[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
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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\
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\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.
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\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