[Senate Hearing 112-456]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-456


 
   ENHANCED SUPERVISION: A NEW REGIME FOR REGULATING LARGE, COMPLEX 
                               FINANCIAL
                              INSTITUTIONS

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

                                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

EXAMINING ENHANCED SUPERVISION FOR REGULATING LARGE, COMPLEX FINANCIAL 
                              INSTITUTIONS

                               __________

                            DECEMBER 7, 2011

                               __________

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


                 Available at: http: //www.fdsys.gov /



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     Riker Vermilye, 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, DECEMBER 7, 2011

                                                                   Page

Opening statement of Chairman Brown..............................     1

Opening statements, comments, or prepared statements of:
    Senator Hagan................................................     3

                               WITNESSES

Sheila C. Bair, Senior Advisor, Pew Charitable Trusts............     5
    Prepared statement...........................................    37
Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT 
  Sloan School of Management.....................................     7
    Prepared statement...........................................    44
The Honorable Phillip L. Swagel, Professor of International 
  Economic Policy, University of Maryland School of Public Policy     9
    Prepared statement...........................................    48
Arthur E. Wilmarth, Jr., Professor of Law and Executive Director 
  of the Center for Law, Economics and Finance (C-LEAF), George 
  Washington University Law School...............................    11
    Prepared statement...........................................    54

              Additional Material Supplied for the Record

Three Years Later: Unfinished Business in Financial Reform by 
  Paul A. Volcker................................................   128
Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket or Is 
  Lap-Band Surgery Required? by Richard W. Fisher................   161

                                 (iii)


   ENHANCED SUPERVISION: A NEW REGIME FOR REGULATING LARGE, COMPLEX 
                         FINANCIAL INSTITUTIONS

                              ----------                              


                      WEDNESDAY, DECEMBER 7, 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 CHAIRMAN SHERROD BROWN

    Chairman Brown. The Banking Subcommittee on Financial 
Institutions and Consumer Protection will come to order.
    Thank you to the four very distinguished witnesses who have 
played a very positive role in helping this country work our 
way through this terrible mess of the last 5 years, and thank 
you very much for joining us. Senator Corker, I understand, is 
on his way and was very cooperative in this hearing. Thank you, 
Professor Swagel. I know he invited you, and I appreciate that.
    Three years ago, we experienced what can happen when 
excessive risk taking and lax oversight are concentrated in our 
Nation's largest financial institutions. The result, as we 
painfully know, was the near collapse of our entire economy. In 
response to the financial crisis of 2008, we passed Dodd-Frank. 
This legislation provides regulators with significant authority 
to oversee U.S. megabanks' should they choose to use them, the 
power to curtail the use of leverage and increase equity 
funding; at the largest financial companies, the ability to 
preemptively downsize risky companies. Thanks to the efforts of 
my colleague Senator Corker, it gave the ability and power to 
resolve large, complex companies that are on the brink of 
failure and restrictions on the ability of large banks and 
financial companies to engage in risky proprietary trading and 
investment fund activities.
    Important questions remain, and that is what we will 
discuss today. Have we provided the regulators with adequate 
authority to address the cause of the financial crisis? Will 
regulators use these authorities that we have provided them to 
downsize those institutions in order to prevent the next 
financial crisis, particularly when they had similar powers 
prior to the 2008 financial crisis? Will the markets force 
these institutions to increase their equity funding or exit 
risky lines of business? Is it even possible to understand or 
unwind trillion-dollar institutions that have had hundreds of 
diverse lines of business and operate in sometimes as many as 
100 countries? Should we continue to put all our faith in 
regulators, or is it time to address too big to fail by putting 
some more fundamental reforms into law?
    Last year, Senator Kaufman and I offered an amendment to 
Dodd-Frank that would have sent the clear message that Congress 
believes that too big to fail means simply too big. It would 
have broken up the six biggest U.S. megabanks. In the past 15 
years, these banks have grown in total assets from 15 percent 
of our Nation's GDP 15 years ago to 63 percent of our Nation's 
GDP today. The amendment failed, but much has changed since 
then that should make us reconsider this and similar proposals.
    We have seen that a small U.S. broker-dealer, MF Global, 
can go bankrupt without taking the entire financial system with 
it while a nearly $700 billion Belgian bank, Dexia, with assets 
that make up over 150 percent of that nation's economy, had to 
be bailed out by three countries 3 months after they passed 
their regulator's stress test.
    Last week, we found out that the six biggest megabanks 
borrowed as much as $400 billion in secret, low-cost loans from 
the Fed, accounting for 63 percent of the average daily debt. 
These loans accounted for 23 percent of the combined net income 
for these megabanks 23 percent during the time they were 
occurring. We know this assistance also helped these 
institutions to grow even bigger, and that is another thing the 
financial crisis did.
    In today's Wall Street Journal, over the last 5 years, they 
pointed out, the four largest banks in this country have grown 
from 54 percent to 62 percent of all commercial banking assets. 
At the time we considered the Brown-Kaufman amendment, many 
people pointed to European banks as the model for ours in 
arguing against the amendment. But recent events have shown it 
would be unwise to replicate their banking system.
    While we have chosen to empower our regulators, other 
nations, including England, are proposing to restrict the 
activities that their banks can engage in. Maybe it is time we 
begin to seriously consider that option.
    I look forward to hearing from our panelists and look 
forward to hearing Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I think you 
know I am not much for opening comments. I look forward to 
hearing from our witnesses and asking questions, but I thank 
you all for being here.
    Chairman Brown. I like it. You give really good opening 
comments. Thank you.
    [Laughter.]
    Chairman Brown. Senator Hagan, you have an opening 
statement, I understand.

                 STATEMENT OF SENATOR KAY HAGAN

    Senator Hagan. I do. Thank you, Mr. Chairman. I appreciate 
that. But before I turn to the issue of enhanced supervision, I 
did want to talk briefly about the upcoming vote on the 
nomination of Richard Cordray. I know, Senator Brown, that you 
have definitely been a tireless advocate for Mr. Cordray. I was 
proud to support his nomination to become the first Director of 
the Consumer Financial Protection Bureau when it was considered 
by the Banking Committee. I will be proud to do so again later 
on this week when his nomination is brought before the full 
Senate.
    For too long, Americans have fallen victim to schemes at 
the hands of predatory lenders. As a State Senator, I remember 
witnessing payday lenders in North Carolina, who would trap 
many, many families in endless long-term debt before we put a 
stop to predatory lending practices in North Carolina.
    There was a woman, Sandra Harris, who was a Head Start 
employee from Wilmington. When her husband lost his job, she 
got a $200 payday loan to help pay for car insurance. When she 
went to repay the loan, she was told that she could renew it. 
She really found herself at her wits' end when she ended up 
having six different payday loans and paid some $8,000 in fees.
    Well, there are many more of these individuals across the 
country that I think would greatly benefit from the Consumer 
Financial Protection Bureau. We cannot afford to continue to 
leave these families at risk. We need a strong Director to help 
improve the oversight over these predatory lenders who continue 
to prey on American families across our country. This is not 
about financial interest versus consumer protection. North 
Carolina is home to some of the largest financial institutions 
in our country and a vibrant network of community banks. We are 
a banking State, and I am very proud of that.
    We also understand that responsible financial regulation 
also protects consumers and businesses. That is why I supported 
the creation of the CFPB and why I believe it is well past time 
that we put a strong director in place. I believe Mr. Cordray 
is that strong Director.
    Mr. Chairman, I know that today we are here to talk about 
another immensely important topic--the supervision of large, 
complex financial institutions. Dodd-Frank represents a major 
step forward on this issue by granting important new 
authorities to our prudential regulators. Living wills, orderly 
liquidation authority, and enhanced prudential standards give 
financial regulators the tools to make our financial system 
safer.
    Chairman Bair, it is good to have you back with us today. I 
think everybody knows that you were instrumental in crafting 
the rules that we are talking about. In April, under your 
leadership the FDIC released a study that examined how the FDIC 
could have successfully used Dodd-Frank's orderly liquidation 
authority to execute a cross-border resolution of Lehman 
Brothers, a systemically important financial institution. It 
found that with the new authorities, the FDIC could have 
``promoted systemic stability while recovering substantially 
more for creditors than the bankruptcy proceedings.''
    In addition to the FDIC study, the Economist recently 
gathered Larry Summers, Rudgin Cohen, Donald Kohn, and others 
to demonstrate how the orderly liquidation of a large, 
systemically important financial institution would be 
successful under Dodd-Frank's new authorities.
    Chairman Bair, I know that you have also advocated for a 
robust cross-border resolution framework. It appears that those 
efforts are bearing fruit in crucial jurisdictions such as 
Japan, the United Kingdom, and the EU--where comment is 
currently being sought on a regime akin to Title II. I will be 
interested in how you respond to Simon Johnson's comments about 
the cross-border resolution.
    Finally, I wanted to comment briefly on the work of the 
Basel Committee as it relates to enhanced prudential 
regulation. Yesterday, Governor Tarullo testified that capital 
requirements are of paramount importance in the future of our 
financial system. I could not agree with him more. Domestic 
implementation of Basel III deserves a thorough review so that 
it does not become a Euro-centric rule book. I was glad to hear 
that the Federal Reserve is looking closely at the example of 
liquidity cover ratios. These rules will need to adequately 
account for the unique components of our domestic banking 
system such as the Federal Home Loan Bank System, agency debt, 
and the lack of a legislative framework for covered bonds.
    Again, Senator Brown, I appreciate you holding this 
hearing, and I look forward to our witnesses' testimony.
    Chairman Brown. Thank you, Senator Hagan, and just to 
follow up briefly on your comments, I probably know Richard 
Cordray better than any Member of the Senate. I knew him when 
he was a State representative and county treasurer and State 
treasurer and Attorney General and have continued to work with 
him, and there is no question of his qualification. Sometime 
ago I asked the Senate historian if this has ever happened that 
a political party has blocked the nomination of someone because 
they did not like the construction of the agency, and he said 
no, it has never happened. And I am hopeful that this will be 
different.
    Let me introduce the four witnesses, and we will hear from 
them, and Senator Corker and Senator Hagan and I will have 
questions.
    Sheila Bair is certainly--a cliche among cliches--no 
stranger to this Committee, she really is not, and has served, 
has given great public service from her work with Senator Dole 
to her work with the FDIC from 2006 to 2011. She is now a 
senior advisor at Pew Charitable Trusts, working on a book, and 
she has assumed a prominent role in the Government's response 
to the recent financial crisis, including bolstering public 
confidence and system stability that resulted in no runs on 
bank deposits. Thank you, Ms. Bair.
    Simon Johnson is the Ronald Kurtz Professor of 
Entrepreneurship at MIT Sloan School of Management, senior 
fellow at the Peterson Institute for International Economics. 
He is the former chief economist at the IMF and coauthor with 
James Kwak of the book ``13 Bankers''--and it is a terrific 
book--and the financial blog ``The Baseline Scenario.''
    The Honorable Phillip Swagel is professor of international 
economic policy at the Maryland School of Public Policy. 
Professor Swagel was Assistant Secretary for Economic Policy at 
Treasury from 2006 to 2009, a rather crucial time in that 
period, and in that position he advised Secretary Paulson on 
economic policy and also on the Troubled Asset Relief Program.
    Arthur Wilmarth is professor of law and executive director 
of the Center for Law, Economics and Finance at George 
Washington University here. He is the author of publications in 
the fields of banking law and American constitutional history 
and the coauthor of a book on corporate law. In 2005, the 
American College of Consumer Financial Services Lawyers awarded 
him its prize for the best Law Review article published in the 
field of consumer financial services law during the year 2004.
    Ms. Bair, if you would begin.

  STATEMENT OF SHEILA C. BAIR, SENIOR ADVISOR, PEW CHARITABLE 
                             TRUSTS

    Ms. Bair. Chairman Brown, Ranking Member Corker, and 
Senator Hagan, it is my pleasure to address you today at this 
hearing entitled ``A New Regime for Regulating Large, Complex 
Financial Institutions.''
    There is no single issue more important to the stability of 
our financial system than the regulatory regime applicable to 
large, complex financial institutions. I hope that by now there 
is general recognition of the role certain large, mismanaged 
institutions played in the lead-up to the financial crisis and 
the subsequent need for massive, governmental assistance to 
contain the damage caused by their behavior. The 
disproportionate failure rate of large, so-called systemic 
entities stands in stark contrast to the relative stability of 
smaller, community banks of which less than 5 percent have 
failed. As our economy continues to reel from the financial 
crisis, with high unemployment and millions losing their homes, 
we cannot afford a repeat of the regulatory and market failures 
which allowed this debacle to occur.
    There is nothing inherently wrong with size in and of 
itself. However, size should be driven by market forces, not 
implied Government subsidies. With the implied Government 
support provided to Fannie Mae, Freddie Mac, and so-called too-
big-to-fail financial institutions, the smart money fed the 
beasts and the smart money proved to be right. As failures 
mounted, the Government blinked and opened up its checkbook. 
Creditors and trading partners were made whole. Many executives 
and board members survived. In most cases, the Government did 
not even wipe out shareholders.
    Regulators for the most part did not try to constrain these 
trends, but left the market largely to regulate itself. In some 
cases, such as derivatives, Congress explicitly told the 
regulators ``hands off.'' As free markets became free-for-all 
markets, compensation rose, skyrocketing past wages paid to 
equally skilled employees in other fields. This enticed many of 
our best and brightest to forgo careers in areas like 
engineering and technology to heed the siren song of quick, 
easy money from an overheated, overleveraged financial 
industry.
    In recognition of the harmful effects of too-big-to-fail 
policies, a central feature of Dodd-Frank is the creation of a 
resolution framework which will impose losses and 
accountability on shareholders, creditors, boards, and 
executives when mismanaged institutions fail. We cannot end too 
big to fail unless we can convince the market that shareholders 
and creditors will take losses if the institution in which they 
have invested goes down.
    An essential component of resolution authority is the 
requirement that large bank holding companies and nonbank 
systemic entities submit resolution plans demonstrating how 
they could be resolved during a crisis without systemic 
disruptions. The Dodd-Frank standard of resolvability in 
bankruptcy is very tough, and my sense is that all the major 
banks will need to make significant structural changes to 
achieve it. They will need to do much more to rationalize their 
business lines with their legal entities to make it much easier 
for the FDIC--or a bankruptcy court--to hive off and sell 
healthy operations, while maintaining troubled operations in a 
``bad bank.'' Rationalizing and simplifying legal structures 
will improve the ability of boards and management to understand 
and monitor activities in these large banks' far-flung 
operations. I hope regulators will consider requiring strong 
intermediate boards and managers to oversee major subsidiaries. 
Many of these centralized boards and management do not have a 
comprehensive understanding of what is going on inside their 
organizations. This was painfully apparent during the crisis.
    One element of Dodd-Frank's living will provision that has 
not yet been implemented is the requirement for credit exposure 
reports. Credit exposure reports are essential to make sure 
regulators understand crucial interrelationships between 
distress at one institution and its potential to cause major 
losses at other institutions. This type of information was 
lacking during the crisis. For those concerned about the 
potential domino effect of a large bank failure, it is 
essential not only to identify, understand, and monitor these 
exposures but also to limit them in advance. I would urge the 
FDIC and the Federal Reserve Board to complete this final piece 
of the living will rule as soon as possible.
    Another benefit of resolution authority emanates from the 
harshness of the process, and it is a harsh process, 
particularly for certain board members and senior management 
who not only lose their jobs but are subject to a 2-year 
clawback of all their compensation. This will give them strong 
incentives to avoid resolution by raising capital or selling 
their operations, even if the terms seem unfavorable. With this 
new resolution, the management of large financial firms now 
know what their fate will be, and it is not a pretty one. 
Bailouts are prohibited and there will be no exceptions. If 
they cannot right their own ship, they will sink with it.
    As important as it is, resolution authority obviously 
cannot substitute for high-quality prudential supervision. 
Excessive leverage was a key driver of the 2008 crisis as it 
has been for virtually all financial crises. This was forgotten 
in the early 2000s when regulators stood by and effectively 
lowered capital minimums among U.S. investment banks through 
implementation of Basel II.
    We need to correct those mistakes through timely 
implementation of Basel III and the SIFI surcharges which 
strengthen the definition of high-quality capital and 
substantial raise risk-based capital ratios for large 
institutions. Regulators also need to focus on constraining 
absolute leverage through an international leverage ratio that 
is significantly higher than the Basel Committee's proposed 3-
percent standard.
    Many industry advocates continue to argue that higher 
capital requirements will inhibit lending. It is fallacy to 
think that thinly capitalized institutions will do a better job 
of lending. A large financial institution nearing insolvency 
will quickly pull credit lines and cease lending to maintain 
capital. On the other hand, a well-capitalized bank will keep 
functioning even when the inevitable business cycle turns 
downward.
    Liquidity also needs more attention from regulators, both 
in the U.S. and abroad. We need to dramatically toughen the 
types of collateral than can be used to secure repos and other 
short-term loans. We should also think about caps on the amount 
of short-term debt that financial institutions can use, as well 
as the establishment of minimum requirements for the issuance 
of long-term debt. And money market mutual funds should be 
required to use a floating NAV which should substantially 
reduce this highly volatile source of short-term funding.
    Finally, I hope that regulators will give high priority to 
finalizing simple, enforceable rules to implement the Volcker 
provision of the Dodd-Frank statute, rules that focus on the 
underlying economics of a transaction as opposed to its label 
or accounting treatment. If the transaction will make money by 
the customer paying for a service through fees, interest, and 
commissions, it should pass the test. But if profitability or 
loss is driven by market movements, then it should fail. And 
gray areas associated with market making and investment banking 
should be done outside of the insured bank and supported by 
high levels of capital.
    Much work remains to be done to rein in the types of 
activities that caused our 2008 financial crisis. It is my hope 
that the Fed will soon issue its long-anticipated rules on 
heightened prudential standards for large financial 
institutions. Robust implementation of a credible resolution 
mechanism, strong capital and liquidity requirements, and curbs 
on proprietary trading can once again make our financial system 
the envy of the world and an engine of growth for the real 
economy.
    Thank you very much.
    Chairman Brown. Thank you, Ms. Bair.
    Mr. Johnson, welcome.

   STATEMENT OF SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF 
        ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF MANAGEMENT

    Mr. Johnson. Thank you very much, Senator.
    I think the Brown-Kaufman amendment, which would have 
imposed a hard cap on the size of banks relative to the 
economy, was exactly right when it was proposed. I think that 
is exactly what we need today, and I would like to point out to 
the Committee that this is absolutely not a partisan issue. 
Presidential candidate Jon Huntsman in his financial reform 
program has endorsed exactly this approach, perhaps even wants 
to go a little bit further than you, Senator Brown, in terms of 
making this actually happen immediately. And his point and I 
think the point that resonates across the political spectrum is 
the arrangements we have right now are not a market. We are 
looking at--with the continued existed of too-big-to-fail 
banks, we have an unfair, nontransparent, and extremely 
dangerous Government subsidy scheme. I think sensible people on 
the right and on the left recoil in horror when they see the 
details of this scheme, and we should work to end it. And I 
think the Brown-Kaufman amendment is the best workable 
bipartisan idea that we have before us.
    Now, to answer your four questions directly, Senator Brown: 
Did you grant enough authority under Dodd-Frank? No, I am 
afraid you did not, and the problem, Senator Hagan, is exactly 
the global nature of these businesses. Let me use two quotes 
that are in my written testimony. One was a senior--I have 
heard the same things from many people in private. These are 
on-the-record remarks. A senior Federal Reserve Board regulator 
said in, apparently 2011, post-Dodd-Frank, ``Citibank is a $1.8 
trillion company, in 171 countries with 550 clearance and 
settlement systems . . . .We think we're going to effectively 
resolve that using Dodd-Frank? Good luck!''
    I think the problem relative to the Economist simulation, 
Senator Hagan, which I have also paid attention to, is they 
were doing a very simple business there. They said it was a 
trillion-dollar bank. They had a U.S. and U.K. operation. There 
was a deus ex machina, a sleight of hand. They assumed a stay 
on the U.K. business, derivative business, that actually would 
be illegal. Anyone operating a U.K. business on that basis 
would go to jail. But they used that in their simulation, in 
one country. There is no cross-border authority you can grant. 
The U.S. Congress cannot do that. You need an intergovernmental 
agreement. There is no such agreement. There is nobody at the 
level of the G20 with whom I am familiar who is pushing for 
such agreement. It is not going to happen. Despite all the very 
hard and great work done by Ms. Bair and her colleagues, you 
cannot do cross-border resolution, and that is the issue for 
the big six megabanks.
    Your second question was: Will the regulators use the 
authority which you granted them? I do not think so, and I 
would turn specifically, not to single them out but it is a 
graphic case, to Bank of America, the exemption they apparently 
received from Section 23A that allowed them to transfer the 
derivative business to the deposit side of the bank, insured by 
the FDIC. We are just encouraging the same sort of risk taking, 
but an egregious, dangerous level. This is the taxpayer subsidy 
at work in our faces. And what do the regulators say about 
this? I understand the matter is still being discussed, but as 
far as I hear, they are just going to let it go. So you gave 
them the authority to stop exactly this kind of activity, and 
they will not stop it.
    Your third question, Senator, was: Will the market increase 
the equity funding? Will there be more capital in these banks 
due to market pressure? And I think the answer to that is 
obviously no. The externalities, the spillover effects are what 
this game is all about. That is how you get the subsidies. 
These executives are paid on a return-on-equity basis 
unadjusted for risk. They like leverage. This is the mechanism. 
And the regulators, again, will not move sufficiently--Anat 
Admati, for example, a professor at Stanford, has been pressing 
very hard on the basis of deep knowledge of corporate finance--
and absolutely unanswerable arguments. She has been pressing 
for the suspension of dividends by these banks until they have 
reached a much higher level of capital. And she has not just 
been rebuffed by the regulators. Typically, they will not even 
speak to her.
    What kind of process is this? If you want to see where this 
is going, Senators, I suggest you look carefully at Europe. The 
European banking system is in a slow, dramatic meltdown because 
of insufficient capital. Their banks, of course, are likely 
beyond too big to fail. They are in the too-big-to-save, which 
is the Irish experience. That is where we are heading, too.
    Your last question, Senator, was: Will the market force 
these banks to exit their lines of business? Will we have any 
version of the Volcker Rule as proposed by Senators Merkley and 
Levin? Will that really come into force? I do not think so. I 
think that that amendment--the legislation as drafted is 
exactly on target, but what we are seeing now come out of the 
regulatory process is not convincing, and I have the details in 
my written testimony.
    Thank you, Senator.
    Chairman Brown. Thank you, Mr. Johnson.
    Mr. Swagel, welcome.

  STATEMENT OF THE HONORABLE PHILLIP L. SWAGEL, PROFESSOR OF 
INTERNATIONAL ECONOMIC POLICY, UNIVERSITY OF MARYLAND SCHOOL OF 
                         PUBLIC POLICY

    Mr. Swagel. Thank you, Chairman Brown, Ranking Member 
Corker, and Members of the Committee. Thank you for the 
opportunity to testify today.
    The diversity of firm sizes in the U.S. financial system is 
an important strength of the U.S. economy. I would say that 
both small banks and large financial institutions play an 
important role in fostering a strong U.S. economy.
    As discussed in my written testimony, I believe it would be 
a mistake to break up large, complex financial institutions. 
This would sacrifice considerable benefits to the U.S. economy 
and to broader society without a commensurate gain in terms of 
a safer financial system.
    The Dodd-Frank Act takes a better approach, which is to 
strengthen regulation and oversight of large, complex financial 
institutions, including with features that will help regulators 
detect, avoid, and respond to future crises. The Financial 
Stability Oversight Council, the FSOC, in particular will help 
avoid a repetition of the problems in which no regulator had 
clear responsibility for AIG.
    Increased capital and liquidity requirements on large 
financial institutions will better allow firms to absorb losses 
and weather market strains. But there will be an impact on 
financial intermediation, and thus on the economy. Real-world 
banks react to binding capital requirements by making fewer 
loans, and increased capital requirements could again drive 
activity into the less regulated shadow banking system. Higher 
capital standards are useful, but they do not escape the 
tradeoff between stability and economic vitality.
    The new regulatory regime in Dodd-Frank does not break up 
large financial institutions or reinstate the Glass-Steagall 
separation of commercial and investment banking. I think this 
is appropriate. The repeal of Glass-Steagall is not well 
correlated with failures in the recent crisis. Bear Stearns and 
Lehman Brothers, for example, both remained investment banks 
and failed, while JPMorgan Chase crossed the Glass-Steagall 
line, combining investment banking and commercial banking, but 
weathered the strains of the crisis. I would focus instead on 
the characteristics of firms, assets, liabilities, and 
activities.
    As I said, small banks play a vital role in our economy. At 
the same time, there are important benefits to the U.S. economy 
from having financial institutions with large and diverse 
balance sheets that can best make liquid markets for large 
transactions and across a broad range of assets. Large banks 
are best able to serve large clients in trade finance, global 
lending, cash management, and other aspects of capital markets.
    My view is that it is a reality that large financial 
institutions are the ones that are best able to undertake 
commercial transactions for the large multinational clients 
that are a hallmark of the globalized economy.
    Now, having said that, my view is that the Title II 
resolution authority in Dodd-Frank is an important step forward 
in addressing the phenomenon of too big to fail. Title II puts 
bond holders firmly on notice that they will take losses when a 
firm is resolved. It would be desirable for this resolution to 
proceed as much as possible along the lines of a bankruptcy 
proceeding and with as little interference from the Government 
as possible. And in this I would include that the Government 
should refrain from propping up firms for an extended period of 
time, and especially refrain from ordering firms that fall into 
Government control from taking actions for policy purposes.
    Finally, the unfinished business of financial regulatory 
reform includes the future of Fannie Mae and Freddie Mac, 
regulation of money market mutual funds, and improvements to 
the international coordination of bankruptcies of financial 
firms. And I would just note that an event in the week that 
Lehman and AIG failed that especially deepened the severity of 
the crisis was the breaking of the buck by a large money market 
mutual fund. It was a very large fund but very far from a 
complex one. It was almost the simplest asset class you could 
imagine. And yet that was really the spark that greatly 
increased the severity of the crisis.
    The new regulatory regime for large, complex financial 
institutions represents progress, but much of the new regime 
remains a work in progress.
    Thank you very much.
    Chairman Brown. Thank you, Mr. Swagel.
    Mr. Wilmarth, welcome.

  STATEMENT OF ARTHUR E. WILMARTH, JR., PROFESSOR OF LAW AND 
EXECUTIVE DIRECTOR OF THE CENTER FOR LAW, ECONOMICS AND FINANCE 
       (C-LEAF), GEORGE WASHINGTON UNIVERSITY LAW SCHOOL

    Mr. Wilmarth. Thank you. Chairman Brown, Ranking Member 
Corker, distinguished Members of the Subcommittee, thank you 
for allowing me to participate in this important hearing.
    In an article published in 2002, I warned that too big to 
fail was the great unresolved problem of bank supervision 
because it undermined both supervisory and market discipline. I 
noted that Congress' enactment of the Gramm-Leach-Bliley Act 
allowed financial conglomerates to span the entire range of our 
financial markets. I warned that these financial giants would 
bring major segments of the securities and life insurance 
industries within the scope of too big to fail, thereby 
expanding the scope and cost of Federal safety net subsidies.
    I predicted that financial conglomerates would take 
advantage of their new powers under Gramm-Leach-Bliley and 
their too-big-to-fail status by pursuing risky activities in 
the capital markets and by increasing their leverage through 
capital arbitrage.
    In another article written 7 years later, I pointed out the 
financial crisis confirmed all of my earlier predictions. As I 
explained, regulators in developed nations encouraged the 
expansion of large financial conglomerates and failed to 
restrain their pursuit of short-term profits through increased 
leverage and high-risk activities. As a result, those 
institutions were allowed to promote an enormous credit boom 
that precipitated a worldwide financial crisis.
    Private sector debt in this country increased from $10 
trillion in 1991 to $40 trillion in 2007, and the majority of 
that increase took place in the household and financial 
sectors. That unhealthy credit expansion, in my view, could not 
have happened without the financial conglomerates that Gramm-
Leach-Bliley made possible.
    In order to avoid a complete collapse of global financial 
markets, central banks and Governments in the U.S. and Europe 
provided more than $10 trillion of support for major banks, 
securities firms, and insurance companies. Those support 
measures, which are far from over, established beyond any doubt 
that too big to fail now embraces the entire financial services 
industry.
    The Dodd-Frank Act does improve the regulation of 
systemically important financial institutions, or SIFIs, and 
certainly Chairman Bair deserves great credit for her role in 
making that possible. However, Dodd-Frank does not completely 
shut the door to future Government bailouts for creditors of 
SIFIs. The Fed can still provide emergency liquidity assistance 
through discount window lending and, in my view, through group 
liquidity facilities similar to the primary dealer credit 
facility, designed to help the largest financial institutions.
    Federal home loan banks can still make collateralized 
advances. The FDIC can potentially use its Treasury borrowing 
authority and the systemic risk exception to the Federal 
Deposit Insurance Act to protect uninsured creditors of failed 
SIFIs and their subsidiary banks.
    Dodd-Frank has made too-big-to-fail bailouts more 
difficult, but the continued existence of these avenues for 
financial assistance indicates that Dodd-Frank has not 
eliminated the possibility of too-big-to-fail bailouts. And 
certainly Standard & Poor's agreed with that view recently in a 
July 2011 report.
    Dodd-Frank also relies heavily on the same supervisory 
tools--capital regulation and prudential supervision--that 
failed to prevent the banking and thrift crises of the 1980s 
and the current financial crisis. As you have explained, 
Chairman Brown, one other approach would be to break up in a 
mandatory way the largest banks. I am sympathetic to that 
approach, but I think it is unlikely, given the megabanks' 
enormous political clout, that Congress would vote to require 
involuntary break-ups absent a second and perhaps cataclysmic 
crisis. Professor Johnson has pointed out that it took the 
panic of 1907 and the Great Depression to produce the Glass-
Steagall Act. I hope we do not have a second bite of the same 
poisoned apple.
    The third possible approach, and the one I advocate, is to 
impose structural requirements and activity limitations that 
would prevent SIFIs from using the Federal safety net to 
subsidize their speculative activities in the capital markets 
and would also make it easier for regulators to separate banks 
from their nonbank affiliates if a SIFI fails. First, I propose 
a prefunded orderly liquidation fund that would require all 
SIFIs to pay risk-based assessments to finance the future costs 
of resolving failed SIFIs. We would not accept a postfunded 
deposit insurance fund. We know that would be far too hazardous 
to the welfare of bank depositors. Why should we accept a 
postfunded orderly liquidation fund that will deal with much 
more massive potential payments?
    Second, we should repeal the systemic risk exception to the 
Federal Deposit Insurance Fund. That provides a very large 
potential bailout fund for uninsured creditors of failed 
megabanks. We should not allow that backdoor bailout device to 
exist. The Deposit Insurance Fund should not be exposed to that 
risk. Community banks cannot benefit from it. Why should they 
have to pay for it?
    Last--and I can explain this more in response to 
questions--I believe we should adopt a two-tiered system of 
financial regulation. Traditional banks could operate much the 
way they do now, but they would have to restrict their 
activities to those that are closely related to banking. 
Financial conglomerates would have to adopt a narrow bank 
structure that would rigorously separate the FDIC-insured bank 
subsidiary from all of their nonbank affiliates and all their 
capital markets activities. That would prevent SIFIs from using 
FDIC-insured, low-cost funds to cross-subsidize risky 
speculative capital markets activities. The danger of cross-
subsidization is certainly raised by exactly the derivatives 
transfer issue that Professor Johnson pointed out with Bank of 
America.
    In conclusion, my proposed reforms would strip away many of 
the safety net subsidies currently exploited by SIFIs and would 
subject SIFIs to the market discipline that investors have 
applied in breaking up many commercial and industrial 
conglomerates over the past 30 years. SIFIs have never 
demonstrated that they can provide beneficial services to 
customers and attractive returns to investors without relying 
on safety net subsidies during good times and Government 
bailouts during crises. It is long past time for financial 
conglomerates to prove, based on a true market test, that their 
claimed synergies are real and not mythical. If, as I believe, 
SIFIs cannot produce favorable returns when they are deprived 
of their current too-big-to-fail subsidies, market forces 
should compel them to break up voluntarily.
    Thank you again for the opportunity to present this 
testimony.
    Chairman Brown. Thank you very much, Mr. Wilmarth, for your 
testimony.
    I would first like to ask the Subcommittee's unanimous 
consent to include two excellent speeches on too big to fail in 
the hearing record. Former Fed Chair Paul Volcker wrote, 
``Three Years Later: Unfinished Business Of Financial Reform'', 
and Federal Reserve Bank of Dallas President and CEO Richard 
Fisher wrote, ``Taming the Too Big to Fails: Will Dodd-Frank Be 
the Ticket or is Lap-Band Surgery Required?'' With no 
objection, so ordered.
    I will start the questioning, and if we need to do 
certainly two rounds, if the witnesses are willing, we would 
probably like to do that.
    I would like to address an issue that Senator Vitter raised 
at the hearing in the full Committee yesterday. Tom Hoenig 
points out, the just recently retired Kansas City Fed 
President, that the biggest banks enjoy funding advantages over 
their community bank competition and regional bank competition. 
Chairwoman Bair has shown that the biggest banks operate with 
less capital and more leverage.
    Each of you, if you would give your opinion on the 
question, is this--the advantages they have to attract 
capital--is it due to Government support for these 
institutions, explicit or implicit support? Think about that 
question for a moment. And also, does it seem fair that 
Government is intervening that way, implicitly or explicitly in 
the market by providing the biggest banks with those subsidies? 
I will start with Mr. Wilmarth, if you would.
    Mr. Wilmarth. I absolutely agree. I discuss this issue in 
my written testimony, particularly on pages six and seven. A 
recent study by Joseph Warburton and Deniz Anginer, ``The End 
of Market Discipline'', gives the following figures. They 
calculate that the implicit too big to fail subsidy gave the 
largest banks an annual average funding cost advantage of 
approximately 16 basis points before the financial crisis, 
increasing to 88 basis points during the crisis, peaking at 
more than 100 basis points in 2008. The total value of the 
subsidy amounted to about $4 billion per year before the 
crisis, increasing to $60 billion annually during the crisis, 
topping at $84 billion in 2008.
    And they also found that the passage of Dodd-Frank did not 
take that subsidy away. In fact, expectations of Government 
support rose in 2010 compared to 2009. That study provides 
dramatic evidence of the size and magnitude of the subsidy that 
SIFIs enjoy today and have enjoyed for a number of years. Their 
study covered 20 years, from 1990 to 2010.
    Chairman Brown. Mr. Swagel.
    Mr. Swagel. This is an area in which the situation is 
changing and will change as a result of Dodd-Frank. When I look 
at the funding of small banks and of large banks, and every 
bank is different, so this is a very broad statement, small 
banks generally fund themselves with deposits, a good thing, 
covered by FDIC Insurance for which they pay premiums and with 
FHLB advances, which are covered by a Government guarantee. So 
that is the funding, the main funding sources for smaller 
banks.
    Large banks, on the other hand, pay premiums on their 
funding that are not deposits. So nondeposit funding now 
requires a premium to be paid to the FDIC even though it is not 
actually covered by the Deposit Insurance Fund. Then looking 
forward, there will be a capital surcharge for systemically 
important banks. And then importantly, as I discuss in my 
written testimony, the resolution authority under Title II is 
really a regime change. That will say to bondholders in the 
future, you will take losses. If a bank goes down, you 
bondholders, there are no more bailouts. There is no more 100 
cents on the dollar. You will take losses. I expect, going 
forward, that to have a big change on funding, as well.
    Chairman Brown. Mr. Johnson.
    Mr. Johnson. Reasonable estimates of the funding advantage 
for large banks range between 25 and 75 basis points, 0.25 
percentage point to 0.75 percentage point. This is the same 
sort of funding advantage that Fannie Mae and Freddie Mac had. 
I do not think Fannie and Freddie were the primary cause of the 
financial crisis in 2008, but there is no question that they 
took excessive risks. They had far too much leverage. They were 
too powerful politically and they blew themselves up at great 
cost to the American taxpayer. Who are the Government Sponsored 
Enterprises of today? It is the too-big-to-fail banks with a 
massive, unfair, nontransparent, and extremely dangerous 
funding advantage.
    Chairman Brown. Ms. Bair.
    Ms. Bair. Yes. We have been--I have been personally 
concerned about this for a long time and the funding 
differentials remain much worse after 2008 as a result of the 
crisis and the bailout strategies that were employed.
    Phil is right. There is a difference in how small banks 
fund themselves and large banks, but even if you look at the 
comparative costs that they pay for deposits, there is a 
differential, and so, clearly, we have a problem. I think we do 
not end too big to fail until we convince the market and 
specifically the bondholders that they are not going to get 
bailed out anymore. That cheap debt that the large banks can 
issue right now is a big driver of their funding advantages. 
The rating agencies have eliminated some of the bump-up that 
they give large banks now based on the assumptions of implied 
Government support, but we still have a long ways to go. We do 
not end too big to fail until we convince the market that it is 
gone.
    I would also add, to echo Art's comments during his opening 
statement, I also supported a prefunded reserve during Dodd-
Frank and one of the reasons we wanted to do that, we wanted to 
calibrate the assessment based on the funding differential. And 
as we ended too big to fail over time, that funding difference 
would have narrowed the assessment. But in the near term, it 
could have helped end this advantage that they had. We got the 
fund through the House, not through the Senate. But I do think 
that would have been an advantage of having the prefunded 
reserve.
    Chairman Brown. OK. Thank you.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman.
    Mr. Johnson, you, I know, have made quite a name for 
yourself talking about this issue. You are somewhat 
entertaining. I would say on the 23(a) issue you mentioned, 
that actually is not the case, just for what it is worth. The 
transfer from Merrill Lynch to B of A was actually below the 10 
percent threshold. But you might just want to take note of 
that.
    But let me, Sheila, you feel like that we, based on the 
Title II resolution, you feel like that we have solved the too-
big-to-fail issue, is that correct?
    Ms. Bair. I think the tools are there to end too big to 
fail.
    Senator Corker. But you would agree that if we had a 
systemic failure where multiple institutions, we have not dealt 
with that, is that correct?
    Ms. Bair. Well, I think Dodd-Frank provides the ability for 
the Fed under 13(3) to provide systemic support to solvent 
institutions if you have some type of external shock, for 
instance, if the European banking system goes down----
    Senator Corker. Right.
    Ms. Bair. ----I do not think we should hold our banks for 
that----
    Senator Corker. And there is almost no regime that can deal 
with systemic----
    Ms. Bair. Right. You have to have some flexibility for 
that. We would have liked actually higher hurdles for 13(3), 
but it is much better now. There are much better disclosure 
requirements and required explanations to Congress, so it has 
improved a bit.
    Senator Corker. Good. Thank you. You, like me, answer 
fully.
    On the Volcker issue we were talking about where banks at 
the end should not make or lose money off transactions, it was 
interesting to me that Volcker excluded Treasury. So do you 
include Treasuries in that, that banks should not buy 
Treasuries and make or lose money off of that, and why did we 
exclude Treasuries? Is that because the Treasury Department 
actually hated Volcker and they did not want to be impacted 
themselves by it? Why did we do that, briefly, if you could.
    Ms. Bair. I do not know, maybe because it has traditionally 
been a fairly--not a highly----
    Senator Corker. Well, you can make or lose a lot of money 
on Treasuries.
    Ms. Bair. You can, and certainly if interest rates start 
going north at some point, which they probably will, you could 
probably lose a lot of money. So I do not know the rationale. 
We were not there----
    Senator Corker. So, really, banks, though, should not own 
Treasuries to make or lose. They should not own----
    Ms. Bair. Well, I think if they are buying a lot of 
Treasuries as a speculative bet, they should not, absolutely 
not. If they are buying Treasuries to keep liquid assets on 
hand, if they are using it to collateralize repos, that is 
probably OK. But, no, if they are taking big positions in 
Treasuries to make money, they should not do that.
    Senator Corker. So I am actually still trying to understand 
where we need to be on the size of these institutions, and I 
did think that the amendment offered on the floor, had no 
hearings and was not well thought out at the time, but I think 
we are all kind of evolving and learning.
    How small is small? I mean, we have 15--of the 15 largest 
banks in the world, we have two of those and we have a 
Government that borrows huge amounts of monies nonstop because 
of our lack of discipline and we need banks to actually buy 
those Treasuries for us. We need primary dealers.
    So, Mr. Johnson, briefly, what size should be the right 
size when we have--you know, we dominate the world as far as 
GDP. We have two of the largest 15 banks in the world, not the 
top. What is the right size?
    Mr. Johnson. Well, Senator, on the size comparisons, I 
would urge us all to be careful, because if you are comparing 
banks under U.S. GAAP with European banks, for example, under 
IFRS, their accounting system, for a bank that has a large 
derivative book, that would be understanding the U.S. GAAP 
bank. So I think if you do the correct numbers, and I am happy 
to go through this with your staff, we actually have many more 
of the big banks--we have some of the biggest banks in the 
world on that basis.
    On size, I believe the Brown-Kaufman amendment would have 
rolled back the largest six banks to, roughly speaking, the 
size they had in the mid-1990s. Goldman Sachs, for example, in 
1998 was a $200 billion bank. It was about $280 billion in 
today's money. It was one of the world's leading investment 
banks, absolutely great business----
    Senator Corker. So give me the number. I mean, what is the 
size?
    Mr. Johnson. Two percent of GDP was the size cap for 
investment-type banks under Brown-Kaufman and 4 percent of GDP 
was the size cap proposed for retail-type banks and that is 
eminently sensible. Between 300--this is not risk-weighted. 
There is no risk-weighting gaming here because that gets out of 
hand. So let us say between $300 billion and $600 billion total 
assets.
    Senator Corker. And Mr. Swagel, I know that I personally 
was highly involved in Title II and worked closely with 
Chairman Bair. One of the pieces we did not really ever have 
the opportunity to deal with properly was bankruptcy. Are there 
things in Title II that you think ought to be altered to take 
into account a large highly complex bankruptcy?
    Mr. Swagel. Thank you. I worry about the amount of 
discretion that is left to Government policy makers within 
Title II. One can look at the derivative book, and there are 
proposals about whether derivatives should be stayed or not 
stayed and essentially kept out of the resolution--a change in 
the bankruptcy code, so that is one area to look at.
    One other area that I am really the most concerned about 
is, as I said, the discretion that policy makers have within 
the resolution authority. It is meant to follow a bankruptcy-
like proceeding with an order of priority for creditors, and 
the FDIC has said that they will do that. But ultimately, it is 
really up to the discretion of the regulator, and it is really 
the difference between a judicial system like bankruptcy and a 
political one, which ultimately Title II is.
    Senator Corker. Thank you. I know my time is up and look 
forward to the second round.
    Chairman Brown. Thank you.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    I wanted to turn, Ms. Bair, to page two of your testimony, 
when you note essentially that--let me see here--shareholders 
were not wiped out before the Government took exposure. I think 
people still kind of wonder why, even under those emergency 
circumstances, why did shareholders not take a loss before the 
taxpayer did? And as we look back on it with a little bit of 
distance now, is there a clear explanation that, a sort of 
explanation I can share with my constituents when they ask the 
question why their task funds were put at risk but shareholders 
did not take a loss?
    Ms. Bair. Well, I think that is what it means to bail out 
an institution. You keep the institution open. You preserve 
value even at the shareholder--the common equity level. And 
shareholders did take loss when the market punished them, but 
the Government did not impose losses. That is what a bailout 
is. You keep the institution open. And I think we did it 
because we did not have tools outside of insured banks. We did 
not have tools to resolve the entity in a holistic way. Lehman 
did obviously wipe out the shareholders, but the bankruptcy was 
highly disruptive. WAMU, the shareholders were wiped out. That 
was a good example of the FDIC resolution process working in a 
way that imposed discipline on shareholders and bondholders, 
took a haircut, as well. But I think the legal tools were not 
there.
    I think looking back, hindsight is always 20/20, and I say 
this because I want to make sure we do not make the same 
mistakes again going forward if we ever, God forbid, get into a 
kind of situation like that again. But I think perhaps the 
Government could have been a little more muscular. There was no 
obligation on the Government to come in and bail out an AIG or 
whoever, and so, you know, insisting that at least 
counterparties who were made whole or bondholders who were made 
whole as well as shareholders should have voluntarily taken 
some additional losses or set up bad bank structures where 
their liabilities would have funded the bad assets, I think 
those were mechanisms that we did not explore. We did not have 
time, and I just wish we had. But the point is, we were behind 
the curve and we did not have a lot of information and had to 
make decisions quickly and the easiest thing to do was just to 
keep the institution open and prop it up.
    Senator Merkley. Well, thank you. The reason I raised that 
is because later in your testimony, you flag it as a key 
indicator related to too big to fail, and hopefully I am not 
pulling this out of context, but we cannot end too big to fail 
unless we can convince the market that shareholders and 
creditors will take losses if the institution in which they 
have invested fails. So I just wanted to flag that as an 
indication of the future.
    You also note in your testimony that many large financial 
institutions found trading assets, that is proprietary trading, 
to be much easier and more profitable than going through the 
hard work of developing and writing standards for loans that 
the institutions plan to keep on their books. And this is kind 
of--this goes right to the heart of the Volcker Rule. Do we 
provide a discount window and insurance for depositors in order 
to have and support institutions that provide loans to maintain 
liquidity to families and businesses, or are these type of 
advantages going to be applied to carry advantages into the 
high-risk trading world, and does that high-risk trading, as 
important as it is in aggregating capital and allocating 
capital, belong outside of that framework.
    I believe I am reading into your comments that you believe 
it should be outside that framework, but I wanted to make sure 
that you had a chance to comment on that.
    Ms. Bair. Well, I think--well, trading assets can be a 
broad category, and not all trading assets would be viewed as 
proprietary under the Volcker Rule. But I think securitization, 
for instance, a lot of this is driven by securitization, so you 
are originating loans or buying loans, mortgage loans 
originated by others, but securitizing them and then buying 
back the securities. A lot of that is responsible for the 
growth in trading assets, and, of course, that process is 
accompanied by a loss of underwriting discipline in the 
process.
    So I do think that insured losses are there to extend 
credit to the real economy and I think that makes loans and 
services that are incidental to the provision of credit to the 
real economy. And if it does not pass that test, then no, I 
would rather it not be outside of insured banks, and I know 
Dodd-Frank is what it is and the Volcker Rule provisions are as 
they are, but it might have been easier in retrospect to try to 
think, instead of trying to say what we do not want insured 
banks and affiliates to do, try to think what we want insured 
banks to do and recognize that there are some legitimate 
functions, financial services functions performed by securities 
affiliates that do involve some position taking, Market making 
and investment banking are two prime examples, but make sure 
those are kept outside--insulated from the insured institution 
and, frankly, supported by higher capital, not lower capital.
    So I do. I am a traditionalist and I think insured deposits 
should be there for credit support for the real economy and 
things that go beyond that should not be in the bank.
    Senator Merkley. Do I have time to restate my understanding 
of what Sheila just said? Do I understand you to say it would 
have been easier, if you will, to say this is the business, the 
business of lending, is what the commercial banks are in----
    Ms. Bair. Right.
    Senator Merkley. ----and that if you want to do wealth 
management, if you want to do market making, if you want to do 
those things, all of that should be outside the framework, and 
then we should not have the complexities of trying to 
distinguish market making from proprietary trading.
    Ms. Bair. I think that is right. It is very difficult, I 
think, to know where that line is. You are going to have gray 
areas, so I would force those outside the insured bank. I think 
you can keep them within the larger holding company structure 
so long as there is a good firewall and you have higher capital 
supporting that activity. But, again, my preference would be to 
force them outside of the insured bank, yes.
    Senator Merkley. Thank you, and I know you have thoughts on 
this which I hope to come back to during additional time. Thank 
you.
    Chairman Brown. Thanks, Senator Merkley.
    Senator Moran.
    Senator Moran. Chairman Brown, thank you. Thank you all for 
your presence here today. I wish we would do more of this in 
which we take a broader picture, a more, perhaps, thoughtful 
opportunity to discuss these issues. They are somewhat new to 
me in the sense I have never been on the Banking Committee 
before and I want to raise just a couple of topics in the time 
that I have.
    This may be for you, Mr. Secretary, and really for any 
panel member who would like to respond, but you indicate in 
your testimony the key element for addressing too big to fail 
is that bondholders take losses. Is there anything in Dodd-
Frank that now causes investors in banks in the United States 
to believe that they will take a loss should a failure occur? 
What did Dodd-Frank do to emphasize that message? So the 
question, I guess, is are we better off with Dodd-Frank than we 
were before on this issue?
    Mr. Swagel. I will be very quick. I think the answer is 
yes, that the orderly liquidation authority means that the 
equity holders, the shareholders will be wiped out and then if 
the Government puts money in and there are any losses to the 
Government, bondholders will get clawbacks retroactively. So I 
think that is it.
    Senator Moran. So is there evidence that bondholders, 
investors, and, therefore, the management of financial 
institutions are behaving differently because they now believe 
that potential exists? What evidence is there that that message 
has been received and, therefore, conduct has changed?
    Mr. Swagel. Right. So the evidence I know of is the one 
that Chairman Bair mentioned, that the rating agencies have 
said, we are changing our view of these institutions because of 
less support as a result of OLA, orderly liquidation authority. 
I think it is too early to say that funding is more expensive. 
Now, that is something that we are all going to be looking at 
going forward.
    Senator Moran. But nothing, no evidence at this point that 
management would have a different discussion. In a board room, 
you are going to have a different conversation about the risk 
that the bank is willing to take because, oh my gosh, Dodd-
Frank passed and our bondholders or investors may be at risk. I 
mean, are we at that level?
    Mr. Swagel. I think we are. Again, it is hard to know 
because it is so new and it has never been used so we do not 
know exactly how it is going to take place. But I think going 
forward, bondholders, especially of risky institutions, will 
exercise much more scrutiny. In a sense, there will be more of 
a ``let us flee to the exit.'' As soon as a firm gets into 
trouble, bondholders are going to say, hey, we are getting 
close to the red line. We want to be out of here.
    Senator Moran. Sheila Bair, being a Kansan, demonstrated 
her agreement with you by body language----
    [Laughter.]
    Senator Moran. ----but I also think that Mr. Johnson 
perhaps indicated that that was not the case. Did I read your 
body language? Do you have something that you would like to----
    Mr. Johnson. Yes, Senator. I strongly disagree. I talk to 
people--I agree that this is new territory and I agree with the 
intention here. But I talk to a lot of people in the financial 
sector, including people who work in and around these big 
banks. I do not think their attitudes have changed at all. 
There is still the perception of too big to fail. As Ms. Bair 
said, it is all about the market perception. Does the market 
think that JPMorgan Chase or Bank of America or Citigroup or 
Wells Fargo or Goldman or Morgan Stanley could fail, and I talk 
to people in the market and they tell me no.
    I ask audiences whenever I address them, who in the room 
thinks that Goldman Sachs, for example--a hypothetical 
example--who thinks Goldman Sachs could fail so the bondholders 
lose their money? I asked it at a conference recently that 
Professor Wilmarth organized. Typically, no more than one 
person in the audience raises his or her hand, and it turns out 
that one person is engaging in wishful thinking.
    Senator Moran. Let me ask perhaps what I hope is not a 
timely question, but very well may turn out to be. My 
assumption would be that financial institutions in Europe are 
at some risk. What has happened as a result of Dodd-Frank that 
limits the ability for U.S. banks to also become more at risk 
because of the challenges of the financial circumstances in 
Europe or elsewhere in the world?
    I asked a slightly different question yesterday of 
Government officials. I was trying to figure out, it seems to 
me just a perspective that too big to fail, there are still 
institutions that are just as large as they ever were, perhaps 
even larger, so that the common perception of too big to fail 
has not changed. I mean, I do not know that Kansans would see 
the evidence that we have a lot of smaller institutions. In 
fact, as Sheila Bair would have--could testify, we have fewer 
smaller institutions as a result of bank closures, and it often 
seems that it is the small banks that are, in many ways, paying 
the price, even though they present no systemic risk.
    And so my question is, have we done something that reduces 
the chances that what happens elsewhere in the world affects 
our financial institutions, and at the same time, is there a 
regulatory arbitrage--there is probably a better phrase for 
that than what I have said--between the two, between banking 
institutions or financial institutions that are chartered in 
the United States and chartered someplace else in the world? Do 
we get all the burden of the additional regulations but still 
have to worry about the consequences of a bank failure that is 
less regulated, perhaps, elsewhere in the world, but we get the 
stuff that flows from their failure? Anyone.
    Mr. Johnson. Senator, I would commend to your attention 
Taunus Corporation, which is the eighth or ninth largest bank 
holding company in the United States. It is a wholly owned 
subsidiary of Deutsche Bank. It is 77-to-one times leveraged. 
Deutsche Bank itself is a very highly leveraged global 
corporation. Public news reports say that the U.S. regulators 
have asked for additional capital to be put into Taunus because 
they regard the leverage as excessive in today's environment 
because of the situation in Europe. It has not happened.
    And I think the problem is exactly what you just put your 
finger on, that we are no less vulnerable, perhaps more 
vulnerable now to this incredible disaster in and around the 
banking system in Europe. It is going to spill over to us in 
many ways through counterparty risk in derivatives, for 
example. But Taunus Corporation is a spectacular in our faces 
demonstration of these risks becoming bigger, not getting 
smaller.
    Senator Moran. Mr. Chairman, I do not know whether your 
rules are that they get to answer my question as long as I ask 
it within the 5 minutes, or if my 5 minutes is up before they 
respond, but----
    Chairman Brown [gesturing].
    Senator Moran. Mr. Chairman, thank you. I know the 
Professor was nodding and----
    Mr. Swagel. I will be very brief. I think two things have 
changed. One is Dodd-Frank, the Financial Stability Oversight 
Council, and again, I think that can get somewhat at the AIG 
problem of cracks in the system, in the regulatory system. I 
suspect the regulators, the members of the FSOC, have been very 
diligent about looking at the exposure of American banks to 
European problems. I would have hoped they would have done that 
before Dodd-Frank, but I suspect they are really on top of it 
now to the extent they can be.
    Number two is not Dodd-Frank but our financial system is 
better capitalized, is in better shape, is less risky than it 
was before the crisis. That is not a solution, but at least it 
is progress.
    Ms. Bair. May I say something? Just a couple of things. I 
think Simon and I are talking to different people. I talk to a 
lot of bondholders and I think they are very aware of Dodd-
Frank and very aware of the strong rules that the FDIC has put 
forward and the strong rhetoric coming out of a lot of the 
leadership, not just from me, when I was in my Government 
position. I think they are very focused on this and 
understanding what the ramifications will be and understanding 
that they will be at risk of loss. I think the rating agencies 
are reflecting that by providing downgrades. They used to give 
a bump-up and there is still a little bit of that left. But I 
think it is starting to change the mindset of bondholders.
    With regard to Europe, I would just say that Dodd-Frank 
cannot fix everything that is beyond our borders. I do think 
that certain jurisdictions, like the United Kingdom, are 
serious about resolution authority and I think we are making 
progress there. The FSB just recently came out, with heavy 
input from the FDIC, with a framework for a multinational 
resolution regime. There are tools that can be used now for 
cross-border failures and the Lehman paper, I think, is 
instructive in terms of one of the approaches that could be 
used for cross-border resolution, pending development of a 
broader multinational resolution regime.
    I would also say that there were some regulators warning 
early on about problems in Europe. Back in 2006, my first Basel 
Committee meeting as Chairman of the FDIC, I went to them and I 
said, you need to have a leverage ratio. They had started 
implementing the Basel II advanced approaches and they were 
lowering the capital levels substantially with what is called a 
risk-weighted approach. Leverage ratios are an absolute 
constraint on leverage. We have had one here for a long time 
and it really--it saved our bacon during the crisis.
    But Europe has refused to do that. They have quite 
different attitudes about the relationship between regulators 
and banks and what is appropriate in terms of the capital 
regime and I think they are learning now, but I think there 
were U.S. regulators who were trying to advocate and prevent 
some of the problems we are seeing now in Europe many years 
ago.
    Chairman Brown. Thank you, Senator Moran.
    We will begin a second round of questions, if my colleagues 
want to join in that.
    I assume some of you saw or at least heard of the ``60 
Minutes'' piece on Sunday might. They ran two segments of the 
three segments on the show questioning the whole issue of 
whether--why none of these bank executives from Countrywide to 
any of the larger institutions went to prison, raising the 
question of the complexity of these institutions. Is the 
Government too timid, in part because they do not want to lose 
a case? Was there outside pressure on the Justice Department? 
That seemed to be answered probably no on that, but no one 
knows for sure, I guess, or we do not know for sure. Was the 
Government simply the--when you think of a Government lawyer 
making $150,000 matched up against a battery of lawyers making 
significantly more money than that and more experienced in 
dealing with the complexity of these institutions.
    It sort of brings me to this next question. The Financial 
Crisis Inquiry Commission report noted that the largest U.S. 
bank in 2007 had a $2 trillion balance sheet with more than 
2,000 subsidiaries. Today, that bank is now under $2 trillion, 
but there are now two banks that, I guess, JPMorgan Chase is 
over $2 billion as is Bank of America. Andy Haldane from the 
Bank of England said that calculating the regulatory capital 
ratio of the average large bank under the Basel regime would 
require over 200 million calculations.
    Professor Wilmarth cited a study that investors tend to 
look at banks' credit ratings, which include the likelihood of 
Government support, to make their investment decisions. 
Chairman Bair mentions that the rating agencies have begun to 
remove the bump-up they assign to the credit ratings of large 
financial institutions based on their previous assumption of 
Government support.
    It may lead to the conclusion that too big to fail just 
means too big to manage, too big to regulate. Are the markets, 
when making investment decisions, are they looking at the 
perceived level of Government support for these banks when they 
make these decisions? Is it too complicated for the market to 
make it any other way? Chairman Bair.
    Ms. Bair. Well, I think that--I think there is not--or we 
are transitioning out of that, but I think in the lead-up to 
the crisis, too big to fail was very much a factor in making 
investment decisions. And then, of course, in 2009 with the 
stress test, we pretty much told everybody, if you are above 
$100 billion, we are going to backstop these institutions. And 
so, clearly, that capital raising was based on an assumption of 
Government protection.
    So now in Dodd-Frank we are trying to transition back out 
of that and get rid of all that moral hazard that we created 
with the bailouts that continued well into 2009, but it is 
going to take some time. My sense is that if we can convince 
the market that it is gone, you are going to see market 
pressure for these institutions to downsize because these 
bondholders cannot understand everything that is going on 
inside of a multinational entity with over 2,000 legal 
entities.
    And as a parallel process to that, I hope that the Fed and 
the FDIC will be very aggressive in requiring structural 
changes so that some of them have 20 legal entities as opposed 
to 2,000 and making sure those legal entities are rationalized 
with their business lines, so if they need to break off and 
sell the mortgage servicing operation or the credit card 
operation or the derivatives dealer or whatever, it is feasible 
to do that if the institution comes under distress.
    Chairman Brown. Do you think that is a natural evolution, 
natural in the sense within the----
    Ms. Bair. I think it is----
    Chairman Brown. ----context of what we did with Dodd-Frank?
    Ms. Bair. I think shareholders and bondholders, to some 
extent, have seen value in these large institutions based on 
their implied Government subsidies. Once that is gone, I am not 
so sure they are going to see value anymore with these very 
large institutions, and you might even see shareholders think 
that they can unlock value if some of these entities are broken 
up. They might be worth more in separate entities that are 
easier to manage and easier to understand on the investing----
    Chairman Brown. Is that happening, Mr. Johnson, in your 
mind?
    Mr. Johnson. No, sir----
    Chairman Brown. Or will it happen?
    Mr. Johnson. Well, not until you end too big to fail, 
effectively. I agree with Ms. Bair totally on the objective 
here and exactly on the mechanism. But if you read the speeches 
of the CEOs, what do the CEOs say to their shareholders? What 
do they communicate to the market? And I cover these in detail 
and I am happy to send you and your staff examples. Mr. Vikram 
Pandit, for example, the head of Citigroup, says he wants to 
make Citi bigger, more global, operate in more markets, and 
from the, again, the on-the-record comments of Mr. Timothy 
Geithner, the Treasury Secretary, he thinks that having our 
banks go out and become more global, take more risk in emerging 
markets, for example, he thinks that is a good idea.
    Well, it was not a good idea in the 1970s when Citigroup 
under Walter Wriston bulked up on loans to Latin America, 
Communist Poland, and Communist Romania, leading in large part 
to the crisis of 1982 in this country and around the world. 
Citibank back then was a much smaller bank. It is more than 
five times the size now. But that is what they want--that is 
what the executives want to do. That is what they are saying to 
the market. And I do not yet see the market pressure on them to 
break up. Ms. Bair is absolutely correct. That is the litmus 
test.
    Chairman Brown. Ms. Bair, do executives not want to do 
that? They all want to grow their institutions. They all want 
bigger market share. So why is Dodd-Frank pushing them in the 
other direction through their shareholders and bondholders?
    Ms. Bair. Well, if you increase their capital requirements, 
I would like to have higher capital requirements. I would like 
to have at least another 10 percent of the long-term unsecured 
debt on top of the higher capital requirements. I think you 
make it more expensive for them to fund themselves, that is 
going to make it more difficult to grow. It is going to make it 
more expensive to attract investment dollars. They are going to 
have to have really good management and convince the investment 
community that the management knows what they are doing and 
they have control of their institution and are managing the 
risk of that institution well. And I think all but the very 
best managed are not going to be able to make that kind of 
showing.
    So it is hard and I do think it is important for the 
Government to be sending all the signals, the right signals. 
And I do not think there should be any ambiguity by anybody in 
the U.S. Government, wherever they are, that we do not view it 
as a good in and of itself to keep these institutions alive 
just because they are big and we do not----
    Chairman Brown. Are we sending those messages?
    Ms. Bair. Well, I think Simon has referred to some of the 
statements that I think send mixed signals to the market and I 
do think it is important for the Government to speak with one 
voice on this. Again, I want the market to drive this. I 
think--and I would certainly have no objection to your 
amendment, and given where we are, maybe that is the fastest 
way to eliminate this threat. But I would prefer that the 
market drive the appropriate size of these institutions and my 
sense is if we can convince the market there are no more 
Government subsidies, you will get significant pressure for 
them to downsize and break up on their own.
    Chairman Brown. Professor Wilmarth, you have something to 
say to that?
    Mr. Wilmarth. I want to reiterate the importance of the 
2009 stress tests, because not only did Federal regulators say, 
``we will provide any capital needed to allow 19 largest banks 
to survive,'' and they actually put capital into GMAC when GMAC 
could not raise any, they also said, ``we are not going to 
apply the prompt corrective action sanctions against these 
banks for being undercapitalized,'' even though those are 
nondiscretionary sanctions that must be applied by statute. In 
contrast, there have been hundreds of PCA orders issued against 
community banks. Unlike the megabanks, community banks got no 
wiggle room if they were undercapitalized.
    Now, the other thing I want to say is that the Dexia rescue 
which just happened in Europe, provide strong evidence that we 
have not ended too big to fail. Every time we see the markets 
under stress, and when major banks that are heavily involved in 
the markets are under stress, the Governments do everything 
possible to maintain stability, to prop them up. The Fed just 
opened major swap lines to get dollars to European banks. We 
now know that the Fed not only provided help to European banks 
by bailing out AIG, they were also giving huge amounts of 
liquidity assistance to European banks throughout the financial 
crisis. So this European crisis has been bubbling along under 
the surface ever since 2008, 2009, but it was kept relatively 
quiet until last year.
    Everything we see the Fed doing is designed to prop up and 
stabilize and make sure none of these large institutions go 
down. And so I align myself with Professor Johnson. When I see 
Federal regulators actually force a bank of the size of 
Citigroup or Bank of America into what looks like 
nationalization, where all the shareholders are gone, and where 
bondholders take major haircuts, then I will begin to believe 
that too big to fail has ended. But I do not think you can find 
such an example, other than Lehman, which I think everyone now 
admits they are sorry they allowed to fail. Other than Lehman, 
where can you find an example where an institution was taken 
that way? RBS in Britain, yes, was nationalized. We have not 
done it here. We have not done the complete nationalization, 
wipe out the shareholders, impose major haircuts on 
bondholders, for any of the top six banks.
    Chairman Brown. Mr. Swagel.
    Mr. Swagel. I would just add, another way to demonstrate to 
markets that firms will be allowed to fail is to take the 
living will process seriously, to say, we do not want a firm to 
fail, but we are ready. We as a Nation, we as regulators, and 
the firms themselves have to be ready, as well.
    Chairman Brown. Well said. Last comment, then Senator 
Corker.
    Mr. Johnson. You could simplify these banks massively under 
the living will provision so that you could make it easier for 
them to fail, simple enough to fail as a criteria. I do not 
think we have seen any progress yet on that front either.
    Chairman Brown. Thanks. Senator Corker.
    Senator Corker. I think this has been interesting. Mr. 
Wilmarth, are you saying then that you do not think the Fed 
should open swap lines right now to Europe? I think if Europe 
failed, it would be a little bit of an issue for us. Are you 
saying that is what you would like to see happen?
    Mr. Wilmarth. No. I am not opposed to it. I am just saying 
that as long as these behemoths exist, it is inevitable that 
regulators will feel they have to support them. In other words, 
it is a chicken-and-egg problem.
    Senator Corker. But is it really the behemoths, or is it 
the countries? We in essence have urged all banks to buy 
sovereign debt.
    Mr. Wilmarth. Well, I think you are right. The problem is, 
as financial institutions become very large--and Professor 
Johnson has explained this eloquently--there becomes a 
synergistic relationship between Governments and these major 
banks. And not surprisingly, the Governments support the banks, 
and then they want the banks to buy the sovereign debt. And it 
becomes, I think, an incestuous relationship.
    I thought letting Lehman fail was a terrible mistake. I 
think when you are in the soup, you should not turn up the heat 
and make things worse. But the problem is, can we begin to 
change the system going forward? The United Kingdom, as I 
mentioned in my written testimony, through the report of the 
Independent Commission on Banking, which the Cameron government 
has pledged to enact, they would ring-fence the insured 
depositories from everything else, and they would say, ``We are 
going to make sure there is no cross-subsidization.'' The ICB 
has also indicated that they want to make sure that the market 
will force nonbank capital market subsidiaries to increase 
their capital because investors in those subsidiaries will know 
that they are not going to get protection from deposit 
insurance and other aspects of the safety net.
    We could do that here. I think that is the way going 
forward to actually convince the market. We should protect the 
so-called utility banks, as the English call them. The utility 
banks which take deposits, make loans to households and small- 
and medium-sized enterprises, do traditional fiduciary 
services, we should protect those. But everything else in the 
financial conglomerate should not be protected and investments 
in nonbank affiliates will have to be priced at market.
    And so I think going forward we could change, but we have 
not gone to the extent where the market believes that, in fact, 
we would separate the institutions in that manner.
    Senator Corker. Mr. Johnson.
    Mr. Johnson. Senator, I am opposed to the swap lines. This 
is the euro zone. It is a reserve currency area. They have one 
of the most credible central banks in the world. They are 
basically trying--they are transferring credit risk to the 
Federal Reserve, and they hope to do it to the U.S. taxpayer. 
You will, I think, shortly see stories about ECB loans to the 
IMF that will be turned around and lent back to Europe. The 
IMF's capital--16 percent of it is your capital, the U.S. 
taxpayers' capital--is absolutely on the line here. It is a 
culture of bailouts.
    Now, I agree with you that we have encouraged banks to lend 
to sovereigns, and that is part of the irresponsibility, and 
the Europeans have done that in a----
    Senator Corker. Well, they have to set aside no capital for 
that. I mean, it is totally--
    Mr. Johnson. It is ludicrous, Senator. No argument. But my 
point is they should sort this out for themselves. It is their 
problem. They got themselves into it. We have created a culture 
of bailouts at the level of the major central banks in the 
world in this instance where we are providing them with these 
swap lines so that we can keep it off their balance sheet so 
they will not be accountable to their taxpayers fully for the 
mess they have gotten themselves into. It is crazy. It makes no 
sense. We should not be participating on that basis.
    Senator Corker. Do you agree with that, Chairman?
    Ms. Bair. Actually, I would be more sympathetic to what the 
Fed is doing here. I do think that there is a broader economic 
reason. As demand for dollars has increased, that has a 
potential to hurt our export market. A lot of international 
trade--most of it is done with U.S. dollars. Europe is a huge 
export market, and we want to make sure that there is plenty of 
dollar credit availability in Europe. Also many European banks 
lend to developing countries in dollars that buy our exports.
    So I do think that there is a reason beyond just 
stabilizing the financial sector that can help the real 
economy, and I think that is what drove the Fed's decision. So 
on that I--as much as I abhor bailouts, I do not really view 
that as a bailout move, and I have some sympathy for what the 
Fed did there.
    Senator Corker. So as I listen, it seems to me that, you 
know, when we talk about too big to fail, we are talking about 
several different things. One--and I do not think we have 
answered this in our country--are there institutions that are 
allowed to get too big and too complex that they threaten our 
system? And I do not think that has been dealt with, and nobody 
has come up with the right answer. Do they add more merit than 
negative? And, obviously, there are people here on the panel 
that think yes, some people say no.
    It seems to me, though, when you talk about failing, it 
means lots of things. I really do not have a question that in a 
one-off situation, a bank, no matter how big it is, fails, my 
sense is that the bond holders and certainly the equity know 
they are toast. I mean, I do not think that--is there somebody 
that disagrees with that, that if we have a one-off situation, 
not a systemic failure but a one-off situation, X large bank 
fails, are there people here that believe that Title II would 
not be instituted in a one-off situation?
    Mr. Johnson. Yes, Senator, I believe that if Goldman Sachs 
would have failed, hypothetically, right now this week, the 
Government, the Federal Reserve, the authorities, would do 
whatever it could in this environment, with the economy as it 
is, with elections coming up, all of these people would work 
very hard to make sure that--they would take out management and 
shareholders possibly this time. I agree with that. But----
    Senator Corker. Well, now----
    Mr. Johnson. No, no, but the key question, Senator, is the 
creditors. Do the creditors face losses, the bond holders? As 
you and your----
    Senator Corker. So you are saying that you do not believe 
if the U.S. taxpayers had a loss the clawback position would be 
taken into account? You do not think that would happen?
    Mr. Johnson. I do not believe the creditors of Goldman 
Sachs would lose any money.
    Senator Corker. Chairman?
    Ms. Bair. I absolutely think and know it would be used in a 
one-off situation. There is no doubt in my mind. And, you know, 
I think, you know, when I hear Title II does not work, the 
resolution authority does not work, I hear that from two sides. 
I hear it from Simon, whom I respect deeply, who really wants 
to just break up the banks now, so, you know, let us say 
resolution authority does not work, and really the only 
solution is to break up the banks. Then I hear it from some of 
the weaker institutions who want to continue the assumption of 
Government bailouts so it cannot work. It can work in a one-off 
situation, it absolutely can, and would be used.
    I would also like to echo--and I have been saying this for 
a long time. The living will rule is a tremendous tool to get 
these institutions to restructure themselves, to create more 
operating subsidiaries that would be smaller, that might align 
themselves more with your idea of what the appropriate size of 
a financial institution should be, which would make it much 
easier to resolve them, much less costly, and efficient to 
resolve them. And I do think this is a powerful tool over time 
to--these large institutions can be resolved now in a one-off 
situation, but going forward, it will make it less costly and 
more efficient if we can get them to rationalize their business 
lines with their legal entities and simplify their legal 
structures.
    Senator Corker. Yes, sir?
    Mr. Wilmarth. I would caution that as we have allowed the 
banks to get larger, more complex, more interconnected, you do 
not get one-off problems, because when one of these big guys 
gets in trouble, inevitably either through spillover or 
contagion or because they are all pursuing the same high-risk 
activities, they are all in trouble. When you look at the 
history of the 1970s, the 1980s, the early 1990s, the 2000s, 
banks during those periods did not get into trouble one at a 
time. They got in trouble in groups, and the problem is now 
that the group has gotten smaller in number and bigger in size 
and more interconnected, more opaque, and so my view is that 
inevitably we will not have a problem with just one big 
financial conglomerate. We will have a problem with multiple 
conglomerates. And we will not be able to allow any of them to 
fail in your definition under those circumstances.
    Senator Corker. Well, but I would say then, if you broke 
up, let us say, the largest institutions, you created thirty 
$400 to $500 billion institutions, if you had a systemic 
crisis, you would do exactly the same thing. They would be 
incredibly interconnected, even maybe more so at that size. And 
so are you telling me that if we had a systemic crisis in this 
country and every bank in the country was under $500 billion, 
you are telling me that we would not do exactly the same thing 
you would with four or five large banks? I absolutely believe 
we would do exactly the same thing. Somebody argue against 
that.
    Ms. Bair. I think that if we had a repeat of the 2008 
situation, with the authorities we have now, you would have a 
combination. It is pretty obviously the outliers--the multiple 
doses of bailout assistance, and those that really just needed 
liquidity support. The ones that were insolvent would go into a 
resolution. The ones that were not would get liquidity support 
under 13-3 from the Fed, possibly debt guarantees from the FDIC 
as approved by Congress, and I think you would have a 
combination.
    But you are right, if the system is having wider problems, 
there are going to be some subset of insolvent institutions 
that should go into a bankruptcy-like resolution and the rest 
should get liquidity support until we get out of it.
    Mr. Johnson. Senator, the evidence from banking crises 
around the world is typically--yes, a meteor can strike the 
Earth, I grant you that. But typically it is not the case that 
all of the medium-size financial institutions fail at the same 
time. Their portfolios do differ.
    So I think this hypothetical that if we broke them up they 
would all become exactly the same and fail at exactly the same 
moment is extreme.
    Senator Corker. I am just saying that a systemic crisis, a 
systemic crisis, when you say the big guys all do the same 
size, well, you know, the banks that are all $500 billion are 
going to be doing the same thing, too. You are not going to 
change human behavior. You are not going to change the market.
    And so all I am saying is that--and I am not arguing 
against--by the way, I am still learning on the size issue. I 
do not think we as a country have come to grips with large, 
highly complex, systemic risk organizations. But I am just 
saying that if you have a systemic crisis, like Europe totally 
fails and contagion comes this way, if every bank in our 
country was under $500 billion or were under the construct we 
are in right now, you would still have the same issues to deal 
with, is all I am saying. Do you agree or disagree?
    Mr. Johnson. I agree with that statement, Senator.
    Senator Corker. OK.
    Chairman Brown. Senator Moran.
    Senator Moran. I do not know exactly my question here, but 
to follow up on what Senator Corker is talking about, 
everything that I have read about the discussions about the 
collapse in 2008 suggests to me that the Federal Reserve, 
perhaps the FDIC, the Treasury Department were all worried 
about the confidence of others. And so they all were 
interrelated, even though each bank may have been different. 
And so to separate the financial institutions, if I am right in 
what I have read, the goal being of those who saw that we 
needed to bail out the financial institutions, it was that we 
cannot let this spread so that there is a lack of confidence in 
the system.
    And so you have got to take care of this institution 
because if it goes, there is going to be a run on the next 
institution. Again, I do not know what went on in those 
discussions in those rooms, but at least what I read as being 
reported as to what occurred suggests that a failure of one--it 
is perhaps what the professor was saying, that it does not 
happen in isolation, that you cannot have the--you would not 
have the scenario, the example that you described in which one 
major financial institution failed with no consequence to 
anyone else, if there is this genuine concern about the 
confidence in the system with a failure.
    And so I do not know how you separate--how you get rid of 
the systemic risk when you have so few large players, all of 
which seem to be interrelated, at least in the psyche of those 
who do business with that institution. Professor.
    Mr. Wilmarth. Yes. In thinking about the possibility of 
encouraging banks to slim down and to become less complex, in 
other words, to break up--we should go back to the 1980s and 
1990s when we had a very thriving investment banking industry 
and a commercial banking industry, and they actually tended to 
offset each other. When one was in trouble, the other could 
help. And you saw that in 1987, for example, with the stock 
market crash, and you saw it going the other way during the 
1998 Asian crisis, that each side could offset each other, and 
they were not all in the same things, that the securities firms 
tended to do something different from what commercial banks 
were doing. And so you did not have huge chunks of the system 
all exposed to the same risk.
    Senator Moran. Is that not an argument then against the 
Volcker Rule, which then would spread the risks among two 
separate kinds of banking activities?
    Mr. Wilmarth. No, the idea is that you do not want to have 
all the capital markets risks and all the lending risks 
residing together, which is what we now have. Under the ICB's 
proposal in the U.K., if capital markets mistakes are made, 
they will not automatically take down your so-called utility 
banking.
    Of course, the other thing is if creditors believe that 
there will not be any cross-subsidization from utility banking 
and from the FDIC, the Federal safety net, over to what the 
English call ``casino banking,'' which is wholesale capital 
markets, then investors who put money into the capital markets 
through bonds and whatever are going to price that risk much 
differently than if they think the Government is going to 
cross-subsidize from utility banking into casino banking.
    So, I agree that we are in a bad space right now, and we 
have to decide how we get out of that space so we are in a 
better position next time. I believe that if we move the two 
segments apart into utility and casino with strong firewalls in 
between, first of all, you would not get cross-subsidization. 
Second, I think eventually specialist institutions would begin 
to reemerge. People would conclude that there is no advantage 
to being tied to a bank if I am a capital markets guy; let us 
go back to being the old Goldman Sachs.
    In the 1990s, our pure investment banks were beating the 
pants off everybody in Europe. They were the best at what they 
did.
    Senator Moran. What is the advantage of being tied 
together?
    Mr. Wilmarth. Cross-subsidization, in my view.
    Senator Moran. So we know it happens. That is----
    Mr. Wilmarth. That is my view. It is pure cross-
subsidization, the fact that too big to fail is not just 
covering banks.
    Senator Moran. When you say cross-subsidization, you mean 
the support by the Federal Government, the FDIC----
    Mr. Wilmarth. Yes.
    Senator Moran. The Federal Reserve.
    Mr. Wilmarth. Too big to fail covers this. Until 1999, at 
least you could argue that too big to fail only covered the 
banking system. After 1999, it became clear that it covered all 
segments of the financial markets.
    Senator Moran. I am happy as long as the Chairman allows 
you to----
    Mr. Swagel. I was going to add, I am as puzzled as you are 
by some of that, that it seems like it is an argument not just 
against the Volcker Rule but also against the repeal of--the 
reinstitution of Glass-Steagall since, you know, the activities 
that cross the Glass-Steagall line can balance each other out, 
and that would suggest that it is useful to have them under the 
same roof.
    Just the other thought I had was on your original question 
about confidence and the discussions inside the Treasury. It is 
exactly right that banks exist, financial institutions exist on 
confidence, and imagine if Lehman and/or Bear Stearns has 2 
percentage points more capital, or 4 or 5. It would not have 
mattered. I mean, once markets lost confidence--and that really 
was the point of the TARP, of the CPP, the capital injections, 
and the FDIC's loan guarantees at the same time, was to boost 
confidence in the entire system as a whole.
    Mr. Johnson. Just to add, Senator, the Europeans are on 
their way to nationalizing their banking system. It is a 
complete disaster. These are nationalized universal banks that 
are going to try and do everything--these slimmed down or more 
specialized American investments banks that Professor Wilmarth 
wants to take us back to will absolutely dominate that market. 
Of course they will. It is American capitalism at work. Taking 
away the cross-subsidization is going to help them be tougher 
and win in that global marketplace. The Europeans have no 
chance.
    Chairman Brown. Ms. Bair, last word.
    Ms. Bair. Yes, I just wanted to get back to your earlier 
comment about the arguments used during 2008. I must say, to be 
honest, I think those arguments were overused, and it was 
frustrating to me that we did not have good analysis. I kept 
hearing this, we cannot let one institution go down, everybody 
else is going to go down. I never really got what I considered 
hard analysis to back that up.
    But in a crisis situation, you err on the side of doing 
more as opposed to doing less because if you do not do enough, 
you could have a very big problem on your hand. But one of the 
things I emphasized in my testimony was the credit exposure 
report provision of Dodd-Frank. This is part of the living will 
requirement as well as the heightened prudential supervision 
standards the Fed is supposed to impose on large institutions. 
Under the credit exposure reports, the institutions have to 
identify their major credit exposures. In other words, they 
have to say, ``If I go down, who else is going to go down? Or 
what other institutions are out there if they get in trouble, 
it is going to get me into trouble?'' We did not have that kind 
of information. It is essential--I think that is one of the 
priority items in Dodd-Frank to get that rule out there and get 
that information and limit those exposures as a preventative 
measure.
    Senator Moran. Mr. Chairman, thank you. Let me critique 
your selection of witnesses to your face.
    Chairman Brown. Yes, sir.
    Senator Moran. You could not have made it more difficult by 
finding sides that do not agree at all with each other. I am 
looking for the answer, and I get the arguments.
    Chairman Brown. But they all look good.
    Senator Moran. Agreed.
    Chairman Brown. All right. We are going to do something a 
little unorthodox here. I have to leave. Senator Corker has a 
couple more questions that he is going to ask, so thank you for 
joining us. If the witnesses can stay another 5 or 10 minutes. 
I have got a conference call I have got to do. And I appreciate 
it so much. If there are any questions from the Committee, any 
letters or any questions to submit in writing, if you will give 
up to 5 business days, if you would answer those, and I turn it 
over to Senator Corker.
    Senator Corker [presiding]. Thank you. I appreciate it.
    You know, I think if you went and talked to Goldman today, 
they would tell you they would be more than glad to move back 
to the way things were and only went public because of what 
occurred. I mean, my sense is they would strongly love to see 
us in Washington separate the two as it was pre-1999.
    But let me just ask a question. Pre-1999, there still 
existed prop trading on the banking side, right? I mean, I 
think that is a myth that people have that prop trading did not 
occur in the banking side. Go ahead.
    Mr. Wilmarth. Yes, I have been a big critic for a long time 
of the fact that we allow derivatives in the insured bank. 
Financial derivatives are synthetic securities.
    Senator Corker. But they were there, prerepeal of Glass-
Steagall.
    Mr. Wilmarth. Yes, and I think that was one of the big 
things that broke down Glass-Steagall. I think the Fed and the 
OCC were quite intentional in allowing the spreading and 
proliferation of derivatives as synthetic securities and 
synthetic insurance to break down both the Glass-Steagall Act 
and the Bank Holding Company Act barriers between insurance, 
securities, and banking.
    My proposal is that if you adopt my narrow bank utility/
casino approach, derivatives do not belong on the utility side 
of banking. They belong on the casino side because they are a 
capital markets activity.
    Senator Corker. So you would actually propose something 
more stringent than where we were in 1998.
    Mr. Wilmarth. Yes, certainly in the sense that if you want 
to do both--if you want to be a financial conglomerate doing 
both traditional banking and wholesale banking, yes, I am being 
tougher in the derivatives area than the Fed and the OCC were 
in the 1990s. But I think, frankly, since derivatives have 
ended up being in the midst of every one of these big crises 
going back to the 1980s, somewhere you find a derivatives 
connection, it seems to me it is about time we took that step.
    Senator Corker. So you used the words ``straight banking'' 
and ``casino.'' I assume the casino piece is a pejorative term.
    Mr. Wilmarth. That is what the English call it. ``Wholesale 
banking'' is a more neutral term. Thank you.
    Senator Corker. Which is more risky? I mean, it is a 
serious question. It seems to me the lending piece is a more 
risky side of the equation, is it not?
    Mr. Wilmarth. We have certainly seen that if you do not 
supervise lending well, you will come to regret it. And 
certainly part of the story of the last crisis, as well as the 
previous ones, is a failure to supervise lending by regulators. 
But I think the key point that made everything worse is that we 
have allowed our desire to protect the traditional banking 
function to cross-subsidize the capital markets. And so the 
capital markets no longer price bonds of financial institutions 
in the way that they would if it was truly a market and risk 
was priced without a Government subsidy. The pricing has been 
distorted because if you are dealing with the largest 
institutions, bond holders will not price that risk the way 
they would if you were dealing with a pure Goldman Sachs 
without any banking connection, just a pure wholesale merchant 
bank, as Professor Johnson has explained.
    Senator Corker. Go ahead, sir.
    Mr. Johnson. Senator, I think you asked the right question: 
Which is more risky? We have seen cycles where it goes either 
way, absolutely. But, remember, part of the argument for the 
development of these megaconglomerates was this would diversify 
risk. We have not seen that. In fact, they have actually 
concentrated risk. And I think Professor Wilmarth has a very 
important point when he says you want to have different 
players, a more decentralized system actually, to go back to 
one of the points Mr. Swagel made at the beginning, a more 
decentralized system with more different people. You cannot 
just have one group or one person or one small set of 
executives make these big mistakes, if they are mistakes, that 
bring down the system or threaten to bring down the system or 
put a credible threat on Sheila Bair's desk. That is what you 
want to avoid.
    And in terms of the value of these conglomerates to 
society, what have they brought to the table? I know of no 
study, none, that shows economies of scale or scope in banking 
above $100 billion in total assets. And we are talking about 
$1, $2, $3 trillion banks. So we have gone way beyond where the 
economies of scale and scope are. And it would be great--
perhaps that you should bring Goldman Sachs down here to 
testify under oath that they would be delighted to go back to a 
broken-up smaller bank system. That would be incredibly 
helpful.
    Senator Corker. I am, by the way, surmising. I am not 
speaking on their behalf.
    Mr. Johnson. I understand. But that would be a very helpful 
statement if they would like to go on the record.
    Senator Corker. Let me ask a question. On the issue of 
Volcker--I know that is not the subject of this, but I know 
Sheila brought it up in her testimony. It does appear to me 
that Volcker as written is not written in a way that really 
deals with the issue in an appropriate manner. Is that agreed 
by all four panelists?
    Ms. Bair. Yes, I do, I think it is somewhat at cross 
purposes. I really do. I think there are two different issues. 
There are safety and soundness issues. Obviously, you do not 
want any kind of high-risk activity, whether it is lending or 
anything else. But there is a separate question of what 
Government wants--what is the appropriate use of insured 
deposits? I think we would all agree that if the FDIC got a 
deposit insurance application of somebody wanting to bring in 
broker deposits to take speculative bets on Greek debt, we 
would not view that as an appropriate business plan for insured 
depository institutions.
    There has been a long-standing understanding that pure prop 
trading or speculative trading is not an appropriate use of 
deposits, and I think over time it has become harder and harder 
to know where the line is, and the fact that Volcker goes--to 
not only to the insured bank but to the affiliates of insured 
banks, which can be securities firms when we got rid of Glass-
Steagall, I think that is extremely hard. But there are really 
two separate issues. One is safety and soundness. We have got 
that covered. The other is: What is the appropriate use of 
insured deposits? And I am not sure there is clarity on that 
point in the framework now.
    Mr. Johnson. Senator, I worked with proprietary trading in 
a major global investment bank in 1997 and 1998, and I would 
strongly urge you not to have those activities in an important 
part of the financial system. It was pure speculation, and they 
lost a lot of money. ``Other people's money'' was their 
attitude. I think that is----
    Senator Corker. But do you think Volcker as written 
addresses that issue?
    Mr. Johnson. I think the act is fine. I think what we are 
seeing coming from the regulators is not going to do as much 
good at all, unfortunately. That is my read of the process.
    Senator Corker. Yes, I sure would love your written 
comments about a better way for the regulators to deal with the 
text.
    Mr. Johnson. I would be happy to provide those.
    Senator Corker. Yes sir?
    Mr. Swagel. I just think that the Volcker Rule is meant to 
solve a problem that did not really matter in the crisis and 
does not clearly exist and would be very difficult to solve 
even if it did exist because it is so difficult to tell what is 
prop trading from what is normal market making. And I think the 
hundreds of pages from the regulators, they are doing their 
best, but in some sense that reflects it.
    Senator Corker. You think that is one of the reasons 
treasurys were excluded?
    Mr. Swagel. Exactly. I mean, in some sense, the U.S. 
Government is in the business of selling Treasury securities 
and it would be kind of awkward to exclude a big demander, a 
big buyer of Treasuries.
    Senator Corker. Yes, sir?
    Mr. Wilmarth. It seems to me that the ring-fencing approach 
advocated by the Independent Commission on Banking, like the 
narrow banking approach I have talked about, attacks the issue 
from the other way around, which is exactly the issue that 
Chairman Bair has identified. We should define the activities 
that we think are so important to the unique functions of banks 
that they deserve Federal safety net protection. We should put 
those activities within the ring-fenced, insulated bank. And 
then, I do not think repeal of Glass-Steagall would be 
necessary because if you did what the Independent Commission on 
Banking has proposed, or my narrow bank approach has proposed, 
the market will determine whether, in fact, it makes sense to 
keep these two different functions together. If the market does 
not believe that financial conglomerates provide attractive 
returns to investors without Government subsidies, 
conglomerates will break up voluntarily. It is essential that 
you put all the capital markets activities, including market 
making, including underwriting, including prop trading, 
including derivatives, in the wholesale bank, which cannot be 
subsidized by the Federal safety net. You have to make people 
believe that investors will bear the risks of those activities 
and the market will price those risks. I am not saying it is 
simple. But it is much more conceptually straightforward to 
view it that way. And since the U.K. is moving in that 
direction, and London and New York are the two leading 
financial markets, why shouldn't we join in? If the two markets 
that dominate the world adopted that approach, Europe might 
also do so because it has to figure out a new way forward. I 
think we have a chance to convince people that there is a 
better way to attack these issues and begin to restrain the 
safety net instead of wrapping the entire financial markets 
with the too-big-to-fail guarantee.
    Senator Corker. So that Chairman Brown allows me to do this 
again when he has to make a conference call, I just want to ask 
one more question. It seems to me that the risk-weighted nature 
of the way we look at assets that we are--that Governments put 
in place through regulators, that has driven us to where we 
are. And I am wondering how you all would feel about just doing 
away with risk weighting period where we do not drive people to 
sovereigns saying they are risk free, we do not drive people to 
mortgage-backed securities where it is 50-percent risk 
weighted. What would be your response to that? And, Sheila, you 
are giving me no body language, so answer the question.
    [Laughter.]
    Ms. Bair. OK. Well, I am a big fan of leverage ratio. I 
would like to see--it is 5 percent here. I would love to see it 
higher, and I would certainly love the international leverage 
ratio to be higher, which it is not being implemented in 
Europe, and there is no sign that it will be anytime soon.
    I think leverage ratios can be gamed, too. I think you need 
both. But absolute constraints on leverage should be your 
starting point, and then any capital additive to that should be 
based on if there is excessive risk on the bank's balance sheet 
or riskier assets on the bank's balance sheet.
    If you do not have some type of risk measure for capital as 
well with the leverage ratio, you will provide incentives for 
them to use the highest-risk, highest-yielding assets. So you 
need a combination. But the constraint on absolute leverage 
should be the starting point and risk-based should be above 
that.
    Mr. Johnson. I agree with you completely, Senator, on this 
point. I think we should have a 30-percent capital requirement 
where capital is not relative to risk-weighted assets. And I 
hear laughter around me, but----
    Senator Corker. It sounds like a railroad.
    Mr. Johnson. If you go back historically, the history of 
U.S. banking, before we had Federal guarantees of any kind, 
before the creation of the Federal Reserve, these are the kinds 
of capital levels that we used to have across the country in 
small banks and in big banks. This is what commodity trading 
firms with a lot of risk and no Government guarantee have in 
terms of capital. It is just equity funding. We are asking them 
to be more funded with equity, less funded with debt. We have 
become a very debt-centric society, Senator, and I think we 
should back away from that.
    Senator Corker. We give tax benefits to debt and penalize 
equity, no question.
    Yes, sir?
    Mr. Swagel. I would just note that in the pre-FDIC era, it 
is true banks had a lot more capital. They had signs in the 
windows saying here is how much surplus capital we have. And we 
still had banking panics and banking crises, and really that is 
why the FDIC was created, to prevent that. You know, I think 
the crisis showed us we need more capital, and we definitely do 
not want to follow the Europeans in there and sort of march--
the race to the bottom in less capital.
    What the right number is, that is the key question. And my 
point is that there is an effect on activity. Going from where 
we are now to 30 percent or 50 or whatever it is, that would 
have an effect, and it is really the tradeoff between safety 
and economic vitality.
    Mr. Wilmarth. I think your instinct is absolutely right. I 
think the risk weightings have done much more mischief than 
good. It seems to me that a very strong leverage ratio focused 
on equity capital as opposed to all these hybrid instruments 
that do not stand up under stress is the most important thing.
    The second most important thing is to adopt a very good 
approach that would prevent excessive credit exposures or 
excessive credit concentrations or asset concentrations. That 
is harder to legislate across the board, but if supervisors 
were given strong tools to work with in controlling credit 
concentrations, asset concentrations, and they were able to 
enforce those against specific banks, then, if you trust your 
regulators and give them enough power, they should be able to 
see that particular banks are too much focused on one asset 
class or one type of credit exposure. But it is hard to 
legislate a mathematical formula and say that all sovereigns 
are risk free or all mortgages are only 50-percent risk 
weighted. We have seen what those types of formulas did.
    It seems to me the whole Basel II methodology needs to be 
taken back down to the foundation, and we need to think again 
about how we assess the risks of individual institutions.
    Senator Corker. Well, listen, you all have been great 
witnesses. I thank you for your time. I thank the majority 
Committee for being sports and letting me do this, and the 
meeting is adjourned. Thank you.
    [Whereupon, at 3:48 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

                  PREPARED STATEMENT OF SHEILA C. BAIR
                 Senior Advisor, Pew Charitable Trusts
                            December 7, 2011

    Chairman Brown, Ranking Member Corker, and distinguished Members of 
this Subcommittee: It is my pleasure to address you today at this 
hearing entitled ``A New Regime for Regulating Large, Complex Financial 
Institutions''.
    There is no single issue more important to the stability of our 
financial system than the regulatory regime applicable to large 
financial institutions. I would hope that by now there is general 
recognition of the role certain large, mismanaged institutions played 
in the lead-up to the financial crisis, and the subsequent need for 
massive, governmental assistance to contain the damage caused by their 
behavior. The disproportionate failure rate of large, so-called 
systemic entities stands in stark contrast to the relative stability of 
smaller, community banks of which less than 5 percent have failed. As 
our economy continues to reel from the financial crisis, with high 
unemployment and millions losing their homes, we cannot afford a repeat 
of the regulatory and market failures which allowed this debacle to 
occur.
    There is nothing inherently wrong with size in and of itself. In 
many business areas, large institutions can achieve significant 
economies and public benefits. However, size should be driven by market 
forces, not implied Government subsidies. Capital allocation should be 
determined by investors pursuing sound, innovative business models 
which promise sustainable returns based on acceptable risk tolerances. 
It should not be based on highly leveraged bets which promise 
privatization of benefits but socialization of losses if those bets 
fail. With the implied Government support provided to Fannie Mae, 
Freddie Mac, and so-called too-big-to-fail financial institutions, the 
smart money fed the beasts and the smart money proved to be right. As 
failures mounted, the Government blinked and opened up its check book. 
Creditors and trading partners were made whole. Many executives and 
board members survived. In most cases, the Government didn't even wipe 
out shareholders before taking exposure.
    Implied Government subsidies of large financial institutions not 
only produce an unstable financial system, but they also skew 
allocation of capital away from other, more stable business sectors. As 
the charts in the appendix to my testimony show, beginning in the mid-
1990s, the assets of financial firms grew much more rapidly than ``real 
economy'' assets, with financial firm assets peaking in 2007. Most of 
this growth was concentrated in the 30 largest institutions. From 2000 
to 2008, leverage increased dramatically among large U.S. investment 
banks and large European and U.K. institutions. Fortunately, for U.S. 
commercial banks, leverage remained flat--primarily because the FDIC 
successfully blocked implementation of the Basel II advanced approaches 
for setting bank capital. These trends in growth and leverage were not 
accompanied by increases in traditional lending to support the 
nonfinancial sector. Rather, portfolio lending fell significantly as 
many large financial institutions found trading assets to be much 
easier and more profitable than going through the hard work of 
developing and applying sound underwriting standards for loans these 
large financial institutions planned to keep on their books. Regulators 
for the most part did not try to constrain these trends, but left the 
market largely to regulate itself. In some cases, for instance with the 
repeal of Glass-Steagall and passage of the Commodity Futures 
Modernization Act, Congress explicitly told the regulators ``hands 
off.'' As free markets became free-for-all markets, compensation rose, 
skyrocketing past wages paid to equally skilled employees in other 
fields. This enticed many of our best and brightest to forego careers 
in areas like engineering and technology to heed the siren song of 
quick, easy money from an overheated, over-leveraged financial 
industry.
    In recognition of the harmful effects of too big to fail policies, 
a central feature of the Dodd-Frank statute is the creation of a 
resolution framework which going forward will impose losses and 
accountability on shareholders, creditors, boards, and executives when 
mismanaged institutions fail. Under Title II of Dodd-Frank, the 
Government can now resolve systemic bank holding companies and nonbank 
entities using the same time tested tools the FDIC has used to resolve 
failing banks for decades. Such tools were not available during the 
2008 crisis. I am very proud of the fact that the FDIC has already put 
into place regulations spelling out the process that will be used under 
Title II to resolve large financial institutions, including making 
clear the bankruptcy-like claims priority schedule that will impose 
losses on shareholders and creditors, not on taxpayers. We cannot end 
too big to fail unless we can convince the market that shareholders and 
creditors will take losses if the institution in which they have 
invested fails. For this reason, when I chaired the FDIC, we made the 
claims priority rules a first order of business after Dodd-Frank was 
enacted, and I am very pleased that the ratings agencies have begun to 
remove the ``bump up'' they assign to the credit ratings of large 
financial entities based on their previous assumption of Government 
support.
    Another central feature of ending too big to fail is the Dodd-Frank 
requirement that large bank holding companies and nonbank systemic 
entities submit to both the Federal Reserve Board and the FDIC their 
resolution plans demonstrating how those financial firms could be 
resolved in a bankruptcy proceeding during a crisis without systemic 
disruptions. Rules implementing this so-called ``living will'' 
requirement were recently finalized by the FDIC and the FRB, with the 
first round of living will submissions required of the largest 
institutions next summer. The Dodd-Frank standard of resolvability in 
bankruptcy is a very tough one, and my sense is that all of the major 
banks will need to make significant structural changes to achieve it. 
In particular, they will need to do much more to rationalize their 
business lines with their legal entities, which will make it much 
easier for the FDIC--or a bankruptcy court--to hive off and sell 
healthy operations, while maintaining troubled operations in a ``bad 
bank'' which can be worked off over time. Aligning business lines with 
legal entities will also have important safety and soundness benefits. 
In particular, it will make it easier for distressed banks to sell 
operations to either raise capital or wind themselves down absent 
Government intervention. Finally, rationalizing and simplifying legal 
structures will improve the ability of boards and management to 
understand and monitor activities in these large banks' far-flung 
operations. In this regard, I hope regulators will also give some 
consideration to requiring strong intermediate boards and managers to 
oversee major subsidiaries. Many of these centralized boards and 
management do not have a comprehensive understanding of what is going 
on inside their organizations. This was painfully apparent during the 
crisis.
    One element of Dodd-Frank's living will provision that has not yet 
been implemented by the agencies is the requirement for credit exposure 
reports. Credit exposure reports are also required as part of Dodd-
Frank's mandate to the Federal Reserve Board to impose heightened 
prudential standards on large bank holding companies and other systemic 
entities. Credit exposure reports are essential to make sure regulators 
understand crucial interrelationships between distress at one 
institution and its potential to cause major losses at other 
institutions. This type of information was missing during the crisis. I 
know that many Members of this Subcommittee heard the same arguments 
that I heard during the crisis--that bailouts were necessary or the 
``entire system'' would come down. But we never really had good, 
detailed information about the derivatives counterparties, bondholders, 
and others who we were ultimately benefiting from the bailouts and why 
they needed protecting. For those concerned about the potential 
``domino'' effect of a large bank failure, it is essential not only to 
identify, understand, and monitor these exposures but also to limit 
them in advance to contain any possible contagion. I would urge the 
FDIC and FRB to complete this final piece of the living will rule as 
soon as possible.
    Resolution authority and planning are important to make sure the 
Government is prepared and has the right legal tools to handle a large 
institution when it fails. And make no doubt; there will always be 
failures, though hopefully they will be rare. No amount of prudential 
regulation will be able to eliminate the risk of failures. As I have 
discussed, resolution authority and planning also entail prophylactic 
benefits by improving regulatory and management understanding of these 
large institutions and by giving the investor community stronger 
incentives to conduct stringent due diligence before committing their 
investment dollars. A final prophylactic benefit emanates from the 
harshness of the resolution process, and it is a harsh process, 
particularly for boards and management who not only lose their jobs but 
are subject to a 2-year clawback of all of their compensation. This 
will give them strong incentives to avoid Title II resolution by 
raising capital or selling their operations, even if the terms seem 
unfavorable. More than one commentator has observed that Lehman 
Brothers' management had multiple opportunities to sell the firm, 
albeit at punitive pricing, but refused to do so because they thought--
unrealistically--that their firm was worth more and that. also, the 
Government would come in and provide assistance, as it had with the 
much smaller Bear Sterns. With Title II, large financial firms now know 
their fate if they fail, and it is not a pretty one. Bailouts are 
prohibited and there will be no exceptions. If they can't right their 
own ship, they will sink with it.
    As important as resolution authority is, it obviously cannot 
substitute for high quality prudential supervision. We must do all that 
we can to prevent failures while at the same time recognizing that a 
healthy financial services sector needs reasonable latitude to innovate 
and take risks. Recognizing that there will always be some measure of 
risk taking in any profit-making endeavor, it is essential that we make 
sure our financial institutions have thick enough cushions of capital 
to absorb unexpected losses when they occur. Excessive leverage was a 
key driver of the 2008 crisis as it has been for virtually every 
financial crisis in history. The perils of too much borrowing in 
creating asset bubbles, and the massive credit contractions that occur 
once the bubbles pop, have been learned and then forgotten throughout 
every major financial cycle. These perils were forgotten again in the 
early 2000s during the so-called golden age of banking when instead of 
acting to raise capital requirements and implement strong mortgage 
lending standards, regulators stood by and effectively lowered capital 
minimums among U.S. investment banks and European institutions through 
implementation of Basel II.
    We need to correct those mistakes through timely implementation of 
Basel III and the so-called ``SIFI surcharges'' which taken together, 
strengthen the definition of high quality capital and also impose risk 
based ratios as high as 9.5 percent on our largest institutions. In the 
near term, given the obvious flaws in the way banks risk-weight assets 
under Basel II, regulators' primary focus should be on constraining 
absolute leverage through an international leverage ratio that is 
significantly higher than the Basel Committee's proposed 3 percent 
standard. We must also not backtrack on agreements to maintain 
stringent standards for true tangible common equity. Both Basel III as 
well as the Collins amendment in Dodd-Frank phase-out the use of hybrid 
debt instruments for Tier 1 capital because these instruments proved to 
have no real loss absorbing capacity during the crisis. Fortunately, in 
the U.S. at least, there seems to be emerging consensus that 
convertible debt instruments should also not count as Tier 1 capital. I 
deeply fear that so-called ``cocos,'' if ever triggered, would likely 
cause a run on the issuing bank instead of stabilizing it.
    Many industry advocates continue to argue that higher capital 
requirements will inhibit lending. It is true that equity capital is 
marginally more expensive than debt. This is due, in part, to the ``too 
big to fail'' doctrine as well as the favored tax treatment of debt 
over equity. But this is not a reason to allow them to keep leveraging 
up. It is fallacy to think that thinly capitalized institutions will do 
a better job of lending. Throughout the crisis, better capitalized 
community banks maintained stronger loan balances than their large bank 
competitors. A large financial institution nearing insolvency will 
quickly pull credit lines and cease lending to maintain capital. This 
is why we had such a severe recession. On the other hand, a well 
capitalized bank will keep functioning even when the inevitable 
business cycle turns downward. There may be some small, incremental 
increase in the cost of credit from higher capital levels in good 
times, but the benefit of stability in bad times more than outweighs 
those costs.
    If there is any question as to why we need strongly capitalized 
banks, one need look no further than Europe where lax capital 
regulation has resulted in a highly leveraged banking system that is 
poorly positioned to absorb losses associated with its sovereign debt 
crisis. I know some American bank CEOs have complained about the higher 
capital standards we have in the U.S.--and they are right--in part. 
Capital regulation is much tougher here and I hope it's going to get 
even tougher. But do we want the European banking system? That system 
is now so fragile it is doubtful that even the strongest banks could 
raise significant new capital from nongovernment sources. The choices 
in Europe are not pretty. They can let a good portion of their banking 
system fail or they can commit to massive financial assistance through 
a combination of ECB bond buying and loans and guarantees from the IMF 
and stronger Eurozone countries. Frankly, I don't know which is worse.
    Liquidity is another area which needs more attention from 
regulators, both in the U.S. and internationally. In the years leading 
up to the crisis, financial institutions became more and more reliant 
on cheap, short-term credit, which they would use to fund longer term, 
illiquid mortgage-related assets. Much of this credit was provided by 
money market mutual funds. As the market began to lose confidence in 
the values of those assets, creditors refused to keep extending credit 
which caused widespread funding shortages. Money market mutual funds in 
particular took flight at the first sign of trouble to keep from 
``breaking the buck.''
    Though financial institutions have made significant progress in 
extending the average maturities of their liabilities, this has been 
driven in part by market conditions. We need to put strong rules in 
place on the liability side of the balance sheet to prevent a 
recurrence of the liquidity failures of 2008. For instance, we need to 
dramatically toughen the types of collateral than can be used to secure 
repos and other short term loans. We should also think about caps on 
the amount of short term debt that financial institutions can use to 
fund their balance sheets, as well as the establishment of minimum 
requirements for the issuance of long term debt. And finally, money 
market mutual funds should be required to use a floating NAV which 
should substantially reduce this highly volatile source of short term 
funding.
    A final preventative measure I would like to discuss is the Volcker 
Rule. The basic construct of the Volcker Rule is one that I strongly 
support. FDIC insured banks and their affiliates should make money by 
providing credit intermediation and related services to their 
customers, not by speculating on market movements with the firm's 
funds. However, to some extent this basic construct is at odds with 
Congress' 1999 repeal of Glass-Steagall, which allowed insured banks to 
affiliate with securities firms, and--let's be honest--making money off 
of market movements is one of the things that securities firms have 
long done. Recognizing these competing policy priorities, Congress 
recognized exceptions from the Volcker Rule for traditional securities 
activities such as market making and investment banking. But the line 
between these exceptions and prohibited proprietary trading is unclear.
    I fear that the recently proposed regulation to implement the 
Volcker Rule is extraordinarily complex and tries too hard to slice and 
dice these exceptions in a way that could arguably permit high risk 
proprietary trading in an insured bank while restricting legitimate 
market making activities in securities affiliates. I believe that the 
regulators should think hard about starting over again with a simple 
rule based on the underlying economics of the transaction, not on its 
label or accounting treatment. If it makes money from the customer 
paying fees, interest, and commissions, it passes. If its profitability 
or loss is based on market movements, it fails. And the inevitable gray 
areas associated with market making and investment banking should be 
forced outside of the insured bank and supported by higher capital 
given the greater risk profile of those activities.
    In addition, the new rules should require executives and boards to 
be personally accountable for monitoring and compliance. Bank 
leadership needs to make it clear to employees that they are supposed 
to make money by providing good customer service, not by speculating 
with the firm's funds.
    Complex rules are easy to game and difficult to enforce. We have 
too much complexity in the financial system already. If regulators 
can't make this work, then maybe we should return to Glass-Steagall in 
all of its 32 page simplicity.
    Much work remains to be done to rein in the types of activities 
undertaken by large financial institutions that caused our 2008 
financial crisis. However, through robust implementation of a credible 
resolution mechanism, strong capital and liquidity requirements, and 
curbs on proprietary trading, we can once again make our financial 
system the envy of the world and an engine of growth for the real 
economy.
    That concludes my testimony. Thank you again for the opportunity of 
testifying.







                  PREPARED STATEMENT OF SIMON JOHNSON
  Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan School of 
                               Management
                            December 7, 2011
Main Points
  1.  Recent adjustments to our regulatory framework, including the 
        ``Dodd-Frank Wall Street Reform and Consumer Protection Act'', 
        have not fixed the core problems that brought us to the brink 
        of complete catastrophe in fall 2008: \1\
---------------------------------------------------------------------------
     \1\ Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT 
Sloan School of Management; Senior Fellow, Peterson Institute for 
International Economics; and cofounder of http://BaselineScenario.com. 
This testimony draws on joint work with James Kwak, particularly 13 
Bankers: The Wall Street Takeover and The Next Financial Meltdown, and 
Peter Boone, including Europe on the Brink. Please access an electronic 
version of this document, e.g., at http://BaselineScenario.com, where 
we also provide daily updates and detailed policy assessments. For 
additional affiliations and disclosures, please see: http://
baselinescenario.com/about/.

      Powerful people at the heart of our financial system 
        still have the incentive and ability to take on large amounts 
        of reckless risk--through borrowing large amounts relative to 
        their equity. When things go well, a few CEOs and a small 
        number of others get huge upside--estimated at over $2 billion 
---------------------------------------------------------------------------
        from 2000 to 2008 at the top 14 U.S. financial institutions.

      When things go badly, society, ordinary citizens, and 
        taxpayers get the downside, including more than 8 million jobs 
        lost and a medium-term increase in debt-to-GDP of at least $7 
        trillion (roughly 50 percent of GDP).

  2.  This is a classic recipe for financial instability and fiscal 
        calamity.

  3.  Our six largest bank holding companies currently have assets 
        valued at close to $9.5 trillion, which is around 62.5 percent 
        of GDP (using the latest available data, from end of Q3, 2011). 
        The same companies had balance sheets worth around 55 percent 
        of GDP before the crisis (e.g., 2006) and no more than 17 
        percent of GDP in 1995.

  4.  With assets ranging from around $800 billion to nearly $2.5 
        trillion (under U.S. GAAP), these bank holding companies are 
        perceived by the market as ``too big to fail,'' meaning that 
        they are implicitly backed by the full faith and credit of the 
        U.S. Government. They can borrow more cheaply than their 
        competitors--estimates place this advantage between 25 and 75 
        basis points--and hence become larger.

  5.  In public statements, top executives in these very large banks 
        discuss their plans for further global expansion--presumably 
        increasing their assets further while continuing to be highly 
        leveraged. In its public statements, the U.S. Treasury appears 
        to endorse this strategy.

  6.  In this context, the Troubled Asset Relief Program (TARP) played 
        a significant role preventing the deep recession of 2008-09 
        from becoming a full-blown Great Depression, primarily by 
        providing capital to financial institutions that were close to 
        insolvency or otherwise under market pressure. But these 
        actions further distorted incentives at the heart of Wall 
        Street. Neil Barofsky, the Special Inspector General for the 
        Troubled Assets Relief Program put it well in his January 2011 
        quarterly report, emphasizing: ``perhaps TARP's most 
        significant legacy, the moral hazard and potentially disastrous 
        consequences associated with the continued existence of 
        financial institutions that are `too big to fail.' ''

  7.  To see just the fiscal impact of the finance-induced recession, 
        consider changes in the CBO's baseline projections over time. 
        In January 2008, the CBO projected that total Government debt 
        in private hands--the best measure of what the Government 
        owes--would fall to $5.1 trillion by 2018 (23 percent of GDP). 
        As of January 2010, the CBO projected that over the next 8 
        years, debt would rise to $13.7 trillion (over 65 percent of 
        GDP)--a difference of $8.6 trillion.

  8.  Most of this fiscal damage is not due to the Troubled Assets 
        Relief Program--and definitely not due to the part of that 
        program which injected capital into failing banks. Of the 
        change in CBO baseline, 57 percent is due to decreased tax 
        revenues resulting from the financial crisis and recession; 17 
        percent is due to increases in discretionary spending, some of 
        it the stimulus package necessitated by the financial crisis 
        (and because the ``automatic stabilizers'' in the United States 
        are relatively weak); and another 14 percent is due to 
        increased interest payments on the debt--because we now have 
        more debt. \2\
---------------------------------------------------------------------------
     \2\ See also, the May 2010 edition of the IMF's cross-country 
fiscal monitor for comparable data from other industrialized countries, 
http://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf. The box on debt 
dynamics shows that mostly these are due to the recession; fiscal 
stimulus only accounts for \1/10\ of the increase in debt in advanced 
G20 countries. Table 4 in that report compares support by the 
Government for the financial sector across leading countries; the U.S. 
provided more capital injection (as a percent of GDP) but lower 
guarantees relative to Europe.

  9.  In effect, a financial system with dangerously low capital 
        levels--hence prone to major collapses--creates a 
        nontransparent contingent liability for the Federal budget in 
        the United States. It also damages the nonfinancial sector both 
        directly--when there is a credit crunch, followed by a deep 
        recession--and indirectly through creating a future tax 
---------------------------------------------------------------------------
        liability.

  10.  In principle, Section 165 of Dodd-Frank strengthens prudential 
        standards for large, interconnected financial institutions--
        including ``nonbanks.'' In practice, all the available evidence 
        suggests that big banks and other financial institutions are 
        still seen as Too Big To Fail. This is not a market; it is a 
        large-scale, nontransparent, and unfair Government subsidy 
        scheme. It is also very dangerous.

  11.  There is nothing in the Basel III accord on capital requirements 
        that should be considered encouraging. Independent analysts 
        have established beyond a reasonable doubt that substantially 
        raising capital requirements would not be costly from a social 
        point of view (e.g., see the work of Anat Admati of Stanford 
        University and her colleagues).

  12.  But the financial sector's view has prevailed--they argue that 
        raising capital requirements will slow economic growth. This 
        argument is supported by some misleading so-called ``research'' 
        provided by the Institute for International Finance (a lobby 
        group). The publicly available analytical work of the official 
        sector on this issue (from the Bank for International 
        Settlements and the New York Fed) is not convincing--if this is 
        the basis for policymaking decisions, there is serious trouble 
        ahead.

  13.  Even more disappointing is the failure of the official sector to 
        engage with its expert critics on the issue of capital 
        requirements. This certainly conveys the impression that the 
        regulatory capture of the past 30 years (as documented, for 
        example, in 13 Bankers) continues today--and may even have 
        become more entrenched.

  14.  There is an insularity and arrogance to policy makers around 
        capital requirements that is distinctly reminiscent of the 
        Treasury-Fed-Wall Street consensus regarding derivatives in the 
        late 1990s--i.e., officials are so convinced by the arguments 
        of big banks that they dismiss out of hand any attempt to even 
        open a serious debate.

  15.  The purpose of the Volcker Rule (section 619 of Dodd-Frank, but 
        also sections 620 and 621) is to restrict activities by large 
        banks that have implicit Government support. The legislative 
        intent is to create an eminently sensible failsafe mechanism--
        to prevent speculative ``proprietary trading'' by banks that 
        have implicit Government support.

  16.  Unfortunately, the draft Volcker Rule-related regulations give 
        undue primacy to preserving market structure ``as is.'' In 
        particular, the Federal Reserve seems inclined to keep 
        universal banks engaged in securities trading, regardless of 
        the consequences for systemic risk. There are too many 
        regulator created loopholes and exemptions. Systemically 
        important nonbank financial companies should be included within 
        the scope of the Rule. There should be better communication of 
        what is and what is not proprietary trading--to ensure 
        consistency across firms and integration with their reporting 
        systems. There needs to be guidance on what constitutes 
        significant loss and substantial risk. We also have no clear 
        picture regarding how compliance would be enforced.

  17.  In any case, the Volcker Rule is a complement not a substitute 
        for any other reasonable measures taken to reduce the dangers 
        inherent in large-scale financial institutions.

  18.  Section 622 of Dodd-Frank, ``Concentration Limits on Large 
        Financial Firms'' also held considerable promise--aiming to 
        ensure that no one firm be able to ``merge and consolidate'' in 
        such a way as to raise its share of ``aggregate consolidated 
        liabilities of all financial companies'' above 10 percent. 
        Unfortunately, there appears to be little or no willingness on 
        the part of regulators for turning this in real rules that can 
        be enforced. Big is still beautiful, it appears, in the eyes of 
        key members of the Financial Stability Oversight Council.

  19.  Next time, when our largest banks get into trouble, they may be 
        beyond Too Big To Fail. As seen recently in Ireland and as may 
        now happen in other parts of Europe, banks that are very big 
        relative to an economy can become ``too big to save''--meaning 
        that while senior creditors may still receive full protection 
        (so far in the Irish case), the fiscal costs overwhelm the 
        Government and push it to the brink of default (or beyond).

  20.  The fiscal damage to the United States in that scenario would be 
        immense, including through the effect of much higher long term 
        real interest rates. It remains to be seen if the dollar could 
        continue to be the world's major reserve currency under such 
        circumstances. The loss to our prestige, national security, and 
        ability to influence the world in any positive way would 
        presumably be commensurate.

  21.  In 2007-08, our largest banks--with the structures they had 
        lobbied for and built--brought us to the verge of disaster. 
        TARP and other Government actions helped avert the worst 
        possible outcome, but only by providing unlimited and 
        unconditional implicit guarantees to the core of our financial 
        system. At best, this can only lead to further instability in 
        what the Bank of England refers to as a ``doom loop.'' At 
        worst, we are heading for fiscal disaster and the loss of 
        reserve currency status.

  22.  During the Dodd-Frank legislative debate, there was an 
        opportunity to cap the size of our largest banks and limit 
        their leverage, relative to the size of the economy. 
        Unfortunately, the Brown-Kaufman Amendment to that effect was 
        defeated on the floor of the Senate, 33-61, in part because it 
        was opposed by the U.S. Treasury. \3\
---------------------------------------------------------------------------
     \3\ See, http://baselinescenario.com/2010/05/26/wall-street-ceos-
are-nuts/, which contains this quote from an interview in New York 
Magazine: `` `If enacted, Brown-Kaufman would have broken up the six 
biggest banks in America,' says the senior Treasury official. `If we'd 
been for it, it probably would have happened. But we weren't, so it 
didn't.' ''
---------------------------------------------------------------------------
Resolution Under Dodd-Frank
    The U.S. economic system has evolved relatively efficient ways of 
handling the insolvency of nonfinancial firms and small- or medium-
sized financial institutions. It does not yet have a similarly 
effective way to deal with the insolvency of large financial 
institutions. The dire implications of this gap in our system have 
become much clearer since fall 2008 and there is no immediate prospect 
that the underlying problems will be addressed by the regulatory reform 
proposals currently on the table. In fact, our underlying banking 
system problems are likely to become much worse.
    In spring 2010, during the Dodd-Frank financial reform debate--
Senator Ted Kaufman of Delaware emphasized repeatedly on the Senate 
floor that the proposed ``resolution authority'' was an illusion. His 
point was that extending the established Federal Deposit Insurance 
Corporation (FDIC) powers for ``resolving'' (jargon for ``closing 
down'') financial institutions to include global megabanks simply could 
not work.
    At the time, Senator Kaufman's objections were dismissed by 
``experts'' both from the official sector and from the private sector. 
The results are reflected in Title II of Dodd-Frank, ``Orderly 
Liquidation Authority.''
    Now these same people (or their close colleagues) are arguing 
resolution cannot work for the country's giant bank holding companies. 
The implication, which these officials and bankers still cannot grasp, 
is that we need much higher capital requirements for systemically 
important financial institutions.
    Writing in the March 29, 2011, edition of the National Journal, 
Michael Hirsch quotes a ``senior Federal Reserve Board regulator'' as 
saying:

        Citibank is a $1.8 trillion company, in 171 countries with 550 
        clearance and settlement systems,'' and, ``We think we're going 
        to effectively resolve that using Dodd-Frank? Good luck!

    The regulator's point is correct. The FDIC can close small- and 
medium-sized banks in an orderly manner, protecting depositors while 
imposing losses on shareholders and even senior creditors. But to 
imagine that it can do the same for a very big bank strains credulity.
    And to argue that such a resolution authority can ``work'' for any 
bank with significant cross-border is simply at odds with the legal 
facts. The resolution authority granted under Dodd-Frank is purely 
domestic, i.e., it applies only within the United States. The U.S. 
Congress cannot make laws that apply in other countries--a cross-border 
resolution authority would require either agreement between the various 
Governments involved or some sort of synchronization for the relevant 
parts of commercial bankruptcy codes and procedures.
    There are no indications that such arrangements will be made--or 
that there are serious intergovernmental efforts underway to create any 
kind of cross-border resolution authority, for example, within the G20.
    For more than a decade, the International Monetary Fund has been on 
the case of the eurozone to create a cross-border resolution mechanism 
of some kind within their shared currency area. But European (and 
other) Governments do not want to take this kind of step. Rightly or 
wrongly, they do not want to credibly commit to how they would handle 
large-scale financial failure--preferring instead to rely on various 
kinds of ad hoc and spontaneous measures. The adverse consequences are 
apparent for all to see in Europe at present; yet there is still no 
move to establish a viable cross-border resolution authority.
    I have checked these facts directly and recently with top Wall 
Street lawyers, with leading thinkers from left and right on financial 
issues (U.S., European, and others), and with responsible officials 
from the United States and other relevant countries. That Senator 
Kaufman was correct is now affirmed on all sides.
    Even leading figures within the financial sector are candid on this 
point. Hirsch quotes Gerry Corrigan, former head of the New York 
Federal Reserve Bank, and an executive at Goldman Sachs since the 
1990s.

        In my judgment, as best as I can recount history, not just the 
        last 3 years but the history of mankind, I can't think of a 
        single case where we were able execute the orderly wind-down of 
        a systemically important institution--especially one with an 
        international footprint.

    It is most unfortunate that Mr. Corrigan did not make the same 
point last year--for example, when he and I both testified before the 
Senate Banking Committee on the Volcker Rule (in February 2010).
    In fact, rather ironically in retrospect, Mr. Corrigan was among 
those arguing most articulately that some form of ``Enhanced Resolution 
Authority'' (as he called it) could actually handle the failure of 
Large Integrated Financial Groups (again, his terminology).
    The ``resolution authority'' approach to dealing with very big 
banks has, in effect, failed before it even started.
    And standard commercial bankruptcy for global megabanks is not an 
appealing option--for reasons that Anat Admati has explained. The only 
people who are pleased with the Lehman bankruptcy are bankruptcy 
lawyers. Originally estimated at over $900 million, bankruptcy fees for 
Lehman Brothers are now forecast to top $2 billion (more detail on the 
fees here).
    It's too late to reopen the Dodd-Frank debate--and a global 
resolution authority is a chimera in any case. But it's not too late to 
affect policy that matters. The lack of a meaningful resolution 
authority further strengthens the logic behind the need for larger 
capital requirements, as these would provide stronger buffers against 
bank insolvency.
    The Federal Reserve has yet to announce the precise percent of 
equity funding--i.e., bank capital--that will be required for 
systemically important financial institutions (so-called SIFIs). Under 
Basel III, national regulators set an additional SIFI capital buffer. 
The Swiss National Bank is requiring 19 percent capital and the Bank of 
England is moving in the same direction. The Fed should also move 
towards such capital levels or--preferably--beyond.
    Unfortunately, there are clear signs that the Fed's thinking--both 
at the policy level and at the technical level--is falling behind this 
curve.
    It is not too late to listen to Senator Kaufman. In his capacity as 
chair of the Congressional Oversight Panel for TARP during 2011 (e.g., 
in this hearing), Mr. Kaufman argued consistently and forcefully for 
higher capital requirements. This would work as a global approach to 
make banking safer. Unfortunately, making progress on this issue with 
European countries will be much delayed--at least until the eurozone 
has sorted out its combined fiscal-monetary-financial disaster.
    The best approach for the United States today would be to make all 
financial institutions small enough and simple enough so they can 
fail--i.e., go bankrupt--without adversely affecting the rest of the 
financial sector. The failures of CIT Group in fall 2009 and MF Global 
in fall 2011 are, in this sense, encouraging examples. But the balance 
sheets of these institutions were much smaller--about $80 billion and 
$40 billion, respectively--than those of the financial firms currently 
regarded as Too Big To Fail.
                                 ______
                                 
         PREPARED STATEMENT OF THE HONORABLE PHILLIP L. SWAGEL
  Professor of International Economic Policy, University of Maryland 
                        School of Public Policy
                            December 7, 2011

    Chairman Brown, Ranking Member Corker, and Members of the 
Committee, thank you for the opportunity to testify on the new regime 
for regulating large, complex financial institutions. I am a professor 
at the University of Maryland's School of Public Policy and a faculty 
affiliate of the Center for Financial Policy at the Robert H. Smith 
School of Business at the University of Maryland. I am also a visiting 
scholar at the American Enterprise Institute and a senior fellow with 
the Milken Institute's Center for Financial Understanding. I was 
previously Assistant Secretary for Economic Policy at the Treasury 
Department from December 2006 to January 2009.
    Failures in the regulation of large complex financial institutions 
played an important role in the financial crisis. Many large American 
financial firms required substantial assistance from the Federal 
Government, including capital injections and asset guarantees through 
the TARP and access to a range of liquidity facilities from the Federal 
Reserve. At the same time, the main problems in subprime housing that 
gave rise to the crisis arose outside the most heavily regulated parts 
of the financial system among nonbank mortgage originators, Fannie Mae 
and Freddie Mac, and participants in the so-called shadow banking 
system.
    Indeed, a broad view of the crisis shows failures by market 
participants at all levels of the financial system: sophisticated asset 
managers who bought subprime mortgage-backed securities (MBS) without 
understanding what was inside or demanding more information; 
securitizers who put those faulty securities together; rating agencies 
that stamped them as AAA; bond insurers who covered them; originators 
who made the bad loans in the first place; mortgage brokers who 
facilitated the process; and so on, including crucial deficiencies at 
the Government-Sponsored Enterprises (GSEs) of Fannie Mae and Freddie 
Mac. (Unfortunately one must also add to the list of failures the 
actions of some home buyers in providing inaccurate information on 
mortgage applications or in signing on the dotted line for a house they 
could not afford--though of course there was someone on the other side 
of each of these transactions willing to extend the loan.)
    Moreover, the severe credit strains that ensued following the 
failure of Lehman Brothers in September 2008 were made considerably 
worse by problems in money market mutual funds--large, to be sure, but 
hardly a complex type of financial institution. The new regulatory 
regime for large, complex financial institutions is a vital part of 
lessening the likelihood of future crises, but it is important to keep 
in mind that there were many contributors to recent events beyond these 
firms and that an undue focus on this one element risks missing out on 
others.
    Getting the right balance between financial market regulation and 
dynamism, including the possibility of failure and creative 
destruction, is an essential element of fostering a more robust 
economic recovery and a strong U.S. economy into the future. The slow 
recovery from the recent recession reflects many factors, including the 
drag on demand from deleveraging by consumers and firms, the negative 
impact of policy and regulatory decisions, and the overhang of 
uncertainty about future taxes, health and energy costs, and so on. But 
drag from the financial system is likely playing a role as well, with 
many families and businesses still finding constrained access to 
credit. While loans were too readily available before the crisis, a 
danger today is that the pendulum has swung too far in the other 
direction. The caution of market participants in putting capital at 
risk could be exacerbated by uncertainty over the impact of ongoing 
financial regulatory changes. This uncertainty will weigh on the 
financial sector and the economy.
Detecting and Avoiding Future Problems in the New Regulatory Regime
    Regulators did not detect problems in the financial system and act 
upon the mounting stresses in time to avert the crisis. This reflects 
failures by the regulators (as was evident in the problems at 
institutions such as Countrywide, WAMU, IndyMac, and many other firms) 
and shortcomings and gaps in the regulatory system (as revealed, for 
example, in the case of AIG, in which no regulator had an adequate line 
of sight over the activities of the financial products division). This 
latter problem of the fragmented nature of the U.S. regulatory system 
was long-understood; indeed, the Treasury Department under the 
direction of Secretary Paulson in early 2008 put out a thoughtful 
blueprint to reshape U.S. regulatory system by function.
    The Dodd-Frank Wall Street Reform and Consumer Protection Act 
(Dodd-Frank) includes important provisions that will help avoid future 
problems and improve the likelihood of detecting them as they arise. 
Dodd-Frank further provides authorities with tools to deal with severe 
problems when necessary. The new regulatory regime has the promise of 
improvement over the one that failed to prevent the recent financial 
crisis. But much of the change embodied in Dodd-Frank remains to be 
finalized by regulators, some provisions of the Act do not seem to 
contribute positively to an improved regulatory regime, and there are 
still important missing elements in the legislation, notably with 
respect to reform of the housing finance system and of money market 
mutual funds.
    Improved capital standards and more robust liquidity requirements 
in both the Dodd-Frank Act and through the Basel III process will help 
make large, complex financial institutions more robust to losses and 
thereby help to avoid future crises. While it is hard to imagine that 2 
or 4 percentage points of additional capital would have saved Lehman 
Brothers or Bear Stearns once investors lost confidence in those 
institutions, more capital will help deepen the buffer in the future 
before confidence is lost. As discussed below, however, there are costs 
as well as benefits to increased capital requirements--the challenge 
for regulators (and for society) is to find the balance.
    The establishment of the Financial Stability Oversight Council 
(FSOC) and the Office of Financial Research (OFR) make it more likely 
that regulatory authorities will detect building problems. The FSOC in 
particular will help avoid a repetition of the problems evident in 
oversight of AIG, where risky activities at one division slipped 
between the cracks in the sense that no regulator had clear 
responsibility. Going forward, all systemically important financial 
institutions will be subject to bank-like regulation. Dodd-Frank 
further empowers the regulatory agencies acting jointly, but especially 
the Federal Reserve, to look across firm activities and across industry 
participants to watch for mounting risks. This will help get at the 
issue that subprime lending was not necessarily a problem for many 
individual industry participants (though it was for some such as 
Countrywide and WAMU), but subprime lending taken together across firms 
posed a risk to the financial sector.
    The Office of Financial Research likewise has the potential to help 
regulators obtain and analyze information across firms and asset 
classes. Asking for information involves costs, however, and it will be 
important for the OFR to avoid overly burdensome requests. But the 
potential is there to help detect systemic risk. Moving forward with a 
system for a uniform legal entity identifier would help foster greater 
transparency and allow regulators and firms themselves to better 
measure and monitor risks. Such transparency can help beyond just 
immediate tracking of performance because improved availability of 
information would be expected to affect firms' reputational capital. 
For example, information that allows investors to more readily link, 
say, poorly performing loans back to particular originators would 
provide powerful reputational incentives for better lending 
performance.
    It is impossible to avoid or detect all problems--regulators are 
only human after all--but these provisions will help.
    The benefits of other aspects of the Dodd-Frank Act are less clear 
in terms of helping to safeguard the financial system against future 
crises. I would see the so-called Volcker Rule as falling into this 
category. Proprietary trading does not appear to have a contributing 
factor in the crisis, and indeed, revenues from this activity helped to 
offset losses in other areas and thus stabilize some financial firms. 
It is difficult in practice to distinguish proprietary trading from the 
normal market-making activities of a broker dealer--a difficulty that 
is perhaps reflected in the voluminous attempt of the regulatory 
agencies to define the rule. A poorly implemented Volcker Rule could 
reduce liquidity in financial markets and thus raise costs and decrease 
investment in the broader economy. Indeed, the flat exemption of 
trading in Treasury securities from the rule illustrates the potential 
downside. Removing this activity from large financial institutions 
could have had a meaningful negative impact on demand for Treasury 
securities and thus lead to increased yields and higher costs for 
public borrowing. The same concern applies to other activities that 
will be affected by the rule--all investors and savers will be 
affected. And investors and savers are not just large, complex 
financial institutions, but include workers whose pension funds and 
401(k)s invest in these securities. Families will have less access to 
credit and thus less ability to buy homes, cars, and put children 
through college. Businesses will find it harder to borrower, which will 
make it harder for them to do research and development, make capital 
investments, and create jobs. Asset prices will be pushed down, which 
will punish investors and savers. It is not clear what problem this 
rule is meant to solve, making it likely that this aspect of the new 
regulatory regime for large, complex financial institutions strikes a 
poor tradeoff between the gains from the regulation and the impairment 
to markets and overall economic vitality.
    The impact of many other provisions is unclear because rules are 
still to be determined or finalized. The new regime for derivatives, 
including the increased role for clearinghouses and exchanges in 
derivative transactions, has the potential to usefully strengthen 
transparency and thus improve the overall financial regulatory regime, 
including for large, complex financial institutions. On the other hand, 
it difficult to understand the benefits of the so-called Lincoln 
Amendment that requires some derivatives-related activities to be spun 
off into separately capitalized entities. Part of the value of large 
financial institutions to markets and the broader economy is the 
ability to conduct a wide range of transactions, including making 
markets in derivatives. Indeed, the decision by the Obama 
administration to exempt the foreign exchange market from these aspects 
of Dodd-Frank suggests that the Administration shares the concern that 
these provisions likewise do not strike an appropriate balance between 
the benefits and the costs in terms of diminished economic vitality.
The Benefits of Large Financial Institutions
    The tradeoff between increased regulation and economic vitality 
applies as well to regulations under Section 165 of the Dodd-Frank Act 
relating to enhanced supervision and prudential standards (many of 
which are not yet final). Heightened capital requirements provide an 
increased margin of safety for firms to absorb losses (though this does 
not necessarily reduce the impact of the failure on the broader 
financial system once a large firm burns through the added capital). 
But requiring firms to hold more capital is not free--there is an 
impact on financial intermediation and thus on the economy that must be 
kept in mind. Importantly, the empirical evidence is that real-world 
banks react to binding capital requirements mainly by reducing assets--
by making fewer loans--rather than by adding capital. There is a 
tradeoff, unlike in the theoretical construct in which there are no 
frictions and a firm's capital structure (the mix of debt and equity in 
the enterprise) does not matter. In the real world, the tax system 
favors debt over equity and the bankruptcy system (including the new 
resolution mechanism discussed below) imposes costs on market 
participants. These realities are at odds with the assumptions in 
recent academic work calling for considerably higher capital 
requirements.
    An overly large increase in required capital might impose 
considerable costs on financial firms and the broader economy without a 
commensurate increase in financial stability. Banks with very high 
capital requirements would be less apt to perform the role of providing 
liquidity services such as through demand deposits and other types of 
short-term financing. Moreover, increased capital requirements would 
drive lending activity once again out of the banking system into the 
less-regulated ``shadow banking system.'' Increased capital would make 
banks safer, but these firms would no longer perform the functions that 
society expects of them and risk-taking will migrate outside the 
regulated banking sector.
    The new regulatory regime should also pay attention to the 
differential impact of financial reforms proceeding at different paces 
and in various ways across countries. Capital requirements are measured 
against risk-weighted assets, but financial institutions in Europe 
(especially) appear to have considerably more aggressive weightings in 
terms of denoting assets as less risky than is the case in the United 
States. This means that European firms hold less capital than U.S. 
competitors with similar assets, thus distorting the competitive 
balance between firms across borders. This is not to say that the 
United States should follow Europe in a race-to-the-bottom of lower 
risk weightings and less capital. The Basel process would be a natural 
channel through which to ensure that U.S. firms are not disadvantaged.
    Similar considerations apply to new liquidity standards, which 
should take into account the actual characteristics of assets during 
the recent crisis. GSE securities, for example, have been essentially 
guaranteed by the Federal Government since Fannie Mae and Freddie Mac 
were taken into conservatorship in September 2008 and thus remained 
liquid throughout the crisis. Advances from the Federal Home Loan Banks 
(FHLBs) were likewise important sources of liquidity for many U.S. 
financial institutions during the crisis. Until there is a change in 
the GSEs or FHLBs, these recent experiences should inform the use of 
such assets in meeting heightened liquidity requirements.
    The process by which large, complex financial institutions will 
undergo annual capital assessments (stress test) has already proved a 
valuable addition to the prudential regulatory toolkit. The 2009 stress 
tests, for example, provided an important signal to market participants 
that key financial institutions would not be nationalized and thus 
lifted a barrier to renewed private sector investment in financial 
firms. The key going forward is to develop realistic scenarios against 
which to test bank balance sheets. An overly optimistic scenario is not 
a test, while an unduly pessimistic one could turn into a 
nontransparent mechanism by which to restrict financial firms' capital 
distributions--which would ultimately affect firms' ability to attract 
capital.
    Similarly, the process of drawing up so-called living wills could 
be useful (so long as the undertaking is not extraordinarily 
burdensome), even though it is inevitable that plans made ahead of time 
will not be perfectly applicable in a crisis.
The Value of Large, Complex Financial Institutions
    The regulatory regime brought about by the Dodd-Frank Act places 
new burdens on large firms and requires them to hold more capital and 
have more robust access to liquidity. But the Act does not seek to 
break up large financial institutions or to reinstitute broader 
barriers to their activities such as by reinstituting the Glass-
Steagall separation of commercial and investment banking. This is 
appropriate.
    The end of the Glass-Steagall restrictions is not well correlated 
with the failures evident in the recent financial crisis. Bear Stearns 
and Lehman Brothers both failed, but these firms had remained 
investment banks. JPMorgan Chase, on the other hand, combined 
investment banking and commercial banking and yet weathered the strains 
of the crisis relatively well. The problems revealed by the crisis seem 
to be in the riskiness of the activities themselves--subprime lending, 
for example--and not in the combination of commercial and investment 
banking.
    The aftermath of the crisis has meant increased scale for the 
largest of the surviving institutions. This has both benefits and 
costs. Among the potential costs are that the failure of a large 
financial institution could have important impacts on markets and the 
broader economy. At the same time, there are benefits to the U.S. 
economy from having large financial institutions, including important 
advantages to society arising from economies of scope and of scale. A 
recent study from the Clearing House Association (for which I am a 
member of the academic advisory committee) discusses and quantifies 
these benefits. \1\ The benefits of scope and scale go together, as 
banks that are large banks in both size (scale) and footprint (scope) 
are best able to undertake commercial transactions for large 
multinational corporations. This reflects the evolution of the 
globalized economy, as large banks have a relatively strong ability to 
offer financial products to large customers with specific needs, 
including in trade finance, global lending, and cash management. 
Smaller banks can offer these services, but the Clearing House 
Association study shows that there are benefits to having banks large 
enough to do them on a scale commensurate with the largest corporate 
customers.
---------------------------------------------------------------------------
     \1\ The study is available on http://www.theclearinghouse.org/
index.html?f=073071.
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    Similar benefits of scope and scale apply to capital market 
activities outside of commercial banking, including offering and 
arranging derivatives-related transactions and investment banking. 
These benefits reflect the fact that firms with large and diverse 
balance sheets can best make liquid markets for large transactions and 
across a broad range of assets. Large financial institutions are best 
positioned to stand ready as a market-maker to buy and sell assets, 
including derivatives that allow the beneficial transfer of risk by end 
users. Sometimes it is helpful and necessary to have a large balance 
sheet to put to work. Taken together, the benefits for society through 
increased economic efficiency resulting from the scale and scope of 
large banks are estimated at 50 to 100 billion dollars per year.
    The diversity of small and large institutions and in other 
dimensions is a feature of the U.S. financial system. Different sizes 
of U.S. financial institutions stand ready to deal with different types 
of customers and products. Large banks are essential for firms 
requiring large amounts of financing--transactions undertaken by large 
global companies involving multiple billions of dollars of financing. 
Foreign banking systems are typically far more concentrated than that 
of the United States--and large foreign banks would stand ready to 
serve U.S. multinationals in the event that the larger U.S. banks were 
dismantled. And as with excessive capital requirements, policy actions 
that diminished the capacities of large U.S. banks could well lead some 
financial business to move to the less-regulated shadow banking system.
    It should be kept in mind that smaller banks present risks--
something illustrated in the U.S. savings and loan crisis of the late 
1980s and reflected in other countries in the more recent crisis. In 
Spain, for example, the large banks have been broadly stable (perhaps 
more so than the sovereign), while smaller and less-diversified 
financial institutions have been in severe distress.
    The diversity of the U.S. financial system is reflected in the 
different ways that institutions fund themselves. Smaller banks tend to 
fund their activities using low-cost deposits that benefit from the 
FDIC guarantee and with FHLB advances that likewise have a Federal 
guarantee. Larger institutions that fund with a greater diversity of 
sources now pay deposit insurance premiums on nondeposit liabilities 
even though these liabilities are not actually covered by the FDIC. 
Larger institutions, especially the so-called globally systemically 
important banks but also possibly including U.S. banks that are not 
designated as globally systemic, will face increased capital 
requirements. The diversity of funding sources is again a strength of 
the U.S. system; the point here is that it is important to avoid 
overstating the potential funding advantage of larger financial 
institutions. This is especially the case going forward with the new 
resolution authority in the Dodd-Frank Act that makes meaningful 
changes to the notion that some institutions will be rescued by 
Government action and thus that market participants will be willing to 
fund these firms at lower costs. This idea of ``too big to fail'' is 
discussed next.
Dealing With a Future Financial Crisis: Resolution Authority
    The Title II resolution authority will have important effects on 
large, complex financial institutions and on the providers of funding 
to these institutions. For bondholders and other nondeposit funders, 
the Dodd-Frank resolution authority puts them on notice that they 
should expect to take losses in the event that a firm fails and is 
taken into resolution. Resolution authority could well involve the 
deployment of Government resources (later to be repaid by market 
participants) to support a firm and slow its demise. But the outcome is 
virtually certain to involve losses for bondholders, unlike what 
generally happened during the crisis.
    For better or worse, the Title II authority will be used in the 
event that a large complex financial institution fails. After all, it 
is difficult to imagine another TARP facility to intervene in the 
financial sector. The authorities in Title II give Government officials 
some TARP-like ability to put money into failing firms, and the 
experience of the recent crisis is that policy makers are likely to use 
these authorities to avoid the full impact of the collapse of a large 
systemically significant firm. This likelihood in turn will affect the 
behavior of market participants today. In this way, Title II makes for 
a profound change in the regulatory environment facing large, complex 
financial institutions, including a meaningful change from the past 
belief that institutions were too big to fail.
    It is hard to know precisely how the resolution authority will be 
used, notably because the authority is likely to be exercised in a time 
of broad financial market stress when regulators face a variety of 
challenges. For making changes to the concept of too big to fail, what 
matters most is the ability of the FDIC in undertaking the resolution 
to make ex post clawbacks from bondholders to cover losses after 
shareholder equity is wiped out. Indeed, the FDIC has been clear that 
bondholders should not expect to get additional payments through use of 
the Dodd-Frank resolution authority--it is more likely the opposite. 
This can take place even if the FDIC initially uses Government funds to 
keep a firm in operation in resolution--this might occur, for example, 
if the FDIC seeks to preserve the ``franchise value'' of a large firm 
while it arranges a sale of the firm or of components to new owners. 
Another possible outcome is that the FDIC uses the Title II authorities 
to arrange a debt-for-equity swap that recapitalizes the failing firm 
(or perhaps some parts of it) in a new form and with new management and 
shareholders (namely, the former bondholders). Such a debt-for-equity 
recapitalization would be similar to a prepackaged Chapter 11 
reorganization under the bankruptcy code, though the Title II 
authorities would allow this to be done faster and with funding 
provided by the Government (though eventually paid back by private 
market participants). It should be noted that much of this was already 
possible with the regular bankruptcy process and that it remains an 
open question as to whether Title II will make policy makers more 
likely to intervene in markets. That is, Title II could help limit the 
notion of too big to fail but give rise to more Government interference 
that has other negative impacts on the economy.
    The key element for addressing too big to fail is that bondholders 
take losses. This is likely to be the case, given that the ability to 
do this is clear in the legislation. In contrast to the resolution of 
WAMU by the FDIC in the fall of 2008, the imposition of (possibly 
substantial) losses will not be a surprise to bondholders and therefore 
should not cause massive spillover effects that adversely impact the 
ability of other firms to fail. The key is that Title II makes clear 
that bondholders will take losses.
    It must be kept in mind that there are other, possibly troublesome, 
effects from the new authority. The certainty of losses in resolution 
will give providers of funding to banks an incentive to flee at early 
signs of trouble. This sort of run from failing institutions is an 
important disciplining device, but the regime change could mean a more 
hair trigger response than previously and thus inadvertently prove 
destabilizing. This would be the case if market participants move away 
from long-term funding of financial institutions because of the 
increased possibility of losses.
    The ability of policy makers to deploy public resources in the 
resolution process also gives rise to concerns that firms taken into 
resolution could be used for policy purposes. Losses to the Government 
are ultimately borne ex post by the bondholders once the equity of the 
firm is exhausted, which seems likely to be the case. The legislation 
seeks to narrow the scope of action for the FDIC in resolution by 
guaranteeing bondholders that they will receive as much in resolution 
as would have been the case under bankruptcy, but this still gives 
scope for actions to use the firm under resolution. In a sense, the 
resolution authority provides Government officials with an open 
checkbook to act through the troubled firm, with bondholders picking up 
the tab. This is not an empty concern; witness, for example, efforts to 
have the GSEs undertake loss-making policy activities which would then 
be offset by new capital injections from the Treasury. The funds under 
Title II would come first from bondholders and then from assessments on 
other market participants rather than from taxpayers, but the concern 
is over the ability of the Government to act and transfer resources 
without a vote of the Congress. This concern remains even if it 
bondholders on the hook rather than taxpayers.
    Finally, the resolution authority will be incomplete and perhaps 
unworkable until there is more progress on the international 
coordination of bankruptcy regimes.
Conclusion
    The new regulatory regime for large, complex financial institutions 
will be a vast change from the system before the financial crisis. 
Important aspects of the change are for the good, including changes 
that address the phenomenon under which some firms were too big to 
fail. But there is still much that is unclear in the workings of the 
new regulatory regime and much rulemaking to be done.
    It is important to keep in mind that many of the changes will 
involve costs as well as benefits. Higher capital and liquidity 
requirements, for example, will impose costs on financial institutions 
that will affect lending activity and thus the overall economy. Changes 
are still desirable in the wake of the crisis; the key is to be 
cognizant of the tradeoffs involved and avoid regulatory requirements 
that provide inadequate benefits relative to the costs involved.
    This tradeoff applies to discussions about the role of large, 
complex financial institutions in the U.S. financial system and the 
broader economy. These institutions provide important benefits for 
financial markets and for the economy. Changes that lessen their role 
or impair their functioning would have meaningful costs to society.
    Finally, there are important aspects of financial regulatory reform 
that were not accomplished in the Dodd-Frank legislation and that 
pertain to the regulatory regime for large, complex financial 
institutions. The unfinished business of regulatory reform notably 
includes the future of the housing finance system, including Fannie Mae 
and Freddie Mac, reforms to money market mutual funds, and changes to 
the oversight of broader aspects the collateralized lending that takes 
place in the so-called shadow banking system. If anything, some 
provisions of Dodd-Frank could make the shadow banking system larger as 
activities migrate (or are forced to migrate) out of the more heavily 
regulated large financial institutions.

             PREPARED STATEMENT OF ARTHUR E. WILMARTH, JR.
    Professor of Law and Executive Director of the Center for Law, 
Economics and Finance (C-LEAF), George Washington University Law School
                            December 7, 2011





















































































































































              Additional Material Supplied for the Record
``Three Years Later: Unfinished Business in Financial Reform'' by Paul 
                               A. Volcker


































































``Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket or Is Lap-
             Band Surgery Required?'' by Richard W. Fisher





















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