back to the world as it was before 
the crisis. Nor can we.
    We had too big of a financial sector. In the post-crisis era, the 
financial sector as a whole will shrink. Do we want it all to shrink 
proportionately? Or do we want to strengthen those parts that have done 
well, forcing most of the cutbacks on the too-big-to-fail institutions 
that have held a gun at our head and demanded the payment of hundreds 
of billions of dollars, lest the whole economy fails? There is no good 
case for making the smaller, competitive, community-oriented 
institutions take the brunt of the down-sizing, as opposed to the 
bloated, ungovernable, and predatory institutions that were at the 
center of the crisis.
    I believe that one of the key problems comes from our allowing 
certain institutions to grow to be too big to fail--or, at the very 
least, very expensive to save. Some of them have demonstrated that they 
are too large to be managed. As Edward Liddy put it, ``When I answered 
the call for help and joined AIG in September 2008, one thing quickly 
became apparent: The company's overall structure is too complex, too 
unwieldy and too opaque for its component businesses to be well managed 
as one entity.''\1\
---------------------------------------------------------------------------
    \1\ Liddy, Edward M., ``Our Mission at AIG: Repairs, and 
Repayment,'' Washington Post, p. A13, March 18, 2009.
---------------------------------------------------------------------------
    And yet, the response to the crisis has led to a consolidation of 
the big banks, increasing the risk of surviving banks becoming ``too 
big to fail.'' The Congressional Oversight Panel has made it clear that 
some of the too-large-to-fail banks have been the recipients of huge 
subsidies under TARP. As I am sure you are aware, in the first set of 
TARP transactions, the largest subsidies, both in amounts and in 
percentage, went to Citigroup, Inc. and AIG. The value of the subsidy 
in the second Citigroup bail-out was estimated to be 50% of the $20 
billion they received. AIG's subsidy was estimated to be 63% of the $40 
billion they received. Back of the envelope calculations suggest that 
the more recent Citigroup subsidy may have been even larger.
    There are other large subsidies implicit or explicit in government 
guarantees for newly issued bonds. Still other subsidies are hidden 
within the FDIC, when insurance premiums do not accord with actuarial 
risks. I and many others fear that the Public Private Partnerships will 
result in the banks being overpaid for some of their risky mortgages; 
it is again a hidden subsidy tilting the playing field--in favor of the 
banks that were most engaged in excessively risky practices and that 
are in the best position to exploit a flawed bail-out program. As I 
pointed out in my New York Times op-ed,\2\ in spite of the rhetoric, 
this is not about price discovery of the assets as a result of problems 
of liquidity. What is being priced is an option on the asset, and the 
value of these options can be much, much larger than the actuarial 
value of the asset itself, with the difference being paid either by 
depositors (through FDIC insurance premiums)--and thus potentially, by 
a massive transfer from our good banks to our bad banks--or by 
taxpayers, if that proves too onerous, as well it might. Nor is it an 
ordinary partnership--the private sector gets 50% of the profits, 
though it puts up only 8% of the money, and yet the government is left 
bearing the brunt of the losses.
---------------------------------------------------------------------------
    \2\ Stiglitz, Joseph E., ``Obama's Ersatz Capitalism,'' New York 
Times, p. A31, April 1, 2009.
---------------------------------------------------------------------------
    We should recognize that there is no free lunch, and the basic laws 
of conservation of matter apply in economics as they do in physics. 
There have been real losses, as loans were made on the basis of a 
housing bubble. The bubble has now broken, and no expressions of 
confidence are going to change that. Moving losses from the banks' 
balance sheets to the taxpayers or FDIC--even when done in a non-
transparent way--does not make them go away. Indeed, because of the 
adverse incentive effects of the structure of the program, the losses 
may be increased. Adverse selection and winners' curse problems may 
further increase the costs to the taxpayers and depositors. Professor 
Jeffrey Sachs\3\ and others have written about the large opportunities 
for gaming the system. I illustrated this in my New York Times article 
by showing that an asset with a 50-50 chance of either being worth 0 or 
$200--so whose actuarial value is $100--could be purchased by the so-
called Partnership at a price of $150 and still yield a handsome profit 
for the private partner. Had I had space, I would have gone on to 
illustrate an even worse possibility: the bank (or a surrogate of the 
bank, such as a hedge fund associate) becomes the ``partner'' with the 
government and pays $300 for the asset. In doing so, it converts a 
risky asset worth, on average, $100, into a safe asset--it receives net 
$284 in both the good and bad outcomes. The government (TARP, FDIC) 
bears an expected loss of $184. With so much money being thrown around, 
we should expect problems.
---------------------------------------------------------------------------
    \3\ Sachs, Jeffrey, ``Obama's Bank Plan Could Rob the Taxpayer,'' 
Financial Times, March 25, 2009.
---------------------------------------------------------------------------
    We need a transparent accounting of the potential losses, based on 
realistic and worst case scenarios of declines in real estate prices--
not based on rosy scenarios suggesting that there will be no declines. 
Congress should demand a full risk analysis of the potential losses, 
not just from the TARP program but also from the other actions taken in 
response to this crisis: the increased coverage of deposit insurance; 
the guarantee of money markets (which acts as a subsidy to banks 
through its indirect impact on the commercial paper market); guarantees 
for bank fixed obligations; the value to the banks of the bail-outs of 
AIG, Fannie Mae, and Freddie Mac (the banks benefited indirectly as 
holders of Fannie and Freddie paper and as counterparties in AIG 
derivative swaps); the subsidies received as a result of the overpaying 
in the settling of AIG credit default swaps; and the variety of actions 
taken by the Fed. The Credit Reform Act made it clear that government 
should not provide guarantees and loans without taking into account an 
estimate of the losses. This is an important initiative in enhancing 
transparency in government, and it should apply equally to government 
agencies, like the FDIC and the Fed. Playing by the rules would have 
required such an accounting. This Committee should, in addition, ask 
the CBO for a full analysis of potential losses.
    In short, our bail-outs run the risk of transferring large amounts 
of money, often in nontransparent ways, to those banks that did the 
worse job in risk management--hardly principles on which normal market 
economics is based. Among these are some of the too-big-to-fail banks. 
In effect, the government is tilting the playing field--towards the 
losers, worsening the tilt that is always there simply from the 
implicit guarantees associated with being too big to fail. As I argue 
below, some of these subsidies may be an inevitable consequence of 
these banks' too big to fail status, but much of it is not. It has been 
a matter of policy choice.
    The non-transparent way we have been bailing out the banks will 
almost surely increase the total cost to the economy and to the 
taxpayer. We have confused two different principles: bailing out the 
banks and bailing out the bankers, their shareholders, and (possibly) 
certain categories of bondholders. We could have saved the banks but 
not the shareholders at a much lower cost than the amount spent. To put 
it another way, we have confused financial restructuring of an 
institution with the collapse of the institution. Even an institution 
which is too big to fail is not too big to be financially restructured.
    Inevitably, when an institution fails, there are effects on other 
institutions. Some of these may need help. Some may themselves be 
systemically significant. But it is often, perhaps usually, far cheaper 
to target money where it is needed than to rely on trickle down 
economics. As one looks at the recipients of the largesse given to AIG, 
relatively little of the money went to institutions that were 
systemically significant to the U.S., and at least the largest such 
recipient has claimed that it would not have failed, even had it not 
received the money. To be sure, it did not turn down the gift.
    The way we have conducted the bail-outs has almost surely added to 
both the budgetary costs and the real economic costs, both those that 
are being encountered today, and those costs which we will bear in the 
future.
    Regrettably, some of the discussion of regulatory reform has 
skirted the main issues. There is talk about the need for comprehensive 
oversight, bringing in the hedge funds. We should remember that the 
core problems were not with hedge funds; they were with regulations and 
regulatory enforcement of our big commercial and investment banks. This 
is what has to be fixed.
    Being too big to fail creates perverse incentives for excessive 
risk taking. The taxpayer bears the loss, while the bondholders, 
shareholders, and managers get the reward. It also distorts the 
marketplace in another way: as we have noted, there are hidden 
subsidies (which have been increased in the current crisis), for 
instance in deposit insurance, in the government-provided explicit 
guarantees to newly issued bonds, and in the implicit guarantees to 
bondholders and shareholders associated with the bail-outs. (Even if 
the FDIC bears the cost, it does not stay there; ultimately, it gets 
borne by market participants. Unless a strict ``polluter pays'' 
principle is adopted, the costs will be shifted in part to other 
financial institutions, with consequent distortions to the financial 
sector.)
    What we have seen has long been predicted by economists. The first 
lesson of economics is that incentives matter. When there are perverse 
incentives, there are perverse outcomes--unless we constrain behavior. 
We should not have been surprised with what has happened.
    Furthermore, this is neither the first failure of our big banks, 
nor the first bail-out. Their failures to judge creditworthiness have 
been repeated--in Mexico, in East Asia, in Latin America, in Russia. 
The only novel aspect of this is that it is the first major bail-out at 
the expense of the U.S. taxpayer since the S&L debacle. In these bail-
outs, there was much discussion of the problem of moral hazard. With 
each bail-out, it became worse.
    With the bail-out of AIG, we have officially announced that any 
institution which is systemically significant will be bailed out.
    We could have reduced the extent of moral hazard had we made an 
obvious distinction in the subsequent bail-outs between bailing out the 
banks and bailing out the bankers, their shareholders, and their 
bondholders. The decisions of both the Obama and Bush Administrations 
to extend unnecessarily the corporate safety net have meant not only 
that incentives are more distorted but also that our national debt will 
be massively larger than it otherwise would have been. Going forward, I 
think it is imperative that Congress narrow the breadth of this new 
corporate welfare state. It is people that we should be protecting, not 
corporations. But even were we to correct what I view to be these 
grievous mistakes, the problem of too-big-to-fail institutions remains.
    There are but too solutions: breaking up the institutions or 
regulating them heavily. For reasons that I will make clear, we need to 
do both.
    The only justification for allowing these huge institutions to 
continue is that there are significant economies of scope or scale that 
otherwise would be lost. I have seen no evidence to that effect. 
Indeed, as I have suggested, these big banks are not responsible for 
whatever dynamism there is in the American economy. The touted 
synergies of bringing together various parts of the financial industry 
have been a phantasm; more apparent are the conflicts of interest--
evidenced so clearly in the Worldcom and Enron scandals earlier this 
decade. In short, we have little to lose, and much to gain, by breaking 
up these behemoths, which are not just too big to fail but also too big 
to save and too big to manage.
    Thus, we need to begin now the admittedly gargantuan task of 
breaking out their commingled activities--insurance companies, 
investment banking, anything that is not absolutely essential. There 
needs to be a very heavy burden of proof to show that the economies of 
scope and scale are large and cannot be achieved in any other way, to 
justify forcing the public to bear the risk and the market to bear the 
inevitable distortions.
    The recent G-30 report put it well.\4\
---------------------------------------------------------------------------
    \4\ Group of Thirty, Financial Reform: A Framework for Financial 
Stability, Washington, DC, January 2009.

        Almost inevitably, the complexity of much proprietary capital 
        market activity, and the perceived need for confidentiality of 
        such activities, limits transparency for investors and 
        creditors alike . . . .In practice, any approach must recognize 
        that the extent of such risks, potential volatility, and the 
        conflicts of interests will be difficult to measure and 
        control. Experience demonstrates that under stress, capital and 
        credit resources will be diverted to cover losses, weakening 
        protection of client interests. Complex and unavoidable 
        conflicts of interest among clients and investors can be acute. 
        Moreover, to the extent that these proprietary activities are 
        carried out by firms supervised by government and protected 
        from the full force of potential failure there is a strong 
        element of unfair competition with ``free-standing'' 
        institutions . . . [And] is it really possible, with all the 
        complexities, risks, and potential conflicts, that even the 
        most dedicated board of directors and top management can 
        understand and maintain control over such a diverse and complex 
---------------------------------------------------------------------------
        mix of activities.

    We know that there will be pressures, over time, to soften any 
regulatory regime. We know that these too-large-to-fail banks also have 
enormous resources to lobby Congress to deregulate. We have seen it, 
and we are now suffering as a consequence. This was not an 
unforeseeable accident. It was predictable and predicted. Accordingly, 
I think it would be far better to break up these too-big-to-fail 
institutions and strongly restrict the activities in which they can be 
engaged than to try to control them.
    In short, we need to admit that those that predicted dire 
consequences to come from the repeal of the Glass-Steagall Act were 
correct. They warned about conflicts of interest, the increase in 
concentration of the banking system, with increasing risks of too-big-
to fail institutions--and increasing systemic risk as a result. They 
warned about the consequences of transferring the investment banking 
culture to the commercial banks, who are entrusted with the management 
of the payment system and ordinary individuals' savings--insured by the 
government. The critics suggested that the benefits from economies of 
scope and scale were exaggerated, and, if present at all, these were 
almost surely outweighed by the costs. As painful as it may be, we need 
to revisit these questions. Depression-era regulations may not be 
appropriate for the twenty-first century, but what was needed was not 
stripping away regulations but adapting the regulatory system to the 
new realities, e.g. the enhanced risk posed by derivatives and 
securitization.
    The process of breaking them up may be slow; there may be political 
resistance--even if the shareholders have not done well, their officers 
have, and their political contributions have not gone unnoticed. Hence, 
our regulatory structure must be prepared to deal with any financial 
institutions that are too big to fail. We cannot allow them to 
undertake the one-sided bets they have been making. There must be 
strong restrictions on the kinds of risk-taking positions that they can 
undertake. None should be allowed to have any off-balance sheet 
activities. They should not be allowed to have employee (and especially 
managerial) incentive structures that encourage excessive risk-taking 
and short-sighted behavior. We should limit credit default swaps and 
certain other derivatives to exchange traded transactions and to 
situations where there is an ``insurable risk.'' We should limit 
leverage, and capital adequacy standards should adjust to, say, the 
expansion of portfolios. Elsewhere, Elizabeth Warren has put forth a 
convincing case for a Financial Products Safety Commission. One of the 
tasks of such a Commission would be to identify which financial 
products were safe enough to be held or issued by the too-big-to-fail 
financial institutions. This is the comprehensive regulatory agenda 
that I have outlined in previous testimony.\5\ More than oversight is 
needed; what is needed are strong restrictions on what they can do.
---------------------------------------------------------------------------
    \5\ Stiglitz, Joseph, Testimony at the Regulatory Reform Hearing, 
Congressional Oversight Panel, January 14, 2009.
---------------------------------------------------------------------------
    Too big to fail banks should be forced to return to the boring 
business of doing conventional banking, leaving tasks of risk taking or 
management to others. There are plenty of other institutions (not 
depository institutions but smaller, more aggressive companies that are 
not so big that their failure would bring the entire economy down) that 
are able to take on risk. Such a reform would increase the efficiency 
of the economy, because as noted, in current institutional 
arrangements, the playing field is tilted against stand-alone 
institutions because of the implicit subsidy given to the too-big-to-
fail institutions.
    Too-big-to-fail banks are of particular concern because of the 
added problems of insured depositors. (Too-big-to-fail insurance 
companies should face corresponding restrictions, e.g. they should be 
limited to selling conventional insurance products, with well defined 
actuarial risks.)
    The restrictions on their activities may yield low returns--but 
that is as it should be: the high returns that they earned in the past 
were the result of risk taken at the expense of American taxpayers. A 
basic law in economics is that there is no free lunch; higher than 
normal returns come with risk--and these too-big-to-fail institutions 
are not the ones that should be undertaking this risk. There are plenty 
of other institutions in our society to fill the role.
    We should, at this point, recognize that for these too-big-to-fail 
institutions, we taxpayers are a peculiar implicit owner: we share in 
any (tax reported) profits (they are often clever not only in 
accounting and regulatory arbitrage but also in tax arbitrage), but we 
bear a disproportionate share of the losses. However, we have little 
control over what they do. Given our implicit stake, we should demand 
the highest standards of corporate governance, including full expensing 
of stock options.
    What I am arguing for is a variant of what is sometimes called the 
Public Utility Model. The too-big-to-fail banks should be put at the 
center of a new electronic payment system that will use modern 
technology to provide a twenty-first century payment system (at low 
costs) for America. They should not be allowed to engage in the 
predatory credit card practices that have become commonplace. We should 
have a twenty-first century efficient and fair credit system to 
correspond to our twenty-first century electronic payment mechanism. 
The too-big-to-fail banks should also be required to provide banking 
services to underserved communities--and at prices and terms that are 
competitive, reflecting actual costs.
    Nor does it make sense, as we have been doing, to force those banks 
that have been performing the job of real-banking to pay for the losses 
of the too-big-to-fail banks. It is neither equitable nor efficient. 
With bonds guaranteed by the FDIC, we are, in effect, forcing all 
depositors, including those in good banks, to bear at the very least 
some of the risk and costs associated with the mistakes of our banks 
that are too big to fail. They should bear this cost, e.g. in the form 
of a special tax imposed on profits, dividend distributions, bonuses, 
and interest payments on bonds. (If we can make a credible commitment 
not to bail out bondholders--demonstrated by allowing the current 
bondholders to take a haircut--the latter should be exempted. Given our 
current policy stance, they should not be.)
    In environmental economics there is the basic principle of the 
polluter pays. Those who pollute must pay the cost of clean-up. It is a 
matter of efficiency and equity. The too big-to-fail institutions have 
contributed to the pollution of the global economy with toxic 
mortgages; they should now pay for the cost of clean-up.
    One of the disturbing aspects of the recent bail-outs is the 
absence of a clear set of criteria--and a seeming inconsistency in 
practice. Ten years ago, many argued that it was appropriate for the 
government to take a key role in the bail-out of Long Term Capital 
Management, a hedge fund, because it was too big to fail--this after 
claims had been made that no hedge fund was large enough to pose 
systemic risk.
    The list of those that received AIG money includes many who did not 
pose systemic risk to the U.S., suggesting that it may have been far 
cheaper to target money to those that posed systemic risk; certainly, 
such a policy could have been designed to ensure a far higher expected 
return to Treasury than the strategy chosen.
    Before a crisis, every financial institution will claim that it 
does not pose systemic risk; in a crisis, almost all (and those that 
would be affected by a collapse) will make such claims. Recognizing 
this, we must take a precautionary approach: a systemically significant 
firm is any whose failure, alone or in conjunction with other firms 
following similar investment strategies, would lead to a cascade of 
effects significant enough to justify government intervention.
    If those in the financial market continue to insist, as they have 
been, that allowing any major bank to go under would lead to a cascade 
of effects simply because of fears that it might induce among 
bondholders, the reach of institutions that fall within the rubric of 
``too-big-to-fail'' needs to be greatly broadened. One cannot have it 
both ways: claim that we need only to regulate tightly the largest 
institutions that are too big to fail, and claim at the same time that 
a bankruptcy of any large institution would lead to a cascade of 
effects through market expectations. If the taxpayer is told he must 
pony up billions of dollars because allowing bondholder interests, or 
even shareholder interests, to be diminished as they would under normal 
rules of a market economy, then the net of strong regulation has to be 
correspondingly wide.
    We should recognize too that systemic significance is not only 
related to the size of the firm itself but also to its 
interconnectedness with the rest of the economy, and that a firm which 
is not systemically significant could easily turn into one. Even a 
small firm may be systemically significant. It was only a small part of 
AIG that was responsible for posing systemic risk. It might have done 
so as a stand-alone institution. Hence, we will have to impose 
analogous restrictions, perhaps slightly softened, on any financial 
institution that could turn into a too-big-to-fail institution. This is 
one of the reasons that regulation and oversight have to be 
comprehensive. (The mathematics of ascertaining systemic importance is 
complicated, but today, with adequate reporting requirements, we have 
the tools to do a far better job than in the past.)
    One of the quandaries we face going forward is that any 
restrictions on the banking system will encourage the development of a 
shadow-banking system. This is another reason why any regulatory system 
has to be comprehensive and flexible--flexible in extending the net of 
tight regulation to any new institutions or markets that represent 
systemic risk. However, there should be no flexibility in relaxing the 
net of regulation in response, perhaps, to some mistaken belief that 
markets are self-regulating (as we did during the past quarter century) 
on old institutions that continue to pose systemic risk.
    Even if we regulate our too-big-to-fail institutions reasonably 
well, some of them will fail. Of course, if we don't regulate them 
well--as we have not--failures will be more frequent. How we handle 
these failures is important. If we continue on the current path, it 
will increase the risk of moral hazard and will encourage excessive 
risk taking. We need to have a clear rule book, and we need to play by 
the rules. We know that in the next crisis, financial markets will 
again point a gun at our head, threatening the end of the world unless 
there is a massive bail-out. Never again, however, should we confuse 
bailing out the banks with bailing out the bankers and their 
shareholders.
    I applaud the Administration in their efforts to get stronger 
resolution powers. An appropriately designed system, fairly 
implemented, might enable government to take prompt corrective action--
before a calamity is on us--and, by forcing shareholders and 
bondholders to absorb the losses before imposing burdens either on 
taxpayers or the FDIC, might mitigate problems of moral hazard.
    Not only would such a system improve incentives, it might also 
address one of the concerns that is leading to such demoralization of 
the public--the appearance of selective enforcement of rules, of double 
standards, of some institutions and sectors being treated in a 
preferential way, perhaps not uncoincidentally, related to campaign 
contributions.
    We should recognize that, in a sense, the too-big-to-fail 
institutions have succeeded in managing their risk well--but not in the 
way advertised. A relatively small investment in campaign contributions 
(the combined campaign contributions of U.S. financial, insurance, and 
real-estate firms has been estimated at around $5 billion over the past 
decade) has succeeded in transferring losses to the public, estimated 
well in excess of a trillion dollars.
    There will be those who argue that this regulatory regime will 
stifle innovation. However, a disproportionate part of the innovations 
in our financial system have been aimed at tax, regulatory, and 
accounting arbitrage. They did not produce innovations which would have 
helped our economy manage some critical risks better--like the risk of 
home ownership. In fact, their innovations made things worse. I believe 
that a well-designed regulatory system, along the lines I've mentioned, 
will be more competitive and more innovative--with more of the 
innovative effort directed at innovations which will enhance the 
productivity of our firms and the well-being, including the economic 
security, of our citizens.
                               __________
               Prepared Statement of Dr. Simon Johnson\1\
---------------------------------------------------------------------------
    \1\ This testimony draws on joint work with James Kwak, 
particularly ``The Quiet Coup'' (The Atlantic, May 2009), and with 
Peter Boone. Our updates and detailed policy assessments are available 
daily at http://BaselineScenario.com.
---------------------------------------------------------------------------
    The depth and suddenness of the U.S. economic and financial crisis 
today are strikingly and shockingly reminiscent of experiences we have 
seen recently only in emerging markets: Korea in 1997, Malaysia in 1998 
and even Russia and Argentina, repeatedly.
    The common factor in those emerging market crises was a moment when 
global investors suddenly became afraid that the country in question 
wouldn't be able to pay off its debts, and stopped lending money 
overnight. In each case, the fear became self-fulfilling, as banks 
unable to roll over their debt did, in fact, become unable to pay off 
all their creditors.
    This is precisely what drove Lehman Brothers into bankruptcy on 
September 15, and the result was that, overnight, all sources of 
funding to the U.S. financial sector dried up. From that point, the 
functioning of the banking sector has depended on the Federal Reserve 
to provide or guarantee the necessary funding. And, just like in 
emerging markets crises, the weakness in the banking system has quickly 
rippled out into the real economy, causing a severe economic 
contraction and hardship for millions of people.
    This testimony examines how the United States became more like an 
emerging market, the politics of a financial sector with banks that are 
now ``too big to fail,'' and what this implies for policy--
particularly, the pressing need to apply existing antitrust laws to big 
finance.
                         how could this happen?
    The US has always been subject to booms and busts. The dotcom craze 
of the late 1990s is a perfect example of our usual cycle; many 
investors got overexcited and fortunes were lost. But at the end of the 
day we have the Internet which, like it or not, profoundly changes the 
way we organize society and make money. The same thing happened in the 
19th century with waves of investment in canals, railroad, oil, and any 
number of manufacturing industries.
    This time around, something was different. Behind the usual ups and 
downs during the past 25 or so years, there was a long boom in 
financial services--something you can trace back to the deregulation of 
the Reagan years, but which got a big jolt from the Clinton 
Administration's refusal to regulate derivatives market effectively and 
the failure of bank regulation under Alan Greenspan and the George W. 
Bush Administration. Finance became big relative to the economy, 
largely because of these political decisions, and the great wealth that 
this sector created and concentrated in turn gave bankers enormous 
political weight.
    This political weight had not been seen in the US since the age of 
J. P. Morgan (the man). In that period, the banking panic of 1907 could 
only be stopped by coordination among private-sector bankers, because 
there was no government entity able to offer an effective 
counterweight. But the first age of banking oligarchs came to an end 
with the passage of significant banking regulation during and in 
response to the Great Depression. But the emergence of a financial 
oligarchy during a long boom is typical of emerging markets.
    There were, of course, some facilitating factors behind the crisis. 
Top investment bankers and government officials like to lay the blame 
on low U.S. interest rates after the dotcom bust, or even better--for 
them--the flow of savings out of China. Some on the right of the 
spectrum like to complain about Fannie Mae or Freddie Mac, or even 
about longer-standing efforts to promote broader home ownership. And, 
of course, it is axiomatic to everyone that the regulators responsible 
for ``safety and soundness'' were fast asleep at the wheel.
    But these various policies--lightweight regulation, cheap money, 
the unwritten Chinese-American economic alliance, the promotion of 
homeownership--had something in common, even though some are 
traditionally associated with Democrats and some with Republicans: they 
all benefited the financial sector. The underlying problem was that 
policy changes that might have limited the ability of the financial 
sector to make money--such as Brooksley Born's attempts at the 
Commodity Futures Trading Commission to regulate over-the-counter 
derivatives such as credit default swaps--were ignored or swept aside.
    Big banks enjoyed a level of prestige that allowed them to do what 
they liked, for example with regard to ``risk management'' systems that 
allowed them to book large profits (and pay large bonuses) while taking 
risks that would be borne in the future--and by the rest of society. 
Regulators, legislators, and academics almost all assumed the managers 
of these banks knew what they were doing. In retrospect, of course, 
they didn't.
    Stanley O'Neal, CEO of Merrill Lynch, pushed his firm heavily into 
the mortgage-backed securities market at its peak in 2005 and 2006; in 
October 2007, he was forced to say, ``The bottom line is we . . . I . . 
. got it wrong by being overexposed to subprime, and we suffered as a 
result of impaired liquidity . . . in that market. No one is more 
disappointed than I am in that result.'' (O'Neal earned a $14 million 
bonus in 2006; forced out in October 2007, he walked away with a 
severance package worth over $160 million, although it is presumably 
worth much less today.)
    At the same time, AIG Financial Products earned over $2 billion in 
pretax profits in 2005, largely by selling underpriced insurance on 
complex, poorly-understood securities. Often described as ``picking up 
nickels in front of a steamroller,'' this strategy is highly profitable 
in ordinary years, and disastrous in bad years. As of last fall, AIG 
had outstanding insurance on over $500 billion of securities. To date, 
the U.S. government has committed close to $200 billion in investments 
and loans in an effort to rescue AIG from losses largely caused by this 
one division--and which its sophisticated risk models said would not 
occur.
    ``Securitization'' of subprime mortgages and other high-risk loans 
created the illusion of diversification. While we should never 
underestimate the human capacity for self-delusion, what happened to 
all our oversight mechanisms? From top to bottom, executive, 
legislative and judicial, were effectively captured, not in the sense 
of being coerced or corrupted, but in the equally insidious sense of 
being utterly convinced by whatever the banks told them. Alan 
Greenspan's pronouncements in favor of unregulated financial markets 
have been echoed numerous times. But this is what the man who succeeded 
him said in 2006: ``The management of market risk and credit risk has 
become increasingly sophisticated . . . banking organizations of all 
sizes have made substantial strides over the past two decades in their 
ability to measure and manage risks.''
    And they were captured (or completely persuaded) by exactly the 
sort of elite that dominates an emerging market. When a country like 
Indonesia or Korea or Russia grows, some people become rich and more 
powerful. They engage in some activities that are sensible for the 
broader economy, but they also load up on risk. They are masters of 
their mini-universe and they reckon that there is a good chance their 
political connections will allow them to ``put'' back to the government 
any substantial problems that arise. In Thailand, Malaysia, and 
Indonesia prior to 1997, the business elite was closely interwoven with 
the government; and for many of the oligarchs, the calculation proved 
correct--in their time of need, public assistance was forthcoming.
    This is a standard way to think about middle income or low income 
countries. And there are plenty of Americans who are also comfortable 
with this as a way of describing how some West European countries 
operate. Unfortunately, this is also essentially how the U.S. operates 
today.
                            the u.s. system
    Of course, the U.S. is unique. And just as we have the most 
advanced economy, military, and technology in the world, we also have 
the most advanced oligarchy.
    In a primitive political system, power is transmitted through 
violence, or the threat of violence: military coups, private militias, 
etc. In a less primitive system more typical of emerging markets, power 
is transmitted via money: bribes, kickbacks, and offshore bank 
accounts. Although lobbying and campaign contributions certainly play a 
major role in the American political system, old-fashioned corruption--
envelopes stuffed with $100 bills--is probably a sideshow today, Jack 
Abramoff notwithstanding.
    Instead, the American financial industry gained political power by 
amassing a kind of cultural capital--a belief system. Once, perhaps, 
what was good for General Motors was good for the United States. In the 
last decade, the attitude took hold in the U.S. that what was good for 
Big Finance on Wall Street was good for the United States. The banking 
and securities industry has become one of the top contributors to 
political campaigns, but at the peak of its influence it did not have 
to buy favors the way, for example, the tobacco companies or military 
contractors might have to. Instead, it benefited from the fact that 
Washington insiders already believed that large financial institutions 
and free-flowing capital markets were critical to America's position in 
the world.
    One channel of influence was, of course, the flow of individuals 
between Wall Street and Washington. Robert Rubin, co-chairman of 
Goldman Sachs, served in Washington as Treasury Secretary under 
President Clinton, and later became chairman of the executive committee 
of Citigroup. Henry Paulson, CEO of Goldman Sachs during the long boom, 
became Treasury Secretary under President George W. Bush. John Snow, an 
earlier Bush Treasury Secretary, left to become chairman of Cerberus 
Capital Management, a large private equity firm that also counts Vice 
President Dan Quayle among its executives. President George H. W. Bush 
has been an advisor to the Carlyle Group, another major private equity 
firm. Alan Greenspan, after the Federal Reserve, became a consultant to 
PIMCO, perhaps the biggest player on international bond markets.
    These personal connections--which were multiplied many times over 
on lower levels of the last three presidential administrations--
obviously contributed to the alignment of interests between Wall Street 
and Washington.
    Wall Street itself is a very seductive place, imbued with an aura 
not only of wealth but of power. The people who man its towers truly 
believe that they control the levers that make the world go 'round, and 
a civil servant from Washington invited into their conference rooms, 
even if just for a meeting, could be forgiven for falling under its 
sway.
    The seduction extended even (or especially) to finance and 
economics professors, historically confined to the cramped hallways of 
universities and the pursuit of Nobel Prizes. As mathematical finance 
became more and more critical to practical finance, professors 
increasingly took positions as consultants or partners at financial 
institutions. The most famous example is probably Myron Scholes and 
Robert Merton, Nobel Laureates both, taking positions at Long-Term 
Capital Management, but there are many others. One effect of this 
migration was to lend the stamp of academic legitimacy (and 
intellectual intimidation) to the burgeoning world of high finance.
    Why did this happen, and why now? America is a country that has 
always been fascinated with rather than repelled by wealth, where 
people aspire to become rich, or at least associate themselves with the 
rich, rather than redistribute their wealth downward. And roughly from 
the 1980s, more and more of the rich have made their money in finance.
    There are various reasons for this evolution. Beginning in the 
1970s, several factors upset the relatively sleepy world of banking--
taking deposits, making commercial and residential loans, executing 
stock trades, and underwriting debt and equity offerings. The 
deregulation of stock brokerage commissions in 1975 increased 
competition and stimulated participation in stock markets. In Liar's 
Poker, Michael Lewis singles out Paul Volcker's monetary policy and 
increased volatility in interest rates: this, Lewis argues, made bond 
trading much more popular and lucrative and, it is true, the markets 
for bonds and bond-like securities have been where most of the action 
has been in recent decades. Good old-fashioned innovation certainly 
played its part: the invention of securitization in the 1970s (and the 
ability of Salomon Brothers to make outsized amounts of money in 
mortgage-backed securities in the 1980s), as well as the invention of 
interest-rate swaps and credit default swaps, vastly increased the 
volume of transactions that bankers could make money on. Demographics 
helped: an aging and increasingly wealthy population invested more and 
more money in securities, helped by the invention of the IRA and the 
401(k) plan, again boosting the supply of the raw material from which 
bankers make money. These developments together vastly increased the 
opportunities to make money in finance.
    Not surprisingly, financial institutions started making a lot more 
money, beginning in the mid-1980s. 1986 was the first year in the 
postwar period that the financial sector earned 19% of total domestic 
corporate profits. In the 1990s, that figure oscillated between 21% and 
30%; this decade, it reached as high as 41%. The impact on compensation 
in the financial sector was even more dramatic. From 1948 to 1982, 
average compensation in the financial sector varied between 99% and 
108% of the average for all domestic private industries. From 1983, it 
shot upward in nearly a straight line, reaching 181% in 2007.
    The results were simple. Jobs in finance became more prestigious, 
people in finance became more prestigious, and the cult of finance 
seeped into the culture at large, through works like Liar's Poker, 
Barbarians at the Gate, Wall Street, and Bonfire of the Vanities. Even 
the convicted criminals, like Michael Milken and Ivan Boesky, became 
larger than life. In a country that celebrates the idea of making 
money, it was easy to infer that the interests of the financial sector 
were the same as the interests of the country as a whole--and that the 
winners in the financial sector knew better what was good for American 
than career civil servants in Washington.
    As a consequence, there was no shadowy conspiracy that needed to be 
pursued in secrecy. Instead, it became a matter of conventional 
wisdom--trumpeted on the editorial pages of The Wall Street Journal and 
in the popular press as well as on the floor of Congress--that 
financial free markets were good for the country as a whole. As the 
buzz of the dotcom bubble wore off, finance and real estate became the 
new American obsession. Private equity firms became the destination of 
choice for business students and hedge funds became the surefire way to 
make not millions but tens of millions of dollars. In America, where 
wealth is less resented than celebrated, the masters of the financial 
universe became objects of admiration or even adulation.
    The deregulatory policies of the past decade flowed naturally from 
this confluence of campaign finance, personal connections, and 
ideology: insistence on free flows of capital across borders; repeal of 
the Depression-era regulations separating commercial and investment 
banking; a Congressional ban on the regulation of credit default swaps; 
major increases in the amount of leverage allowed to investment banks; 
a general abdication by the Securities and Exchange Commission of its 
enforcement responsibilities; an international agreement to allow banks 
to measure their own riskiness; a short-lived proposal to partially 
privatize social security; and, most banally but most importantly, a 
general failure to keep pace with the tremendous pace of innovation in 
financial markets.
              american oligarchs and the financial crisis
    The oligarchy and the government policies that aided it did not 
alone cause the financial crisis that exploded last year. There were 
many factors that contributed, including excessive borrowing by 
households and lax lending standards out on the fringes of the 
financial world. But major commercial and investment banks--and their 
fellow travelers--were the big beneficiaries of the twin housing and 
asset bubbles of this decade, their profits fed by an ever-increasing 
volume of transactions founded on a small base of actual physical 
assets. Each time a loan was sold, packaged, securitized, and resold, 
banks took their transaction fees, and the hedge funds buying those 
securities reaped ever-larger management fees as their assets under 
management grew.
    Because everyone was getting richer, and the health of the national 
economy depended so heavily on growth in real estate and finance, no 
one in Washington had the incentive to question what was going on. 
Instead, Fed Chairman Greenspan and President Bush insisted repeatedly 
that the economy was fundamentally sound and that the tremendous growth 
in complex securities and credit default swaps were symptoms of a 
healthy economy where risk was distributed safely.
    In summer 2007, the signs of strain started appearing--the boom had 
produced so much debt that even a small global economic stumble could 
cause major problems. And from then until the present, the financial 
sector and the federal government have been behaving exactly the way 
one would expect after having witnessed emerging market financial 
crises in the past.
    In a financial panic, the critical ingredients of the government 
response must be speed and overwhelming force. The root problem is 
uncertainty--in our case, uncertainty about whether the major banks 
have sufficient assets to cover their liabilities. Half measures 
combined with wishful thinking and a wait-and-see attitude are 
insufficient to overcome this uncertainty. And the longer the response 
takes, the longer that uncertainty can sap away at the flow of credit, 
consumer confidence, and the real economy in general--ultimately making 
the problem much harder to solve.
    Instead, however, the principal characteristics of the government's 
response to the financial crisis have been denial, lack of 
transparency, and unwillingness to upset the financial sector.
    First, there was the prominent place of policy by deal: when a 
major financial institution, got into trouble, the Treasury Department 
and the Federal Reserve would engineer a bailout over the weekend and 
announce that everything was fine on Monday. In March 2008, there was 
the sale of Bear Stearns to JPMorgan Chase, which looked to many like a 
gift to JPMorgan. The deal was brokered by the Federal Reserve Bank of 
New York--which includes Jamie Dimon, CEO of JPMorgan, on its board of 
directors. In September, there were the takeover of Fannie Mae and 
Freddie Mac, the sale of Merrill Lynch to Bank of America, the decision 
to let Lehman fail, the destructive bailout of AIG, the takeover and 
immediate sale of Washington Mutual to JPMorgan, and the bidding war 
between Citigroup and Wells Fargo over the failing Wachovia--all of 
which were brokered by the government. In October, there was the 
recapitalization of nine large banks on the same day behind closed 
doors in Washington. This was followed by additional bailouts for 
Citigroup, AIG, Bank of America, and Citigroup (again).
    In each case, the Treasury Department and the Fed did not act 
according to any legislated or even announced principles, but simply 
worked out a deal and claimed that it was the best that could be done 
under the circumstances. This was late-night, back-room dealing, pure 
and simple.
    What is more telling, though, is the extreme care the government 
has taken not to upset the interests of the financial institutions 
themselves, or even to question the basic outlines of the system that 
got us here.
    In September 2008, Henry Paulson asked for $700 billion to buy 
toxic assets from banks, as well as unconditional authority and freedom 
from judicial review. Many economists and commentators suspected that 
the purpose was to overpay for those assets and thereby take the 
problem off the banks' hands--indeed, that is the only way that buying 
toxic assets would have helped anything. Perhaps because there was no 
way to make such a blatant subsidy politically acceptable, that plan 
was shelved.
    Instead, the money was used to recapitalize (buy shares in) banks--
on terms that were grossly favorable to the banks. For example, Warren 
Buffett put new capital into Goldman Sachs just weeks before the 
Treasury Department invested in nine major banks. Buffett got a higher 
interest rate on his investment and a much better deal on his options 
to buy Goldman shares in the future.
    As the crisis deepened and financial institutions needed more 
assistance, the government got more and more creative in figuring out 
ways to provide subsidies that were too complex for the general public 
to understand. The first AIG bailout, which was on relatively good 
terms for the taxpayer, was renegotiated to make it even more friendly 
to AIG. The second Citigroup and Bank of America bailouts included 
complex asset guarantees that essentially provided nontransparent 
insurance to those banks at well below-market rates. The third 
Citigroup bailout, in late February 2009, converted preferred stock to 
common stock at a conversion price that was significantly higher than 
the market price--a subsidy that probably even most Wall Street Journal 
readers would miss on first reading. And the convertible preferred 
shares that will be provided under the new Financial Stability Plan 
give the conversion option to the bank in question, not the 
government--basically giving the bank a valuable option for free.
    One problem with this velvet-glove strategy is that it was simply 
inadequate to change the behavior of a financial sector used to doing 
business on its own terms. As an unnamed senior bank official said to 
The New York Times, ``It doesn't matter how much Hank Paulson gives us, 
no one is going to lend a nickel until the economy turns.''
    At the same time, the princes of the financial world assumed that 
their position as the economy's favored children was safe, despite the 
wreckage they had caused. John Thain, in the midst of the crisis, asked 
his board of directors for a $10 million bonus; he withdrew the request 
amidst a firestorm of protest after it was leaked to the Wall Street 
Journal. Merrill Lynch as a whole was no better, moving its bonus 
payments forward to December, reportedly (although this is disputed) to 
avoid the possibility they would be reduced by Bank of America, which 
would own Merrill beginning on January 1.
    This continued solicitousness for the financial sector might be 
surprising coming from the Obama Administration, which has otherwise 
not been hesitant to take action. The $800 billion fiscal stimulus plan 
was watered down by the need to bring three Republican senators on 
board and ended up smaller than many hoped for, yet still counts as a 
major achievement under our political system. And in other ways, the 
new administration has pursued a progressive agenda, for example in 
signing the Lilly Ledbetter law making it easier for women to sue for 
discrimination in pay and moving to significantly increase the 
transparency of government in general (but not vis-a-vis its dealings 
with the financial sector).
    What it shows, however, is that the power of the financial sector 
goes far beyond a single set of people, a single administration, or a 
single political party. It is based not on a few personal connections, 
but on an ideology according to which the interests of Big Finance and 
the interests of the American people are naturally aligned--an ideology 
that assumes the private sector is always best, simply because it is 
the private sector, and hence the government should never tell the 
private sector what to do, but should only ask nicely, and maybe 
provide some financial handouts to keep the private sector alive.
    To those who live outside the Treasury-Wall Street corridor, this 
ideology is increasingly not only at odds with reality, but actually 
dangerous to the economy.
                              the way out
    Looking just at the financial crisis (and leaving aside some 
problems of the larger economy), we face at least two major, 
interrelated problems. The first is a desperately ill banking sector 
that threatens to choke off any incipient recovery that the fiscal 
stimulus might be able to generate. The second is a network of 
connections and ideology that give the financial sector a veto over 
public policy, even as it loses popular support.
    That network, it seems, has only gotten stronger since the crisis 
began. And this is not surprising. With the financial system as fragile 
as it is, the potential damage that a major bank could cause--Lehman 
was small relative to Citigroup or Bank of America--is much greater 
than it would be during ordinary times. The banks have been exploiting 
this fear to wring favorable deals out of Washington. Bank of America 
obtained its second bailout package (in January 2009) by first 
threatening not to go through with the acquisition of Merrill Lynch--a 
prospect that Treasury did not want to consider.
    In some ways, of course, the government has already taken control 
of the banking system. Since the market does not believe that bank 
assets are worth more than their liabilities--at least for several 
large banks that are a large proportion of the overall system--the 
government has already essentially guaranteed their liabilities. The 
government has already sunk hundreds of billions of dollars into banks. 
The government is the only plausible source of capital for the banks 
today. And the Federal Reserve has taken on a major role in providing 
credit to the real economy. We have state control of finance without 
much control over banks or anything else--we can try to limit executive 
compensation, but we don't get to replace boards of directors and we 
have no say in who really runs anything.
    One solution is to scale-up the standard FDIC process. A Federal 
Deposit Insurance Corporation (FDIC) ``intervention'' is essentially a 
government-managed bankruptcy procedure for banks. Organizing 
systematic tough assessments of capital adequacy, followed by such 
interventions, would simplify enormously the job of cleaning up the 
balance sheets of the banking system. The problem today is that 
Treasury negotiates each bailout with the bank being saved, yet 
Treasury is paradoxically--but logically, given their anachronistic 
belief system--behaving as if the bank holds all the cards, contorting 
the terms of the deal to minimize government ownership while 
forswearing any real influence over the bank.
    Cleaning up bank balance sheets cannot be done through negotiation. 
Everything depends on the price the government pays for those assets, 
and the banks' incentive is to hold up the government for as high a 
price as possible. Instead, the government should thoroughly inspect 
the banks' balance sheets and determine which cannot survive a severe 
recession (the current ``stress tests'' are fine in principle but not 
tough enough in practice). These banks would then face a choice: write 
down your assets to their true value and raise private capital within 
thirty days, or be taken over by the government. The government would 
clean them up by writing down the banks' toxic assets--recognizing 
reality, that is--and transferring those to a separate government 
entity, which would attempt to salvage whatever value is possible for 
the taxpayer (as the Resolution Trust Corporation did after the Savings 
and Loan debacle of the 1980s).
    This would be expensive to the taxpayer; according to the latest 
IMF numbers, the bank clean-up itself would probably cost close to $1.5 
trillion (or 10% of our GDP) in the long term. But only by taking 
decisive action that exposes the full extent of the financial rot and 
restores some set of banks to publicly verifiable health can the 
paralysis of the financial sector be cured.
    But the second challenge--the power of the oligarchy--is just as 
important as the first. And the advice from those with experience in 
severe banking crises would be just as simple: break the oligarchy.
    In the U.S., this means breaking up the oversized institutions that 
have a disproportionate influence on public policy. And it means 
splitting a single interest group into competing subgroups with 
different interests. How do we do this?
    First, bank recapitalization--if implemented right--can use private 
equity interests against the powerful large bank insiders. The banks 
should be sold as going concerns and desperately need new powerful 
shareholders. There is a considerable amount of wealth ``on the 
sidelines'' at present, and this can be enticed into what would 
essentially be reprivatization deals. And there are plenty of people 
with experience turning around companies who can be brought in to shake 
up the banks.
    The taxpayer obviously needs to keep considerable upside in these 
deals, and there are ways to structure this appropriately without 
undermining the incentives of new controlling shareholders. But the key 
is to split the oligarchy and set the private equity part onto sorting 
out the large banks.
    The second step is somewhat harder. You need to force the new 
private equity owners of banks to break them up, so they are no longer 
too big to fail--and making it harder for the new oligarchs to 
blackmail the government down the road. The major banks we have today 
draw much of their power from being too big to fail, and they could 
become even more dangerous when run by competent private equity 
managers.
    Ideally, big banks should be sold in medium-sized pieces, divided 
regionally or by type of business, to avoid such a concentration of 
power. If this is practically infeasible--particularly as we want to 
sell the banks quickly--they could be sold whole, but with the 
requirement of being broken up within a short period of time. Banks 
that remain in private hands should also be subject to size 
limitations.
    This may seem like a crude and arbitrary step, but it is the most 
direct way to limit the power of individual institutions, especially in 
a sector that, the last year has taught us, is even more critical to 
the economy as a whole than anyone had imagined. Of course, some will 
complain about ``efficiency costs'' from breaking up banks, and they 
may have a point. But you need to weigh any such costs against the 
benefits of no longer having banks that are too big to fail. Anything 
that is ``too big to fail'' is now ``too big to exist.''
    To back this up, we quickly need to overhaul our anti-trust 
framework. Laws that were put in place over 100 years ago, to combat 
industrial monopolies, need to be reinterpreted (and modernized) to 
prevent the development of financial concentrations that are too big to 
fail. The issue in the financial sector today is not about having 
enough market share to influence prices, it is about one firm or a 
small set of interconnected firms being big enough so that their self-
destruction can bring down the economy. The Obama Administration's 
fiscal stimulus invokes FDR, but we need at least equal weight on Teddy 
Roosevelt-style trust-busting.
    Third, to delay or deter the emergence of a new oligarchy, we must 
go further: caps on executive compensation--for all banks that receive 
any form of government assistance, including from the Federal Reserve--
can play a role in restoring the political balance of power. While some 
of the current impetus behind these caps comes from old-fashioned 
populism, it is true that the main attraction of Wall Street--to the 
people who work there, to the members of the media who spread its 
glory, and to the politicians and bureaucrats who were only too happy 
to bask in that reflected glory--was the astounding amount of money 
that could be made. To some extent, limiting that amount of money would 
reduce the allure of the financial sector and make it more like any 
other industry.
    Further regulation of behavior is definitely needed; there will be 
costs, but think of the benefits to the system as a whole. In the long 
run, the only good solution may be better competition--finally breaking 
the non-competitive pricing structures of hedge funds, and bringing 
down the fees of the asset management and banking industry in general. 
To those who say this would drive financial activities to other 
countries, we can now safely say: fine.
    Of course, all of this is at best a temporary solution. The economy 
will recover some day, and Wall Street will be there to welcome the 
most financially ambitious graduates of the world's top universities. 
The best we can do is put in place structural constraints on the 
financial sector--antitrust rules and stronger regulations--and hope 
that they are not repealed amidst the euphoria of a boom too soon in 
the future. In the meantime, we can invest in education, research, and 
development with the goal of developing new leading sectors of our 
economy, based on technological rather than financial innovation.
    In a democratic capitalist society, political power flows towards 
those with economic power. And as society becomes more sophisticated, 
the forms of that power also become more sophisticated. Until we come 
up with a form of political organization that is less susceptible to 
economic influences, oligarchs--like booms and busts--are something 
that we must account for and be prepared for. The crucial first step is 
recognizing that we have them.
                               __________
                 Prepared Statement of Thomas M. Hoenig
    Madam Chair Maloney, Vice Chair Schumer, ranking members Brady and 
Brownback, and members of the committee, I appreciate the opportunity 
to talk with you about the issues surrounding the exceptionally large 
financial institutions whose failure may pose systemic threats to the 
financial system.
    The United States currently faces economic turmoil related directly 
to a loss of confidence in these large institutions. Although the 
response to the events of the past year has taken on various forms, so 
far, we have not seen the return of confidence and transparency to 
financial markets, leaving lenders and investors wary of making new 
commitments. Until that faith is restored, it is impossible for us to 
achieve full economic recovery.
    When the crisis began to unfold last year, and its full depth was 
not yet clear, we were quick to pump substantial liquidity into the 
system. In the world we find today, with the crisis continuing and 
hundreds of thousands of Americans losing their jobs every month, it 
remains tempting to pour additional funds into these institutions in 
hopes of a turnaround. We have taken these steps instead of defining a 
consistent plan or addressing the core issue of how to deal with these 
institutions that now block our path to recovery. Our actions so far 
risk prolonging the crisis while increasing the cost and raising 
serious questions about how we eventually unwind these programs without 
creating another financial crisis as bad or worse than the one we 
currently face.
    These large and systemically important institutions are regularly 
referred to as ``too big to fail,'' but yet we all know that a free 
market system requires that insolvent firms, regardless of their size, 
market position or the complexity of their operations, must fail. We 
have been unwilling to allow this to happen to these firms, ignoring 
that we have an existing mechanism that can be used for firms of all 
sizes and allows for their dissolution while controlling damage to the 
broader financial system.
    There seems to be a prevalent line of thinking that the problems we 
now face with these institutions are simply too complex for us to 
resolve without widespread damage to the financial system. I don't 
think those who managed the Reconstruction Finance Corporation, the 
Resolution Trust Corporation or the Swedish financial crisis were 
provided with a blueprint that guaranteed their success. And though I 
would be the first to acknowledge that the path I propose is not easy, 
I do not accept the idea that we have lost our ability to solve the 
challenges we now face.
    This system has a proven track record in the United States as well 
as abroad and it would serve us well in the current crisis. I have 
included in this written testimony the text of a speech I delivered 
recently in Tulsa, Okla., that spells out the details of how this 
program would work. Additionally, I have included supplementary 
information including further details related to the resolution 
framework for large institutions; the process used to handle the 1984 
failure; of Continental Illinois, which was one of our nation's largest 
financial institutions at the time of its failure, and the approach 
Sweden took in response to that nation's banking crisis in the 1990s, 
which is very similar in many ways to what we face in the United States 
today.
    In addition to the current turmoil, from a regulatory perspective 
we must also make the changes necessary to protect the financial system 
from a similar crisis in the future. For some time, there has been an 
ongoing debate in the regulatory community pitting proponents of a 
broad principles-based approach against those favoring a more rigid 
rules-based system that can be widely understood and more readily, and 
evenly, enforced. The current crisis has made the case that the rules 
system is our only alternative, as the principles-based approach leaves 
far too much open for the discretion of the firms in question and not 
enough authority for the various regulatory agencies.
    Along these same lines, this crisis has been the first real test of 
the Basel II capital framework, and it has failed miserably. Basel II 
relies on firms making their own detailed assessments of the risks they 
have assumed so a capital requirement can be assigned. I would doubt 
any of us today would believe such a system to be desirable or even 
workable.
    Enforcement under Basel II relies on examiners understanding and 
evaluating extremely complex mathematical models. When it becomes clear 
that these models understate capital needs, examiners often have 
difficulty arguing the technical merits of their views and convincing 
bank management to add capital. In many ways, Basel II provides banks 
with a rationale, a defense and an opportunity for taking excessive 
leverage. Banks have strong competitive and financial incentives to 
increase leverage. During good times, leverage increases profitability, 
but it also increases risk. We have seen the broad systemic effects of 
excessive leverage. To limit such problems in the future, we must 
maintain limits on financial leverage through strict rules setting 
minimum capital-to-asset ratios. It would be the easiest, most 
equitable and clear-cut way to set capital requirements for all sizes 
of banks and for a broader range of firms throughout financial markets.
    One of the more troubling aspects of this crisis has been that in 
many ways these events have not been unpredictable. A decade ago, I and 
others anticipated that the financial megamergers we were seeing at 
that time would lead to a situation like the one we face today.
    Although we did not have any way of knowing the events that would 
provide the stimulus for this crisis, there were already concerns in 
1999 that, ``In a world dominated by mega financial institutions, 
governments could be reluctant to close those that become troubled for 
fear of systemic effects on the financial system. To the extent these 
institutions become `too big to fail,' and where uninsured depositors 
and other creditors are protected by implicit government guarantees, 
the consequences can be quite serious. Indeed, the result may be a less 
stable and a less efficient financial system.''\1\
    This is clearly the result we now face, and it is even more 
pressing that we deal with the problem at hand in a manner that brings 
stability and transparency back into our system for the current 
environment or it is a certainty that this is an environment in which 
we will find ourselves yet again.
---------------------------------------------------------------------------
    \1\ ``Financial Industry Megamergers and Policy Challenges,'' 
speech by Thomas M. Hoenig, delivered March 25, 1999. Accessible at 
www.KansasCityFed.org/home/subwebnav.cfm?level=3&theID=9983&SubWeb=6.
---------------------------------------------------------------------------
                       SUCCESS DEPENDS ON FAILURE

   (Thomas M. Hoenig, President and Chief Executive Officer, Federal 
             Reserve Bank of Kansas City, Kansas City, MO)

    As you all know, we are in the middle of a very serious financial 
crisis, and our economy is under significant stress. There has been 
much debate about how we should address these challenges, but 
regardless of the method one supports, all agree that the economy will 
not recover until the financial system is stabilized and credit flows 
improve.
    The restoration of normal financial market activity depends on how 
we deal with the problems of our largest financial institutions. It is 
has been a little more than a year since the first major government 
rescue occurred with Bear Stearns being acquired by JPMorgan. Since 
then, numerous programs have been enacted and trillions of dollars of 
public funds have been committed, much of it directly to our largest 
institutions. Despite these well-intentioned efforts, the problems 
remain, and the public's dissatisfaction with how their money is being 
spent grows.
    It is not surprising that the initial measures taken in this crisis 
were ad hoc. The depth and extent of the problems were not anticipated. 
However, more than a year has passed and the challenge that still 
remains is to define a plan that addresses the significant asset 
problems embedded in our largest institutions. We must provide 
financial firms, investors and consumers with a clear and fair plan for 
dealing with firms that many call ``too big to fail.''
    Last month, I gave a speech that outlined a resolution framework 
and a plan for how we should deal with these large systemically 
important financial firms. I believe that failure is an option. Those 
who disagree with my resolution proposal say that it is unworkable. In 
my remarks today, I will offer more details about how the process would 
work and explain why I think it is the best solution for getting our 
financial system and economy on the road to recovery.
                 principles for a resolution framework
    For a free market system to be successful, firms must be allowed to 
fail based upon a predefined set of rules and principles that market 
participants can rely on when determining their strategies and making 
decisions. This is particularly important for problem financial 
institutions. These key principles should apply if we are talking about 
a small bank in Tulsa or a large international financial conglomerate 
in New York City.
    The first principle is to properly understand our goals and 
correctly identify the problems we are attempting to solve. This may 
sound obvious. However, when we are in the middle of a crisis where 
more than a half million people are losing their jobs every month, it 
is tempting to pour money into the institutions thinking that it will 
correct the problem and get credit flowing once again. Also, rather 
than letting the market system objectively discipline the firms through 
failure and stockholder loss, we tend to micromanage the institutions 
and punish those within reach.
    This lack of confidence in the market's remedy is most acute for 
our largest financial institutions, which have publically disclosed 
substantial losses. The question that the supervisory authorities must 
answer is whether the losses are large enough to threaten the solvency 
of any of these firms. This assessment is the first step in determining 
actions necessary to restoring public confidence in our financial 
system.
    A second principle is that we must do what is best for the overall 
economy and not what is best for one group. We need to make sure that 
when one financial firm fails, the resolution process does not cause 
significant disruptions to financial markets and the economy or make 
the current problems worse. Furthermore, we must do it for the lowest 
possible cost so that we don't create a long-term fiscal burden on 
taxpayers.
    It is important to recognize that there are not just the direct 
costs but, more importantly, long-term costs to the economy and 
financial system. The direct cost of resolving a failed bank, such as 
the government bearing some of a failed bank's losses, is simple to 
determine. However, it is much more difficult to know the costs from 
some of the unintended consequences. For example, market discipline is 
reduced when a resolution process does not make management, 
shareholders and creditors bear the costs of their actions.
    The third principle is equity of treatment. Regardless of an 
institution's size, complexity or location, the resolution process must 
provide consistent treatment of a failing institution's owners, 
managers, employees and customers. The process must be transparent and 
clearly stated so that everyone understands what to expect if they 
gamble with the firm's assets.
    When talking about equity of treatment, it is important to 
recognize that a single process can lead to different outcomes. For 
example, if any bank is examined and found to be insolvent, it needs to 
go through the resolution process with the owners losing their 
investment. However, the eventual outcomes for the institution can be 
different. A smaller bank's assets and deposits will likely be sold to 
another bank. In the case of a larger bank, the firm might be 
temporarily operated as a bridge bank before either being sold or 
reprivatized. Regardless, it is important that the banks go through the 
same process or else an incentive will be created for banks to take on 
excessive risks in an effort to grow large enough to gain favorable 
treatment.
    A final principle is that we must base the resolution process on 
facts about what works and what does not work. One way to do this is to 
look at past financial crises. This is not the first financial crisis, 
and we can learn a lot about what will and will not be successful by 
looking back at our own history with financial crises, as well as at 
the experiences in other countries.
                        identifying the problem
    With these principles in mind, how should we go about resolving the 
current problems at our largest institutions?
    First, we must determine both the location and size of the losses. 
Admittedly, it will not be easy. These firms are very large--the four 
largest bank holding companies each have more than $1 trillion of 
assets, which accounts for about half of the banking industry's assets. 
They have offices around the world, and they are involved in many 
complex businesses. But in order to repair the financial system, we 
must get the best estimates of the condition and viability of these 
firms, and we must require them to reflect their losses in their 
financial statements.
    Normally, we think of a business' solvency in terms of the value of 
its equity capital. When the value of its assets is less than the value 
of its liabilities, it has negative equity and it has failed. A 
financial firm, however, can also fail if its liquidity is insufficient 
to meet its current payment obligations, either because it can't sell 
its assets for enough to pay off maturing liabilities, or it loses 
market confidence and cannot borrow enough.
    I would note that these are concrete definitions and not subjective 
conditions. I mention this because it points out that the term ``too 
big to fail'' is a misstatement. It does not matter what size the firm 
is. Although a bank might still be open and operating, if it is 
insolvent by these definitions, it has failed.
    Once we determine a bank's status, we would classify these 
institutions into three categories, depending on whether they are 
solvent and what their prospects are for continuing as an ongoing 
concern.
    The first category would be firms whose operations are strong and 
whose equity remains above minimum requirements. These firms would not 
require much government support, if any. Some might need to raise 
additional capital to provide a greater cushion against the losses they 
may suffer during the current crisis. But these institutions are 
basically sound and should be able to raise private capital.
    The second category would be those institutions whose equity 
temporarily falls below minimum requirements but are expected to 
recover in a reasonable period of time as economic conditions improve. 
These firms have generally sound management, who may have made some 
mistakes and suffered greater losses than normal due to the economic 
downturn. It is reasonable to expect these banks to raise additional 
private capital. However, the government may need to provide some 
capital in the form of preferred shares and possibly some warrants in 
return. As an equity holder, the government would have an oversight 
role regarding the firms' operations and activities.
    The final category is for the institutions that are no longer 
viable either because of liquidity problems or their equity capital is 
currently negative or it is likely to become negative, based on 
reasonable expectations of future market and economic conditions. These 
firms, which would likely soon become equity insolvent without 
government protections and guarantees, would be declared insolvent by 
the regulatory authority. Shareholders would be forced to bear the full 
cost of the positions they have taken and risk losing their investment. 
Senior management and the board of directors would be replaced because 
they are responsible for the failed strategy.
                          a resolution process
    The question then becomes how to resolve these failed institutions 
while minimizing the cost and disruption to the economy.
    The method most often used when a bank fails is to arrange for a 
sale of its assets and an assumption of its liabilities by another 
institution. For these extremely large firms, there are a couple of 
significant roadblocks preventing this solution. First, the acquiring 
firm must have the capacity for the acquisition, which means it would 
have to be in the same size range as the failed institution. And 
secondly, if such a deal was forged, it would create an even larger 
firm with greater systemic risks to the economy.
    Instead, an extremely large firm that has failed would have to be 
temporarily operated as a conservatorship or a bridge organization and 
then reprivatized as quickly as is economically feasible. We cannot 
simply add more capital without a change in the firm's ownership and 
management and expect different outcomes in the future.
    Experience shows that this approach has worked. The best example 
was with the failure of Continental Illinois National Bank and its 
holding company in 1984. Because we are in Oklahoma today, I will note 
that Continental's problems began with some bad loans it purchased from 
Oklahoma City's Penn Square Bank. As an officer in our Bank's 
regulatory function at that time, I was directly involved in the 
closing of Penn Square. In fact, from 1982 to 1992, 347 banks failed or 
received FDIC assistance in the Tenth Federal Reserve District states. 
I was involved in almost every one of these resolutions and all were 
tragedies. I tell you this to make clear that I do not take this 
proposal lightly nor do I expect any size bank failure to be easy or 
painless. But the process that worked for Continental Illinois is a 
viable approach to addressing important aspects of today's crisis.
    At the time of its failure, Continental Illinois had $40 billion in 
assets and was the nation's largest commercial and industrial lender. 
It was the seventh- largest bank in the United States. It had 57 
offices in 14 states and 29 foreign countries, a large network of 
domestic and international correspondent relationships, and a separate 
function for making residential and commercial real estate loans. It 
also provided specialized services to a variety of companies.
    When Continental failed, its top management and directors were 
replaced with individuals who had experience operating large, complex 
organizations. John Swearingen, former chairman of Standard Oil of 
Indiana, became CEO of the holding company, and William Ogden, a former 
vice chairman of Chase Manhattan Bank, became CEO.
    The FDIC committed to taking a book value of $4.5 billion of bad 
assets off of Continental's balance sheet and placed them in a separate 
work-out unit to recover as much of the value of the assets as 
possible. Among those bad assets, $1 billion was written off as a loss 
at the time of the transaction.
    To offset the $1 billion loss to Continental's capital, the FDIC 
provided $1 billion in capital in exchange for preferred stock, of 
which $720 million was convertible to common stock upon sale. When 
converted, the $720 million would amount to a 79.9 percent ownership 
stake in Continental.
    The FDIC also received five-year warrants to purchase the remaining 
common stock for far below one cent per share ($0.00001). If at the end 
of five years, the cost of the resolution was more than $800 million, 
the FDIC would exercise 100 percent of the warrants; if losses were 
lower, the amount of warrants exercised would be in proportion to the 
amount of the losses.
    To economize on FDIC staff and to provide additional expertise, the 
loan liquidation unit was staffed by a combination of FDIC personnel, 
hired specialists and Continental employees under incentive contracts.
    Continental Illinois was fully reprivatized by 1991 and eventually 
purchased by Bank of America in 1994. The FDIC exercised all of the 
warrants so the shareholders in Continental's holding company 
effectively lost their entire investment. The FDIC sold all of the 
preferred shares and shares from exercising the warrants for $1.2 
billion, which was a net gain of $200 million. The FDIC also earned 
$200 million in dividends. The ultimate resolution cost to the FDIC was 
$1.1 billion, which was 3.28 percent of Continental's assets at the 
time of resolution.
    There has been much talk lately about a new resolution process for 
systemically important firms that Congress could enact, and I would 
encourage this be implemented as quickly as possible, but we do not 
have to wait for new authority. We can act immediately, using 
essentially the same steps we used for Continental.
    Stock could be issued and control assumed by a government entity. A 
bridge institution could be created within the institution so essential 
services and operations would continue as normal. Where necessary, the 
government would provide capital in exchange for preferred shares 
convertible to common stock upon sale. Existing shareholders would 
provide the government warrants to purchase all outstanding shares with 
the amount exercised determined by the government's resolution cost. 
Senior management and directors would be replaced.
    The most difficult part of resolving these large firms without a 
new resolution process is how to make creditors bear the cost of their 
positions. Ideally, when a firm fails, all existing obligations would 
be addressed and dealt with according to the covenants and contractual 
priorities set up for each type of debt. Insured creditors would have 
immediate access to their funds, while other creditors would have 
immediate access to maturing funds with the potential for haircuts, 
depending on expected recoveries, any collateral protection and likely 
market impact. However, this is difficult because it would require 
negotiating with groups of creditors, unless there's a process that 
allows regulatory authorities to declare a nonbank financial firm 
insolvent.
    Regardless of how the firm is resolved, short-term liabilities in 
particular would need to be addressed immediately because of their 
importance in meeting the creditors' daily payment obligations and 
operational needs. Quick decisions should also be made on all 
counterparty arrangements because of the widespread impact that 
uncertainty would have on the counterparties.
    Authorities would also need to assess the market impact--
specifically, whether the losses associated with this outcome would 
lead to a loss of confidence in financial markets and serious funding 
problems that would threaten the viability of other financial firms. If 
so, it may be necessary to honor all counterparty arrangements and/or 
short-term liabilities, as we did with Continental Illinois.
    However, this guarantee must be considered as an exception to the 
normal process. Congress would have to enact an approval process 
similar to the systemic exception for banks as specified in the 1991 
FDIC Improvement Act, requiring approval by two-thirds of the Federal 
Reserve Board, two-thirds of the FDIC Board and the secretary of the 
Treasury, in consultation with the president.
    As much as I dislike extending government guarantees and thereby 
reducing market discipline, if we were to implement this exception, I 
believe we would also need to extend the same guarantees to all other 
institutions or we would give failed institutions a competitive 
advantage.
    Another key part of the resolution is that the bad assets need to 
be taken off the balance sheet of the failed institution at realistic 
market values and placed in an asset management company, resulting in 
two entities often referred to as a ``good bank'' and ``bad bank.'' 
Alternatively, the FDIC or Treasury as the receiver could take the bad 
assets and work them out. After writing off the bad assets, the 
government would provide the ``good bank'' with enough capital so that 
it can become a profitable ongoing concern and attractive to private 
investors for reprivatization. Any recoveries from the bad bank would 
first go toward paying off the costs of the government, and any 
proceeds left over would be distributed according to the priority of 
remaining claimants.
    The separation of the bad assets is critical. When a bank has a 
large share of nonperforming assets, they remain a burden when they are 
left on the balance sheet, even if they are written down appropriately. 
For example, they must be funded although they are not producing 
income. Such a circumstance creates uncertainty about the bank's 
financial condition and diverts management's attention from the 
business objectives necessary for recovery. The focus of the ``good 
bank'' must be on the future, gaining new customers and expanding 
operations, while the goal of the ``bad bank'' must be on getting rid 
of customers and winding down the operations.
    As part of the reprivatization process, it is also important to 
determine the advisability of breaking up or selling off operations and 
independent subsidiaries where possible, especially given the market 
discipline problems we have encountered with institutions regarded as 
``too big to fail.'' Moreover, assessing the condition and viability of 
large, complex financial firms is difficult, and the failure of such a 
firm may be an indication that it is also too large and complex to 
manage well. We should avoid setting conditions that only repeat past 
mistakes in creating too big and too complex an institution.
    This system is clearly more equitable than what we have seen so 
far.
    At the start of the TARP I program, $125 billion was provided to 
the nine largest financial firms without an in-depth, thorough exam of 
their condition. However, all other banks received TARP funds only if 
their primary regulator concluded they were strong enough to weather 
the crisis and continue as an ongoing concern.
    The $10 per share that Bear Stearns' stockholders received from the 
JPMorgan Chase acquisition would not have been possible without the 
government's guarantee of $29 billion of problem assets. Additionally, 
the government has committed $173 billion to support AIG's continued 
operations, with their shareholders standing to reap financial gain if 
AIG ultimately recovers.
    Meanwhile, 46 banks in the United States have failed since the 
beginning of 2008. All of them were resolved through one of the bank 
resolution problems I have discussed here today.
            how do we know the resolution process will work?
    It is understandable that there are concerns about letting these 
large firms fail, but it should be noted that the program I have just 
described has a record of success elsewhere.
    The economic situation in Sweden in the early 1990s was similar to 
that in the United States today. Its financial system was dominated by 
six large banks that accounted for 90 percent of the industry's assets. 
Sweden took decisive steps to identify losses in its major financial 
institutions. The viable Swedish banks were soon recapitalized, largely 
through private sources, and public authorities quickly took over two 
large insolvent banks and spun off their bad assets to be managed 
within a separate entity. Sweden was able to systematically restore 
confidence in its financial system, and although it took several years 
to work down and sell off all of the bad assets, there was minimal net 
cost to the taxpayers.
    Some argue that the Swedish situation is not a valid comparison 
because it only dealt with only six banks. In addition, some argue that 
the Swedish system was much less complex, and that the Swedish 
government had to work out primarily commercial real estate loans 
instead of the complex financial assets, structured securities and 
derivatives that we would have to work out today.
    These are valid concerns, but I would point out, first, that 
although the United States has several thousand banks, only 19 have 
more than $100 billion of assets, and that after supervisory 
authorities evaluate their condition, it is likely that few would 
require further government intervention. Second, as for complexity, I 
would point out that real estate assets involve considerable 
complexity, no less so than many financial derivatives.
    Another important example is the Reconstruction Finance Corporation 
(RFC), which was used to deal with banking problems in the United 
States in the 1930s. The RFC followed a process very similar to what I 
have described. It began by examining problem banks and writing down 
the bad assets to realistic economic values, making any needed and 
appropriate changes in bank management, injecting public equity as 
needed into these banks, and returning the banks to private ownership. 
The RFC proved to be highly successful in recapitalizing banks, and 
like Sweden, there was essentially no net cost to taxpayers. More 
detailed information on both the Continental Illinois and Swedish 
models for large bank resolution will be posted today with a text of my 
remarks on our Bank's website at KansasCityFed.org. Absent a detailed 
explanation of why this approach can't be done, it is my hope that it 
will be useful to provide more details around my view that it can be 
done.
    Let me make two final points.
    First, the debate over the resolution of the largest financial 
firms is often sensationalized because it is framed in terms of 
nationalizing failed institutions. It is also pointed out that 
government officials may not be effective managers of private business 
concerns.
    In response, I would note that no firm would be nationalized in 
this program. Nationalization is the process of the government taking 
over a going concern with the intent of operating it. Though a bridge 
institution is the most likely outcome when a large financial firm 
fails, the goal is for the firm to be reprivatized as quickly as 
possible. In addition, subject to regulatory agency oversight, the 
bridge firm would be managed by private sector managers selected for 
their experience in operating well-run, large, complex organizations.
    The second point is related to the complexity issue, which is that 
it would be hard to find enough people with the required knowledge, 
experience and skills to fill the open positions. Going back to the 
Continental Illinois example, we were able to do it then. More 
generally: The United States is a vast country with a tremendous amount 
of management resources in a broadbased economic and industrial system. 
If the United States does not have the talent to run these firms, then 
we are much worse off than I thought. I refuse to accept that 
conclusion.
     MATERIALS REFERENCED IN THE SPEECH: SUCCESS DEPENDS ON FAILURE
                a resolution process for financial firms
      The United States is in the middle of a serious financial 
crisis, and the economy is under significant stress. While there has 
been a lot of debate about how to revive the economy and restore 
financial stability, there is broad agreement that the economy will not 
recover until the financial system is stabilized and credit starts 
flowing more normally.
      The recovery of the financial system depends critically 
on the public regaining trust and confidence in financial institutions, 
particularly the largest financial institutions. The public's 
confidence in the largest institutions has been seriously shaken by the 
risks they have taken, the poor management of those risks and the 
resulting losses. Thus, the restoration of normal financial market 
activity depends importantly on how the problems of the largest bank 
and nonbank financial institutions are addressed.
      Despite the best of intentions, the policies and actions 
directed at restoring the health of the financial system have not been 
consistent or transparent. It is understandable that the initial 
measures were ad hoc and inconsistent because the depth and breadth of 
the problems were not expected and there were no plans in place for 
addressing the problems.
      The solution must be a clear and fair plan so that 
financial firms, investors and consumers know what to expect when any 
financial institution runs into problems. Specifically, the plan must 
provide a process for how policymakers will address the deterioration 
of the financial condition of all financial firms, regardless of their 
size, and resolve them if they become insolvent.
      A resolution process is particularly important for the 
largest, most complex and interconnected institutions because they have 
been considered by many as ``too big to fail,'' at least since the 
early 1980s. This paper describes a resolution process that can be used 
for any financial firm involved in the intermediation process or 
payments system, but the focus is on the large, systemically important 
institutions. The premise of the paper is that no firm is too big to 
fail and that resolving a large failed firm is the best solution for 
the economy.

                 principles for a resolution framework
      A free market system requires that business owners 
capture the profits from their successes and bear the costs of their 
failures. Firms that meet the market test will grow, while those that 
do not will shrink and, ultimately, must be allowed to go out of 
business if they fail. The consequences of failure and the resolution 
framework must be clearly stated and transparent so that business 
owners have clear expectations about the consequences of their actions.
      The resolution framework must prescribe a predefined set 
of rules, guided by an agreed upon set of principles. This is 
particularly important for financial institutions, big or small, 
because their success depends critically on the public's trust that 
they are solvent and a viable, ongoing concern.

      There are two key principles that the resolution process 
should follow.

      First, the resolution process should minimize the cost to 
the overall economy.
        --When resolving an insolvent firm, it is important that it 
        does not cause significant financial and economic disruptions 
        or exacerbate current problems.
        --The process should minimize the cost of resolving an 
        insolvency to avoid a long-term fiscal burden on taxpayers.
        --The relevant costs are not just the direct costs but, more 
        importantly, the current and future impact on the economy and 
        financial system.
        --The direct costs of resolving a failed bank, such as the 
        government bearing some of the failed bank's losses, is simple 
        to add up.
        --However, minimizing the future costs on the economy and 
        financial system, particularly the unintended consequences, is 
        much more difficult.
        --To minimize the future cost to the economy, the resolution 
        process must not create adverse incentives that are 
        inconsistent with economic efficiency. Specifically, the 
        resolution process must not allow a firm's management, 
        shareholders and creditors to avoid the consequences of their 
        mistakes because it reduces market discipline, creates adverse 
        incentives for firms to take too much risk, and inefficiently 
        directs resources and financial capital to less-productive 
        uses.
        --The process must be transparent and clearly stated so that 
        everyone understands what to expect and the consequences of 
        their actions. Management must know beforehand what will happen 
        if they gamble and take excessive risks that turn out to have a 
        significant, negative effect on the firm's financial condition.
        --Finally, to minimize costs, the resolution process should be 
        based on solid research and information about what works and 
        what does not work. Policymakers can learn a lot about what 
        will and will not be successful by looking back at previous 
        U.S. financial crises, as well as at crises in other countries.

      The second principle is the resolution process must be 
equitable in that it is the same for all financial firms regardless of 
size or location, although it is possible that the outcome will differ.
        --The resolution process must provide consistent treatment of a 
        failing institution's owners, managers, employees and 
        customers, regardless of the institution's size, complexity or 
        location.
        --When talking about equity, it is important to recognize the 
        difference between process and outcome.
        --For example, if a bank is examined and found to be insolvent, 
        the bank should go through the resolution process and the 
        owners should lose their investment regardless of the bank's 
        size. The outcome may be that a relatively small bank is 
        resolved by another institution purchasing its assets and 
        assuming its deposits, while a relatively large bank is 
        temporarily operated as a bridge bank.
        --In both cases, the banks go through the same process of being 
        declared insolvent and the same procedures for determining how 
        it will be resolved.
        --Otherwise, banks may take on excessive risks just to grow to 
        a size large enough to receive favorable treatment, and 
        customers may choose to go with a large bank instead of a small 
        bank.
          options for resolving a failed financial institution
      There are several options for resolving a failed firm, 
but it is important to first define insolvency.
        --By definition, a firm is insolvent if its common equity 
        capital is negative--that is, the firm's outstanding 
        liabilities owed to creditors is greater than the total value 
        of its assets.
        --However, a financial firm, even if it has a positive amount 
        of equity capital, is not viable and will fail if its liquidity 
        is insufficient to meet its current payment obligations, either 
        because it cannot sell its assets for enough to pay off 
        maturing liabilities, or it loses market confidence and cannot 
        borrow enough.
        --It is important to note that these are definitions of 
        insolvency and are not subjective conditions, which points out 
        that the term ``too big to fail'' really is a misstatement. It 
        does not matter what size a firm is--if it is insolvent by 
        these definitions, it has failed.

      The question becomes, what do we do when a firm fails?

      One option is for the government to allow an insolvent 
firm to maintain ongoing operations by providing funds to bring capital 
ratios up to required minimums or to meet payment obligations.
        --In this case, nothing is actually resolved, and the insolvent 
        firm is essentially bailed out so that it can continue normal 
        operations.
        --This option may be used for a large financial firm that is 
        considered ``too big to fail'' because of concerns that it is 
        systemically important, in the sense that other resolution 
        methods would have large, negative spillover effects on the 
        economy.
        --Under this option, the term ``too big to fail'' should be 
        restated as ``too big to resolve'' because of the near-term 
        negative spillover effects and disruptions to the economy and 
        financial system.
        --In a bailout, senior management and directors keep their 
        jobs; current shareholders do not lose their investment, 
        although the government may impose some restrictions on the 
        firm's activities and practices; and creditors do not suffer 
        any losses.
        --A bailout is the worst option in terms of the first principle 
        of minimizing costs.
        --While a bailout may temporarily stabilize current economic 
        conditions or not immediately cause further problems, it sets 
        the stage for significant future problems. In a bailout, senior 
        management, directors and current shareholders stand to reap 
        any gains that may result, which weakens market discipline and 
        creates the moral hazard that the firm will take too much risk.
        --Bailouts are also inequitable because they are used only for 
        the ``too big to fail'' firms and not for smaller firms that 
        are not expected to cause spillover effects if other resolution 
        methods are used.

      Alternatively, bank regulators have for years used a 
variety of options to resolve insolvent banks. These options include:
        --liquidation,
        --arranging for the sale of a failed bank's assets and 
        assumption of its liabilities by another institution,
        --or operating the bank for a short period of time through 
        open-bank assistance or as a bridge bank or conservatorship 
        until the bank can be sold to another bank or group of private 
        investors.

      When most people think of a firm as failing, they 
generally think the firm is shut down and liquidated.
        --In a bank liquidation, the FDIC is appointed as a receiver 
        and it pays off insured depositors up to the deposit insurance 
        limit.
        --Uninsured depositors are generally paid partial amounts based 
        on expected recoveries.
        --The FDIC maximizes the value of the assets by selling them or 
        holding on to them and working them out. The proceeds from the 
        assets are used to first pay remaining amounts owed to 
        uninsured depositors and other unsecured creditors, and if 
        anything is left over, to shareholders.
        --Because the firm is insolvent, the uninsured creditors will 
        suffer some losses, and they may have to wait for a long time 
        to receive their final payouts.
        --While liquidation strongly enforces market discipline and 
        does not promote moral hazard, it tends to be the most 
        disruptive option for resolving a big or small financial firm, 
        and therefore is the least desirable choice.
        --This option is disruptive for individuals and business 
        customers because they tend to hold short-term instruments, 
        such as deposits and commercial paper, for making payments or 
        as a temporary way of storing their funds. Many business 
        customers also have counterparty arrangements, such as 
        derivatives contracts, that would go into default when the bank 
        is liquidated.

      The resolution method used most often is a purchase and 
assumption (P&A) transaction, where the FDIC as receiver finds another 
bank to purchase the insolvent bank's assets and assume its 
liabilities.
        --In terms of the direct costs to the government, this is 
        typically the least-cost resolution method because the FDIC may 
        receive a premium from the acquiring bank. And even if the FDIC 
        has to pay the acquiring bank to assume the liabilities, it is 
        often less costly than paying off insured depositors and having 
        to manage and liquidate the failed bank's assets.
        More importantly, though, it generally has the least negative 
        impact on the economy.
        Short-term creditors and counterparties have immediate access 
        to all insured deposits and at least a large portion of 
        uninsured obligations, while borrowers continue to have access 
        to credit.
        In addition, because management and directors are replaced and 
        shareholders lose their investment, a P&A transaction does not 
        reduce market discipline or create adverse incentives for bank 
        management and shareholders.

      While a P&A transaction is often the best option for most 
failed banks, it generally is not the best option if one of the largest 
financial institutions fails because it creates even larger companies 
that pose even greater systemic risks to the economy.
        --A major difficulty in the current financial crisis has been 
        that some institutions are so large and complex that resolving 
        them when they fail is complicated and disruptive no matter 
        what option is used.
        --Only another institution in the same size range would have 
        the capacity and resources to purchase the assets and assume 
        the liabilities of another large institution.
        --Indeed, over the past year, there have been several examples 
        of large institutions taking over other large, problem 
        institutions. It only makes sense that if institutions can get 
        ``too big to fail,'' then all else held constant, the 
        resolution process should not result in even larger 
        institutions.

      The final option, which is the most feasible for a large, 
complex financial institution that fails, is to run it temporarily as a 
conservatorship or bridge organization.
        --Clearly, a liquidation would be too disruptive to the 
        economy.
        --This option also provides time for potential acquirers of the 
        institution or its parts to conduct the necessary due 
        diligence.
        --The institution would then reprivatized as soon as it is 
        economically feasible.
        --As will be discussed below, management, shareholders and 
        creditors would be forced to bear the full cost of their 
        actions and positions they have taken to maintain market 
        discipline and economic efficiency.

      One of the difficulties with all of these options is that 
while there are time-tested, fast resolution processes in place for 
depository institutions, today's largest financial institutions are 
conglomerate financial holding companies with many financial 
subsidiaries that are not banks.
        --The bank subsidiaries could be placed into FDIC receivership, 
        but the only other option under current law for the holding 
        company and other subsidiaries is a bankruptcy process.
        --Bankruptcy proceedings can take a long time to complete--
        sometimes years--which works well for a nonfinancial firm 
        because it can continue normal operations while in bankruptcy.
        --It does not work for financial firms, however, because they 
        have a variety of complex, short-term liabilities and 
        counterparty arrangements that customers depend on for 
        maintaining daily operations. A long, drawn-out bankruptcy 
        proceeding would prevent customers and counterparties from 
        having access to their funds, which would cause significant 
        economic disruptions.
        --In addition, the cornerstone of a financial institution's 
        franchise value is trust in its viability as an ongoing 
        concern, and that trust is sure to quickly erode in a long, 
        drawnout bankruptcy proceeding.
        --The difficulty in resolving failed holding companies quickly 
        and in a way that minimizes the disruption to the economy is 
        why the Treasury secretary recently proposed a resolution 
        process for systemically important financial holding companies.

      Enacting a resolution process for financial companies is 
clearly important, but the supervisory authorities do not need to wait 
for it to happen and should act immediately to resolve a large 
financial company should one fail.
                     a proposed resolution process
      The resolution process discussed below is applicable to 
any financial firm that is part of the intermediation process or 
payments system, but in light of the current financial crisis, the 
focus is on systemically important financial institutions that are 
found to be insolvent.

      To prevent systemic disruptions to the economy, a failed 
institution should be allowed to continue its operations through a 
bridge institution or conservatorship so that all essential services 
and operations would go on as normal.
        --Because the firm is insolvent, it would need additional 
        capital to continue operating.
        --To recapitalize the firm, the government could provide the 
        capital in exchange for preferred shares, convertible to common 
        stock upon sale.

      In general, the supervisory authorities would not have 
the authority to declare the institution insolvent. Thus, to ensure 
that management and shareholders bear the costs of their actions and 
investment decisions, the government's investment would be conditional 
on:
        --Replacement of the senior management and board of directors 
        that led the firm to failure.
        --Existing shareholders providing the government warrants to 
        purchase all outstanding shares, with the amount exercised 
        determined by the net costs of resolving the firm.
        --While shareholders may be reluctant to agree to these 
        conditions, in most cases, they would have little choice given 
        the immediate need for liquidity and capital assistance.

      The specific steps to be taken would depend on several 
factors, such as the type of financial organization and the 
supervisor's existing legal authority.
        --For example, if a holding company's primary asset is an 
        insured bank and the bank and holding company become insolvent, 
        the bank could be closed and the FDIC could set up a bridge 
        bank.
        --In this case, the holding company would also fail, and the 
        supervisory authorities could take actions to mitigate the 
        impact on the rest of the economy.

      The most difficult part of resolving these large firms 
without a new resolution process is how to make creditors bear the cost 
of their positions.
        --Ideally, when a firm fails, all existing obligations would be 
        addressed and dealt with according to the covenants and 
        contractual priorities set up for each type of debt.
        --Insured creditors would have immediate access to their funds, 
        while other creditors would have immediate access to maturing 
        funds with the potential for haircuts, depending on expected 
        recoveries, any collateral protection and likely market impact.
        --However, this is difficult because it would require 
        negotiating with groups of creditors, unless there's a process 
        that allows regulatory authorities to declare a nonbank 
        financial firm insolvent.

      Regardless of how the firm is resolved, it is critical to 
make quick decisions on how creditors will be treated.
        --Short-term liabilities in particular would need to be 
        addressed immediately because of their importance in meeting 
        the creditors' daily payment obligations and operations needs.
        --Quick decisions also need to be made on all counterparty 
        arrangements because of the widespread impact that uncertainty 
        about their status or default would have on their 
        counterparties.
        --So that unsecured creditors bear the cost of their decisions 
        and market discipline is maintained, the resolution authorities 
        should consider leaving these creditors standing in line behind 
        more senior creditors as the claims on the bank are resolved.
        --However, the authorities would also need to assess the market 
        impact--specifically, whether the losses associated with this 
        outcome would lead to a loss of confidence in financial markets 
        and serious funding problems that would threaten the viability 
        of other financial firms.

      In a severe financial crisis, such as is occurring today, 
it may be necessary to honor short-term liabilities and/or all 
counterparty arrangements to prevent a systemic disruption to the 
economy.
        --However, this guarantee should be considered as a 
        ``systemic'' exception to the normal process.
        --To limit the use of this exception to truly systemic 
        situations, Congress should enact an approval process similar 
        to the systemic exception for banks as specified in the 1991 
        FDIC Improvement Act.
        --This exception requires approval by two-thirds of the Federal 
        Reserve Board, two-thirds of the FDIC Board and the secretary 
        of the Treasury, in consultation with the president.
        --In addition, though the extension of government guarantees 
        and the resulting reduction in market discipline should 
        generally be avoided, extension of the same guarantees would 
        need to be made to every other institution. Otherwise, failed 
        institutions would have a competitive advantage over sound 
        institutions, which clearly violates the principle of equitable 
        treatment.

      Another key part of the resolution is the bad assets need 
to be taken off the balance sheet of the failed institution at 
realistic market values.
        --One option is to place the bad assets in a separate asset 
        management company, resulting in two new entities often 
        referred to as a ``good bank'' and ``bad bank.''
        --Alternatively, the FDIC or Treasury as the receiver could 
        take the bad assets and work them out.
        --After writing off the bad assets, the government would 
        provide the good bank with enough capital so that it can become 
        a profitable ongoing concern and attractive to private 
        investors for eventual reprivatization.
        --Any recoveries from the bad bank would first go toward paying 
        off the costs of the government, and any proceeds left over 
        would be distributed according to the priority of remaining 
        claimants.

      The separation of the bad assets is critical for creating 
a forward-looking process for recovery and the eventual reprivatization 
of the good bank.
        --When a bank has a large share of nonperforming assets, they 
        remain a burden when they are left on the balance sheet, even 
        if they are written down appropriately.
        --For example, they still have to be funded even though they 
        are not producing income, they create uncertainty about the 
        bank's financial condition, and they divert a lot of 
        management's attention from more productive activities for the 
        future growth and profitability of the bank.
        --In addition, the business objectives and the skills necessary 
        for managing bad assets and recovering their maximum value is 
        very different from the objectives and necessary skills for 
        running an ongoing financial firm.
        --In other words, the goal of the good bank is to attract new 
        customers and expand operations, while the goal of the bad bank 
        is to get rid of customers and wind down the operations.

      As part of the reprivatization process, the supervisory 
authorities should consider breaking up or selling off operations and 
independent subsidiaries where possible.
        --The growth of firms into ``too big to fail'' institutions has 
        created significant market discipline problems.
        --In addition, if such a firm were to fail, it may also be an 
        indication that it is too large and complex to manage well.
            how do we know the resolution process will work?
      A variety of concerns has been raised about letting the 
largest financial firms fail. These concerns are legitimate and it is 
clear that any solution will be difficult and costly. However, the 
resolution process being advocated here has a record of success 
elsewhere.

      First, the proposed resolution process is exactly what 
the Swedes did to solve an equally severe banking crisis that they had 
in the early 1990s (see attachment ``Swedish Response to 1990s Banking 
Crisis'' for a more detailed description of the Swedish crisis and 
resolution process).
        --The economic situation in Sweden was similar to today's, and 
        their financial system was dominated by six large banks that 
        accounted for 90 percent of the industry's assets.
        --Sweden took decisive steps to identify losses in its major 
        financial institutions.
        --The viable Swedish banks were soon recapitalized, largely 
        through private sources, and public authorities quickly took 
        over two large insolvent banks and spun off their bad assets to 
        be managed within a separate entity.
        --Sweden was able to quickly restore confidence in its 
        financial system, and although it took several years to work 
        down and sell off all of the bad assets, there was essentially 
        no net cost to the taxpayers.
        --Creditors, however, were fully protected because the 
        supervisory authorities were concerned about the systemic 
        consequences of imposing losses on uninsured depositors and 
        other unsecured creditors.

      Some people do not think that the Swedish situation is a 
valid comparison because it dealt with only six banks. In addition, 
some argue that the Swedish system was much less complex, and that the 
government primarily had to work out commercial real estate loans, not 
the complex financial assets, such as structured securities and 
derivatives, that would have to be worked out today if a large 
financial institution was allowed to fail. While these concerns are 
valid, it should be noted that:
        --Although the United States has several thousand banks, only 
        19 banks have more than $100 billion of assets, and that after 
        supervisory authorities evaluate their condition, it is likely 
        that only a few would have to be resolved.
        --It is actually very difficult to work out problems on real 
        estate assets, and it is not necessarily more difficult to work 
        out even complex securities.

      As an aside, an additional lesson that can be learned 
from Sweden is that a resolution process is much more likely to succeed 
if it has broad political support and is structured to be independent 
of the political process.
        --The plan should be put largely under the control of 
        independent supervisory agencies.
        --Political involvement should be confined largely to 
        specifying the program's goals and basic rules.
        --The Swedes also found that a commitment to providing the 
        supervisory authority the funds necessary for resolutions 
        reduces the need for political involvement.

      A second example is this is essentially the process the 
Reconstruction Finance Corporation (RFC) used to deal with banking 
problems in the United States in the 1930s.
        --The RFC began by examining problem banks and writing down the 
        bad assets to realistic economic values.
        --It then made any needed and appropriate changes in bank 
        management and provided public equity capital as needed.
        --Finally, it returned the banks to private ownership and 
        essentially recovered all of its costs.

      A final example is the failure of Continental Illinois 
National Bank and its holding company in 1984. This is a good 
comparison because it is an example of a holding company resolution 
using preferred stock and warrants as described in the proposed 
process. In addition, it is an example of a resolution of a large, 
complex, interconnected holding company.
        --Continental Illinois was the largest U.S. commercial and 
        industrial lender and the seventh- largest U.S. bank. It had 57 
        offices in 14 states and 29 foreign countries, a network of 
        2,300 domestic and international correspondent relationships, 
        and a separate function for making residential and commercial 
        real estate loans. It also provided specialized services to a 
        variety of companies.
        --The attached document, ``Assistance for Continental 
        Illinois,'' provides details about the process used to resolve 
        the bank and holding company.
        --The result was that the bank and holding company management 
        were replaced, the holding company shareholders lost their 
        entire investment, and the bank was restored to sound condition 
        and returned to private ownership.
        --As in Sweden, Continental Illinois' creditors were fully 
        protected because of concerns about the systemic consequences 
        of imposing losses on uninsured depositors and other unsecured 
        creditors.

      Another concern that has been raised about letting the 
largest financial firms fail is that it nationalizes these 
institutions. As part of this concern, it is also often pointed out 
that government officials may not be effective managers of private 
business concerns.
        --In the proposed process, no firm would be nationalized.
        --Nationalization is the process of the government taking over 
        a going concern with the intent of continued ownership.
        --Though a bridge institution is the most likely outcome for a 
        large financial firm that fails, the goal is for the firm to be 
        reprivatized as quickly as possible, subject to the government 
        not wasting taxpayer funds.
        --In addition, subject to regulatory agency oversight, the 
        bridge firm would be managed by private sector managers 
        selected for their experience in operating well-run, large, 
        complex organizations.

      Some opponents to the proposed process also claim it 
would be very difficult to take over these firms and bring in new 
management because they are too complex to manage, as well as there is 
not enough people with the required knowledge, experience, and skills 
to fill the open positions.
        --The Continental Illinois example shows it is possible bring 
        in a management team with experience running large, complex 
        organizations.
        --In addition, while the institution might be complex, a new 
        management team is clearly better than leaving the institution 
        under the control of the management team that caused it to fail 
        in the first place.
        --More generally, it is hard to believe that there is not 
        enough talent, either from the United States or other 
        countries, to run these organizations.
                  assistance for continental illinois
I. Problems at Continental Illinois
      In the late 1970s and early 1980s, Continental Illinois 
pursued a strategy of rapid growth in commercial lending, particularly 
energy lending, that was largely funded by purchased money.
      It became the seventh-largest U.S. bank and largest 
commercial lender in the United States.
      Penn Square's failure in 1982, LDC debt problems and the 
downturns in energy markets led to declining asset quality and earnings 
at Continental from 1982 into 1984 and forced Continental to rely 
heavily on foreign money markets for funding.
      News stories in May 1984 on Continental's problems 
started a run by foreign depositors on Continental, and by May 19, they 
had withdrawn more than $6 billion.
      The Federal Reserve Bank of Chicago began lending through 
the discount window to cover the lost deposits, and Continental put 
together a $4.5 billion loan package funded by 16 large U.S. banks, but 
these steps did not stop the deposit run.
II. Interim Financial Assistance
      On May 17, 1984, the FDIC, OCC and Federal Reserve 
announced an interim assistance package for Continental, which was 
based on the FDIC's open bank assistance authority.
      The FDIC explicitly guaranteed all deposits at 
Continental in order to keep a liquidity crisis from spreading to other 
U.S. banks, prevent significant losses at the many banks that had 
correspondent accounts at Continental and avoid other negative effects 
in U.S. financial markets.
      A $2 billion capital infusion for Continental was 
arranged in the form of interestbearing subordinated notes, with the 
FDIC providing $1.5 billion and the remaining $500 million provided by 
seven of the largest U.S. banks.
      The Federal Reserve agreed to meet any liquidity needs of 
Continental, and a group of 24 major U.S. banks also agreed to provide 
more than $5.3 billion in funding on an unsecured basis until a 
permanent solution was developed.
      The FDIC was unable to find any merger partners for 
Continental during this interim period, presumably due to Continental's 
asset problems, substantial litigation and funding issues, along with 
the limited number of merger partners under Illinois' interstate 
banking restrictions.
III. Permanent Financial Assistance
        --In July 1984, a permanent assistance plan was put in place 
        for Continental.
        --Continental's top management and board of directors were 
        removed. John Swearingen, former chairman of Standard Oil of 
        Indiana, became CEO of the holding company, and William Ogden, 
        a former vice chairman of Chase Manhattan, became CEO of the 
        bank.
        --The FDIC assumed $3.5 billion of Continental's discount 
        window borrowings from the Federal Reserve.
        --In exchange for assuming this debt, the FDIC received $3.5 
        billion (adjusted book value) of assets from Continental. This 
        consisted of poor quality loans that Continental had already 
        written down to $3 billion (these loans were further written 
        down to $2 billion in this transaction, and Continental was 
        forced to take a charge of $1 billion against capital) and a 
        note from Continental for $1.5 billion, which Continental could 
        repay within three years by giving the FDIC additional loans of 
        Continental's choice with a book value of $1.5 billion.
        --To offset the $1 billion charge to Continental's capital that 
        was required by the loan sale, the FDIC infused $1 billion in 
        capital into Continental. The FDIC's capital infusion consisted 
        of $720 million of permanent, convertible, nonvoting, junior 
        perpetual preferred stock in Continental's holding company 
        (this amounted to a 79.9 percent ownership stake in Continental 
        if converted) and another $280 million of permanent, 
        adjustable-rate, cumulative preferred stock in the holding 
        company. This assistance was provided through the holding 
        company rather than the bank because covenants in the holding 
        company's debt instruments required debtholder approval to sell 
        the bank or to inject capital directly into it.
        --The FDIC also received an option designed to compensate it 
        for any losses, carrying costs or collection costs on the loans 
        it acquired.
        --The $2 billion in subordinated notes issued under the interim 
        plan was repaid.
        --To economize on FDIC staff and to provide additional 
        expertise, the loan liquidation involved a combination of FDIC 
        personnel, Continental employees under incentive contracts and 
        hired specialists.
IV. Return to Private Ownership and the Cost of Resolving Continental 
        Illinois
        --In a series of sales that took place between December 1986 
        and June 1991, the FDIC sold all of its preferred stock and the 
        stock acquired through its option.
        --The shareholders in Continental's holding company lost their 
        entire investment once the FDIC exercised the option it 
        received as compensation for loan liquidation losses.
        --From the sale of stock, which completed the return of 
        Continental to private ownership, the FDIC had a net gain of 
        $200 million over its initial $1 billion capital investment, 
        and it also received more than $200 million in dividends on 
        this stock.
        --Overall, the loss on the FDIC's books from Continental's 
        failure was $1.1 billion, which is equal to 3.28 percent of 
        Continental's assets at the time of resolution.
        --Bank of America eventually bought Continental in August 1994.
                swedish response to 1990s banking crisis
      Economic and financial market conditions leading up to 
the Swedish banking crisis were very similar to the conditions leading 
up to the current crisis.
        --Deregulation of financial markets (elimination of 
        quantitative controls on bank lending, ceilings on interest 
        rates and restrictions on capital flows) is similar to recent 
        deregulation (Gramm-Leach-Bliley) and financial innovations 
        (securitization, derivatives).
        --Large inflow of foreign capital and expansion of domestic 
        lending and debt.
        --Low/negative real interest rates.
        --Strong growth in consumption and real estate investment and 
        low savings rate.
        --Sharp increases in asset prices (stocks and real estate).
      Although the economic downturn leading to the crisis was 
precipitated by rising real interest rates, the impact on the economy 
was similar to the current crisis.
        --Stock and real estate prices fell sharply (tangible asset 
        values fell about 30 percent).
        --Bankruptcies increased dramatically (bankruptcies grew about 
        20 percent, 40 percent and 70 percent in 1989, 1990 and 1991, 
        respectively).
        --Consumption fell and the savings rate rose from being 
        slightly negative at the end of the 1980s to 8 percent in 1993.
        --Residential real estate investment froze.
      Goal of financial support and recovery plan--temporary 
government investment in banks where necessary, but banks were to be 
placed in private ownership as soon as economically feasible.
      Political support--the program had broad political 
support, which was important for quick decisive actions and providing 
the national leadership necessary for public support.
      Political independence--a Bank Support Authority, 
separate from the financial supervisory authority and central bank, was 
established under the Ministry of Finance to manage the program. The 
Bank Support Authority (BSA) had open-ended funding and was free from 
political interference in making decisions, although the BSA worked 
closely with the supervisory authority and central bank.
      Debt guarantees
        --All bank depositors, counterparties, and other creditors were 
        fully protected from future losses, including foreign creditors 
        (accounted for about 40 percent of bank funding).
        --Guarantees were eliminated when the crisis ended in the mid-
        1990s, and a bank-financed deposit insurance system was created 
        (Sweden did not have deposit insurance prior to the crisis).
      Transparency
        --The government was very open about the process.
        --A valuation board composed of real estate experts was used to 
        ensure consistent and realistic asset values, and asset values 
        that had declined were promptly written down.
      Bank recapitalization
        --A bank's future viability was estimated using a quantitative 
        model of profitability subject to various economic scenarios. 
        Banks were placed in one of three categories based on their 
        viability in the worst-case scenario, which determined the type 
        of government support they would receive.
        --Category 1--Capital deteriorates but remains above minimum 
        requirements.
            The bank was expected to raise additional capital, with 
            temporary government guarantees available if necessary to 
            help maintain public confidence.
        --Category 2--Capital falls below minimum requirements but is 
        expected to rise above the minimum in a reasonable period of 
        time.
            Shareholders were expected to contribute additional 
            capital, with the government contributing capital as 
            necessary to meet operating requirements. Government 
            received preferred shares.
        --Category 3--Capital becomes negative and bank is unlikely to 
        become profitable.
            Bank declared insolvent and government resolves the bank in 
            the least-costly manner, including the possibility of 
            liquidation.
      Good bank, bad bank model--used for banks that received 
government support and for insolvent banks. Nonperforming loans were 
transferred to work-out companies at realistic market values. The good 
bank is provided additional capital as necessary for sound operations 
and managed by financial market professionals with clear business 
objectives.
      Shareholders were not protected (except for one bank in 
which the government was the majority shareholder, as noted below).
        --Government's preferred shares were offset by a corresponding 
        reduction in private shares.
        --The government also received voting power that would grow 
        over time, so the government would eventually become the 
        majority shareholder if the support was large enough and 
        maintained for a long period of time.
      Banks that received assistance were given conditions to 
make operational improvements. Government representatives were placed 
on the bank boards to ensure compliance.
      Results
        --Among the six major banks, Nordbanken (Category 2) received 
        government capital (the government was already the majority 
        shareholder and it also purchased the outstanding privately 
        held shares); Gota (Category 3) failed, was taken over by the 
        government and eventually merged with Nordbanken; and 
        Sparbanken received a government loan.
        --The banking crisis was largely over by 1996 and the banking 
        system remained largely intact--there were no runs and few 
        signs of a credit crunch.
        --While there is no official estimate of the cost of the 
        support program, the most recent estimate of the net fiscal 
        cost is that the government broke even, which is based on 
        government outlays during the most acute phases of the crises 
        and revenues from the sale of bad assets, referred shares and 
        other proceeds over the past 15 years. The initial gross fiscal 
        cost of the support program is estimated to have been about 4 
        percent of GDP.
        --Ultimately, Nordbanken was largely privatized and is now part 
        of Nordea (the government owns about 20 percent), which 
        operates in Sweden, Norway, Finland and Denmark.
      Lessons learned
        --Political consensus on a support plan is crucial.
        --Once the plan is formed and implemented, it is just as 
        important for the process to be independent of political 
        interference and fully transparent to the public.
        --The government officials in charge of the program must take 
        timely and decisive actions to resolve problem firms, which is 
        one reason political independence is important.
        --Assets must be given realistic valuations.
        --Shareholders at failing banks must lose their investment, and 
        senior management and the board of directors must be replaced 
        for both efficiency and equity purposes. Markets will not be 
        efficient unless those who may benefit from taking risk actions 
        also bear the costs when those actions lead to losses, and 
        equitable treatment requires that the same rules apply to all 
        firms regardless of size.
        --The program's success also requires that the new management 
        of the good and bad banks are financial industry professionals, 
        are given sound business objectives and clearly understand to 
        whom they are responsible, which is another reason why 
        political independence is important.
                               references
Davison, Lee. ``Continental Illinois and `Too Big to Fail,''' History 
of the Eighties, Lessons for the Future, Vol. 1, An Examination of the 
Banking Crises of the 1980s and Early 1990s, Federal Deposit Insurance 
Corporation, 1997, Chapter 7, pp. 235-257.

Englund, Peter. ``The Swedish Banking Crisis: Roots and Consequences,'' 
Oxford Review of Economic Policy, Vol. 15, No. 3, pp. 80-97.

Ergungor, O. Emre. ``On the Resolution of Financial Crises: The Swedish 
Experience,'' Federal Reserve Bank of Cleveland, Policy Discussion 
Paper, Number 21, June 2007.

Ingves, Stefan, and Lind, Goran. ``Is the Swedish Model Still Valid?'' 
Presentation at G30 Conference, Sveriges Riksbank, New York, December 
5, 2008.

Ingves, Stefan, and Lind, Goran. ``The Management of the Bank Crisis--
In Retrospect,'' Quarterly Review, 1/1996, pp. 5-18.

Jonung, Lars. ``The Swedish Model for Resolving the Banking Crisis of 
1991-93: Seven Reasons Why it was Successful,'' DG ECFIN, European 
Commission, Brussels, European Economy, Economic Papers 360, February 
2009.

Jonung, Lars, Kiander, Jaakko, and Vartia, Pentti. ``The Great 
Financial Crisis in Finland and Sweden: The Dynamics of Boom, Bust and 
Recovery, 1985-2000,'' DG ECFIN, European Commission, Brussels, 
European Economy, Economic Papers 350, December 2008.

McDermott, Kate. ``Continental Illinois National Bank and Trust 
Company,'' Managing the Crisis, Federal Deposit Insurance Corporation, 
1998, Chapter 4, pp. 545-65.


                                  
