[Senate Hearing 112-270]
[From the U.S. Government Publishing Office]
S. Hrg. 112-270
DEBT FINANCING IN THE DOMESTIC FINANCIAL SECTOR
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
CAPITAL REQUIREMENTS AND DEBT FINANCING IN THE DOMESTIC FINANCIAL
SECTOR
__________
AUGUST 3, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Levon Bagramian, Hearing Clerk
Jana Steenholdt, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Financial Institutions and Consumer Protection
SHERROD BROWN, Ohio, Chairman
BOB CORKER, Tennessee, Ranking Republican Member
JACK REED, Rhode Island JERRY MORAN, Kansas
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MIKE JOHANNS, Nebraska
DANIEL K. AKAKA, Hawaii PATRICK J. TOOMEY, Pennsylvania
JON TESTER, Montana JIM DeMINT, South Carolina
HERB KOHL, Wisconsin DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon
KAY HAGAN, North Carolina
Graham Steele, Subcommittee Staff Director
Michael Bright, Republican Subcommittee Staff Director
(ii)
C O N T E N T S
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WEDNESDAY, AUGUST 3, 2011
Page
Opening statement of Chairman Brown.............................. 1
WITNESSES
Joseph E. Stiglitz, Ph.D., Professor of Finance and Economics,
Columbia Business School, Columbia University.................. 4
Prepared statement........................................... 27
Response to written question of:
Senator Shelby........................................... 47
Edward J. Kane, Ph.D., Professor of Finance, Boston College...... 6
Prepared statement........................................... 31
Response to written question of:
Senator Shelby........................................... 47
Eugene A. Ludwig, Chief Executive Officer, Promontory Financial
Group.......................................................... 9
Prepared statement........................................... 34
Response to written question of:
Senator Shelby........................................... 49
Paul Pfleiderer, Ph.D., C.O.G. Miller Distinguished Professor of
Finance, Graduate School of Business, Stanford University...... 12
Prepared statement........................................... 38
Response to written question of:
Senator Shelby........................................... 49
(iii)
DEBT FINANCING IN THE DOMESTIC FINANCIAL SECTOR
----------
WEDNESDAY, AUGUST 3, 2011
U.S. Senate,
Subcommittee on Financial Institutions,
and Consumer Protection,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:04 p.m., in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF SENATOR SHERROD BROWN
Senator Brown. Thank you for joining us. The Subcommittee
on Financial Institutions and Consumer Protection of the Senate
Banking Committee will come to order.
Thank you very much for joining us today, the four
witnesses and those in the audience and staff. Thank you. I
know that when you schedule a hearing, when you schedule it
ahead of time, you do not always really know, but when there is
one that happens after people start leaving town, there is no
telling what will happen. So I am just honored the four of you
still showed up and that staff on both sides showed up and have
been helpful in the planning of this hearing.
I will do an opening statement, then have each of you do
the same, and the questions and answers may be a little more
free flowing than they might at another hearing. I am going to
probably ask you to respond to each other's assertions and
statements and observations. All four of you are highly
respected in these fields and have thought a lot about this and
reflected a lot about this, and so it should be an interesting
discussion for an hour or so.
The recent debate that we just concluded--and mercifully is
concluded, or at least round one is--obviously was fixated on
the national debt, but it was more than just the national debt
that we should be worried about. Too many people in Washington
seem to have forgotten about the debt that helped put us in
this deep recession and cost our country and almost everyone in
it so much, and that is the debt of the financial sector.
CBO estimates the entire cost of rescuing our failing
banking system--the bailouts, decreased tax revenues, new
spending programs in response to the trouble economy, and
interest payments--will cost our Nation some $8.6 trillion,
meaning 8 thousand billion dollars. That is more than 57
percent of our GDP. We cannot allow collective amnesia to
obscure the role that excessive financial service debt played
in causing the deepest recession since the Great Depression,
and that really is the purpose of this hearing.
In nearly the last century and a half, U.S. banks' capital
ratios declined from about 25 percent--and all of you have
written and thought about this a lot--to around 5 percent of
total assets. In the last two decades, the 10 largest banks
nearly doubled their leverage--that is, they have halved
assets, if you will, that they have available to pay off that
debt.
At the time of the financial crisis in 2007-08, four of our
five largest investment banks were leveraged 30, 35, and in one
case 40 to 1. That means when their assets declined by even the
smallest amount, they were unable to cover to pay their debts.
They were essentially insolvent, as we know. This overreliance
on borrowing from other businesses makes the financial system
so interconnected, so interdependent that the failure of one
firm can bring down the entire sector, if not the entire
economy. The implicit assumption that the Government will
backstop their losses gives companies an incentive to engage in
what economists George Akerlof and Paul Romer have called
``looting.'' Companies can risk bankruptcy at the expense of
the rest of society instead of bearing the losses themselves.
According to Kansas City Fed President Thomas Hoenig, the
20 biggest banks are more highly leveraged than their community
bank competitors--if I can use that word ``competitors'' in
that case. The largest banks are able to borrow more cheaply
than they otherwise would because it is assumed that the
Government will step in to prevent them from failing.
As a result, the largest banks make bigger profits than
those do not enjoy Government subsidies of one form or another.
They are least able to weather an economic downturn because of
that significant leverage. And not surprisingly, the largest
banks are often bigger than before. Prior to 2006, the 10
largest banks held 68 percent of total bank assets. By the end
of 2010, they had 77 percent of total banking assets.
Simply put, were there another economic calamity, bailing
these banks out again would impose an even higher cost on
taxpayers. This is not capitalism in any sense of the word. The
easiest way to prevent the need for future bailouts is simple:
requiring banks to hold increased capital reserves. Capital
buffers simply require banks to fund themselves using their own
money instead of other people's money.
Last Tuesday, the Ranking Member of the full Committee,
Senator Shelby, said one of the lessons of the financial crisis
should be the importance of maintaining strong capital
requirements, especially for large global banks. I could not
agree more. The least we can do is ask the financial sector to
have a prudent amount of its own money to cover its own losses.
We require as much of our community banks, much less a SIFI,
much less a threat to our system, and the same rules should
apply to everyone. That is why we are having this hearing today
and testifying are some of the Nation's greatest economic minds
that have great insight into all of this.
Let me introduce each of the four of you, and then we will
call on all four of you and work our way across.
Joseph Stiglitz, born in Gary, Indiana, in 1943, has taught
at Princeton, Stanford, MIT, and was Drummond Professor and
Fellow at All Souls College in Oxford. He is now a university
professor at Columbia and co-chair of Columbia's Committee on
Global Thought. He is the co-founder and executive director of
the Initiative for Policy Dialogue there. He was awarded the
Nobel Prize in Economics 10 years ago for his analyses of
markets with asymmetric information. He was lead author of the
1995 report on the Intergovernmental Panel on Climate Change,
which shared the 2007 Nobel Peace Prize. Stiglitz was a member
of the Council of Economic Advisers in the early Clinton years
and served as chair from 1995 to 1997. He then became chief
economist and senior vice president at the World Bank from 1997
to 2000. Dr. Stiglitz, thank you for joining us.
Edward Kane is a professor of finance at Boston College.
For 20 years he held the Everett Reese Chair of Banking and
Monetary Economics of Ohio State University and had the bad
judgment to leave.
[Laughter.]
Senator Brown. Currently he consults for the World Bank and
is a senior fellow in the Federal Deposit Insurance
Corporation's Center for Financial Research. Previously, Dr.
Kane has consulted for numerous agencies, including IMF,
components of the Federal Reserve System, and three foreign
central banks. He has consulted for the Congressional Budget
Office, the Joint Economic Committee, and the Office of
Technology Assessment when we had one in the U.S. Congress.
Eugene Ludwig is founder and chief executive officer of
Promontory Financial Group, the leading consulting firm for
financial companies worldwide. Prior to founding Promontory,
Mr. Ludwig was vice chair and senior control officer of Bankers
Trust Deutsche Bank. Earlier he served for 5 years as
Comptroller of the Currency. As Comptroller, Mr. Ludwig headed
the Office of the Comptroller of the Currency, the Federal
agency responsible for supervising the preponderance of bank
assets in the U.S. Prior to being Comptroller, he was a partner
in the law firm of Covington & Burling in Washington,
specializing in banking law.
And last, Paul Pfleiderer received a B.A., a Master of
Philosophy, and Ph.D. degrees from Yale, all in the field of
economics. He has been teaching at Stanford for some 30 years.
His research, much of which is jointly pursued with Anat
Admati, another professor of finance at the GSB, is generally
concerned with issues that arise when agents acting in
financial markets are differentially informed. His current
research concerns corporate governance. In addition to his
academic research, Professor Pfleiderer has consulted for
various companies and banks. He has been involved in developing
risk models and optimization software for use by portfolio
managers.
Dr. Stiglitz, if you would begin.
STATEMENT OF JOSEPH E. STIGLITZ, Ph.D., PROFESSOR OF FINANCE
AND ECONOMICS, COLUMBIA BUSINESS SCHOOL, COLUMBIA UNIVERSITY
Mr. Stiglitz. Well, thank you for this opportunity to
address the question of the financial structure of the banking
industry, which I believe is central to the future stability
and prosperity of the American and global economy. And let me
thank you, Senator Brown, for holding these hearings.
Two fundamental analytic insights, buttressed by some
empirical observations, should inform our thinking about the
appropriate regulation of banks, including capital requirements
and risk taking. The first is that when information is
imperfect and risk markets incomplete--that is, always--there
is no presumption that unfettered markets will result in
efficient outcomes. The reason is that actions give rise to
externalities, consequences that are not borne by those
undertaking them. There is a systematic misalignment of private
and social returns.
This result is of central importance in banking and finance
because the very rationale for the sector arises out of risk
management and the acquisition and utilization of information
necessary for the efficient allocation of capital. The
externalities consequent to the excessive risk taking of the
banks are manifest: It is not just the costs of the bailouts
and the millions of Americans who have lost their homes, but
the literally trillions of dollars of lost output, the gap
between the economy's actual and potential output, the
predictable and predicted fallout of the crisis. The resulting
suffering--including that of the 25 million Americans who would
like a full-time job and can't get one--is incalculable. The
budgetary problems facing the country too are in no small
measure a result of the inevitable decline in revenues and
increase in expenditures that follow. It is well known that
recoveries from financial crises are slow and painful.
This crisis not only demonstrated the importance of the
externalities to which failures in financial markets give rise,
but also the importance of what economists call agency
problems--those, like bank officials, who are supposed to take
actions on behalf of others, who have a fiduciary
responsibility, often have incentives that lead them to take
actions that benefit themselves at the expense of those they
are supposed to serve.
The second fundamental insight is that increased leverage
in general does not create value, but simply shifts risk. As
leverage increases, increased risk is placed on the equity
base. This is the central insight of the Modigliani-Miller
theorem. In the 1960s and 1970s, I showed that that result was
far more general than Modigliani-Miller had thought, but that
there were limitations too, most of which cautioned against
excessive leverage: If there were real costs to bankruptcy (as
there are), then increased leverage increased the likelihood of
these dissipative costs.
In the financial sector, the social costs of increased
leverage are even greater because of the societal costs
associated with the externalities that I described earlier. The
misalignment of incentives is even more in the case of too-big-
to-fail banks--banks that are so large that the potential
consequences of allowing them to go bankrupt poses an
unacceptable risk.
The key empirical observation is that markets are often not
rational in assessing risk; this is true even of the so-called
experts, but even more so of those who are financially
unsophisticated. Alan Greenspan testified to this before
Congress when he expressed his surprise that the financial
markets had not managed risk as well as he had expected. But
while he was correct in the conclusion that financial markets
had done a miserable job of managing risk, I was surprised at
his surprise. After all, anyone looking at the incentive
structures confronting key decisionmakers should have realized
that they had incentives for excessive risk taking and short-
sighted behavior.
But beyond that, Greenspan made another error: If I
mismanage risk, if I am irrational in my risk analyses, I and
my family suffer, but there are unlikely to be societal
consequences. But if a bank and especially a very large bank
mismanages risk, the macroeconomy can be seriously affected.
There are externalities. It is these externalities that provide
the motivation for Government programs. It is these
externalities that explain why self-regulation simply will not
work. It is deeply troubling when the country's major financial
regulators do not understand the rationale for regulation.
Rational markets would realize that increasing leverage
shifted risk and would demand compensating differentials. As we
see banks striving to increase their leverage, there may be
uncertainty about what is driving this. Is it because in doing
so, they increase the implicit subsidy from the Government? Is
it because they do not understand the fundamentals of risk? Is
it because they understand the fundamentals of risk, but
realize that their bondholders and shareholders do not, so that
they can extract more money for themselves? But about this
there is no uncertainty. Excessive leverage has large societal
costs. Banks, and especially the big banks, need to be
restrained.
Indeed, the analysis above suggests that there are few or
no societal costs to doing so and considerable benefits. It is
not as if leverage somehow manufactures resources out of thin
air. Lending is risky. The risk has to be borne somehow. It is
borne by equity holders of lending institutions--to the extent
it is not shifted to Government, FDIC, bondholders, or
depositors. It is better to have it better distributed, among a
large equity base, given the high social costs of financial
disruption.
Recent empirical research has provided considerable support
for the views expressed here. Even if there were some increases
in lending costs as a result of increased equity requirements,
those costs have to be offset against the benefits.
There are very large societal costs from bank failures, as
I said before, and these can be substantially reduced by higher
equity requirements.
Some have argued that even if it makes sense in the long
run to increase capital requirements, doing so in the short run
can be costly, especially at a time such as this when the
economy is fragile and the banking system already weak. At
most, this is an argument for a paced increase in capital
requirements and one which would not allow any dividends or
share buybacks or extravagant bonus pools until the desired
capital ratios are reached. But one should at the same time be
aware of the large risks, especially under the current
circumstances, of delay. It is precisely because the economy is
fragile, banks have inadequate capital, and the banking sector
in the aftermath of the crisis is more concentrated than before
that the risk of a financial catastrophe of the kind that we
experienced in 2008 is so great today. The downside risks of
not doing something are especially grave now.
I have focused my remarks this afternoon on increasing
banks' equity capital. There are a number of other factors
affecting the risk to the economy posed by the banking and
financial sector. I have noted the risk of too-big-to-fail
banks. We should not allow any bank to grow to a size that it
poses a systemic risk to the economy. Yet in the aftermath of
the crisis, as you pointed out, the banking sector has become
more concentrated, and the risk posed by too-big-to-fail banks
has, if anything, increased. We saw too in the crisis that the
risks posed by non-transparent transactions, such as over-the-
counter CDSs and off-balance-sheet activities. One of the
reasons that the financial system froze was that everyone knew
that there was no way that they could know the true financial
position of most of the banks. While the Dodd-Frank bill
improved matters, it went nowhere far enough. The problems
continue, and as long as they continue, our economy is at risk.
We may never fully protect the economy against the risk of
another crisis such as the one we have been through. But this
much should be clear: Our economic and financial system is
badly distorted. Resources were misallocated before the crisis.
No Government has ever wasted resources--outside of war--on the
scale that has resulted from the failures of America's
financial system. We may have begun the work of making our
financial system once again become the servant of the society
which it is supposed to serve, but there is a long way to go.
Lending, especially to small- and medium-sized enterprises, is
constrained. Activities that pose unnecessary risks to our
entire economy continue.
We cannot rely on the self-restraint or self-regulation of
financial markets. We learned that lesson in the aftermath of
the Great Depression, and the decades following World War II,
with this strong regulatory system, were among the most
prosperous this country has experienced. The question is: Will
we relearn that lesson in the aftermath of the Great Recession
of 2008?
Senator Brown. Thank you, Dr. Stiglitz.
Dr. Kane, thank you for joining us.
STATEMENT OF EDWARD J. KANE, Ph.D., PROFESSOR OF FINANCE,
BOSTON COLLEGE
Mr. Kane. Thank you, Mr. Chairman. It is an honor and
privilege to share with you my concerns about the
distributional effects----
Senator Brown. Is your microphone on?
Mr. Kane. Shall I start again?
Senator Brown. Go ahead.
Mr. Kane. [Continuing] The distributional effects of making
taxpayers back up Treasury and Federal Reserve bailouts of
insolvent and ungrateful financial institutions.
During the housing bubble, our representative democracy
better served the interests of foreign and domestic financial
institutions than the interests of society as a whole, as Joe
Stiglitz has been saying. But why were taxpayer interests
poorly represented? It is because of regulatory capture.
The financial industry sewed huge loopholes into the
capital requirements and regulatory definitions of risk that--
then and now--are supposed to keep financial instability in
check. The Dodd-Frank Act left many critical issues open. It
did not try to define ``systemic risk'' or to confront the
ongoing foreclosure mess and Fannie and Freddie disasters. And
implementation of its strategy for dealing with regulation-
induced innovation and for disciplining lead institutions is
left to regulators. The Keating 5 episode tells us how hard it
can be for regulators to write rules that truly crack down on
politically influential firms. Sadly, the same gaps and issues
exist in reform efforts unfolding in Basel and in the European
Union.
The issue before us is to put reform on a more promising
path. To me, this means Governments must do three things:
redefine the supervisory missions of regulatory agencies,
rework bureaucratic incentives in these agencies, and refocus
reporting responsibilities for regulators and for protected
institutions on the value of taxpayers' safety net support.
Unless these duties are embraced explicitly and enforced in an
operational and accountable way, it is unreasonable to believe
that authorities will adequately measure and contain systemic
risk during future booms and busts, let alone in the bust we
are still living through today.
A first step would be to strengthen training and
recruitment procedures for top regulators. As you know, most
top regulators leave behind them, under current appointment
procedures, a trail of political debts they have to surface. If
it were up to me, I would establish the equivalent of an
academy for financial regulators and train cadets from around
the world. Among other things, students would be drilled in the
duties they owe the citizenry and in how to overcome the
unhealthy political pressures elite institutions exert when and
as they become undercapitalized.
The public recognizes that the Fed and Treasury rescue
programs placed heavy and less than fully acknowledged burdens
on the citizenry. Evaluating Fed and TARP rescue programs
against the unrealistic standard of doing nothing at all, high
officials tell us that their bailout programs were necessary to
save us from an economic depression and actually made money for
the taxpayer. Both claims are false, but in different ways.
Bailing out firms indiscriminately--and the lack of
discrimination is the point--hampered rather than promoted
economic recovery. It evoked reckless gambles for resurrection
among rescued firms and created uncertainty about what set of
citizens would finally bear the extravagant costs of these
programs. Both effects continue to disrupt the flow of credit
and real investment that is necessary to trigger and sustain
economic recovery.
The claim that the Fed and TARP programs actually ``made
money'' for the taxpayer is half-true. The true part of the
proposition is that, thanks to the vastly subsidized terms of
these programs, most institutions were eventually able to repay
the formal obligations they incurred. But the other half of the
story is that these rescue programs forced taxpayers to provide
undercompensated equity funds to deeply troubled institutions,
and that the largest, as you said, and most influential of
these firms were allowed to make themselves bigger and even
harder to fail.
Government credit support transferred to taxpayers the bill
for past and fresh losses at protected firms. Authorities chose
this path without weighing the full range of out-of-pocket and
implicit costs of indiscriminate rescues against the costs of
alternative programs such as prepackaged bankruptcy or
temporary nationalization and without documenting differences
in the way each deal would distribute benefits and costs across
the population of this country.
Going forward, the crucial problem is how to relate capital
requirements to systemic risk. We do want to raise capital
requirements, but we have to relate them to more securely
systemic risk.
Acting in concert, market and regulatory discipline force a
firm to carry a capital position that outsiders regard as large
enough to support the risks it takes. Taxpayers become involved
in capitalizing major firms because creditors regard the
conjectural value of the off-balance-sheet capital that
Government guarantees supply as a put option--a ``taxpayer
put''--that serves as a partial substitute for on-balance-sheet
capital supplied by the firm's shareholders. So Citicorp was
not undercapitalized. It was just capitalized too heavily with
its taxpayer put.
So the root problem is that supervisory conceptions of
capital and systemic risk fail to make Government officials and
protected firms accountable for the roles they play in
generating adverse movements in either variable. Policymakers'
knee-jerk support of creative forms of risk taking among the
client firms they supervise and officials' proclivity for
absorbing losses in crisis situations make sure that tough
decisions favor industry interests over those of the taxpayer.
Systemic risk can be likened to a disease that has two
symptoms. The Dodd-Frank Act and the Basel III framework use
higher capital requirements to treat only the first of these
symptoms: the extent to which institutions expose themselves in
directly and readily observable ways to credit risks that in
extremis might fly across a chain of connected counterparties.
But to be effective, the medicine of capital requirements must
be adapted to take fuller account of a firm's funding patterns
and to treat a second and more subtle symptom. This second
symptom is the ease with which actual or potential living-dead
institutions can use financial accounting tricks and innovative
instruments to hide risk exposures and to accumulate fresh
losses until their insolvency becomes so immense that they can
drive regulators into a panic and extort life support from
them.
So in good times and in bad, the existence of this
``taxpayer put'' allows elite private institutions to issue the
equivalent of Government debt and makes ordinary citizens
uncompensated equity investors in such firms.
My recommendations for regulatory reform are rooted in the
straightforward ethical contention that protected institutions
and regulatory officials owe fiduciary duties to taxpayers. The
existence of a safety net makes taxpayers silent equity
partners in major financial firms. Not only are they silent
partners, they are uncompensated or poorly compensated
partners. So as de facto investors, taxpayers deserve to be
informed at regular intervals about the value of their side of
the taxpayer put. Consistent with U.S. securities laws,
managers of important financial firms should measure and report
under penalties for deception and negligence the value of
taxpayers' stake in their firm on the same quarterly frequency
that they report to stockholders, and Government officials
should examine, challenge, aggregate, and publicize this
information.
My two-piece conception of systemic risk clarifies that it
is embodied in a coercive option-like equity investment by
taxpayers in the firms the safety net protects. The value of
taxpayers' position varies with the risk that an institution
might sustain losses that exceed its ownership capital--a
guaranty that is often called ``tail risk'' by economists--and
with the percentage of this tail risk that the Government is
likely to absorb. It is one of these bets that heads, the
institution wins, and tails, the taxpayer loses.
Defining systemic risk as taxpayers' side of an unfavorably
structured claim also provides a metric for tracking systemic
risk over time. That is the advantage of this definition.
Requiring authorities to calculate and disclose fluctuations in
the aggregate value of the taxpayer puts would make regulatory
authorities operationally accountable for the quality of their
supervisory performance in booms and recessions alike. Most
existing measurement strategies incorporate the pioneering
perspective of Robert Merton. Studies using this approach show
that regulators could have tracked the growing correlation of
institutional risk exposures as an early warning system for the
current crisis. Expanding the format for collecting information
from covered institutions to include estimates of the potential
variability of their returns over different horizons should
improve the precision of systemic risk estimates and officials'
accountability for regulatory and supervisory performance.
Under current rules, accounting standards for recognizing
emerging losses make evidence of an institution's insolvency
dangerously slow to surface. Efficient safety net management
requires a more sophisticated informational framework than
current methods of bank accounting and examination provide. To
protect taxpayers and to enhance financial stability,
examinations and bank accounting reports should not focus
narrowly on measures of tangible capital. They should also
develop and report explicit estimates of the intangible value
of an institution's claim on taxpayer resources. To hold
financial institutions and regulators accountable for carrying
out these tasks conscientiously, regulators and financiers must
be made to accept a system of ethical constraints that would
make them share this information with the public.
Thank you, Mr. Chairman.
Senator Brown. Thank you, Dr. Kane.
Mr. Ludwig, welcome. Thank you for joining us.
STATEMENT OF THE EUGENE A. LUDWIG, CHIEF EXECUTIVE OFFICER,
PROMONTORY FINANCIAL GROUP
Mr. Ludwig. Thank you very much, Mr. Chairman, for having
me here today. I would like to commend you, Chairman Brown,
Ranking Committee Member Senator Corker, and the other Members
of the Committee for holding this hearing.
Chairman Brown and Ranking Member Corker and the rest of
the Members of the Committee can take pride in having worked
hard to address the challenges posed by the financial crisis.
You have brought important congressional focus on the issues of
financial stability, safety and soundness, and the regulatory
framework. You have passed landmark legislation in this area
and continue to engage in serious oversight.
We must never lose sight of the tremendous toll that the
financial crisis has taken on our country. Millions of
Americans are reeling from lost jobs, lost homes, and lost life
savings. This loss has hit our low- and moderate-income
citizens the hardest. It is a terrible tragedy for many
families across America.
As we continue to recover from the financial crisis, our
challenge now is to successfully implement the very powerful
post-crisis reforms enacted through Dodd-Frank, the Basel
Committee and the Financial Stability Board. Implemented
correctly, these new rules will add markedly to financial
stability. However, if they are implemented without a sense of
their cumulative impact on financial institutions and the
system and without a sense of balance and proportion, these
rules will put a drag on the financial system, our economy, and
on job growth. Furthermore, if the implementation of these
rules is excessive, we could actually see a decrease in safety
and soundness.
Now, I would like to take a moment to discuss capital
requirements--an issue that I know is of great interest to this
Subcommittee. Clearly, capital is critical to a safe and sound
financial system. The Dodd-Frank Act, Basel III, and the
Financial Stability Board reforms recognize the importance of
capital, and they have acted forcefully. Through their reforms
we now have very tough capital requirements and capital levels
that significantly exceed previous requirements.
Under Basel III, banks will have to hold 10.5 percent total
capital and 7 percent common equity. On top of that, U.S.
regulators may add an additional countercyclical capital buffer
of up to 2.5 percent. Furthermore, most of the financial
institutions typically carry a buffer above the required
minimums.
At a minimum, this is over a 300-percent increase in
required common equity before additional buffers and revised
risk weights are factored into the equation--three times, 300
percent, a very significant addition. This is an important
change because common equity is the highest quality capital,
although it is the most expensive for banks to raise.
Now, it is also important to note that prior to the crisis
several of our largest non-bank institutions were subject to a
much less rigorous capital regime. Post-crisis, due in part to
major investment banks converting to or being purchased by
commercial banks, and in part to the ability of the FSOC to
designate non-bank financial institutions as systemically
important, a number of institutions will see an even more
marked increase in their capital requirements. So we are seeing
a real uptick in the amount of capital in the system.
But while capital is an important tool in the supervisory
toolkit, it is only one tool. I believe we have achieved
important reforms involving capital and, therefore, I would not
at this time advise any further increases in capital
requirements beyond the Dodd-Frank and tough Basel standards.
What I would like to stress is that critically important to
safety and soundness is balance, balance, balance.
So how do you achieve the right balance and ensure that our
regulators and regulations are both serious and meaningful but
not so elaborate that they needlessly weigh down the economy?
Unfortunately, there is no quick fix. But I can provide seven
suggestions.
First, constant and thoughtful congressional oversight. I
think this Committee, as I mentioned, is to be commended for
this hearing. Congressional oversight is enormously important
for the regulatory mechanism to function correctly. Bringing
regulators up here, calling them to task, asking the right
questions, as you are doing today, is just critical.
Number two, support of the work of the Office of Financial
Research and its critical role in monitoring systemic risk and
promoting financial stability. The OFR, one of the creations of
Dodd-Frank, is, I think, one of the greatest steps forward in
this piece of legislation. It creates a body of economists who
think and worry independently about the next financial bubble,
and it helps financial regulators to target their resources in
the right direction. That is just getting started. Ensuring
that the OFR is moving forward is critical.
Number three, ensure that our regulators continue to be top
professionals who are balanced in their views and devoted to a
safe and sound banking system that supports prudent innovation
and economic growth. I certainly agree with Professor Kane that
education in the regulatory field, for which there are too few
opportunities, is critically important. Today you can get a
degree in almost everything in America, but there is simply no
degree program in regulation and supervision, which I think is
terrible.
Number four, avoid waste and excess at all costs. In fact,
many of our rules and procedures can be applied very well with
much less waste than is currently the case. This is critical
because it is not a matter of not having tough regulation, but
it is having effective regulation that is targeted, and waste
actually decreases safety and soundness because it mis-targets
resources.
Number five, periodically review regulatory rules to ensure
that they are both effective and cause the least burden
possible. Regulations tend to grow up around financial
institutions like barnacles on a ship, and in order to keep the
ship sailing forward, one simply has to clear the barnacles off
from time to time.
Number six, impose international capital and liquidity
rules for global banks on a level playing field basis. Global
standards must not simply put U.S. financial firms at a
disadvantage. I think this is a very big issue. We have tough
regulators, we have tough regulations. The new Dodd-Frank rules
are demanding. But we need to impose these globally in a level
playing field basis.
Number seven, properly regulate the shadow banking system,
which currently owns one-quarter of the United States financial
sector. This is significant because if you look at the
institutions that failed and triggered the crisis, it was not
the commercial banking sector. The shadow banking sector, which
is still loosely regulated, is a genuine danger.
With that said, I look forward to answering your questions.
Mr. Chairman, thank you very much for having me today.
Senator Brown. Thank you, Mr. Ludwig, very much.
Professor Pfleiderer.
STATEMENT OF PAUL PFLEIDERER, Ph.D., C.O.G. MILLER
DISTINGUISHED PROFESSOR OF FINANCE, GRADUATE SCHOOL OF
BUSINESS, STANFORD UNIVERSITY
Mr. Pfleiderer. Thank you, Chairman Brown, for allowing me
to be here today in what I think is a very important issue that
is being discussed here.
I want to start with a very simple proposition that I think
is completely uncontroversial, and that is the notion that the
Government should not in any way encourage firms to take
actions that have large social costs and produce little or no
social benefit.
And just to make this particularly salient, imagine a
uranium processing firm that wanted to locate one of its plants
in a crowded residential area. Obviously, we would have zoning
regulations and other regulations that would prohibit that. But
what if the Government had a tax policy that encouraged the
uranium processing plant to locate in a crowded area and in and
above that actually provided health benefits in terms of
insurance protection for health claims against the uranium
processing plant only if it locates in the crowded residential
area? That would be a perverse policy, clearly.
We, fortunately, do not have a perverse policy for uranium
processing plants, but we do have a perverse policy when it
comes to our banking sector, and the reason for that is our
Government subsidizes debt and makes equity expensive, and it
does that in two main ways. First of all, there is a tax
subsidy--debt provides a tax shield--that is available to all
corporations, but particularly available to banks.
But the other subsidy is the one that is absolutely
critical here, and that is there is a too-big-to-fail subsidy,
a number of implicit and explicit guarantees that are given in
the Government's safety net that basically subsidize firms when
they issue debt and make equity expensive.
Now, this creates huge distortions, and if it affected only
a few small banks it would not be a problem, but it affects our
entire financial system, especially the too-big-to-fail banks,
and makes the system extraordinarily fragile, and the evidence
of what that can create is just a few years ago in our crisis,
and we are actually seeing more of it play out in Europe as we
sit here today. Highly levered banks with too little equity
create huge externalities that are negative in the sense that
they create the possibility of a crisis. So there is a huge
social cost to this and the question is, is there any social
benefit, and the answer is, no, there is absolutely no social
benefit.
Now, a lot of people claim that equity is expensive, but
that is based upon a lot of fallacies and mistaken notions. The
first notion is that banks hold equity. Banks do not hold
equity. Banks hold assets. Equity has to do with the right-hand
side of the balance sheet and in particular the promises banks
make to those that are providing their funds, and the promises
come in two sorts of forms. One is promises that are
contractual obligations that are made to debt providers, and
then equity holders have no contractual promises made by the
banks. They just get whatever is left. So the problem, of
course, is if you make too many promises to debt holders, debt
funders of the bank, you get into a situation such as what we
had in 2008, where the system is teetering on the brink of
insolvency, and, in fact, is insolvent.
So with little equity, we have losses that are essentially
socialized. With more equity, we have losses that are
privatized. In a capitalistic system, we want the latter, not
the former.
So one of the important things in this debate is to
distinguish private from social costs. Let us go back to the
uranium processing firm. Imagine that the uranium processing
firm is located close to a highly populated residential area
and the Government says that it must be moved. Now, the owners
of that plant could claim it is costly, but they would say it
is costly because we are going to lose tax benefits and we are
going to lose the insurance you are providing if we were in a
highly populated area. We are going to move that if we move the
uranium processing plant. That is clearly a private cost. You
are just simply taking away subsidies.
Well, the analogy is perfect with the banks here. If we
force the banks to move toward higher capital to safety, we are
taking away subsidies that they had that were encouraging them
to do bad things. That is not costly from a social cost point
of view.
Now, there are a number of other fallacies that are brought
up in this debate. One of them is that banks require a specific
return on equity and that this equity return that is required
is fixed, somehow independent of how the bank is financed. And
Professor Stiglitz, following up on work done by Franco
Modigliani and Merton Miller, has showed that this is a basic
fallacy. So that is an argument that is based not on science.
It is based pretty much on wishful thinking about how the
market might be fooled when you change risk exposures.
Another thing that we see in the marketplace is that a lot
of compensation is based upon ROE. Well, you can simply go
through a very simple experiment, just a little back-of-the-
envelope calculation. Let us imagine we had two managers, a
very good manager and a very bad manager, and the good manager
has 10 percent equity, not a lot, but 10 percent, and manages
the bank's assets very well and has a 3-percent return on
assets before interest. Then at a 2-percent interest rate paid
to its funders, that is a 12 percent ROE.
Now let us talk about a bad manager who has a much less
safe bank with only 3 percent equity and manages the assets
rather poorly, earning only 2.5 percent return on assets before
interest. Well, that results in almost a 19 percent ROE. In
other words, if you are a bad manager, you can make yourself
look good and actually better than a good manager by just
having higher leverage, which may very well be, in part, some
of the incentives for the high leverage that we see out there.
One of the questions that is often asked is where will all
this equity come from? Well, that is an easy question to
answer. First of all, it does not require new resources. It
does not require new saving. It just requires that the banks
change the promises that they have been making. In fact, it can
come very easily. It can be built up rather rapidly by just
preventing banks from paying dividends or other payouts to
shareholders. They will not do that voluntarily because it
takes away the subsidy, but they should be required to do that
in the interest of the social good.
There is also a statement that is made that we should have
a level playing field. I agree with that up to a point. I
certainly do not agree with that, if we were leveling our
playing fields by making our banks risky at taxpayers' expense.
That is no way to run our financial system.
So ultimately, my analysis is really quite simple here.
What we need to do is get the Government less involved in the
financial sector, and to get it less involved, that means we
have to require that the private sector put up more equity and
bear the risks that the taxpayers are now bearing that distorts
the system and leads to financial crisis.
Thank you, and I look forward to questions.
Senator Brown. Thank you, Dr. Pfleiderer. I will start with
you.
I want to sort of take perhaps to another step your uranium
processing plant metaphor, analogy. In an article you wrote,
``Fallacies, Irrelevant Facts, and Myths in the Discussion of
Capital Regulation: Why Bank Equity is Not Expensive,'' you
point out that non-financial companies typically hold more
capital than is require of banks. That is according to a
research paper by the New York Fed. You pointed out the typical
non-financial firm has equity that exceeds 50 percent of its
assets while the median capital ratio of commercial banks is
about 8.5 percent.
Two questions. Why do we allow financial companies to hold
so much less of their own money, and is that a sort of a long-
term--are we sort of subsidizing, encouraging finance over
other sectors, perhaps manufacturing, in the economy? And let
me parenthetically add, before you answer, my State is the
third-largest manufacturing State in the country behind only
States much larger, Texas and California, in terms of what we
produce. In our country, only 30 years ago, we were about 25
percent of GDP was manufacturing and financial services was 10
or 11. That has more or less flipped in the last 30 years. Is
that part of the reason that we allow financial companies to
hold so much less of their own money, in essence, than we do
other sectors of the economy?
Mr. Pfleiderer. So I think this comes about through several
methods. First of all, neither I nor my co-authors or, I think,
anyone else at this table is arguing that banks should have 100
percent equity. Certainly, some of the debt that banks use to
fund, in particular deposits, and most particularly deposits,
has social value. It is used in the payment system. So we are
not arguing for 100 percent equity, but there is a lot of debt
that the banks use that is just used basically to get
additional funding that exploits the Government subsidies that
I mentioned.
So I think one of the things that has happened, especially
probably after 1970 or so, is this notion of too-big-to-fail
has created subsidies to the banks in the sense that there is a
backstop that the investing public realizes is there that
basically encourages debt. And the problem feeds on itself
because a lot of companies out there would love to have the
Government insure their debt, as well, because that would allow
them to issue more debt and get a bigger tax advantage because
of the tax advantage of debt. The only sector that can do that
is the financial sector because they do have this implicit
subsidy and that is what has caused them to lever up.
And what I think is pretty easy to document is that that
has created incentives for the financial sector to grow far
bigger than what is probably socially justified, and the
increase in the size has basically been to exploit this
subsidy.
Senator Brown. Dr. Stiglitz, the implicit subsidies he
talked about, what are the effects of those distortions and the
implications for our economy?
Mr. Stiglitz. Well, they are very severe. First, the point
is, following up on what Paul said, that because of the
implicit subsidy, particularly the too-big-to-fail banks can
get access to capital at a lower cost. So you can see it in
their cost of funding. So they get capital at lower cost than
one of your manufacturing firms in Ohio, and that leads them to
expand.
The second point is that because the too-big-to-fail banks
have lower costs than community banks, and the too-big-to-fail
banks often do not focus on lending to SMEs and the community
banks, we get a distorted economy. So the parts of the
financial sector that are involved in small and medium-sized
enterprise lending are relatively starved of funds relative to
the big banks that are engaged in more speculative activities.
The net result of this is that our economy gets distorted
in several ways. We have been focusing on the size, but it is
also the case that the kinds of activities that they engage in
is distorted so that, for instance, if you have a Government
guarantee, you are more willing to undertake greater risk
taking. So rather than lending on the basis of solid
information to small and medium-sized enterprises, you start
going into non-transparent CDSs and engaging in speculation,
knowing that if you gamble big and you win, you walk off with
the profits. If you gamble big and lose, the taxpayer picks up
the losses.
So both ex ante, before crisis, the economy is distorted.
But then, of course, once the crisis happens, the economy bears
an enormous price, and this is what has been said by several
people this afternoon. This is not capitalism. You mentioned, I
think, in your own remarks that when you have socializing
losses while you are privatizing gains, you get a distorted
market economy. So this is really undermining the functioning
of a market economy, and that is why economists of both the
left and the right agree that this is a very serious distortion
in our economy.
Senator Brown. Dr. Kane, his comments about advantaging or
disadvantaging various banks, large banks, small banks, you
said that we have sewed huge loopholes into capital
requirements. Talk through, if you would, how the fact that
large banks are more highly leveraged than regional banks or
community banks, how this advantages big banks. What other--and
Dr. Stiglitz talked about how they can borrow money, obviously,
at less cost than other entities, I assume. He was talking
about manufacturing, but also smaller banks. Talk to me about
the advantages that the larger banks enjoy as a result of that,
if you would.
Mr. Kane. Sure. Dr. Stiglitz emphasized that there was an
implicit subsidy to risk taking in the financial sector. The
larger institutions can hire better accountants and better
lawyers and better lobbyists to see that the way in which risk
is assessed in the capital requirement system favors them. We
have seen a number of institutions around the world fail even
though they met the Basel requirements for capital-to-risk-
weighted assets. That is because the Basel risk weights were
wrong. In fact, a lot of the riskiest assets were not even
being counted in the system. That is no accident. The industry
is always here before Congress and other legislative bodies and
before regulatory agencies exaggerating how devastating it
would be if innovative assets were treated in a more
transparent way.
Most loopholes come from non-transparency, and in practice,
from a fixed-weight system that, once it is set in place, can
be gamed. It is a little bit like blackjack, where you have a
fixed strategy on the part of a dealer and a variable strategy
on the part of the player. If the player plays optimally, he
will kill the house in the long run.
Mr. Stiglitz. Can I make----
Senator Brown. Sure.
Mr. Stiglitz.----one more example of the nature of the
difficulty, and going back to the CDSs, and one of the issues
that was debated before the Dodd-Frank bill was passed, and
that was the issue of whether depository institutions that had
a Government guarantee, FDIC-insured institutions, should be
allowed to write CDSs. In other words, the extent to which they
should be allowed to engage in non-transparent over-the-counter
gambles. It is not clear--they will call them insurance
policies. If they are insurance, they ought to be regulated by
insurance. But if they are gambles, it is really peculiar that
the Government is insuring people's gambling.
But whether they are insurance or gambling, they are not a
lending activity. So what are they doing inside a Government-
insured depository institution? But once you have it inside the
depository institution with the Government backing them, they
have an incentive to engage in this kind of trading, and that
is why in the months after the crisis it was so clear. Most of
the profits they were making were associated with trading, not
with lending. The American people were told the reason for the
TARP bailout was to get lending started, but that never
happened. But they used that basis and access to the Fed window
at zero interest rate--close to zero interest rate--to
undertake a high leverage and to undertake very highly risky
trading activities which they generated high returns, but with
the Government backstopping them.
Mr. Kane. Could I make a point about those high returns,
that one of the questions that come up about the safety net, if
you go back in time, was that nobody seemed to lose money on
these gambles. They were actually making money. But we see now
in the crisis that this money was actually extracted from the
taxpayer in advance. It was not profitable at all. It did not
help anyone. In fact, it hurt.
Senator Brown. Thank you. Mr. Ludwig, I want to read a
sentence written by Anat Admati, a finance professor at Dr.
Pfleiderer's Stanford. She said, ``There is no credible way to
get rid of bailouts except with capital.'' Do you agree with
that?
Mr. Ludwig. I think that capital is tremendously important,
as Professor Admati said. No regulator would look at that as an
unimportant tool. But I would say a couple of things about
capital.
First, the high leverage, which has been rightly criticized
by my fellow panelists, the excesses of 40:1 to which you
referred, Mr. Chairman, was largely outside the commercial
banking system. I think it is excessive. It should not exist.
Fortunately, you and the rest of the Congress has put a lot of
that to rest in terms of the banking system with very, very
strong capital requirements.
The second thing I would say is that capital is only one
tool. It is almost impossible to have so much capital that you
can prevent failures of financial institutions. Financial
institutions, particularly commercial banks, typically fail not
because of a lack of capital. They fail because of liquidity
inadequacies. It is the nature of the fractional banking
system. Fortunately, there, too, both Dodd-Frank and Basel have
been focusing attention over the last year-plus on the
liquidity ratios that banks maintain. That is yet another tool
in the toolbox. There are multiple tools, and what we lacked in
the last decade was the utilization of those tools with
sufficient vigor. Again, fortunately because of the new law as
well as the increased energy at the financial regulators, those
tools are being used vigorously now.
I think our issue going forward is striking a balance so
that we have a stable financial system, which we must have. We
must have a financial system that can support the economy of
the United States, and I think right now, the dangers we face
are losing that balance and becoming overzealous in the way we
implement Dodd-Frank in a way that actually will retard growth.
Senator Brown. Let me follow up on that, with balance. You
had said earlier in your testimony, you said, we now have very
tough capital standards because of Dodd-Frank, because of Basel
III. You might want to ask your seatmates to comment on that.
But first, tell me what you think the Fed should do with
SIFIs in terms of--I assume you are saying the capital
requirements of Basel III are about right now. Give me your
thoughts on what the Fed should--what they should impose on
SIFIs, the largest banks, the financial companies. Should they
go beyond Basel III? If so, give me your thoughts on a range.
Mr. Ludwig. Well, you know, Basel III gives the national
regulator a two-and-a-half percent capital cushion on top----
Senator Brown. And you agree with that?
Mr. Ludwig. I think that makes sense. However, I would not
go beyond that. Why? Because the capital increases have been so
significant. We are in new territory now, and capital increases
do have an impact on lending and on the ability of these
institutions to support the economy. We have multiple other
tools, and before we take additional steps, we ought to see
what the cumulative impact is of the implementation of those
tools so that we can again have a tough regulatory environment
and a stable financial system, but also one that can support
the economy of the United States.
Senator Brown. Thank you. The push-back that I hear
around--in Ohio and here--against higher capital requirements,
significantly higher, higher than Basel III, higher than some
bankers have said, and as high as some of you have recommended
on the panel, were two things. One is the comparative
competitive disadvantage with European banks, and second, that
it would cause banks not to lend if we required higher capital
standards, especially higher equity standards. Would the other
three panelists comment on your thoughts about that push-back,
that higher capital standards would mean U.S. banks are at a
competitive disadvantage and would mean U.S. banks would not
lend to the degree that we would like them to optimally. Do you
want to start, Mr. Pfleiderer.
Mr. Pfleiderer. So I want to actually, with your
permission, just address an issue that came up here. Liquidity
is potentially a problem. It has always been a problem in the
banking system. But liquidity in our modern system is only a
problem when there is really a problem with insolvency. So if a
bank has a liquidity problem but it is very solvent, in other
words, has a lot of equity, then there is no problem at all
with going to the Fed and pledging assets, taking a big haircut
on them and getting liquidity. It does not put the taxpayer at
risk.
The real issue and the issue that we had in the last crisis
was not just a liquidity issue. It was really an issue that
related to insolvency, understanding that potentially a
counterparty may be below water.
So the issue in terms of, first of all, competitiveness
with European banks and also with cutting back on lending,
first of all, we do not want to be competitive if it requires
that we put our whole economy in jeopardy. If banks require a
subsidy, and it is not clear that they do, but if banks require
a subsidy, by all means, we should give it in a way that does
not require high leverage. So we could have high capital
requirements and that does take away some subsidies that the
banks are now getting. If for some reason we decide that banks
need to be subsidized because they are doing something that is
underproduced, we need to give those subsidies in a way that
does not create a fragile banking system.
And just to tell us where we are right now with respect to
these capital requirements, one thing that I was going to
mention in my opening remarks and did not is that just a few
weeks ago, Moody's announced that the support rating that it
was giving to, say, Bank of America, was five notches above
what it would give without Government support. So this
indicates that, looking forward, to the extent the rating
agency is factoring things in correctly, the Government support
is moving the Bank of America debt from what would be minimum
investment grade up to very high quality.
So one way to answer the question of how much capital do we
need, well, one barometer, one monitor for that would be if we
have enough capital so that players in the economy, including
the rating agencies, do not see Government support in there. In
other words, we are not subsidizing banks.
Senator Brown. Does it bother you, Dr. Pfleiderer that Joe
Nocera, in an article he wrote a couple of months ago, said
that European banks have fought fiercely against capital
requirements. Does that bother you as an observer of what this
means for American banks and our competitiveness and our
behavior, if you will?
Mr. Pfleiderer. It bothers me to the extent that we live in
a global economy and, unfortunately, we cannot insulate
ourselves from mistakes that are made in Europe. So we have an
integrated economy and if the Europeans run their banks such
that they are very fragile, there is no doubt that problems
created there can spill over into our economy. So I----
Senator Brown. And they are surely more fragile than ours.
Mr. Pfleiderer. They certainly are. So I think that the
goal here is to----
Senator Brown. Let me interrupt----
Mr. Pfleiderer.----not race to the bottom, but race to the
top. We need to get global standards that are much higher. But
what we should not do is sink to the low standards of the
Europeans so that we put ourselves in jeopardy as well as the
Europeans. Rather, we should figure out a way, if we need to,
to subsidize our banks that does not require high leverage. And
again, that is a proposition that I do not think has been
demonstrated, that banks need subsidies. But if they do, we
should do it in a way that does not create fragility in our own
economy.
Senator Brown. Comments, Dr. Kane and then Dr. Stiglitz,
and then Mr. Ludwig.
Mr. Kane. The mistakes being made in Europe have come back
to affect the credibility of the sovereign support that
European banks enjoy. If you take Ireland, the banks there were
allowed to run up more debts under Government guarantees than
the Government of Ireland could ever pay off by collecting
taxes from taxpayers. Somebody is going to have to absorb the
differences. Europe is going to learn that subsidizing risk
taking by their banks is eventually going to ruin their
economies for a while. Because governments have been
subsidizing banks in the past does not mean they will take away
business in the future. I think one of the lessons of this
crisis is that depositors and other creditors are going to look
through the banks to the condition of the sovereigns and look
for regulation that they can trust.
Senator Brown. And the lesson, the primary lesson, is
higher capital requirements?
Mr. Kane. Well, I think the primary lesson is you have to
focus on the difference between average versus marginal
requirements. We are talking about high average requirements
and banks are fighting them. But even banks ought to want to be
sure that, at the margin, governments are not subsidizing
foolish risk taking. That is the issue that needs to be
addressed around the world. We can have lots of differences in
the systems adapted to the countries and the cultures of those
countries, but we want to make sure that, at the margin, we
have found ways to discourage firms from finding ways to hide
risks, or hiding or disguising a shortage of capital.
Senator Brown. Dr. Stiglitz.
Mr. Stiglitz. Yes. First, I want to address the second
question you raised about would banks not lend. I think I want
to go back to my first remark, which is that a change in the
debt equity--change in the financial structure of banks does
not really increase their costs except to the extent that there
is a hidden subsidy through the bank bailout, so that to the
extent that we can put aside the subsidy, the fact is that
there would not be higher cost and, therefore, there would be
no reason there would be less lending.
Now, this is where the point----
Senator Brown. Do you agree with that, Mr. Ludwig, there
would not be higher costs for the bank? And then I will get
back to the rest of your answer, Dr. Stiglitz.
Mr. Ludwig. I think the issue here, as a practical matter,
Mr. Chairman, is that raising equity capital is so costly,
particularly at this time. And banks have already done so much
to increase their capital positions. So instead of raising
additional capital, they may consider simply shrinking their
balance sheets in order to accommodate higher capital charges.
Senator Brown. Will it make them more reluctant to issue
dividends?
Mr. Ludwig. As you know, dividends actually have been
restrained by the Federal regulators----
Senator Brown. Right, but recently, they were, in fact,
distributed, and there was some thought from Simon Johnson and
some others that the banks, because of equity issues and their
saying that they could not attract enough equity, that they
ought to hold on to their profits for a period of time for
equity reasons. Is that sort of the line of thinking?
Mr. Ludwig. It is a matter of balance, Mr. Chairman. If
they cannot issue reasonable dividends, it makes it harder to
attract capital. And it also undercuts the confidence the
public has in the institutions themselves. If they are not in a
position to pay a reasonable dividend--one is not talking about
anything excessive here--then I think the public loses
confidence in the institution. So I think it is a matter of
balance and proportion.
Senator Brown. Dr. Stiglitz.
Mr. Stiglitz. I actually would argue just the opposite,
that if they have more capital, there will be more confidence
in the public, and that, as I said in my testimony, that, in
fact, there is a problem of transition. How serious it is, it
is hard to ascertain. But if there is that problem with
transition, we should impose this requirement that they not pay
out dividends, not pay out excessive bonus pools, and that
would allow them to recapitalize the banks and put it on a
safer basis so that we would not have the taxpayer underwriting
them.
The important point I wanted to emphasize, though, is the
fact that, as Paul emphasized, equity is not costly, that
actually, when you have a higher leverage, what you are
effectively doing is increasing the risk of equity. It is not
like there is a fixed price. So that is the fundamental flaw in
those who emphasize the high cost of equity, that when you go
to high leverage, you are actually driving up, in effect, the
cost of equity, or you are just shifting risk.
I want to come to just a couple of other points related to
the question you posed. One of them is the issue of--this is
related--the discussion about--this debate about liquidity risk
versus solvency risk. The point here is that when there is a
lower equity base, there is a higher probability of a
bankruptcy, of a problem, and, therefore, a higher likelihood
that nobody will give money to the banks. That is what causes a
liquidity crisis. If everybody knew the banks were solvent,
there would be no liquidity problem. It is because they get
afraid that the bank is solvent that there is a liquidity
crisis. So these two issues are intertwined and the risk of a
liquidity crisis which shrinks lending and undermines the
economy is related very much to inadequate capital.
Now, on the issue of the competitive disadvantage, I want
to agree with what was said. We have to prevent a race to the
bottom, and that is what has been going on. But I guess there
are two other points I would also raise. First, the framework
for regulation inside the United States should be national
treatment, so that if we have companies, financial institutions
coming into the United States, we regulate them as national
institutions. They ought to be, I think, incorporated if they
become significant and have a subsidiary, not a branch.
This basic principle means that the United States is a
large market. Banks will want to operate in the United States
and we can set the regulations that protect the American
economy. That is our first responsibility, protecting the
American economy, protecting our jobs, protecting the stability
of our society.
The issue about can our banks compete abroad--well, first,
I am not really that worried about that, but if it were the
case, this is a small--you know, in terms of our national
economy, how many jobs are created in America by the banks
operating in Europe, or in Latin America? Relatively few. This
is not a major industry for the rest of our society.
So in my view, we should be focusing on the United States
and protecting the United States and not on creating some jobs
in Europe in which, yes, there are little profits that go into
American banking firms, but this is a really minor issue for
our economy.
The final point is that if--to look at the other extreme,
we should not have the set of regulations in the United States
dictated by the worst banking regulator in the world. We do not
want Iceland and Ireland to dictate the terms of American
banking regulation. So, yes, the banks are always going to say
there is some country that has been bought by the banks and is
going to have low regulation and can do things that we cannot
do. But what we need to do is to be focusing on what is good
for the American economy.
Mr. Ludwig. Joe, if I might say so, I could not agree with
you more, but there are three points to note. Number one, we do
not need to fight the old war. The fact is that, thanks to
Congress and the Basel Committee, in a sense, we have already
won the war. We have much higher capital standards.
Number two, I could not agree with you more: We do not want
to have a race to the bottom. We do not want to change what we
have by way of regulation and supervision. What we want to do
is use our clout to ensure that the regulation and supervision
abroad, particularly with respect to capital standards which
are set internationally, are applied fairly. The reason is
anomalies and blow-ups abroad affect our economy. So the issue
in terms of competitiveness is to raise the standards of
regulation and supervision outside the United States to meet
our higher standards.
Number three, I would take issue with what a number of
panelists have said. Irrespective of the amount of capital, if
people get panicked enough, they withdraw funds. And the reason
is, in part, because the genius of banking is two-fold. One is
the maturity transformation ability of banks. That is, they
take in short-term funds, people's deposit accounts, checking
accounts, and they lend it for longer periods of time, because
if you are going to build a plant and equipment, it may be 5
years' payback. And as I said, the genius of the banking system
is that maturity transformation.
That means that the bank is always going to be short if
everybody runs to the window, and we have seen this in the
1930s movies of the Great Depression. You never have enough in
the till. It is a matter of confidence, so that capital is
certainly important, but all the capital in the world will not
in and of itself stop banking runs. Banking runs get stopped by
the public having enough confidence that the regulatory
mechanism is doing its job, and that the institutions are
functioning correctly. That is precisely the framework that has
been put in place by Dodd-Frank and the heightened regulatory
vigor.
Senator Brown. Mr. Ludwig, if you were to--if, some say,
higher capital requirements will dampen, will reduce the amount
of lending, why not have--and this is a bit rhetoric, but a bit
not--why not have no capital requirements? Would that mean more
lending? Would that mean our economy would get back on its feet
and people can get capital?
Mr. Ludwig. No, Mr. Chairman. The art of banking and the
art of finance are matters of balance and proportion, and no
capital would have some of the unfortunate externalities that
Dr. Stiglitz and others have referred to. People would say,
``Oh, my God, they have got no money in the till at all.'' I
think that is going way too far.
But the practical problem for today is having raised
capital so significantly--as I mentioned, a 300-percent
increase in common equity--you get to a point at which even if
it is only a transition period, and we are in a very delicate
economic period right now, that banks faced with additional
capital requirements are going to start shrinking their balance
sheets. After all, lending takes up a lot of that balance sheet
and a lot of the capital need, and lending is a risky business.
So it is easier for the institutions in terms of these
commercial loans, which get 100 percent capital weight, to
shrink their balance sheet.
Senator Brown. Dr. Kane.
Mr. Kane. I want to say several things.
First, we do not really have much higher capital
requirements now. These are all to come in the future, and we
have a lot of lobbying against their actually being installed.
We actually have a capital-short banking system today, the
taxpayer.
Senator Brown. The numbers Mr. Ludwig is talking about are
the future, not today?
Mr. Kane. Not today.
Mr. Ludwig. Well, that is right on paper, but what happens
is that the markets, anticipating those requirements, actually
impose pressure on the institutions to raise capital in the
short term. So the institutions have, in fact, been raising
capital in advance of the requirements and have been pressed by
the regulators, correctly, to push those capital standards up
now.
Senator Brown. Dr. Kane.
Mr. Kane. They are being pushed that way, but as you know,
weak banks were trying to get permission to pay dividends, as
you mentioned, Senator, and had to be restrained.
Congress is seeing a lot of lobbying pressure against the
implementation of cutting-edge Dodd-Frank reforms. I do not
think we have to worry about the U.S. banking system ever being
overregulated. I think that the lobbyists will see to it that
the system is underregulated at the margin. And the main point
about runs is not that when we have a crisis, we can never have
enough capital. The larger point is that capital deters runs.
Where did we have the runs in this last crisis? At money market
mutual funds and in various off-balance-sheet vehicles, such as
structured investment vehicles. Structured investment vehicles
were allowed to be pulled back onto bank balance sheets. That
is when the banking system began to look terribly, terribly
weak.
And, finally, on maturity transformation, you know, the S&L
industry shows us that you have to regulate maturity
transformation. The S&Ls that were making 30-year loans with
passbook money became insolvent very quickly when interest
rates went up. And interest rates are going to go up again in
this country, and when they do we have to be very concerned
about institutions that are borrowing, say, overnight and
lending for even 4 or 5 months, never mind 5 years.
Senator Brown. Thank you.
I am going to conclude. I want to ask Mr. Ludwig one more
question, but I am going to conclude--and I will give you a
moment to think about it--with each of you to give me the one
or two significant improvements you would suggest to Dodd-
Frank. I will finish with that, so give me one or two thoughts
of improving Dodd-Frank in your mind.
Mr. Ludwig, Richard Cordray, the former Attorney General of
Ohio, came to see me this week. I have known him for many
years. He is the new--I will not say the new Director of the
Consumer Financial Protection Bureau because this confirmation
is probably in some doubt. You recently wrote an article for
American Banker about competitive advantages of the shadow
banking system, the shadow banking sector--system, if you will.
You said, ``If the newly minted Consumer Financial Protection
Bureau does not have a Senate-approved leader by the first
anniversary of Dodd-Frank''--last week, July 21st--``an
unintended consequence kicks in. The CFPB will be free to
examine and take action against banks with more than $10
billion of assets, but not against their non-bank
competitors.''
Are you saying traditional banks are hurt by efforts to
block the appointment of the Director?
Mr. Ludwig. Yes, they are, actually. I am, as you know, Mr.
Chairman, a huge supporter of consumer protections and services
to low- and moderate-income people. I think it is very
important that we have a functioning agency, and in that regard
the odd anomaly of not confirming Mr. Cordray, is that there
will be imposition on the banking sector of consumer rules--not
a bad thing--but there will not be an imposition of those rules
on the non-bank financial sector, the shadow banking system--
not a good thing. So I think we ought to get about moving
forward here.
Senator Brown. OK. Thank you.
In conclusion, I would let each of you start. Dr. Stiglitz,
since you began, what one or two improvements would you make to
Dodd-Frank?
Mr. Stiglitz. Well, it is hard to limit it to just two.
Senator Brown. But you are going to have to.
Mr. Stiglitz. If I can, I will go a little beyond that.
Senator Brown. And, certainly, any of you can submit in
writing anything about today's hearing. You have 7 days
afterwards, including Dr. Stiglitz's 28 recommendations for
changing Dodd-Frank.
Mr. Stiglitz. OK. Well, the first is the point that I think
most of us have raised, the concern about too-big-to-fail
banks. Something should have been done about that, something on
the Brown-Kaufman amendment should have been included.
Senator Brown. I would vote for that.
Mr. Stiglitz. The second one is much higher capital
requirements along the lines that we have been, most of us have
been talking about. And I do not think Basel III goes anywhere
near far enough.
The third is the CDSs exemplifying the continuing excessive
risk taking. The point I made before that they continue to be
engaged in by FDIC-insured institutions makes absolutely no
sense. The fact that a large fraction of them continue to be
over-the-counter and non-transparent, and the increasing
concern that the exchanges themselves, there were not adequate
capital requirements imposed on the exchanges, so that there is
a risk that if the exchange goes down, again, we have systemic
risk.
There should have been joint and several liability of all
of those trading in the exchange for the losses so that the
taxpayer does not have to pick them up, and the IMF has put
forward actually some recommendations along those lines.
The final point is the anticompetitive practices of the
banking sector in the control of the means of payment, the
credit cards, the debit fees, are an outrage and are a major
source of revenue which distorts our economy and hurts ordinary
retail merchants throughout our country--small businesses,
again, grocery stores that--there are some cases where 50
percent of their profits go on the sales of groceries are given
to the banks when they are paid for by credit card. And that
seems disproportionate to the services provided.
Senator Brown. Thank you, Dr. Stiglitz.
Dr. Kane?
Mr. Kane. Well, I can reduce my advice to two themes,
though many of Joe's ``points'' would go under my ``themes.''
Mr. Ludwig made the point that the Office of Financial
Research is potentially one of the great innovations of Dodd-
Frank. Missing today is a Director for this Office of Financial
Research, and, of course, its governance has been placed under
a very complicated 17-member committee. So I think that
Congress really has to address the need to measure and
publicize the cost taxpayers incur in supporting national and
international safety nets. This will be the job of the Office
of Financial Research, but it needs to be assigned to them in
an independent way. Second, to help authorities to contain
systemic risk skillfully and conscientiously in the long run,
governments need to change the way regulators are trained,
recruited, and incentivized. I believe that a national or
international academy for financial regulators could help in
both tasks.
Senator Brown. Thank you. Terrific idea.
Mr. Ludwig.
Mr. Ludwig. Three things.
One, I lament the fact that we do not have a single
prudential supervisor. Dr. Stiglitz and I advocated for that
early on in the Clinton administration. The countries that have
done better--Australia, Canada, and Japan--during the crisis
had a single, pure-play, focused, and professional prudential
supervisor. I think that would advance the cause of the
financial stability in this country markedly.
I agree with Dr. Kane that education for financial
supervisors is critical, and we do not have it adequately in
this country. As I said, no college or university offers a
degree in regulation and supervision.
The third is not a new change to the law, but I think it is
absolutely essential that we implement Dodd-Frank with prudence
and care. Excess here will actually not advance the benefits of
safety and soundness. There are only so many hours in a day,
and we want our financial institutions and regulators targeted
on those things that matter most, not on those things that are
extraneous.
Furthermore, excess here will put a drag on the economy,
which we can ill afford at this time.
Senator Brown. Thank you.
Dr. Pfleiderer.
Mr. Pfleiderer. I am afraid since I am going last, I
probably do not have much to add here, so I will just in some
ways just reinforce what has been said here.
I have made the analogy--it may not be the best analogy--
that we are basically trying to regulate cars that are speeding
down the road at 100 miles an hour that are only 5 feet apart.
And, of course, that requires very careful regulation to make
sure that the cars do not hit each other when the obvious
solution is just to have the cars have a greater buffer between
them and follow each other at much greater lengths. And that is
capital. I do not think we have enough. I think that Basel III
is not enough. I think that capital does not solve everything
here, clearly, but it solves a lot by just putting in much more
privatization of losses rather than the socialization of losses
we have now. So I want to reinforce that idea that we need more
capital.
I have not thought very much about having a single
regulator, but having heard this idea, it makes a lot of sense
to me, and I think that that probably moves in the direction of
taking care of a lot of the fragmentation that we have now.
And I think that getting the Office of Financial Research
up--the problem is that the next crisis may not happen in the
way--almost certainly will not happen in the way the last one
did, and we need to constantly be vigilant, and being ahead of
the ball rather than behind it is going to be useful. And I
think that the OFR can help us that way. So getting that up and
running is certainly important.
Senator Brown. Good. Thank you. Thank you all for the
spirited discussion and for your public service. It was very
helpful today.
Thanks especially to Laura and the majority committee and
the minority committee staff, and to Jeremy and to Eve and to
Graham in my office, I appreciate all of this.
Thank you. We are adjourned.
[Whereupon, at 3:28 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF JOSEPH E. STIGLITZ, Ph.D.\1\
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\1\ University Professor, Columbia University; recipient of the
2001 Nobel Memorial Prize in Economics; former Chair, President
Clinton's Council of Economic Advisers, Former Chair, Commission of
Experts on Reforms of the International Monetary and Financial System,
appointed by the President of the General Assembly of the United
Nations, 2009, President of the International Economic Association. All
views are personal.
---------------------------------------------------------------------------
Professor of Finance and Economics, Columbia Business School, Columbia
University
August 3, 2011
Thank you for this opportunity to address the question of the
financial structure of the banking industry, which I believe is central
to the future stability and prosperity of the American and global
economy.
Two fundamental analytic insights, buttressed by some empirical
observations should inform our thinking about the appropriate
regulation of banks, including capital requirements and risk taking.
The first is that when information is imperfect and risk markets
incomplete--that is, always--there is no presumption that unfettered
markets will result in efficient outcomes. The reason is that actions
give rise to externalities, consequences that are not borne by those
undertaking them.\2\ There is a misalignment of private and social
returns.
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\2\ See B. Greenwald and J.E. Stiglitz, ``Externalities in
Economies with Imperfect Information and Incomplete Markets,''
Quarterly Journal of Economics, Vol. 101, No. 2 (May), pp. 229-264,
1986. For an excellent discussion of these externalities at the
macroeconomic level, see A. Korinek, ``Systemic Risk-Taking:
Amplification Effects, Externalities, and Regulatory Responses,''
working paper, University of Maryland, 2011.
---------------------------------------------------------------------------
This result is of central importance in banking and finance,
because the very rationale for the sector arises out of risk management
and the acquisition and utilization of information necessary for the
efficient allocation of capital. The externalities consequent to the
excessive risk taking of the banks are manifest: it is not just the
costs of the bailouts and the millions of Americans who have lost their
homes, but the literally trillions of dollars of lost output, the gap
between the economy's actual and potential output, the predictable and
predicted fallout of the crisis. The resulting suffering--including
that of the 25 million Americans who would like a full-time job and
can't get one--is incalculable. The budgetary problems facing the
country too are in no small measure a result of the inevitable decline
in revenues and increase in expenditures that follow. It is well-known
that recoveries from financial crises are slow and painful.\3\
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\3\ See, e.g., C. Reinhardt, and K. Rogoff, 2009, This Time Is
Different: Eight Centuries of Financial Folly. Princeton University
Press or J.E. Stiglitz, ``Rethinking Macroeconomics: What Failed and
How to Repair It,'' Journal of the European Economic Association, 2011.
---------------------------------------------------------------------------
This crisis not only demonstrated the importance of the
externalities to which failures in financial markets give rise, but
also the importance of what economists call agency problems--those,
like bank officials, who are supposed to take actions on behalf of
others, who have a fiduciary responsibility, often have incentives that
lead them to take actions that benefit themselves at the expense of
those that they are supposed to serve. The so-called incentive systems
in place in the financial sector may have served the bank managers
well, but they did not serve well shareholders or bondholders, let
alone the rest of society.\4\
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\4\ There is by now a large literature explaining and documenting
this observation. See, e.g., J.E. Stiglitz, Freefall: America, Free
Markets, and the Sinking of the World Economy, New York: W.W. Norton,
2010. Indeed, well before the crisis, it was noted that managerial
incentive structures (``incentive pay'') had perverse effects, not only
in encouraging excessive risk taking and shortsighted behavior--which
is particularly costly when it occurs in the financial sector--but also
in encouraging dishonest accounting, so manifest not only in this
crisis, but in the scandals that marked the beginning years of this
decade, epitomized by the Enron bankruptcy, the largest bankruptcy up
to that point. See, e.g., J.E. Stiglitz, 2003, The Roaring Nineties,
New York: W.W. Norton.
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The second fundamental insight is that increased leverage in
general does not create value, but simply shifts risk--as leverage
increases, increased risk is placed on the equity base. This is the
central insight of the Modigliani-Miller theorem.\5\ In the 1960s and
1970s, I showed that that result was far more general than Modigliani-
Miller had thought--but that there were limitations too, most of which
cautioned against excessive leverage: if there were real costs to
bankruptcy (as there are), then increased leverage increased the
likelihood of these dissipative costs.\6\
---------------------------------------------------------------------------
\5\ F. Modigliani and M. Miller, 1958, ``The Cost of Capital,
Corporation Finance and the Theory of Investment,'' American Economic
Review, 48, 1958, pp. 261-267. From early on, it was recognized that
theorem was relevant to financial firms as well as non-financial firms.
See M. Miller, 1995, ``Do the MM propositions apply to banks?'',
Journal of Banking and Finance, 19(3), pp. 483-489.
\6\ See, in particular, J.E. Stiglitz, 1969, ``A Re-Examination of
the Modigliani-Miller Theorem,'' American Economic Review, 59(5),
December, pp. 784-793 and J.E. Stiglitz, 1974, ``On the Irrelevance of
Corporate Financial Policy,'' American Economic Review, 64(6),
December, pp. 851-866. In particular, I showed that the kind of
arbitrage that Modigliani and Miller had invoked in their analysis was
not necessary to establish the result. I established that there did not
have to exist a set of risk classes as they had assumed; and that the
conclusions held in a very generally specified general equilibrium
model. What was required was that the level of debt was not so high
that there was a risk of bankruptcy. For a discussion of some of the
other restrictions that have to be satisfied for the result to be true,
see the footnotes below.
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In the financial sector, the social costs of increased leverage are
even greater, because of the societal costs associated with the
externalities that I described earlier.\7\ The misalignment of
incentives is even more in the case of too-big-to fail banks--banks
that are so large that the potential consequences of allowing them to
go bankrupt poses an unacceptable risk. Their failure poses a systemic
risk. They can reap returns from risk taking, with the losses borne by
the Government. But too-big-to-fail banks present another major
distortion: because those providing them with capital know that they
are too-big-to-fail, that there is at least a higher probability of
their being rescued (evidenced so clearly in the recent crisis), they
can get access to finance at lower costs,\8\ and thus they can grow
relative to competitors, not because of their relative competence, but
because of the implicit subsidy. As they grow, the likelihood of a
rescue increases, and their profitability is enhanced not just because
of the increase in the implicit subsidy but because of growing market
power, providing further distortions to the market. Moreover, banks
know that if they become too-big-to-fail (or too intertwined to fail,
or too correlated to fail) they will have an enhanced likelihood of
being rescued; they thus have strong incentives to become too-big-to-
fail, too intertwined to fail, and too correlated to fail--as we saw in
the recent crisis. Systemic risk is real, and markets by themselves
work to increase it, not to mitigate it. The notion that risk would be
spread efficiently, through diversification, was either pure
propaganda, or based on models that showed insufficient understanding
of market incentives, of the nature of contagion, and/or of the
consequences to systemic stability posed by the non-convexities to
which contagion and bankruptcy give rise.\9\
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\7\ The problem would arise even if all the costs were borne by a
self-financed deposit insurance scheme, and if there were no
macroeconomic externalities.
\8\ See for example D. Baker and T. McArthur, 2009, ``The Value of
the `Too Big to Fail' Bank Subsidy,'' Center for Economic Policy and
Research Issue Brief, September, available at http://www.cepr.net/
documents/publications/too-big-to-fail-2009-09.pdf (accessed on August
1, 2011).
\9\ See, e.g., A.G. Haldane, 2009, ``Rethinking the Financial
Network,'' address to the Financial Students Association, Amsterdam,
April, available at http://www.bankofengland.co.uk/publications/
speeches/2009/speech386.pdf (accessed August 2, 2011); A.G. Haldane and
R.M. May, 2010, ``Systemic risk in banking ecosystems,'' University of
Oxford mimeo; J.E. Stiglitz, ``Contagion, Liberalization, and the
Optimal Structure of Globalization,'' Journal of Globalization and
Development, 1(2), Article 2, 45 pages; and J.E. Stigltiz, 2010, ``Risk
and Global Economic Architecture: Why Full Financial Integration May be
Undesirable,'' American Economic Review, 100(2), May, pp. 388-392.
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The key empirical observation is that markets are often not
rational in assessing risk; this is true even of the so-called experts,
but even more so of those who are financially unsophisticated.\10\ Alan
Greenspan testified to this before Congress, when he expressed his
surprise that the financial markets had not managed risk as well as he
had expected.\11\ But, while he was correct in the conclusion that
financial markets had done a miserable job of managing risk--one of
their central societal functions--I was surprised at his surprise.
After all, anyone looking at the incentive structures confronting key
decisionmakers should have realized that they had incentives for
excessive risk taking and short sighted behavior. (That they had such
perverse incentive structures is testimony to the importance of the
agency problems to which I referred earlier.)
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\10\ There is a large literature documenting both systematic and
non-systematic but persistent anomalies in capital markets. See, for
instance, R.J. Shiller, 2000, Irrational Exuberance, Princeton:
Princeton University Press; or G. Akerlof and R. Shiller, 2010, How
Human Psychology Drives the Economy, and Why It Matters for Global
Capitalism, Princeton, New Jersey: Princeton University Press. See also
J.E. Stiglitz, 1982, ``Information and Capital Markets,'' in William F.
Sharpe, Cathryn M. Cootner, eds.: Financial Markets: Essays in Honor of
Paul Cootner, Englewood Cliffs, NJ: Prentice-Hall, Inc; and the broader
discussion of irrationality in capital and financial markets in J.E.
Stiglitz, forthcoming, The Selected Works of Joseph Stiglitz, Volume
II, Oxford University Press. For more on the lack of rationality in
much economic decisionmaking, see for instance R. Thaler, 1994, The
Winner's Curse: Paradoxes and Anomalies of Economic Life, Princeton,
NJ: Princeton University Press.
\11\ In Congressional testimony on October 23, 2008, Greenspan
described being ``in a state of shocked disbelief'' that the lending
institutions' self-interest had not protected shareholders' equity.
Testimony available at http://democrats.oversight.house.gov/images/
stories/documents/20081023100438.pdf (accessed August 1, 2011).
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But beyond that, Greenspan made another error--if I mismanage risk,
if I am irrational in my risk analyses, I and my family suffer, but
there are unlikely to be societal consequences. But if a bank and
especially a very large bank mismanages risk, the macroeconomy can be
seriously affected. There are externalities. It is these externalities
that provide the motivation for Government programs (like FDIC
insurance and regulation). It is these externalities that explain why
self-regulation simply won't work. It is deeply troubling when the
country's major financial regulators do not understand the rationale
for regulation.
Rational markets would realize that increasing leverage shifted
risk, and would demand compensating differentials. (Rational market
participants in well-functioning markets would have realized too that a
shift to variable rate mortgages from fixed rate mortgages would, on
average, not save on financing costs, but would expose ordinary
citizens to increased risk. But not even Greenspan seemed to understand
this, as he seemed to advise ordinary citizens on the virtues of
variable rate mortgages.\12\)
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\12\ See for example ``Understanding Household Debt Obligations,''
Remarks by Chairman Alan Greenspan at the Credit Union National
Association 2004 Governmental Affairs Conference, available at http://
www.federalreserve.gov/boarddocs/speeches/2004/20040223/ (accessed
August 1, 2011).
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As we see banks striving to increase their leverage, there may be
uncertainty about what is driving this: is it because in doing so, they
increase the implicit subsidy from the Government? Is it because they
do not understand the fundamentals of risk? Is it because they
understand the fundamentals of risk, but realize that their bondholders
and shareholders do not, so that they can extract more money for
themselves? But about this there is no uncertainty: excessive leverage
has large societal costs. Banks, and especially the big banks, need to
be restrained.\13\
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\13\ There are a few other reasons that have been mentioned for
banks' seeming preference for excessive leverage. One is that the tax
system, by allowing tax deductibility of interest, increases the
private return on increased leverage. But if so, this is not an
argument for allowing greater leverage, but for correcting a tax
distortion. (A full analysis of the tax consequences has to integrate
an analysis of the corporate and individual income tax system. The
results are more complex and ambiguous, once the preferential treatment
of capital gains is taken into account. See J.E. Stiglitz, 1973,
``Taxation, Corporate Financial Policy and the Cost of Capital,''
Journal of Public Economics, 2, pp. 1-34.) Another criticism of the
Modigliani-Miller analysis (which I raised in my original evaluations
of their work) is that financial structure may convey information.
(See, e.g., H. Leland and D. Pyle, 1977, ``Informational Asymmetries,
Financial Structure, and Financial Intermediation,'' 32(2), pp. 371-
387; N. Maljuf and S. Myers, 1984, ``Corporate Financing and Investment
Decisions When Firms Have Information That Investors Do Not Have,''
Journal of Financial Economics, 13, pp. 187-221; B. Greenwald, J.E.
Stiglitz, and A. Weiss, 1984, ``Informational Imperfections in the
Capital Markets and Macro-economic Fluctuations.'' American Economic
Review, 74 (1), pp. 194-199; and J.E. Stiglitz, 1982, Op. cit. But as
A.R. Admati, et al., point out, if banks are required by regulation to
raise capital when their capital ratio falls below a certain level,
then there is in fact no adverse signal (A.R. Admati, P.M. DeMarzo,
M.F. Hellwig and P. Pfleiderer, 2010, ``Fallacies, Irrelevant Facts,
and Myths in the Discussion of Capital Regulation: Why Bank Equity is
Not Expensive,'' Stanford University Working Paper No. 86). To the
contrary, the only firms in such a situation that would not raise new
equity would be those that believed that their future prospects were
bleak: raising new equity would thus provide a positive signal. While
it may be the case that the cost of raising equity funds may be high in
recessions, this is an argument for macroprudential regulations, which
adjust capital requirements to the state of the business cycle, or the
adoption of related provisioning requirements. A still weaker argument
for high leverage is based on the ``back to the walls theory of
corporate finance''--high leverage force gives management less leeway
to behave badly. (See, e.g., M.C. Jensen, 1986, ``Agency Costs of Free
Cash Flow, Corporate Finance, and Takeovers,'' American Economic
Review, 76(2), pages 323-29.) No evidence of this effect was observed
in the run up to the crisis. On the contrary, the convexities in
payoffs generated by bankruptcy encourage excessive risk taking, of
particular concern in the financial sector. These non-convexities, in
turn, have important consequences for systemic stability, which the
standard literature ignored. See below.
---------------------------------------------------------------------------
Indeed, the analysis above suggests that there are few or no
societal costs to doing so, and considerable benefits. It is not as if
leverage somehow manufacturers resources out of thin air. Lending is
risky. The risk has to be borne somehow. It is borne by equity holders
of lending institutions--to the extent it isn't shifted to Government,
FDIC, or bondholders, or depositors. It is better to have it better
distributed, among a large equity base, given the high social costs of
financial disruption. Advocates of low equity requirements for banks
need to argue that this is the best way by which the risks of lending
should be distributed within the economy--and I have seen not even an
attempt to do so.
Recent empirical research has provided considerable support for the
views expressed here. Miles, et al., of the Bank of England find no
relationship between bank leverage and the spread on business loan
rates over T-bill rates, and after a careful (but conservative)
analysis of the consequences of increasing bank-equity requirements,
concludes that very substantial increases would have very little effect
on lending rates.\14\
---------------------------------------------------------------------------
\14\ D. Miles, J. Yang and G. Marcheggiano, 2011, ``Optimal bank
capital'', Bank of England Discussion Paper No. 31, April. In their
analysis, they typically ignore the increased cost of borrowing funds
that results from increased leverage, thus overestimating the benefits
of leverage. They also find no relationship for the UK between Bank
leverage and economic growth. Similarly, K. Kashyap, J. Stein, and S.
Hanson argue that the effect on lending rates of a substantial increase
in equity requirements would be very small (``An Analysis of the Impact
of `Substantially Heightened' Capital Requirements on Large Financial
Institutions,'' Working Paper, 2010).
---------------------------------------------------------------------------
But even if there were some increases in lending costs as a result
of increased equity requirements, those costs have to be offset against
the benefits: (a) To the extent that the increased costs are a result
of increased taxes paid by banks, then in principle, the Government
could, for instance, have broader based reductions in, say, taxes on
investment-enhancing growth and efficiency. (b) There are very large
societal costs from bank failures, and these can be substantially
reduced by higher equity requirements. Based on a conservative estimate
of the increased cost of borrowing and plausible magnitudes for the
shocks facing an economy, Miles, et al., conclude that substantial
increases in the equity requirements are warranted.\15\
---------------------------------------------------------------------------
\15\ They look at shocks over a sample of 31 countries over 200
years. We suspect that Miles, et al., estimate of the small benefit
from increased equity in fact considerably overestimates the net social
benefit, taking into account the costs of bankruptcy and financial
distress.
---------------------------------------------------------------------------
There are two responses to this perspective. The first is that
increasing equity requirements will increase the cost of borrowing and
lead to less investment. But (in a closed economy) aggregate investment
is limited by aggregate savings, and there is no reason to believe that
the latter will be adversely affected.\16\ But most critically, we have
argued that in the case of well-functioning markets, there is no basis
to this belief. If, of course, markets irrationally do not take into
account the additional risk imposed on equity (in the short run), then
with increased leverage, funds might be able to be provided at lower
than their true social costs. But it would be a big mistake (as we
should have learned) to allow banks to do this. As we have learned,
society will eventually pay the price for this market distortion--and
that price can be very, very high.
---------------------------------------------------------------------------
\16\ Indeed, if the argument that changing bank capital structure
increased the cost of capital to banks were correct, it would imply
that the return to those providing funds to the financial system would
have increased, and thus arguably that savings might have increased. In
fact, we have contended that the systemic cost of capital (return to
capital) would be essentially unchanged, and thus, whether the economy
is open or closed, whether it is operating at full employment or less
than full employment, there is little reason to believe that aggregate
savings or investment would be affected.
---------------------------------------------------------------------------
The second is that the existing banks (perhaps especially the large
banks) have an absolute advantage in judging credit worthiness.
Restricting leverage in effect restricts their ability to leverage
their core competencies to ensure the efficient allocation of resources
in society. The crisis has shown that the predicate of this hypothesis
is simply false: the large banks' performance was hardly stellar, and
some of their (admittedly low) returns were undoubtedly related to the
implicit subsidy provided by the Government. But again, more
fundamentally, putting aside concerns about too-big-to-fail and anti-
competitive practices, if the existing banks can demonstrate to the
market their greater competency, including at managing risk, they will
have no difficulty raising capital at the appropriate risk adjusted
rate; indeed, if they are better at risk management, then their cost of
funds will be lower than that of their competitors.
Some have argued that even if it makes sense in the long run to
increase capital requirements, doing so in the short run can be costly,
especially at a time such as this when the economy is fragile and the
banking system already weak. At most, this is an argument for a paced
increase in capital requirements, and one which would not allow any
dividends or share buybacks or extravagant bonus pools until the
desired capital ratios are reached, unless the bank is raising on the
market a more than offsetting amount of capital. But one should, at the
same time, be aware of the large risks, especially under the current
circumstances, of delay: it is precisely because the economy is
fragile, banks have inadequate capital, and the banking sector in the
aftermath of the crisis is more concentrated than before that the risk
of a financial catastrophe of the kind that we experienced in 2008 is
so great today. The downside risks of not doing something are
especially grave now. It may be desirable, or even necessary, for the
Government to provide funds for another round of equity injections
(hopefully done in a far better way than under TARP), if the private
sector cannot raise the necessary funds. But with literally hundreds of
billions of cash available in the private sector, it should tell us
something about the riskiness of the banks (and perhaps their lack of
transparency) if the private sector is not willing to make these
investments.
I have focused my remarks this afternoon on increasing banks'
equity capital. There are a number of other factors affecting the risk
to the economy posed by the banking and financial sector. I have noted
the risk of too-big-to fail banks. We should not allow any bank to grow
to a size that it poses a systemic risk to the economy. Yet in the
aftermath of the crisis, the banking sector has become more
concentrated, and the risk posed by too-big-to fail banks has, if
anything, increased. We saw in the crisis the risks posed by non-
transparent transactions, such as over-the-counter CDS's, and off-
balance sheet activities. One of the reasons that the financial system
froze was that everyone knew that there was no way that they could know
the true financial position of most of the banks. While the Dodd-Frank
Bill improved matters, it went nowhere far enough: the problems
continue, and as long as they continue, our economy is at risk. The
gravity of the situation is illustrated by what has been happening in
Europe, where the European Central Bank has warned against the risk to
Europe's financial system posed by a Greek default. In principle, the
direct exposure of the banks outside of Greece should be limited, well
within the capacity of adequately capitalized banks to withstand. But
it is clear that the risks can be amplified as a result of the high
levels of interconnectivity and through CDS's. The facts of the matter
are that no one seems to know with any degree of precision to what
extent individual banks on either side of the Atlantic are at risk; and
to protect the banks from the excesses of their own risk taking, the
ECB had demanded that European taxpayers bear the full costs of any
restructuring. The ECB's vehement opposition to what is essential to
all capitalist economies--the restructuring of debt of failed or
insolvent entities--is evidence of the continuing fragility of the
Western banking system. (The appropriate response of the ECB should not
have been to oppose the restructuring, but rather to insist on an
appropriate banking and financial sector regulatory framework.)
We may never fully protect the economy against the risk of another
crisis such as the one that we have been through. But this much should
be clear: our economic and financial system is badly distorted.
Resources were misallocated before the crisis. No Government has ever
wasted resources (outside of war) on the scale that has resulted from
the failures of America's financial system. We may have begun the work
of making our financial system once again become the servant of the
society which it is supposed to serve, but there is a long way to go.
Lending, especially to small and medium sized enterprises is
constrained. Activities that pose unnecessary risks to our entire
economy continue.
We cannot rely on the self-restraint or self-regulation of
financial markets. We learned that lesson in the aftermath of the Great
Depression, and the decades following World War II, with this strong
regulatory system, were among the most prosperous this country has
experienced. The question is, will we relearn that lesson in the
aftermath of the Great Recession of 2008?
______
PREPARED STATEMENT OF EDWARD J. KANE, Ph.D.
Professor of Finance, Boston College
August 3, 2011
Ours is a representative democracy that espouses the principle that
all men and women are equal under the law. This ought to mean that, in
difficult times, Government officials responsible for managing the
Nation's financial safety net would treat the interests of all citizens
more or less equally. But this was demonstrably not the case during the
run-up of the housing bubble, nor beginning in 2007 in Government
efforts to tame the widespread financial crisis that the bursting
bubble brought about. Throughout both periods, the interests of
domestic and foreign financial institutions were much better
represented than the interests of society as a whole.
Taxpayer interests were poorly represented because, over the years,
the financial industry has infiltrated the bureaucratic system that is
supposed to regulate its risk-taking and sewed huge loopholes into the
capital requirements that then and now are supposed to keep financial
instability in check. Unfortunately, the industry's capture of the
regulatory system is politically well-defended. This can be
demonstrated in two complementary ways: (1) by enumerating the problems
that last year's Dodd-Frank Act did not even try to address (such as
how to define systemic risk operationally or how to resolve the Fannie
and Freddie mess) and (2) by examining the loose ends left in the Act's
efforts to deal with regulation-induced innovation and with
institutions that have made themselves too large, too complex, and too
well-connected politically to be closed and unwound. Living wills,
enhanced resolution authority, claw-backs of undeserved executive
compensation, and a newly minted Office of Financial Research are all
good ideas. But the Keating 5 episode tells us how hard it can be for
regulators to discipline politically influential firms. Sadly, the very
same criticisms can be levied against the reform efforts unfolding in
Basel and in the European Union as well.
What can we do to put reform on a more promising path? Governments
must rework bureaucratic incentives to refocus reporting
responsibilities for regulators and institutions on the value of
safety-net support. Until regulatory duties are embraced explicitly and
enforced in operational and accountable ways, it is unreasonable to
hope that authorities can or will adequately measure and contain
systemic risk during future booms and busts.
A first step would be to strengthen training and recruitment
procedures for top regulators. If it were up to me, I would establish
the equivalent of a nonmilitary academy for financial regulators and
train cadets from around the world. The curriculum would teach cadets
how to calculate and aggregate the costs of safety-net support in
individual institutions and countries. Among other things, students
would be drilled in the duties they owe the citizenry and in how to
overcome the political pressures elite institutions exert when and as
they become increasingly undercapitalized.
Fed and Treasury Rescue Programs Placed Great Burdens on the Citizenry
GAO data (Government Accountability Office, July 2011) show that,
using funds that belong ultimately to ordinary citizens, the Fed bought
massive amounts of debt on greatly subsidized terms from important
foreign and domestic banking and securities firms between December 2007
and July 2010. Starting in the last quarter of 2008, the Treasury's
Troubled Asset Relief Program (TARP) piled additional bailout
obligations onto these same citizens.
Evaluating Fed and TARP rescue programs against the convenient
standard of doing nothing at all, high officials tell us that both
bailout programs were necessary to save us from worldwide depression
and made money for the taxpayer. Both claims are false, but in
different ways.
A financial crisis may be described as a struggle by financial
firms whose asset values have collapsed to offload the bulk of their
resulting losses onto creditors, customers, and taxpayers. In the early
months of the crisis, Fed and Treasury officials assisted economically
insolvent zombie institutions (such as Bear Stearns and AIG) to develop
new risks and to transfer losses onto the Government's balance sheet.
Authorities did this by mischaracterizing the causes of these
institutions' distress as a shortage of market liquidity and helping
insolvent firms to expand and rollover their otherwise unattractive
debt. Far from assisting zombie institutions to address their
insolvency, unwisely targeted and inadequately monitored Government
credit support encouraged troubled firms not only to hold, but even to
redouble the kinds of gambles that pushed them into insolvency in the
first place.
Bailing out firms indiscriminately has hampered, rather than
promoted economic recovery. It evoked reckless gambles for resurrection
among protected firms and created uncertainty about who would finally
bear the extravagant costs of these programs. Both effects disrupted
the flow of credit and real investment necessary to trigger and sustain
economic recovery.
The claim that the Fed and TARP programs actually ``made money''
for the taxpayer is half-true. The true part of the proposition is
that, thanks to the vastly subsidized terms these programs offered,
most institutions were eventually able to repay the obligations they
incurred. But the neglected parts of the story are that these rescue
programs forced taxpayers to provide under-compensated equity funds to
deeply troubled institutions, and that the largest and most influential
of these firms were allowed to become even bigger. The Government's
deals compare unfavorably with the deal Warren Buffet negotiated in
rescuing Goldman-Sachs. His deal carried a running yield of 10 percent
and included warrants that gave him a substantial claim on Goldman's
future profits. Lifelines provided to an underwater firm are not truly
loans; they are unbalanced equity investments whose substantial
downside deserves to carry at least a 15 percent to 20 percent return.
Government credit support transferred or ``put'' to taxpayers the
bill for past and interim losses rung up by protected financial firms.
Authorities chose this path without weighing the full range of out-of-
pocket and implicit costs of their rescue programs against the costs
and benefits of alternative programs such as prepackaged bankruptcy or
temporary nationalization and without documenting differences in the
way each deal would distribute benefits and costs across the populace.
The Crucial Problem is: How to Define and Measure Systemic Risk?
Acting in concert, market and regulatory discipline force a
financial firm to carry an equity position that outsiders regard as
large enough to support the risks it takes. Taxpayers become involved
in capitalizing major firms because creditors regard the conjectural
value of the off-balance-sheet capital that Government guarantees
supply through the taxpayer put as at least a partial substitute for
on-balance-sheet capital supplied by the firm's shareholders.
The nature, frequency and extent of modern financial crises support
the hypothesis that changes in risk-taking and concealment technologies
available to aggressive financial institutions have repeatedly
outstripped social controls on the job performance of the parties that
society asks to control the safety and soundness of interlocking
financial systems. The root problem is that supervisory conceptions of
capital and systemic risk fail to make Government officials accountable
for the role they play in generating either variable. Policymakers'
knee-jerk support of client firms' creative forms of risk-taking and
officials' proclivity for absorbing losses in crisis situations
encourage opportunistic firms to foster and exploit incentive conflicts
within the supervisory sector and to make sure that tough decisions
favor industry interests over those of the taxpayer.
Systemic risk can be likened to a disease that has two symptoms.
The Dodd-Frank Act and the Basel III framework seek to use higher
capital requirements to treat only the first of these symptoms: the
extent to which institutions expose themselves in directly observable
ways to credit risks that might transmit exposures to default across a
chain of leveraged and short-funded financial counterparties. But to be
effective, the medicine of capital requirements must be adapted to take
fuller account of a firm's particular funding patterns and to treat a
second and more-subtle symptom. This second symptom is the ease with
which actual or potential zombie institutions can use financial
accounting tricks and innovative instruments to hide risk exposures and
accumulate losses until their insolvency becomes so immense that they
can panic regulators and command life support from them.
It is this second symptom that gives large and politically powerful
institutions the ability to shift responsibility for potentially
disastrous losses to taxpayers. In good times and in bad, the existence
of this ``taxpayer put'' allows these elite institutions to issue the
equivalent of Government debt and makes ordinary citizens uncompensated
equity investors in such firms. Offering taxpayer support to zombie
firms impedes macroeconomic recovery by making crippled institutions
look stronger than they are and turns a blind eye to the ways in which
their underlying weakness disposes such firms to seek out long-shot
investments instead of fostering flows of healthy business and consumer
credit.
My recommendations for regulatory reform are rooted in the
straightforward ethical contention that protected institutions and
safety-net managers owe fiduciary duties to taxpayers. The existence of
a safety net makes taxpayers silent equity partners in major financial
firms. As de facto investors, taxpayers deserve to be informed at
regular intervals about how their side of the taxpayer put is doing.
Consistent with U.S. securities laws, Kane (2011) calls for managers of
important financial firms to measure and report under penalties for
fraud the value of taxpayers' stake in their firm on the same quarterly
basis that they report to stockholders and for Government officials to
examine, challenge, aggregate, and publicize this information.
My two-piece conception of systemic risk casts it as an option-like
equity investment by taxpayers in the firms the safety net protects.
The value of taxpayers' position varies inversely both with the risk
that an institution might sustain losses that exceed its ownership
capital (i.e., the size of a firm's tail risk) and the percentage of
this tail risk that the Government may be expected to absorb. If tail
risks turn out favorably, the institution reaps most of the gains. But
when things go disastrously sour, the management ``puts'' the losses to
taxpayers.
Defining systemic risk as taxpayers' side of an unfavorably
structured claim also provides a metric for tracking systemic risk over
time. Requiring authorities to calculate and disclose fluctuations in
the aggregate value of the taxpayer puts enjoyed by large institutions
would make regulatory authorities operationally accountable for the
quality of their supervisory performance in booms and recessions alike.
Although considerable disagreement exists about the best way to
construct a measure of systemic risk, everyone agrees that it arises as
a mixture of leverage and the volatility of financial-institution
returns. Most existing measurement strategies incorporate the
pioneering perspective of Nobel Prize Winner Robert Merton. For
example, Carbo, Kane, and Rodriguez (2011) use Merton-type contingent-
claim models with a 1-year horizon to undertake cross-country
comparisons of the quality of banking supervision before and during the
crisis. Hovakimian, Kane, and Laeven (2011) use such a model to
evaluate U.S. financial supervision during 1974-2009 and to show that
regulators could have used the growing correlation of institution risk
exposures as an early warning system for the current crisis. Expanding
the format for collecting information from covered institutions to
include estimates of the loss exposure (i.e., the ``volatility'') of
their positions over different horizons in individual countries could
improve both the precision of systemic-risk estimates and officials'
accountability for regulatory and supervisory performance.
Traditional Reporting and Incentive Frameworks are Inadequate
Accounting standards for recognizing emerging losses make evidence
of an institution's insolvency dangerously slow to surface. During the
housing and securitization bubbles that preceded the 2007-2008
financial meltdown, top managers and top regulators of U.S. and EU
financial institutions claim that there was no way they could see the
buildup of crisis pressures. Moreover, as the crisis unfolded, these
same officials were reluctant to prepare and publicize timely estimates
of the financial and distributional costs of bailing out firms that
benefited from open-bank assistance.
By engaging in regulation-induced innovation, nurturing clout, and
exerting lobbying pressure, a country's systematically important
financial institutions (SIFIs) have kept their tail risks from being
adequately disciplined. The importance of political, bureaucratic, and
career interests in regulatory decisionmaking allows such firms to
screen regulatory appointments and to distort regulatory policies ex
ante and to reshape their enforcement ex post.
In a world of derivative transactions, top regulators need special
training to understand--and considerable mental toughness to
discipline--the incremental taxpayer exposures to risk that innovative
instruments and portfolio strategies entail. Efficient safety-net
management requires a more sophisticated informational framework than
current methods of bank accounting and examination provide. To protect
taxpayers and to enhance financial stability, examinations and bank
accounting reports should not focus so narrowly on measures of tangible
capital. They should also develop and report explicit estimates of the
intangible value of an institution's claim on taxpayer resources. To
keep up with the regulated, regulators must develop adaptive
statistical strategies that can extract from an ever-wider array of
market data the evolving size of the public risks that they should be
sworn to protect. Finally, to hold themselves accountable for carrying
out these tasks conscientiously, regulators must accept a system of
ethical constraints that requires them to share this information with
the public.
Summarizing, regulators need to measure and publicize the implicit
and explicit costs taxpayers incur in supporting national and
international safety nets. To help them to do this skillfully and
conscientiously, we need to change the way they are trained, recruited,
and incentivized. I believe that a National or International Academy
for Financial Regulators could assist in these tasks.
References
Carbo, Santiago, Edward Kane, and Francisco Rodriguez, 2011. ``Safety
Net Benefits Conferred on Difficult-to-Fail-and-Unwind Banks in the
U.S. Before and During the Great Recession,'' Working Paper, Milan:
Paolo Banfi Centre (July 12).
Hovakimian, Armen, Edward Kane, and Luc Laeven, 2011. ``Progress Report
on the Hovakimian-Kane-Laeven Research Project for the Institute
for New Economic Thinking'' (July 1).
Kane, Edward J., 2011. ``Missing Elements in Financial Reform: A
Kubler-Ross Interpretation of the Inadequacy of the Dodd-Frank
Act,'' Journal of Banking and Finance (forthcoming).
U.S. Government Accountability Office, July 2011. Federal Reserve
System: Opportunities Exist to strengthen Policies and Processes
for Managing Emergency Assistance. Washington. (GAO-11-696).
______
PREPARED STATEMENT OF EUGENE A. LUDWIG
Chief Executive Officer, Promontory Financial Group
August 3, 2011
I would like to commend Chairman Brown, the Ranking Committee
Member, Senator Corker, and the other Members of this Committee for
holding this hearing on Debt Financing in the Domestic Financial
Sector. Chairman Brown and Ranking Member Corker, you and the rest of
the Committee Members can take pride in having worked hard to address
the challenges posed by the financial crisis. You have brought
important Congressional focus to the issues of financial stability,
safety and soundness, and regulatory framework of financial
institutions. You have passed landmark legislation in this area and
continue to engage in serious oversight.
One of the greatest challenges facing not just the financial and
regulatory communities but our economy as a whole is the successful
implementation of the very powerful post-crisis reforms enacted by the
Congress and the international reforms currently being proposed by the
Basel Committee on Banking Supervision and the Financial Stability
Board. Properly implemented in a balanced and thoughtful way these
reforms should enhance financial stability in the United States.
If this balance is lost however, the potential exists--particularly
given the potentially great cumulative impact of these rules--that the
financial system will be actually less stable and less able to fulfill
its key function in supporting the economy of the United States,
putting a deleterious drag on capital formation and meaningful job
opportunities for our people.
We must never lose sight of the fact that the financial crisis has
taken a tremendous toll on our country. Millions of Americans are
reeling from the loss of their jobs, their homes, and their life
savings. We need the banking system to serve them again and to fulfill
its critical role of supporting economic growth. Therefore, we must
ensure that the hundreds of rules required by the Dodd-Frank Act are
implemented with great care and in a coordinated fashion. The sum total
of these reforms must contribute to the country's economic recovery and
future stability.
In implementing the Dodd-Frank Act, it is important to emphasize
that the Act is sufficiently comprehensive that each rulemaking should
be evaluated with the recognition that the cumulative impact of the
entirety of the Dodd-Frank Act reforms will have an immense, and not
entirely predictable, impact. It is critical to take a thoughtful
approach to the implementation of all of these reforms--domestic and
international--with an eye toward maintaining the balance of the
financial system and allowing the economy to recover and provide
Americans with much needed jobs and opportunity.
The modern financial system is a complex mechanism that can be a
potent force for development and opportunity. It is hard to imagine how
a developed economy can thrive without a robust financial system. But,
as we have seen, modern finance--like every other human endeavor--has
flaws. Both the Dodd-Frank Act and the rules proposed by the Basel
Committee and the Financial Stability Board seek to rectify those flaws
and provide the medicine needed for a stronger and safer financial
system that can support the critical growth ultimately needed for
America's recovery. This is truly an omnibus effort; the kind of change
that occurs rarely more than once in a generation. However, like any
strong medicine, if applied incorrectly or excessively, the Dodd-Frank
Act, and the Basel Committee and Financial Stability Board reforms can
produce more harm than good.
I have been a regulator, banker, and bank adviser for over 30
years. In these roles, I have developed, implemented, and evaluated
complex financial system rules and controls. There are tremendous
practical challenges in creating and maintaining control systems that
function at a level that modern finance demands and that Congress, the
regulatory community, and the public have a right to expect. Targeting
resources to create controls that matter and refraining from imposing
excess or overkill in reforms are key to successful implementation.
Therefore, in this regard, I like to say that more is not better,
better is better.
Capital Increases
The capital rules are a good case in point. Through the work of the
Basel Committee, the Financial Stability Board, Congress, and U.S.
regulators, we now have very tough capital requirements and capital
levels that significantly exceed previous requirements.
The major source of higher minimum capital requirements is the work
of the Basel Committee, in which the U.S. banking regulators play a
lead role. Under current Basel capital rules, banks have to hold 8
percent total capital and 4 percent Tier 1 capital--only half of which
must be common equity. Under Basel III, which was issued in December
2010 and will be implemented beginning in 2013, banks will have to hold
10.5 percent total capital and 7 percent common equity. On top of that,
U.S. regulators may add on an additional ``countercyclical capital
buffer'' of up to two and a half percent, which, as currently
contemplated, must be composed of common equity. Furthermore, most
financial institutions, out of concern that there will be adverse
consequences if they breach--even for a short period of time--any of
their regulatory minimum ratios, typically carry their own buffers in
excess of those required.
It is hard to quantify just how much additional capital is being
added to the requirements, both because of these complex definitional
elements and the fact that U.S. implementation of Basel III and capital
standards required by Title 1 of the Dodd-Frank Act has not yet taken
place. However, it is notable that under Basel III, banks have to hold
a minimum of 7 percent common equity, as opposed to a minimum of 2
percent common equity under Basel II (because half of the 4 percent
Tier 1 minimum could be held as noncumulative preferred stock and
certain hybrid instruments). This is over a threefold increase in
required common equity, before even factoring in additional buffers and
revised risk weights described below.
This is an important change, because common equity is the highest
quality of capital in terms of loss-absorbing ability, albeit also the
most expensive for banks to raise. Furthermore, prior to the crisis
several of our largest non-bank institutions, notably investment banks,
were subject to a much less rigorous capital regime. Now, given changes
occasioned by the financial crisis, as well as the ability of the
Financial Stability Oversight Council (FSOC) to designate non-bank
financial institutions as ``systemically important'', a number of
institutions will see even more marked increases in the capital they
are required to hold.
It should also be noted that after the financial crisis the Basel
Committee revised certain risk weights on assets that had been
instrumental in the financial disruption. For example, re-
securitizations and trading assets now will have substantially higher
risk weights beginning in 2012. The Basel Committee estimates that
banks will hold four times the amount of capital on trading activities
than under the current framework.
Finally, under a recent Basel Committee proposal, large complex
banking companies--so-called global SIFIs--will have to hold yet
another capital buffer of one to two and a half percent.
The Importance of Balance
At the end of the day, capital is an important tool in the
supervisory toolbox, but it is only one tool; therefore, I would not,
at this time, advise any further increases in capital requirements
beyond the tough new Basel rules. The Dodd-Frank Act provides capital
requirements as a regulatory mechanism with other powerful tools to
enhance safety and soundness of the financial system. While focusing on
capital is appropriate, to do so to the exclusion of other important
mechanisms for ensuring bank safety and soundness is risky. We take the
chance of capital's becoming the Maginot Line of financial institution
safety and soundness. Capital is a necessary condition for good safety
and soundness, but it is not sufficient in and of itself.
In this regard, it is worth noting that bank failures in the recent
crisis were typically not the result of banks running out of capital,
but rather the result of liquidity weaknesses. The Dodd-Frank Act
requires heightened liquidity standards for bank holding companies of
$50 billion or more in assets. The Basel Committee is in the final
stages of issuing stringent new liquidity rules. Furthermore, the Dodd-
Frank Act provides regulators with an armory filled with other
supervisory tools. Some of these tools are new, like the work of the
Office of Financial Research (OFR), and resolution plans. Other tools
are not new, but they are greatly enhanced, like stress testing and an
increased emphasis on governance and risk management.
Taken as a whole, these tools, along with the significant powers
already held by bank regulators, should be, at this point, adequate to
greatly enhance financial stability. Taken to the extreme, any one or a
group of these tools can prove harmful.
In this regard, it is important to recognize that the CAMELS
supervisory rating system is one of the valuable ways to rate a banking
organization's safety and soundness. The ``E'' in CAMELS stands for
earnings. The E is there because regulators know that it is not
possible for a banking organization to be truly safe if it does not
earn steady and safe returns on a risk adjusted basis. Solid earnings
allow banking organizations to make loans to firms that want to expand,
develop new products and equipment, and take sensible risks so they can
grow, providing jobs and prosperity. But, make no mistake; lending
money to even the most sound businesses borrowers is a risky business
even with the best borrowers, best collateral, and best ideas.
Without solid earnings, a banking organization cannot as easily
attract capital, nor can it accumulate as much capital through retained
earnings. In this regard, it is also worth emphasizing that nothing
flows to the bottom line faster than expense, which quickly accumulates
with increased capital and controls. While it is essential to have
strong capital and strong controls, policymakers and regulators must
remember that banks simply have to be able to bear the expense of the
capital and controls that are needed. Excess capital and controls risk
needlessly weighing down a banking organization.
Some would say that we can solve all the weaknesses in the
financial system by adding capital, capital, and more capital. My view
is different. Yes, capital is needed, and much capital is being added.
But we need to be careful about excess. What is critically important to
safety and soundness is balance, balance, and balance.
So how do you achieve the right balance? How do we ensure that our
regulators and regulations are both serious and meaningful, but not so
elaborate that they weigh down banks to the point of dysfunction?
Unfortunately, there is no quick fix, but I can provide some
suggestions.
A well functioning set of regulations and a sound regulatory
mechanism starts with what you are doing at this hearing today:
constant and thoughtful Congressional oversight. The next step is
ensuring that our regulators continue to be top professionals who are
devoted to a safe and sound banking system, one that supports prudent
innovation and economic growth. Third, both from the standpoint of
Congressional oversight and as a former regulator, we must avoid waste
and excess in implementing our rules and procedures. Fourth, I would
insist that our regulators periodically review their rules to insure
that they are both effective and cause the least burden possible.
For example, our current system of multiple regulators is an area
where the burden can be lessened. I have long advocated for one
prudential safety and soundness regulator, not several. However, since
that is the system under which U.S. banking institutions currently
operate, we must encourage our fine regulatory agencies to divide the
work in order to minimize duplication or triplication.
Finally, I want to note two other points that bear on sound
implementation of the Dodd-Frank Act and international rules. First, it
is essential that in implementing international capital and liquidity
rules for global banks, we insist on a level playing field. Setting a
requirement for the amount of risk-based capital we want banks to have
globally will not be effective without uniform implementation. How we
define the numerator--the capital itself, and the denominator--risk
weighted assets, is critical. Equally important, we have to ensure that
standards are applied fairly around the globe if we are to have global
standards that do not simply put U.S. financial firms at a
disadvantage.
This is not an easy issue. Today's Basel capital rules allow banks
around the world to calculate, within certain parameters and
approaches, the risk weights that apply to their portfolio of assets.
While supervisors have a key role in overseeing and approving the
models that the banks use for this purpose, there is an emerging view
that some banks' models may be less rigorous than others.
From my experience as a former supervisor and banker, I can assure
you that the U.S. supervisors have taken this task quite seriously and,
accordingly, U.S. banks' models are quite rigorous. In fact, one of the
primary reasons that U.S. banks are still in the transition stages of
implementing Basel II is because of the high standards to which U.S.
supervisors hold them. If some non-U.S. banks are allowed to use
inadequate modeling to determine their capital risk weights, then U.S.
banks may be at a significant competitive disadvantage. Moreover, the
international banking system is only as strong as its weakest link. The
Basel Committee is beginning to tackle this issue, which is a critical
task before the higher Basel III and G-SIB (Global Systemically
Important Bank) capital requirements become effective. Congress and
U.S. regulators should be watchful here too.
Nonbanks
Another area where more work needs to be done is outside of the
banking system. Less-regulated non-bank financial players own one-
quarter of U.S. financial sector assets. When our capital markets
recover and many of the Dodd-Frank Act restrictions become effective,
non-bank players are likely to become an even greater force. These
entities--the so-called shadow banking system--can put on 20:1; 30:1 or
even 50:1 leverage--effectively capital requirements as low as 2
percent. As long as this severe imbalance continues, it is a serious
threat to the financial system. The FSOC has the authority to level
this playing field in a variety of ways, including designating
activities and non-bank institutions that present systemic risks to the
financial system.
Here again, balance is key. We do want innovative, particularly
smaller players to have room to grow; we do want to encourage free
markets. However, where anomalies become large either in terms of size
or imbalance, the better players are pushed further out on the risk
curve than is desirable and the weaker players become ever more likely
to fail and cause disruption.
Macroprudential Supervision
One area where implementation of the Dodd-Frank Act is particularly
important is with respect to the OFR, which was created to monitor, on
behalf of the FSOC, present and emerging systemic risks in the
financial system. OFR is one of the most important positive and
creative developments resulting from the Dodd-Frank Act. Functioning
correctly, the OFR should give regulators, the financial system and
Congress better headlights as to where the financial system is headed
and any potholes along the road.
However, for the OFR to function effectively, it must have a
Congressionally confirmed director and sufficient staff so it can
conduct systemic risk analysis and present independent views to both
the FSOC and to Congress.
Further, and enormously important, the OFR should work hard not to
create undue additional burdens for the financial system. It needs to
faithfully execute its mandate to use existing data wherever possible,
coordinate its data gathering activities, and standardize data
collection so the same information is not reported multiple times in
multiple formats.
Conclusion
Finally, I would like to say a word about the banking system and
getting our economy moving again. While the fundamental problem with
credit right now is a sluggish overall economy, at the margin, the
elements exist today for a credit crunch much like the time I entered
office in 1993. In 1993, supervisors and bankers were recovering from a
period of boom and bust. The supervisory pendulum had swung to excess
caution in some areas of the country.
Today, the combination of a plethora of new rules to implement in
addition to supervisory caution--of course a natural reaction to a
difficult period--threatens to dampen economic growth. It is essential
for all parties to work toward balance. Regulation and supervision can
be both effective and tough, but balanced, allowing for safe lending
and capital formation. We must all continue to work to strike this
balance.
______
PREPARED STATEMENT OF PAUL PFLEIDERER, Ph.D.
C.O.G. Miller Distinguished Professor of Finance, Graduate School of
Business, Stanford University\1\
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\1\ What follows is largely based on a paper that I co-authored
with Anat Admati, Peter DeMarzo and Martin Hellwig entitled
``Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital
Regulation: Why Bank Equity is Not Expensive.'' That paper and related
materials can be found at: www.gsb.stanford.edu/news/research/
Admati.etal.html.
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August 3, 2011
Government policy should not encourage firms to take actions that
have large social costs and create little or no social benefit. This
simple proposition is supported by both common sense and elementary
economic reasoning. For a transparent case, consider a firm that wants
to locate a uranium processing plant in the center of a densely
populated residential area. Zoning laws and other regulations will
prevent the firm from doing this and for good reason: there is no
social benefit to locating a plant handling radioactive materials in a
densely populated area, and there are significant social costs,
including health risks and declining property values. It would be pure
folly for the Government to give this company a tax break only if it
locates its uranium processing plant in a very populated area. It would
be even greater folly for the Government to provide this tax break and
in addition agree to pay any health claims brought against the firm,
but only if plant is located in a residential area.
Government Policy Perversely Distorts Banks' Funding and Creates
Unnecessary Risk
While we don't have policies that perversely affect the location of
uranium processing plants, we do have policies that perversely distort
the funding choices made by banks and other financial institutions.
These policies make it cheap for banks to fund themselves with debt and
expensive to fund with equity.
First, our tax system favors debt financing over equity financing.
This is because interest payments are treated as a deductable expense
in the computation of corporate tax, but payments to shareholders are
not treated in this way. Debt provides a ``tax shield'' and, holding
everything else equal, a company that uses more debt financing has a
lower tax bill than a company funded with less debt.
Second, as is well known, banks, especially ``too-big-to-fail''
banks, benefit from implicit guarantees that the Government provides
for the banks' debt. By lowering the risk of holding debt, these
implicit guarantees lower the interest rate banks must pay to their
creditors and constitute a significant subsidy to the banks based on
their using debt rather than equity. It is difficult to measure
precisely the magnitude of this subsidy, but there are many reasons to
believe that it is quite large. First, rating agencies explicitly
account for the Government support by giving two ratings for banks: a
standalone rating and a support rating. The latter accounts for the
implicit Government guarantee, and the difference between the two
ratings gives some indication of the importance of Government support.
Moody's recently gave five notches of ``uplift'' to Bank of America due
to Government support, four notches to Citibank, and three to Wells
Fargo. In the case of Bank of America, this means that Government
support lifts the bank's credit rating on senior debt from Baa2 to Aa3,
changing the category for its bonds from ``minimum investment grade''
to ``very high quality.'' A study \2\ conducted after the crisis looked
at the differences between funding costs of smaller and larger banks
and used these differences to estimate that the value of the ``too-big-
to-fail'' subsidy for the 18 largest U.S. banks. The estimates put the
aggregate value of the Government subsidy between $6 billion and $34
billion per year, which accounts for somewhere between 9 percent and 48
percent of bank profits. Using a completely different approach, three
researchers in a recent paper \3\ examined the pricing of put options
on financial firms and used these market prices to infer the market's
assessment of the value of the subsidy to bank shareholders. They find
that the subsidy substantially reduces the cost of capital for
systemically important banks, and in their calibration the bailout
guarantee accounts for at least half of the market value of the banks'
stock. In addition to the ``too-big-to-fail'' subsidies that the
Government delivers through implicit guarantees and bailouts, bank
funding can also be subsidized by the Government through explicit
guarantees such as deposit insurance. Banks pay premiums to the FDIC
for this insurance, but if these premiums are too low, the insurance is
underpriced and the banks benefit.
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\2\ See Dean Baker and Travis McArthur, ``The Value of the `Too Big
to Fail' Big Bank Subsidy,'' CEPR Issue Brief, September, 2009.
\3\ See Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburg,
``Too-Systematic-To-Fail: What Option Markets Imply about Sector-Wide
Government Guarantees,'' NBER Working Paper Series, June, 2011.
---------------------------------------------------------------------------
Both the tax system and the Government safety net subsidize the
banks' use of debt. These subsidies make debt cheap relative to equity.
The distortions this creates are not innocuous. Encouraging banks to
fund themselves almost exclusively with debt makes them much more
fragile than they need to be. If this just affected a few small banks
in isolation, it would not be a significant problem. Unfortunately it
affects the whole banking sector and particularly the ``too-big-to-
fail'' banks. When highly interconnected banks and other financial
institutions are funded with small slivers of equity, there is little
margin for error and modest shocks to asset values can put the entire
system on the verge of insolvency. Slightly larger shocks make the
system insolvent. As was demonstrated in 2008, when a highly leveraged
financial system becomes distressed, the results can spill over into
the rest of the economy with devastating consequences. A mere 3 years
after the crisis we are seeing in Europe further evidence of the
vulnerability of economies to a fragile, highly leveraged banking
system. There are clearly huge social costs to having thinly
capitalized banks. This might be tolerated if there were offsetting
social benefits. There are not.
We are told that ``capital is expensive'' for banks and if we raise
equity capital requirements by even modest amounts, awful things will
happen. These claims and dire warnings are based on a number of
fallacies and confusions.
Banks Do Not ``Hold'' Capital and Capital is Not Idle Funds
One pervasive confusion stems from the completely misleading notion
that banks ``hold'' capital. This terminology gives rise to fundamental
misunderstandings of what capital is and the role it plays. To explain
the importance of capital and why banks do not ``hold'' capital
requires that we look at a bank's balance sheet. Figure 1 presents a
simplified version of a bank balance sheet.
On the left-hand side of the balance sheet are the bank's assets.
Among these assets are its cash reserves, its trading account assets
and the loans the bank has made. On the right-hand side of the balance
sheet are the liabilities the bank has incurred in raising funds. These
liabilities include deposits and various forms of debt the bank has
issued. Also on the right-hand side is shareholders' equity.
Capital is basically shareholders' equity. This means that the
amount of capital a bank has is determined by how the right-hand side
of the balance sheet is constructed. In Figure 1 the value of the
bank's equity capital is 5 percent of the total asset value, i.e., 100/
2,000 = 5 percent. It should be noted that before the crisis many major
banks had capital that was as little as 2 percent or 3 percent of asset
value.\4\
---------------------------------------------------------------------------
\4\ Throughout this discussion the capital ratio will be taken to
mean the ratio of equity to total assets. In practice bank capital is
measured in a number of different ways. Reported measures are generally
based on ``book'' values of assets, which can be quite different from
actual market values. In addition, reported capital ratios are often
calculated in terms of ``risk-weighted'' assets. Since many types of
assets receive risk-weights less than 100 percent, this and the use of
book values can make capital ratios look high even when a bank is very
thinly capitalized.
---------------------------------------------------------------------------
The right-hand side of the balance sheet can be understood in terms
of the promises the bank has made to the providers of the bank's
funding. When a bank funds with debt, it makes an explicit, contractual
promise to pay the creditors specified amounts. When a bank funds with
equity, it makes no explicit promise to pay a given amount; the
shareholders providing the equity funding are simply entitled to what
is left (if anything) after the creditors (depositors and bond holders)
have been paid.
Financial crises and the need for Government bailouts occur when
banks suffer losses on their assets and become insolvent or close to
insolvent. Insolvency quite simply means that the bank is unable to
meet the contractually specified promises it has made to its creditors
because its assets are worth less than its liabilities. Imagine the
bank whose balance sheet is given in Figure 1 suffers a loss of 25 on
its trading assets and a loss of 125 on its loan portfolio. Its balance
sheet becomes:
The bank is now ``underwater,'' and this is reflected in the fact
that shareholders' equity is negative. Bank shareholders, like all
shareholders, have limited liability. This means that they cannot be
forced to kick in the 50 required to make up the shortfall between the
value of the bank's assets and the contractual promises made to the
depositors and other debt holders. If this were a non-financial company
rather than a ``too-big-to-fail'' bank, bankruptcy would occur, the
shareholders would be ``wiped out,'' and creditors would be forced to
take some losses. In the case of a systemically important, ``too-big-
to-fail'' bank, the Government will be under tremendous pressure to
keep a bank from failing and will provide support to keep the bank
afloat. The result will be something like what is depicted in Figure 3:
By various means the Government can ``inject money'' into the bank.
For example, it can buy bank assets at inflated prices, provide
additional guarantees that increase the value of some of the bank's
assets, or provide funding at below market rates. However value is
injected, the only way that the Government can truly make an insolvent
bank solvent is to increase the value of the bank's assets on the left-
hand side of the balance sheet by more than the value of any claims
(e.g., preferred shares) it gets from the bank on the right-hand side.
In the example shown in Figure 3, the Government increases the value of
the bank's assets by 75 and only takes a claim worth 20. The difference
is 55. Of this 55, 50 goes to filling in the amount the bank was
underwater (the shortfall between the bank's assets and its
liabilities) and the remaining 5 is a benefit to the shareholders.
Now let's start the story again, except in this case we will assume
that the bank is much better capitalized. Instead of having only 5
percent equity capital to total assets, the bank has a much more
prudent ratio of 15 percent equity to total assets. This is shown in
Figure 4.
On the left we have the balance sheet of the original, poorly
capitalized bank. On the right we have our much better capitalized
bank. First note that the two banks are holding exactly the same
assets. The better capitalized bank is not being forced to ``hold''
something that its poorly capitalized twin is not holding. Claims such
as the one made by Steve Bartlett (Financial Services Roundtable,
September 17, 2010) that ``every dollar of capital is one less dollar
working in the economy'' are simply false. Our better-capitalized bank
has the same assets and the same number of dollars working in the
economy as the poorly capitalized bank.
The difference between the balance sheets in Figure 4 relates to
the contractual promises the two banks have made. The better-
capitalized bank has only taken on 600 in non-deposit debt, not 800,
and has funded itself with more equity. This means that it has much
more equity to absorb losses. Assume now that both banks suffer the
losses discussed above: a loss of 25 in trading assets and a loss of
125 in the value the loan portfolio. Figure 5 shows the balance sheets
after the losses:
With 15 percent initial capital our prudent bank remains strongly
solvent after the loss in asset value that completely crippled the bank
with only 5 percent initial capital. Unlike the poorly capitalized
bank, the better-capitalized bank requires no Government bailout. In
fact, even after the drop in asset value, our better-capitalized bank's
capital ratio is 8.1 percent (150/1850 = 8.1 percent), higher than the
initial capital ratio of the poorly capitalized bank. The better-
capitalized bank can sustain even further losses without requiring
Government support.
Because of the possibility of Government support, shareholders will
prefer that their bank be thinly capitalized. In other words, they will
prefer the left-hand sides of Figures 4 and 5, not the right-hand
sides. To see why, we must keep track of the money. Assume we start
with the bank being well capitalized as shown on the right-hand side of
Figure 4. The shareholders can either leave their bank well-capitalized
at 15 percent, or they can have the bank borrow 200 and pay out the 200
in proceeds as a dividend to the shareholders. If they do the latter,
they convert their well-capitalized bank into the bank with 5 percent
capital shown on the left-hand side of figure 4. We can now compare
their positions after the bank loses 25 on trading assets and 125 on
its loan portfolio.
If they had converted their bank into a thinly capitalized
bank, they would have the 200 they received as a dividend plus
the 5 in shareholder equity shown on the left-hand side of
Figure 5.
If they had left their bank well capitalized, they would
end up with 150 in shareholder equity, as shown on the right-
hand side of Figure 5.
In other words, they end up with 205 with the thinly capitalized bank
and only 150 with the better capitalized bank. The difference of 55 is
exactly what the Government puts into the bank to bail it out.
Something very important is evident in Figures 4 and 5: losses are
socialized on the left-hand sides and losses are privatized on the
right-hand sides. As well as imposing unwarranted costs on the
taxpayers, socializing losses creates all kinds of incentive problems.
For example, socializing losses creates incentives for inefficient and
excessive risk taking, since the shareholders get the benefits of the
``upside'' and the Government and taxpayers bear the costs of the
``downside.''
Figure 5, however, doesn't reveal all the advantages of higher
equity capital. The left-hand side of Figure 5 may lead to a financial
crisis and collateral damage to the rest of the economy. This is much
less likely on the right-hand side. The benefits of having more equity
in preventing a crisis are widely recognized. For example, Alan
Greenspan wrote in 2010:\5\
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\5\ See Alan Greenspan, ``The Crisis,'' Brookings Papers, April 15,
2010.
Had the share of financial assets funded by equity been
significantly higher in September 2008, it seems unlikely that
the deflation of asset prices would have fostered a default
---------------------------------------------------------------------------
contagion much, if any, beyond that of the dotcom boom.
One Must Not Confuse Private With Social Costs
Requiring banks to have much more prudent levels of equity capital
clearly produces many benefits, but bankers insist that ``equity is
expensive'' and must be used sparingly. These claims are also based on
confusions and fallacies. Perhaps most egregious among them is the
confusion between private and social costs.
Consider again the uranium processing plant example discussed
above. Assume that the Government has a perverse policy on plant
location: the firm will receive tax breaks and free Government
insurance against health risks only if the plant is located in a
crowded residential area. The firm's managers can legitimately say that
it would be costly for them to locate the processing plant far away
from a crowded residential area. It would be costly for them because
they would be giving up both the favorable tax treatment and the freely
provided Government insurance that is protecting them against health
claims. But giving these subsidies up is a private cost to the firm,
not a social cost. The tax benefits and insurance all come at the
expense of the general taxpayer. What the firm loses in giving these
up, the general public gains. Of course the general public gains much
more because it is much safer to have the plant located away from a
crowded area.
The situation is precisely the same for banks. If banks are
required to fund themselves with more equity, they will give up tax
benefits (the debt tax shield) and freely provided or underpriced
Government guarantees (particularly for banks that are considered
``too-big-to-fail''). Giving up these subsidies is a private cost to
the banks, not a social cost. And just like moving the uranium
processing plant away from a crowded residential area produces a huge
social benefit, so does moving the banks away from imprudent levels of
equity capital with all the risks this brings to the economy.
It is clear that our system subsidizes banks by making debt cheap.
It might be argued that these subsidies are good if the banks pass them
on to borrowers in the form of lower lending rates. If we remove the
subsidies that make it cheap for the banks to fund with debt, won't the
banks increase the rate they charge to borrowers and won't this hurt
the economy? Let us pose the exact analogue of this question in the
context of the uranium processing plant: Won't forcing the uranium
processing firm to locate its processing plant far away from a crowded
residential area reduce the subsidy the firm gets, and won't this force
the firm to charge more for processed uranium? Whether or not it makes
sense for the Government and its taxpayers to subsidize uranium
processing, it certainly does not make sense for a subsidy to be given
in a way that requires the processing firm to locate its dangerous
plant in a crowded residential area. Now consider banks. Whether or not
it makes sense for the Government to subsidize banks' lending, it
certainly does not make sense for a subsidy to be given in a way that
requires banks to fund themselves in a fragile way that is dangerous to
the rest of the economy. Arguments that bank capital requirements
should not be significantly increased because this would remove a
subsidy that the banks use to keep lending costs low are completely
unfounded. If bank lending needs to be subsidized, this should be done
in a direct way that does not put the economy at risk.
Arguments Based on a Fixed Required Return on Equity (ROE) are Flawed
Another source of confusion and fallacious reasoning about equity
capital requirements for banks is associated with the notion of a
fixed, required rate of return on equity for banks. It is well
established that investors are risk averse and they must be compensated
for the risk they bear. Prices are set in markets so that securities
that add more risk to investors' portfolios have higher expected
returns than those that add less risk. There is absolutely no reason to
think that investors ignore risk when investing in banks' equity.
The risk that a bank's shareholders bear depends on how that bank
funds itself. Consider two banks of equal size. Assume that the first
bank is funded with $40 billion in equity and $960 billion in debt,
while the second is funded with $100 billion in equity and only $900
billion in debt. Now consider what happens if each bank suffers a loss
of $8 billion. For the first bank this $8 billion loss is spread across
a small equity base and results in a 20 percent loss for the
shareholders (-8/40 = -20 percent). For the second bank the $8 billion
loss is spread across a bigger equity base and results in only an 8
percent loss (-8/100 = -8 percent). By concentrating its losses on a
smaller equity base, the first bank makes its equity returns much
riskier than the second bank's equity returns. Because of this the
first bank's shareholders will have a higher required rate of return on
their equity to compensate for this risk.
The claim is often made that bank shareholders have a required
return that is fixed and will not change when the bank funds itself
with more equity and less debt, even though this reduces the riskiness
of equity returns. This notion of a rigid required rate is used to
argue that increasing equity requirements will increase banks' funding
costs. The implicit assumption behind this claim appears to be that
bank investors fail to account for the risk they are bearing or are
somehow fooled. If this is true, we must seriously question the ability
of markets to properly allocate capital in the financial sector. In
fact, there is no reason to come to any drastic conclusions. A required
return on (or cost of) equity that is independent of the risk of a
bank's equity makes no sense and violates all we know about security
markets. Arguments based on this reasoning are deeply flawed.
It should also be noted that return on equity (ROE) is often used
as a performance measure and the compensation of many bank managers
appears to be tied to ROE. This creates perverse incentives for funding
banks with minimal amounts of equity. Consider two bank managers whose
banks have similar assets. Manager A's bank is more prudently funded
with 10 percent equity, while Manager B's bank has only 3 percent
equity. In addition to having a safer bank, assume that Manager A has
managed his bank's assets very well, earning a return on assets (ROA)
of 3 percent, while Manager B has managed his assets quite poorly,
earning a return on assets of only 2.5 percent. As the table below
shows, Manager B posts a much higher ROE despite the fact that Manager
A is the better manager.
Manager B's ROE exceeds Manager A's ROE only because Manager B's bank
is more highly leveraged and more fragile. If Manager A is compensated
on the basis of ROE, he has incentives to reduce his equity funding and
the safety of his bank.
Requiring Banks to Fund with More Equity is Not Socially Costly
Many policy decisions are quite challenging since they involve
difficult tradeoffs between social costs and benefits. For an example,
consider levees that are built for flood protection. Should a levee be
built for the once-in-a-100-year flood or the once-in-500-year flood?
Building a safer levee produces clear social benefits, but it also
entails social costs, since the construction of a safer levee requires
the use of more resources (e.g., more labor) that could have been used
elsewhere for other purposes. Fortunately we do not face this sort of
difficult tradeoff when thinking about bank capital requirements. This
is because requiring banks to fund with more equity does not use up any
social resources that could have been used for other purposes. It only
entails that banks change the nature of the contractual promises that
they make to those providing their funding. Some securities that would
have been sold by a bank with the label ``debt'' must now be sold with
the label ``common share.'' In fact, banks can over relatively short
periods of time increase their equity capital significantly by not
making dividend or other payments to shareholders, but instead using
the cash that they would have paid out to shareholders to pay off their
debt and reduce their overall leverage. Of course we know that banks
will not do this voluntarily since it will reduce the subsidies that
they get from the Government. In addition, managers may be concerned
because this will mechanically reduce the return on equity (ROE) even
as it makes their banks safer and less of a danger to the economy. The
reduction in bank subsidies and the reduced return on equity due to
lower risk and lost subsidies are private costs to the managers and
shareholders of the bank (when considering only their holdings in the
banks, not necessarily their entire portfolio or economic welfare), but
they are not social costs.
Requiring banks to fund more with significantly more equity will
make our financial system safer and substantially reduce the risk of
another financial crisis that imperils the rest of the economy. Of
course, a significant increase in required equity funding is not a
panacea that solves all problems and removes the need for any other
types of regulation or supervision. However, contrary to the flawed
arguments against it, requiring significantly more bank equity produces
significant social benefits at little or no social cost.
Note that it does not follow from this that banks should be funded
with 100 percent equity. A nontrivial portion of bank liabilities,
e.g., deposits, is socially valuable. But much of the debt that banks
have used in funding is used simply because incentives (tax and
guarantee subsidies, compensation based on ROE measures) make it
privately, but not socially, desirable.
Level Playing Fields and Playing in the Shadows
It is often argued that our overriding concern must be that playing
fields are level. The claim is that if other jurisdictions permit their
banks to be thinly capitalized, we also must permit our banks to be
thinly capitalized. Otherwise our banks will be unable to compete. It
is important to understand what is really being said by those making
this argument. They are really contending that if other countries
provide too-big-to-fail and other types of subsidies (at taxpayer
expense) to their banks and these subsidies encourage their banks to be
highly leveraged and fragile, posing a threat to their economies, we
must provide similar subsidies to our banks (at taxpayer expense), so
that our banks are fragile and highly leveraged and pose a danger to
our economy. This makes no sense. In broad terms banks can generate
profits in three ways:
They can make and monitor loans to households and
commercial enterprises.
They can facilitate payments, transactions and the issuance
and trading of various securities.
They can exploit their ability to borrow at Government
subsidized rates, becoming highly leveraged, thinly capitalized
and systemically risky in the process.
True social value is potentially created by the first two
activities, but not by the third, even though the third can be a great
source of bank profits. Taking away the third activity is not socially
costly and actually produces significant social benefits. As mentioned
above, if either of the first two activities requires a Government
subsidy, that subsidy should not be provided through the third
activity. Arguing that other jurisdictions permit their banks to earn
great profits through the third activity is not an argument for saying
this should be permitted in our country.
It is also often claimed that if higher capital and other
regulatory requirements are imposed, banks and other entities will just
find a way to do ``risky stuff'' in the shadows (e.g., the unregulated
shadow banking sector). This claim sounds a bit like the unruly
teenager who argues that if his parents don't permit him to take
illegal drugs in their house, he will simply do it at his friend's
house. It is clearly a challenge for regulators to monitor risk and
make sure that it is not being hidden in ways that ultimately burden
the taxpayer and put the economy at risk. But this is not an
insurmountable challenge. It should, for example, be noted that before
the crisis much of the shadow banking system relied on support from
regulated entities. This meant that regulators had the potential to
control it.
We Need the Government to be Less Involved
Because of too-big-to-fail guarantees and other subsidies our
Government is enmeshed in the financial system. As a consequence prices
and decisions are distorted and private markets are not working as they
should. Figure 5 shows the difference between the system that we have
now (the left side of the figure) in which losses are socialized and
the system we should have (the right side) in which losses are
privatized. Some may contend that the imposition of higher capital
requirements is a case of the Government interfering with private
markets. This is completely wrong. Higher capital requirements that
lead to prudent bank funding actually take the Government out of the
system and put the responsibility for bearing risk on the private
markets, not the taxpayer. In addition they produce a huge social
benefit by making the risk of another devastating financial crisis much
lower.
RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM JOSEPH E.
STIGLITZ
Q.1. Did Dodd-Frank end too-big-to-fail?
A.1. Dodd-Frank did not end the risk of too-big-to-fail.
Indeed, in the aftermath of the crisis, the banking sector is
more concentrated and the problem of too-big-to-fail has, in
that sense, become worse. These large banks are too big to
fail--and allowing them to fail would potentially cause large
disruption to the market.
Some argue that ``resolution authority'' will prevent the
kind of massive bail-out that occurred in 2008-2009. I am
unconvinced. The Government had powers at its disposal even
then that would have reduced the magnitude of the risk to which
taxpayers were exposed. They could have used standard
procedures of conservatorship. The Fed and Treasury were
evidently afraid to do so. In the midst of another crisis, they
are likely to use emergency powers to engineer a bail-out. In
the alternative, they may (as in the case of Lehman Brothers)
not do enough to ensure an orderly process, in which the
institution is saved by bondholders and shareholders bear most
of the costs. The result could be massive disruption.
There are some who believe that there is no way that a
truly effective ``living will'' could be established for these
mega-institutions, and rigid enforcement of living will
requirements would force the break up of these banks. I am less
sanguine that there will be such effective enforcement-and
certainly so far that has not been the case. Certainly, as of
today, the problem of too-big-to-fail and too-intertwined-to-
fail institutions persists.
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RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM EDWARD J.
KANE
Q.1. Did Dodd-Frank end too-big-to-fail?
A.1. No. The Dodd-Frank Act puts the responsibility for ending
Government credit support of large, complex, and politically
powerful financial firms on the backs of incentive-conflicted
future regulators. But the Act does not lessen the force of
political incentives to rescue these firms when they get into
trouble. To contain these forces, further legislation is needed
whose object would be to realign bureaucratic incentives and
reporting responsibilities with taxpayer interests in
accountable ways. In the absence of such legislation, it is
unreasonable to believe that authorities either can or will
adequately measure and contain tail risk at large, politically
powerful firms or sectors. The presumption that regulators can
succeed year after year in these tasks--in the face of perverse
Congressional pressures and recruitment procedures--ignores the
facts and mechanisms of regulatory capture.
What we can call a cycle of temporarily successful
regulatory reforms repeats itself in a dialectical fashion. For
example, important new powers were conferred on regulators by
the FDIC Improvement Act of 1991, but over time hidden risk-
taking and self-serving lobbying pressure from elite sectors
neutralized these powers and enfeebled rulemaking and oversight
during the housing and securitization bubbles. The hard-to-
document nature of safety-net benefits in good times and the
financial industry's overwhelming lobbying power provide good
reason to doubt that the financial rules U.S. regulators are
struggling to develop today can come close to meeting the
aspirations that the Act sets for them.
Financial-sector lobbyists' ability to influence regulatory
and supervisory decisions remains strong because the Dodd-Frank
framework that regulators are trying to implement gives a free
pass to the dysfunctional ethical culture of exploitive
lobbying that helped both to generate the crisis and to dictate
the extravagant costs that poorly conceived financial-sector
bailouts imposed on ordinary citizens. Framers of the Act
ignored mountains of evidence that, thanks in large part to
industry pressure, top officials tend to suppress and deny
evidence of developing industry weakness in good times and have
almost never detected and resolved widespread financial-
institution insolvencies in a fair, timely, or efficient
fashion.
Part of the problem is that Government regulators'
conception of systemic risk neglects the pivotal role they
themselves play in generating it. Officials are conditioned to
tolerate innovative forms of contracting that are designed to
be hard to supervise (such as the shadow banking system) and to
rescue loss-making creditors and derivatives counterparties by
nationalizing their losses in crisis situations. Although the
fiscal deficits this behavior implies cannot be sustained
forever, the predictability of bailout policies encourages
opportunistic financial firms to foster and to exploit
incentive conflicts that undermine the effectiveness of the
various private and governmental watchdog institutions that
society expects to identify and police complicated forms of
leveraged risk-taking.
The U.S. regulatory system broke down in the 2000s because
Government-sponsored enterprises, OTC derivatives dealers, and
other systemically important financial institutions could not
resist opportunities to shift risks to the taxpayer in clever
but exploitive ways and private and Government supervisors did
not adapt their surveillance systems conscientiously to curtail
these opportunities by consolidating off-balance-sheet leverage
and counteracting surges in taxpayer loss exposure in a timely
manner. Risk managers at too-big-to-fail firms used changes in
contracting forms and information technology to promote and
expand regulatory and accounting loopholes that invited
supervisory blindness and subsidy-sustaining mistakes by
society's private and governmental watchdog institutions. Far
from gratefully thanking taxpayers for rescuing them, these
firms refuse to acknowledge their moral obligation to provide
meaningful information to taxpayers on the value of Government
credit support or to offer taxpayers a fair return for
providing this support.
To build a robust, reliable, and fair system of financial
regulation, relationships between financial regulators and the
firms they regulate must be restructured to acknowledge their
obligations to taxpayers in accountable ways. Good corporate
governance requires that financial-institution managers and
Federal regulators accept joint responsibility for identifying
and disclosing taxpayers' de facto equity stake in financial
firms. Until taxpayers' stake is made observable, incentives to
manage the distributional consequences of regulation-induced
innovation will remain weak.
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RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM EUGENE A.
LUDWIG
Q.1. Did Dodd-Frank end too-big-to-fail?
A.1. The Dodd-Frank Wall Street Reform and Consumer Protection
Act (Dodd-Frank) takes a number of important steps toward
ending too-big-to-fail and ensuring that the U.S. Government
will no longer need to sustain a failing financial institution
in order to prevent catastrophic damage to the American
financial system.
First, if executed properly, the heightened prudential
requirements in Dodd-Frank will make large, interconnected U.S.
financial institutions less likely to fail. Measures such as
increased capital and broader liquidity standards could
strengthen these firms and make them more resistant to future
shocks. Concentration limits will prevent risk from pooling
rapidly in one corner of the financial sector, ensuring
regulators can both minimize and effectively monitor systemic
dangers to the financial system.
Second, Dodd-Frank's orderly liquidation process and living
will provisions give the Government tools to unwind a
systemically important financial company minimizing the
imposition of costs on the taxpayer. Whether the new resolution
authority can be successfully deployed remains to be seen, and
difficult issues of cross-border resolution linger.
Taken together, these steps have begun to shift market
expectations that the Government will rescue large collapsing
financial institutions. Belief in a Government backstop can
foster inappropriate risk-taking by banks, in addition to
fostering false hope in investors. Dodd-Frank is a serious step
in the direction of lessening the use of the safety net.
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RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM PAUL
PFLEIDERER
Q.1. Did Dodd-Frank end too-big-to-fail?
A.1. Despite the fact that Dodd-Frank has a number of
provisions designed to ``streamline'' the failure of SIFIs and
make sure that losses are properly imposed on creditors rather
than taxpayers, I firmly believe Dodd-Frank falls short of
eliminating too-big-to-fail. In many respects the too-big-to-
fail problem has become more acute after the subprime crisis
than it was before. By a number of measures the banking sector
has become more concentrated as a result of the financial
meltdown with, for example, Wells Fargo acquiring Wachovia and
JP Morgan Chase acquiring Washington Mutual. This, coupled with
the continued weakness of the U.S. (and global) economy and the
precarious state of Europe and its banks, means that too-big-
to-fail risks are still pronounced.
The main problem that I see in the Dodd-Frank approach to
too-big-to-fail is that it presumes that it is possible to
quickly resolve the complicated set of claims issued by very
large and complex global financial institutions in a way that
does not have significant adverse effects on the functioning of
credit markets and the financial system. It attempts to do this
in part by requiring that SIFIs demonstrate up front that they
can be resolved under the bankruptcy code in situations of
distress or insolvency. It also creates an alternative to
bankruptcy by giving the FDIC ``Orderly Liquidation Authority
(OLA)'' to impose a resolution through FDIC receivership of a
SIFI.
The key question is whether, taken together, these measures
are enough to remove the uncertainties and systemic risks that
compel regulators and the Government to support too-big-to-fail
entities. Our financial sector is still highly interconnected
and much of it is opaque. This means that distress in one
institution can create uncertainties throughout system. As we
saw in 2008, these uncertainties can lead to credit freezes and
the shutdown of key markets. In crisis situations there will be
strong pressure on regulators and the Government to remove
these uncertainties in order to protect the economy, and
arguably the most effective (and perhaps only) way to do this
is to inject liquidity (i.e., money) into the banks and other
systemically important entities (e.g., AIG). If this were truly
``liquidity support'' and the solvency of the institutions were
not in question, the problem would not be as bad, but knowing
whether a complex financial institution is solvent when it is
highly leveraged and many of its assets are illiquid makes this
very difficult. In such cases the line between ``liquidity
support'' and bailout becomes quite unclear.
As a thought experiment, assume that Institution A (a SIFI)
is distressed and may be insolvent. Having a plan in place for
it to be resolved under the bankruptcy code or by the FDIC
through its Orderly Liquidation Authority doesn't remove the
systemic uncertainty in the market. Which other systemically
important entities hold claims on A or will be affected through
a chain of claims by A's losses? How large will these losses be
and how exactly will they be allocated among A's creditors?
Will the FDIC (if it is resolving A) distribute losses in a way
that protects other SIFIs and if so, which ones? If the
financial sector, and particularly the large banks, continues
to be highly leveraged and fragile, these uncertainties can
easily lead to a crisis of the sort we experienced in 2008. The
pressure on regulators to keep things afloat through some sort
of bailout program that might include asset purchase,
guarantees, or capital injection will be enormous. Since ex
ante commitments not to use tax payer money to bail out
financial institutions are difficult to make ironclad given the
many ways support can be given, bailouts are still possible.
Even if it were possible to make absolutely ironclad
commitments up front, it may not be desirable to do so, as this
puts the economy at risk in extreme situations when bailouts
may be the best of bad alternatives.
This does not mean that attempts to make the resolution of
distressed financial institutions simpler and less disruptive
are futile. In my view increasing transparency and reducing
unnecessary complexity in the system are both very important
steps to take. However, they unfortunately do not eliminate
too-big-to-fail. I believe that one of the most important steps
in reducing the problems of too-big-to-fail is to reduce the
risk of failure by requiring much more equity (capital) and
restricting leverage. Reducing the fragility of our financial
system through significantly higher equity requirements is a
straight-forward way to make sure that losses are borne by
investors and not taxpayers and that these losses do not
paralyze financial markets and the economy.
I fear that provisions such as the OLA will be viewed as a
substitute for higher equity requirements, rather than a
complement. They may serve as an excuse to allow SIFIs to
continue to operate with fairly low levels of equity capital,
creating the false sense of security that resolution mechanisms
will be able to resolve them quickly when they fail. As
suggested above, these mechanisms don't remove the systemic
uncertainties that can lead to a crisis, and they also put
tremendous burden on the regulators. It is quite obvious that
an FDIC resolution of a SIFI such as the Bank of America will
be a much taller order than the resolution of Indymac.
Requiring much more equity reduces the regulatory burden and
lowers both the risk of SIFI failures and a future crisis.