[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 /





                  U.S. GOVERNMENT PRINTING OFFICE
72-961                    WASHINGTON : 2012
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing 
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC 
area (202) 512-1800 Fax: (202) 512-2104  Mail: Stop IDCC, Washington, DC 
20402-0001





            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

                              ----------                              

                       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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.)
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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\)
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
                             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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
                                ------                                


 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.
                                ------                                


 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.
                                ------                                


   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.
