[Senate Hearing 111-179]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-179


  REGULATION AND RESOLVING INSTITUTIONS CONSIDERED ``TOO BIG TO FAIL''

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

 REGULATING AND RESOLVING INSTITUTIONS WHOSE FAILURE WOULD POSE A RISK 
  TO THE FINANCIAL SECTOR AND UNDERLYING ECONOMY IN THE UNITED STATES

                               __________

                              MAY 6, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html







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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                       Amy Friend, Chief Counsel

                     Dean Shahinian, Senior Counsel

                Mark Oesterle, Republican Chief Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)






                            C O N T E N T S

                              ----------                              

                         WEDNESDAY, MAY 6, 2009

                                                                   Page

Opening statement of Senator Dodd................................     1

                               WITNESSES

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     3
    Prepared statement...........................................    48
    Response to written questions of:............................
        Senator Vitter...........................................   108
Gary H. Stern, President and Chief Executive Officer, Federal 
  Reserve Bank of Minneapolis....................................     5
    Prepared statement...........................................    56
    Response to written questions of:............................
        Senator Vitter...........................................   112
Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy 
  Studies, American Enterprise Institute.........................    32
    Prepared statement...........................................    80
    Response to written questions of:............................
        Senator Vitter...........................................   114
Martin Neil Baily, Senior Fellow, Economic Studies Program, the 
  Brookings Institution..........................................    33
    Prepared statement...........................................    91
    Response to written questions of:............................
        Senator Vitter...........................................   116
Raghuram G. Rajan, Eric J. Gleacher Distinguished Service 
  Professor of Finance, University of Chicago, Booth School of 
  Business.......................................................    35
    Prepared statement...........................................   102

                                 (iii)

 
  REGULATION AND RESOLVING INSTITUTIONS CONSIDERED ``TOO BIG TO FAIL''

                              ----------                              


                         WEDNESDAY, MAY 6, 2009

                              United States Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                   Washington, D.C.
    The Committee met, pursuant to notice, at 9:05 a.m., in 
room SD-538, Dirksen Senate Office Building, Senator 
Christopher J. Dodd (Chairman of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order.
    Let me apologize to my colleagues and the witnesses as 
well. It was a late hour last night when we changed the 
schedule, but as I am sure my colleagues are aware, anyway, we 
are going to have about six votes beginning around 10:30 to try 
and finish up the housing bill. And, therefore, I thought we 
would try to move this up a half an hour so we could have at 
least a good hour and a half with you.
    I am going to ask my colleagues to restrain themselves, if 
they can, in opening statements so we can get right to the 
witnesses and hear their thoughts.
    Sheila, welcome. Nice to have you back before the 
Committee.
    Let me just share some opening comments. Senator Shelby has 
a meeting. He will be here shortly. He had something around 
9:10, so he will be coming along. I am going to begin. 
Normally, of course, I would wait for my colleague from 
Alabama, but in light of the fact of the change in the time 
here, we are going to begin, anyway, on this. So let me share 
some opening thoughts on this subject matter, and then we will 
go right to the witnesses.
    This morning is the 13th in a series of hearings since 
January to identify causes of the financial crisis and specific 
responses that will guide the Committee's formulation of the 
new architecture for 21st century financial services 
regulation. I welcome all of our witnesses.
    This morning, we are going to discuss regulating and 
resolving institutions whose failure would pose a risk to the 
financial sector and our underlying economy. To be sure, we 
meet at a moment when many of these so-called ``too-big-to-
fail'' institutions are under a microscope, and for good 
reason. Consider for a moment the following financial 
institutions: Bear Stearns, Fannie and Freddie, Lehman 
Brothers, AIG, Washington Mutual, Wachovia, Citigroup, Bank of 
America. Inside of 14 months, every one of these institutions 
either failed or posed a risk of failing absent Government 
intervention. Some were sold under duress; others failed 
outright. Many were saved because the Government resorted to an 
array of loans, guarantees, and capital injections to keep 
these large, complex financial firms afloat.
    But, regardless, the result of this turmoil is clear, with 
20,000 layoffs and 10,000 homeowners entering into foreclosure 
each and every day. As this Committee works to modernize our 
financial architecture, I believe it is essential that we 
identify ways to give the Government the tools it needs to 
unwind troubled, systemically important institutions in an 
orderly way that will put adequate safeguards in place to 
prevent unwarranted risky behavior on the part of the largest 
market actors and puts our economy at risk. And I would commend 
the administration again for sharing my belief that the 
resolution authority be given to the FDIC, with whom the 
expertise of unwinding failed institutions clearly lies.
    To be sure, we have seen unprecedented consolidation in the 
banking industry over the last few decades. In 1992, the 25 
largest insured depository institutions accounted for a quarter 
of banking industry assets. As of 2008, the top 25 held over 60 
percent of industry assets. Four U.S. bank holding companies 
now have over $1 trillion each in banking assets.
    At the same time the industry became increasingly 
consolidated, the institutions themselves became more 
interconnected, and as many of these failures have illustrated, 
their relationships with one another even more complex. The 
growth of the largely unregulated credit derivatives market and 
the ability to process transactions with increasing speed added 
to the unprecedented level of complexity as well.
    But it was the performance of our regulators, in my view, 
that spun this all out of control, allowing these financial 
institutions to take on more and more risk, more and more 
leverage, with far too much autonomy and far too little 
accountability. Essentially, regulators took our largest 
financial institutions at their word that they understood what 
they were doing, and clearly they did not. In fact, some had no 
idea at all.
    The question before this Committee today is how to prevent 
this from happening again and how do we create an architecture 
to allow for wealth creation and for productivity to be 
restored.
    Some have looked at the failure of many large, complex 
financial firms to manage their risks and the failure of 
regulators to adequately supervise them. They concluded that we 
can no longer afford to let institutions grow to a point where 
they put our financial system at risk. As economist Joseph 
Stiglitz has put it, many of these institutions became not just 
``too big to fail,'' but also too big to save and too big to 
manage.
    Some would strictly limit the size of balance sheets or 
restore some of the restrictions on business line affiliations 
lifted a decade ago. Another option would be to impose more 
stringent capital requirements, deposit insurance assessments, 
and other costs to provide disincentives to becoming either too 
big or to complex. And still others suggest that it is 
unrealistic to believe that we could somehow abolish large, 
complex financial organizations. They suggest designing a 
regulatory framework that would make sure that taxpayers are 
not on the hook each time one of these companies gets in 
trouble. That would mean finding ways to ensure that the 
creditors as well as the shareholders can suffer losses when 
these companies get in trouble.
    As Warren Buffett said last week, the key to ensuring large 
financial institutions are run well is not only proper 
incentives for success, but also severe disincentives for 
failure.
    The truth is, unlike the average family in my State or my 
colleagues' States who has no choice but to live within their 
means, the large institutions throughout the crisis were always 
able to borrow more, draw down more, and relax their 
underwriting standards as their regulators stood by. Whatever 
else we do, that has to stop, in my view. Large financial 
companies may well need a different set of capital rules to 
ensure that they will have sufficient funds to absorb large, 
unprecedented losses. They may need new disclosure and 
responding requirements that would enable regulators to close 
them in an orderly way if they become troubled. If the AIG 
contemporary mess that this Committee helped to expose has 
taught us anything, it is that regulators need a much clearer 
picture of the arrangement that these firms get themselves 
into, not only to regulate them better but to extricate them 
from those arrangements if need be.
    Each of these approaches that I have mentioned this morning 
has merit, and it is my hope that today's hearing will offer an 
opportunity to fully explore each of these options.
    I will say again that I believe there is a need for 
systemic risk regulation to ensure that we no longer need to 
treat any institution as ``too big to fail.'' It is my 
preference that that authority not lie in one body. We cannot 
afford to replace Citi-sized financial institutions with Citi-
sized regulators. The goals of our financial modernization 
efforts must be more transparency, more accountability, and 
more checks and balances. Today's witnesses I think will help 
us become better informed as to these steps.
    With that, I thank again everyone for being here, and, 
Sheila, we will begin with you.

    STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Ms. Bair. Good morning, Chairman Dodd, members of the 
Committee. Thank you for the opportunity to testify on the need 
to address the issue of systemic risk and the existence of 
financial firms that are deemed ``too big to fail.''
    The financial crisis has taught us that too many financial 
organizations have grown in both size and complexity to the 
point that they pose systemic risk to the broader financial 
system. In a properly functioning market economy, there will be 
winners and losers. When firms are no longer viable, they 
should fail. Unfortunately, the actions taken during the recent 
crisis have reinforced the idea that some financial 
organizations are ``too big to fail.'' The most important 
challenge now is to find ways to impose greater market 
discipline on systemically important financial organizations. 
Taxpayers have a right to question how extensive their exposure 
should be to such entities.
    A strong case can be made for creating incentives that 
reduce the size and complexity of financial institutions. A 
financial system characterized by a handful of giant 
institutions with global reach, even with a single systemic 
regulator, is making a huge bet that they will always make the 
right decisions at the right time.
    There are three key elements to addressing the problem of 
``too big to fail.'' First, financial firms that pose systemic 
risks should be subject to regulatory and economic incentives 
that require these institutions to hold larger capital and 
liquidity buffers to mirror the heightened risk they pose to 
the financial system. In addition, restrictions on leverage and 
the imposition of risk-based assessments on institutions and 
their activities would act as disincentives to the types of 
growth and complexity that raise systemic concerns.
    The second important element in addressing ``too big to 
fail'' is an enhanced structure for the supervision of 
systemically important institutions. This structure should 
include both the direct supervision of systemically significant 
financial firms and the oversight of developing risks that may 
pose risks to the overall U.S. financial system.
    Centralizing the responsibility for supervising these 
institutions in a single systemic risk regulator would bring 
clarity and accountability to the efforts needed to identify 
and mitigate the build-up of risk at individual institutions. 
In addition, a systemic risk council could be created to 
address issues that pose risks to the broader financial system 
by identifying cross-cutting practices and products that create 
potential systemic risk.
    The third element to address systemic risk is the 
establishment of a legal mechanism for quick and orderly 
resolution of these institutions similar to that which we use 
for the FDIC-insured banks. Over the years we have used this to 
resolve thousands of failed banks and thrifts. The purpose of 
the resolution authority should not be to prop up a failed 
entity indefinitely or to insure our liabilities, but to permit 
a timely and orderly resolution and the reabsorption of assets 
by the private sector as quickly as possible. Done correctly, 
the effect of the resolution authority will be to increase 
market discipline and protect taxpayers.
    For example, our good bank/bad bank model would allow the 
Government to spin off the healthy parts of an organization 
while retaining the bad assets that we could work out over 
time. To be credible, the resolution authority must be 
exercised by an independent entity with powers similar to those 
available to the FDIC to resolve banks and clear direction to 
resolve firms as quickly and inexpensively as possible.
    To enable the resolution authority to be exercised 
effectively, there should be a resolution fund paid for by fees 
or assessments on large, complex financial organizations. To 
ensure fairness, there should be a clear priority system for 
stockholders, creditors, and other claimants to distribute the 
losses when a financial company fails.
    Finally, separate and apart from establishing a resolution 
structure to handle systemically important institutions, our 
ability to resolve non-systemic bank failures would be greatly 
enhanced if Congress provided the FDIC with the authority to 
resolve bank and thrift holding companies affiliated with a 
failed institution. By giving the FDIC authority to resolve a 
failing bank's holding company, Congress would provide the FDIC 
with a vital tool to deal with the increasingly complicated and 
highly symbiotic business structures in which banks currently 
operate.
    The choices facing Congress in addressing ``too big to 
fail'' are complex, made more so by the fact that we are trying 
to address problems while dealing with one of the greatest 
economic challenges we have seen in decades. The FDIC stands 
ready to work with Congress to ensure that the appropriate 
steps are taken to strengthen our supervision and regulation of 
all financial institutions--especially those that pose systemic 
risk.
    Thank you.
    Chairman Dodd. Thank you very much.
    Mr. Stern, who is the President, I should point out, of the 
Federal Reserve Bank of Minneapolis, welcome to the Committee 
this morning, and thank you for accommodating the change in 
time as well.

   STATEMENT OF GARY H. STERN, PRESIDENT AND CHIEF EXECUTIVE 
          OFFICER, FEDERAL RESERVE BANK OF MINNEAPOLIS

    Mr. Stern. Chairman Dodd, members of the Committee, thank 
you for the opportunity to review the ``too-big-to-fail'' 
problem with you today. The key to addressing ``too big to 
fail'' is to reduce substantially the negative spillover 
effects stemming from the failure of a systemically important 
financial institution. Before briefly going into specifics, I 
want to emphasize that these remarks reflect my views and not 
necessarily those of the Federal Reserve.
    To address the ``too-big-to-fail'' problem, we must 
understand the incentives of uninsured creditors of 
systemically important financial institutions, the incentives 
of the management of such institutions, and the incentives of 
policymakers responsible for economic and financial stability. 
We have a ``too-big-to-fail'' problem because creditors of such 
financial institutions expected, on the basis of relatively 
well-established precedents and on an understanding of 
policymakers' motivations, that protection would be provided if 
failure threatened. As a consequence, they had a most modest 
incentive to monitor the condition and prospects of these large 
institutions, leading to underpricing of risk taking. With risk 
underprices, and for a variety of other reasons as well, these 
institutions took on excessive amounts of it, leading 
eventually to the precarious position of some of them. And 
policymakers, fearing massive negative spillover effects to 
other institutions, financial markets more generally, and the 
economy itself, provided protection and validated creditor 
expectations.
    Just as incentives are at the heart of the ``too-big-to-
fail'' problem, they necessarily must be at the heart of the 
solution. To address incentives, policymakers must deal with 
them at their core. Creditors must be put at risk of loss.
    Once uninsured creditors face appropriate incentives and 
change their behavior, the risk taking of systemically 
important institutions should diminish, reducing policymakers' 
concerns about spillovers. I have long maintained that ``too-
big-to-fail'' bailouts are driven by concerns about potentially 
serious spillover effects. As a result, I recommend reforms 
that reduce the perceived or real threat of the spillovers that 
motivate after-the-fact protection of uninsured creditors, 
recognizing that policymakers first need to address the short-
term problems in the financial system.
    I would start with three reforms that combined I call 
``systemically focused supervision.''
    First, I would increase supervisory focus on preparation 
for the potential failure of a large financial institution. 
This preparation will reveal the interconnections between firms 
and markets that may produce serious spillovers and identify 
the steps policymakers must take to address them.
    Second, I would enhance the existing prompt correct action 
regime by including forward-looking market data. This would 
help identify weak institutions that need early closure, which 
should reduce the losses and spillovers such institutions 
impose on others.
    Finally, I would advocate forthright communication of 
efforts to put creditors of systemically important firms at 
risk of loss. Creditors are not mind readers, and policymakers 
cannot expect them to divine the intention to put them at risk 
absent clear communication to that effect.
    I also support Government pricing through insurance 
premiums, for example, of the activities of systemically 
important financial institutions that potentially create 
significant negative spillovers. This seems like an efficient 
method for taking costs imposed on society and putting them 
rightly back on the firms to influence their behavior. I have 
considered other options as well for taking on ``too big to 
fail'' and discuss them in the written testimony.
    In contrast to these proposals, increasing the intensity of 
traditional supervision and regulation of large institutions 
has no clear ability to improve incentives and ultimately 
imposes losses on creditors. While I support efforts to improve 
it, I recognize that the recent record of traditional 
supervision and regulation in preventing excessive risk taking 
by systemically important firms is not encouraging.
    I have the same general reaction to proposals to reduce the 
size of large financial institutions. I have no particular 
empathy for managers and equity holders of large firms, but 
think efforts to break up these organizations will result in a 
focus on a very small number, thereby leaving many systemically 
important firms as is. Moreover, I am skeptical for the reasons 
noted previously that policymakers will effectively prevent the 
newly constituted smaller firms from taking on risks that can 
bring down others. In short, this reform does not seem to alter 
incentives sufficiently.
    I am more supportive of efforts to bring bank-like 
resolution regimes to non-bank but systemically important 
financial institutions. These proposals address some important 
spillovers and likely would work best if combined with the 
reforms I have already advocated.
    In closing, maintaining the status quo with regard to ``too 
big to fail'' could impose large costs on the U.S. economy. The 
economy cannot afford and does not have to ensure such costs. I 
encourage you to focus on proposals that address the underlying 
reason for protection of creditors of `too-big-to-fail'' 
financial institutions, namely, policymaker concerns about 
financial spillovers. I have offered a plan to address this 
crucial point. Absent this or a similar approach, I am 
concerned that we will not make significant progress against 
``too big to fail.''
    Thank you.
    Chairman Dodd. Thank you very much, Mr. Stern. We 
appreciate it. We appreciate both of you being with us.
    I will have the clerk turn on the clock. We will take about 
5 minutes apiece or so as we move along here. I will not be 
rigid about it, but I will try to make sure everyone here--we 
have only a few members here this morning.
    Let me begin with you, Mr. Stern. You addressed this at 
least in your opening comments, and I wonder if you might be a 
bit more specific about it, and that is, this resolution 
mechanism we are talking about. I mentioned in my opening 
comments about the Treasury sort of embracing the idea that the 
FDIC probably has, of the existing regulatory agencies, the 
expertise and the background given their experience in dealing 
with banks to move in this direction. I wonder how you might 
react to it. Is there some idea of a bankruptcy court idea that 
may be more appealing? Can the FDIC, in your view, fill this 
function? What are your more specific----
    Mr. Stern. Well, I am in favor of a bank-like resolution 
process for systemically important non-bank financial firms. I 
have been giving more thought, rather than to who, to how, and 
what I mean by that is it seems to me it is important that the 
resolution regime be established in a way that losses can, in 
fact, be put on uninsured creditors. And that requires, it 
seems to me, preparation in advance. That is, it gets to the 
spillover question I alluded to in my testimony.
    Policymakers will be unwilling to impose losses on 
creditors if they think the spillovers are going to do 
significant damage to other financial institutions, markets 
more generally, and the economy. So you want to prepare in the 
sense of both identifying, limiting, containing, and other ways 
of constraining the potential for spillovers. That has to be 
part of the preparation, in my judgment, for the effectiveness 
of that kind of resolution regime.
    Chairman Dodd. Okay. Let me raise this with both of you, if 
I can. Peter Wallison is going to testify in our second panel, 
be a witness in the second panel, and he raises an interesting 
concern: that a new system that tries to identify, regulate, 
resolve systemically important financial institutions may 
create a new class of protected companies that enjoy lower 
funding costs due to perceived Government backing and the like. 
I find that idea he has is intriguing, one that needs to be 
addressed. He sees this framework as expanding the safety net 
and adding moral hazard to the financial system in a way.
    Sheila, how do you react to that?
    Ms. Bair. I think the concern relates to what we are 
talking about. We are talking about a resolution mechanism, not 
a bailout mechanism, and we think if you are going to create a 
new systemic risk regulator and identify it, particularly if 
that will involve identifying in advance institutions that 
could be systemic, that to do that without a separate 
resolution mechanism would dramatically increase moral hazard, 
because then you would be anointing institutions as those that 
the Government would continue to step in and support.
    So we think there needs to be a resolution mechanism that 
takes care of that, but we would certainly hope that Congress, 
if you took this step, would clearly set out a claims priority 
and say that the private stakeholders--the shareholders, and 
the unsecured creditors--would take losses and the priority for 
collateralized counterparties, et cetera. Also, the direction 
should be to resolve the institution promptly, not to just keep 
it going, but to break it up. I think a good bank/bad bank 
model would be a good one. We are set up already with our 
bridge bank authority to do that type of model.
    There was a good op-ed in the Wall Street Journal yesterday 
by Glenn Hubbard outlining that type of approach. Others have 
talked about it as well. But I think we need to be very clear 
that we are talking about a resolution mechanism, not a bailout 
mechanism, if we do that.
    Chairman Dodd. Mr. Stern, do you want to comment on that?
    Mr. Stern. Sure. I think that the issue that Peter Wallison 
identified is a serious and potential concern, and that is why 
I put my emphasis on imposing losses on creditors and making it 
known well in advance not only that you intend to do it, but 
you have put yourself in a position where you are, in fact, 
able to do it. So I----
    Chairman Dodd. Yes, is this sort of the Warren Buffett 
disincentives, the thing he talked about, having the serious--
there are incentives to do things, and then there ought to be 
disincentives.
    Mr. Stern. Sure.
    Chairman Dodd. Go ahead. I did not mean to interrupt.
    Mr. Stern. No. That was the sum and substance of my 
comment.
    Chairman Dodd. Okay. Let me, if I can--by the way, I want 
to raise, Sheila, with you the issue of the idea of looking 
at--we are having a lot of conversations among ourselves and 
others about this structure and architecture. Nothing has been 
decided firmly, but there is a lot of conversation, obviously, 
about how to approach this.
    One of the conversations that we are having among ourselves 
is this systemic risk regulator and the idea of having maybe 
more of a council idea rather than a single regulator. And, 
again, the single regulator idea has a certain amount of appeal 
because there is an existing structure. It is the known. If we 
start talking about a council or a collegial approach, you are 
talking about something new. And, obviously, when you start 
talking about things new and how does it work--without trying 
to express the views of all of my colleagues, those who are 
sort of attracted to this idea, it is a multiple set of eyes 
looking at something, rather than a single set of eyes. I 
wonder if you might share some thoughts on that.
    Ms. Bair. Well, yes. We make a distinction between the 
potential oversight of systemic institutions, and the broader 
need for a coordinating body to be looking at the system for 
risk, for interrelationships among securities firms, banks, 
hedge funds and insurance companies. That is really where we 
saw some serious shortcomings.
    So we think for that latter issue, a council is much better 
equipped to deal with those types of systemwide issues that 
cross markets and cross different types of institutions. We 
think that would work, and the President's working group could 
transition into something like that. But it should be a real 
authority with the ability to set rules, for instance, set 
capital standards that might be across markets to make sure 
there is no arbitrage of capital standards, which we have had. 
The council should have the ability to write rules and collect 
data--those types of legal authorities. Yes, we think a council 
is much better suited for addressing that type of risk.
    Chairman Dodd. Do you have any quick comments on that, Mr. 
Stern? I do not know if you have heard----
    Mr. Stern. I think if we established a systemic risk 
regulator, it would be very important what we ask them to do, 
and I would put at least a good deal of emphasis on making sure 
that we identified and understood the interconnections, the 
large exposures among important firms, large reliance on 
particular markets, what happens if a particular market were, 
for whatever combination of reasons, to shut down and so on and 
so forth.
    Exactly who ought to do it, I might have a preference for 
having only one or two institutions do it as opposed to a 
council because of accountability. But I must admit I do not 
have a firm conviction about that.
    Chairman Dodd. Thank you.
    Senator Johanns?
    Senator Johanns. Thank you, Mr. Chairman.
    Let me, if I could, think out loud for a second, and then I 
would like your reaction to this. As I have sat through these 
hearings, there are dozens of complicated issues. You mentioned 
holding companies, for example. That in itself you could spend 
weeks on trying to figure that out. But I agree with you there 
needs to be something done here. There seems to be a real lack 
of ability to deal with that issue.
    But, in my mind, when I kind of think about what we are 
trying to figure out here, I am thinking about three areas, 
kind of three umbrella areas. The first one is oversight. When 
you are dealing with systemic risk, how do you put in place the 
oversight to deal with that?
    The second piece of this is the bailout piece. I would like 
to be able to sit here today and say to the American public 
this is never going to happen again, thank goodness that is 
behind us. But the reality is we have to have something in 
place because the oversight will not be effective if you do not 
have the next step.
    And then the third piece of this or the third umbrella is 
exit strategy. Once you are entangled in oversight bailout, how 
do you get yourself out of it? I would tell you personally I am 
personally appalled by this discussion by the Treasury 
Secretary, even the President has acknowledged, well, there may 
be other CEOs that get fired, and I am using my own words 
there. I never thought I would live long enough to see the day 
that somebody walked into the White House, a CEO in a private 
company, and left without their job. I just find that very, 
very troubling in terms of governmental intervention.
    Now, the first question about the first umbrella, the 
oversight. I like this idea of the panel, a group versus a 
person. Let me ask you this: Is there a governmental structure 
in place where that panel would fit? And I must admit I have 
the FDIC in my mind, and so, Sheila, I am just going to ask you 
directly: Is that something that fits within the FDIC?
    Ms. Bair. It could fit within the FDIC. We already have two 
other principals on our board. The head of the OCC and the OTS 
are, by statute, on our board. We already have all but one of 
the banking regulators represented on our board, so it could be 
modeled along those lines.
    We think the President's Working Group may be another 
model. That is an informal group that was set up by Executive 
Order after the 1987 market breakdown, and it has been a more 
informal way for regulators to have discussions and information 
sharing. That might be another model.
    Gary is right, it creates a little more complexity if you 
have a number of different people involved. But, this is so 
important, especially rearding the decision to resolve a 
systemically important institution. If you have the resolution 
authority, too, having multiple players involved in that 
decision is key. I am assuming that there will be some 
consolidation among banking regulators. So we suggest in the 
testimony that the Federal Reserve Board, the U.S. Treasury, 
the FDIC, and the SEC would be a good starting point. But, yes, 
the FDIC Board currently has the principals of other agencies 
on it, and it works pretty well.
    Senator Johanns. The FDIC seems to work very well. You go 
in and you make very tough decisions, and yet it does not 
disrupt our economy.
    Ms. Bair. Right. Well, we think so. It is a painful process 
to close a bank, there is no doubt about it. And, we kind of 
joke internally about who else would want this responsibility. 
Who would you give it to? It is hard. You do get rid of 
management, and sometimes the lower-level employees lose their 
jobs, too. For the smaller banks, we always try to sell the 
whole bank to another local institution to provide that 
continuity of customer services and employees.
    But, it is a painful process. It does involve some 
specialized expertise, some specialized public relations in 
dealing with the communities that are impacted. But, we are 
well equipped. We have contractors in place that deal with 
asset management and auctioning assets or auctioning whole 
banks. I think we already have much of the talent that is out 
there now to deal with troubled institutions. We have been 
doing this for 75 years. We have resolved thousands of 
institutions.
    Senator Johanns. Gary, now if I could turn to you, and I am 
just about out of time, so I will have to urge you to answer a 
very complex question very, very quickly. But on the bailout 
and exit, what role do you see for the Federal Reserve in those 
areas? For example, yesterday Chairman Bernanke provided us 
with the balance sheets showing the various things that had 
been done. Is this a matter where in these two areas if we work 
to clean up their authority and deal with those kinds of 
issues, is that a workable approach?
    Mr. Stern. Well, let me be brief and just make two 
comments.
    I think one of the objectives should be to reduce the 
probability and magnitude of bailouts going forward.
    Senator Johanns. I agree.
    Mr. Stern. And I think we can reduce the probability. I 
think we can reduce the extent of coverage, both who is covered 
and the amount of coverage. But it is going to take preparation 
and some of the steps I mentioned at the outset in terms of 
dealing with the incentives that uninsured creditors and 
policymakers confront. That is really all about preparation at 
the end of the day. It needs to be done in stable, relatively 
tranquil times. Obviously, in the midst of the crisis, it is 
very hard to work on those kinds of things.
    As far as exit strategy, I guess I would make one comment, 
and that is, I think that is mostly about credibility, and what 
I mean by that is we have to try to put ourselves in a position 
so that even if you do have to bail somebody out because the 
cost/benefit calculation suggests that is the right thing to do 
for the economy as a whole, so even if you do that, you want to 
make sure that the next steps you take reduce the probability 
that you will have to do it again.
    Senator Johanns. Thank you.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Bennet.
    Senator Bennet. Thank you, Mr. Chairman. Thank you for 
holding the hearing, and thank you for your testimony.
    Mr. Stern, I wanted to come back to something you said a 
minute ago; when we think about the systemic risk regulator, 
that it is important that we think about what we are asking 
them to do. One of the things that I have been struck by in my 
conversations with people in the financial industry is not just 
that this is a leverage problem, a ``too-big-to-fail'' problem, 
but it may also be a complexity problem, particularly in a 
rising market, the tendency to create more and more complex 
instruments that people cannot necessarily keep track of, 
either in their scope or in their relationships among various 
financial institutions.
    I wonder in the context of thinking about--and I guess the 
other thing I would say is it makes a person somewhat skeptical 
that an incentive and disincentive regime is ever going to be 
strong enough to counteract those temptations.
    I guess my question to you is how do we manage to keep up 
with that level of complexity without diminishing the 
innovation that all of us need to see in our financial markets, 
but at the same time prospectively protect us from the kind of 
collapse that we have just faced?
    Mr. Stern. Well, I think there are several aspects to that. 
One is, certainly, I am not trying to curtail appropriate 
innovation in the financial markets. I think, to the extent 
that we get the incentive--improve the incentives, we will get 
better pricing of risk. And that will deal directly with some 
of the concerns you have and the development of some of these 
instruments that, obviously, with the benefit of hindsight 
anyway, contained a good deal more risk than was appreciated at 
the outset. So I think that is one way to go.
    I think something we can also probably do in the 
supervisory area is where we see a very complex structure of an 
organization, ask about the economic rationale for that 
structure. And it is very good economic rationale for having X-
hundred subsidiaries, for example. And if not, we could ask for 
streamlining of that kind of structure. So I think that is 
something else that could be done to help clarify the 
situation.
    I should also add--and this will be my final comment right 
now on this--is I think it is not just a question of 
incentives. I think ``too big to fail'' is a big, challenging 
problem. We need to improve incentives where we can. We also 
need to improve capital where we can. We should charge 
institutions some kind of insurance premiums, as I commented, 
where they are of systemic importance and pose systemic risks. 
I think we really need to address this on a number of fronts.
    Senator Bennet. Chairwoman Bair, I do not know if you would 
like to add anything to that. As I have puzzled through the 
news accounts of this, one of the things you are really struck 
by is how evolutionary all of this is. You start out with 
credit default swaps that are based on one set of assets, and 
then you move over time to another set of assets, mortgages. 
And people lose track; the risk gets higher.
    I just wonder how we are going to write those rules in such 
a way that we are going to stay ahead of the curve rather than 
following behind.
    Ms. Bair. Well, it is a challenge. And that is why we think 
there is a need to have greater market discipline. Too big to 
fail has diluted market discipline. There is only so much 
regulators can do, and you really need the market. You need 
people who want to invest or extend credit to these 
institutions, looking at their balance sheet, looking at their 
management, looking at the sophistication of their management 
and the risk management systems. What are their off-balance 
sheet exposures--are they done with proprietary trading, 
structured finance? All the things that we have seen have posed 
heightened risks for these larger institutions.
    You want the private sector in there looking at that as 
well. If they think the institution is ``too big to fail,'' you 
are going to dilute market discipline. And that is why we think 
it is particularly important to have a resolution authority.
    We also think that an assessment system can complement and 
enhance regulation. We have risk-based insurance assessments 
now for depository institutions. So there are certain 
categories of higher risk activity where we charge them a 
higher insurance assessment, for instance, for excessive 
reliance on broker deposits. This can also influence behavior, 
and I think this would be another tool that should be used for 
the systemic institutions.
    Senator Bennet. I am going to ask the Chairman's indulgence 
because while I have got you here, I want to ask a slightly 
unrelated question about New Frontier Bank in Greeley, 
Colorado, which I know you are aware of. I wonder if you might 
say a word about where we are with that; and, also, more 
broadly, in the context of a region like that, a rural part of 
my state, where the local economy is heavily reliant on one 
institution, namely that one. That carries with it its own 
systemic risk for that little corner of the world.
    I wonder if you might talk a little about that situation; 
also, more broadly, the FDIC's approach in an area like that 
versus one where there are many other options.
    Ms. Bair. Well, we did. We had a nice chat with 
Congresswoman Markey yesterday, too, about this.
    For the depositors, we have arranged for another bank to 
take over their accounts and help them transition into a new 
deposit account relationship. And for the loans, we are trying 
very hard to find other lenders to refinance those loans or to 
purchase them.
    I think one of the things where we engaged Congresswoman 
Markey, and I will take the opportunity to engage you as well, 
is to encourage other local lenders in the area to work with us 
and help these borrowers find new lending relationships. We are 
working very hard on that, and have been providing some 
additional financing out of the receivership to borrowers as we 
seek to transition them to lenders that are stronger.
    But we would love to work with your office. We talked with 
her about maybe having a town hall meeting. So we would be 
happy to work with you on that.
    Senator Bennet. Thank you. I would appreciate that.
    Mr. Chairman, thank you very much.
    Chairman Dodd. Thank you, Senator.
    Senator Bunning?
    Senator Bunning. Thank you, Mr. Chairman.
    Mr. Stern, do you think the market disruption, following 
Bear Stearns' bailout and Lehman Brothers' failure, in other 
words, the government picking a winner and a loser, was because 
of the bankruptcy itself or because everybody expected the 
creditors would be saved and the market had to adjust their 
expectations when they let Lehman go?
    Mr. Stern. I do think that when Lehman was let go, that 
probably came as a surprise to at least some of the creditors 
of Lehman, even though, of course, I think it was widely known 
in the financial marketplace that Lehman was experiencing some 
funding and other difficulties.
    Having said that, I think it is worth adding that, clearly, 
in the wake of Lehman, AIG and--the difficulties of AIG were 
revealed, and Merrill Lynch was purchased by Bank of America. 
So I think the----
    Senator Bunning. Under the gun.
    Mr. Stern. So I think the whole scale of the problem turned 
out to be much greater than anticipated by people in the 
markets. And AIG was a AAA rated company. I think that came as 
a genuine and sizable shock.
    Senator Bunning. But the AIG was rated a AAA company with 
the hedge fund in England not being attached. They are 
insurance companies.
    Mr. Stern. You will have to ask AAA. You will have to ask 
the rating agencies.
    Senator Bunning. Yeah, the rating--that is who I really 
need to ask, is the rating agencies.
    Mr. Stern, you mentioned that regulators needed to be 
better understood, the connection between firms.
    Do you think there are some types of connections or 
products that should be limited or banned?
    Mr. Stern. I am not knowledgeable enough a priori to say 
that we ought to ban some interconnections or some products. 
What I would say is if we identified interconnections and 
exposures and potential vulnerabilities that looked like they 
would lead to serious problems at a number of institutions--
that is, if one institution got into serious difficulty, it 
would spread in substantial ways to others--then it is an 
opportunity to do one or both of two things; either to push to 
reduce those exposures as a regulator and/or to figure out how 
you are going to deal with the spill-over effect should 
problems arise. That is, how are you going to contain the 
problems.
    So I do think that would be a very valuable, important 
exercise. That is part of my proposal when I talk about----
    Senator Bunning. I complimented you in my opening 
statement, but I did not get to make it.
    Mr. Stern.----preparing for these kinds of problems. Thank 
you.
    Senator Bunning. That is all right.
    For either of the witnesses, what specifically in the 
bankruptcy laws is not sufficient for resolving financial 
institutions?
    Ms. Bair. Well, I go into that in a little more detail in 
my testimony. I think there are a couple of things. First, 
there is the ability to set up a bridge bank. I think 
continuity of operations, especially for the systemic 
functions, is important to a resolution mechanism. We have it 
now with banks. We think that works well.
    Another key difference is how derivative contracts are 
treated. In a bankruptcy, the derivatives counterparties have 
the immediate right to close out their position. With Lehman 
Brothers, you saw a situation where everyone was doing that, 
grabbing the collateral, selling it off and going out and re-
hedging.
    Senator Bunning. Can I just interrupt you a second?
    Ms. Bair. Sure.
    Senator Bunning. Because we had testimony from the 
Secretary of the Treasury, past and present, and the head of 
the Federal Reserve, both present and past, that we should not 
involve ourselves in overseeing derivatives and credit-default 
swaps.
    Ms. Bair. Well, yes.
    Senator Bunning. I mean, sitting right where you sat----
    Ms. Bair. You never heard that from me, Senator. No. And I 
would say, high on the priority of this body should be to 
review the Commodity Futures Modernization Act. I think that 
has shackled the ability of regulators to provide greater 
oversight of those markets. I do not know what they said, but I 
feel strongly we need greater oversight of those markets.
    Senator Bunning. So do I.
    Ms. Bair. Okay. But our resolution mechanism allows us to 
accept or reject those contracts. We can require the 
counterparties to continue to perform in those contracts 
instead of grabbing the collateral. I think that is another key 
advantage of our process.
    Senator Bunning. Mr. Sterns, just hold on just a second, 
while I have Sheila.
    When do you expect to end the TLGP, and can all banks 
survive without it?
    Ms. Bair. We have been trying to ease out of that program. 
We have put surcharges on the program, and are putting those 
surcharges into the Deposit Insurance Fund to try to reduce 
pressure on the special assessment.
    Senator Bunning. To other banks.
    Ms. Bair. Yes, exactly, the smaller institutions.
    We are working to stabilize the situation. We very much 
want to end it on October 31st.
    Senator Bunning. Are you going to be able to do that?
    Ms. Bair. I am optimistic that we will. We will have to 
wait and see where we are, but I am optimistic that we will.
    Mr. Sterns, would you like to say something about 
bankruptcy?
    Mr. Stern. No. The only thing I would add to Chairman 
Bair's comments is with regard to some of the derivatives and 
credit-default swaps, obviously, we are moving to central 
counterparties' clearinghouses. I think that is a very 
important step. I think that will help to standardize the 
products. It will take a good deal of risk out of the business. 
And I am cautiously optimistic that that will turn out to be a 
way to effectively address at least some of your concerns.
    Senator Bunning. In other words, we were just a little 
behind the curve in regulatory oversight by the advice of the 
Federal Reserve chief, both Chairman Greenspan and Chairman 
Bernanke. And both Treasury secretaries said they did not need 
those oversights.
    Senator Bunning. Well, you know, all I can say at this 
point is it has been a difficult lesson.
    Mr. Stern. It certainly has, and an expensive one. Thank 
you.
    Chairman Dodd. Thank you very much.
    By the way, on that clearinghouse idea, I know of no 
dissenting voices, at least on this Committee or others I have 
talked to about it. It is going to be very much a part of that 
architecture we are talking about.
    Senator Warner?
    Senator Warner. Thank you, Mr. Chairman. Thank you for the 
hearing.
    Let me move to a slightly different subject as well. I want 
to come back to systemic regulator, but I would like to hear 
Ms. Bair and Mr. Stern--we all have been waiting for some time 
for the release of the so-called stress test results. And we 
have heard Treasury say that none of the 19 banks are going to 
``fail.''
    One, I would like to get your evaluation of have these 
tests been rigorous enough, number one. Two, what additional 
steps can you or we take to give confidence to the markets the 
analysis has been rigorous enough? And, three, what else can we 
do to encourage these institutions that need additional capital 
to push and prod them into hopefully finding that in the 
private sector?
    Ms. Bair. All of these institutions that exceed regulatory 
standards are well capitalized. The stress test really was to 
determine, if we have a more adverse economic scenario over the 
next couple of years, will the banks have adequate capital 
buffers now to withstand that more adverse economic scenario. 
So in that sense, the stress test is more rigorous than the 
current regulatory standards for being well capitalized.
    Senator Warner. Although, again, we are rapidly approaching 
the outer reaches of----
    Ms. Bair. Well, that is true.
    Senator Warner.----the downside.
    Ms. Bair. I think that is right. This is something that 
needs to continue to be monitored. And we do this all the time, 
and we will continue to do so.
    But I think even though the unemployment rate used in the 
more adverse scenario could have been a little bit higher, I 
think on home price declines, we have been pretty aggressive. 
So I am hoping that all nets out. But, clearly, it needs to 
continue to be monitored. I think this will be a confidence-
instilling announcement. There will be additional needs for 
capital buffers for some institutions, but I think there will 
be mechanisms to do that within the next six months.
    And, yes, certainly I would agree, those institutions need 
to look to non-government sources first. The Treasury can be 
there as a backstop, but they should look to non-government 
sources, first and foremost to raise new equity, if possible. 
If they cannot do that, or in conjunction with that, banks can 
consider converting some of their other securities in their 
capital structure into common stock to increase the level of 
tier 1 common equity, which is very important for market 
perception right now.
    Senator Warner. And you are confident that there will be 
enough data released that will result in a confidence building 
rather than a confidence weakening?
    Ms. Bair. Well, I hope so. This is an interagency process, 
and it is a holding company process. It has been led by the 
Federal Reserve as it should be. They are the holding company 
regulator. I think they have done an outstanding job. They have 
a great staff. And so I think that it will be confidence 
instilling.
    Obviously, there are judgment calls that have to be made on 
all of this, and I am sure there will be some that say we are 
being too tough, and there will be analysts that say we are not 
being tough enough. But, hopefully, we are in the middle there, 
at the right place. But a lot of it is just judgment.
    Senator Warner. Mr. Stern, do you have a comment?
    Mr. Stern. I think Chairman Bair covered it thoroughly. And 
I would prefer not--until the results are out, I would prefer 
not to go further.
    Senator Warner. I would like to go back, on my own 
remaining time, to the notion that the Chairman raised in terms 
of systemic risk and the idea of a council, which I think has 
some attractiveness but also some challenges.
    What guidance/advice would you have if we were to, at 
least, continue to pursue the possibilities of this option, of 
how we would make sure that information would actually be 
forced up and truly shared? Number one.
    Two, how would we ensure, and what structural advice could 
you give us to ensure that this council would not end up 
becoming simply a debating society?
    And number three, when this council or group reach some 
conclusion, how could we ensure that it could act with some 
force?
    I would love you to comment on all three.
    Ms. Bair. Well, I think accountability will be key. The 
statute needs to put accountability for systemic risk with this 
council. It needs to be given real authority to write rules, to 
set capital standards, to collect information, and make sure it 
is shared with the other regulators.
    If you provide that mandate and that accountability, as 
well as real legal authority, I think you will get the result 
that you want. There is nothing perfect about supervision, and 
this is why we have also suggested a resolution mechanism to 
enhance market discipline as well as protect taxpayers. In 
addition, we have suggested an assessment system that the 
resolution authority would have as well to provide 
disincentives for higher risk behavior. I think with those 
three steps in combination, you would dramatically improve the 
situation.
    Part of the problem is nobody really has the mandate right 
now for the entire system. There were problems. For instance, 
capital arbitrage between investment banks and commercial 
banks--different capital standards. That is exactly the kind of 
issue this type of council could have not only identified but 
also addressed.
    Senator Warner. But one of the things we need to do is make 
sure that that information that may currently reside in the 
day-to-day prudential regulator actually would get pushed up 
and actually shared, which----
    Ms. Bair. That is right.
    Senator Warner.----seems in the past that some of this 
information has been out there, but it has not been----
    Ms. Bair. That is exactly right. There needs to be clear 
authority to collect and to force the sharing of the 
information. We give the SEC our bank data; they give us their 
trading data. You need a mechanism to do that.
    Right now, sometimes it eventually happens, but it can be a 
long process, and it is not a coordinated, systematic process. 
Establishing a council with the mandate and the legal authority 
to carry out that mandate would dramatically improve the 
situation.
    Senator Warner. Mr. Chairman, I know I have gone beyond my 
time, but if I could have Mr. Stern answer the question, too, 
sir?
    Mr. Stern. Yes. Well, I think two things are going to be 
very important in that regard. One is authority to act. And I 
would add that working with the supervisors is very important 
because they have a lot of on-the-ground information that would 
be valuable in this process.
    But I also would think that for systemic supervision to be 
effective, this group, whether it is an institution or whether 
it is a council, or whatever it is, would have to have the 
ability, under the right circumstances, to intervene if they 
thought that the consolidated supervisor, whether it was a bank 
supervisor or an insurance company supervisor or whatever, was 
not doing an adequate, sufficient job.
    So from their judgment, if the job that was being done by 
the principal supervisor just was not adequate, they could step 
in and ask for more forceful action, and I think that would be 
important.
    Senator Warner. Thank you, Mr. Chairman.
    Chairman Dodd. That is a very important point because that 
gets central to the debate, in a sense, whether or not you have 
sort of the corporate model or you have a risk assessment 
officer that is watching everything and advises the corporation 
when they think things are straying off or actually has the 
authority to reach in and stop something from happening. And 
that debate is one we have not resolved.
    That is a very critical moment, as to what kind of 
authority you actually invest, whether it is the individual or 
whether it is the council. And I am more attracted to the 
council idea.
    Senator Corker?
    Senator Corker. Mr. Chairman, thank you. Thanks for having 
this hearing. I appreciate our witnesses coming in and thank 
them for their testimony, which I read this morning early. I 
have to tell you that I especially----
    Excuse me, Gary. But I especially liked the testimony by 
our FDIC leader. And I find it to be just an absolute stunning 
rejection of the policies that have been put forth by our 
Treasury Secretary. And I very much like what you had to say. 
There might be some details.
    But I find it amazing that your embrace of the free market 
is so different from our Treasury Secretary, who, in essence, 
has come up here talking about wanting the powers, in 
perpetuity, to invest taxpayer money in entities that pose 
systemic risks, forever. In essence, creating another Fannie or 
a Freddie in the process. So it is an amazing thing to me. And, 
also, by the way, sharing with the public who those entities 
are by causing them to pay higher premiums so that everybody 
understands that they are never going to fail.
    So I just want to thank you for bringing sanity into this 
discussion. I very much appreciate your presentation, and very 
much appreciate your willingness to take something that is more 
the American way into your thinking here and certainly 
presenting to us.
    Now, let me ask you a question. Timing. We have had--I 
actually appreciate the way our chairman has handled this in 
that he has not tried to rush through this. I know that he and 
the ranking member agree on that. I know that this resolution 
authority, though, is important right now. Okay?
    The other pieces of it do not have to come into play 
necessarily. We are not going to solve this problem through 
regulation we put in place today. But I would love to hear 
about the resolution authority piece, number one, if you feel 
it can be done separately and what the timing of that should 
be.
    Ms. Bair. Well, I think that just giving us the authority 
to resolve bank and thrift holding companies could be done more 
quickly. You do not need to decide what is systemic and what is 
not, nor who is going to be providing the broader systemic 
regulation. That would be a huge contribution to the tools that 
we have in dealing with the current situation. So I think that 
this could be addressed separately, and it would be very 
helpful to have.
    Senator Corker. I do hope there is some--that you will 
coach us and help us figure out a way to maybe deal with the 
resolution issue and let the other be dealt with when there is 
not a crisis; otherwise, we will probably not end up with a 
cause-neutral solution. Okay? We will be focused on CDS's and 
everything else. But thank you.
    Let me ask you this. Many of our institutions have talked 
about wanting to leave the TARP program, but one of the most 
beneficial pieces of what we have done is the TGLP program, 
TLGP program, where, in essence, they are able, through 
government guarantees, to borrow money.
    If we cause these folks--if we allow these folks to leave 
the TARP program, should we also make them leave this other 
thing that is actually a greater benefit to them, a government 
guarantee for their debt? Should we also cause them to leave at 
the same time?
    Ms. Bair. I would point out that the TLGP program has been 
a moneymaker for us. We have collected over $7 billion in 
premiums from it, and we have had no losses. That has helped. 
Some of the surcharges on that program are now helping to 
replenish the Deposit Insurance Fund, where we have losses 
through our normal resolution activity. So I think there have 
been some benefits to the government and the FDIC for that 
program.
    Senator Corker. So now you are moving the free enterprise 
into government and we are making money----
    Ms. Bair. I do not. We would like to get out of that 
program October 31st, and that is the plan right now. We had an 
opt-in or opt-out procedure when we instituted the program. I 
was worried about adverse selection.
    So I think we would like the institutions that are in the 
TLGP now to stay in it until October 31st under the current 
terms. But then after that, we would like to end the program.
    Senator Corker. Is that possible?
    Ms. Bair. I sure hope so, Senator. I think we will know 
more in the third quarter. But that is the current strategy. I 
will guarantee you that if we cannot end the TLGP for 
everybody, the fees will go up.
    Something we had originally talked about, which we did not 
do because the markets were under such stress, would be to only 
guarantee a percentage, say 90 percent or 80 percent, to start 
weaning the private markets off of this and take some 
percentage of the risk. So there are different ways we can exit 
if we cannot by October 31st. But our strong preference is just 
to get out on October 31st.
    Senator Corker. This is, apparently, going to be my last 
question.
    If we end the program on October 31st, my sense is that we, 
potentially, may need this resolution ability in place prior to 
then because it would be my sense that there are a lot of 
institutions in this country that cannot survive without that 
program being in place. I am just wondering if you might 
respond to that.
    Ms. Bair. I think that is a valid observation. The 
flexibility and the tools we have to deal with this, have been 
hampered by our lack of ability to deal with structures at the 
holding company level. So a lot of this open institution 
assistance has been needed because we do not have other tools 
available. It would be helpful to give us flexibility. It is 
the kind of thing you hope you will never have to use. But I 
think having it now would be extremely helpful.
    Also, we find with the smaller institutions that just a 
thread of resolution authority can trigger actions that might 
not otherwise take place. And so, for a variety of reasons, it 
will be a helpful tool to have.
    Senator Corker. We appreciate your willingness to talk with 
us on the telephone from time to time, and I hope that will 
continue. And, again, I know that you have spent most of your 
life in government. I thank you for proposing something that is 
sane, that actually alleviates the moral hazards that our 
Treasury Secretary has tried to lay out.
    I would love to hear of you-all's interpersonal 
conversation some time, but I will not ask for that now. Thank 
you very much.
    Chairman Dodd. You are really treading on thin ice there. 
Thank you.
    By the way, the resolution mechanism is something we all 
feel pretty strongly about, and whether or not we are able to 
move forward with a larger proposal, including the resolution 
mechanism, is a good point. And this is something I have to 
take the temperature of my colleagues on as to how they feel 
about it. But I hear what you are saying, and I do not disagree 
with my friend and colleague from Tennessee about the 
importance of that issue, having a mechanism in place. I regret 
we do not now. It would have been a very different situation, 
in many ways, if we had such.
    So I will be in conversations with my colleagues, certainly 
Senator Shelby, about the best way to proceed on that. And I 
invite the comments of my colleagues and thoughts on this 
matter as well, as to whether or not we ought to proceed with 
that or whether or not we will be in a position where we can 
actually accommodate that as part of a larger proposal.
    With that, Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairlady Bair, let me thank you for all your work. I think 
it has been extraordinary. And I was listening to my dear 
friend and colleague, Senator Corker, laud your proclivities to 
the free market, which we share. But you are not for a free-
for-all market, are you?
    Ms. Bair. No, no.
    Senator Menendez. That is what I thought. So let me ask you 
a couple of questions. One of the fundamental questions--I know 
we have talked about how we regulate and how we look at 
systemic risk and systemic regulators. I would like to take a 
step back from that because I think you have some testimony 
that maybe you did not do in your oral presentation that is 
very important for the Committee to be considering as well, and 
that is, if we have gotten to the point that an institution is 
``too big to fail,'' haven't we in some respects already 
failed?
    Ms. Bair. I think that is right. It has diluted market 
discipline and helped contribute to getting us into this 
situation, and we need to end it. I think that is true.
    Senator Menendez. So in that respect, because it poses 
potentially such risk to the overall system and the economy, 
how do we--I think you had some very interesting suggestions. 
One is that in your testimony on page 4, you say that ``the 
academic evidence suggests that benefits from economies of 
scale are exhausted at levels far below the size of today's 
largest financial institutions.'' And then you went on, on page 
6, to talk about some of those things that we might do 
prospectively and preventively to not only regulate the system, 
but to create, I would say, safeguards from maybe getting to 
that point where we might be ``too big to fail.'' Can you talk 
about some of those?
    Ms. Bair. Right. We charge premiums for deposit insurance 
on a, risk-adjusted basis. We charge a higher assessment for 
institutions that engage in behaviors that we know are higher 
risk and that can increase our resolution costs.
    I think you could have an assessment system that would help 
build up a fund so that if a very large, complex organization 
got itself into trouble, you could put it into a resolution 
process. If the Government had to absorb losses as part of that 
resolution, you could fall back on this fund as opposed to 
going to the taxpayer, which is what is happening now.
    I think that type of process could provide economic 
disincentives for higher-risk behavior. That might be 
preferable to just trying to say you cannot do this or you 
cannot do that. Frequently, when you try to just ban certain 
products or practices, people find a way around the ban, or you 
can create an arbitrage in an unintended fashion. So I think 
creating the economic disincentives so banks pay a much higher 
assessment for actions that post more systemic risk would be a 
powerful tool.
    There are certain areas where it is quite obvious that the 
activities were higher risk--for example, structured finance, 
and credit dafault swaps. This would be one additional tool 
that could be used.
    Senator Menendez. How about graduated capital reserve 
requirements?
    Ms. Bair. Yes, absolutely. There is broad consensus on 
having countercyclical capital requirements. During good times, 
the larger institutions in particular must build up their 
capital so that they can draw down upon those in bad times. 
That is absolutely essential. I think there is broad 
international consensus on that point.
    Senator Menendez. You also said here, ``there firms''-- 
referring to the ones who create some higher risk--``should be 
subject to higher Prompt Corrective Action . . . limits under 
U.S. laws.''
    Ms. Bair. Right.
    Senator Menendez. ``Regulators also should take into 
account off-balance-sheet assets and conduits as if these risks 
were on-balance-sheet.''
    Ms. Bair. Yes. That is right.
    Menendez. Something that you promote as well.
    Ms. Bair. Yes, absolutely. The off-balance-sheet exposures 
where institutions were not required to maintain capital 
against those exposures were found very quickly when those off-
balance-sheet vehicles got into trouble. They came back on-
balance-sheet pretty fast. I think the accounting industry is 
moving in that direction as well. Those exposures should be 
reflected on-balance-sheet and capital should be held against 
them.
    Senator Menendez. Let me ask you one question that is not 
per se on topic, but since you are here: Since we seem like we 
are moving in the direction of giving you the higher borrowing 
authority, and I continue to hear from all those community 
banks who were not really part of our challenge in this 
economy, how quickly, assuming that it is signed into law, do 
you anticipate that the FDIC will be able to stabilize or lower 
the fees it is charging these banks?
    Ms. Bair. I think we will do it very quickly, certainly 
before the end of the month, assuming this authority goes 
through, and it looks like it will. And thank you all for your 
leadership in getting this done. It will be before the end of 
the month. We will make an announcement on that.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much. And let me say just on 
that point, we thank you, Ms. Bair, for the work of the FDIC 
and the communication with the Committee. We have had a good 
debate this week on the subject matter and have expanded the 
legislation, but I think on the central points regarding the 
deposit insurance and the lending authority, borrowing 
authority, there is pretty much consensus--not everyone, but 
pretty much consensus on this. But there has been some debate 
about other matters before the floor, but we have resolved at 
least some of those and are moving forward.
    Senator Shelby.
    Senator Shelby. Thank you. Thank you, Mr. Chairman.
    I would like to ask--this may have been asked earlier. I 
was not here early this morning. A threshold question comes to 
me: What constitutes ``too big to fail''? What constitutes 
that?
    Ms. Bair. Right.
    Senator Shelby. How do you define that?
    Ms. Bair. It is difficult to define. I think it is market 
perception as much as a precise definition. It is not just a 
function of size, it is really a function of interrelationship. 
In general, an institution would be ``too big to fail'' if, in 
a situation where it did fail and repudiated all its various 
obligations, there would be collateral systemic impact so that 
other firms would start being brought down because of that. 
That is how I look at it, and I think that is why we found 
ourselves in a box with some of these financial institutions. 
Because of the potential domino effect, that Government 
intervention was deemed necessary.
    Senator Shelby. Mr. Stern, President Stern.
    Mr. Stern. My definition would be similar. I think of it in 
terms of an institution who, if it ran into substantial 
difficulty, would impose significant spillover effects on other 
significant institutions and/or a range of financial markets as 
well. So I would define it in that kind of very practical, 
operational way having to do with significant spillovers.
    Senator Shelby. Could a hands-on regulator or regulators--
hands-on--help prevent this, in other words, from becoming too 
interconnected, see what is going to happen or could happen 
down the road? Because if you can prevent something, it is a 
lot better than picking up the pieces, is it not?
    Mr. Stern. Yes, I would say two things about that. I think 
it would take a reorientation of traditional supervision and 
regulation. Rather than worrying principally about the safety 
and soundness of the institution per se, you have to broaden 
your perspective to think about who would be affected and to 
what magnitude if the institution got into serious difficulty. 
But even if you did that, I would be concerned that that by 
itself would not be sufficient without going the next step and 
preparing, one way or the other, to limit, to diminish the 
potential for spillovers.
    Senator Shelby. Mr. Stern, the idea of imposing higher 
capital requirements--this has been talked about here, alluded 
to this morning--on ``too-big-to-fail'' institutions has some 
appeal. Your testimony advocates, as I understand it, capital 
tools that create capital when firms need it most. You need it 
most, it seems to me, when you do not have it, so to speak, 
when you are in a downturn.
    What type of capital tools were you referring to in your 
testimony? And how would these additional tools be put in 
place? And could regulators take action under existing 
authority to require those types of tools? Or will it be 
something we will have to address in legislation?
    Mr. Stern. Well, one suggestion that has a lot of appeal to 
me is something called ``contingent capital,'' where a firm 
would issue a debt instrument which would have, as its capital 
diminished at some point, with a formal trigger or perhaps 
under regulatory instructions, that debt instrument would 
convert to equity. That is why it is called ``contingent 
capital.'' So you would have additional capital, in fact, when 
you needed it most, when your capital was diminishing and your 
position was deteriorating. And I think that is an attractive 
idea, and I would certainly advocate and support it.
    Senator Shelby. In your tenure as President of the Reserve 
Bank there, have you known any banks in the area to fail that 
were well capitalized, well managed, and well regulated?
    Mr. Stern. Well, I think with the benefit of hindsight, the 
answer to that is no. But, occasionally--usually I think it is 
fair to say, especially if it is a relatively small, 
straightforward institution, the problems are well recognized 
in a timely way. I think the problem is with large, complex 
institutions that is a much more significant challenge, 
especially to do it in a timely way. And even if you identify 
the problems in a timely way, taking corrective action in a 
timely way is a very significant challenge, in my judgment.
    Senator Shelby. To both of you, is there really in the 
banking business any substitute for capital, real capital?
    Ms. Bair. Well, I think capital is absolutely central in 
its importance, and we need more capital now and in the future. 
And we need countercyclical capital requirements, and I like 
the contingent debt concept. It is a good idea as well.
    I think you need market discipline, too. If an institution 
is undertaking very high risk activities, even at a 20-percent 
capital level--and we have seen this in smaller institutions--
it can go pretty fast. So I think you need good, common-sense 
oversight, but you also need that complemented by market 
discipline, which, again, ``too big to fail'' has diluted.
    Mr. Stern. Yes, market discipline and capital are 
complements, not substitutes. I think they are both critical 
here.
    Senator Shelby. They work together.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you. I am glad you made that point, 
Sheila, because I can think of several institutions today that 
have very high capital standards but are in trouble. And the 
assumption because they have a lot of capital that they are not 
in trouble is the conclusion, and that is not the case. But I 
agree with my friend from Alabama that is an important--capital 
standards are critically important, but I am glad you mentioned 
the market discipline as well in all of that.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Thank you both not only for your testimony but 
particularly, Chairwoman Bair, for your very effective 
leadership. Do you think we should return to something much 
closer to Basel I capital standards rather than continue the 
Basel II regime?
    Ms. Bair. Well, I absolutely think that the structure of 
Basel II, the Advanced Approaches, continues to be highly 
problematic. There has been a lot of work to try to fix it. At 
some point you wonder, well, should we just start over as 
opposed to trying to fix it? Thank goodness we have always 
maintained the leverage ratio in the United States, and that we 
are still under Basel I.
    I think there is increasing international agreement that we 
need an international leverage ratio. We are calling it a 
``supplemental capital standard'' now, but that is in essence 
what we are talking about. And, in terms of the capital 
standard based on risk-weighted assets, it could be made more 
nuanced and more granular. But we can do that by building on 
the Basel I framework of buckets of different asset categories 
with hard and fast risk weights and capital requirements as 
opposed to this more subjective model-based regimen that we had 
with the Advanced Approaches under Basel II.
    The basic approach under Basel I is workable. It needs to 
be improved. It needs to be more granular. But, making 
enhancements to Basel I might be more productive at this point 
than continuing to try to work with Basel II.
    Senator Reed. We have operated under Basel I. It is a known 
entity. Rather than inventing a new third approach, it might be 
better to return back to something that we have operated under.
    Ms. Bair. I think that would be a very viable path. It is 
just one opinion. Obviously, there are a lot of voices on 
capital standards. But I think that would be faster and get us 
to a stronger capital regime. Yes, I do.
    Senator Reed. Mr. Stern, do you have any views?
    Mr. Stern. Yes, I think it is very important that we get 
capital right, and I certainly think that Basel II ought to 
undergo a very thorough review, and we should ask ourselves if 
that is going to take us where we want to go. And as I have 
already suggested, I think while we need to get the capital 
right, I think that the ``too-big-to-fail'' problem is 
sufficiently challenging, that capital by itself is not likely 
to be the entire solution. And so that is the reason I have 
suggested a number of other initiatives as well.
    Senator Reed. Do you believe that the Federal Reserve has 
the authority to require a regulated entity to divest itself of 
an operation or enterprise because they do not have the 
managerial capacity to do it correctly?
    Mr. Stern. As a legal matter, I do not know if we have the 
authority for that. As a practical matter, I think that is a 
very difficult thing to do. You might prevail. But, obviously, 
if the organization thought it was integral to its operations 
and to its profit-making opportunities, it would undoubtedly 
want to resist such action.
    Senator Reed. Well, if you are the authority and you have 
the--since I am continually impressed with the authority of the 
Federal Reserve over the last few weeks and months to do 
things, I think you are not giving yourself enough credit for 
the leverage you might have. But one of the issues of not only 
correcting a situation but preventing a situation is having 
perhaps the authority to step in and say these activities are 
great, but they are just--you are not managing them well--which 
would send a stronger signal to management than simply saying 
we know we cannot do anything, but we wish you were better 
managers.
    Mr. Stern. Yes, and, you know, as I commented a little bit 
earlier, I do think that identifying those situations is an 
important responsibility and a challenging one. But as I 
commented, even when you identify those things, taking timely 
action is very challenging, especially in good times, by the 
way, when it looks as if everything is operating smoothly, and 
the rationale for such a divestiture, for example, would not be 
immediately accepted.
    Senator Reed. I think you are absolutely right. I mean, I 
think that the irony here is it is the good times where the 
seeds are sown for the bigger harvest of the future, and it is 
hard in practice.
    Let me ask just a final point. One of the problems we have 
is we have talked about the leverage and the capital ratios of 
regulated entities. But what about the embedded leverage of 
some of their counterparties, the hedge funds, so that what 
looks like an appropriate loan based on the capital of the 
regulated entity becomes, you know, much less acceptable? How 
do we deal with that?
    Ms. Bair. Hopefully, if it is a regulated bank, they should 
be looking at their counterparty exposure. If their 
counterparty is overleveraged, then that might not be a 
transaction they should do.
    One area that a systemic risk council, with the regulators 
coming together, should look at is how leverage constraints 
apply across the board. It is very difficult to have even 
higher capital standards than we have now for banks. If there 
are other major parts of the banking sector that can lever up 
much higher, you are going to be creating incentives to drive 
activity into less regulated venues.
    We need some minimal standards that apply across markets, 
and leverage is probably one area we need to review.
    Senator Reed. Let me just follow up quickly. This systemic 
council of regulators I think--well, let me ask you: Should 
they also have sort of the responsibility to have an analytical 
staff that would try to anticipate issues? Coming from my other 
Committee, the Armed Services Committee, we spend a lot of time 
and a lot of money gaming what could happen, what might not 
happen, what are the pressures on systems? That I do not 
believe exists in any sort of consistent way within financial 
regulation.
    Ms. Bair. We do it within our respective spheres. We do 
that internally at the FDIC with insured depository 
institutions. So I absolutely think that there should be an 
analytical staff. That would be a key part of the council to 
enable it to collect the data and analyze it and identify 
issues to try to get ahead of them.
    Senator Reed. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Dodd. Just on that point, that is a very good 
point. I was thinking when you were defining it, giving your 
definition of ``systemic risk,'' and I agree with you, size 
alone is--if we gravitate on that, we are going to miss an 
awful lot. But one thing I did not hear you say, and that is, 
products. What is maybe a relatively small product can migrate 
very quickly through the system, and that product can become a 
source of tremendous systemic risk. And so in addition to the 
entity itself having tentacles that reach out that cause 
problems, we need to be looking--I think Jack's point is a good 
one--an analytical staff that is looking at what products are 
and can that product pose systemic risks.
    Ms. Bair. I agree.
    Chairman Dodd. While it may be innocent enough or small 
enough, at some juncture the analysis that that product could 
create problems I think is a very important issue as well.
    Ms. Bair. I agree.
    Chairman Dodd. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    I want to ask--and this question is more directed to Mr. 
Stern, but, Sheila, please feel free to chime in here.
    Mr. Stern, in your writings, you have noted the unintended 
side effects of stepped-up prudential capital requirements may 
encourage banks with those stepped-up requirements to actually 
increase their risk to gain the same returns, and this raised 
kind of an inherent dilemma, if you will, of that strategy. And 
how does that play out in terms of the pros and cons of public 
policy?
    Mr. Stern. Well, I think that is a potential reaction and 
something of potential concern, and that is why I have 
advocated not relying just on capital or just on one or two 
approaches to dealing with ``too big to fail.'' I think this 
has to be a multifaceted approach with a number of initiatives 
that straighten out the best we can the incentives and improved 
market discipline as well as doing things like improving 
capital and so forth, because this is a difficult issue to 
address. Its consequences are potentially very serious, and so 
I think we need to address it across a number of fronts.
    Senator Merkley. Do you wish to add anything on that?
    Ms. Bair. Well, I think that is a risk. We have capital 
standards based on the riskiness of assets in addition to the 
leverage ratio, which is core capital to total assets. So 
through our risk-based capital system, we try to address that 
problem. But it is imprecise, necessarily imprecise, and so it 
is something that supervisors have to be constantly vigilant 
of.
    Senator Merkley. To follow on, Mr. Stern, I think another 
point you have made is that we in some degree already have a 
systematic risk regulator in the Fed. But can the Fed really 
balance its various requirements and play that role?
    Mr. Stern I do not think I have suggested that the Fed is 
the systemic risk regulator. Obviously, that is an issue that 
is under discussion and consideration at the moment.
    I do think the Federal Reserve, because we have 
longstanding responsibilities in holding computer and bank 
supervision, as well as experience in payment systems and 
because we are ultimately the last provider of liquidity in the 
system, have a role to play in this, clearly. But I have not 
tried to weigh in exactly on what the exact structure of the 
systemic risk regulator ought to be.
    Senator Merkley. And I apologize if you have already been 
asked this question before, but I think you have emphasized--
and correct me if I am wrong--that policymakers should focus on 
counterparty risk and not risking shareholders, but that one of 
our challenges is to convince uninsured creditors that they 
will bear losses when their financial institution gets into 
trouble.
    Do we need to do that in a statutory sense to address the 
moral hazard, if you will, of expectations that shareholders 
will be bailed out?
    Mr. Stern. Well, shareholders, of course, in some of these 
cases have lost a lot of money, and that has been appropriate, 
but it is not sufficient to address moral hazard. It is the 
creditors, the uninsured creditors, that need to take some 
losses going forward--not in the middle of a crisis like this, 
I will hasten to add, but going forward. And so we want to put 
ourselves in a position to do that.
    The legislation is not up to me, but, obviously, if it is 
going to contain, as it may well appropriately contain, a 
systemic risk exception so that, you know, if there really is 
the threat of systemic difficulties that would threaten not 
only the functioning of the financial system but maybe parts of 
the economy as well, clearly policymakers ought to be able to 
deal with those.
    What you want to put yourself in the position to do is to 
invoke that systemic risk exception as infrequently with as low 
a probability as possible. So it seems to me that legislation 
can help, but it is not going to get you the entire way, 
assuming it has that systemic risk exception--and, indeed, it 
seems appropriate to have such a thing.
    Senator Merkley. Sheila, do you wish to add at all to that?
    Ms. Bair. No. I would agree with that. With the bank 
resolution process we have now, Congress has laid out a very 
clear claims priority for us. One of the benefits of having a 
resolution authority for holding companies and perhaps non-bank 
financial institutions is that Congress would lay out what the 
rules of the game are so market participants could understand 
in advance what their losses will be if an institution gets 
into trouble. I think that increases the market discipline, 
which is what we are all trying to get back into the system.
    Senator Merkley. Well, thank you very much to both of you 
for your testimony and for helping us wrestle with this pretty 
sizable issue.
    Chairman Dodd. Thank you very much, Senator.
    Before I turn to Senator Bennett, just to inform my 
colleagues and others who are gathered here today, there has 
been a little change in the order on the floor of the Senate. 
Several of our colleagues have to be at the White House for a 
meeting. We are going to begin at 10:40 having three votes 
regarding the housing bill. And then there will be a break, and 
they are going to bring up the defense procurement bill for 
opening statements for an hour. And then we will come back to 
finish up the remaining votes and final passage on the housing 
bill sometime after 11:30, in which case what I am going to 
suggest is that Senator Warner has graciously agreed to take 
over the chair and the gavel--which means you can only conduct 
a hearing. You cannot pass any bills, Mark. Then we will start 
the second panel--obviously complete with this panel, and we 
thank both of our witnesses. We will recess and then come back 
for the second panel. And I apologize to them, but I cannot 
control the order of business on the floor of the Senate. So we 
will come back and have to finish up. But we can get started, 
anyway, with the second panel, if that is appropriate, Mark.
    Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman, and 
thanks to the two witnesses. I apologize for not having been 
here for your testimony. I had other assignments.
    One of the things that has come out of this experience we 
are going through that I had not realized before--maybe both of 
you did--is that, in addition to bank and traditional kinds of 
banking activities, at least Citi performs a series of 
functions that are very profitable and are systemically 
absolutely essential--that is, the evening sweeps, the 
transactions that go on, et cetera.
    I understand that as much as 80 percent of some of these 
almost clerical functions worldwide run through Citi in one way 
or another. And if City were allowed to fail as a bank, it 
would be unable to perform these services that it performs for 
the system as a whole, and I have been pondering that ever 
since I found out about it as to how that impacts this whole 
question of what we do with City or any other organization.
    Now, as I have talked with some people outside of Citi 
about it, they have said, ``Senator, that is a very profitable 
business, and there would be plenty of people who would step 
forward and say we will be happy to perform it.'' Well, it is 
one thing for them to say, ``Yes, we will be happy to perform 
it,'' and it is another thing mechanically for them to be able 
to perform it in a seamless fashion that does not create 
tremendous difficulties. So I would like your response to that.
    Then the other thing that occurs to me that I have learned 
about all of this, I will not quote the numbers because I will 
get them wrong, but during this period of time, again picking 
on City, where they have taken enormous losses, they have at 
the same time paid a very significant amount of taxes, because 
the IRS rules are different from the accounting rules, and when 
you have an enormous loss that comes from mark-to-market, the 
IRS says, no, we will not allow that to happen until the assets 
are actually sold; so that we have had, to me, the enormous 
anomaly of having tremendous injections of cash into City to 
keep them viable, at the same time that Citi is making 
tremendous contributions or payments into the Treasury in the 
form of taxes. And I have a little bit of a hard time 
understanding why that makes much sense.
    So I would appreciate your responses to those two issues 
that have come up as we have deal with the realities of the 
meltdown that we have experienced.
    Ms. Bair. Well, I never comment on open, operating 
institutions, so I will try to address some of the issues in a 
generic way.
    Senator Bennett. Yes, put them in a generic way.
    Ms. Bair. Where an institution performs activities that 
have systemic significance so that if they just ceased and 
repudiated those obligations you would have a systemic 
situation. Congress long ago gave us the authority to set up a 
bridge bank to maintain functions that are perhaps profitable 
and have value, but also need to be continued to avoid systemic 
risk. This mechanism allows us to move good parts of an 
institution into a bridge bank, which then can be sold back to 
the private sector. The problem assets or other loans or 
securities that may be causing losses are retained in the 
receivership.
    This kind of generic situation is why bankruptcy does not 
work, because you do not have that bridge bank process. You do 
not have a way to continue these types of important systemic 
functions as you try to wind down and resolve the institution. 
We do not have this authority for holding companies. But we do 
have that kind of mechanism that we use now for banks.
    Mr. Stern. You are clearly right that there are several 
major financial institutions that are relied upon in financial 
markets for clearing and settlement, sort of the back-office 
plumbing. And if they were to get into various serious 
difficulty, that could be very disruptive, and so it could have 
certainly systemic repercussions. That has been a difficult 
issue to build an adequate response for in advance, although I 
would note that--gee, this was probably at least 15 years or so 
ago now--one of these institutions experienced a very serious 
computer glitch that threatened-- it threatened operations and 
threatened its liquidity position, and as I recall, the Federal 
Reserve Bank of New York loaned something like $20-some billion 
to it overnight to address that problem, and it was addressed 
effectively.
    But you are clearly right that this would be something that 
a systemic risk supervisor would want to take a careful look 
at.
    Senator Bennett. Can you comment on the disparity between 
accounting mark-to-market and taxes?
    [Laughter.]
    Mr. Stern. I am not knowledgeable about the tax situation, 
and like Chairman Bair, I am more than reluctant to comment 
about a particular institution.
    I would say that as far as mark-to-market accounting is 
concerned, it is not perfect; although, obviously, in more 
normal times, I think it works reasonably well. When some 
markets are not functioning, it is difficult to price assets, 
of course. But it is not clear that there is a preferable 
alternative, and it may be better to, on the margin at least, 
run the risk of overstating the problems rather than 
understating them.
    Ms. Bair. I think just, generally, having worked at 
Treasury, the inconsistency between tax rules and GAAP 
accounting rules and regulatory treatment has arisen in a lot 
of contexts. I am uncomfortable with commenting on tax policy. 
Those laws are out of my bailiwick.
    If I could go back to your first question, though, we had a 
bank closing on Friday, Silverton Bank. It was a banker's bank. 
It had a lot of correspondent accounts with many other banking 
institutions. It was systemic in its functions for those other 
institutions, so we set up a bridge to preserve those 
relationships as we try to market and unwind them over time. It 
is a good, real-life example of how the bridge bank mechanism 
works. If you would like a more detailed briefing, our staff 
would be happy to give it to you.
    Senator Bennett. Well, yeah. I would appreciate it. But 
there is no question, as I think you have said, that there is a 
systemic risk beyond just the safety and soundness of the bank, 
the function the bank performs.
    Mr. Chairman, I still am baffled, the idea that the federal 
government is injecting money into an institution to help keep 
it solvent, and at the same time, the federal government is 
taking money out of the same institution in the form of taxes 
to make sure they do not make a profit. Somehow that picture 
just does not compute for me.
    Senator Warner. [Presiding.] Senator, we have all heard the 
death and taxes, the comments, and I think it is one more time 
being proven out. I am sorry.
    Ms. Bair?
    Ms. Bair. Going forward--the situation is what it is, and I 
think steps were taken because there were no good alternatives 
going forward. I think, again, a resolution mechanism will get 
you out of this. So it would provide an orderly way, providing 
what we call open bank or open institution assistance. It would 
give you a mechanism where you do not have this kind of 
incongruity.
    Senator Bennett. If I could, Mr. Chairman.
    Do you ever consider or run in to a situation where a tax 
forgiveness would keep the institutions solvent so that you do 
not have to seize it? And if you did, would you have the 
authority to----
    Ms. Bair. We do not. Our statute is very strict. In 
determining what is the least cost resolution, we may not 
consider tax benefits. So Congress has constrained us somewhat 
in that capacity. I can check and see if, prior to that, there 
were instances in the past where a change in tax policy would 
have kept the institution viable. But I will have to get back 
to you on that.
    Senator Bennett. Thank you.
    Senator Warner. I know we have a second panel, but I have 
one more question for this panel, and I will ask my colleagues 
if they have any more questions, and we can move to the second 
panel.
    Interesting discussion earlier on resolution authority, 
and, clearly, I cannot speak for all the colleagues, I have 
seen a great deal of interest in expanding the FDIC's authority 
to look at bank holding companies. I guess two quick questions.
    One. Mr. Stern, if we were to move on that action 
independent of the overall financial modernization activities, 
what would be the push back, and would there be reluctance from 
the Fed of turning over a bank holding company's resolution 
authority to the FDIC? And are there other early warning signs 
that seems kind of, at least to me, logical that we take that 
step?
    Secondarily, perhaps for both Mr. Stern and Ms. Bair, if we 
were to expedite that independently of the overall financial 
modernization, would it have any--even before passage of such 
legislation, if we were to advance that, could it have any 
effect on the current crisis?
    Mr. Stern. Well, I will try to be succinct about that. I, 
obviously, will not speak for the Federal Reserve as a whole. I 
think it could be constructive to accelerate that effort with 
regard to resolution authority, staying away from exactly who 
has responsibility for what, for the reasons that have already 
been covered here.
    The one thing that would concern me about that is it might 
reduce the urgency of taking other steps that might be 
appropriate and important and necessary as well. And I would be 
concerned that we might think that, well, that addresses the 
problem and we do not need to take actions down the road. And 
so, there may be a value in trying to put together a more 
comprehensive package that would attack the issues that are of 
concern here and achieve the objectives that we have been 
talking about today in a comprehensive way.
    Senator Warner. There is a great deal of interest in taking 
on the comprehensive. I wonder if there were any, though, in 
this moment, at this moment of the crisis, an expedited effort 
to expand to at least the bank holding companies.
    Mr. Stern. Yes. As I said, I think that would be 
constructive.
    Senator Warner. Could there be even the advancement of that 
type of legislation? Could that have any short-term, positive--
--
    Ms. Bair. I think it could be an important catalyst, 
perhaps, for more fundamental restructurings or assets sales. 
It could serve as a wake-up call, to perhaps move things along 
a little faster.
    Senator Warner. It might force some of our banks to move 
quicker into which assets they might be willing to dispose of.
    Ms. Bair. Right. Well, in these smaller institutions, we 
find that it is a viable mechanism to use. Just having that 
there is a good catalyst to take more aggressive action, 
whether it is major changes or restructurings, or asset sales 
or just selling the whole institution, which is more practical 
with the small institution. I think, absolutely, just having 
the lever there can contribute to some very constructive 
activity.
    Senator Warner. Well, I hope Chairman Dodd and Ranking 
Member Shelby get a chance to weigh in on that. I would love to 
see their sense of whether expedited on that would make some 
sense.
    Again, we will go very quickly, if any other member wants 
to ask this panel.
    Senator Merkley?
    Okay. Then I would then thank the panel for their very 
productive testimony and, always, your good work.
    Thank you. And we will move now to the second panel.
    Recognizing we have some votes, I will go ahead, and as the 
panel is setting up, I will go through a few introductory 
comments.
    For our second panel, we will hear from Peter J. Wallison, 
the Arthur F. Burns Fellow in Financial Policy Studies at the 
American Enterprise Institute for Public Policy Research, where 
his research focuses on banking, insurance and Wall Street 
regulation. Previously, Mr. Wallison served as general counsel 
to the U.S. Treasury, the depository institution's Deregulation 
Committee, and as White House counsel to President Ronald 
Reagan.
    After Mr. Wallison, we will hear from the Honorable Martin 
Baily, Senior Fellow in Economics Studies at the Brookings 
Institution. Mr. Baily served as chairman of the Council of 
Economic Advisors during the Clinton Administration.
    Finally, we will hear from Mr. Raghuram R.J. Rajan, the 
Eric J. Gleacher Distinguished Service Professor of Finance, 
University of Chicago, Booth School of Business. He served as 
chief economist at the International Monetary Fund. His major 
research focuses in the role of finance, planning and economic 
growth.
    We were asked for Mr. Wallison to testify first, but we 
seem to be missing Mr. Wallison.
    Mr. Baily. He was here a minute ago.
    Senator Warner. Mr. Wallison, you are up first. You have 
been appropriately introduced, and we have said great things 
about you in your absence, and we are anxious to hear your 
testimony.

   STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN 
  FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE FOR 
                     PUBLIC POLICY RESEARCH

    Mr. Wallison. I appreciate it very much, Mr. Chairman.
    I am very pleased to have this opportunity to appear before 
the Committee. The chairman's letter of invitation asked four 
questions, and I have attempted to answer them in detail in my 
prepared testimony. I will try to summarize both the questions 
and my responses as follows.
    First, is it desirable or feasible to prevent institutions 
from becoming ``too big to fail''? I do not believe it is 
possible to identify in advance those institutions that are 
``too big to fail'' because they pose systemic risk. Even if we 
could do that, the current condition of the heavily regulated 
banking sector shows that regulation is not an effective way to 
control growth or risk taking. Only the failure of a large 
commercial bank is likely to create the kind of systemic 
breakdown that we fear.
    Banks are special. Businesses and individuals rely on them 
for ready cash, necessary to meet payrolls, provide working 
capital, and pay daily bills. Small banks deposit funds in 
large banks. If a large bank should fail, that could cause a 
cascade of losses through the economy, and that is the 
definition, really, of systemic risk or a systemic breakdown.
    I doubt, however, that other kinds of financial 
institutions, insurance companies, securities firms, hedge 
funds, no matter what their size, can cause a systemic 
breakdown if they fail. This is because creditors of these 
firms do not expect to have immediate access to the funds that 
they have lent.
    If a large, non-bank financial firm should fail, its 
creditors suffer its losses over time with no immediate cascade 
of losses through the economy. The turmoil in the markets after 
Lehman's bankruptcy was the result of the extreme fragility of 
the world's financial system at that time and not the result of 
any losses actually caused by Lehman.
    The failure of a non-bank financial firm is not much 
different, in my view, from the failure of a large operating 
firm like General Motors. If General Motors fails, it will 
cause many losses throughout our economy, but not even the 
administration is contending that GM is ``too big to fail.'' 
The Committee should consider why if GM is not ``too big to 
fail,'' a large non-bank, financial firm might be; or if GM is 
``too big to fail,'' whether we need a government agency that 
will resolve big operating firms, as some are proposing to 
resolve big financial firms.
    Second. Should firms that are ``too big to fail'' be broken 
up? This would not be good policy. Our large operating 
companies need large banks and other financial institutions for 
loans, for insurance, for funds transfers, and for selling 
their securities. If we broke up large financial institutions 
on the mere supposition that they might cause a systemic event, 
we would be depriving our economy of something it needs without 
getting anything certain in return.
    Third. What regulatory steps should be taken to address the 
``too-big-to-fail'' problem? Since I do not think that non-bank 
financial institutions can create systemic risk, I would not 
propose new regulation for them at all. However, regulation of 
banks can be improved. We should require higher minimum capital 
levels. Capital should be increased during profitable periods 
when banks are growing in size. Regulators should develop 
indicators of risk taking and require banks to publish them 
regularly. This would assist market discipline.
    Fourth. How can we improve the current framework for 
resolving systemically important non-bank financial firms? 
There is no need to set up a government-run system for 
resolving non-bank financial institutions the way we resolve 
banks. They do not pose the risks that banks do. Giving an 
agency the power to take them over would virtually guarantee 
more bailouts like AIG with the taxpayers paying the bill.
    The bankruptcy system is likely to work better with greater 
certainty and with fewer losses. Within two weeks after its 
bankruptcy filing, Lehman had sold its investment banking, 
brokerage and investment advisory businesses to four different 
buyers. And unlike the $200 billion disaster at AIG, all 
Lehman's bankruptcy costs are being paid by the shareholders 
and the creditors of Lehman, not the taxpayers. Because of 
their special role in the economy, banks must have a special 
resolution system. I agree with that. But there is no reason to 
do the same thing for the creditors of non-bank financial 
institutions.
    Thank you, Mr. Chairman.
    Senator Warner. Thank you, Mr. Wallison. Some interesting 
comments. I am anxious to ask a couple of questions.
    Mr. Baily?

    STATEMENT OF MARTIN NEIL BAILY, SENIOR FELLOW, ECONOMIC 
               STUDIES, THE BROOKINGS INSTITUTION

    Mr. Baily. Thank you, Senator, and members of the Committee 
for giving me this opportunity. I am going to make a quick 
preamble and then get to the same questions that Peter was 
referring to.
    The U.S. economy has been in free-fall. Hopefully, the pace 
of decline is easing. But in order to get a transition back to 
sustained economic growth, that will not be possible without a 
restoration of the financial sector to health. In this 
situation, policymakers must deal with ``too-big-to-fail'' 
institutions because, at this time, we cannot afford to see the 
disorderly failure of another major financial institution that 
would exacerbate systemic risks and threaten economic recovery.
    The stress tests are being completed and some banks are 
being told how much extra capital they will need. However, I 
think there is a lot more to be done after that because large 
volumes of troubled or toxic acids remain on the books of the 
banks, and more such acids are being created as the recession 
continues.
    It is possible that one or more banks will become insolvent 
and will have to be taken over by the authorities. I think it 
would be a terrible mistake, however, any kind of preemptive 
nationalization of other banks. At the same time, getting the 
U.S. financial sector up and running is essential, will be very 
expensive, and is deeply unpopular with the electorate. If 
Americans want a growing economy next year with an improving 
labor market, I think Congress will have to provide more 
Treasury TARP funds maybe on a large scale. The cost of 
taxpayers in the country will be lower than a deeper recession 
and lower than nationalization.
    Let me turn now, specifically, to the questions that were 
asked.
    Should regulation prevent financial institutions from 
becoming ``too big to fail''? I tend to agree with Peter on 
this one. I think we actually need very large financial 
institutions. New York is really the center of the financial 
world, New York and London, and we need large-scale 
institutions to continue and sustain the process of 
globalization that I think contributes to global prosperity. 
Well, some of the institutions are going to end up being ``too 
big to fail,'' really, whether we like it or not.
    I do think ``too-big-to-fail'' institutions, or too 
interconnected institutions, can be regulated in a way that at 
least partially offsets the risks they pose to the rest of the 
financial system because of their status. We need better 
capital standards. They need to be increased progressively as a 
bank increases in size or another financial institution. And I 
think financial regulators should have special ability to look 
at these institutions to make sure that their portfolios are 
not unduly taking on too much risk. And I think there should 
also be some restrictions on bank mergers so that we are not 
creating more ``too-big-to-fail'' institutions than we need to 
have. In other words, ``too big to fail'' is sort of a 
necessary evil but not something that we should really like.
    Should the existing institutions be broken up? No, I do not 
think so, particularly if they have grown organically. If they 
have become efficient and grown, performing services for the 
U.S. and the global economy, I do not think there is a case for 
breaking them up. On the other hand, if we are--for example, if 
Sheila Bair is dealing with another bank failure, I think it 
certainly should be part of her mandate not to end up with 
creating a ``too-big-to-fail'' bank. Again, like the previous 
answer, we are stuck with ``too big to fail,'' but we certainly 
do not want more of them than we have to.
    Now, what requirements should be imposed on ``too-big-to-
fail'' institutions? The one thing I would say about that is 
that if you are a ``too-big-to-fail'' institution, you have an 
advantage. Your borrowing costs are lower than they would be 
otherwise. Alan Greenspan at a meeting at Brookings suggested 
that that number was about 50 basis points. I think we need to 
take a good, hard look at what that number is because I think 
it actually gives us some room to impose on large banks certain 
additional regulations, additional capital requirements, 
additional supervision of their portfolios, certain things that 
we can do.
    You see, there is a concern that if you impose extra 
regulations on large banks, then they become uncompetitive, and 
then all of a sudden, activities migrate out of those banks. 
They go to the Caribbean or something like that. So we want 
these big banks to be carefully regulated, but at the same time 
not to have to pay an undue penalty that makes them 
uncompetitive.
    We do need improved resolution procedures. I would be happy 
to talk about that more. I know my colleague is going to say 
something about that.
    The final point I want to make in this--I will just say I 
endorse, by the way, the idea of this convertible debt. I think 
that is a good way of increasing the capital requirements for 
some of these large banks.
    The last point I want to make in my last second is 
essentially that this crisis, I believe, was a market failure 
and regulatory failure. And if we try to brand it one or the 
other, we are not going to find the right answer to the 
problem. Markets fail. People who had their own money at risk 
did stupid things and lost the money. So market incentives did 
not work the way we hoped they would. At the same time, we had 
rooms full of regulators regulating some of these banks, and 
they did not do their job either.
    So what we have to find going forward is a way of combining 
good, well-paid, well-trained regulators with good market 
incentives to try to improve this system in the future. Thank 
you.
    Senator Warner. Thank you, Mr. Baily.
    Professor Rajan?

STATEMENT OF RAGHURAM G. RAJAN, ERIC J. GLEACHER DISTINGUISHED 
  SERVICE PROFESSOR OF FINANCE, UNIVERSITY OF CHICAGO, BOOTH 
                       SCHOOL OF BUSINESS

    Mr. Rajan. Thank you. Mr. Chairman, Senators, there is, in 
my view, a more important concern arising from this financial 
crisis than when private institutions are deemed ``too big to 
fail.'' Other than the reasons that have already been laid out, 
let me add one more.
    When systemically important institutions are bailed out, it 
is very hard for the authorities to refute allegations of crony 
capitalism, for the outcomes are observationally equivalent; 
after all, the difference is only one of intent. In this kind 
of system, the authorities do not want to bail out the 
systemically important institutions but are forced to, while in 
crony capitalism they do so willingly.
    The collateral damage in this system to public faith and 
free enterprise is enormous, especially when the public senses 
two sets of rules, one for the systemically important and 
another one for the rest of us. I have avoided saying ``too big 
to fail.'' That is because size, in my view, is neither 
necessary nor sufficient for an institution to be deemed too 
systemic to fail.
    Given my limited time, let me focus on how we can overcome 
the problems of too systemic to fail institutions in some 
measure. The three obvious possibilities: one, prevent 
institutions from becoming too systemic in the first place; 
second, create additional private sector buffers that keep them 
from failing; and, third, make it easier for the authorities to 
fail them when they do become truly distressed.
    Let me explain each in turn.
    I personally believe, like Mr. Baily does, that proposals 
to prevent institutions from expanding beyond a certain size or 
to significantly limit the activities of some institutions may 
be very costly without achieving their intent.
    Consider some economic costs. Some institutions get large 
not through unwise acquisitions but through organic growth 
based on superior efficiency. A crude size limit applied across 
the board will prevent the economy from benefiting from such 
institutions. Furthermore, size can imply greater 
diversification, which can reduce risk. Moreover, the threshold 
size can vary across activities and across time. A trillion 
dollar mutual fund family may not be a concern, while a $25 
billion mortgage guarantor might well be.
    Finally, size itself is hard to define. Do we mean assets, 
gross derivative positions, net derivative positions, 
transactions or profitability? Given these difficulties, any 
legislation on size limits will have to give regulators 
substantial discretion. That creates its own problems.
    Similar issues arise with activity limits. What activities 
will be prohibited? Some suggest banning banks from proprietary 
trading, that is trading for their own account. But how would 
the law distinguish between illegitimate proprietary trading 
and legitimate risk-reducing hedging?
    Many of the activities that were prohibited to commercial 
banks under Glass-Steagall were peripheral to this crisis, and 
activities that did get banks into trouble, such as holding 
sub-prime mortgage-backed securities, would have been 
permissible under Glass-Steagall.
    Finally, regulating size or activity limits would be a 
nightmare because the regulator would be strongly tempted to 
arbitrage the regulations. I would suggest rather than focusing 
on these limits, we focus on creating stronger private-sector 
buffers in making institutions easier to fail.
    Now, the traditional buffer is capital, and I do agree that 
raising capital might be a good thing, but one should not put 
too much weight for reasons that have already been stated; in 
particular, that banks will tend to take more risks when they 
are asked to hold more capital. In some ways, I would rather 
advocate a more contingent buffer where systemically important 
institutions arrange for capital to be infused when the 
institution or the system is in trouble. And the difference 
between the two is quite important.
    As an analogy, additional capital is like keeping buckets 
full of water ready to douse a potential fire. As the years go 
by and the fire does not appear, the temptation is to use up 
the water. My contrast, contingent capital is like installing 
sprinklers. There is no water to use up, and when the fire 
threatens, the sprinklers actually turn on.
    One version of contingent capital, proposed by the 
nonpartisan Squam Lake Group, is for a portion of a bank's debt 
to be automatically converted to equity when two conditions are 
met: one, the system is deemed in crisis either based on 
regulatory assessments or based on objective indicators like 
the size of losses of the system; and, second, the bank's 
capital ratio falls below a certain value.
    There are other versions of contingent capital, such as 
requiring banks to purchase fail-safe insurance policies from 
unlevered institutions that will provide them an insurance 
payment when they are in trouble, and there are ways of 
structuring this that I would be happy to go into.
    Let me turn to the other possible remedy, making them 
easier to fail. And here I think that there are a number of 
issues that have been talked about, which makes banks hard to 
fail. I would suggest we also want to recruit banks in the 
process of making themselves easier to fail. And this is why I 
would suggest that banks also be subject to a requirement where 
they focus on creating a shelf bankruptcy plan, which would 
focus on how they themselves could be made easier to fail. For 
example, over time, the amount of time it will take to fail a 
bank could be reduced to such time as we could actually fail 
some of these large institutions, over a weekend.
    By putting this requirement and stress testing it at 
regular intervals, I think you would give banks an incentive to 
become less complicated, not to add layers of complexity in the 
capital structure or in the organization structure, and we 
could well get easier resolution.
    Senator Warner. Thank you, sir.
    The vote has started, I think, about 10:56. I will try to 
ask two to three minutes worth, and then if Senator Bennett or 
Senator Merkley want to try to get it in before the vote. If 
not, we will go into recess. And I am not sure how many votes 
there are going to be, so we will have to have a little 
flexibility.
    Very quickly, without lots of extra commentary, Peter, I 
would love to hear your comment about not having the need in 
terms of a non-bank financial systemic risk regulator, where we 
deal with the AIGs of the world.
    For all of the panel, perhaps very briefly, Mr. Baily, Mr. 
Wallison, you both said we do not want to make a line in the 
sand about ``too big to fail,'' but, in effect, what we want to 
do is we want to try and stop more institutions from becoming 
``too big to fail.'' At some point, if we are going to have 
additional capital requirements, or if we are going to have 
added insurance fees or other kinds of resolution fees, we are 
going to have make some definition. We are still going to be 
backed into a definition, are we not?
    Third, questions where we are saying we ought to allow 
these to grow organically. But some of the actions of, for 
example, the combination of Merrill and Bank of America, and 
some of the other things that have taken place in the last six 
months, I am not sure these would have all have been in the 
normal course of organic growth. And does that mean because of 
the crisis, we have to then live with these institutions that 
were, in effect, created out of the crisis?
    I know that is a lot. If you could keep your comments or 
answers fairly short, so, again, my colleagues may get a word 
in before we go to vote.
    Mr. Wallison. Okay. Well, let me try first. I will go 
first, and let me just talk about two things. First, the idea 
of being backed into a definition, I think it is very dangerous 
for Congress to say to a regulatory agency, ``You make this 
choice,'' because the inclination of the regulatory agency 
under all circumstances will be to be very liberal--small ``L'' 
here--in choosing because they will get into trouble if some of 
that occurs and they have not put an institution within the 
charmed circle that would be regarded as a systemically 
important or a ``too-big-to-fail'' institution.
    So Congress has to be very specific, it seems to me, about 
what constitutes systemic risk, what is ``too big to fail,'' 
and under what circumstances it is possible for an agency to 
take them over in that sense.
    Now, AIG is a really great example of a lot of things, and 
we do not really have time to talk about it all. But AIG 
probably should have gone into bankruptcy, and if they had gone 
into bankruptcy--and I cover this in detail in my prepared 
statement. If they had gone into bankruptcy, there would not 
have been any substantial impacts throughout the rest of the 
economy.
    We also saw that Lehman did go into bankruptcy, and right 
after that, there was turmoil, but the reason for that is that 
the market was unprecedentedly fragile. I do not think we have 
ever seen, at least certainly in my lifetime, probably not 
since the Great Depression, a market where almost all of the 
financial institutions in the world were regarded as unstable 
and possibly insolvent. And when--and I think Gary Stern said 
this. When that institution failed, when Lehman was allowed to 
fail, suddenly everyone said, ``Oh, there is a different world 
out here because I had assumed,'' they said to themselves, 
``after Bear Stearns that no large institution would be allowed 
to fail. I now have to look at all of the institutions I deal 
with.'' And that is why all the lending came to a halt. That 
was a classic case of moral hazard.
    And if we allow ourselves to get into a position where we 
are bailing out institutions like an AIG on a regular basis--
and if we give regulators the power to do it, they will do it--
then we will bring much more moral hazard into our economy.
    Thank you.
    Mr. Baily. The Volcker Commission used this with SIFIs, or 
``systemically important financial institutions,'' maybe that 
is a better word than ``too big too fail,'' but, anyway, 
certainly institutions in which there is a danger that the 
whole system will come down. How do you define that? I do not 
know the answer to that. I think it has to be done through 
guidelines provided by Congress with some discretion for the 
regulators.
    In terms of AIG going down and Lehman going down, I 
disagree with Peter fundamentally. I think we had to do what 
was done with AIG to prevent further repercussions. I do think 
that the failure of Lehman was a mistake, and I think most 
people looking back would agree that it would not have taken 
that much to prevent the disorderly collapse of Lehman, which 
had substantial impacts in London and other parts of the world. 
So I do think we do need to make sure not that shareholders 
benefits--because shareholders go down, as they should, but 
that some of the fallout from those institutions is prevented.
    You mentioned that we have sort of created these monsters 
now by putting together some of the banks. I think the Treasury 
and the Federal Reserve were acting quickly to try to deal with 
a very difficult crisis. I think with the benefit of hindsight, 
maybe it would not have been such a great idea to make Bank of 
America take over Merrill, or whatever. I think some of those 
mistakes--or some of those decisions that were made rather 
quickly were not always--may not have been the best ones. But 
in point of fact, we are now stuck with those institutions. 
They are SIFIs, and they have to be regulated with additional 
capital requirements and some of the additional requirements so 
that they do not pose systemic dangers.
    Senator Warner. We are down to 7 minutes, and we have got 
to get over to the capital, so, Professor, briefly.
    Mr. Rajan. Very quickly, I think it is a mistake to 
identify systemically important institutions. Then you make the 
market actually treat them as systemically important and act 
accordingly. That is a problem.
    I think you can talk about systemically important. You can 
sort of have a broad definition. But, in general, regulations 
should not identify them and create a difference between 
systemically important and others.
    Perhaps you can have increasing capital requirements based 
on size, but it would not have to be capital requirements which 
suddenly change when you move from being an ordinary bank to 
becoming a systemically important bank. I think that will be 
the challenge that Congress has in devising regulations, how to 
deal with systemically important without actually identifying 
the specific institutions that are systemically important.
    Senator Warner. If I heard correctly, I think you have all 
said, you know, this is very challenging, do not leave it to 
the regulator, and you better not mess up, Congress.
    Thank you. I think the Committee will stand in recess until 
we are finished voting.
    [Recess.]
    Senator Akaka. [Presiding.] This hearing, Martin Baily, 
Raghuram Rajan and Peter Wallison, I will begin with you on 
questions to all of you.
    It is pretty clear that our current regulatory system 
failed to address the risks taken by many large financial 
organizations that resulted in the current economic crisis. It 
is equally clear that these companies grossly failed to manage 
their risks. And with all of this, we have been making every 
effort to deal with the problems they face and to try to 
stabilize the problems that we have.
    So, the second panel, I would like to ask you, should 
Congress impose a new regime that would simply not allow 
financial organizations to become too large or too complex, 
perhaps, by imposing strict size or activity restrictions?
    So let me first all on Mr. Wallison for your response.
    Mr. Wallison. Yes. In my prepared testimony, Mr. Chairman, 
I said that that would not be a good policy to keep 
institutions from growing. My colleagues here, in answer to 
questions from the first part of this panel before we recessed, 
took fundamentally the same point, saying that, well, if an 
institution has gotten very large because it is very efficient 
and a good competitor, then it ought not to be penalized and 
broken up for that reason.
    I want to go just a little bit further and say that we have 
very large operating companies in this country. We are 
continuing to grow these operating companies. And large 
operating companies need--especially if they are operating 
globally, need large, globally operating banks. And if you try 
to imagine an oil company trying to pay all of its employees 
around the world on the same day, without a bank that can do 
all of that in every major area, you can see the kind of 
problem that arises.
    So I do not think it would be good policy to break up 
companies or keep them from getting larger if they are getting 
larger because they are competing well.
    Senator Akaka. Thank you.
    Mr. Baily?
    Mr. Baily. Thank you. First of all, I agree with you very 
much that we failed to address the risks and companies failed 
to manage their risks.
    One of the most interesting and revealing documents that I 
read in all of this was written by UBS, the Swiss Bank, at the 
insistence of the Swiss Central Bank, that described its own 
risk management procedures and how they had failed. And it is 
an extraordinary document of how they did not follow their own 
internal risk management. They jeopardized their own company. 
They subsequently had to be supported by the Swiss Central 
Bank, which in turn has had to rely, to some extent, on our 
federal reserve. It is an extraordinary story, which goes to 
the point that you mentioned.
    I agree with Peter, generally, in the remarks that he made, 
that we require these very large banks. When the crisis hit, 
for example, there was a huge collapse in global trade. Traders 
in India could not import and export because they had relied on 
financing coming through New York. So I agree with him very 
much that we need these large banks, particularly if they are 
growing and providing services to the U.S. and the global 
economy and are doing it efficiently.
    At the same time--and I think, again, we have some not 
complete agreement, but some broad agreement, that as banks 
become bigger or more interconnected--it is not always size, 
obviously--that we need special supervision, either increased 
cap requirements, increased supervision of their portfolios, or 
some mechanism to make sure that we do not get a repeat of what 
happened to UBS.
    Now, I do not think we are going to get that next year 
because I think a lot of people have learned their lesson. But 
we have to have in place a system that 10 years from now, 20 
years from now, when some of these lessons have been forgotten, 
that we have in place a better regulatory regime.
    I would say one more thing about that regulatory regime. We 
cannot, probably in this country, ever pay regulators what 
people earn on Wall Street. Some countries pay their regulators 
very high salaries. There are limits to what we can do here. 
But I do think it would make a difference if we could pay 
reasonably competitive salaries, more than they are currently 
making. We should insist on training regulators so we give 
ourselves the best chance of avoiding some of the regulatory 
failures that happened in the course of this crisis. Thank you.
    Senator Akaka. Thank you very much, Mr. Baily.
    Mr. Rajan.
    Mr. Rajan. Thank you, Mr. Chairman. I agree substantially 
with my co-panelists that size limits are relatively crude, 
very hard to enforce, because there are also ways around it; 
very hard to determine ex ante for Congress through 
legislation.
    Similarly, with activities; again, activity limits, which 
products are you going to limit? The same product can be used 
in a good and purposeful way, and the same product can be used 
for taking on speculative risks of extraordinary levels. And 
so, given that intent is often what distinguishes a product 
used appropriately and a product used inappropriately, it is 
very hard to have legislation governing that.
    So anytime you go into size limits or activity limits, you 
are going to have to give a lot of discretion to regulators. 
And I think, as Mr. Baily pointed out earlier, regulators have 
to also cover themselves with a lot of glory during this 
crisis, and do we really want to put a lot of weight on their 
judgment.
    I think there is no magic bullet to this problem. I think 
it is a very serious problem. It is a problem we have to deal 
with. And there have been a number of suggestions that have 
been made by this panel. One I would re-emphasize is that in 
addition to trying to find ways to, perhaps, make activities a 
little safer and create some buffers, I think we should also 
make these institutions easier to fail. And that is a focus 
that is not present in much of the debate; that if we could 
make these institutions less complex, make their capital 
structures a little easier to resolve, I think that would go a 
long way in reducing the problem.
    One of the suggestions that I would like to emphasize is 
that if we try and enlist these institutions in preparing their 
own funeral plans, get them to talk about business termination, 
if the authorities had to close them down, how would the 
authorities go about it, and try and get them to start 
preparing these plans so that, in fact, when the authorities 
intervene, there is already a ready-made process.
    I think that would help us also in this. It would also 
force these institutions to stay away from excessively 
complicated structures or excessive derivative positions. And 
so, that could be part of the legislative agenda, prepare your 
own business termination plans or pre-packaged bankruptcy, 
which you have to negotiate and discuss with regulators on a 
periodic basis.
    Senator Akaka. Thank you very much for that.
    Let me give some time back to the panel to make any further 
comments that you would like to make on this.
    Mr. Wallison?
    Mr. Wallison. Yes. I would like to just address one point 
that I think is fundamental here. And that is, we have to put 
some boundaries around what we mean by ``too big to fail.'' We 
have to make--Congress has to do something to give guidance to 
the regulatory agency.
    One of the worst things that could happen here, if 
legislation is adopted, is that we create a system in which 
companies that should fail are bailed out because the 
regulators decide that they are ``too big to fail.'' And since 
we do not know what is ``too big to fail,'' we have not really 
got a definition of that, we cannot even--we know that it is 
out there somewhere, but we cannot define it well. By giving 
regulatory agencies the opportunity to resolve, it is said, 
these institutions, they will say, in many cases, that the 
institution is ``too big to fail.'' And they will bail out that 
institution when it should have been allowed to fail.
    The result of that, I am afraid, is that whenever an 
institution that should have been allowed to fail continues in 
life a bad business model and a bad management, is there to 
continue operating, when if it had disappeared, better 
management and better business models would have come up to 
replace it. So we weaken our entire competitive system if we do 
not allow institutions that should fail to fail.
    Senator Akaka. Thank you.
    Mr. Baily?
    Mr. Baily. Thank you. First of all, let me talk about the 
context under which an institution becomes ``too big to fail'' 
or where we decide that it cannot be just allowed to fail.
    I have studied the automobile industry over a number of 
years, and if you had asked me a few years ago if one of our 
big automobile companies gets into trouble, should we let it 
fail, I would have said let it go down. I am not going to name 
names, but I think there were a lot of failures of management, 
of workers, of technology. So, you know, let the market work.
    When that same question came up in the last year, with 
great reluctance, when I was asked that question, I said, no, I 
do not think we can allow a disorderly bankruptcy of some of 
our largest automobile companies. And it is not because I 
wanted to do that; it is because we are in a time of economic 
crisis, and I felt that such a bankruptcy at that time would 
have brought the economy down.
    So, again, in the case of banks, there may be circumstances 
under which even quite large banks can be allowed to fail. And 
so I agree very much with the sentiment that we would like to 
have kind of plans in place for how we resolve large banks, 
allow them to fail. I do not think they can go through the 
normal bankruptcy process, but they go through a process in 
which they either go to the FDIC or resolved if they are bank 
holding companies.
    Now, Raghuram has made the suggestion, which he did in a 
very interesting article in The Economist, that we should have 
these funeral plans, that the banks should set up their own 
funeral plans. So they should be required to say, if we go 
broke, here is how you should go about regulating us.
    I have to say I was a bit skeptical in a comment that I 
made on that. It is sort of not the way businesses really work. 
Maybe you could do it, but I think it is probably more up to 
the regulators, maybe with some insistence from the banks, in 
figuring out if you do have these very large institutions, how 
interconnected are they, what are the counterparties to some of 
their positions, and what would be necessary; can we, in fact, 
let them go down under normal times without getting lots of 
taxpayer money caught up in this.
    Senator Akaka. Mr. Rajan?
    Mr. Rajan. Yes. The one comment I will make is it seems to 
me that the one concern is that a number of institutions, and 
the way they structure their activities, essentially make 
themselves ``too big to fail.'' And that is why I think you 
want to give them incentives not to become that way.
    Let me give an example. One of the reasons we worried about 
these large banks is the destruction of the payment and 
settlement system that happens when we fail these banks. Well, 
there are intricate ways in which the liability system of these 
banks is tied to the payment and settlement system. Right?
    One example is derivative contracts, which come due and 
have to be replaced if, in fact, the bank cannot make good on 
its debt. When you reduce the value of the debt, immediately, 
there is a consequence to the derivative contracts that the 
bank is involved in.
    These kinds of connections, interconnections, actually make 
the bank essentially too complicated, ``too big to fail.'' And 
my suggestion of forcing them to think about their own demise 
and proving to regulators that they could be closed in a 
relatively short time period--a weekend was just a number out 
of the box; but in a week, I think the rationale for that is 
you want to give these banks an incentive to think about not 
making themselves excessively complicated. And one way to do it 
is to put the onus on them to make their structures more 
simple, their liability structures, their organizational 
structures, so that when the regulator actually comes to unwind 
this bank, they have a less complicated entity to deal with.
    It is not going to be the answer by itself, and I think we 
need a lot of proposals on the table to do it, but it could be 
one piece of what we need.
    Senator Akaka. Thank you.
    This next question is for the panel, again, and has to do 
with about setting standards.
    A lot of commentators criticize our capital standards as 
being pro-cyclical, demanding that financial companies raise 
expensive capital at the worst possible times and too little 
capital in good times.
    What are your views on having regulators set standards that 
require banks and other financial companies to build capital 
when the economy is strong as a cushion to weather the 
downturns?
    Mr. Wallison?
    Mr. Wallison. I will take that first, I think. My view is--
first of all, I do not--in my prepared testimony and in my oral 
testimony, I said that I thought that banks were the only 
organizations that really required serious regulation for a 
variety of reasons. They can create systemic risk, but I do not 
think others can.
    On the question of this capital, what we do about banks 
that are growing and yet they still have the same amount of 
capital, which increases their leverage, I am one who does 
believe that we ought to increase capital requirements as 
growth occurs. As profitability and growth occurs, capital 
should go up so that it can perform the function that it was 
supposed to perform, which is as a buffer for the bad times.
    I think we are seeing today that the 10 percent risk-based 
capital requirement that was imposed in the United States under 
Basel I and Basel II, for well capitalized, was insufficient. 
Banks should have had more capital. But in addition, they 
should have added to their capital positions as a percentage, 
as they have grown larger and larger, and as they have more and 
more profits.
    That is something that we could very profitably do. And as 
a matter of fact, it would also go some distance to addressing 
this question of institutions getting too large and complex, 
because if additional capital requirements are imposed on them 
as they get larger and more complex, they will not get larger 
and more complex. They will make a judgment about what they 
have to do to be profitable rather than just getting larger.
    Senator Akaka. Mr. Baily?
    Mr. Baily. I agree with much of what Peter said. I think we 
do need to increase capital requirements, and capital needs to 
play its role as a buffer. When there is a loss of assets, then 
the capital goes down, and now the capital that is left should 
be enough still to satisfy, certainly, the markets and the 
regulators, who are taking the appropriate cyclical view of 
capital that the bank is still an adequate position. So I think 
we do need to raise capital requirements and allow it to work 
appropriately as a buffer.
    One concern about capital is that many of our banks are 
competing internationally. Even before this crisis, there were 
many complaints that I heard, I think correctly, that U.S. 
banks were required--not the investment banks, that U.S. banks 
were required to hold more capital than European or other 
banks, and were having difficulty competing globally. So I 
think this is something that needs to be done with some degree 
of level cooperation.
    I say that cautiously because global cooperation on 
financial regulation has been difficult to do and has not 
worked very well. But I think this is an area we need to at 
least try to keep the playing field level in terms of capital. 
So higher capital requirements.
    It is not just capital requirements, though, obviously, 
because--so you had 20 percent capital requirement, but you had 
all these sub-prime mortgages, and that probably might not well 
have saved you. So I think it is a matter of--and in other 
cases where there was people borrowing--well, banks were 
borrowing at overnight rates or one-week rates and issuing 
mortgages on the other side of that, as Northern Rock in the UK 
did, for example.
    So it is a combination of more capital, some reasonable 
level of match so that there is not too much of a mismatch on 
the balance sheet, and the quality of the portfolio. So those 
combinations of things I think we need to do.
    Senator Akaka. Mr. Rajan?
    Mr. Rajan. This is probably where I part a little with my 
fellow panelists. I think that capital can do a little bit. I 
would be skeptical about putting too much weight on it. And the 
reason is simply that the market in good times is very tolerant 
of institutions that have very high levels of leverage. As you 
know, some banks had 30, 40 to 1 leverage. Some investment 
banks had that kind of leverage.
    The market was willing to tolerate very low levels of 
capital. When the market is willing to tolerate those very low 
levels of capital, somebody who is sitting on a lot of capital 
has an incentive to undertake actions, which will reduce that 
level of capital relative to the activities they are taking.
    One example of such actions include creating off-balance 
sheet vehicles, which banks did a lot of. The SIVs and the 
conduits are examples. A second example of that kind of 
activity is for banks to take up risks, which is not penalized. 
UBS did that when it took on all these sub-prime mortgages on 
its balance sheet.
    So I think capital can help a little, but I think that 
banks, if the market does not require them to hold a lot of 
capital, banks are going to offset the capital requirement in 
ways that the regulator will not see.
    Moreover, this notion that in down times, banks can reduce 
the level of capital because the regulator allows them to, I am 
skeptical about that also because in times like these, this is 
when the market has taken fright. This is when the market wants 
banks to hold much higher levels of capital. Whatever the 
regulators say, the markets are going to dominate. And so, 
banks are going to raise their capital levels at this point, 
which is why you see this extreme level of de-leveraging taking 
place in the market, in the banking sector.
    So my sense is capital requirements which go against what 
the market wants are going to have limited effect. They will 
have some effect, no doubt, but let's not be overly convinced 
about the effect it will have.
    Senator Akaka. Thank you.
    Mr. Baily. Can you allow me just to respond to that? 
Because I think it is a very interesting question, and I do not 
think I have all the answers by any means.
    But, presumably, if you set a high enough level of capital 
in the good times, then when the losses come in, the bank 
capital goes down. But if you have started high enough, you 
still have enough capital left to satisfy the market that you 
are still sold on. That is the idea of having high capital 
levels in good times.
    By the way, I agree with you, you need other things besides 
capital.
    Senator Akaka. Mr. Rajan?
    Mr. Rajan. I agree that they could have some effect. But my 
point is when you set capital requirements at 20 percent of 
bank assets, they are going to do a lot of things, which you 
will be surprised about in bad times because those SIVs, they 
have created the conduits. It will all come back on balance 
sheets at that point, and you will find that even the 20 
percent is not enough. That is one.
    The second is we also have to worry about costs. When you 
ask banks, which are naturally funded with debt, to take on a 
lot of capital, intermediation is also going to suffer. I mean, 
I agree with you. You could have some benefits, but maybe not 
that much.
    Senator Akaka. Thank you.
    Speaking about capital and ensuring adequate capital, Mr. 
Rajan raises the idea of having large, complex financial 
companies buy capital insurance plans or issue bonds that will 
convert to equity if capital deteriorates as a way to guard 
against the failure of these institutions.
    Mr. Rajan, can you elaborate on this idea?
    Mr. Rajan. Well, this follows on the comments I just made, 
which is that if capital on the balance sheet is not going to 
work that well because banks will find ways to offset it, maybe 
the idea is to get capital which comes only in bad times. It 
might be cheaper to arrange for that kind of capital rather 
than have capital sitting on balance sheets through good times 
and bad times. And if you can do it in a clever enough way, 
banks will not be able to exploit that capital and take on more 
risks a priori, given that they know that capital will come in.
    So two examples of how this could be done. One, which Mr. 
Baily has also talked about, which comes from a common group 
that we work in, is this idea of what is called reversed 
convertible debt. And this convertible debt is debt which will 
convert into equity in times like the current ones. So it is a 
pre-assured source of buffer which will protect the taxpayer 
from having to fund these institutions. And that debt will 
convert, provided the bank's capital ratio goes below a certain 
level. That is one condition.
    The second condition is that this be a systemic crisis so 
that banks do not sort of willfully convert this debt and get 
additional buffers. Another variant of this would be what we 
call the capital insurance plan, which is you issue bonds, 
which are called capital insurance bonds. The bank issues these 
bonds. The proceeds from the bonds are taken and invested in 
Treasuries. And the holders of these bonds get the Treasury 
rate of return plus an insurance premium, which the banks pays. 
In bad times, when the bank's capital goes below a certain 
level and there is a systemic crisis, the bonds will start, 
essentially, paying out to the bank. It would be equity at that 
point for the bank, and the bank would be recapitalized.
    So the main difference is, in one, the bonds convert to 
equity; in the other, the bonds just pay in. There is no 
commensurate equity, which is issued. Both have the effect of 
recapitalizing the bank in bad times.
    Senator Akaka. Thank you.
    Further comment, Mr. Wallison?
    Mr. Wallison. I think what Raghu has said is a very 
interesting proposal. I have this concern, however. And if we 
keep our eye on the ball, we are talking about systemic risk. 
And what is systemic risk? Systemic risk is the risk that when 
a large financial institution fails, a large bank fails, it has 
effects on all others throughout the economy, or many others, a 
contagion, if you will, a cascading of losses.
    The idea that we would convert debt into equity is good for 
the bank, but you have to consider what it does to the holders 
who previously had debt and now have equity; what it does to 
their balance sheets and what it does to their risk profiles. 
And what it does, of course, it make them much more risky.
    So in other words, in a time when we are talking about 
trying to prevent systemic risk, we are also thinking favorably 
about an idea that, actually, encourages, increases the 
possibility of contagion from a failed institution or a failing 
institution, to institutions that might otherwise be healthy.
    Mr. Rajan. Could I respond?
    Senator  Akaka. Mr. Rajan?
    Mr. Rajan. The quick response is this is a clear problem 
that Mr. Wallison has pointed out. And the answer is that the 
holders of this debt should not be levered financial 
institutions. It should not be other banks. It should not be 
insurance companies.
    So who would hold? It would be un-levered financial 
institutions, such as pension funds, mutual funds, sovereign 
wealth funds.
    Now, the immediate question, then, is, well, is there any 
evidence that there are people who buy this kind of instrument? 
And the answer is yes. There is a very liquid market in credit-
default swaps on bank debt. That credit-default swap on bank 
debt has exactly the properties of the kind of insurance we are 
talking about. That is, it pays out when the bank is doing 
really badly, which typically is when the economy is in 
trouble. And there are people who are willing to buy this 
instrument, so much so, that this market has gone beyond 
bounds. It has become extremely large and we are trying to 
contain it.
    But it is suggesting demand is not going to be a problem if 
we do this right. And we can try and regulate so that the costs 
are borne by financial institutions that are not levered. And 
the costs are not forced to be borne by the taxpayer, which, to 
my mind, is worse than getting some people who bear it, knowing 
that they have been paid for bearing that risk.
    Senator Akaka. Mr. Baily?
    Mr. Baily. I like this proposal. Obviously, we have jointly 
put our names to it. I think it is possible that there could be 
more severe kinds of systemic crises in which the convertible 
capital would not be adequate, in which case we do need to go 
to other procedures, processes, for orderly resolution of some 
of these institutions. But I think having this kind of capital 
would make that less likely and make the system more stable.
    Senator Akaka. Well, I want to thank you so much. This has 
been stimulating to hear from you. And it, certainly, without 
question, will help the Committee in its legislative efforts 
here.
    I want to thank our witnesses for joining us today. I want 
you to know that the hearing record will remain open for a week 
for statements from members or questions that members may have.
    Thank you again. This hearing is adjourned.
    [Whereupon, at 12:11 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
follow:]
                  PREPARED STATEMENT OF SHEILA C. BAIR
            Chairman, Federal Deposit Insurance Corporation
                              May 6, 2009
    Chairman Dodd, Ranking Member Shelby and members of the Committee, 
I appreciate the opportunity to testify on behalf of the Federal 
Deposit Insurance Corporation (FDIC) on the need to address the issue 
of systemic risk and the existence of financial firms that are deemed 
``too big to fail.''
    It has been a difficult 18 months since the financial crisis began, 
but despite some long weekends and tense moments, government and 
industry have worked together to take extraordinary measures to 
maintain the stability of our financial system. The FDIC has been 
working with other federal agencies, Congress, and the White House to 
protect insured depositors and preserve the stability of our banking 
system. We have sought input from the public and the financial industry 
about our programs and how to structure them to produce the best 
results to turn this crisis around. There are indications that progress 
is being made in the availability of credit and the profitability of 
financial institutions. As we move beyond the liquidity crisis of last 
year, we must examine how we can improve our financial system for the 
future.
    The financial crisis has taught us that many financial 
organizations have grown in both size and complexity to the point that, 
should one of them become distressed, it may pose systemic risk to the 
broader financial system. The managers, directors and supervisors of 
these firms ultimately placed too much reliance in risk management 
systems that proved flawed in their operations and assumptions. 
Meanwhile, the markets have funded these organizations at rates that 
implied they were simply ``too big to fail.'' In addition, the 
difficulty in supervising these firms was compounded by the lack of an 
effective mechanism to resolve them when they became troubled in a way 
that controlled the potential damage their failure could bring to the 
broader financial system.
    In a properly functioning market economy there will be winners and 
losers, and some firms will become insolvent and should fail. Actions 
that prevent firms from failing ultimately distort market mechanisms, 
including the market's incentive to monitor the actions of similarly 
situated firms. Unfortunately, the actions taken during the past crisis 
have reinforced the idea that some financial organizations are ``too 
big to fail.'' The most important challenge now is to find ways to 
impose greater market discipline on systemically important financial 
organizations.
    My testimony will examine whether large institutions posing 
systemic risk are necessary for the efficient functioning of our 
financial system--that is, whether they promote or hinder competition 
and innovation among financial firms. I also will focus on some 
specific changes that should be undertaken to limit the potential for 
excessive risk in the system, including identifying systemically 
important institutions, creating incentives to reduce the size of 
systemically important firms and ensuring that all portions of the 
financial system are under some baseline standards to constrain 
excessive risk taking.
    In addition, I will explain why an independent, special failure 
resolution authority is needed for financial firms that pose systemic 
risk and describe the essential features of such an authority. Finally, 
independent of the systemic risk issue, I will discuss the benefits of 
providing the FDIC with a statutory structure under which we would have 
authority to resolve a non-systemic failing or failed bank or thrift 
holding company, and how this authority would improve the ability to 
effect a least cost resolution for the depository institution or 
institutions it controls.
Do We Need Financial Firms That Are Too Big to Fail?
    Before policymakers can address the issue of ``too big to fail,'' 
it is important to analyze the fundamental issue of whether there are 
economic benefits to having institutions that are so large and complex 
that their failure can result in systemic issues for the economy. 
Because of their concentration of economic power and interconnections 
through the financial system, the management and supervision of 
institutions that are large and complex has proven to be problematic. 
Unless there are clear benefits to the financial system that offset the 
risks created by systemically important institutions, taxpayers have a 
right to question how extensive their exposure should be to such 
entities.
    Over the past two decades, a number of arguments have been advanced 
about why financial organizations should be allowed to become larger 
and more complex. These reasons include being able to take advantage of 
economies of scale and scope, diversifying risk across a broad range of 
markets and products, and gaining access to global capital markets. It 
was alleged that the increased size and complexity of these 
organizations could be effectively managed using new innovations in 
quantitative risk management techniques. Not only did institutions 
claim that they could manage these new risks, they also argued that 
often the combination of diversification and advanced risk management 
practices would allow them to operate with markedly lower capital 
buffers than were necessary in smaller, less-sophisticated 
institutions.
    Indeed many of these concepts were inherent in the Basel II 
Advanced Approaches, resulting in reduced capital requirements. In 
hindsight, it is now clear that the international regulatory community 
over-estimated the risk mitigation benefits of diversification and risk 
management when they set minimum regulatory capital requirements for 
large, complex financial institutions.
    Notwithstanding expectations and industry projections for gains in 
financial efficiency, the academic evidence suggests that benefits from 
economies of scale are exhausted at levels far below the size of 
today's largest financial institutions. Also, efforts designed to 
realize economies of scope have not lived up to their promise. In some 
instances, the complex institutional combinations permitted by the 
Gramm-Leach-Bliley (GLB) Act were unwound because they failed to 
realize anticipated economies of scope. Studies that assess the 
benefits produced by increased scale and scope find that most banks 
could improve their cost efficiency more by concentrating their efforts 
on improving core operational efficiency.
    There also are practical limits on an institution's ability to 
diversify risk using securitization, structured financial products and 
derivatives. Over-reliance on financial engineering and model-based 
hedging strategies increases an institution's exposure to operational, 
model and counterparty risks.
    Clearly, there are benefits to diversification for smaller and less 
complex institutions, but the ability to diversify risk is diminished 
as market concentration rises and institutions become larger and more 
complex. When a financial system includes a small number of very large, 
complex organizations, the system cannot be well-diversified. As 
institutions grow in size and importance, they not only take on a risk 
profile that mirrors the risk of the market and general economic 
conditions, but they also concentrate risk as they become the only 
important counterparties to many transactions that facilitate financial 
intermediation in the economy. These flaws in the diversification 
argument become apparent in the midst of financial crisis when large, 
complex financial organizations--because they are so interconnected--
reveal themselves as a source of risk to the system.
Creating a Safer Financial System
    A strong case can be made for creating incentives that reduce the 
size and complexity of financial institutions as being bigger is not 
necessarily better. A financial system characterized by a handful of 
giant institutions with global reach and a single regulator is making a 
huge bet that those few banks and their regulator over a long period of 
time will always make the right decisions at the right time.
    Reliance solely on the supervision of these institutions is not 
enough. We also need a ``fail-safe'' system where if any one large 
institution fails, the system carries on without breaking down. 
Financial firms that pose systemic risks should be subject to 
regulatory and economic incentives that require these institutions to 
hold larger capital and liquidity buffers to mirror the heightened risk 
they pose to the financial system. In addition, restrictions on 
leverage and the imposition of risk-based premiums on institutions and 
their activities would act as disincentives to growth and complexity 
that raise systemic concerns.
    In contrast to the standards implied in the Basel II Accord, 
systemically important firms should face additional capital charges 
based on both their size and complexity. To address pro-cyclicality, 
the capital standards should provide for higher capital buffers that 
increase during expansions and are drawn down during contractions. In 
addition, these firms should be subject to higher Prompt Corrective 
Action (PCA) limits under U.S. laws. Regulators also should take into 
account off-balance-sheet assets and conduits as if these risks were 
on-balance-sheet.
    One existing example of statutory limitations placed on 
institutions is the 10 percent nationwide cap on domestic deposits 
imposed in the Riegle-Neal Interstate Banking and Branching Efficiency 
Act of 1994. While this regulatory limitation has been somewhat 
effective in preventing concentration in the U.S. system, the Riegle-
Neal constraints have some significant limitations. First, these limits 
only apply to interstate bank mergers. Also, deposits in savings and 
loan institutions generally are not counted against legal limits. In 
addition, the law restricts only domestic deposit concentration and is 
silent on asset concentration, risk concentration or product 
concentration. The four largest banking organizations have slightly 
less than 35 percent of the domestic deposit market, but have over 45 
percent of total industry assets.\1\ As we have seen, even with these 
deposit limits, banking organizations have become so large and 
interconnected that the failure of even one can threaten the financial 
system.
---------------------------------------------------------------------------
    \1\ FDIC, Call Report data, 4th Quarter 2008.
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    In addition to establishing disincentives to unchecked growth and 
increased complexity of institutions, two additional fundamental 
approaches could reduce the likelihood that an institution will be 
``too big to fail.'' One action is to create or designate a supervisory 
framework for regulating systemic risk. Another critical aspect to 
ending ``too big to fail'' is to establish a comprehensive resolution 
authority for systemically significant financial companies that makes 
the failure of any systemically important institution both credible and 
feasible. A realistic resolution regime would send a message that no 
institution is really too big to ultimately fail.
Regulating Systemic Risk
    Our current system has clearly failed in many instances to manage 
risk properly and to provide stability. While U.S. regulators have 
broad powers to supervise financial institutions and markets and to 
limit many of the activities that undermined our financial system, 
there are significant gaps that led to the current crisis. First, there 
were gaps in the regulation of specific financial institutions that 
posed significant systemic risk--most notably very large insurance 
companies, private equity and hedge funds, and differences in 
regulatory leverage standards for commercial and investment banks. 
Second, there were gaps in the oversight of certain types of risk that 
cut across many different financial institutions. A prime example of 
this was the credit default swap (CDS) market which was used to both 
hedge and leverage risk in the structured mortgage finance market. Both 
of these aspects of oversight and regulation need to be addressed.
    A distinction should be drawn between the direct supervision of 
systemically-significant financial firms and the macro-prudential 
oversight of developing risks that may pose systemic risks to the U.S. 
financial system. The former appropriately calls for a single regulator 
for the largest, most systemically-significant firms, including large 
bank holding companies. The macro-prudential oversight of system-wide 
risks requires the integration of insights from a number of different 
regulatory perspectives--banks, securities firms, holding companies, 
and perhaps others. Only through these differing perspectives can there 
be a holistic view of developing risks to our system. As a result, for 
this latter role, the FDIC would suggest creation of a systemic risk 
council (SRC) to provide analytical support, develop needed prudential 
policies, and have the power to mitigate developing risks.
Systemic Risk Regulator
    With regard to the regulation of systemically important entities, a 
systemic risk regulator (SRR) should be responsible for monitoring and 
regulating their activities. Centralizing the responsibility for 
supervising institutions that are deemed to be systemically important 
would bring clarity and focus to the efforts needed to identify and 
mitigate the buildup of risk at individual institutions. The SRR could 
focus on the adequacy of complex institutions' risk measurement and 
management capabilities, including the mathematical models that drive 
risk management decisions. With a few additions to their existing 
holding company authority, the Federal Reserve would seem well 
positioned for this important role.
    While the creation of a SRR would be a significant improvement over 
the current system, risks that resulted in the current crisis grew 
across the financial system and supervisors were slow to identify them 
and limited in our ability to address these issues. This underscores 
the weakness of monitoring systemic risk through the lens of individual 
financial institutions, and argues for the need to assess emerging 
risks using a system-wide perspective.
Systemic Risk Council
    One way to organize a system-wide regulatory monitoring effort is 
through the creation of a systemic risk council (SRC) to address issues 
that pose risks to the broader financial system. Based on the key roles 
that they currently play in determining and addressing systemic risk, 
positions on this council should be held by the U.S. Treasury, the 
FDIC, the Federal Reserve Board and the Securities and Exchange 
Commission. It may be appropriate to add other prudential supervisors 
as well.
    The SRC would be responsible for identifying institutions, 
practices, and markets that create potential systemic risks, 
implementing actions to address those risks, ensuring effective 
information flow, completing analyses and making recommendations on 
potential systemic risks, setting capital and other standards and 
ensuring that the key supervisors with responsibility for direct 
supervision apply those standards. The standards would be designed to 
provide incentives to reduce or eliminate potential systemic risks 
created by the size or complexity of individual entities, 
concentrations of risk or market practices, and other interconnections 
between entities and markets.
    The SRC could take a more macro perspective and have the authority 
to overrule or force actions on behalf of other regulatory entities. In 
order to monitor risk in the financial system, the SRC should also have 
the authority to demand better information from systemically important 
entities and to ensure that information is shared more readily.
    The creation of a comprehensive systemic risk regulatory regime 
will not be a panacea. Regulation can only accomplish so much. Once the 
government formally establishes a systemic risk regulatory regime, 
market participants may assume that the likelihood of systemic events 
will be diminished. Market participants may incorrectly discount the 
possibility of sector-wide disturbances and avoid expending private 
resources to safeguard their capital positions. They also may arrive at 
distorted valuations in part because they assume (correctly or 
incorrectly) that the regulatory regime will reduce the probability of 
sector-wide losses or other extreme events.
    To truly address the risks posed by systemically important 
institutions, it will be necessary to utilize mechanisms that once 
again impose market discipline on these institutions and their 
activities. For this reason, improvements in the supervision of 
systemically important entities must be coupled with disincentives for 
growth and complexity, as well as a credible and efficient structure 
that permits the resolution of these entities if they fail while 
protecting taxpayers from exposure.
Resolution Authority
    The most important challenge in addressing the issue of ``too big 
to fail'' is to find ways to impose greater market discipline on 
systemically important institutions. The solution must involve, first 
and foremost, a legal mechanism for the orderly resolution of these 
institutions similar to that which exists for FDIC insured banks. The 
purpose of the resolution authority should not be to prop up a failed 
entity indefinitely, but to permit the swift and orderly dissolution of 
the entity and the absorption of its assets by the private sector as 
quickly as possible. Creating a resolution regime that applies to any 
financial institution that becomes a source of systemic risk should be 
an urgent priority.
    The ad-hoc response to the current banking crisis was inevitable 
because no playbook existed for taking over an entire complex financial 
organization. There were important differences in the subsequent 
outcomes of the Bear Stearns and Lehman Brothers cases, and these 
difference are due, in part, to issues that arise when large complex 
financial institutions are subjected to the bankruptcy process. 
Bankruptcy is a very messy process for financial organizations and, as 
was demonstrated in the Lehman Brothers case, markets can react badly. 
Following the Lehman Brothers filing, the commercial paper market 
stopped functioning and the resulting decrease in liquidity threatened 
other financial institutions.
    One explanation for the freeze in markets was that the Lehman 
failure shocked investors because, following Bear Stearns, they had 
assumed Lehman was too big too fail and its creditors would garner 
government support. In addition, many feel that the bankruptcy process 
itself had a destabilizing effect on markets and investor confidence. 
While the underlying causes of the market disruption that followed the 
Lehman failure will likely be debated for years to come, both 
explanations point to the need for a new resolutions scheme for 
systemically important non-bank financial institutions which will 
provide clear, consistent rules for all systemically important 
financial institutions, as well as a mechanism to maintain key systemic 
functions during an orderly wind down of those institutions.
    Under the first explanation, investors found it incredible that the 
government would allow Lehman, or firms similar to Lehman, to declare 
bankruptcy. Because the protracted proceedings of a Chapter 11 
bankruptcy were not viewed as credible prior to the bankruptcy filing, 
investors were willing to make ``moral hazard'' investments in the 
high-yielding commercial paper of large systemic institutions. Had a 
credible resolution mechanism been in place prior to the Lehman 
bankruptcy, investors would not have made these bets, and markets would 
not have reacted so negatively to the shock of a bankruptcy filing.
    Under the second explanation, the legal features of a bankruptcy 
filing itself triggered asset fire sales and destroyed the liquidity of 
a large share of claims against Lehman. In this explanation, the 
liquidity and asset fire sale shock from the Lehman bankruptcy caused a 
market-wide liquidity shortage.
    Under both explanations, we are left with the same conclusion--that 
we need to develop a new credible and efficient means for resolving a 
distressed large complex non-bank institution. When the public interest 
is at stake, as in the case of systemically important entities, the 
resolution process should support an orderly unwinding of the 
institution in a way that protects the broader economic and taxpayer 
interests, not just private financial interests, and imposes losses on 
stakeholders in the institution.
    Unlike the clearly defined and proven statutory powers that exist 
for resolving insured depository institutions, the current bankruptcy 
framework available to resolve large, complex non-bank financial 
entities and financial holding companies was not designed to protect 
the stability of the financial system. This is important because, in 
the current crisis, bank holding companies and large non-bank entities 
have come to depend on the banks within their organizations as a source 
of strength. Where previously the holding company may have served as a 
source of strength to the insured institution, these entities now often 
rely on a subsidiary depository institution for funding and liquidity, 
but carry on many systemically important activities outside of the bank 
that are managed at a holding company level or non-bank affiliate 
level.
    In the case of a bank holding company, whether systemically 
significant or not, the FDIC has the authority to take control of only 
the failing bank subsidiary, thereby protecting the insured depositors. 
However, in some cases, many of the essential services for the bank's 
operations lie in other portions of the holding company and are left 
outside of the FDIC's control, making it difficult to operate and 
resolve the bank. When the bank fails, the holding company and its 
subsidiaries typically find themselves too operationally and 
financially unbalanced to continue to fund ongoing commitments. In such 
a situation, where the holding company structure includes many bank and 
non-bank subsidiaries, taking control of just the bank is not a 
practical solution.
    While the depository institution could be resolved under existing 
authorities, the resolution would likely cause the holding company to 
fail and its activities would then be unwound through the normal 
corporate bankruptcy process. Putting the holding company through the 
normal corporate bankruptcy process may create additional instability 
as claims outside the depository institution become completely illiquid 
under the current system. Without a system that provides for the 
orderly resolution of activities outside of the depository institution, 
the failure of a large, complex financial institution includes the risk 
that it will become a systemically important event.
    If a bank-holding company or non-bank financial holding company is 
forced into, or chooses to enter, bankruptcy for any reason, the 
following is likely to occur. In a Chapter 11 bankruptcy, there is an 
automatic stay on most creditor claims--with the exception of specified 
financial contracts (futures and options contracts and certain types of 
derivatives) that are subject to immediate termination and netting 
provisions. The automatic stay renders illiquid the entire balance of 
outstanding creditor claims. There are no alternative funding 
mechanisms, other than debtor-in-possession financing, available to 
remedy this problem. On the other hand, the bankrupt's financial market 
contracts are subject to immediate termination--and cannot be 
transferred to another existing institution or a temporary institution, 
such as a bridge bank. In bankruptcy, without a bridge bank or similar 
type of option, there is really no practical way to provide continuity 
for the holding company's or its subsidiaries' operations. Those 
operations are based principally on financial agreements dependent on 
market confidence and require continuity through a bridge bank 
mechanism to allow the type of quick, flexible action needed. The 
automatic stay and the uncertainties inherent in the judicially-based 
bankruptcy proceedings further impair the ability to maintain these key 
functions. As a result, the current bankruptcy resolution options 
available--taking control of the banking subsidiary or a bankruptcy 
filing of the parent organization--make the effective resolution of a 
large, systemically important financial institution, such as a bank 
holding company, virtually impossible. This has forced the government 
to improvise actions to address individual situations, making it 
difficult to address systemic problems in a coordinated manner and 
raising serious issues of fairness.
Addressing Risks Posed By the Derivatives Markets
    One of the major risks demonstrated in the current crisis is the 
tremendous expansion in the size, concentration, and complexity of the 
derivatives markets. While these markets perform important risk 
mitigation functions, financial firms that rely on market funding can 
see it dry up overnight. If the market decides the firm is weakening, 
other market participants can demand more and more collateral to 
protect their claims. At some point, the firm cannot meet these 
additional demands and it collapses. In bankruptcy, current law allows 
market participants to terminate and net out derivatives and sell any 
pledged collateral to pay off the resulting net claim. During periods 
of market instability--such as during the fall of 2008--the exercise of 
these netting and collateral rights can increase systemic risks. At 
such times, the resulting fire sale of collateral can depress prices, 
freeze market liquidity as investors pull back, and create risks of 
collapse for many other firms.
    In effect, financial firms are more prone to sudden market runs 
because of the cycle of increasing collateral demands before a firm 
fails and collateral dumping after it fails. Their counterparties have 
every interest to demand more collateral and sell it as quickly as 
possible before market prices decline. This can become a self-
fulfilling prophecy--and mimics the depositor runs of the past.
    One way to reduce these risks while retaining market discipline is 
to make derivative counterparties keep some ``skin in the game'' 
throughout the cycle. The policy argument for such an approach is even 
stronger if the firm's failure would expose the taxpayer or a 
resolution fund to losses. One approach to addressing these risks would 
be to haircut up to 20 percent of the secured claim for companies with 
derivatives claims against the failed firm if the taxpayer or a 
resolution fund is expected to suffer losses. This would ensure that 
market participants always have an interest in monitoring the financial 
health of their counterparties. It also would limit the sudden demand 
for more collateral because the protection could be capped and also 
help to protect the taxpayer and the resolution fund from losses.
Powers
    The new resolution entity should be independent of the 
institutional regulator. In creating a new resolution regime, we must 
clearly define roles and responsibilities and guard against creating 
new conflicts of interest. No single entity should be able to make the 
determination to resolve a systemically important institution. The 
resolution entity should be able to initiate action, but the final 
decision should involve other affected regulators. For example, the 
current statute requires that decisions to exercise the systemic risk 
authorities for banks must have the concurrence of several parties. 
Yet, Congress also gave the FDIC backup supervisory authority, 
recognizing there might be conflicts between a primary regulator's 
prudential responsibilities and its willingness to recognize when an 
institution it supervises needs to be closed. Once the decision to 
resolve a systemically important institution is made, the resolution 
entity must have the flexibility to implement this decision in the way 
that protects the public interest and limits costs.
    This new resolution authority should also be designed to limit 
subsidies to private investors by assisting a troubled institution. If 
financial assistance outside of the resolution process is granted to 
systemically important firms, the process should be open, transparent 
and subject to a system of checks and balances that are similar to the 
systemic-risk exception to the least-cost test that applies to insured 
depository institutions. No single government entity should be able to 
unilaterally trigger a resolution strategy outside the defined 
parameters of the established resolution process.
    Clear guidelines for this process are needed and must be adhered to 
in order to gain investor confidence and protect public and private 
interests. First, there should be a clearly defined priority structure 
for settling claims, depending on the type of firm. Any resolution 
should be subject to a cost test to minimize any public loss and impose 
losses according to the established claims priority. Second, the 
process must allow continuation of any systemically significant 
operations. Third, the rules that govern the process, and set 
priorities for the imposition of losses on shareholders and creditors 
should be clearly articulated and closely adhered to so that the 
markets can understand the resolution process with predicable outcomes.
    The FDIC's authority to act as receiver and to establish a bridge 
bank to maintain key functions and sell assets offers a good model. A 
temporary bridge bank allows the government to prevent a disorderly 
collapse by preserving systemically significant functions. The FDIC has 
the power to transfer needed contracts to the bridge bank, including 
the financial market contracts, known as QFCs, which can be crucial to 
stemming contagion. It enables losses to be imposed on market players 
who should appropriately bear the risk. It also creates the possibility 
of multiple bidders for the bank and its assets, which can reduce 
losses to the receivership. The FDIC has the authority to terminate 
contracts upon an insured depository institution's failure, including 
contracts with senior management whose services are no longer required. 
Through its repudiation powers, as well as enforcement powers, 
termination of such management contracts can often be accomplished at 
little cost to the FDIC. Moreover, when the FDIC establishes a bridge 
institution, it is able to contract with individuals to serve in senior 
management positions at the bridge institution subject to the oversight 
of the FDIC. The new resolution entity should be granted similar 
statutory authority as in the current resolution of financial 
institutions.
    These additional powers would enable the resolution authority to 
employ what many have referred to as a ``good bank-bad bank'' model in 
resolving failed systemically significant institutions. Under this 
scenario, the resolution authority would take over the troubled firm, 
imposing losses on stockholders and unsecured creditors. Viable 
portions of the firm would be placed in the good bank, using a 
structure similar to the FDIC's bridge bank authority. The nonviable or 
troubled portions of the firms would remain behind in a bad bank and 
would be unwound or sold over time. Even in the case of creditor claims 
transferred to the bad bank, these claims could be made partially 
liquid very quickly using a system of ``haircuts'' tied to FDIC 
estimates of potential losses on the disposition of assets.
Who Should Resolve Systemically Significant Entities?
    As the only government entity regularly involved in the resolution 
of financial institutions, the FDIC can testify to what a difficult and 
contentious business it is. Resolution work involves making hard 
choices between competing interests with very few good options. It can 
be delicate work and requires special expertise.
    In deciding whether to create a new government entity to resolve 
systemically important institutions, Congress should recognize that it 
would be difficult to maintain an expert and motivated workforce when 
there could be decades between systemic events. The FDIC experienced a 
similar challenge in the period before the recent crisis when very few 
banks failed during the years prior to the current crisis. While no 
existing government agency, including the FDIC, has experience with 
resolving systemically important entities, probably no agency other 
than the FDIC currently has the kinds of skill sets necessary to 
perform resolution activities of this nature.
    In determining how to resolve systemically important institutions, 
Congress should only designate one entity to perform this role. 
Assigning resolution responsibilities to multiple regulators creates 
the potential for inconsistent resolution results and arbitrage. While 
the resolution entity should draw from the expertise and consult 
closely with other primary regulators, spreading the responsibility 
beyond a single entity would create inefficiencies in the resolution 
process. In addition, establishing multiple resolution entities would 
create significant practical difficulties in the effective 
administration of an industry funded resolution fund designed to 
protect taxpayers.
Funding
    Obviously, many details of a special resolution authority for 
systemically significant financial firms would have to be worked out. 
To be truly credible, a new systemic resolution regime should be funded 
by fees or assessments charged to systemically important firms. Fees 
imposed on these firms could be imposed either before failures, to pre-
fund a resolution fund, or fees could be assessed after a systemic 
resolution.
    The FDIC would recommend pre-funding the special resolution 
authority. One approach to doing this would be to establish assessments 
on systemically significant financial companies that would be placed in 
a ``Financial Companies Resolution Fund'' (FCRF). A FCRF would not be 
funded to provide a guarantee to the creditors of systemically 
important institutions, but rather to cover the administrative costs of 
the resolution and the costs of any debtor-in-possession lending that 
would be necessary to ensure an orderly unwinding of a financial 
company's affairs. Any administrative costs and/or debtor-in-possession 
lending that could not be recovered from the estate of the resolved 
firm would be covered by the FCRF.
    The FDIC's experience strongly suggests that there are significant 
benefits to an industry funded resolution fund. First, and foremost, 
such a fund reduces taxpayer exposure for the failure of systemically 
important institutions. The ability to draw on the accumulated reserves 
of the fund also ensures adequate resources and the credibility of the 
resolution structure. The taxpayer confidence in the Deposit Insurance 
Fund (DIF) with regard to the resolution of banks is a direct result of 
the respect engendered by its funding structure and conservative 
management. The FCRF would be funded by financial companies whose size, 
complexity or interconnections potentially could pose a systemic risk 
to the financial system at some point in time (perhaps the beginning of 
each year). Those systemically important firms that have an insured 
depository subsidiary or other financial entity whose claimants are 
insured through a federal or state guarantee fund could receive a 
credit for the amount of their assessment to cover those institutions.
    It is anticipated that the number of companies covered by the FCRF 
would be fluid, changing periodically depending upon the activities of 
the company and the market's ability to develop mechanisms to 
ameliorate systemic risk. Theoretically, as companies fall below the 
threshold for being potentially systemically important, they would no 
longer be assessed for coverage by the FCRF. Similarly, as companies 
undertake activities or provide products/services that make them 
potentially more systemically important, they would fall under the 
purview of the FCRF and be subject to assessment.
    Assessing institutions based on the risk they pose to the financial 
systems serves two important purposes. A strong resolution fund ensures 
that resolving systemically important institutions is a credible option 
which enhances market discipline. At the same time, risk-based 
assessments are an important tool to affect the behavior of these 
institutions. Assessments could be imposed on a sliding scale based on 
the increasing level of systemic risk posed by an entity's size or 
complexity.
Resolution of Non-Systemic Holding Companies
    Separate and apart from establishing a resolution structure to 
handle systemically important institutions, the ability to resolve non-
systemic bank failures would be greatly enhanced if Congress provided 
the FDIC the authority to resolve bank and thrift holding companies 
affiliated with a failed institution. The corporate structure of bank 
and thrift holding companies, with their insured depositories and other 
subsidiaries, has become increasingly complex and inter-reliant. The 
insured depository is likely to be dependent on affiliates that are 
subsidiaries of its holding company for critical services, such as loan 
and deposit processing, loan servicing, auditing, risk management and 
wealth management. Moreover, in many cases the non-bank affiliates 
themselves are dependent on the bank for their continued viability. It 
is not unusual for many business lines of these corporate enterprises 
to be conducted in both insured and non-insured affiliates without 
regard to the confines of a particular entity. Examples of such multi-
entity operations often include retail and mortgage banking and capital 
markets.
    Atop this network of corporate relationships, the holding company 
exercises critical control of its subsidiaries and their mutually 
dependent business activities. The bank may be so dependent on its 
holding company that it literally cannot operate without holding 
company cooperation. The most egregious example of this problem emerged 
with the failure of NextBank in northern California in 2002. When the 
bank was closed, the FDIC ascertained that virtually the entire 
infrastructure of the bank was controlled by the holding company. All 
of the bank personnel were holding company employees and all of the 
premises used by the bank were owned by the holding company. Moreover, 
NextBank was heavily involved in credit card securitizations and the 
holding company threatened to file for bankruptcy, a strategy that 
would have significantly impaired the value of the bank and the 
securitizations. To avert this adverse impact on the DIF, the FDIC was 
forced to expend significant funds to avoid the bankruptcy filing.
    As long as the threats exists that a bank or thrift holding company 
can file for bankruptcy, as well as affect the business relationships 
between its bank and other subsidiaries, the FDIC faces great 
difficulty in effectuating a resolution strategy that preserves the 
franchise value of the failed bank and so protects the DIF. Bankruptcy 
proceedings, involving the parent or affiliate of a bank, are time-
consuming, unwieldy, and expensive. The FDIC as receiver or conservator 
occupies a position no better than any other creditor and so lacks the 
ability to protect the receivership estate and the DIF. The threat of 
bankruptcy by the BHC or its affiliates is such that the Corporation 
may be forced to expend considerable sums propping up the holding 
company or entering into disadvantageous transactions with the holding 
company or its subsidiaries in order to proceed with a bank's 
resolution. The difficulties are particularly egregious where the 
Corporation has established a bridge bank to preserve franchise value, 
protect creditors (including uninsured depositors), and facilitate 
disposition of the failed institution's assets and liabilities. By 
giving the FDIC authority to resolve a failing or failed bank's holding 
company, Congress would provide the FDIC with a vital tool to deal with 
the increasingly complicated and highly symbiotic business structures 
in which banks operate in order to develop an efficient and economical 
resolution.
    The purpose of the authority to resolve non-systemic holding 
companies would be to achieve the least cost resolution of a failed 
insured depository institution. It would be used to reduce costs to the 
DIF through a more orderly and comprehensive resolution of the entire 
financial entity. If the current bifurcated resolution structure 
involving resolution of the insured institution by the FDIC and 
bankruptcy for the holding company would produce the least costly 
resolution, the FDIC should retain the ability to use that structure as 
well. Enhanced authorities that allow the FDIC to efficiently resolve 
failed depository institutions that are part of a complex holding 
company structure will provide immediate efficiencies in bank 
resolutions result in reduced losses to the DIF and not require any 
additional funding.
Conclusion
    The current financial crisis demonstrates the need for changes in 
the supervision and resolution of financial institutions, especially 
changes relative to large, complex organizations that are systemically 
important to the financial system. The choices facing Congress in this 
task are complex, made more so by the fact that we are trying to 
address problems while dealing with one of the greatest economic 
challenges we've seen in decades. While the need for some reforms is 
obvious, such as a legal framework for resolving systemically important 
institutions, others are less clear and we would encourage a 
thoughtful, deliberative approach. The FDIC stands ready to work with 
Congress to ensure that the appropriate steps are taken to strengthen 
our supervision and regulation of all financial institutions--
especially those that pose a systemic risk to the financial system.
    I would be pleased to answer any questions from the Committee.
                                 ______
                                 
                 PREPARED STATEMENT OF GARY H. STERN *
                President and Chief Executive Officer, 
                  Federal Reserve Bank of Minneapolis
                              May 6, 2009
    Chairman Dodd, Ranking Member Shelby, and members of the Committee, 
thank you for the opportunity to review the ``too-big-to-fail'' (TBTF) 
problem with you today. I will develop a simple conclusion in this 
testimony: The key to addressing TBTF is to reduce substantially the 
negative spillover effects stemming from the failure of a systemically 
important financial institution. Let me explain how I have come to that 
conclusion.
---------------------------------------------------------------------------
    * These remarks reflect my views and not necessarily those of 
others in the Federal Reserve.
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    The TBTF problem is one of undesirable incentives which we need to 
address if we hope to fix the problem. TBTF arises, by definition, when 
the uninsured creditors of systemically important financial 
institutions expect government protection from loss when these 
financial institutions get into financial or operational trouble. The 
key to addressing this problem and changing incentives, therefore, is 
to convince these creditors that they are at risk of loss. If creditors 
continue to expect special protection, the moral hazard of government 
protection will continue. That is, the creditors will continue to 
underprice the risk-taking of these financial institutions, overfund 
them, and fail to provide effective market discipline Facing prices 
that are too low, systemically important firms will take on too much 
risk. Excessive risk-taking squanders valuable economic resources and, 
in the extreme, leads to financial crises that impose substantial 
losses on taxpayers. Put another way, if policymakers do not address 
TBTF, the United States likely will endure an inefficient financial 
system, slower economic growth, and lower living standards than 
otherwise would be the case.
    To address TBTF, policymakers must change these incentives, and I 
recommend the following steps to achieve that goal. And let me 
emphasize that these are my personal views.
    First, identify why policymakers provide protection to uninsured 
creditors. If we do not address the underlying rationale for providing 
protection, we will not credibly put creditors of systemically 
important firms at risk of loss. The threat of financial spillovers 
leads policymakers to provide such protection.\1\ Indeed, I would 
define systemically important financial institutions by the potential 
that their financial and operational weaknesses can spill over to other 
financial institutions, capital markets, and the rest of the economy. 
As a result, my recommendations to address the TBTF problem focus on 
mitigating the perceived and real fallout from financial spillovers.
---------------------------------------------------------------------------
    \1\ We discuss other potential motivations that could lead to TBTF 
support and why we think spillovers are the most important motivation 
in Gary H. Stern and Ron J. Feldman, 2009, Too Big To Fail: The Hazards 
of Bank Bailouts, chapter 5.
---------------------------------------------------------------------------
    Second, enact reforms to reduce the perceived or real threat of the 
spillovers that motivate after-the-fact protection of uninsured 
creditors. These reforms include, but are not limited to, increased 
supervisory focus on preparation for the potential failure of a large 
financial institution, enhanced prompt corrective action, and better 
communication of efforts to put creditors of systemically important 
firms at risk of loss. I call this combination of reforms systemic 
focused supervision (SFS). Other reforms outside of SFS will help 
address TBTF as well. I also recommend, for example, capital regimes 
that automatically provide increased protection against loss during bad 
times and insurance premiums that raise the cost for financial 
institution activities that create spillovers. I recognize the 
substantial benefits of highlighting a single reform that would fix 
TBTF, but I believe a variety of steps are required to credibly take on 
TBTF.\2\
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    \2\ More generally, see the testimony of Daniel K. Tarullo on March 
19, 2009, before the U.S. Senate Committee on Banking, Housing, and 
Urban Affairs for options for modernizing bank supervision and 
regulation, including many that seek to foster financial stability.
---------------------------------------------------------------------------
    Third, be careful about relying heavily on reforms that do not 
materially reduce spillovers. In particular,
    I do not think that intensification of traditional supervision and 
regulation of large financial firms will effectively address the TBTF 
problem. In a similar vein, while I support the creation of a new 
resolution regime for systemically important nonbank financial 
institutions, I would augment the new resolution regime with the types 
of reforms I just noted.
    I will now discuss these points quite briefly. I will provide 
additional detail in the appendix to this testimony.\3\
---------------------------------------------------------------------------
    \3\ The appendix includes summaries of the key arguments in our 
book on TBTF, more recent analysis applying the recommendations in the 
book to the current crisis, and an initial analysis of proposals to 
address TBTF by making large financial institutions smaller. Our 
writings on TBTF can be found at http://www.minneapolisfed.org/
publications_papers/studies/tbtf/index.cfm.
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Spillovers Produce the TBTF Problem
    Uninsured creditors of systemically important firms come to expect 
protection because they understand the motivation of policymakers. 
Policymakers provide protection, in my experience, believing that such 
protection will contain costly financial spillovers. Policymakers 
understand that protecting creditors reduces market discipline, but 
they judge the costs of such a reduction to be smaller than the fallout 
from the collapse of a major institution. Policymakers worry about 
spillovers--for example, the failure of other large financial firms due 
to their direct exposure to a weak firm or because of a more general 
panic--and the potential impact they may have on the rest of the 
economy.
    I see three general approaches to addressing concerns over 
spillovers and thus increasing market discipline (and reducing moral 
hazard). First, enact reforms that make policymakers more confident 
that they can impose losses on creditors without creating spillovers 
that would justify government protection. Second, reduce the losses 
that failing firms can impose on other firms or markets, which helps 
reduce spillovers. Third, alter payments systems to reduce their 
transmission of losses suffered by one firm to others.
    Policymakers cannot eliminate spillovers entirely, nor can they 
credibly commit to never providing protection to creditors of 
systemically important firms. But they can make significant progress in 
reducing the probability of providing protection, reducing the number 
of creditors who might receive protection, and reducing the amount of 
coverage that creditors receive. These are all valuable results.
    I will now provide several specific examples of approaches to deal 
with spillovers.
Examples of Reforms That Credibly Address TBTF by Taking on Spillovers
    To take on spillovers, I recommend starting with SFS, a combination 
of reforms that would identify and better manage spillovers, reduce 
losses from the failure of systemically important financial 
institutions, and alter uninsured creditor expectations so that they 
better price risk-taking. To provide a sense for additional reforms I 
have endorsed, I will provide two other examples of reforms you might 
consider beyond SFS. Others have begun endorsing reforms of this type, 
which indicates that attacking spillovers is not considered impossible.
Systemic Focused Supervision. 
    This approach to addressing spillovers has three components.
    Engage in Early Identification. I would focus financial institution 
oversight, defined broadly, on identifying potential spillovers both in 
general and for specific firms, and offering recommendations to 
mitigate them. To my mind, this is conceptually similar to the 
macroprudential or systemic-risk supervision others have supported. I 
would concentrate such efforts, which would require significant input 
from bank supervisors and others, on carefully mapping out the 
exposures that systemically important firms have with each other and 
other basic sources of spillovers. Once the responsible supervisory 
entity documents where and how spillovers might arise, it would take 
the lead in offering recommendations to address them. This effort 
either would assure policymakers that a perceived spillover did not in 
fact pose a significant threat or would direct resources to fix the 
vulnerability and generate such comfort.
    Lest such an exercise sound like it would be unproductive, I 
believe that fairly simple failure simulation exercises over the years 
confirmed the potential spillovers, created by the overseas and 
derivative operations of some large financial firms, that now bedevil 
us. I would also note that macroprudential supervision can and should 
put some of the burden of early identification on the systemically 
important firms themselves by, for example, requiring them to prepare 
for and explain the challenges of entering what would amount to a 
prepackaged bankruptcy.\4\
---------------------------------------------------------------------------
    \4\ Raghuram Rajan made a similar recommendation in ``The Credit 
Crisis and Cycle Proof Regulation,'' the Homer Jones Lecture at the 
Federal Reserve Bank of St. Louis, April 15, 2009.
---------------------------------------------------------------------------
    Enhanced Prompt Corrective Action (PCA).  To focus supervisors on 
closing weak institutions early, which reduces the losses they can 
impose on others, I recommend incorporating market signals of firm risk 
into the current PCA regime. The incorporation would require care. 
Market signals contain noise, but such signals also offer forward-
looking measures of firm specific-risk with valuable information for 
bank and other supervisors.
    Improve Communication. The goals here are to establish the 
credibility of efforts to put creditors at risk of loss and to give 
creditors the opportunity to alter their behavior. As a result, I 
recommend that supervisory and other stability-focused agencies clearly 
communicate the steps in process to avoid full protection. Simply put, 
creditors cannot read minds and will not alter their expectations and 
behavior unless they understand the policy changes under way.
    SFS is not the only approach to addressing spillovers. Let me 
highlight two other reforms by way of example.
    Develop Capital Instruments to Absorb Losses When Problems Arise. 
Requiring firms to hold substantially more capital offers a path to 
absorb losses before they spill over and directly affect other firms. 
But having to raise expensive capital can either encourage firms to 
avoid socially beneficial lending or to take on more risk to generate 
targeted returns. I urge policymakers to examine capital tools that 
effectively create capital when firms need it most, which reduces their 
cost and avoids fueling downcycles.\5\
---------------------------------------------------------------------------
    \5\ We discuss such a recommendation, based on work by Mark 
Flannery, briefly on page 128 of the TBTF book. For a more current 
discussion of this idea, along with other proposals to address TBTF, 
see the analysis carried out by the Squam Lake Working Group on 
Financial Regulation at http://www.cfr.org/thinktank/greenberg/
squamlakepapers.html.
---------------------------------------------------------------------------
    Price for Spillover Creation. A direct way to discourage the types 
of activities that generate spillovers is to put a price on them 
because, after all, spillovers impose costs on all of us. Using the 
early-identification approach noted above to identify the major causes 
of spillovers would offer a first step. The actual pricing of such 
activities could occur via something like an insurance premium. The 
FDIC already has made important progress in creating such an approach 
for large banks, although the price it charges is capped at a low level 
at this time.
    I now turn to reforms to address TBTF where I am concerned 
policymakers may be asking too much.
Do Not Rely Too Heavily on Traditional Supervision and Regulation 
        (S&R), Resolution Regimes, or Downsizing
    Based on direct observation, I am not convinced that supervisors 
can consistently and effectively prevent excessive risk-taking by the 
large firms they oversee in a timely fashion, absent draconian measures 
that tend to throw out the good with the bad. For this reason, I am not 
confident that traditional S&R can reduce risk sufficiently such that 
it addresses the problems associated with TBTF status.\6\ While 
policymakers should improve S&R by incorporating the lessons learned 
over the last two years, it cannot be the bulwark in addressing TBTF.
---------------------------------------------------------------------------
    \6\ For a fuller discussion, see Appendix C of the TBTF book.
---------------------------------------------------------------------------
    I do see clear benefits in increasing the scope of bank-like 
resolution systems to entities such as bank holding companies. Such 
regimes would facilitate imposition of losses on equity holders, allow 
for the abrogation of certain contracts, and provide a framework for 
operating an insolvent firm. These steps address some spillovers and 
increase market discipline. But I have long argued that the resolution 
regime created by FDICIA would not, by itself, effectively limit after-
the-fact protection for creditors of systemically important banks.\7\ 
Events over the last two years have largely reinforced those concerns. 
A bank-like resolution regime for nonbanks, which creates a systemic-
risk exception, leaves some potential spillovers remaining, and so it 
is a necessary but not sufficient reform to address TBTF.
---------------------------------------------------------------------------
    \7\ For a fuller discussion of limitations of the FDICIA resolution 
process, see Appendix A of the TBTF book.
---------------------------------------------------------------------------
    Finally, there has been increased discussion of efforts to address 
TBTF by making the largest financial firms smaller. My concerns here 
are practical and do not reflect any particular empathy for managers or 
equity holders of large firms. In short, I think efforts to break up 
the firms would result in a focus on a very small number of 
institutions, thereby leaving many systemically important firms as is. 
Moreover, I am skeptical, for the reasons noted above, that 
policymakers will effectively prevent the newly constituted (smaller) 
firms from taking on risks that can bring down others.
Conclusion
    Maintaining the status quo with regard to TBTF could well impose 
large costs on the U.S. economy. We cannot afford such costs. I 
encourage you to focus on proposals that address the underlying reason 
for protection of creditors of TBTF financial institutions, which is 
concern for financial spillovers. I have offered examples of such 
reforms. Absent these or similar reforms, I am skeptical that we will 
make significant progress against TBTF.
    Addressing TBTF by Shrinking Financial Institutions: An Initial 
                               Assessment
                         The Region,  June 2009
By Gary H. Stern President Federal Reserve Bank of Minneapolis and Ron 
   Feldman Senior Vice President Supervision, Regulation and Credit 
                  Federal Reserve Bank of Minneapolis
    ``If financial institutions raise systemic concerns because of 
their size, fix the TBTF problem by making the firms smaller.'' A 
number of prominent observers have adopted this general logic and 
policy recommendation.\1\ While we're sympathetic to the intent of this 
proposal, we have serious reservations about its likely effectiveness 
and associated costs. Our preferred approach to addressing the ``too-
big-to-fail'' problem continues to be better management of financial 
spillovers.\2\
---------------------------------------------------------------------------
    \1\ Examples include Robert Reich in an Oct. 21, 2008, blog post 
(``If they're too big to fail, they're too big period''), George Shultz 
in the Aug. 14, 2008, Wall Street Journal (``If they are too big to 
fail, make them smaller''), Gerald O'Driscoll in the Feb. 23, 2009, 
Wall Street Journal (``If a bank is too big to fail, then it is simply 
too big''), Meredith Whitney in a Feb. 19, 2009, CNBC interview 
(reported to advocate ``disaggregating'' market share of largest banks) 
and Simon Johnson in a Feb. 19, 2009, blog post (``Above all, we need 
to encourage or, most likely, force the large insolvent banks to break 
up'').
    \2\ The Minneapolis Fed Web site (minneapolisfed.org/
publications_papers/studies/tbtf/index.cfm) provides access to our 
fairly extensive prior writing on TBTF.
---------------------------------------------------------------------------
    In this essay, we review our concerns about this ``make-them-
smaller'' reform. We also recommend several interim steps to address 
TBTF that share some similarities with the make-them-smaller approach 
but do not have the same failings. Specifically, we support (1) 
imposing special deposit insurance assessments for TBTF banks to allow 
for spillover-related costs, (2) retaining the national deposit cap on 
bank mergers and (3) modifying the merger review process for large 
banks to provide better focus on reduction of systemic risk. If our 
suggested reforms prove less effective than we believe, policymakers 
will have to take the make-them-smaller approach seriously.
The reform
    While its proponents have not provided details, this reform-if 
taken literally-seems straightforward. Policymakers would demark some 
firms as TBTF through the use of a specific measure, such as share of a 
given market(s), asset size or revenue. Policymakers would then force 
those firms to (1) shrink their balance sheets organically (that is, 
not replacing loans or securities after repayment), (2) divest certain 
operations or assets and/or (3) split them into smaller constituent 
parts such that the resulting firms fall below a specified threshold. 
(We distinguish such measures from short-term efforts to wind down the 
operations of a targeted, insolvent financial institution to position 
it for resolution, a reform we support.)
Rationale for reform
    On its surface, the proposal has two attractive features, both 
related to simplicity. First, size seems to offer an easily measured 
and verifiable means of identifying financial institutions whose 
financial or operational failure would raise systemic concern. After 
all, firms that are frequently identified as posing TBTF concerns are 
large in some important, obvious way.
    Second, implementing this reform appears to be fairly 
straightforward. The government could simply order across-the-board 
shrinkage of balance sheets for certain firms. Since many larger 
financial institutions came about through mergers of smaller 
institutions, and because the popularity among corporate leaders of 
creating and then destroying conglomerates tends to wax and wane, a 
simple ``unbundling'' would merely return the financial world to a 
period when the TBTF problem did not loom as large.
    A third rationale for the reform appears rooted in desperation. 
Recent events suggest profound failure in the supervision and 
regulation of large and complex financial institutions. Likewise, a 
number of observers have long seen the TBTF problem as intractable 
because policymakers will always face compelling incentives to support 
creditors at the time systemically important firms get into trouble. 
Society therefore appears to have no way to impose meaningful restraint 
on large or complex financial institutions. An option that makes firms 
neither large nor complex may appear to offer the only real means of 
imposing either market or supervisory discipline.
The reform's weaknesses
    Shrinking firms so they don't pose systemic concern faces static 
and dynamic challenges that seem to seriously limit its effectiveness 
as a potential reform.
    The static challenge involves the initial metric used to identify 
firms that need to be made smaller. Given the severity of the 
punishment (that is, breakup), policymakers will have to use a simple 
standard they can make public and defend from legal challenge. They 
might consider using, for example, the current limit on bank size that 
can be achieved via merger: 10 percent of nationwide deposits. 
Importantly, we assume (and again, because of the high-stakes nature of 
the reform) that policymakers would make only a few firms subject to 
forced contraction. This ``high bar'' raises the stakes in getting the 
``right'' firms cut down to size.
    But such a metric will not likely capture some or perhaps many 
firms that pose systemic risk. Some firms that pose systemic risk are 
very large as measured by asset size, but others--Northern Rock and 
Bear Stearns, for example--are not. Other small firms that perform 
critical payment processing pose significant systemic risk, but would 
not be identified with a simple size metric. We believe that a 
government or public agent with substantial private information could 
identify firms likely to impose systemic risk, but only by looking 
across many metrics and making judgment calls. Policymakers cannot 
easily capture such underlying analytics in a simple metric used to 
break up the firms. The dynamic challenge concerns both the ability of 
government to keep firms below the size threshold over time and the 
future decisions of firms that could increase the systemic risk they 
pose.
    On the first point, we anticipate that policymakers would face 
tremendous pressure to allow firms to grow large again after their 
initial breakup. The pressure might come because of the limited ability 
to resolve relatively large financial institution failures without 
selling their assets to other relatively large financial firms and 
thereby enlarging the latter. We would also anticipate firms' 
stakeholders, who could gain from bailouts due to TBTF status, putting 
substantial pressure on government toward reconstitution. These 
stakeholders will likely point to the economic benefits of larger size, 
and those arguments have some heft. Academic research has typically 
found economies of scale exhausted before banks reach the size of the 
largest banking organizations, although some recent analysis suggests 
such economies may exist at these large sizes as well.\3\ (Indeed, 
policymakers will have to consider the loss of scale benefits when they 
determine the net benefits of breaking up firms in the first place.)
---------------------------------------------------------------------------
    \3\ For literature that did not find economies of scale for large 
banks, see Allen N. Berger, Rebecca Demsetz, and Philip E. Strahan, 
1999, ``The Consolidation of the Financial Services Industry: Causes, 
Consequences, and Implications for the Future,'' Journal of Banking and 
Finance 23 (2-4), pp. 35-94; and Group of Ten, 2001, ``Report of 
Consolidation in the Financial Sector,'' p. 253. For summaries of more 
current research finding economies of scale for larger institutions, 
see Joseph P. Hughes and Loretta J. Mester, 2008, ``Efficiency in 
Banking: Theory, Practice and Evidence,'' Chap. 18 in Oxford Handbook 
of Banking, Oxford University Press. See also Loretta J. Mester, 2008, 
``Optimal Industrial Structure in Banking,'' in Section 3 of Handbook 
of Financial Intermediation and Banking, Elsevier.
---------------------------------------------------------------------------
    Prominent examples suggest our concern about reconsolidation is not 
theoretical. Consider the breakup of the original AT&T and the 
subsequent mergers among telecommunication firms. Scholars have also 
highlighted the historical difficulty in limiting the long-run market 
share of powerful financial firms, including those found in the 
``zaibatsus'' of Japan.\4\
---------------------------------------------------------------------------
    \4\ See Raghuram G. Rajan and Luigi Zingales, 2003, ``The Great 
Reversals: The Politics of Financial Development in the Twentieth 
Century,'' Journal of Financial Economics 69, July, pp. 5-50.
---------------------------------------------------------------------------
    Even if policymakers could get the initial list of firms right and 
were able to keep the post-breakup firms small, this reform does 
nothing to prevent firms from engaging in behavior in the future that 
increases potential for spillovers and systemic risk. Newly shrunken 
firms could, for example, shift their portfolios to assets that suffer 
catastrophic losses when economic conditions fall off dramatically. As 
a result, creditors (including other financial firms) of the ``small'' 
firms could suffer significant enough losses to raise questions about 
their own solvency precisely when policymakers are worried about the 
state of the economy. Moreover, funding markets might question the 
solvency of other financial firms as a result of such an implosion. 
Such spillovers prompted after-the-fact protection of financial 
institution creditors in the current crisis, and we believe they would 
do so again, all else equal. One might call on supervision and 
regulation to address such high-risk bets. But the rationale for the 
make-them-smaller reform seems dubious in the first place if such 
oversight were thought to work.
     These dynamics of firm risk-taking mean that the make-them-smaller 
reform offers protection with a Maginot line flavor. That is, it 
appears sensible and effective-even impregnable-but in fact it provides 
only a false sense of security that may lull policymakers into inaction 
on other fronts. In our experience, policymakers would likely view this 
reform as a substitute for other desirable actions, including some of 
the key reforms we think necessary to address spillovers. In the past, 
policymakers have thought-mistakenly-that the strong condition of 
banks, the FDICIA resolution regime or initiatives around new capital 
rules all provided rationales for not addressing the underlying sources 
of spillovers and the TBTF problem. If we exclusively embrace a reform 
that misleadingly promises victory over TBTF by constraining the size 
of large financial firms, we may squander the time and resources needed 
to address the problem at its roots.
Interim steps
    While we would not move forward with a plan to make large financial 
firms smaller, we take seriously its intent to put uninsured creditors 
at risk of loss and to address concerns over size, spillovers and 
government support. In that vein, we recommend three interim steps that 
address concerns that might lead to support for the make-them-smaller 
option. They are (1) modify the FDIC insurance premium to better allow 
for spillover-related charges, (2) maintain the current national 
deposit cap on bank mergers and (3) modify the merger review process 
for bank holding companies to focus on systemic risk. We conclude this 
section with a brief discussion on when the make-them-smaller option 
might make sense.

    Expand FDIC insurance premiums

      First, we recommend expanding the ability of the FDIC to charge 
banks (through the deposit insurance premium it levies) for activities 
that increase potential for spillovers.\5\ The presence of spillovers 
makes it more likely that policymakers will resolve bank failures in a 
manner outside of the FDIC's mandated ``least-cost'' resolution, 
because those spillovers impose broader costs on society. Premiums 
offer an established mechanism by which society can force banks to 
internalize potential costs.\6\
---------------------------------------------------------------------------
    \5\ More generally, George Pennacchi argues that premiums for banks 
should incorporate a ``systematic risk'' factor to account for links 
between a bank's specific condition and overall economic conditions. 
See George G. Pennacchi, 2009, ``Deposit Insurance,'' paper for AEI 
Conference on Private Markets and Public Insurance Programs, January.
    \6\ Some observers have outlined a broader reform along the same 
lines that would charge all systemically important financial firms an 
assessment. We focus on banks in the short term because the 
infrastructure for such charges already exists; charging other 
systemically important financial firms should have similar benefits. 
For a discussion of the broader change, see Viral Acharya, Lasse 
Pedersen, Thomas Philippon and Matthew Richardson, 2008, ``Regulating 
Systemic Risk,'' Chap. 13 in Restoring Financial Stability: How to 
Repair a Failed System, Wiley.
---------------------------------------------------------------------------
        We use the term ``expand'' in referring to the FDIC's ability 
to charge banks, because the FDIC has already created an infrastructure 
to facilitate spillover-related charges. In particular, the current 
premium structure allows under certain conditions for a ``large bank 
[premium] adjustment.'' The FDIC offers several rationales for the 
adjustment, including the need ``to ensure that assessment rates take 
into account all available information that is relevant to the FDIC's 
risk-based assessment decision.''\7\
---------------------------------------------------------------------------
    \7\ See Federal Register, Oct. 16, 2008, p. 61568.
---------------------------------------------------------------------------
    The FDIC lists the types of information it would consider in 
setting the adjustment, and several of them provide reasonable proxies 
for potential spillovers. For example, the FDIC would review (1) 
potential for ``ring fencing'' of foreign assets (which would limit the 
FDIC's ability to seize and sell those assets to pay off insured 
depositors, for example), (2) availability of information on so-called 
qualified financial contracts (which include a wide range of 
derivatives) and (3) FDIC ability to take over key operations without 
paying extraordinary costs.\8\ We might propose that the FDIC include 
other proxies of systemic risk, including measures of organizational 
complexity (such as number and type of legal entities) and a 
supervisory ``score'' of each bank's contingency plan for winding down 
operations while minimizing spillovers.
---------------------------------------------------------------------------
    \8\ See Federal Register, May 14, 2007, p. 27125.
---------------------------------------------------------------------------
    The FDIC apparently believes it can price spillover risk without 
having to rely on size per se (although it limits this assessment 
adjustment to large institutions). Not having to rely on size of 
financial institutions seems desirable, as it more directly targets 
activities causing spillovers. And imposing a price on these activities 
would discourage them, which is the point.
    However, the FDIC has limited its ability to fully incorporate such 
spillover-related factors into its premium. It can, for example, only 
adjust large bank premiums by 100 basis points or less (recently 
increased from 50 basis points).\9\ We recommend that the FDIC remove 
such artificial restrictions so that it can fully price the potential 
costs of spillovers.
---------------------------------------------------------------------------
    \9\ See Federal Register, March 4, 2009, p. 9525.

---------------------------------------------------------------------------
    Keep the cap

      Second, we recommend retaining the current national deposit cap. 
In general terms, Congress forbids authorities from approving mergers 
or acquisitions if it would result in the acquiring bank holding more 
than 10 percent of U.S. bank deposits. This cap, which applies to M&As 
across state lines, was put in place by the Riegle-Neal Banking Act of 
1994. Note that a bank can exceed the national cap if its deposit 
growth comes from a non-M&A source (that is, so-called organic growth).
    Why keep the cap at the current level? We see some serious 
downsides to lowering the cap as a way of addressing TBTF. A lower cap 
could cause the bank to increase its funding from nondeposit sources, 
which, all else equal, could increase its susceptibility to a run. Or a 
firm could meet the target by jettisoning its retail banking operations 
and increase its securities, payments or wholesale operations. This 
outcome, too, would seem to increase systemic risk.
    Lowering the cap effectively taxes deposits, thereby directing 
energies at the wrong target. While this argument might suggest 
abolishing or increasing the cap, we would keep it at its current level 
at least for the foreseeable future because its costs do not seem 
large. In particular, the cap has not prevented the creation of 
extremely large and diversified financial institutions through mergers. 
Thus, we doubt it has had significant scale or scope costs.
    Moreover, we think the cap offers some benefits. It provides a 
binding limit on size growth that may offer a marginal contribution to 
managing TBTF. The cap may also have the salutary effect of keeping 
policymakers' attention on the TBTF issue over time. Because the costs 
of keeping the cap seem quite low, we feel comfortable with our 
recommendation, even though the benefits seem low as well.

    Reform the merger review process

      Third, we recommend implementing a reform to the merger reviews 
that the Federal Reserve conducts for large bank holding companies. In 
2005, we proposed that ``for mergers between two of the nation's 50 
largest banks, the Federal Reserve, the Federal Deposit Insurance 
Corporation (FDIC) and the U.S. Treasury should report publicly on 
their respective efforts to address and manage potential TBTF 
concerns.''\10\ Such a requirement, which needn't be restricted to the 
50 largest banks if policymakers favor another cutoff, would highlight 
the key policy issues raised by the merger itself and provide a 
communication focus for spillover-reduction efforts. We could envision 
this as an interim approach if spillover reduction does not prove 
possible to achieve. The Federal Reserve may find it appropriate over 
time to support changes to the statutes governing merger reviews to 
allow for explicit consideration of potential spillover costs created 
or made worse by the merger.\11\
---------------------------------------------------------------------------
    \10\ See Gary H. Stern and Ron J. Feldman, 2005, ``Addressing TBTF 
When Banks Merge: A Proposal,'' The Region, September, Federal Reserve 
Bank of Minneapolis.
    \11\ For discussions of how policymakers should or should not 
consider TBTF in the antitrust review process, see statements by 
Deborah A. Garza and Albert A. Foer before the House Judiciary 
Committee, Subcommittee on Courts and Competition Policy, March 17, 
2009.
---------------------------------------------------------------------------
    We have confidence in our preferred approach of tackling spillovers 
directly by putting TBTF creditors at credible risk of loss. But others 
with equally strong convictions have been proven wrong when it comes to 
financial instability, and we could be wrong as well. In that case, we 
must go with an alternative, and the proposed reform to make firms 
smaller may offer the only promising choice.
    Moreover, we view addressing spillovers as the primary motivation 
for providing after-the-fact protection to uninsured creditors. To the 
degree that other motivations drive provision of such protection in the 
United States (for example, to reward ``cronies'' of elected officials 
or other entrenched interests), our reforms may not adequately address 
the TBTF problem, and other reforms might. That said, we continue to 
strongly believe that spillovers are the salient motivation that 
policymakers must address to fix TBTF (and our prior writings comment 
extensively on why we do not think other motivations have equal 
weight).
Conclusion
    There is no easy solution to TBTF. Our longstanding proposal to put 
creditors at risk of loss by managing spillovers will prove challenging 
to implement effectively. Cutting firms down to size may seem easy by 
comparison. It is not. The high stakes of making firms smaller will 
make it difficult to determine which to shrink, and even then, the 
government will not have an easy time managing risk-taking by newly 
shrunken firms. We do take the aims of the make-them-smaller reform 
seriously and in that vein suggest options in this regard that we think 
would be more effective, including a spillover-related tax built on the 
FDIC's current deposit insurance premiums.
           Better Late Than Never: Addressing Too-Big-To-Fail
 Remarks presented at the Brookings Institution, Washington, DC, March 
                                31, 2009
    By Gary H. Stern, President, Federal Reserve Bank of Minneapolis
    Destiny did not require society to bear the cost of the current 
financial crisis. To at least some extent, the outcome reflects 
decisions, implicit or explicit, to ignore warnings of the large and 
growing ``too-big-to-fail'' problem and a failure to prepare for and 
address potential spillovers. While I am, as usual, speaking only for 
myself, there is now I think broad agreement that policymakers vastly 
underestimated the scale and scope of ``too big to fail'' and that 
addressing it should be among our highest priorities.
    From a personal point of view, this recent consensus is both 
gratifying and disturbing. Gratifying because many initially dismissed 
our book,\1\ published five years ago by Brookings, as exaggerating the 
TBTF problem and underestimating the value of FDICIA in strengthening 
bank supervision and regulation. In turn, I would point out that we 
identified:
---------------------------------------------------------------------------
    \1\ See Gary H. Stern and Ron J. Feldman, 2004, Too Big to Fail: 
The Hazards of Bank Bailouts, Washington, D.C.: Brookings Institution.

    virtually all key facets of the growing TBTF problem, 
        including the role that increased concentration and increased 
        organizational and product complexity, as well as increased 
        reliance on short-term funding, played in creating the current 
---------------------------------------------------------------------------
        TBTF mess; and

    important reforms which, if taken seriously, could have 
        reduced the risk-taking that produced the crisis.

    But belated recognition of the severity of ``too big to fail'' is 
also disturbing because it implies that inaction raised the costs of 
the current financial crisis, as our analyses and prescriptions went 
unheeded. Despite our warnings, important institutions, public and 
private alike, were unprepared. And I am quite concerned that 
policymakers may double-down on previous decisions; some ideas 
presented in the current environment to address TBTF are unlikely to be 
effective and, if pursued, will waste valuable time and resources.
    In the balance of these remarks, I will principally cover three 
subjects: (1) the nature of the current TBTF problem; (2) policies 
essential to addressing the problem effectively; (3) policies that, 
although well intentioned, are unlikely to make a material difference 
to TBTF at the end of the day.
The current TBTF problem
    As matters stand today, the risk-taking of large, complex financial 
institutions is not constrained effectively by supervision and 
regulation nor by the marketplace. If this situation goes uncorrected, 
the result will almost surely be inefficient marshaling and allocation 
of financial resources, serious episodes of financial instability and 
lower standards of living than otherwise. Certainly, we should seek to 
improve and strengthen supervision and regulation where we can, but 
supervision and regulation is not a credible check on the risk-taking 
of these firms. I will go into this issue in more detail later and will 
simply note at this point that the recent track record in this area 
fails to inspire confidence. Similarly, market discipline is not now a 
credible check on the risk-taking of these firms; indeed, a critical 
plank of current policy is to assure creditors of TBTF institutions 
that they will not bear losses. Given the magnitude of the crisis, I 
have supported the steps taken to stabilize the financial system by 
extending the safety net, but I am also acutely sensitive to the moral-
hazard costs of these steps and have no illusion that losses 
experienced by equity holders and management will somehow resurrect 
market discipline.
    How did we arrive at such a bleak point in terms of TBTF? Let me 
make just two observations. First, the crisis was made worse, in my 
view significantly worse, by the lack of preparation I mentioned above. 
To provide some examples, policymakers did not create and/or execute 
(1) an effective communication strategy regarding government intentions 
for uninsured creditors of firms perceived as TBTF; (2) a program to 
systematically identify the interconnections between these large firms; 
and (3) systems aimed at reducing the losses that these large firms 
could impose on other firms. I raise these examples, not surprisingly, 
because we identified these steps as critical to addressing TBTF in the 
book and related analysis.\2\
---------------------------------------------------------------------------
    \2\ See Gary H. Stern, 2008, ``Too Big to Fail: The Way Forward,'' 
Nov.13, 2008.
---------------------------------------------------------------------------
    Second, addressing the TBTF problem earlier could have avoided some 
of the risk-taking underlying the current crisis. To be sure, many 
small institutions have failed as a result of the crisis in housing 
finance but, nevertheless, the bulk of the losses seem concentrated in 
the largest financial institutions. And creditors of these large firms 
likely expected material support, thereby facilitating excessive risk-
taking by such institutions. Policymakers should correct problems at 
credit-rating agencies with off-balance-sheet financing, mortgage 
disclosures and the like. But if, fundamentally, TBTF induces too much 
risk-taking, then these firms will continue to find routes to engage in 
it, other things equal.
Addressing sources of spillovers
    I have spoken and written about TBTF concerns and policy proposals 
with sufficient frequency that some observers characterize my views on 
the topic as ``boilerplate,'' a backhanded compliment I presume. 
Nonetheless, it suggests I only judiciously review the key points of 
the reforms we have long endorsed. The logic for our approach is clear.
    In order to reduce expectations of bailouts and reestablish market 
discipline, policymakers must convince uninsured creditors that they 
will bear losses when their financial institution gets into trouble. A 
credible commitment to impose losses must be built on reforms directly 
reducing the incentives that lead policymakers to bail out, that is 
provide significant protection for uninsured creditors. The dominant 
motivation for bailouts is to prevent the problems in a bank or market 
from threatening other banks, the financial sector and overall economic 
performance. That is, policymakers intervene because of concerns about 
the magnitude and consequences of spillovers.
    Thus, the key to addressing TBTF is to reduce the potential size 
and scope of the spillovers, so that policymakers can be confident that 
intervention is unnecessary.What specifically should policymakers do to 
achieve this outcome? To answer this question we have taken reforms 
proposed in the book and combined them in a program we call systemic 
focused supervision (SFS), which we have discussed in detail elsewhere. 
In general, SFS, unlike conventional bank supervision and regulation, 
focuses on reduction of spillovers; it consists of three pillars: early 
identification, enhanced prompt corrective action (PCA) and stability-
related communication.
    Early identification. As we have described in detail elsewhere, 
early identification is a process to identify and to respond, where 
appropriate, to the material direct and indirect exposures among large 
financial institutions and between those institutions and capital 
markets.We anticipate valuable progress simply by having central banks 
and other relevant supervisory agencies focus resources on, and take 
seriously, the results of failure simulation exercises, for example. 
Indeed, such exercises appear to have identified the precise type of 
issues-around derivative contracts, resolution regimes and overseas 
operations-that have plagued policymakers' ability to adequately 
address specific TBTF cases.\3\
---------------------------------------------------------------------------
    \3\ For a discussion of preparing for large bank failure, see 
Shelia Bair, 2007, ``Remarks,'' March 21, and Shelia Bair, 2008, 
``Remarks,'' June 18.
---------------------------------------------------------------------------
    In fact, it appears that the policy failure was not primarily in 
identification of potential spillovers, but rather in making corrective 
action a sufficiently high priority. One constructive option related to 
early identification would require the relevant TBTF firms to prepare 
documentation of their ability to enter the functional equivalent of 
``prepackaged bankruptcy.''\4\ The appropriate regulatory agencies 
should require TBTF firms to identify current limitations of the 
resolution regime they face and the spillovers that might occur if 
their major counterparties entered such proceedings.
---------------------------------------------------------------------------
    \4\ For a similar suggestion, see page 62 of Markus Brunnermeier, 
Andrew Crockett, Charles Goodhart, Avinash D. Persaud, and Hyun Shin, 
2009, ``The Fundamental Principles of Financial Regulation.''
---------------------------------------------------------------------------
    Without doubt, implementing early identification will prove 
challenging. That said, recommendations from other knowledgeable 
observers suggest that the task is possible and worthwhile. The G-30 
recommendations, for example, would have firms continuously monitor and 
report on the full range of their counterparty exposures, in addition 
to reviewing their vulnerability to a host of potential risks, many 
related to spillovers.\5\ These reports are precisely the key 
supervisory inputs to early identification.
---------------------------------------------------------------------------
    \5\ See Group of Thirty, 2009, ``Financial Reform: A Framework for 
Financial Stability,'' p. 41.
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    One might reasonably wonder about a plan that seems to give center 
stage to supervisors, when I earlier noted reservations about 
supervision and regulation? I would point out, however, that here we 
are emphasizing a role for supervision where it in fact has a 
comparative advantage. In particular, we would focus supervision on 
collection of private information on financial institutions, looking 
across institutions, and worrying about fallout that potentially 
affects the public, rather than asking supervisors to try to tune risk-
taking to its optimal level. Other entities have neither the incentive 
nor the access to carry out the role we envision for supervision.
    Enhanced prompt corrective action. PCA works by requiring 
supervisors to take specified actions against a bank as its capital 
falls below specified triggers. One of its principal virtues is that it 
relies upon rules rather than supervisory discretion. Closing banks 
while they still have positive capital, or at most a small loss, can 
reduce spillovers in a fairly direct way. If a bank's failure does not 
impose large losses, by definition it cannot directly threaten the 
viability of other depository institutions that have exposure to it. 
Thus, a PCA regime offers an important tool to manage systemic risk. 
However, the regime currently uses triggers that do not adequately 
account for future losses and give too much discretion to bank 
management.We would augment the triggers with more forward-looking 
data, outside the control of bank management, to address these 
concerns.
    Communication. The first two pillars of SFS seek to increase market 
discipline by reducing the motivation policymakers have for protecting 
creditors. But creditors will not know about efforts to limit 
spillovers, and therefore will not change their expectations of support 
and in turn, their pricing and exposures, absent explicit communication 
by policymakers about these efforts. This recommendation highlights a 
key distinction between our approach and that advocated by others: Our 
approach does not simply seek to limit systemic risk, but takes the 
next step of directly trying to address TBTF by putting creditors at 
risk of loss. If we do not do this, we will not limit TBTF.
    Now let me turn to some alternative reforms that have received 
significant attention recently.
Reducing the size of (TBTF) financial institutions
    This proposal is straightforward: If financial institutions raise 
systemic concerns because of their size, make them smaller.We intend to 
discuss this suggestion at some length in a separate document, but 
suffice it to say that we have serious reservations about the ultimate 
effectiveness of such an approach. And I would note, in passing, that 
it is an idea born of desperation since it seems to admit that large, 
complex organizations cannot be supervised effectively.
    To provide a flavor for our concerns about this proposal, consider 
the government's ability to keep the firms ``small'' after dismantling 
has occurred. There might, for example, be tremendous pressure in the 
direction of expansion if, in the future, the smooth resolution of the 
failure of a major institution required the sale of assets to other 
significant institutions. Even if this situation can be avoided, these 
firms could still engage in behavior that increases the risk of 
significant spillovers. They could do so, for example, by shifting 
their portfolios to assets that suffer catastrophic losses only when 
economic conditions deteriorate dramatically, thus making themselves 
and the financial system vulnerable to cyclical outcomes.
Reliance on supervision and regulation and/or FDICIA
    The two broad approaches discussed to this point seek both 
increased market and supervisory discipline to better constrain the 
risk-taking of large financial institutions. But some observers do not 
believe that policymakers can credibly put creditors of these firms at 
risk of loss. And some analysts do not believe that creditors can 
effectively discipline these oft-sprawling firms even if they had an 
incentive to do so. As a result, some proposals to better limit the 
risk-taking of firms perceived TBTF focus primarily on strengthening 
conventional supervisory and regulatory discipline.
    Policymakers could pursue this approach in many ways. After 
identifying TBTF firms, a more rigorous supervisory and regulatory 
regime would be applied to them. The tougher approach might include, 
for example, (a) higher capital requirements, (b) requirements that the 
firms maintain higher levels of liquid assets, (c) additional 
restrictions on the activities in which the firms engage, and (d) a 
much larger presence of on-site supervisors monitoring compliance with 
these dictates.
    My concerns about this approach, and they are considerable, center 
on the heavy reliance on supervision and regulation but are not a 
wholesale rejection of S/R per se. Given the distortion to incentives 
caused by the explicit safety net underpinning banking, society cannot 
rely exclusively on market forces to provide the appropriate level of 
discipline to banks.We must have a system of supervision and regulation 
to compensate. And naturally we should learn from recent events to 
improve that system, a process under way.\6\
---------------------------------------------------------------------------
    \6\ For a discussion of improvement efforts under way for both the 
banking industry and bank supervisors, see Roger T. Cole, 2009, Risk 
Management in the Banking Industry, before the Subcommittee on 
Securities, Insurance, and Investment, Committee on Banking, Housing, 
and Urban Affairs, U.S. Senate, Washington, D.C., March 18, 2009.
---------------------------------------------------------------------------
    But we must recognize the important limitations of supervision and 
regulation and establish objectives that it can achieve. The owners of 
systemically important financial institutions provide incentives for 
firm management to take on risk, which is the source of the returns to 
equity holders (risk and return go hand in hand). Under a tougher S/R 
regime, these firms have no less incentive than formerly to find ways 
of assuming risk that generates the returns required by markets and 
that does not violate the letter of the restrictions they face. By way 
of example, research on bank capital regimes finds ambiguous results 
regarding their ultimate effect, as firms can offset increased capital 
by taking on more risk.
    And, as I noted earlier, the track record of S/R does not suggest 
it prevents risk-taking that seems excessive ex post. True, long shots 
occasionally come in, and perhaps a regime dependent on conventional S/
R would succeed, but it is NCAA Tournament time, and we know that a 15 
seed rarely beats a number two. To pick just one example from the 
current episode, supervisors have been unable once again to prevent 
excessive lending to commercial real estate ventures, a well-known, 
high-risk, high-return business which contributed importantly to the 
serious banking problems of the late 1980s and early 1990s.
    I recognize that creating a new regulatory framework for a small 
number of very large institutions differs from supervising thousands of 
small banks. But I forecast the same disappointing outcome for two 
reasons. First, we have already applied a version of the suggested 
approach; right now, we have higher standards and more intensive 
supervision for the largest banking firms. Second, the failure of 
supervision and regulation reflects inherent limitations. Supervisors 
operate in a democracy and must follow due process before taking action 
against firms. This means that there is an inevitable lag between 
identification of a problem and its ultimate correction. As previously 
noted, management has ample incentive to find ways around supervisory 
restrictions. Further, the time inconsistency problem frequently makes 
supervisory forbearance look attractive.
    A truly draconian regulatory regime could conceivably succeed in 
diminishing risk-taking but only at excessive cost to credit 
availability and economic performance. As Ken Rogoff, a distinguished 
economist at Harvard who has considerable public policy experience as 
well put it: ``If we rebuild a very statist and inefficient financial 
sector--as I fear we will--it's hard to imagine that growth won't 
suffer for years.''
    Just as we should not rely exclusively, or excessively, on S/R, I 
do not think that imposing an FDICIA-type resolution regime on 
systemically important nonbank financial institutions will correct as 
much of the TBTF problem as some observers anticipate. To be sure, 
society will be better off if policymakers create a resolution 
framework more tailored to large financial institutions, in particular 
one that allows operating the firms outside of a commercial bankruptcy 
regime once they have been deemed insolvent. This regime would take the 
central bank out of rescuing and, as far as the public is concerned, 
``running'' firms like AIG. That is a substantial benefit. And this 
regime does make it easier to impose losses on uninsured creditors if 
policymakers desire that outcome.
    But I am skeptical that this regime will actually lead to greater 
imposition of losses on these creditors in practice. Indeed, we wrote 
our book precisely because we did not think that FDICIA put creditors 
at banks viewed as TBTF at sufficient risk of loss.We thought that when 
push came to shove, policymakers would invoke the systemic risk 
exception and support creditors well beyond what a least-cost test 
would dictate.We thought this outcome would occur because policymakers 
view such support as an effective way to limit spillovers. I don't 
think a new resolution regime will eliminate those spillovers (or at 
least not the preponderance of them), and so I expect that a new regime 
will not, by itself, put an end to the support we have seen over the 
last 20 months.
Conclusion
    I recognize the limits of any proposal to address the TBTF 
problem.We will never avoid entirely the financial crises that lead to 
extraordinary government support. But that is a weak excuse for not 
taking the steps to prepare to make that outcome as remote as we can. 
It is with deep regret for damage done to residents of the Red River 
Valley that I note the return of flood season to the Upper Midwest. 
Many residents have noted that the ``100-year flood'' has come many 
more times to this part of the country than its designation implies. 
And these residents have rightly focused on preparing to limit the 
literal spillovers when this extraordinary event becomes routine. In 
contrast, policymakers did not prepare for the TBTF flood; indeed, they 
situated themselves in the flood plain, ignored the flood warning, and 
hoped for the best.We must now finally give highest priority to 
preparation and take the actions required before the next deluge.
                                 ______

    
                                 
                                 
               PREPARED STATEMENT OF PETER J. WALLISON *
          Arthur F. Burns Fellow in Financial Policy Studies,
                     American Enterprise Institute
                              May 6, 2009
    Chairman Dodd, Ranking member Shelby and members of the Committee:
---------------------------------------------------------------------------
    * The views expressed in this testimony are those of the author 
alone and do not necessarily represent those of the American Enterprise 
Institute.
---------------------------------------------------------------------------
    I am very pleased to have this opportunity to appear before this 
Committee to discuss one of the most important issues currently facing 
our country. The financial crisis will eventually end. The legislation 
that Congress adopts to prevent a similar event in the future is likely 
to be with us for 50 years. The terms ``too big to fail'' and 
``systemically important'' are virtually interchangeable. The reason 
that we might consider some financial institutions ``too big to fail'' 
(TBTF) is that their failure could produce substantial losses or other 
ill effects elsewhere in the economy--a systemic breakdown of some 
kind. Thus, if a firm is systemically important, it is also likely to 
be TBTF.
    Understanding the virtual identity between these two terms is 
essential, because we should not be concerned about business failures 
unless they can have knock-on effects that could involve the whole 
economy or the whole financial system. There is real danger that 
policymakers will confuse efforts to prevent simple business failures 
with efforts to prevent systemic breakdowns. It is to the credit of the 
Obama administration that they have not claimed that the bankruptcy of 
General Motors would cause a systemic breakdown, even though GM's 
failure could cause widespread losses throughout the economy.
    In this testimony, I will discuss the GM case frequently, as a way 
of testing whether we have adequate concepts for determining whether a 
financial firm is TBTF. If GM is not TBTF it raises questions whether 
any nonbank financial firm--no matter how large--is likely to be TBTF. 
The discussion that follows will specifically address the four issues 
that Chairman Dodd outlined in his letter of invitation:

    Whether a new regulatory framework is desirable or feasible 
        to prevent institutions from becoming ``too big to fail'' and 
        posing the risk of systemic harm to the economy and financial 
        system;

    Whether existing financial organizations considered ``too 
        big to fail'' should be broken up;

    What requirements under a new regulatory framework are 
        necessary to prevent or mitigate risks associated with 
        institutions considered ``too big to fail;'' for example, new 
        capital and disclosure requirements, as well as restrictions on 
        size, affiliations, transactions, and leverage; and

    How to improve the current framework for resolving 
        systemically important non-bank financial companies.
Is it desirable or feasible to develop a regulatory framework that will 
        prevent firms from becoming TBTF or posing a risk of systemic 
        harm?
    A regulatory framework that will prevent companies from becoming 
TBTF--or causing systemic breakdowns if they fail--is only desirable or 
feasible if Congress can clearly define what it means by systemic harm 
or TBTF. If Congress cannot describe in operational terms where to draw 
the line between ordinary companies and companies that are TBTF--or if 
it cannot define what it means by ``systemic harm''--it would not be 
good policy to give the power to do so to a regulatory agency. The 
standard, ``I know it when I see it'' may work when a systemic event is 
imminent, but not for empowering a regulatory agency to designate TBTF 
or systemically important firms in advance. If Congress does so, the 
likelihood of severe and adverse unintended consequences is quite high.
    First, if a firm is designated in advance as TBTF (that is, as 
systemically important), it will have competitive advantages over other 
firms in the same industry and other firms with which it competes 
outside its industry. This is true because the TBTF designation confers 
important benefits. The most significant of these is probably a lower 
cost of funding, arising from the market's recognition that the risk of 
loss is significantly smaller in firms that the government will not 
allow to fail than it is in firms that might become bankrupt. Lower 
funding costs will translate inevitably--as it did in the case of 
Fannie Mae and Freddie Mac--into market dominance and consolidation. 
Market sectors in which TBTF firms are designated will come to be 
dominated and controlled by the large TBTF firms, and smaller firms 
will gradually be squeezed out. Ironically, this will also result in 
consolidation of risk in fewer and fewer entities, so that the 
likelihood of big firm collapses becomes greater and each collapse more 
disruptive. In some markets, status as TBTF has another advantage--the 
appearance of greater stability than competitors. In selling insurance, 
for example, firms that are designated as systemically important will 
be able to tell potential customers that they are more likely to 
survive and meet their obligations than firms that have not been so 
designated.
    Accordingly, if there is to be a system of designating certain 
firms as systemically important, it is necessary to be able to state 
with some clarity what standards the agency must use to make that 
decision. Leaving the agency with discretion, without definitive 
standards, would be courting substantial unintended consequences. The 
natural tendency of a regulator would be to confer that designation 
broadly. Not only does this increase the regulator's size and power, 
but it also minimizes the likelihood--embarrassing for the regulator--
that a systemic event will be caused by a firm outside the designated 
circle. Accordingly, the ability of Congress to define what it means by 
a TBTF firm would be important to maintain some degree of competitive 
vigor in markets that would otherwise be threatened by the designation 
of one or more large firms as systemically important and thus TBTF.
    Second, apart from competitive considerations, it is necessary to 
consider the possibility that ordinary business failures might be 
prevented even though they would not have caused a systemic breakdown 
if they occurred. Again, the tendency of regulators in close cases will 
be to exercise whatever power they have to seize and bail out failing 
firms that might be TBTF. The incentives all fall in this direction. If 
a systemic breakdown does occur, the regulator will be blamed for 
failing to recognize the possibility, while if a firm is bailed out 
that would not in fact have caused a systemic breakdown, hardly anyone 
except those who are forced to finance it (a matter to be discussed 
later) will complain. This makes bailouts like AIG much more likely 
unless Congress provides clear guidelines on how a regulator is to 
identify a TBTF or systemically important firm.
    The stakes for our competitive system are quite high in this case, 
because bailouts are not only costly, but they have a serious adverse 
effect on the quality of companies and managements that continue to 
exist. If firms are prevented from failing when they are not TBTF or 
otherwise systemically important, all other firms are weakened. This is 
because our competitive market system improves--and consumers are 
better served--through the ``creative destruction'' that occurs when 
bad managements and bad business models are allowed to fail. When that 
happens, the way is opened for better managements and business models 
to take their place. If failures are prevented when they should not be, 
the growth of the smaller but better managed and more innovative firms 
will be hindered. Overall, the quality and the efficiency of the firms 
in any market where this occurs will decline.
    Finally, setting up a mechanism in which companies that should be 
allowed to fail are rescued from failure will introduce significant 
moral hazard into our financial system. This is true even if the 
shareholders of a rescued firm are wiped out in the process. 
Shareholders are not the group whose views we should be worried about 
when we consider moral hazard. Shareholders, like managements, benefit 
from risk-taking, which often produces high profits as well as high 
rates of failure. The class of investors we should be thinking about 
are creditors, who get no benefits whatever from risk-taking. They are 
the one who are in the best position to exercise market discipline, and 
they do so by demanding higher rates of interest when they see greater 
risk-taking in a potential borrower. To the extent that the wariness of 
creditors is diminished by the sense that a company may be rescued by 
the government, there will be less market discipline by creditors and 
increased moral hazard. The more companies that are added to the list 
of firms that might be rescued, the greater the amount of moral hazard 
that has been introduced to the market. The administration's plan 
clearly provides for possible rescue, since it contemplates either a 
receivership (liquidation) or a conservatorship (generally a way to 
return a company to health and normal operations).
    Accordingly, although it is exceedingly important for Congress to 
be clear about when a company may be designated as TBTF, it will be 
very difficult to do so. This is illustrated by the GM case. GM is one 
of the largest companies in the U.S.; its liquidation, if it occurs, 
could cause a massive loss of jobs not only at GM itself but at all the 
suppliers of tires, steel, fabrics, paints, and glass that go into 
making a car, all the dealers that sell the cars, all the banks that 
finance the dealers, and all the communities, localities, and states 
throughout the U.S. that depend for their revenues on the taxes paid by 
these firms and their employees. In other words, there would be very 
serious knock-on effects from a GM failure. Yet, very few people are 
suggesting that GM is TBTF in the same way that large financial 
institutions are said to be TBTF. What is the difference?
    This question focuses necessary attention on two questions: what it 
means to be TBTF and the adequacy of the bankruptcy system to resolve 
large firm failures. If GM is not TBTF, why not? The widespread losses 
throughout the economy would certainly suggest a systemic effect, but 
if that is not what we mean by a systemic effect, what is it that we 
are attempting to prevent? On the other hand, if that is what we mean 
by a systemic effect, should the government then have the power to 
resolve all large companies--and not just financial firms--outside the 
bankruptcy system? The fact that GM may ultimately go into bankruptcy 
and be reorganized under Chapter 11 suggests that the bankruptcy system 
is adequate for large financial nonbank institutions, unless the 
propensity of nonbank financial institutions to create systemic 
breakdowns can be distinguished from that of operating companies like 
GM. Later in this testimony, I will argue that this distinction cannot 
be sustained.
    The forgoing discussion highlights the difficulty of defining both 
a systemic event and a systemically important or TBTF firm, and also 
the importance of defining both with clarity. Great harm could come 
about if Congress--without establishing any standards--simply 
authorizes a regulatory agency to designate TBTF companies, and 
authorizes the same or another agency to rescue the companies that are 
so designated. My answer, then, to the Committee's first question is 
that--given the great uncertainty about (i) what is a systemic event, 
(ii) how to identify a firm that is TBTF, and (iii) what unintended 
consequences would occur if Congress were not clear about these 
points--it would be neither desirable nor feasible to set up a 
structure that attempts to prevent systemic harm to the economy by 
designating systemically important firms and providing for their 
resolution by a government agency rather than through the normal 
bankruptcy process.
    Nevertheless, it would not be problematic to create a body within 
the executive branch that generally oversees developments in the market 
and has the responsibility of identifying systemic risk, wherever it 
might appear to be developing within the financial sector. The 
appropriate body to do this would be the President's Working Group 
(PWG), which consists of most of the major Federal financial 
supervisors and thus has a built-in market-wide perspective. The PWG 
currently functions under an executive order, but Congress could give 
it a formal charter as a government agency with responsibility for 
spotting systemic risk as well as coordinating all financial regulatory 
activity in the executive branch.
Breaking up systemically significant or TBTF firms
    There could be constitutional objections to a breakup--based on the 
takings and due process--unless there are clear standards that justify 
it. I am not a constitutional lawyer, but a fear that a company might 
create a systemic breakdown if it fails does not seem adequate to take 
the going concern value of a large company away from its shareholders. 
As we know from antitrust law, firms can be broken up if they attempt 
to monopolize and under certain other limited circumstances. But in 
those cases, there are standards for market dominance and for the 
requisite intent to use it in order to create a monopoly--and both are 
subject to rigorous evidentiary standards. As I pointed out above, 
there are no examples that define a systemic risk or why one company 
might cause it and another might not. Accordingly, providing authority 
for a government agency to break up companies that are deemed to be 
systemically risky could be subject to constitutional challenge.
    In addition, as a matter of policy, breaking up large institutions 
would seem to create many more problems than it would solve. First, 
there is the question of breaking up successful companies. If companies 
have grown large because they are successful competitors, it would be 
perverse to penalize them for that, especially when we aren't very sure 
whether they would in fact cause a systemic breakdown if they failed. 
In addition, our economy is made up of large as well as small 
companies. Large companies generally need large financial institutions 
to meet their financing needs. This is true whether we are talking 
about banks, securities firms, insurance companies, finance companies, 
or others. Imagine a large oil company trying to insure itself against 
property or casualty losses with a batch of little insurance companies. 
The rates it would have to pay would be much higher, if it could get 
full coverage at all. Or imagine the same oil company trying to pay its 
employees worldwide without a large U.S. bank with worldwide 
operations, or the same company trying to place hundreds of millions of 
dollars in commercial paper each week through small securities firms 
without a global reach.
    There are also international competitive factors. If other 
countries did not break up their large financial institutions, our 
large operating companies would probably move their business to the 
large foreign financial institutions that could meet their needs.
    Leaving our large operating companies without an alternative source 
of funding could also be problematic, in the event that a portion of 
the financial markets becomes unavailable--either in general or for a 
specific large firm. The market for asset-backed securities closed down 
in the summer of 2007 and hasn't yet reopened. Firms that used to fund 
themselves through this market were then compelled to borrow from banks 
or to use commercial paper or other debt securities. This is one of the 
reasons that the banks have been reluctant to lend to new customers; 
they have been saving their cash for the inevitable withdrawals by 
customers that had been paying over many years for lines of credit that 
they could use when they needed emergency funds. The larger firms might 
not have been able to find sufficient financial resources if the 
largest banks or other financial institutions had been broken up.
    The breakup of large financial firms would create very great risks 
for our economy, with few very benefits, especially when we really have 
no idea whether any particular firm that might be broken up actually 
posed a systemic risk or would have created a systemic breakdown if it 
had failed.
Are there regulatory actions we can take to mitigate or prevent 
        systemic risk caused by TBTF companies?
    For the reasons outlined below, it is my view that only the failure 
of a large commercial bank can create a systemic breakdown, and that 
nonbank financial firms--even large ones--are no more likely than GM to 
have this effect. For that reason, I would not designate any nonbank 
financial institution (other than a commercial bank) as systemically 
important, nor recommend safety and soundness supervision of any 
financial institutions other than those where market discipline has 
been impaired because they are backed by the government, explicitly or 
implicitly.
    The track record of banking regulation is not good. In the last 20 
years we have had two very serious banking crises, including the 
current one, when many banks failed and adversely affected the real 
economy. The amazing thing is that--despite this record of failure--the 
first instinct of many people in Washington it is to recommend that 
safety and soundness regulation be extended to virtually the entire 
financial system through the regulation and supervision of systemically 
important (or TBTF) firms. After the S&L debacle and the failure of 
almost 1600 commercial banks at the end of the 1980s and the beginning 
of the 1990s, Congress adopted the Federal Deposit Insurance 
Corporation Improvement Act of 1991 (FDICIA), a tough regulatory 
statute that many claimed would put an end to banking crises. Yet today 
we are in the midst of a banking crisis that some say could be as bad 
as that of the Great Depression, perhaps even worse. If banks were not 
backed by the government--through deposit insurance, a lender of last 
resort, and exclusive access to the payment system--their risk-taking 
would probably be better controlled by market discipline exerted by 
creditors. But given the government support they receive, and its 
effect in impairing market discipline, regulation and supervision of 
their safety and soundness is the only sensible policy.
    Nevertheless, there are some reasonable steps that could be taken 
to improve bank regulation and to mitigate the possibility that the 
failure of a large bank might in the future have a significant adverse 
effect on other economic actors. For the reasons outlined above, I 
don't think that restrictions on size are workable, and they are likely 
to be counterproductive. The same thing is true of restrictions on 
affiliations and transactions, both of which will impose costs, impair 
innovation, and reduce competition. Since we have no idea whether any 
particular firm will cause a systemic breakdown if it fails, it does 
not seem reasonable to impose all these burdens on our financial system 
for very little demonstrable benefit. Restrictions on leverage can be 
effective, but I see them as an element of capital regulation, as 
discussed below.
    A good example of the unintended consequences of imposing 
restriction on affiliations is what has happened because of the 
restrictions on affiliations between banks and commercial firms. As the 
Committee knows, the Bank Holding Company Act provides that a bank 
cannot be affiliated with any activity that is not ``financial in 
nature.'' For many years the banking industry has used this to protect 
themselves against competition by organizations outside banking, most 
recently competition from Wal-Mart. They and others have argued that 
the separation of banking and commerce (actually, after the Gramm-
Leach-Bliley Act was adopted in 1999, the principle became the 
separation of finance and commerce) was necessary to prevent the 
extension of the so-called Federal ``safety net'' to commercial firms. 
That idea has now backfired on the banks, because by keeping commercial 
firms out of the business of investing in banks, they have made it very 
difficult for banks to raise the capital they need in the current 
financial crisis. We should not impose restrictions on affiliations 
unless there is strong evidence that a particular activity is harmful. 
All such restrictions turn out to be restrictions on competition and 
ultimately hurt consumers, who must pay higher prices and get poorer 
services. Because Wal-Mart was unable to compete with banks, many Wal-
Mart customers pay more for banking services than they should, and many 
of them can't get banking services at all.
    Nevertheless, capital requirements can be used effectively to limit 
bank risk-taking and growth, and this would be far preferable to other 
kinds of restrictions. It would make sense to raise bank capital 
requirements substantially. The only reason banks are able to keep such 
low capital ratios is that they have government backing. In addition, 
capital requirements should be raised as banks grow larger, which is in 
part the result of higher asset values that accompany a growing market. 
An increase of capital requirements with size would also have the 
salutary effect of dampening growth by making it more expensive, and it 
would provide a strong countercyclical brake on the development of 
asset bubbles. Higher capital requirements as banks grow larger would 
also induce them to think through whether all growth is healthy, and 
what lines of business are most suitable and profitable. In addition, 
as bank profits grow, capital requirements or reserves should also be 
increased in order to prepare banks for the inevitable time when growth 
will stop and the decline sets in. Before the current crisis, 10 
percent risk-based capital was considered well-capitalized, but it is 
reasonably apparent now that this level was not high enough to 
withstand a serious downturn.
    In addition, regulation should be used more effectively to enhance 
market discipline. Bank regulators are culturally reluctant to release 
information on the banks they supervise. This too often leaves market 
participants guessing about the risks the banks are taking--and wrongly 
assuming that the regulators are able to control these risks. To better 
inform the markets, the regulators, working with bank analysts, should 
develop a series of metrics or indicators of risk-taking that the banks 
should be required to publish regularly--say, once every month. This 
would enable the markets to make more informed judgments about bank 
risk-taking and enhance the effectiveness of market discipline. Rather 
than fighting market discipline, bank regulators should harness it in 
this way to supplement their own examination work.
    Finally for larger commercial banks, especially the ones that might 
create systemic risk if they failed, it would be a good idea to require 
the issuance of a form of tradable subordinated debt that could not by 
law be bailed out. The holders of this debt would have a strong 
interest in better disclosure by banks and could develop their own 
indicators of risk-taking. As the market perceived that a bank was 
taking greater risk, the price of these securities would fall and its 
yield would rise. The spread of that yield over Treasuries would 
provide a continuing strong signal to a bank's supervisor that the 
market foresees trouble ahead if the risk-taking continues. Using this 
data, the supervisor could clamp down on activities that might result 
in major losses and instability at a later time.
Can we improve the current framework for resolving systemically 
        important nonbank financial firms?
    The current framework for resolving all nonbank financial 
institutions is the bankruptcy system. Based on the available evidence, 
there is no reason to think that it is inadequate for performing this 
task or that these institutions need a government-administered 
resolution system. Because of the special functions of banks, a special 
system for resolving failed banks is necessary, but as discussed below 
banks are very different from other financial institutions. The 
creation of a government-run system will increase the likelihood of 
bailouts of financial institutions and prove exceedingly costly to the 
financial industry or to the taxpayers, who are likely to end up paying 
the costs.
    The underlying reason for the administration's proposal for a 
special system of resolution for nonbank financial institutions is the 
notion that the failure of a large financial firm can create a systemic 
breakdown. Thus, although many people look at the administration's 
resolution plan as a means to liquidate systemically important or TBTF 
firms in an orderly way, it is more likely to be a mechanism for 
bailing out these firms so that they will not cause a systemic 
breakdown. The Fed's bailout of AIG is the paradigm for this kind of 
bailout, which sought to prevent market disruption by using taxpayer 
funds to prevent losses to counterparties and creditors.
    As support for its proposal, the administration cites the 
``disorderly'' bailout of AIG and the market's panicked reaction to the 
failure of Lehman Brothers. On examination, these examples turn out to 
be misplaced. Academic studies after both events show that the market's 
reaction to both was far more muted than the administration suggests. 
Moreover, the absence of any recognizable systemic fallout from the 
Lehman bankruptcy--with the exception of a single money market mutual 
fund, no other firm has reported or shown any serious adverse effects--
provides strong evidence that in normal market conditions the reaction 
to Lehman's failure would not have been any different from the reaction 
to the failure of any large company. These facts do not support the 
notion that a special resolution mechanism is necessary for any 
financial institutions other than banks.
    The special character of banks. Although the phrase ``shadow 
banking'' is thrown around to imply a strong similarity between 
commercial banks and other financial institutions such as securities 
firms, hedge funds, finance companies or insurers, the similarity is 
illusory in most important respects. Anyone can lend; only banks can 
take deposits. Deposit-taking--not lending--is the essence of banking. 
By offering deposits that can be withdrawn on demand or used to pay 
others through an instruction such as a check, banks and other 
depository institutions have a special and highly sensitive role in our 
economy. If a bank should fail, its depositors are immediately deprived 
of the ready funds they expected to have available for such things as 
meeting payroll obligations, buying food, or paying rent. Banks also 
have deposits with one another, and small banks often have substantial 
deposits in larger banks in order to facilitate their participation in 
the payment system.
    Because of fear that a bank will not be able to pay in full on 
demand, banks are also at risk of ``runs''--panicky withdrawals of 
funds by depositors. Runs can be frightening experiences for the public 
and disruptive for the financial system. The unique attribute of 
banks--that their liabilities (deposits) may be withdrawn on demand-is 
the reason that banks are capable of creating a systemic event if they 
fail. If bank customers cannot have immediate access to their funds, or 
if a bank cannot make its scheduled payments to other banks, the others 
can also be in trouble, as can their customers. That is the basis for a 
true systemic event. The failure of a bank can leave its customers and 
other banks without the immediate funds they are expecting to use in 
their daily affairs. The failure of a large bank can cause other 
failures to cascade through the economy, theoretically creating a 
systemic event. I say ``theoretically'' because the failure of a large 
bank has never in modern times caused a systemic event. In every case 
where a large bank might have failed and caused a systemic breakdown, 
it has been rescued by the FDIC. The most recent such case--before the 
current crisis--was the rescue of Continental Illinois Bank in 1984.
    The foregoing description of how a large bank's failure can cause a 
systemic breakdown raises a number of questions about whether and how a 
systemic breakdown can be caused by the failure of a nonbank financial 
institution. These financial institutions--securities firms, hedge 
funds, insurance companies, finance companies, and others--tend to 
borrow for a specific term or to borrow on a collateralized basis. In 
this respect, they are just like GM. In common with all other large 
commercial borrowers, nonbank financial institutions also fund 
themselves with short-term commercial paper. Unless they are extremely 
good credits, this paper is collateralized. If they should fail, their 
creditors can recoup their losses by selling the collateral. Their 
failures, then, do not cause any immediate cash losses to their lenders 
or counterparties. Losses occur, to be sure, but in the same way that 
losses will occur if GM should file for bankruptcy--those who suffer 
them do not lose the immediate access to cash that they were expecting 
to use for their current obligations, and thus there is rarely any 
contagion in which the losses of one institution are passed on to 
others in the kind of cascade that can occur when a bank fails. It is 
for this reason that describing the operations of these nondepository 
institutions as ``shadow banking'' is so misleading. It ignores 
entirely the essence of banking--which is not simply lending--and how 
it differs from other kinds of financial activity.
    Because of the unique effects that are produced by bank failures, 
the Fed and the FDIC have devised systems for reducing the chances that 
banks will not have the cash to meet their obligations. The Fed lends 
to healthy banks (or banks it considers healthy) through what is called 
the discount window--making cash available for withdrawals by worried 
customers--and the FDIC will normally close insolvent banks just before 
the weekend and open them as healthy, functioning new institutions on 
the following Monday. In both cases, the fears of depositors are 
allayed and runs seldom occur. The policy question facing Congress is 
whether it makes sense to extend FDIC bank resolution processes to 
other financial institutions. For the reasons outlined above, there is 
virtually no reason to do so for financial institutions other than 
banks.
    Before proceeding further, it is necessary to correct some 
misunderstandings about the effectiveness of the FDIC, which has been 
presented by the administration and others as a paragon in the matter 
of resolving banks. The facts suggest a different picture, and should 
cause policymakers to pause before authorizing the FDIC or any other 
agency to take over the resolution of nonbank financial institutions. 
The FDIC and the other bank regulators function under a FDICIA 
requirement for prompt corrective action (PCA) when a bank begins to 
weaken. The objective of PCA is to give the FDIC and other supervisors 
the authority to close a bank before it actually becomes insolvent, 
thus saving both the creditors and the FDIC insurance fund from losses. 
It has not worked out that way. Thus far in 2009, there have been 32 
reported bank failures for which the FDIC has reported its losses. In 
these cases, the losses on assets have ranged from 8 percent to 45 
percent, with both an average and a weighted average of 28 percent. In 
2008, there were 25 bank failures, with losses averaging 25 percent. 
There may be reasons for these extraordinary losses, including the 
difficulty of dealing with the primary Federal or state regulator, but 
the consistency of the losses in the face of the PCA requirement casts 
some doubt on the notion that even the best Federal resolution agency--
dealing with failing insurance companies, securities firms, hedge funds 
and others--would be able to do a more efficient job than a bankruptcy 
court.
    While the failures of the FDIC as a resolution agency are not well 
known, the weakness of the bankruptcy system as a way of resolving 
failing financial institutions has been exaggerated. The evidence 
suggests that the Lehman's bankruptcy filing--as hurried as it was--has 
resulted in a more orderly resolution of the firm than AIG's rescue by 
the Fed. As reported by professors Kenneth Ayotte and David Skeel, 
things moved with dispatch after Lehman filed for bankruptcy under 
Chapter 11 of the code. Thus, as Ayotte and Skeel note:

        Lehman filed for Chapter 11 on September 15, 2008. Three days 
        later, Lehman arranged a sale of its North American investment 
        banking business to Barclays, and the sale was quickly approved 
        by the court after a lengthy hearing . . . Its operations in 
        Europe, the Middle East, and Asia were bought by Nomura, a 
        large Japanese brokerage firm. By September 29, Lehman had 
        agreed to sell its investment management business to two 
        private equity firms.\1\
---------------------------------------------------------------------------
    \1\ Kenneth Ayotte and David A. Skeel, Jr., ``Bankruptcy or 
Bailouts?'' (March 2, 2009). U of Penn, Inst for Law & Econ Research 
Paper No. 09-11; Northwestern Law & Econ Research Paper No. 09-05, pp 
9-10. Available at SSRN: http://ssrn.com/abstract=1362639.

Chapter 11 allows bankrupt debtors to remain in possession of their 
assets and continue operating while their creditors reach agreement on 
how best to divide up the firm's assets. It also permits firms to 
return to financial health if their creditors conclude that this is 
more likely to result in a greater recovery than a liquidation. In 
other words, Chapter 11 provides a kind of bailout mechanism, but one 
that is under the control of the creditors-the parties that have 
suffered the real losses. Neither the taxpayers nor any other unrelated 
party is required to put in any funds to work out the failed company.
    There are many benefits of a bankruptcy that are not likely to come 
with a system of resolution by a government agency. These include 
certainty about the rights of the various classes of creditors; a well-
understood and time-tested set of procedures; the immediate 
applicability of well-known stay provisions that prevent the disorderly 
seizure of collateral; equally well-known exemptions from stay 
provisions so that certain creditors holding short-term obligations of 
the failed company can immediately sell their collateral; and well 
worked out rules concerning when and under what circumstances 
preferential payments to certain creditors by the bankrupt firm have to 
be returned to the bankrupt estate.
    Still, the examples of Lehman Brothers and AIG have had a 
significant impact on the public mind and a hold on the attitudes of 
policymakers. It is important to understand these cases, and the 
limited support they provide for setting up a system for resolving 
large nonbank financial institutions.
    The market reactions after the failures of AIG and Lehman are not 
examples of systemic risk. Secretary Geithner has defended his proposal 
for a resolution authority by arguing that, if it had been in place, 
the rescue of AIG last fall would have been more ``orderly'' and the 
failure of Lehman Brothers would not have occurred. Both statements 
might be true, but would that have been the correct policy outcome? 
Recall that the underlying reason for the administration's plan to 
designate and specially regulate systemically important firms is that 
the failure of any such company would cause a systemic event--a 
breakdown in the financial system and perhaps the economy as a whole. 
If this is the test, it is now reasonably clear that neither AIG nor 
Lehman is an example of a large firm creating systemic risk or a 
systemic breakdown.
    In a widely cited paper and a recent book, John Taylor of Stanford 
University concluded that the market meltdown and the freeze in 
interbank lending that followed the Lehman and AIG events in mid-
September 2008 did not begin until the Treasury and Fed proposed the 
initial Troubled Asset Relief Program later in the same week, an action 
that implied that financial conditions were much worse than the markets 
had thought.\2\ Taylor's view, then, is that AIG and Lehman were not 
the cause of the meltdown that occurred later that week. Since neither 
firm was a bank or other depository institution, this analysis is 
highly plausible. Few of their creditors were expecting to be able to 
withdraw funds on demand to meet payrolls or other immediate expenses, 
and later events and data have cast doubt on whether the failure of 
Lehman or AIG (if it had not been bailed out) would have caused the 
losses that many have claimed.
---------------------------------------------------------------------------
    \2\ John B. Taylor, ``The Financial Crisis and the Policy 
Responses: An Empirical Analysis of What Went Wrong'' Working Paper 
14,631, National Bureau of Economic Research, Cambridge, MA, January 
2009), 25ff, available at www.nber.org/papers/w14631 (accessed April 8, 
2009).John B. Taylor, Getting Off Track: How Government Actsion and 
Ingterventions Caused, Prolonged, and Worsened the Financial Crisis, 
Hoover Institution Press, 2009, pp 25-30.
---------------------------------------------------------------------------
    In another analysis after the Lehman and AIG events, Ayotte and 
Skeel concluded that the evidence suggests ``at a minimum, that the 
widespread belief that the Lehman Chapter 11 filing was the singular 
cause of the collapse in credit that followed is greatly 
overstated.''\3\ They also show that that there was very little 
difference between the market's reaction to Lehman and to AIG, although 
the former went into bankruptcy and the latter was rescued.
---------------------------------------------------------------------------
    \3\ Ayotte and Skeel, p 27.
---------------------------------------------------------------------------
    Advocates of broader regulation frequently state that financial 
institutions are now ``interconnected'' in a way that they have not 
been in the past. This idea reflects a misunderstanding of the 
functions of financial institutions, all of which are intermediaries in 
one form or another between sources of funds and users of funds. In 
other words, they have always been interconnected in order to perform 
their intermediary functions. The right question is whether they are 
now interconnected in a way that makes them more vulnerable to the 
failure of one or more institutions than they have been in the past, 
and there is no evidence of this. The discussion below strongly 
suggests that there was no need to rescue AIG and that Lehman's failure 
was problematic only because the market was in an unprecedentedly 
fragile and panicky state in mid-September 2008.
    This distinction is critically important. If the market disruption 
that followed Lehman's failure and AIG's rescue was not caused by these 
two events, then identifying systemically important firms and 
supervising them in some special way serves no purpose. Even if the 
failure of a systemically important firm could be prevented through 
regulation--a doubtful proposition in light of the current condition of 
the banking industry--that in itself would not prevent the development 
of a fragile market, or its breakdown in the aftermath of a serious 
shock. The weakness or failure of individual firms is not the source of 
the problem. In terms of a conventional systemic risk analysis, the 
chaos that followed was not the result of a cascade of losses flowing 
through the economy as a result of the failure of Lehman or the 
potential failure of AIG. In the discussion that follows, I show first 
that Lehman did not cause, and AIG would not have caused, losses to 
other firms that might have made them systemically important. I then 
show that both are examples of nonbank financial firms that can be 
successfully resolved--at no cost to the taxpayers--through the 
bankruptcy process rather than a government agency.
    AIG Should Have Been Sent into Bankruptcy. AIG's quarterly report 
on Form 10-Q for the quarter ended June 30, 2008--the last quarter 
before its bailout in September--shows that the $1 trillion company had 
borrowed, or had guaranteed subsidiary borrowings, in the amount of 
approximately $160 billion, of which approximately $45 billion was due 
in less than 1 year.\4\ Very little of this $45 billion was likely to 
be immediately due and payable, and thus, unlike a bank's failure, 
AIG's failure would not have created an immediate cash loss to any 
significant group of lenders or counterparties. Considering that the 
international financial markets have been estimated at more than $12 
trillion, the $45 billion due within a year would not have shaken the 
system. Although losses would eventually have occurred to all those who 
had lent money to or were otherwise counterparties of AIG, these losses 
would have occurred over time and been worked out in a normal 
bankruptcy proceeding, after the sale of its profitable insurance 
subsidiaries.
---------------------------------------------------------------------------
    \4\ American International Group, 10-Q filing, June 30, 2008, 95-
101.
---------------------------------------------------------------------------
    Many of the media stories about AIG have focused on the AIG 
Financial Products subsidiary and the obligations that this group 
assumed through credit default swaps (CDSs). However, it is highly 
questionable whether there would have been a significant market 
reaction if AIG had been allowed to default on its CDS obligations in 
September 2008. CDSs--although they are not insurance--operate like 
insurance; they pay off when there is an actual loss on the underlying 
obligation that is protected by the CDS. It is much the same as when a 
homeowners' insurance company goes out of business before there has 
been a fire or other loss to the home. In that case, the homeowner must 
go out and find another insurance company, but he has not lost anything 
except the premium he has paid. If AIG had been allowed to default, 
there would have been little if any near-term loss to the parties that 
had bought protection; they would simply have been required to go back 
into the CDS market and buy new protection. The premiums for the new 
protection might have been more expensive than what they were paying 
AIG, but even if that were true, many of them had received collateral 
from AIG that could have been sold in order to defray the cost of the 
new protection. CDS contracts normally require a party like AIG that 
has sold protection to post collateral as assurance to its 
counterparties that it can meet its obligations when they come due.
    This analysis is consistent with the publicly known facts about 
AIG. In mid-March, the names of some of the counterparties that AIG had 
protected with CDSs became public. The largest of these counterparties 
was Goldman Sachs. The obligation to Goldman was reported as $12.9 
billion; the others named were Merrill Lynch ($6.8 billion), Bank of 
America ($5.2 billion), Citigroup ($2.3 billion), and Wachovia ($1.5 
billion). Recall that the loss of CDS coverage--the obligation in this 
case--is not an actual cash loss or anything like it; it is only the 
loss of coverage for a debt that is held by a protected party. For 
institutions of this size, with the exception of Goldman, the loss of 
AIG's CDS protection would not have been problematic, even if they had 
in fact already suffered losses on the underlying obligations that AIG 
was protecting. Moreover, when questioned about what it would have lost 
if AIG had defaulted, Goldman said its losses would have been 
``negligible.'' This is entirely plausible. Its spokesman cited both 
the collateral it had received from AIG under the CDS contracts and the 
fact that it had hedged its AIG risk by buying protection against AIG's 
default from third parties.
    Also, as noted above, Goldman only suffered the loss of its CDS 
coverage, not a loss on the underlying debt the CDS was supposed to 
cover. If Goldman, the largest counterparty in AIG's list, would not 
have suffered substantial losses, then AIG's default on its CDS 
contracts would have had no serious consequences in the market. This 
strongly suggests that AIG could have been put into bankruptcy with no 
costs to the taxpayers, and if it had not been rescued its failure 
would not have caused any kind of systemic risk. On the other hand, it 
is highly likely that a systemic regulator would have rescued AIG--just 
as the Fed did--creating an unnecessary cost for U.S. taxpayers and an 
unnecessary windfall for AIG's counterparties.
    Lehman's Failure Did Not Cause a Systemic Event. Despite the 
contrary analyses by Taylor, Skeel, and Ayotte, it is widely believed 
that Lehman's failure proves that a large company's default, especially 
when it is ``interconnected'' through CDSs, can cause a systemic 
breakdown. If that were true, then it might make sense to set up a 
regulatory structure to prevent a failure by a systemically important 
company. But it is not true. Even if we accept that Lehman's failure 
somehow precipitated the market freeze that followed, that says nothing 
about whether, in normal market conditions, Lehman's failure would have 
caused the same market reaction. In fact, analyzed in light of later 
events, it is likely that Lehman's bankruptcy would have had no 
substantial adverse effect on the financial condition of its 
counterparties. In other words, the failure would not--in a normal 
market--have caused the kind of cascade of losses that defines a 
systemic breakdown.
    After Lehman's collapse, there is only one example of any other 
organization encountering financial difficulty because of Lehman's 
default. That example is the Reserve Fund, a money market mutual fund 
that held a large amount of Lehman's commercial paper at the time 
Lehman defaulted. This caused the Reserve Fund to ``break the buck''--
to fail to maintain its share price at exactly one dollar--and it was 
rescued by the Treasury and Fed. The need to rescue the Reserve Fund 
was itself another artifact of the panicky conditions in the market at 
the time. That particular fund was an outlier among all funds in terms 
of its risks and returns.\5\ The fact that there were no other such 
cases, among money market funds or elsewhere, demonstrates that the 
failure of Lehman in a calmer and more normal market would not have 
produced any of the significant knock-on effects that are the hallmark 
of a systemic event. It is noteworthy, in this connection, that a large 
securities firm, Drexel Burnham Lambert, failed in 1990 and went into 
bankruptcy without any serious systemic effects. In addition, when 
Lehman's CDS obligations were resolved a month after its bankruptcy, 
they were all resolved by the exchange of only $5.2 billion among all 
the counterparties, a minor sum in the financial markets and certainly 
nothing that in and of itself would have caused a market meltdown.
---------------------------------------------------------------------------
    \5\ Ayotte and Skeel, Op. Cit., p 25, note 73.
---------------------------------------------------------------------------
    So, what relationship did Lehman's failure actually have to the 
market crisis that followed? The problems that were responsible for the 
crisis had actually begun more than a year earlier, when investors lost 
confidence in the quality of securities--particularly mortgage-backed 
securities (MBS)--that had been rated AAA by rating agencies. As a 
result, the entire market for asset-backed securities of all kinds 
became nonfunctional, and these assets simply could not be sold at 
anything but a distress price. With large portfolios of these 
securities on the balance sheets of most of the world's largest 
financial institutions, the stability and even the solvency of these 
institutions--banks and others--were in question.
    In this market environment, Bear Stearns was rescued through a Fed-
assisted sale to JPMorgan Chase in March 2008. The rescue was not 
necessitated because failure would have caused substantial losses to 
firms ``interconnected'' with Bear, but because the failure of a large 
financial institution in this fragile market environment would have 
caused a further loss of confidence--by investors, creditors, and 
counterparties--in the stability of other financial institutions. This 
phenomenon is described in a 2003 article by professors George Kaufman 
and Kenneth Scott, who write frequently on the subject of systemic 
risk. They point out that when one company fails, investors and 
counterparties look to see whether the risk exposure of their own 
investments or counterparties is similar: ``The more similar the risk-
exposure profile to that of the initial [failed company] economically, 
politically, or otherwise, the greater is the probability of loss and 
the more likely are the participants to withdraw funds as soon as 
possible. The response may induce liquidity and even more fundamental 
solvency problems. This pattern may be referred to as a `common shock' 
or `reassessment shock' effect and represents correlation without 
direct causation.''\6\ In March 2008, such an inquiry would have been 
very worrisome; virtually all large financial institutions around the 
world held, to a greater or lesser extent, the same assets that drove 
Bear toward default.
---------------------------------------------------------------------------
    \6\ George G. Kaufman and Kenneth Scott, ``What Is Systemic Risk 
and Do Regulators Retard or Contribute to It?'' The Independent Review 
7, no. 3 (Winter 2003). Emphasis added.
---------------------------------------------------------------------------
    Although the rescue of Bear temporarily calmed the markets, it led 
to a form of moral hazard--the belief that in the future governments 
would rescue all financial institutions larger than Bear. Market 
participants simply did not believe that Lehman, just such a firm, 
would not be rescued. This expectation was shattered on September 15, 
2008, when Lehman was allowed to fail, leading to exactly the kind of 
reappraisal of the financial health and safety of other institutions 
described by Kaufman and Scott. That is why the market froze at that 
point; market participants were no longer sure that the financial 
institutions they were dealing with would be rescued, and thus it was 
necessary to examine the financial condition of their counterparties 
much more carefully. For a period of time, the world's major banks 
would not even lend to one another. So what happened after Lehman was 
not the classic case of a large institution's failure creating losses 
at others--the kind of systemic event that has stimulated the 
administration's effort to regulate systemically important firms. It 
was caused by the weakness and fragility of the financial system as a 
whole that began almost a year earlier, when the quality of MBS and 
other asset-backed securities was called into question and became 
unmarketable. If Lehman should have been bailed out, it was not because 
its failure would have caused losses to others--the reason for the 
designation of systemically important or TBTF firms--but because the 
market was in an unprecedented condition of weakness and fragility. The 
correct policy conclusion arising out of the Lehman experience is not 
to impose new regulation on the financial markets, but to adopt 
policies that will prevent the correlation of risks that created a weak 
and fragile worldwide financial market well before Lehman failed.
    Thus, Lehman didn't cause, and AIG (if it had been allowed to fail) 
wouldn't have caused, a systemic breakdown. They are not, then, 
examples of why it is necessary to set up a special resolution system, 
outside the bankruptcy process, to resolve them or other large nonbank 
financial firms. Moreover, and equally important, a focus on Lehman and 
AIG as the supposed sources of systemic risk is leading policymakers 
away from the real problem, which is the herd and other behavior that 
causes all financial institutions to become weak at the same time.
    The funding question. There is also the question of how a 
resolution system of the kind the administration has proposed would be 
financed. Funds from some source are always required if a financial 
institution is either resolved or rescued. The resolution of banks is 
paid for by a fund created from the premiums that banks pay for deposit 
insurance; only depositors are protected, and then only up to $250,000. 
Unless the idea is to create an industry--supported fund of some kind 
for liquidations or bailouts, the administration's proposal will 
require the availability of taxpayer funds for winding up or bailing 
out firms considered to be systemically important. If the funding 
source is intended to be the financial industry itself, it would have 
to entail a very large levy on the industry. The funds used to bail out 
AIG alone are four times the size of the FDIC fund for banks and S&Ls 
when that fund was at its highest point--about $52 billion in early 
2007. If the financial industry were to be taxed in some way to create 
such a fund, it would put all of these firms--including the largest--at 
a competitive disadvantage vis-a-vis foreign competitors and would, of 
course, substantially raise consumer prices and interest rates for 
financial services.
    The 24 percent loss rate that the FDIC has suffered on failed banks 
during the past year should provide some idea of what it will cost the 
taxpayers to wind up or (more likely) bail out failed or failing 
financial institutions that the regulators flag as systemically 
important. The taxpayers would have to be called upon for most, if not 
all, of the funds necessary for this purpose. So, while it might be 
attractive to imagine the FDIC will resolve financial institutions of 
all kinds more effectively than the way it resolves failed or failing 
banks, a government-run resolution system opens the door for the use of 
taxpayer funds to unnecessary bailouts of companies that would not 
cause systemic breakdowns if they were actually allowed to fail.
    Sometimes it is argued that bank holding companies (BHCs) must be 
made subject to the same resolution system as the banks themselves, but 
there is no apparent reason why this should be true. The whole theory 
of separating banks and BHCs is to be sure that BHCs could fail without 
implicating or damaging the bank, and this has happened frequently. If 
a holding company of any kind fails, its subsidiaries can remain 
healthy, just as the subsidiaries of a holding company can go into 
bankruptcy without the parent becoming insolvent. If a holding company 
with many subsidiaries regulated by different regulators should go into 
bankruptcy, there is no apparent reason why the subsidiaries cannot be 
sold off if they are healthy and functioning, just as Lehman's broker-
dealer and other subsidiaries were promptly sold off after Lehman 
declared bankruptcy. If there is some conflict between regulators, 
these--like conflicts between creditors--would be resolved by the 
bankruptcy court.
    Moreover, if the creditors, regulators, and stakeholders of a 
company believe that it is still a viable entity, Chapter 11 of the 
Bankruptcy Code provides that the enterprise can continue functioning 
as a ``debtor in possession'' and come out of the proceeding as a 
slimmed-down and healthy business. Several airlines that are 
functioning today went through this process, and--ironically--some form 
of prepackaged bankruptcy that will relieve the auto companies of their 
burdensome obligations is one of the options the administration is 
considering for that industry. (Why bankruptcy is considered workable 
for the auto companies but not financial companies is something of a 
mystery.) In other words, even if it were likely to be effective and 
efficient--which is doubtful--a special resolution procedure for 
financial firms is unlikely to achieve more than the bankruptcy laws 
now permit.
    In addition to increasing the likelihood that systemically 
important firms will be bailed out by the government, the resolution 
plan offered by the administration will also raise doubts about 
priorities among lenders, counterparties, shareholders, and other 
stakeholders when a financial firm is resolved or rescued under the 
government's control. In bankruptcy, the various classes of creditors 
decide, under the supervision of a court, how to divide the remaining 
resources of the bankrupt firm, and whether the firm's business and 
management are sufficiently strong to return it to health. In an FDIC 
resolution, insured depositors have a preference over other creditors, 
but it is not clear who would get bailed out and who would take losses 
under the administration's plan. One of the dangers is that politically 
favored groups will be given preferences, depending on which party is 
in power at the time a systemically important firm is bailed out.
    Perhaps even more important, the FDIC's loss rate even under PCA 
demonstrates that the closing down of losing operations is slow and 
inefficient when managed by the government. Under the bankruptcy laws, 
the creditors have strong incentives to close a failing company and 
stop its losses from growing. As the FDIC experience show, government 
agencies have a tendency to forbear, allowing time for the losses in a 
failing firm to grow even greater.
    Given that bailouts are going to be much more likely than 
liquidations, especially for systemically important firms, a special 
government resolution or rescue process will also undermine market 
discipline and promote more risk-taking in the financial sector. In 
bailouts, the creditors will be saved in order to prevent a purported 
systemic breakdown, reducing the risks that creditors believe they will 
be taking in lending to systemically important firms. Over time, the 
process of saving some firms from failure will weaken all firms in the 
financial sector. Weak managements and bad business models should be 
allowed to fail. That makes room for better managements and better 
business models to grow. Introducing a formal rescue mechanism will 
only end up preserving bad managements and bad business models that 
should have been allowed to disappear while stunting or preventing the 
growth of their better-managed rivals. Finally, as academic work has 
shown again and again, regulation suppresses innovation and competition 
and adds to consumer costs.
    Accordingly, there is no need to establish a special government 
system for resolving nonbank financial institutions, just as there is 
no need to do so for large operating companies like GM. If such a 
system were to be created for financial institutions other than banks--
for which a special system is necessary--the unintended consequences 
and adverse results for the economy and the financial system would far 
outweigh any benefits.
                                 ______
                                 
                PREPARED STATEMENT OF MARTIN NEIL BAILY
  Senior Fellow, Economic Studies Program, the Brookings Institution,
        and former Chairman of the Council of Economic Advisers
            Under President Clinton, and Robert E. Litan \1\
                              May 6, 2009
    Thank you Mr. Chairman and members of the Committee for asking us 
to discuss with you the appropriate policy response to what has come to 
be widely known as the ``too big to fail'' (TBTF) problem. We will 
first outline some threshold thoughts on this question and then answer 
the questions that you posed in requesting this testimony.
---------------------------------------------------------------------------
    \1\ Robert E. Litan is Vice President, Research and Policy, The 
Kauffman Foundation and Senior Fellow, Economic Studies and Global 
Economy Programs, The Brookings Institution. This testimony draws on 
several of the authors' recent essays on the financial crisis on the 
Brookings website, www.brookings.edu, the work of Douglas Elliott of 
Brookings and the papers of the Squam Lake Working Group on Financial 
Regulation http://squamlakeworkinggroup.org/.
---------------------------------------------------------------------------
The Key Points
Too Big to Fail and the Current Financial Crisis
    The U.S. economy has been in free fall. Hopefully the pace 
        of decline is now easing, but the transition to sustained 
        growth will not be possible without a restoration of the 
        financial sector to health.

   The largest U.S. financial institutions hold most of the 
        financial assets and liabilities of the sector as a whole and, 
        despite encouraging signs, many of them remain very fragile.

   Many banks in the UK, Ireland, Switzerland, Austria, 
        Germany, Spain and Greece are troubled and there is no European 
        counterpart to the U.S. Treasury to stand behind them. The 
        global financial sector is in a very precarious state.

   In this situation policymakers must deal with ``too big to 
        fail'' institutions because we cannot afford to see the 
        disorderly failure of another major financial institution, 
        which would exacerbate systemic risk and threaten economic 
        recovery.

   The stress tests are being completed and some banks will be 
        told to raise or take additional capital. There is a lot more 
        to be done after this, however, as large volumes of troubled or 
        toxic assets remain on the books and more such assets are being 
        created as the recession continues.

   It is possible that one or two of the very large banks will 
        become irretrievably insolvent and must be taken over by the 
        authorities and, if so, they will have to deal with that 
        problem even though the cost to taxpayers will be high. But 
        pre-emptive nationalization of the large banks is a terrible 
        idea on policy grounds and is clouded by thicket of legal 
        problems.\2\
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    \2\ See the papers by Doug Elliott on the Brookings website.

   Getting the U.S. financial sector up and running again is 
        essential, but will be very expensive and is deeply unpopular. 
        If Americans want a growing economy next year with an improving 
        labor market, Congress will have to bite the bullet and provide 
        more Treasury TARP funds, maybe on a large scale. The costs to 
        taxpayers and the country will be lower than nationalizing the 
---------------------------------------------------------------------------
        banks.

   Congress recently removed from the President's budget the 
        funds to expand the TARP, a move that can only deepen the 
        recession and delay the recovery.\3\
---------------------------------------------------------------------------
    \3\ If it is any consolation, between 72 and 80 percent of Federal 
income taxes are paid by the top 10 percent of taxpayers. Average 
working families will not be paying much for the bailout.
---------------------------------------------------------------------------
Too Big to Fail: Answering the Four Key Questions (Plus One More)
    Should regulation prevent financial institutions from 
        becoming ``too big to fail''? We need very large financial 
        institutions given the scale of the global capital markets and, 
        of necessity, some of these may be ``too big to fail'' (TBTF) 
        because of systemic risks. For U.S. institutions to operate in 
        global capital markets, they will need to be large. Congress 
        should not punish or prevent organic growth that may result in 
        an institution having TBTF status.

    At the same time, however, TBTF institutions can be 
        regulated in a way that at least partially offsets the risks 
        they pose to the rest of the financial system by virtue of 
        their potential TBTF status. Capital standards for large banks 
        should be raised progressively as they increase in size, for 
        example. In addition, financial regulators should have the 
        ability to prevent a financial merger on the grounds that it 
        would unduly increase systemic risk (this judgment would be 
        separate from the traditional competition analysis that is 
        conducted by the Department of Justice's Antitrust Division).

    Should Existing Institutions be Broken Up? Organic growth 
        should not be discouraged since it is a vital part of improving 
        efficiency. If, however, the FDIC (or another resolution 
        authority) assumes control of a weakened TBTF financial 
        institution and later returns it to the private sector, the 
        agency should operate under a presumption that it break the 
        institution into pieces that are not considered TBTF. And it 
        should also avoid selling any one of the pieces to an acquirer 
        that will create a new TBTF institution. The presumption could 
        be overcome, however, if the agency determines that the costs 
        of breakup would be large or the immediate need to avoid 
        systemic consequences requires an immediate sale to another 
        large institution.

    What Requirements Should be Imposed on Too Big to Fail 
        Institutions? TBTF or systemically important financial 
        institutions (SIFIs) can and should be specially regulated, 
        ideally by a single systemic risk regulator. This is a 
        challenging task, as we discuss further below, but we believe 
        it is both one that can be met and is clearly necessary in 
        light of recent events.

    Too big to fail institutions have an advantage in that 
        their cost of capital is lower than that of small institutions. 
        At a recent Brookings meeting, Alan Greenspan estimated 
        informally that TBTF banks can borrow at lower cost than other 
        banks, a cost advantage of 50 basis points. This means that 
        some degree of additional regulatory costs (in the form of 
        higher capital requirements, for example) can be imposed on 
        large financial institutions without rendering them 
        uncompetitive.\4\
---------------------------------------------------------------------------
    \4\ However it is important that international negotiation be used 
to keep a level playing field globally.

    Improved Resolution Procedures for Systemically Important 
        Banks. This is an important issue that should be addressed 
        soon. When large financial firms become distressed, it is 
        difficult to restructure them as ongoing institutions and 
        governments end up spending large amounts to support the 
        financial sector, just as is happening now. The Squam Lake 
        Working group has proposed one solution to this problem: that 
        systemically important banks (and other financial institutions) 
        be required to issue a long-term debt instrument that converts 
        to equity under specific conditions. Institutions would issue 
        these bonds before a crisis and, if triggered, the automatic 
        conversion of debt into equity would transform an 
        undercapitalized or insolvent institution, at least in 
        principle, into a well capitalized one at no cost to 
        taxpayers.\5\
---------------------------------------------------------------------------
    \5\ http://squamlakeworkinggroup.org/.

    Where the losses are so severe that they deplete even the 
        newly converted capital, there should be a bank-like process 
        for orderly resolving the institution by placing it in 
        receivership. Treasury Secretary Geithner has outlined a 
        process for doing this, which we generally support. There are 
        other important resolution-related issues that must be 
---------------------------------------------------------------------------
        addressed and we discuss them below.

    The Origin of the Crisis and the Structure of the Solution. 
        The financial crisis was the result of market failure and 
        regulatory failure. Market failure occurred because wealth-
        holders in many cases failed to take the most rudimentary 
        precautions to protect their own interests. Compensation 
        structures were established in companies that rewarded 
        excessive risk taking. Banks bought mortgages knowing that 
        lending standards had become lax.\6\
---------------------------------------------------------------------------
    \6\ See ``The Origins of the Financial Crisis'' and ``Fixing 
Finance'' available on the Brookings website.

    At the same time, there were thousands of regulators who 
        were supposed to be watching the store, literally rooms full of 
        regulators policing the large institutions. Warnings were given 
        to regulators of impending crisis but they chose to ignore 
---------------------------------------------------------------------------
        them, believing instead that the market could regulate itself.

    In the future we must seek a system that takes advantage of 
        market incentives and makes use of well-paid highly qualified 
        regulators. Creating such a system will take time and 
        commitment, but it is clearly necessary.
Expanding on the Issues
    As the Committee is well aware, TBTF actually is somewhat of a 
misnomer, since no company is actually ``too big to fail.'' More 
accurately, as we have seen in the various bailouts during this crisis, 
even when the government comes to the rescue, it does not prevent 
shareholders from being wiped out or having the value of their shares 
significantly diminished. The beneficiaries of the rescues instead are 
typically short-term creditors, and in some cases, longer term 
creditors. The rescues are mounted to prevent systemic risk, which can 
arise in two ways: if creditors at one institution suffer loss or have 
to wait for their money, their losses will cascade throughout the 
financial system and threaten the failure of other firms and/or 
creditors in similar institutions will ``run'' and thereby trigger a 
wider crisis.
    In what follows we refer to financial institutions whose failure 
poses systemic risk as ``systemically important financial 
institutions'' or ``SIFIs'' for short. Clearly, large banks can be 
SIFIs because they are funded largely by deposits that can be withdrawn 
on demand. But, as has been painfully learned during this crisis, 
policymakers have feared that certain non-banks--the formerly 
independent investment banks and AIG--can be SIFIs because they, too, 
are or were funded largely by short-term creditors.
    By similar reasoning, other financial institutions--if sufficiently 
large, leveraged, or interconnected with the rest of the financial 
system--also can be systemically important, especially during a time of 
general economic stress:

    --Our entire financial system, for example, depends on the ability 
of the major stock and futures exchanges to price financial 
instruments, and on the major financial clearinghouses to pay those who 
are owed funds at the end of each day.

    --The harrowing experience with the near failure of LTCM in 1998 
demonstrates that large, leveraged hedge funds can expose the financial 
system to real dangers if counter-parties are not paid on a timely 
basis.

    --Large troubled life insurers can also generate systemic risks if 
policyholders run to cash out their life insurance policies, or if the 
millions of retirees who rely on annuities suddenly learn that their 
contracts may not be honored sharply curtail their spending as a 
result.

    --It is an open question whether the large monoline bond insurers, 
which have been hit hard by losses on subprime securities they have 
guaranteed, are systemically important. On the one hand, these losses 
for a time appeared to threaten the ability of these insurers to 
continue underwriting municipal bond issues (their core business), 
which could have had major negative ripple effects throughout the 
economy. On the other hand, as the recent entry of Berkshire Hathaway 
into this business has demonstrated, other entrants eventually can take 
up the slack in the market if one or more of the existing bond insurers 
were to fail. Nonetheless, because the entry process takes time, it is 
possible that one or more of the existing bond insurers could be deemed 
too big (or important) to fail in a time of broad economic distress, 
such as the present time.

    --One or more large property-casualty insurers could be deemed to 
be systemically important if they each were hit suddenly by a massive 
volume of claims--for example, following one or a series of 
catastrophic hurricanes--which, among other things, could trigger a 
large amount of securities sales in a short period of time. A large 
volume of CAT claims could also imperil the solvency of one or more 
large insurers (and/or possibly state backup insurance pools, like the 
one in Florida) and leave millions of policy holders without coverage, 
an outcome that Federal policymakers may deem unacceptable.
    One question we are certain you have been asked by your 
constituents and the media is why the auto companies have been treated 
differently, at least so far, from large financial firms. To be sure, 
in each case, it now appears that the Federal Government will end up 
owning some or, in the case of GM, most of the equity. But the 
creditors of the auto companies are not being protected, unlike those 
of the large financial firms that have been labeled ``too big to 
fail.'' Why the difference?
    There is an economic answer to this question which admittedly may 
be politically less than persuasive to some. Essentially by definition, 
systemically important financial institutions are funded largely if not 
primarily by short-term borrowings--deposits, repurchase agreements, 
commercial paper--which if not fully repaid when due or ``rolled over'' 
will cause not only the firm to fail, but threaten the failure of many 
other firms throughout the economy in one or both of the ways we have 
already described. In contrast, non-financial firms are typically not 
funded primarily by short-term borrowing, but instead by a combination 
of longer-term debt and equity. To be sure, their failure can lead to 
the failure of other firms, such as suppliers, and also trigger a wider 
loss of confidence among consumers, but most economists believe the 
damage to the entire economy is not likely to be as substantial as it 
would be if depositors at one or more of the largest banks or the 
short-term counter-parties of a large hedge fund or insurance company 
are not paid on time.
    We are nonetheless confident that the various financial firm 
bailouts do not please you or your constituents, which presumably is 
why you've convened this hearing. We are all highly uncomfortable with 
having the government bail out some or all possibly all of the 
creditors of large systemically important financial institutions. In 
particular, there are three reasons for this discomfort.
    First, if creditors of some institutions know that they will be 
fully protected regardless of how the managers of those firms act, the 
creditors will have no incentive to monitor the firms' risks and to 
discourage the taking of excessive risk. Economists call this the 
``moral hazard'' effect, and over time, if left unchecked it will lead 
to too much risk-taking by too many institutions, putting the economy 
at risk of future bubbles and the potentially huge costs when they pop.
    Second, bailouts of creditors of failed firms are fundamentally 
inconsistent with capitalism, which rewards and thus provides 
incentives for success, but punishes failure. Socializing the risks of 
failure is not how the game is played, and not only introduces too much 
risk-taking into the economy, but is also rightfully perceived as 
unfair by those firms whose creditors who are not given this 
protection.
    Third, we are learning that bailouts undermine the public's trust 
in government, which can make it harder for elected officials to do the 
public's business. Thus, for example, the unpopularity of the bailouts 
thus far may slow down the much needed cleanup of the financial system, 
which will slow the recovery. Likewise, if the public gets the 
impression that much of what Washington does is bail out mistakes, 
voters may be much more reluctant to support and fund worthy, cost-
effective endeavors by government to ensure more universal health care, 
fix education, and address climate change, among other important 
objectives.
    For all these reasons, policymakers must take reasonable steps now 
to prevent institutions from becoming TBTF, or if that is the outcome 
of market forces, then to prevent these institutions from taking 
excessive risks that expose taxpayers to paying for their mistakes. 
These are essentially the options on which you have requested comment, 
and to which we now turn.
Desirability and Feasibility of Preventing Institutions from Becoming 
        TBTF
    Clearly, we all want a financial and economic system in which those 
who take risks--whether they are large or small--to bear the full 
consequences of their actions if they are wrong, just as they are 
entitled to all of the rewards if they are successful. The policy 
challenge is how best to ensure this result.
    One way to prevent non-banking financial institutions from becoming 
TBTF is to impose limits on their size, measured by assets, 
indebtedness, counter-party risk exposures, or some combination of 
these factors. While, as we discuss further below, these measures are 
useful for establishing whether an institution should be presumptively 
treated as systemically important and thus subject to heightened 
regulatory scrutiny, it would be quite extraordinary and unprecedented 
to actually prevent such institutions from growing above a certain size 
limit. Putting aside the arbitrary nature of any limit, imposing one 
would establish perverse, and we believe, undesirable incentives that 
would undermine economy-wide growth.
    For one thing, any size limit would punish success, and thus 
discourage innovation. There are well-managed large financial 
institutions, such as JP Morgan, TIAA-CREF, Vanguard and Fidelity, to 
name a few. If the managers and shareholders of each of the 
institutions had been told in advance that beyond some limit the 
company could not grow, each of them would have stopped innovating and 
serving customers' needs well before reaching the limit. Employee 
morale also clearly would suffer, especially for those employees paid 
in stock or options, whose value would quite growing and indeed fall as 
companies reached their limit. These outcomes not only would ill serve 
consumers, but would discourage future entrepreneurs from reaching for 
the heights.
    Second, even though this crisis has demonstrated that the failure 
of large financial institutions can impose substantial costs on the 
rest of the financial system economists do not know with any degree of 
precision at what size these externalities outweigh the benefits of 
diversification and economies of scale that large institutions may 
achieve (and further, how these size levels likely vary by activity or 
industry). Accordingly, by essentially requiring large, growing 
companies to split themselves up beyond some point, policymakers would 
be arbitrarily sacrificing these economies.
    Nonetheless, there are steps short of an absolute size limitation 
that policymakers should consider to contain future TBTF problems.
    First, Congress could require regulators to establish a rebuttable 
presumption against financial institution mergers that result in a new 
institution above a certain size. Such a standard would provide 
stronger incentives, if not a requirement, that companies earn their 
growth organically. For reasons just indicated, we are not certain that 
economists yet have sufficient evidence to know with any precision at 
what size level such a presumption should be set, but the harms from 
limiting mergers beyond a size threshold would be less than imposing an 
absolute limit on internal growth.
    If Congress takes this approach, we recommend that it continue to 
require dual approval for mergers by both the antitrust authorities and 
the appropriate financial regulator (either the relevant supervisor for 
the firm, or a new systemic risk regulator, our preference). The reason 
for this is that while the antitrust enforcement agencies (the 
Department of Justice and the Federal Trade Commission) have well-
defined and supportable numerical standards for assessing whether a 
merger in any industry poses an unacceptable risk of harming 
competition, they have no special expertise in making the financial 
decision with respect to the size at which an institution poses an 
undue systemic financial risk. This latter decision is more appropriate 
for the relevant financial regulator to make.
    A second suggestion about which we have even greater confidence is 
for Congress to require the appropriate financial regulator(s) to 
subject systemically important financial institutions to progressively 
tougher regulatory standards and scrutiny than their smaller 
counterparts. We provide greater detail below on how this might be 
done. The basic rationale for this is quite straightforward. Larger 
financial institutions, if they fail or encounter financial trouble, 
imperil the entire financial system. This externality must be offset 
somehow, and a different regulatory regime--one that entails 
progressively tougher capital and liquidity standards in particular--is 
the best way we know how to accomplish this.
    Third, even for large systemically important financial 
institutions, it is possible to retain at least some market discipline 
and thus to limit the need for Federal authorities to protect at least 
some creditors, which is what makes a large and/or highly 
interconnected financial firm ``too big to fail.'' The way to do this 
is to require as many SIFIs as possible (large hedge funds may be 
excepted because their limited partnership interests and/or debt are 
not publicly traded) to fund a certain minimum percentage of their 
assets by convertible unsecured long-term debt. Because the debt would 
be long-term it would not be susceptible to runs (as is true of short-
term debt, which in a crisis may not be rolled over). Furthermore, if 
the debt must be converted to equity upon some pre-defined event--such 
as a government takeover of the institution (discussed below) or if the 
capital-to-asset ratio falls below some required minimum level--this 
would automatically provide an additional cushion of equity when it is 
most needed, while effectively requiring the debt holders to take a 
loss, which is essential for market discipline. The details of this 
arrangement should be left to the appropriate regulators (or the 
systemic risk regulator), but the development of the concept should be 
mandated by the Congress.
Should SIFIs Be Broken Up?
    Even if financial institutions are not subjected to a size limit, a 
number of experts have urged that regulators begin seizing weak banks 
(and perhaps weak non-bank SIFIs), cleaning them up (by separating them 
into ``good'' and ``bad'' institutions), and then breaking up the 
pieces when returning them to private hands (through sale to a single 
acquirer or public offering).
    We address below the merits of adopting a bank-like resolution 
process for non-bank SIFIs. For the numerous practical reasons outlined 
by our Brookings colleague Doug Elliott, we also urge caution in having 
regulators seize full control of financial institutions unless it is 
clear that their capital shortfalls are significant and cannot be 
remedied through privately raised funds.\7\
---------------------------------------------------------------------------
    \7\ Elliot's discussions of the difficulties of even temporary 
nationalizations also appear on the Brookings website.
---------------------------------------------------------------------------
    However, where regulators lawfully assume control of a troubled 
important financial institution (bank or non-bank), we are sympathetic 
with having the FDIC (or any other agency charged with resolution) 
required to make reasonable efforts to break up the institution when 
returning it to private hands (through sale or public offering) if it 
is already deemed to be systemically important or to avoid selling it 
to another institution when the result will be to create a new 
systemically important financial institution, provided the resolution 
authority also has an ``out'' if there is no other reasonable 
alternative.
    The rationale for the proposed presumption should be clear: given 
the costs that taxpayers are already bearing for the failure of certain 
systemically important institutions in this crisis, why, if it is not 
necessary, allow more TBTF problems to be created or aggravated by 
future financial mergers? Congress should recognize, however, that in 
limiting the sale of troubled financial institutions, it may make some 
resolutions more expensive than they otherwise be, at least in the 
short run. Subject to the qualification we next set out, this is an 
acceptable outcome, in our view, since measures that avoid making the 
TBTF problem worse have long-run benefits to taxpayers and to society.
    There must be escape clause, however. The Treasury, the Federal 
Reserve Board and the appropriate regulator may believe that the 
functions of the failing (or failed) institution are so intertwined or 
inseparable, and/or that its purchase by a single entity in a very 
short period of time--as in the case of Bank of America's acquisition 
of Merrill Lynch or JP Morgan's purchase of Bear Stearns--is so 
essential to the health of the overall financial system that 
disposition of the institution in pieces is impractical or 
substantially more costly (as measured by the amount of government 
financing required) than other alternatives. Such a ``systemic risk 
exception'' should be very narrowly drawn, and conceivably require the 
approval of all of the regulatory entities just mentioned.
    We should note, however, that if Congress also creates a bank-like 
resolution process for non-bank SIFIs, the systemic risk situation we 
describe truly should be exceedingly rare. Once regulators have the 
authority to put a non-bank SIFI into receivership and to guarantee 
against loss such creditors as are necessary to preserve overall 
financial stability, then regulators should not be forced by the 
pressure of time to sell the entity in one piece. Of course, it still 
may be the case that the activities of the institution are sufficiently 
inseparable that it would be impractical or highly costly for the 
resolving authority to break up the firm in the disposition process. If 
that is the case, then the regulators should have the ability to sell 
off the institution in one piece.
    One other practical issue must also be addressed. There must be 
some way for the resolving authority to identify the circumstances 
under which the resolution of a troubled institution would create or 
aggravate the TBTF problem. One way to do this is to require an 
appropriate regulator (a topic we discuss shortly) to designate in 
advance certain financial institutions as being systemically important 
(and thus subject to a tougher regulatory scrutiny). Alternatively, the 
resolution authority could make this determination at the time, in 
consultation with the Federal Reserve and/or the Treasury, or with the 
designated systemic risk regulator. In either case, the resolution 
authority must still be able to determine if a particular sale might 
create a new systemically important institution.
Regulating SIFIs
    If SIFIs are not to be broken up (outside of temporary government 
takeover) or subjected to an absolute size constraint, then it is clear 
that they must be subject to more exacting regulatory scrutiny than 
other institutions. Otherwise, smaller financial institutions will be 
disadvantaged and the entire financial system and economy will be put 
at undue risk. That is perhaps one of the clearest lessons from this 
current crisis.
    We recognize, however, that establishing an appropriate regulatory 
regime for SIFIs is a very challenging assignment, and entails many 
difficult decisions. We review some of them now. Our overall advice is 
that because of the complexity of the task, as well as the constantly 
changing financial environment in which these institutions compete, 
that Congress avoid writing the details of the new regime into law. 
Instead, it would be far better, in our view, for Congress to establish 
the broad outlines of the new system, and then delegate the details to 
the appropriate regulator(s).
    First, the regulatory objective must be clear: We suggest that the 
primary purpose of any new regulatory regime for systemically important 
financial institutions should be to significantly reduce the sources of 
systemic risk or to minimize such risk to acceptable levels. The goal 
should not be to eliminate all systemic risk, since it is unrealistic 
to expect that result, and an effort to do so could severely dampen 
constructive innovation and socially useful activity.
    Second, if SIFIs are to be specially regulated, there must be 
criteria for identifying them. The Group of Thirty has suggested that 
the size, leverage and degree of interconnection with the rest of the 
financial system should be the deciding factors, and we agree.\8\ We 
also believe that whether an institution is deemed systemically 
important may depend on both general economic circumstances, as well as 
the conditions in a specific sector at the time. Some large 
institutions may not pose systemic risks if they fail if the economy is 
generally healthy or is experiencing only a modest downturn; but the 
same institution, threatened with failure, could be deemed systemically 
important under a different set of general economic or industry-
specific conditions. This is just one reason why we counsel against the 
use of hard and fast numerical standards to determine whether an 
institution is systemically important. Another reason is that the use 
of numerical criteria alone could be easily gamed (institutions would 
do their best either to stay just under or over any threshold, 
whichever outcome it believes to be to its advantage). Accordingly, the 
regulator(s) should have some discretion in using these numerical 
standards, taking into account the general condition of the economy 
and/or the specific sector in which the institution competes. The 
ultimate test should be whether the combination of these factors 
signifies that the failure of the institution poses a significant risk 
to the stability of the financial system.
---------------------------------------------------------------------------
    \8\ Group of Thirty. ``Financial Reform: A Framework for Financial 
Stability'' (Washington D.C., Jan 2009) .
---------------------------------------------------------------------------
    As we discussed at the outset of our testimony, application of this 
test should result in some banks, insurers, clearinghouses and/or 
exchanges, and hedge funds as being systemically important (certain 
formerly independent investment banks that have since converted to bank 
holding companies or that are no longer operating as independent 
institutions also would have qualified, and conceivably could do so 
again). We doubt whether venture capital firms would qualify.
    Clearly, to the extent possible, the list of SIFIs should be 
compiled in advance, since otherwise there would no method of specially 
regulating them (some institutions that may be deemed systemically 
important only in the context of particular economy-wide or sector-
specific conditions cannot be identified in advance, or may be so 
identified only when such conditions are present). A natural question 
then arises: should this list be made public? As a practical matter, we 
do not think one could avoid making it public. At a minimum, it would 
be apparent from the capital and liquidity positions reported in the 
firms' financial statements that the relevant institutions had been 
deemed by regulators to be systemically important. Meanwhile, the 
presence of more intensive regulatory oversight, coupled with a 
mandatory long-term debt requirement, both not applicable to smaller 
institutions, would counter the concern that public announcement of the 
firms on the list would somehow weaken market discipline or give the 
institutions access to lower cost funds than they might otherwise have.
    Institutions designated as systemically important should have some 
right to challenge, as well as the right to petition for removal of 
that status, if the situation warrants. For example, a hedge fund 
initially highly leveraged should be able to have its SIFI designation 
removed if the fund substantially reduces its size, leverage and 
counter-party risk.
    As this discussion implies, the process of designating or 
identifying institutions as systemically important must be a dynamic 
one, and will depend on the evolution of the financial service 
industry, the firms within in, and the future course of the economy. It 
is to be expected that some firms will be added to the list, while 
others are dropped, over time. In particular, regulators must be 
vigilant to include new variations of the ostensibly off-balance sheet 
structured investment vehicles (SIVs), which technically may have 
complied with existing accounting rules regarding consolidation, but 
which functionally always were the creations and obligations of their 
bank sponsors. Regulators should take a functional approach toward such 
entities in the future for purposes of determining whether an 
institution is systemically important. If the firm's affiliates or 
partners in any way could require rescue by other institutions, then 
that prospect should be considered when assessing the size, leverage, 
and financial interconnection of the firm.
    Third, the nature of regulation should depend on the activity of 
the institutions. For financial intermediaries, such as banks and 
insurance companies, and clearinghouses or exchanges, which are 
considered to be systemically important, the main regulatory tools 
should be higher capital, liquidity and risk management standards than 
those that apply to smaller institutions. It is to be expected that 
these standards will differ by type of institution. Furthermore, the 
appropriate regulator(s) should consider making these standards 
progressively higher as the size of the SIFI increases, to reflect the 
likely increasing bailout risk that SIFIs pose to the rest of the 
financial system as they grow.
    Several more details about these standards also deserve mention. 
Capital standards, for SIFIs and other financial institutions, should 
be made less pro-cyclical, or even counter-cyclical. Another lesson 
from this crisis is that financial regulation should not unduly 
constrain lending in bad times and fail to curb it in booms. The way to 
learn this lesson, however, is not to leave too much discretion to 
regulators in raising or lowering capital (and possibly liquidity) 
standards in response to changes in economic conditions. If regulators 
have too much discretion about when to adjust capital standards, they 
may succumb to heavy pressures to relax them in bad times, and not to 
raise them when times are good. To avoid this problem, Congress should 
require the regulators to set in advance a clear set of standards for 
good times and bad (or, at a minimum, to specify a range for those 
standards, as the Group of Thirty has suggested).
    With respect to their oversight of an institution's risk management 
procedures, regulators must be more aggressive in the future in testing 
the reasonableness of the assumptions that are built into the risk 
models used by complex financial institutions. In addition, regulators 
should consider the structure of the executive compensation systems of 
SIFIs under their watch, paying particular attention to the degree to 
which compensation is tied to long-run, rather than short-run, 
performance of the institution. In the normal course of their 
supervisory activities, regulators should use their powers of 
persuasion, but should also have a ``club in the closet''--the 
authority to issue cease and desist orders--if necessary.
    For private investment vehicles, primarily or possibly only hedge 
funds, the appropriate regulatory regime is likely to differ from 
publicly traded financial intermediaries. Here, we would expect that 
the appropriate regulator, at a minimum, would have the authority to 
collect on a regular basis information about the size of the fund, its 
leverage, its exposure to specific counter-parties, and its trading 
strategies so that the supervisor can at least be alert to potential 
systemic risks from the simultaneous actions of many funds. We would 
expect that most of this information, with the exception of fund size 
and perhaps its leverage, would be confidential, to preserve the trade 
secrets of the funds. We would not expect the regulator to have 
authority to dictate counter-party exposures or trading strategies. 
However, where the authorities see that particular funds are 
excessively leveraged, or when considered in the aggregate their 
trading strategies may create excessive risks, the appropriate 
regulator should have the obligation to transmit that information to 
the banking regulators or the systemic risk regulator, which in turn 
should have the ability to constrain lending to particular funds or a 
set of funds.
    Fourth, ideally a single regulator should oversee and actively 
supervise all systemically important financial institutions (bank and 
non-bank). Splitting up this authority among the various functional 
regulators--such as the three bank regulators, the SEC (for securities 
firms), the CFTC, a merged SEC/CFTC or another relevant body (for 
derivatives clearinghouses), and a new Federal insurance regulator--
runs a significant risk of regulatory duplication of effort, 
inconsistent rules, and possibly after-the-fact finger-pointing in the 
event of a future financial crisis. Likewise, vesting authority for 
systemic risk oversight in a committee of regulators--for example, the 
President's Working Group on Financial Markets--risks indecision and 
delay. The various functional regulators should be consulted by the 
systemic risk regulator. In addition, the systemic risk regulator 
should have automatic and regular access to information collected by 
the functional regulators. But, in our view, systemic risks are best 
overseen by a single agency.\9\
---------------------------------------------------------------------------
    \9\ We are aware that the Committee has not asked for views about 
which regulator should have this authority, but if asked, we would 
suggest either a single new Federal financial solvency regulator, or 
the Federal Reserve. For further details, see Testimony of Robert E. 
Litan before the Senate Committee on Homeland Security, March 4, 2009.
---------------------------------------------------------------------------
    If a single systemic risk regulator is designated, a question that 
must be considered is whether it, or the appropriate functional 
regulator, should actively supervise systemically important 
institutions. There are merits to either approach. However, on balance, 
we believe that the systemic risk regulator should have primary 
supervisory authority over SIFIs. There is much day-to-day learning 
that can come from regular supervision that could be useful to the 
systemic risk regulator in a crisis, when there is no room for delay or 
error.
    In addition to overseeing or at least setting supervisory standards 
for SIFIs, the systemic risk regulator should be required to issue 
regular (annual or perhaps more frequent, or as the occasion arises) 
reports outlining the nature and severity of any systemic risks in the 
financial system. Such reports would put a spotlight on, among other 
things, rapidly growing areas of finance, since rapid growth in 
particular asset classes tends to be associated (but not always) with 
future problems. These reports should be of use to both other 
regulators and the Congress in heading off potential future problems.
    A legitimate objection to early warnings is that policymakers will 
ignore them. In particular, the case can be made that had warnings 
about the housing market overheating been issued by the Fed and/or 
other financial regulators during the past decade, few would have paid 
attention. Moreover, the political forces behind the growth of subprime 
mortgages--the banks, the once independent investment banks, mortgage 
brokers, and everyone else who was making money off subprime 
originations and securitizations--could well have stopped any counter-
measures dead in their tracks.
    This recounting of history might or might not be right. But the 
answer should not matter. The world has changed with this crisis. For 
the foreseeable future, perhaps for several decades or as long as those 
who have lived and suffered through recent events are still alive and 
have an important voice in policymaking, the vivid memories of these 
events and their consequences will give a future systemic risk 
regulator (and all other regulators) much more authority when warning 
the Congress and the public of future asset bubbles or sources of undue 
systemic risk.
    Fifth, Congress should assign regulatory responsibilities for 
overseeing derivatives that are currently traded ``over-the-counter'' 
rather than on exchanges. As has been much discussed, regulators 
already are moving to authorize the creation of clearinghouses for 
credit default swaps, which should reduce the systemic risks associated 
with standardized CDS. But these clearinghouses must still be regulated 
for capital adequacy and liquidity, either by specific functional 
regulators or by the systemic risk regulator.
    Yet even well-capitalized and supervised central clearinghouses for 
CDS and possibly other derivatives will not reduce systemic risks posed 
by customized derivatives whose trades are not easily cleared by a 
central party (which cannot efficiently gather and process as much 
information about the risks of non-payment as the parties themselves). 
Congress should enable an appropriate regulator to set minimum capital 
and/or collateral rules for sellers of these contracts. At a minimum, 
more detailed reporting to the regulator by the participants in these 
customized markets should be required.
    Finally, while there are legitimate concerns about the efficacy of 
financial regulation, we believe that these should not deter 
policymakers from implementing and then overseeing a special regulatory 
system for systemically important financial institutions. We recognize, 
of course, that financial regulators did not adequately control the 
risks that led to the current crisis. But that does not mean that we 
should simply give up on doing something about the TBTF problem.
    We should remember that U.S. bank regulators in fact were able to 
contain risk taking for roughly the 15 year period following the last 
banking crisis of the late 1980s and early 1990s, and financial 
regulators are already learning from their mistakes this time around. 
Furthermore, we take some comfort from the fact that Canadian bank 
regulators have prevented that country's banks from running into the 
trouble that our banks have experienced, by applying sensible 
underwriting and capital standards. So, regulation, when properly 
practiced, can prevent undue risk-taking.\10\
---------------------------------------------------------------------------
    \10\ For a guide to how the Canadians have done it, see Pietro 
Nivola, ``Know Thy Neighbor: What Canada Can Tell Us About Financial 
Regulation,'' March 2009, at www.brookings.edu.
---------------------------------------------------------------------------
    Further, under the regulatory system we recommend, regulators would 
not be the only source of discipline against excessive risk-taking by 
SIFIs. They would be assisted by holders of long-term uninsured, 
convertible debt, who would have their money at risk and thus 
incentives to monitor and control risk-taking by the institutions.
    In short, regulators, working hand in hand with market participants 
under the right set of rules, can do better than simply waiting for the 
next disasters to occur and cleaning up after them. The costs of 
cleaning up after this crisis--which eventually could run into the 
trillions of dollars--as well as the damage caused by the crisis itself 
should be stark reminders that we can and must do better to prevent 
future crises or at least contain their costs if they occur.
Improving Resolution of Non-Bank SIFIs
    The Committee is surely aware of the many calls for extending the 
failure resolution procedure for banks to non-banks determined to be 
systemically important (either before or after the fact). The basic 
idea, known as ``prompt corrective action'' or ``PCA'', is to authorize 
(or direct) a relevant agency (the FDIC in the case of banks) to assume 
control over a weakly capitalized institution before it is insolvent, 
and then either to liquidate it or, after cleaning up its balance sheet 
(by separating out the bad assets), return it to private ownership 
(through sale to another firm or a public offering). Such takeovers are 
meant to be a last resort, only if prior regulatory restrictions and/or 
directives to raise private capital, have failed. Many have argued that 
had something like this system been in place for the various non-banks 
that have failed in this crisis--Bear Stearns, Lehman, and AIG--the 
resolutions would have been more orderly and achieved at less cost to 
taxpayers.\11\
---------------------------------------------------------------------------
    \11\ Lehman was not rescued and thus all its losses have fallen on 
its shareholders and creditors. We won't know for some time the full 
cost of JP Morgan's rescue of Bear Stearns, which was aided by loans 
from the Federal Reserve, or certainly the much larger final cost of 
the Fed's takeover of AIG.
---------------------------------------------------------------------------
    We agree with this view. By definition, troubled systemically 
important financial institutions cannot be resolved in bankruptcy 
without threatening the stability of the financial system. The 
bankruptcy process stays payment of unsecured creditors, while inducing 
secured creditors to seize and then possibly sell their collateral. 
Either or both outcomes could lead to a wider panic, which is why a 
bank-like restructuring process--which puts the troubled bank into 
receivership, allowing the FDIC to transfer the institution's 
liabilities to an acquirer or to a ``bridge bank''--is necessary for 
non-bank SIFIs.
    Congress must resolve a number of complex issues, however, in 
creating an effective resolution process for these non-bank 
institutions.
    First, the law should provide some procedure for identifying the 
systemically important institutions that are eligible for this special 
resolution mechanism in lieu of a normal bankruptcy. This can be done 
either by allowing the appropriate regulator (we would prefer this be a 
single systemic risk regulator) to designate specific institutions in 
advance as SIFIs and therefore subject to a special resolution process 
if they get into financial trouble, or on ad hoc basis, as the 
appropriate regulator(s) deem appropriate. Secretary Geithner, for 
example, has proposed that the Secretary of Treasury could make this 
designation, upon the positive recommendation of the Federal Reserve 
Board and the appropriate regulator, in consultation with the 
President. We favor a combination of these approaches: institutions 
subject to special regulation as SIFIs automatically would be covered 
by the special non-bank resolution process, while the Treasury 
Secretary under the procedure outlined by Secretary Geithner would have 
the ability to use the special resolution process for other troubled 
institutions deemed systemically important given unusual circumstances 
that may be present at a particular time.
    Second, there must be clear and effective criteria for placing a 
financially weak non-bank SIFIs into the special resolution process, 
ideally before it is insolvent. In principle, bank regulators have this 
authority under FDICIA, but in practice, regulators tend to arrive too 
late--after banks are well under water (one recent, notable example is 
the failure of IndyMac, which is going to cost the FDIC several billion 
dollars).
    There is really only one way to address this problem, for banks and 
non-bank SIFIs alike, and that is to raise the minimum capital-to-asset 
threshold that can trigger regulatory takeover of a weak bank or non-
bank SIFI (if, by some chance, there is still some positive equity 
after an early resolution, it can and should be returned to the 
shareholders, as is the case for early bank resolutions, at least in 
principle). Since the appropriate threshold is likely to differ by type 
of institution, this reform is probably best handled by delegating the 
job to the appropriate regulator: the banking regulators for banks and 
Treasury and/or the FDIC for non-bank SIFIs (or the systemic risk 
regulator, if one is established). The capital-to-asset trigger also 
should be coordinated with any new counter-cyclical capital regulatory 
regime that may be established for banks and other financial 
institutions. In particular, once the new standards are phased in, they 
should not be so low in recessions as to render ineffective any 
capital-to-asset trigger designed to facilitate sufficiently early 
interventions by regulators to avoid or at least minimize losses to 
taxpayers.
    Third, the resolution mechanism must have a well-defined procedure 
for handling uninsured creditor claims. Unlike a bank that has insured 
liabilities, the creditors of a non-bank are likely to be uninsured 
(unless they have bought reliable credit default protection, or they 
have some limited protection through other means: through state 
guaranty funds for insurance policy holders or through SPIC for 
brokerage accounts). In a normal bankruptcy, creditors are paid in 
order of seniority and whether their borrowings are backed by specific 
collateral. Market discipline requires that creditors not be paid in 
full if there are insufficient corporate assets to repay them. However, 
what makes a non-bank systemically important is that the failure to 
protect at least short-term creditors can trigger creditor runs on 
other, similar institutions and/or unacceptable losses throughout the 
financial system.
    There are several ways to handle this problem. One approach would 
require all SIFIs, bank and non-bank, to file a resolution plan with 
their regulator, spelling out the procedures for ``haircutting'' 
specific classes of creditors if the regulator assumes control of the 
institution. Another approach is to have the regulators spell out those 
procedures including minimum haircuts that each class of creditors 
would be expected to receive if the regulators assume control of the 
institution. A third idea is to address the issue on a case by case 
basis--for example, by dividing the institution into a ``good'' and 
``bad'' entity, and require shareholders and creditors to bear losses 
associated with the ``bad'' one. Of course, to be truly effective in 
preserving market discipline, regulators actually must imposes losses 
under any of these approaches on unsecured creditors, which as recent 
events have demonstrated, can be difficult, if not impossible, to do.
    In particular, when overall economic conditions are dire, as they 
have been throughout the current crisis, regulators will feel much 
pressure to protect one or more classes of creditors in full, 
regardless of what any pre-filed or mandated resolution plan may say 
(or what the allocation of losses may be as a result of splitting the 
institution in two). Thus, in the banking context, FDICIA enables 
regulators to guarantee all deposits, included unsecured debt, of banks 
when it is deemed necessary to prevent systemic risk. This ``systemic 
risk exception'' to the general rule that only insured deposits are 
covered may be invoked, however, only with the concurrence of \2/3\ of 
the members of the Federal Reserve Board, \2/3\ of the members of the 
FDIC Board, and the Secretary of the Treasury, in consultation with the 
President. Even then, the Comptroller General must make a report after 
the fact assessing whether the intervention was appropriate. A similar 
systemic risk exception (with the perhaps the same or a similar 
approval procedure) should also be established for debt issued by 
troubled non-bank SIFIs (Secretary Geithner has suggested that 
government assistance be provided when approved by the Treasury and the 
FDIC, in consultation with the Federal Reserve and the appropriate 
regulatory authority).
    Fourth, the resolution process should be overseen by a specific 
agency. The Treasury has proposed that the FDIC handle this 
responsibility, as has the current FDIC Chair. Given the FDIC's 
expertise with resolving bank failures, expanding its authority to 
cover suitable non-banks makes sense.
    Fifth, the non-bank resolution process must have a funding 
mechanism. This is relatively easy, as these things go, for banks, 
which are covered by an explicit deposit insurance system that is 
funded by all members of the banking industry. Of special relevance to 
the TBTF issue, if the Federal Government guarantees uninsured deposits 
and other creditors of any banks under the ``systemic risk exception'', 
all other banks must be assessed for the cost, although the FDIC can 
borrow from the Treasury to finance its initial outlays if its reserves 
are insufficient (under current law, the FDIC's borrowing limit is $30 
billion, but in light of the current crisis, the agency is requesting 
that this limit be raised to $500 billion).
    It is difficult to structure an assessment structure for the costs 
of rescuing the creditors of non-bank SIFIs, however. For one thing, 
who should pay? Just the other members of the industry in which the 
failed SIFI is active (such as other hedge funds or insurers, as the 
case may be), all non-bank SIFIs, or even all non-banks? Under any of 
these options, what would be the assessment base, and should the 
contribution rate differ by industry sector? And should any assessment 
be collected in advance, after the fact, or both?
    Merely asking these questions should make clear how difficult it 
can be to design an acceptable industry-based assessment system. We 
realize that on grounds of equity, it would be appropriate only to 
assess other SIFIs, assuming they are specifically identified. But this 
approach may not raise sufficient funds to cover the costs involved. We 
note that the costs of the AIG rescue alone, for example, are 
approaching $200 billion. A similar amount has been put aside for the 
conservatorships of Fannie Mae and Freddie Mac.
    Congress could broaden the assessment base to include all non-bank 
institutions (to cover the costs only of providing financial assistance 
to non-bank SIFIs). This may not appear equitable on the surface, but 
if the institution receiving government funds is truly systemically 
important then even smaller institutions do benefit when the government 
steps in to prevent creditor losses at a SIFI from damaging the rest of 
the financial system.
    Indeed, if an institution is truly systemic, then everyone 
presumably benefits from not having the financial system meltdown, 
which is why it is advisable in our view for Congress to give the FDIC 
and/or the Treasury an appropriation up to some sizable limit--say $250 
billion--that could be tapped, if necessary for future non-bank SIFI 
resolutions. Congress may also want to instruct the FDIC and/or the 
Treasury to use this appropriation only as a resort, and turn to 
assessments on some class of institutions first. We have no objection 
to such an approach, but for reasons just noted, there is no perfect 
way to do that. In any event, as with bank resolutions under the 
systemic risk exception, the Comptroller General should be required to 
report to Congress on all non-bank resolutions, too: whether 
government-provided financial assistance was appropriate, and whether 
the resolution was completed at least cost.
    However the Congress decides these issues, it should do so 
promptly, without waiting to reach agreement on a more a comprehensive 
financial reform bill. The country clearly would be best served if a 
new resolution process were in place before another large non-banking 
firm approaches insolvency before this recession is over.
Concluding Observations
    We would like to close with perhaps the obvious observation that 
addressing the TBTF problem is not simple. Further, as we have noted, 
it is unreasonable to expect any new policy framework to prevent all 
future bailouts, and future bubbles. Perfection is not possible in this 
or any other endeavor, and suggestions for policy improvements should 
not be judged against such a harsh and unrealistic standard.
    The challenge before the Congress instead is to significantly 
improve the odds that future bailouts of large financial institutions 
will be unnecessary, without at the same time materially dampening the 
innovative spirit that has driven our financial system and our economy. 
We believe that goal can be accomplished, but it will take time. 
Congress will write new laws, but will have to place considerable faith 
in regulators to carry them out. In turn, regulators will make 
mistakes, they will learn, and they will make mid-course corrections.
    This Committee is certainly well aware that regulation can never 
fully keep up with market developments. Private actors always find ways 
around rules; economists call this regulatory arbitrage, in which the 
regulatory ``cats'' are constantly trying to keep the private ``mice: 
from doing damage to the financial system.'' This crisis has exposed 
the unwelcome truth that over the past several years, some of the 
private sector mice grew so large and so dangerous that they threatened 
the welfare of our entire financial system. It is now time to beef up 
the regulatory cats, to arm them with the right rules, and to assist 
them with constructive market discipline so that the game of regulatory 
arbitrage will be kept in check, while the financial system continues 
to do what it is supposed to do: channel savings efficiently toward 
constructive social purposes.
    Thank you and we look forward to addressing your questions.
                                 ______
                                 
                PREPARED STATEMENT OF RAGHURAM G. RAJAN
      Eric J. Gleacher Distinguished Service Professor of Finance,
            University of Chicago, Booth School of Business
                              May 6, 2009
Too Systemic to fail: Consequences, Causes, and Potential Remedies\1\
---------------------------------------------------------------------------
    \1\ The opinions expressed in this piece are mine alone, but I have 
benefited immensely from past discussions and work with Douglas 
Diamond, Anil Kashyap, and Jeremy Stein, as well as members of the 
Squam Lake Group (see http://www.cfr.org/project/1404/
squam_lake_working_group_on_financial_regulation.html).
---------------------------------------------------------------------------
    Perhaps the single biggest distortion to the free enterprise system 
is when a number of private institutions are deemed by political and 
regulatory authorities as too systemic to fail. Resources are trapped 
in corporate structures that have repeatedly proven their incompetence, 
and further resources are sucked in from the taxpayer as these 
institutions destroy value. Indeed, these institutions can play a game 
of chicken with the authorities by refusing to take adequate 
precautions against failure, such as raising equity, confident in the 
knowledge the authorities will come to the rescue when needed.
    The consequences are observationally identical to those in a system 
of crony capitalism. Indeed, it is hard for the authorities to refute 
allegations of crony capitalism--after all, the difference is only one 
of intent for the authorities in a free enterprise system do not want 
to bail out systemically important institutions, but are nevertheless 
forced to, while in crony capitalism, they do so willingly. More 
problematic, corrupt officials can hid behind the doctrine of systemic 
importance to bail out favored institutions. Regardless of whether such 
corruption takes place, the collateral damage to public faith in the 
system of private enterprise is enormous, especially as the public 
senses two sets of rules, one for the systemically important, and 
another for the rest of us.
    As important as the economic and political damage created in bad 
times, is the damage created in good times because these institutions 
have an unfair competitive advantage. Some institutions may undertake 
businesses they have no competence in, get paid for guarantees they 
have no ability to honor, or issue enormous amounts of debt cheaply 
only because customers and investors see the taxpayer standing behind 
them. Other institutions may deliberately create complexities, 
fragilities, and interconnections so as to become hard to fail. In many 
ways, therefore, I believe the central focus of any new regulatory 
effort should be on how to prevent institutions from becoming too 
systemic to fail.
Is it only too ``big'' to fail?
    Note that I have avoided saying ``too big to fail.'' This is 
because there are entities that are very large but have transparent, 
simple structures that allow them to be failed easily--for example, a 
firm running a family of regulated mutual funds. By contrast, there are 
relatively small entities--the mortgage insurers or Bear Stearns are 
examples--whose distress caused substantial stress to buildup through 
the system. This means a number of factors other than size may cause an 
institution to be systemically important including (i) the 
institution's centrality to a market (mortgage insurers, exchanges) 
(ii) the extent to which systemic institutions are exposed to the 
institution (AIG) (iii) the extent to which the institution's business 
and liabilities are intertwined, or are in foreign jurisdictions where 
U.S. bankruptcy stay does not apply, so that the act of failing the 
institution will impose substantial losses on its assets, and (iv) the 
extent to which the institution's business interacts in complex ways 
with the financial system so that the authorities are uncertain about 
the systemic consequences of failure and do not want to take the risk 
of finding out.
    This last point takes us to the role of regulators and politicians 
in creating an environment where institutions are deemed too systemic 
to fail. For the authorities, there is little immediate benefit to 
failing a systemically important institution. If events spin out of 
control, the downside risks to one's career, as well as short-term 
risks to the economy, loom far bigger for the authorities than any long 
term benefit of asserting market discipline and preventing moral 
hazard. Moreover, the public is likely to want to assign blame for a 
recognized failure, while a bailout can largely be hidden from public 
eye. Finally, the budgetary implications of recognizing failure can be 
significant, while the budgetary implications of bailouts can be 
postponed into the future. For all these reasons, it will be the brave 
or foolhardy regulator who tries to fail a systemically important 
institution, and give the experience of the events surrounding the 
Lehman bankruptcy, I do not see this happening over the foreseeable 
future.
    If the authorities are likely to bail out systemically--or even 
near-systemically important institutions--the solution to the problem 
of institutions becoming ``too systemically important to fail'' has to 
be found elsewhere than in stiffening the backbone of regulators or 
limiting their discretion.\2\ There are three obvious possibilities: 1) 
prevent institutions from becoming systemically important; 2) keep them 
from failing by creating additional private sector buffers; 3) when 
they do become truly distressed, make it easier for the authorities to 
fail them. Let me discuss each of these in turn.
---------------------------------------------------------------------------
    \2\ For example, the Federal Deposit Insurance Corporation 
Improvement Act (FDICIA) in many ways was meant to ensure regulators 
took prompt corrective action, by reducing their leeway to forbear. 
However, FDICIA was focused on the problem of relatively small thrifts, 
not ``too-big-to-fail'' institutions.
---------------------------------------------------------------------------
Preventing Institutions From Becoming Systemically Important
    Many current regulatory proposals focus on preventing institutions 
from becoming systemically important. These include preventing 
institutions from expanding beyond a certain size or limiting the 
activities of depository institutions (through a modern version of the 
1933 Glass-Steagall Act). I worry that these proposals may be very 
costly, and may still not achieve their intent. Here is why.
    Clearly, casual empiricism would suggest that some institutions 
have become too big to manage. If in addition they are likely to impose 
costs on the system because they are ``too big to fail,'' it seems 
obvious they should be constrained from growing, and indeed should be 
forced to break up.\3\ Similarly, it seems obvious that the peripheral 
risky activities of banks should be constrained or even banned if there 
are underlying core safe activities than need to be protected.
---------------------------------------------------------------------------
    \3\ The academic literature lends support to such a view for banks 
because it finds few economies of scale for banks beyond a certain 
size.
---------------------------------------------------------------------------
Economic Concerns
    More careful thought would, however, suggest serious concerns about 
such proposals. First, consider the economic concerns. Some 
institutions get large, not through opportunistic and unwise 
acquisitions, but through organic growth based on superior efficiency. 
A crude size limit, applied across the board, would prevent the economy 
from realizing the benefits of the growth of such institutions. 
Furthermore, size can imply greater diversification, which can reduce 
risk. The optimal size can vary across activities and over time. Is a 
trillion dollar institution permissible if it is a mutual fund holding 
assets? What if it is an insurance company? What if it is an insurance 
company owning a small thrift? Finally, size itself is hard to define. 
Do we mean assets, liabilities, gross derivatives positions, net 
derivatives positions, transactions, or profitability? Each of these 
could be a reasonable metric, yet vastly different entities would hit 
against the size limit depending on the metric we choose. Given all 
these difficulties, any legislation on size limits will have to give 
regulators substantial discretion. That creates its own problems which 
I will discuss shortly.
    Similar issues arise with activity limits. What activities would be 
prohibited? Many of the activities that were prohibited to commercial 
banks under Glass-Steagall were peripheral to this crisis. And 
activities that did get banks into trouble, such as holding sub-prime 
mortgage-backed securities, would have been permissible under Glass 
Steagall.\4\ Some suggest banning banks from proprietary trading 
(trading for their own account). But how would regulators distinguish 
(illegitimate) proprietary trading from legitimate risk-reducing 
hedging?
---------------------------------------------------------------------------
    \4\ Banks like Citibank have found sufficient ways to get into 
trouble in recent decades even when Glass Steagall was in force.
---------------------------------------------------------------------------
Regulatory Concerns
    Regulating size limits would be a nightmare. Not only would the 
regulator have to be endowed with substantial amounts of discretion 
because of the complexities associated with size regulation, the 
regulated would constantly attempt to influence regulators to rule in 
their favor. While I have faith in regulators, I would not want them to 
be subject to the temptations of the license-permit Raj of the kind 
that flourished in India. Indeed, even without such temptations, 
regulators are influenced by the regulated--one of the deficiencies 
uncovered by this crisis is that banks were allowed under Basel II to 
set their levels of capital based on their own flawed models.
    Moreover, the regulated would be strongly tempted to arbitrage 
draconian regulations. In India, strict labor laws kicked in once firms 
reached 100 employees in size. Not surprisingly, there were a large 
number of firms with common ownership that had 99 employees--every time 
a firm was to exceed 100 employees, it broke up into two firms. 
Similarly, would size limits lead to firms shifting activity into 
commonly owned and managed, but separately capitalized, entities as 
soon as they approach the limits? Will we get virtual firms that are as 
tightly knit together as current firms, but are less transparent to the 
regulator? I fear the answer could well be yes.
    Similar problems may arise with banning activities. The common 
belief is that there are a fixed set of risky possibilities so if 
enough are prohibited to banks, they will undertake safe activities 
only--what one might call the ``lump of risk'' fallacy. The truth is 
that banks make money only by taking risks and managing them carefully. 
If enough old risky activities are banned, banks will find new creative 
ways of taking on risk, with the difference that these will likely be 
hidden from the regulator. And because they are hidden, they are less 
likely to be managed carefully.
Political Concerns
    Finally, the presumption is that the political support for heavy 
regulation will continue into the future. Yet, as the business cycle 
turns, as memories of this crisis fade, and as the costs associated 
with implementing the regulation come to the fore without visible 
benefits, there will be less support for the regulation. Profitable 
banks will lobby hard to weaken the legislation, and they will likely 
be successful. And all this will happen when we face the most danger 
from too-systemic-to-fail entities. If there is one lesson we take away 
from this crisis, it should be this--regulation that the regulated 
perceive as extremely costly is unlikely to be effective, and is likely 
to be most weakened at the point of maximum danger to the system.
    I would suggest that rather than focusing on regulations to limit 
size or activities, we focus on creating private sector buffers and 
making institutions easier to fail. Let us turn to these now.
Adding Additional Private Sector Buffers.
    One proposal making the rounds is to require higher levels of 
capital for systemically important institutions. The problem though is 
that capital is costlier than other forms of financing. In boom times, 
the market requires very low levels of capital from financial 
intermediaries, in part because euphoria makes losses seem remote. So 
when regulated financial intermediaries are forced to hold more costly 
capital than the market requires, they have an incentive to shift 
activity to unregulated intermediaries, as did banks in setting up SIVs 
and conduits during the current crisis. If systemically important 
institutions are required to hold substantially more capital, their 
incentive to undertake this arbitrage is even stronger. Even if 
regulators are strengthened to detect and prevent this shift in 
activity, banks can subvert capital requirements by taking on risk the 
regulators do not see, or do not penalize adequately with capital 
requirements.
    So while increased capital for systemically important entities can 
be beneficial, I do not believe it is a panacea.\5\ An additional, and 
perhaps more effective, buffer is to ask systemically important 
institutions to arrange for capital to be infused when the institution 
or the system is in trouble. Because these ``contingent capital'' 
arrangements will be contracted in good times when the chances of a 
downturn seem remote, they will be relatively cheap (compared to 
raising new capital in the midst of a recession) and thus easier to 
enforce. Also, because the infusion is seen as an unlikely possibility, 
firms cannot go out and increase their risks, using the future capital 
as backing. Finally, because the infusions come in bad times when 
capital is really needed, they protect the system and the taxpayer in 
the right contingencies.
---------------------------------------------------------------------------
    \5\ See the comprehensive discussion of capital requirements in the 
Squam Lake Group's proposal http://www.cfr.org/publication/19001/
reforming_capital_requirements_
for_financial_institutions.html.
---------------------------------------------------------------------------
    Put differently, additional capital is like keeping buckets full of 
water ready to douse a potential fire. As the years go by and the fire 
does not appear, the temptation is to use up the water. By contrast, 
contingent capital is like installing sprinklers. There is no water to 
use up, but when the fire threatens, the sprinklers will turn on.
Contingent Debt Conversions
     One version of contingent capital is for banks to issue debt which 
would automatically convert to equity when two conditions are met; 
first, the system is in crisis, either based on an assessment by 
regulators or based on objective indicators such as aggregate bank 
losses (this could be cruder, but because it is automatic, it will 
eliminate the pressure that would otherwise come on regulators), and 
second, the bank's capital ratio falls below a certain value.\6\ The 
first condition ensures that banks that do badly because of their own 
errors, and not when the system is in trouble, don't get to avoid the 
disciplinary effects of debt. The second condition rewards well-
capitalized banks by allowing them to avoid the forced conversion (the 
number of shares the debt converts to will be set at a level so as 
dilute the value of old equity substantially), while also giving banks 
that anticipate losses an incentive to raise new equity well in time.
---------------------------------------------------------------------------
    \6\ This describes work done by the Squam Lake Group, and a more 
comprehensive treatment is available at http://www.cfr.org/publication/
19002.
---------------------------------------------------------------------------
Capital Insurance
    Another version of contingent capital is to require that 
systemically important levered financial institutions buy fully 
collateralized insurance policies (from unlevered institutions, 
foreigners, or the government) that will infuse capital into these 
institutions when the system is in trouble.\7\
---------------------------------------------------------------------------
    \7\ This is based on a paper I wrote with Anil Kashyap and Jeremy 
Stein, which is available at http://www.kc.frb.org/publicat/sympos/
2008/KashyapRajanStein.03.12.09.pdf
---------------------------------------------------------------------------
    Here is one way it could operate. Megabank would issue capital 
insurance bonds, say to sovereign wealth funds or private equity. It 
would invest the proceeds in Treasury bonds, which would then be placed 
in a custodial account in State Street Bank. Every quarter, Megabank 
would pay a pre-agreed insurance premium (contracted at the time the 
capital insurance bond is issued) which, together with the interest 
accumulated on the Treasury bonds held in the custodial account, would 
be paid to the sovereign fund.
    If the aggregate losses of the banking system exceed a certain pre-
specified amount, Megabank would start getting a payout from the 
custodial account to bolster its capital. The sovereign wealth fund 
will now face losses on the principal it has invested, but on average, 
it will have been compensated by the insurance premium.Clearly, both 
the convertible debt proposal and the capital insurance proposal will 
have to be implemented with care. For instance, it would be silly for 
any systemically important institution to buy these instruments, and 
they should be deterred from doing so. At the same time, some obvious 
objections can be answered easily. For instance, some critics worry 
whether there will be a market for these bonds that fall in value when 
the whole economy is in distress. The answer is there are already 
securities that have these characteristics and are widely traded. 
Moreover, a bank in Canada has actually issued securities of this sort.
Making Institutions Easier to Fail.
    Let us now turn to the other possible remedy--making systemically 
important institutions easier to fail. There are currently a number of 
problems in failing systemically important institutions. Let me list 
them and suggest obvious remedies.

  (i)  Regulators do not have resolution authority over non-bank 
        financial firms or bank holding companies, and ordinary 
        bankruptcy court would take too long--the financial business 
        would evaporate while the institution is in bankruptcy court. 
        This leaves piece-meal liquidation, with attendant loss in 
        value, as the only alternative to a bailout. Regulators need 
        resolution authority of the kind the FDIC has for banks.

  (ii)  Regulators do not have full information on the holders of a 
        systemically important institution's liabilities. They have 
        difficulty figuring out whom the first round of losses would 
        hit, let alone where the second round (as institutions hit by 
        the first round fail) would fall. While in principle they could 
        allow the institution to fail, and ensure the first and second 
        round failures are limited by providing capital where 
        necessary, they do not have the ability to do so at present. 
        Furthermore, because the market too does not know where the 
        exposures are, the failure of a large institution could lead to 
        panic. More information about exposures needs to be gathered, 
        and the authorities need the ability to act on this information 
        (including offering routine warnings to levered regulated 
        entities that have high exposure to any institution), as well 
        as the ability to disseminate it widely if they have to fail an 
        institution.

  (iii)  The foreign operations of institutions are especially 
        problematic since there is no common comprehensive resolution 
        framework for all of a multi-national bank's operations. 
        Failing a bank in the United States could lead to a run on a 
        branch in a foreign country, or a seizure of local assets by a 
        foreign authority in order to protect liability holders within 
        that country. These actions could erode the value of the bank's 
        international operations substantially, resulting in losses 
        that have to be borne by U.S. taxpayers, and making authorities 
        more reluctant to fail the bank. A comprehensive international 
        resolution framework needs to be negotiated with high priority. 


  (iv)  The operations of some systemically important institutions are 
        linked to their liabilities in ways that are calculated to 
        trigger large losses if the bank is failed. For instance, if a 
        bank is on one side of swap transactions and it fails, the 
        counterparties on the other side need to be paid the 
        transactions costs incurred in setting up new substitute swap 
        contracts. Even if the market is calm, these seemingly small 
        transactions costs multiplied by a few trillion dollars in 
        gross outstanding contracts can amount to a large number, in 
        the many billions of dollars. If we add to this the higher 
        transactions costs when the market is in turmoil, the costs can 
        be very high. Regulators have to work with the industry to 
        reduce the extent to which business losses are triggered when 
        the institution's debt is forced to bear losses. These cross-
        default clauses essentially are poison-pills that make large 
        institutions too costly to fail.

  (v)  Finally, the implicit assumption that some of these institutions 
        will not be failed causes market participants to treat their 
        liabilities as backed by the full faith and credit of the 
        government. These liabilities then become the core of 
        strategies that rely indeed on their being fully backed. Any 
        hint that belief in the backing is unwarranted can cause these 
        strategies to implode, making the authorities averse to 
        changing beliefs.\8\ Regulators have to convince the market 
        that no institution is too systemically important to fail. 
---------------------------------------------------------------------------
    \8\ Mohamed El Erian of Pimco phrases this as a situation where 
what the market thinks of as constant parameters become variables, 
resulting in heightened risk aversion. One example of this is the 
failure of Lehman, which resulted in the Reserve Primary money market 
fund ``breaking the buck''. The strategy of money market funds 
investing in the debt of systemically important-but-weak banks in order 
to obtain higher yields imploded, causing a run on money market funds.

    The problem is that none of this can be achieved if the financial 
institutions are working at cross-purposes to the regulator--all will 
be for naught if even while the regulator is working with international 
authorities to devise a comprehensive resolution scheme, the financial 
institution is adding on layers of complexity in its international 
operations. Therefore I end with one last suggestion: Require 
systemically important financial institutions to develop a plan that 
would enable them to be resolved quickly--eventually over a weekend.
    Such a ``shelf bankruptcy'' plan would require institutions to 
track, and document, their exposures much more carefully and in a 
timely manner, probably through much better use of technology. The plan 
will need to be stress tested by regulators periodically and supported 
by enabling legislation--such as one facilitating an orderly transfer 
of the institution's swap books to pre-committed partners. And 
regulators will need to be ready to do their part, including paying off 
insured depositors quickly where necessary.
    Not only will the need to develop a plan give these institutions 
the incentive to work with regulators to reduce unnecessary complexity 
and improve management, it may indeed force management to think the 
unthinkable during booms, thus helping avoid the costly busts. Most 
important, it will convey to the market the message that the 
authorities are serious about allowing the systemically important to 
fail. When we emerge from this crisis, this will be the most important 
message to convey.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM SHEILA C. 
                              BAIR

Q.1. Mr. Wallison testified that, ``In a widely cited paper and 
a recent book, John Taylor of Stanford University concluded 
that the market meltdown and the freeze in interbank lending 
that followed the Lehman and AlG events in mid-September 2008 
did not begin until the Treasury and Fed proposed the initial 
Troubled Asset Relief Program later in the same week, an action 
that implied that financial conditions were much worse than the 
markets had thought. Taylor's view, then, is that AlG and 
Lehman were not the cause of the meltdown that occurred later 
that week. Since neither firm was a bank or other depository 
institution, this analysis is highly plausible.''
    Do you agree or disagree with the above statement? Why, or 
why not?

A.1. Professor Taylor argues that the data on the LIBOR-OIS 
spread indicate that the market had a stronger reaction to the 
testimony by Federal Reserve Board Chairman Ben Bernanke and 
Treasury Secretary Henry Paulson of September 23, 2008, on the 
government policy intervention that would become known as the 
TARP program than to the bankruptcy of Lehman Brothers on 
September 15. Professor Taylor's interpretation does not 
acknowledge that the events of the period happened so rapidly 
and in such short order that it is difficult to disentangle the 
effects of specific news and market events. Other evidence 
suggests that reserves held by banks jumped dramatically 
immediately after Lehman entered bankruptcy (Federal Reserve 
Statistical Release H-3), indicating that banks preferred the 
security of a deposit at the Federal Reserve over the risk-and-
return profile offered by an interbank loan.
    Following the Lehman Brothers bankruptcy filing, Primary 
Reserve--a large institutional money market fund--suffered 
losses on unsecured commercial paper it had bought from Lehman. 
The fund ``broke the buck'' on September 16. This ``failure'' 
instigated a run and subsequent collapse of the commercial 
paper market.
    The events of the week may have had compound effect on the 
market's perception of risk. For example, it is unclear whether 
AIG would have deteriorated as fast if Lehman had not entered 
bankruptcy. Indeed, TARP may not have even been proposed 
without the failure of Lehman. It also took time for markets to 
understand the size of the Lehman bankruptcy losses--which were 
larger than anticipated--and to use this new information to 
reassess the worthiness of all surviving counterparties.
    In the FDIC's view, uncertainty about government action and 
interventions has been a source of systemic risk. As outlined 
in my testimony, the FDIC recommends a legal mechanism for the 
orderly resolution of systemically important institutions that 
is similar to what exists for FDIC-insured banks. The purpose 
of the resolution authority should not be to prop up a failed 
entity, but to permit the swift and orderly dissolution of the 
entity and the absorption of its assets by the private sector 
as quickly as possible. Imposing losses on shareholders and 
other creditors will restore market discipline. A new legal 
mechanism also will permit continuity in key financial 
operations and reduce uncertainty. Such authority can preserve 
valuable business lines using an industry-paid fund when 
debtor-in-possession financing is unavailable because of 
market-wide liquidity shocks or strategic behavior by potential 
lenders who also are potential fire sale acquirers of key 
assets and businesses of the failing institution. Under a new 
resolution process, uninsured creditor claims could be 
liquefied much more quickly than can be done in a normal 
bankruptcy.

Q.2. Do you believe that if Basel II had been completely 
implemented in the United States that the trouble in the 
banking sector would have been much worse? Some commentators 
have suggested that the stress tests conducted on banks by the 
Federal Government have replaced Basel II as the nation's new 
capital standards. Do you believe that is an accurate 
description? Is that good, bad, or indifferent for the health 
of the U.S.-banking system?

A.2. Throughout the course of its development, the advanced 
approaches of Basel II were widely expected to result in lower 
bank capital requirements. The results of U.S. capital impact 
studies, the experiences of large investment banks that 
increased their financial leverage during 2006 and 2007 under 
the Securities and Exchange Commission's version of the 
advanced approaches, and recent evidence from the European 
implementation of Basel II all demonstrated that the advanced 
approaches lowered bank regulatory capital requirements 
significantly. Throughout the interagency Basel II discussions, 
the record shows that the FDIC took the position that capital 
levels needed to be strengthened for the U.S. Basel II banks. 
If the advanced approaches of Basel II had been fully in place 
and relied upon in the United States, the FDIC believes that 
large banks would have entered the crisis period with 
significantly less capital, and would therefore have been even 
more vulnerable to the stresses they have experienced.
    Supervisors have long encouraged banks to hold more capital 
than their regulatory minimums, and we view the stress tests as 
being squarely within that tradition. While stress testing is 
an important part of sound risk management practice, it is not 
expected to replace prudential regulatory minimum capital 
requirements. In many respects, the advanced approaches of 
Basel II do not constitute transparent regulatory minimum 
requirements, in that they depend for their operation on 
considerable bank and supervisory judgment. The FDIC supported 
the implementation of the advanced approaches only subject to 
considerable safeguards, including the retention of the 
leverage ratio and a regulatory commitment that the banking 
agencies would conduct a study after 2010 to identify whether 
the new approaches have material weaknesses, and if so, that 
the agencies would connect those weaknesses.

Q.3. If there is an ordered resolution process, whether that's 
bankruptcy, a new structured bankruptcy or a new resolution 
authority--what can we do to generate the political will to use 
it?

A.3. For a new resolution process to work efficiently, market 
expectations must adjust and investors must assume that the 
government will use the new resolution scheme instead of 
providing government support. It is not simply a matter of 
political will, but of having the necessary tools ready so that 
a resolution can be credibly implemented. A systemic resolution 
authority could step between a failing firm and the market to 
ensure that critical functions are maintained while an orderly 
unwinding takes place. The government could guarantee or 
provide financing for the unwinding if private financing is 
unavailable. Assets could be liquidated in an orderly manner 
rather than having collateral immediately dumped on the market. 
This would avoid the likelihood of a fire sale of assets, which 
depresses market prices and potentially weakens other firms as 
they face write-downs of their assets at below ``normal'' 
market prices.

Q.4. Should we be limiting the size of companies in the future 
to prevent a ``too-big-to-fail'' situation, or can we create a 
resolution process that only needs the political will to 
execute it that will eliminate the need to be concerned about a 
company's size?

A.4. The FDIC supports the idea of providing incentives to 
financial firms that would cause them to internalize into their 
decisionmaking process the potential external costs that are 
imposed on society when large and complex financial firms 
become troubled. While fewer firms may choose to become large 
and complex as a result, there would be no prohibition on 
growing or adding complex activities.
    Large and complex financial firms should be subject to 
regulatory and economic incentives that require these 
institutions to hold larger capital and liquidity buffers to 
mirror the heightened risk they pose to the financial system. 
Capital and regulatory requirements could increase as firms 
become larger so that firms must operate more efficiently if 
they become large. In addition, restrictions on leverage and 
the imposition of risk-based premiums on institutions and their 
activities should provide incentives for financial firms to 
limit growth and complexity that raise systemic concerns.
    To address pro-cyclicality, capital standards should 
provide for higher capital buffers that increase during 
expansions and are drawn down during contractions. In addition, 
large and complex financial firms could be subject to higher 
Prompt Corrective Action limits under U.S. laws. Regulators 
also should take into account off-balance-sheet assets and 
conduits as if these risks were on-balance-sheet.

Q.5. What role did the way financial contracts are treated in 
bankruptcy create in both the AIG and Lehman situations?

A.5. In bankruptcy, current law allows market participants to 
terminate and net out derivatives and sell any pledged 
collateral to pay off the resulting net claim immediately upon 
a bankruptcy filing. In addition, since the termination right 
is immediate, and the bankruptcy process does not provide for a 
right of a trustee or debtor to transfer the contracts before 
termination, the bankruptcy filing leads to a rapid, 
uncontrolled liquidation of the derivatives positions. During 
normal market conditions, the ability of counterparties to 
terminate and net their exposures to bankrupt entities prevents 
additional losses flowing through the system and serves to 
improve market stability. However, when stability is most 
needed during a crisis, these inflexible termination and 
netting rights can increase contagion.
    Without any option of a bridge bank or similar type of 
temporary continuity option, there is really no practical way 
to limit the potential contagion absent a pre-packaged 
transaction or arrangements by private parties. While this 
sometimes happens, and did to some degree in Lehman's 
bankruptcy, it raises significant questions about continuity 
and comparative fairness for creditors. During periods of 
market instability--such as during the fall of 2008--the 
exercise of these netting and collateral rights can increase 
systemic risks. At such times, the resulting fire sale of 
collateral can depress prices, freeze market liquidity as 
investors pull back, and create risks of collapse for many 
other firms.
    In effect, financial firms are more prone to sudden market 
runs because of the cycle of increasing collateral demands 
before a firm fails and collateral dumping after it fails. 
Their counterparties have every interest to demand more 
collateral and sell it as quickly as possible before market 
prices decline. This can become a self-fulfilling prophecy--and 
mimics the depositor runs of the past.
    The failure of Lehman and the instability and bail-out of 
AIG led investors and counterparties to pull back from the 
market, increase collateral requirements on other market 
participants, and dramatically de-leverage the system.
    In the case of Lehman, the bankruptcy filing triggered the 
right of counterparties to demand an immediate close-out and 
netting of their contracts and to sell their pledged 
collateral. The immediate seizing and liquidation of the firm's 
assets left less value for the firm's other creditors.
    In the case of AIG, the counterparties to its financial 
contracts demanded more collateral as AIG's credit rating 
dropped. Eventually, AIG realized it would run out of 
collateral and was forced to turn to the government to prevent 
a default in this market. Had AIG entered bankruptcy, the run 
on its collateral could have translated into a fire sale of 
assets by its counterparties.
    In the case of a bank failure, by contrast, the FDIC has 24 
hours after becoming receiver to decide whether to pass the 
contracts to a bridge bank, sell them to another party, or 
leave them in the receivership. If the contracts are passed to 
a bridge bank or sold, they are not considered to be in default 
and they remain in force. Only if the financial contracts are 
left in the receivership are they subject to immediate close-
out and netting.

Q.6. Chrysler's experience with the Federal Government and 
bankruptcy may prove a useful learning experience as to why 
bankruptcy despite some issues may still best protect the 
rights of various investors. A normal bankruptcy filing is 
straight forward--senior creditors get paid 100 cents on the 
dollar and everyone else gets in line. That imposes the losses 
on those who chose to take the risk. Indeed, the sanctity of a 
contract was paramount to our Founding Fathers. James Madison, 
in 1788, wrote in Federalist Papers Number 44 to the American 
people that, ``laws impairing the obligation of contracts are 
contrary to the first principles of the social compact, and to 
every principle of sound legislation.''
    With that in mind, what changes can be made to bankruptcy 
to ensure an expedited resolution of a company that does not 
roil the financial markets and also keeps government from 
choosing winners and losers?

A.6. Bankruptcy is designed to facilitate the smooth 
restructuring or liquidation of a firm. It is an effective 
insolvency process for most companies. However, it was not 
designed to protect the stability of the financial system. 
Large complex financial institutions play an important role in 
the financial intermediary function, and the uncertainties of 
the bankruptcy process can create `runs' similar to depositor 
runs of the past in financial firms that depend for their 
liquidity on market confidence. Putting a bank holding company 
or other non-bank financial entity through the normal corporate 
bankruptcy process may create instability as was noted in the 
previous answer. In the resolution scheme for bank holding 
companies and other non-bank financial firms, the FDIC is 
proposing to establish a clear set of claims priorities just as 
in the bank resolution system. Under the bank resolution 
system, there is no uncertainty and creditors know the priority 
of their claims.
    In bankruptcy, without a bridge bank or similar type of 
option, there is really no practical way to provide continuity 
for the holding company's or its subsidiaries' operations. 
Those operations are based principally on financial agreements 
dependent on market confidence and require continuity through a 
bridge bank mechanism to allow the type of quick, flexible 
action needed. A stay that prevents creditors from accessing 
their funds destroys financial relationships. Without a system 
that provides for the orderly resolution of activities outside 
of the depository institution, the failure of a large, complex 
financial institution includes the risk that it will become a 
systemically important event.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM GARY STERN

Q.1. Mr. Wallison testified that, ``In a widely cited paper and 
a recent book, John Taylor of Stanford University concluded 
that the market meltdown and the freeze in interbank lending 
that followed the Lehman and AIG events in mid-September 2008 
did not begin until the Treasury and Fed proposed the initial 
Troubled Asset Relief Program later in the same week, an action 
that implied that financial conditions were much worse than the 
markets had thought. Taylor's view, then, is that AIG and 
Lehman were not the cause of the meltdown that occurred later 
that week. Since neither firm was a bank or other depository 
institution, this analysis is highly plausible.''
    Do you agree or disagree with the above statement? Why, or 
why not?

A.1. Members of the Board of Governors of the Federal Reserve 
System have addressed the factors that contributed to the 
market dislocation in mid-September 2008. See, for example, the 
testimony of Chairman Ben S. Bernanke on U.S. financial markets 
before the Committee on Banking, Housing, and Urban Affairs, 
U.S. Senate, on September 23, 2008, and the testimony of Vice 
Chairman Donald L. Kohn on American International Group before 
the Committee on Banking, Housing, and Urban Affairs, U.S. 
Senate, Washington, D.C., on March 5, 2009. Based on my 
understanding of the facts and circumstances around market 
conditions in mid-September, I will defer to these descriptions 
of events.

Q.2. Do you believe that if Basel II had been completely 
implemented in the United States that the trouble in the 
banking sector would have been much worse?

A.2. To the degree that a fully implemented Basel II would have 
left large financial institutions with less capital, the 
financial crisis could have been more severe. To the degree 
that large financial institutions would have had improved risk 
management systems due to Basel II, perhaps the crisis would 
not have been as severe. In short, we cannot know with any 
precision how a fully implemented Basel II would have altered 
bank performance during the recent financial crisis; the effect 
that a fully implemented Basel II would have had on the depth 
and severity of the financial crisis would have depended on 
competing factors such as the two just noted. In any case, and 
consistent with my remarks during the recent hearing, I believe 
Basel II should undergo a thorough review to determine if and 
how policymakers should modify it.

Q.3. Some commentators have suggested that the stress tests 
conducted on banks by the Federal Government have replaced 
Basel II as the nation's new capital standards. Do you believe 
that is an accurate description? Is that good, bad, or 
indifferent for the health of the U.S. banking system?

A.3. As noted by the Board of Governors of the Federal Reserve 
System in ``The Supervisory Capital Assessment Program: 
Overview of Results'' (May 7, 2009), ``the SCAP buffer does not 
represent a new capital standard and is not expected to be 
maintained on an ongoing basis.'' I believe that policy is 
appropriate.

Q.4. If there is an ordered resolution process, whether that's 
bankruptcy, a new structured bankruptcy or a new resolution 
authority--what can we do to generate the political will to use 
it?

A.4. Consistent with my testimony, I believe that financial 
spillovers lead policymakers to provide extraordinary support 
to the creditors of systemically important financial 
institutions. To discourage policymakers from providing such 
support requires them to take action to reduce the threat of 
these spillovers. I provided examples of these actions in my 
written testimony.

Q.5. Should we be limiting the size of companies in the future 
to prevent a ``too-big-to-fail'' situation, or can we create a 
resolution process that only needs the political will to 
execute it that will eliminate the need to be concerned about a 
company's size?

A.5. As I noted in my written testimony, I do not believe that 
either reducing the size of financial institutions or creating 
a new resolution framework for nonbank financial institutions 
will, by itself, sufficiently address the ``too-big-to-fail'' 
problem. Neither step will effectively reduce the spillover 
problem that leads to the provision of government support for 
uninsured creditors of systemically important financial 
institutions in the first place. A resolution regime offers a 
tool to address some spillovers and not others. I detail in my 
written testimony recommendations to address spillovers.

Q.6. What role did the way financial contracts are treated in 
bankruptcy create in both the AIG and Lehman situations?

A.6. We discussed issues surrounding so-called early 
termination, closeout netting, and other aspects of the 
treatment of derivative contracts in bankruptcy and their 
relation to the ``too-big-to-fail'' problem in our earlier 
analysis. (See Gary H. Stern and Ron J. Feldman, 2009, Too Big 
To Fail: The Hazards of Bank Bailouts, pp.118 and 119.) These 
issues deserve careful scrutiny in light of the AIG and Lehman 
situations to ensure that current policy and law adequately 
reflect the ``lessons learned'' from those two cases.

Q.7. Chrysler's experience with the Federal Government and 
bankruptcy may prove a useful learning experience as to why 
bankruptcy despite some issues may still best protect the 
rights of various investors. A normal bankruptcy filing is 
straight forward--senior creditors get paid 100 cents on the 
dollar and everyone else gets in line. That imposes the losses 
on those who chose to take the risk.
    Indeed, the sanctity of a contract was paramount to our 
Founding Fathers. James Madison, in 1788, wrote in Federalist 
Papers Number 44 to the American people that, ``laws impairing 
the obligation of contracts are contrary to the first 
principles of the social compact, and to every principle of 
sound legislation.''
    With that in mind, what changes can be made to bankruptcy 
to ensure an expedited resolution of a company that does not 
roil the financial markets and also keeps government from 
choosing winners and losers?

A.7. I see merit in creating a resolution regime for all 
systemically important financial firms that has similarities to 
the one currently used by the FDIC to resolve banks. As noted 
in my written testimony, ``such regimes would facilitate 
imposition of losses on equity holders, allow for the 
abrogation of certain contracts, and provide a framework for 
operating an insolvent firm. These steps address some 
spillovers and increase market discipline.'' However, as noted 
previously, these advantages do not address the full range of 
potential spillovers and thus may not sufficiently facilitate 
policymakers' decision to impose losses on creditors of 
systemically important firms.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM PETER J. 
                            WALLISON

Q.1. If there is an ordered resolution process, whether that's 
bankruptcy, a new structured bankruptcy or a new resolution 
authority--what can we do to generate the political will to use 
it?

A.1. The problem with a new resolution authority is that there 
will be too much political will to use it. My concern is that 
regulators will use the system to bail out failing financial 
companies when these companies should be allowed to go into 
bankruptcy. The result will be that the taxpayers will end up 
paying for something that--in bankruptcy--would be paid for by 
the company's creditors.

Q.2. Should we be limiting the size of companies in the future 
to prevent a ``too-big-to-fail'' situation, or can we create a 
resolution process that only needs the political will to 
execute it that will eliminate the need to be concerned about a 
company's size?

A.2. There is no reason to be concerned about the size of any 
company other than a commercial bank, and even then it would 
not be good policy to try to limit the size of a bank because 
we are afraid that its failure will cause a systemic problem. 
Companies and banks get large because they are good competitors 
and serve the public well. We shouldn't penalize them for that. 
In addition, our big international operating companies need big 
international banks to serve their needs. If we cut back the 
size of banks or insurance companies or securities firms 
because of fear about systemic risk, we would be adding costs 
for our companies for no good reason. Finally, I don't think 
that any financial company other than a large commercial bank 
can--even in theory--create a systemic problem. Banks alone 
have liabilities that can be withdrawn on demand and are used 
to make payment by businesses and individuals. If a bank fails, 
these funds might not be available, and that could cause a 
systemic problem. But other financial companies are more like 
large commercial operating companies. They borrow money for a 
term. If they fail, there are losses, but not the immediate 
loss of the funds necessary to meet daily obligations. For 
example, if GM goes into bankruptcy, it will cause a lot of 
disruption, but no one who is an investor in GM is expecting to 
use his investment to meet his payroll or pay his mortgage. 
That's also true of insurance companies, securities firms, 
hedge funds and others. If they fail they may cause losses to 
their investors, but over time, not the cascade of losses 
through the economy that is the signature of a systemic 
breakdown. We should not be concerned about losses to creditors 
and investors. It's the wariness about losses that creates 
market discipline-which is the best way to control risk-taking.

Q.3. What role did the way financial contracts are treated in 
bankruptcy create in both the AIG and Lehman situations?

A.3. Most financial contracts are exempt from the automatic 
stay that occurs when a bankruptcy petition is filed. This 
allows the counterparties of a bankrupt company to sell the 
collateral they are holding and make themselves whole, or close 
to it. This prevents losses from cascading through the economy 
when they occur. They are stopped by the ability of 
counterparties to sell the collateral they hold and reimburse 
themselves. As a result, we have only one example of a Lehman 
counterparty encountering a serious and immediate financial 
problem as a result of Lehman's failure. That was the Reserve 
Fund, which was holding an excessive amount of Lehman's short 
term commercial paper. Other than that, Lehman's failure is an 
example of what I said above about nonbank financial 
institutions. They do not cause the kind of cascading losses 
that could occur when a bank fails. We do not therefore need a 
special resolution function for these nonbank firms.
    AIG should have been allowed to go into bankruptcy. I don't 
see any reason why AIG's failure would have caused the kind of 
systemic breakdown that was feared. Again, the ability of 
counterparties to sell their collateral would have reduced any 
possible losses. Much a ttention has been focues on credit 
default swaps, but we now know that Goldman Sachs, which was 
the largest AIG swap counterparty, would not have suffered any 
losses if AIG had been allowed by the Fed to go into 
bankruptcy. The reason that Goldman would not have suffered 
losses is that they had collateral coverage on their swap 
agreements, and if AIG had failed they would have been able to 
sell the collateral and make themselves whole. So the treatment 
of financial contracts in bankruptcy is a strong reason to 
allow bankruptcy to operate rather than substituting a 
government agency.

Q.4.a. Chrysler's experience with the Federal Government and 
bankruptcy may prove a useful learning experience as to why 
bankruptcy despite some issues may still best protect the 
rights of various investors. A normal bankruptcy filing is 
straight forwardsenior creditors get paid 100 cents on the 
dollar and everyone else gets in line. That imposes the losses 
on those who chose to take the risk.

A.4.a. Exactly right.

Q.4.b. Indeed, the sanctity of a contract was paramount to our 
Founding Fathers. James Madison, in 1788, wrote in Federalist 
Papers Number 44 to the American people that, ``laws impairing 
the obligation of contracts are contrary to the first 
principles of the social compact, and to every principle of 
sound legislation.''

A.4.b. Again, exactly right.

Q.4.c. With that in mind, what changes can be made to 
bankruptcy to ensure an expedited resolution of a company that 
does not roil the financial markets and also keeps government 
from choosing winners and losers?

A.4.c. I am not enough of a bankruptcy specialist to make a 
recommendation. However, the Lehman bankruptcy seems to be 
going smoothly without any significant reforms. In the 2 weeks 
following its filing Lehman sold off its brokerage, investment 
banking and investment management businesses to 4 different 
buyers, and the process is continuing. Based on the Lehman 
case, it does not appear to me that any major changes are 
necessary.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MARTIN 
                           NEIL BAILY

Q.1. If there is an ordered resolution process, whether that's 
bankruptcy, a new structured bankruptcy or a new resolution 
authority--what can we do to generate the political will to use 
it?

A.1. Presumably the key thought behind this question is what 
can be done to ensure that some class of creditors, in addition 
to shareholders, can be forced to incur at least some loss in 
the event a large systemically important financial institution 
were to subject to some resolution procedure? One way is to 
ensure that all such institutions are required to back at least 
of their assets by uninsured long-term subordinated (unsecured) 
debt, a security not subject to a ``run'' since its holders 
cannot ask for their money back until the debt matures. 
Precisely for this reason, regulatory authorities can safely 
permit the holders of such instruments to suffer some loss 
without a threat of wider financial contagion. In addition, 
Congress can and should exercise vigilant oversight over the 
activities of any authority that may be given the power to 
resolve such troubled institutions.

Q.2. Should we be limiting the size of companies in the future 
to prevent a ``too-big-to-fail'' situation, or can we create a 
resolution process that only needs the political will to 
execute it that will eliminate the need to be concerned about a 
company's size?

A.2. There is no principled basis, in our view, for imposing 
arbitrary size limits by institution. However, regulation can 
and should be designed to ensure that as institutions grow in 
size and begin to expose the financial system to danger should 
those institutions fail, the institutions internalize this 
``externality.'' This can be accomplished by imposing 
progressively higher capital and liquidity requirements as 
financial institutions grow beyond a certain size, as well as 
more intensive supervision of their risk management practices. 
In addition, resolution authorities should be instructed to 
make an effort to break up troubled systemically important 
financial institutions, unless the costs of such breakups are 
projected to outweigh the benefits (in terms of reducing future 
exposure to systemic risk).

Q.3. What role did the way financial contracts are treated in 
bankruptcy create in both the AIG and Lehman situations?

A.3. We do not claim expertise in this area, and leave it to 
others to comment.

Q.4. Chrysler's experience with the Federal Government and 
bankruptcy may prove a useful learning experience as to why 
bankruptcy despite some issues may still best protect the 
rights of various investors. A normal bankruptcy filing is 
straight forward--senior creditors get paid 100 cents on the 
dollar and everyone else gets in line. That imposes the losses 
on those who chose to take the risk.
    Indeed, the sanctity of a contract was paramount to our 
Founding Fathers. James Madison, in 1788, wrote in Federalist 
Papers Number 44 to the American people that, ``laws impairing 
the obligation of contracts are contrary to the first 
principles of the social compact, and to every principle of 
sound legislation.''

    With that in mind, what changes can be made to bankruptcy 
to ensure an expedited resolution of a company that does not 
roil the financial markets and also keeps government from 
choosing winners and losers?

A.4. We agree that the sanctity of contracts is of paramount 
importance in our constitution and our economy. Bankruptcy law 
is not an area of our expertise. In the area of financial 
institutions in particular, however, we reiterate that one way 
to retain at least some market discipline without threatening 
the financial system is to require large systemically important 
financial institutions to issue at least some long-term 
subordinated (unsecured) debt.
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