[Senate Hearing 112-679]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 112-679
 
 IS SIMPLER BETTER? LIMITING FEDERAL SUPPORT FOR 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

                             SECOND SESSION

                                   ON

EXPLORING POLICIES TO FURTHER LIMIT FEDERAL SUPPORT FOR LARGE, COMPLEX 
                         FINANCIAL INSTITUTIONS

                               __________

                              MAY 9, 2012

                               __________

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


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

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

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

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                     Laura Swanson, Policy Director

                     Jeffrey Siegel, Senior Counsel

                       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, MAY 9, 2012

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Corker...............................................     1
    Senator Merkley..............................................     2

                               WITNESSES

Paul A. Volcker, Chair, President's Economic Recovery Advisory 
  Board, and former Chairman, Board of Governors of the Federal 
  Reserve System.................................................     2
    Prepared statement...........................................    37
Thomas M. Hoenig, Vice Chairperson and Member of the Board of 
  Directors, Federal Deposit Insurance Corporation...............    14
    Prepared statement...........................................    40
Randall S. Kroszner, Professor of Economics, University of 
  Chicago, Booth School of Business..............................    15
    Prepared statement...........................................    54
Tom C. Frost, Chairman Emeritus, Frost National Bank.............    25
    Prepared statement...........................................    61
Marc W. Jarsulic, Chief Economist, Better Markets................    26
    Prepared statement...........................................    62
James E. Roselle, Executive Vice President and Associate General 
  Counsel, Northern Trust Corporation............................    28
    Prepared statement...........................................    89
Anthony J. Carfang, Partner and Director, Treasury Strategies, 
  Inc., on behalf of the U.S. Chamber of Commerce................    30
    Prepared statement...........................................    91

              Additional Material Supplied for the Record

Thomas M. Hoenig speech presented to the European Banking and 
  Financial Forum in Prague, 1999................................   130
Prepared statement of Wallace C. Turbeville, Senior Fellow, Demos   139
Federal Reserve Bank of Dallas 2011 Annual Report................   163

                                 (iii)


 IS SIMPLER BETTER? LIMITING FEDERAL SUPPORT FOR FINANCIAL INSTITUTIONS

                              ----------                              


                         WEDNESDAY, MAY 9, 2012

                                       U.S. Senate,
                     Subcommittee on Financial Institutions
                                   and Consumer Protection,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee convened at 2:03 p.m. in room 538, Dirksen 
Senate Office Building, Hon. Sherrod Brown, Chairman of the 
Subcommittee, presiding.

           OPENING STATEMENT OF SENATOR SHERROD BROWN

    Senator Brown. The Subcommittee on Financial Institutions 
and Consumer Protection will come to order.
    I thank Senator Corker for, always, his cooperation. 
Senator Merkley, thank you for joining us. Mr. Volcker, nice to 
see you.
    We have three panels today. Opening statements, I always 
give moderately short ones. It will be even shorter today, and 
Senator Corker always gives thoughtful and even shorter 
statements, so we will begin briefly with that.
    I want to thank everybody involved for helping pull 
together this important hearing. Getting such excellent and 
qualified individuals to discuss such an important but, 
admittedly, broad set of topics was not easy, so I appreciate 
the cooperation of all of you who are major players in your own 
right throughout our financial system.
    As I said, I will keep my message brief. I would simply say 
it is vital we take the necessary steps sooner rather than 
later to end Government policies that support and encourage 
large, complex institutions. That is why today I am introducing 
my legislation, the SAFE Banking Act. It was known formerly as 
the Brown-Kaufman bill and amendment. The ideas we will explore 
today have traction on both sides of the aisle. For instance, 
we know that the full Committee's Ranking Member, Senator 
Shelby, voted both against the Gramm-Leach-Bliley Act and in 
favor of Brown-Kaufman when it was an amendment to the Dodd-
Frank bill. And thanks again to the witnesses.
    Senator Corker, your comments.

                STATEMENT OF SENATOR BOB CORKER

    Senator Corker. Thank you, Mr. Chairman, and Dr. Volcker, 
thank you for being here. I enjoyed talking to you prior to and 
I enjoyed reading your testimony yesterday evening as it came 
in.
    I think we all agree that we need a safe banking system and 
we want one that also meets the needs of a 21st century 
economy, and that is the balance, I think, that we are all 
looking for.
    I want to thank you, in particular, in your testimony for 
pointing to the fact that Congress still has not dealt with the 
GSEs, and I know as a man who was under extreme stress during 
the early 1980s and made a lot of tough decisions that have 
caused you to be highly honored by people all across this 
country, you must look at amazement on a U.S. Congress that 
fails to deal with an evident huge problem in our country but 
has lacked the courage to deal with that. So I appreciate you 
pointing that out.
    I was thinking as we read a lot of materials getting ready 
for this hearing, and I certainly appreciate all the witnesses 
that have come, you know, the most dangerous thing that a bank 
does is make a loan. At the end of the day, without sound 
underwriting, all the things that we do here do not make a lot 
of sense.
    But I sure thank you for your testimony. I look forward to 
hearing it orally and then the questions, and we are honored to 
have you here.
    Senator Brown. Thank you. Thank you, Senator Corker.
    Senator Merkley.

               STATEMENT OF SENATOR JEFF MERKLEY

    Senator Merkley. Thank you, Mr. Chair.
    Just very briefly, welcome. It is so good to have you, Mr. 
Volcker, and for your leadership in helping establish the 
concept that there needs to be a firewall between ordinary 
banking activities and hedge fund-style investment activities 
by banks in order to create a safer and sounder banking system. 
I certainly look forward to your comments.
    Thank you.
    Senator Brown. Thank you, Senator Merkley.
    Our first panelist, and I do not normally do cliches, but 
he is a man who needs no introduction. I appreciate so much 
Chairman Volcker joining us. He has dedicated his life to 
ensuring, as Senator Corker said, the American financial system 
is safe and sound, first as President of the Federal Reserve 
Bank of New York and as the Chair of the Board of Governors of 
the Federal Reserve System. Through your efforts, Dr. Volcker, 
to reform our financial system, though they may have frustrated 
some bankers on Wall Street and some lobbyists in Washington, 
there is no doubt our country is a better place because of your 
hard work.
    Thank you for your decades of service. You have the floor.

   STATEMENT OF PAUL A. VOLCKER, CHAIR, PRESIDENT'S ECONOMIC 
    RECOVERY ADVISORY BOARD, AND FORMER CHAIRMAN, BOARD OF 
            GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Volcker. Thank you, Mr. Chairman, and I want to thank 
you for holding this hearing. We are kind of in midstream on 
banking reform and banking regulation and I think this is a 
good time to review where we are and where we are going, so it 
is a useful service.
    I know in writing to the panelists, you raised a series of 
questions. I will not attempt to answer them all, but you are 
certainly right in the underlying premise that banking has 
changed a lot in the past 20 years. It has changed very broadly 
from a, I guess what I used to think of as a profession that 
concentrated on relationships with its customers in very 
important ways. It has moved generally toward a much more 
transaction-oriented concentration. That is particularly true 
of the bigger banks. And it has certainly in the process become 
a lot more complex, a lot more opaque, very complicated.
    For a while, it was thought that with all the wisdom and 
engineering and expertise brought to the table, banking would 
be, if not failsafe, safer. That turned out to be an illusion 
when we had the great breakdown. And, obviously, reform is 
necessary, and I think that reform properly has to go into 
structural aspects of banking as well as raising capital 
requirements, better supervision. All that kind of thing is 
important, but I do think we need some structural changes and 
they revolve very fundamentally around this issue of too-big-
to-fail and the moral hazard that was involved and is involved 
if the Government is bailing out failing financial institutions 
and particularly banks, big banks.
    And that is kind of the central issue that runs through a 
lot of the structural changes which are incorporated basically 
in the Dodd-Frank. I do not think there has been any 
legislation in other countries as comprehensive as the Dodd-
Frank bill. They all have the same problem. All the regulators 
and governments are worried about the same thing because this 
has been a worldwide breakdown of finance. And the United 
States, I do think that I can fairly say that it has been in 
the lead on actual legislative changes.
    It deals, one way or another, in almost all the factors 
bearing on relevant structural changes. First of all, it deals 
directly to reduce the risks involved. Senator Brown, you are 
absolutely correct that making loans can be the most risky 
thing in banks. It becomes even riskier when they lose the 
capacity to deal with the relationship one-on-one with adequate 
credit controls. It should not necessarily be all that risky, 
but if you are making subprime mortgages and farming them off 
to other people, it is indeed an exceedingly risky proposition.
    Just take that where it is. Banks must make loans, it is 
essential to the economy, but look at other activities they 
have gotten into in recent years. Dodd-Frank deals with the 
problem of derivatives. They have just been exploding all over 
the place, continue to explode after the crisis, maybe at 
smaller volume, but everything is relative. I am told there is 
$700 trillion of derivatives outstanding in the world today--
$700 trillion. And you wonder whether they are all directed 
toward some explicit protection against some explicit risk that 
can be dealt with by derivatives or whether they have not been 
themselves a kind of trading operation.
    Dodd-Frank does call upon its simplification in that area, 
tries to put as much of it as possible through clearinghouses 
and organized settlement arrangements, which are fiercely 
contested by the banks, but if that can be done for the great 
mass of derivatives, that will be a help.
    Other institutional factors concerning what banks can do or 
not do, of course, is the restraint on proprietary trading, the 
restraint on ownership of hedge funds and equity funds, the 
kind of thing that somehow has my name attached to it. I would 
only say in that connection that is sometimes talked about as 
purely a risk factor. It is a risk factor, there is no 
question. This is speculative trading. But its influence goes 
far beyond the particular risks involved in particular 
transactions. It is a cultural issue.
    Hedge funds, equity funds, and propriety trading itself are 
necessarily involved in big banks' conflicts of interest, 
almost continuously. And traders get to be richly rewarded. 
That affects the compensation practices and the culture of the 
bank throughout, leading to, in my view, unnecessarily 
dangerous behavior.
    The other part of Dodd-Frank I just mentioned, because in a 
way it is the heart of it, Dodd-Frank says no failing financial 
institution is going to be rescued. It will be liquidated, 
merged, sold, but the stockholders will be gone, creditors will 
be at risk, the management will be gone, and that is different, 
obviously, from what happened in 2008, 2009, in the midst of 
the crisis that raised all the questions about too-big-to-fail.
    There is a lot of skepticism in the market, as you are 
aware, as to whatever the law says, when push comes to shove, 
the Government will act, presumably against the law, to 
continue rescuing them with Government money. I think that 
skepticism is overdone, but it has got to be dealt with. And in 
the case of these big banks, the management of the bank after 
its failure, by any resolution authority gets very complicated 
internationally.
    And I just want to say that while I am obviously on the 
sidelines here, I have been impressed by the amount of effort 
going on, particularly between the FDIC and the U.K. 
authorities on this issue, where there is a meeting of minds as 
to the general approach. The legal systems may be different, 
but there is a meeting of the minds as near as I can see in the 
Euro zone generally. But getting that down in a very 
complicated way so that the authorities can work together when 
you have an incipient failure is very important and I do think 
considerable progress is being made in that area.
    So I will just stop there, touching on some of the points 
that I think are critical.
    Senator Brown. Thank you, Chairman Volcker, very much.
    Senator Johanns, welcome to the Subcommittee.
    I will take 5 minutes in questions, turn it to the Ranking 
Member, and then we will go from there.
    You have often talked today and many other times about the 
moral hazard issue, the pattern of Government support for the 
largest institutions breeds greater risk taking. In December at 
that Committee table, Sheila Bair--who had resigned by then, 
was former FDIC Chair Sheila Bair--told the Subcommittee, 
quote, ``It is important for the Government to be sending all 
the right signals that we do not view it as good in and of 
itself to keep these institutions alive just because they are 
big.''
    Your comments a minute ago that the skepticism might be 
overdone about the view of the Government stepping in, legally 
or not, what should regulators do to send messages to the 
markets that these institutions will not be propped up, 
especially when these institutions do have an advantage in the 
money markets, the capital markets?
    Mr. Volcker. Well, the first point I want to make is when 
you are talking about the biggest commercial banking 
institutions, you have a degree of regulation. You have the 
proposals on proprietary trading, hedge funds, equity funds, 
and derivatives, and better capital standards to minimize the 
chance that those biggest institutions are really going to get 
in trouble to the point that they need to be rescued. But if 
they do need to be, they are on the brink of failure or 
actually failing, the law provides authority, I understand in 
this case the FDIC that has experience in this area, will act 
as conservator or liquidator of that institution, will have 
sufficient authority to keep the institution running in 
essential ways in the short run so that there is a continuity 
in the marketplace and you do not incite a spreading, 
contagious kind of panic or connections because the FDIC will 
have the authority--sufficient authority--to keep it operating 
in the short run in areas that are essential.
    I think that is possible. It is done now with smaller 
institutions. But as I said before, to make that effective, I 
think, for some of these biggest institutions that have very 
substantial operations overseas, those operations tend to be 
centered in the U.K. So I think you do want to get consistency 
between the U.K. and U.S. authorities.
    And you also have the provision in the law for so-called 
living wills, where the banks should organize themselves in a 
way that makes it easier to break them up than is the case now. 
And that will be a continuing supervisory challenge, to make 
sure the banks are properly creating these so-called living 
wills.
    Senator Brown. Thank you. Bloomberg released a study 
recently that the banking sector is becoming larger, more 
concentrated, they said having grown seven times faster than 
GDP since the beginning of the financial crisis. Its growth has 
been concentrated, as you know, in the largest banks. The top 
10 banks in the United States grew from 68 percent of all bank 
assets in 2006 to 77 percent of all U.S. bank assets in 2010.
    Based upon these numbers and no sort of end in sight to 
this that I can see, do you--are the regulators doing enough? 
How concerned should we be about this continuing--if, in fact, 
it is a continuing level of--this continuing increase in 
concentration?
    Mr. Volcker. Well, I think there has, obviously, been a 
great increase in concentration. Most of it took place before 
2006, whatever the figures you----
    Senator Brown. Right. Right.
    Mr. Volcker. It took place in the 1990s and the early part 
of this century. It was aided and abetted by the end of Glass-
Steagall. But before that, it seems like yesterday I was in the 
Federal Reserve--it wasn't yesterday, it was a good many 
yesterdays ago--but at that time, banks could not branch 
outside their home States, by and large. And the United States 
had one of the most decentralized banking systems. And it has 
suddenly gone from a very decentralized system into a rather 
concentrated system, which I think is unfortunate. In the midst 
of the crisis, it got worse because the big commercial banks 
were joined with big investment banks.
    Now, how to deal with that, you may have people on this 
panel that are much more aggressive than I. I do not know how 
to break up these banks very easily. But some of the things we 
are talking about, reduced trading, for instance, will reduce 
the overall size of the bank reasonably. Some of the restraints 
on derivatives will reduce their off balance sheet liabilities 
significantly. So these modest steps, there is a provision in 
the law they cannot grow beyond certain limits by merger or 
acquisition.
    So there are some limits here, but as you say--you asked me 
whether I prefer a banking system that had less concentration. 
I would, but I think we can live, more or less, with what we 
have.
    Senator Brown. Thank you, Mr. Chairman.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman and Dr. Volcker. 
Thanks again for being here.
    I have read some of the comments that you have made 
specifically about the Volcker Rule, and I know we had a chance 
to talk in advance of this----
    Mr. Volcker. I am glad somebody has read those comments.
    Senator Corker. Yes, sir. I read them all the time.
    [Laughter.]
    Senator Corker. There has been a--what has happened here, I 
think there has been consensus around the fact that prop 
trading is out the door, and I think that is one of the major 
contributions that you have made to this debate. What is 
happening as the regulators wrestle with this, and some of the 
regulators have differing agendas than others, there really 
have been attempts by some to really do away with market making 
itself. I think you have had some comments about that and I 
wonder if in front of this Committee you might differentiate 
between the two. It is my sense that you had no intentions to 
do away with the legitimate market making ,but prop trading was 
really the focus of what you were trying to do.
    Mr. Volcker. That is correct. I am not involved, obviously, 
in writing the rules, and I am sure it got very complex, and it 
may be an effort to try to identify particular transactions in 
a way that is difficult unless you are sitting on the trading 
desk, but I think can be identifiable.
    My view all along has been two things. One, I think it is 
important that the management of the banks, and I include not 
only chief executive officers but the directors of these banks, 
do understand what the law says, and the law says no 
proprietary trading. Now, all banks, unless they are totally 
irresponsible, and I do not think these big banks are totally 
irresponsible, will have strong controls on their trading desks 
in their own interest. They do not want rogue traders sitting 
around jeopardizing billions of dollars of their capital, so 
they will have, I am sure, rather detailed controls on their 
traders, and what is important is those controls take account 
of the fact that no longer should there be proprietary trading 
and a special proprietary desk, which I think they do 
understand. And no longer should the traders on the market 
making desk be taking proprietary risks under the disguise of 
market making.
    I think that can be identified as a problem by adequate so-
called metrics afterwards. You look at the size of the trading 
relative to the size of their position and you look at the 
volatility and you look at measures like value at risk and 
whether they are suitably narrow for a trading operation or 
very broad, which suggests a proprietary trading operation. If 
you see those telltale signs, there is no question the 
regulator ought to get in there, the supervisor ought to go in 
there and raise questions with the board of directors whether 
the bank is sufficiently charged in what the law says.
    Senator Corker. Some of the--we have looked at some of the 
rules, and by the way, I have always understood that what you 
intended was to keep banks from being involved in prop trading, 
but that legitimate market making was something you thought 
they should continue to do. Some of the rules that are being 
created, though, there is one rule that we just read yesterday 
where the regulators were saying if you engage in market making 
and you make any profit on it, then it is really prop trading. 
Now, I do not know many institutions that are involved in 
businesses where they can only lose money. You would consider 
that, I assume, to be an overreach or not what was intended.
    Mr. Volcker. It is nonsense, frankly.
    Senator Corker. Nonsense. I am glad----
    Mr. Volcker. You can make money on market making. You can 
certainly make money on responding to customer requests. And 
until recently----you know, prop trading in banks is a recent 
phenomenon. Banks did not do that historically. And somehow, 
they did not go out of existence.
    Senator Corker. So keeping----
    Mr. Volcker. Proprietary trading is not a necessary 
ingredient of bank profits. It is a very volatile ingredient of 
bank profits. You know, I have read--I think it is 
appropriate--that all the money that was made on trading in 
this century by banks up until 2007 disappeared in 2008, which 
gives you a sense that this is not a risk-free business.
    Senator Corker. So an institution that would hold a very 
small amount of inventory, a very small amount, that was 
legitimately held for their customers' use, you think that is a 
legitimate thing for banks to be involved in, and I appreciate 
you saying that. I wish that you could sit down with the 
Federal Reserve and some of these other institutions and cause 
them to very simply lay out what it was that you intended when 
you began this process, because I think they are making it 
overly complicated and I think a lot of institutions are in a 
place right now where they have no idea as the ticker is going 
where they are going to end up.
    Mr. Volcker. Well, I do not want to get involved in the 
detailed regulatory process. I had enough of that in my 
lifetime. But the general principle that you describe, I 
believe, is consistent with my position. You emphasize a small 
position. I always wonder, when they tell me it is just like 
running a corner dress shop or Christmas sales, whether the 
market is so predictable as Christmas sales and do you really 
need a big inventory.
    You said small inventory. I sometimes wonder, if they want 
to be prepared for market making and customer trading, why do 
they not have a short position, because the customer may want 
to sell. So they ought to have a balanced position, it seems to 
me, and the position is very unbalanced. It raises a question.
    Senator Corker. Yes. Well, listen. Thank you so much. I 
wish I had more time to talk to you, and hopefully, we will do 
that in person in either my office or your office soon. Thanks 
a lot.
    Mr. Volcker. Thank you.
    Senator Brown. Thank you, Senator Corker.
    Senator Merkley.
    Senator Merkley. Thank you, Mr. Chair, and thank you, Mr. 
Volcker.
    I thought I would ask about a couple of issues that have 
been raised in the context of the Volcker Rule. One argument 
that has been made is that it will result in decreased 
liquidity in the trading world and that will be a very bad 
thing. Is that an issue? Is that a problem?
    Mr. Volcker. Well, I do not think it is a problem. Put it 
the other way around. It would be, I was going to say, a little 
extreme, but I do not think it is really extreme. The markets 
seemed to become very liquid before the crisis. There were a 
lot of complaints from the banking system itself that the 
markets were too liquid and it was hard to make money in very 
liquid markets. Now, I am not worried about being hard to make 
money, but it led to some behavior that I think is not very 
constructive.
    You would not have had all these subprime mortgages tied up 
in CMOs and CDOs if they were not so easily traded. These are 
long-term obligations. If you are buying one of those 
obligations, you should be prepared to keep it for a while. 
That would be the normal investor's reaction, normal banking 
reaction. If you think you can trade it tomorrow at no loss, 
then it becomes a trading proposition and a speculative 
proposition. And if the markets are too liquid, it can give 
rise to behavior that is not very useful in terms of the basic 
fitness of banking or finance markets generally.
    Now, I am not alone in this thinking at all, obviously. 
There is a big movement in Europe to tax transactions to make 
the market less liquid. The fullest analysis I know of this is 
by the chief English regulator who examined this pro and con 
very carefully and came to a conclusion that, yes, beyond a 
certain point, liquid markets--highly liquid markets are not in 
the public interest. I could give you another analyses, but it 
is a matter--obviously, you want to be able to buy and sell 
reasonably. That does not mean you will have to be able to buy 
and sell a long-term security 10 minutes after you bought it at 
no risk.
    Senator Merkley. Well, thank you. Another issue that has 
been raised is that the Volcker Rule creates a handicap for 
American financial institutions vis-a-vis European financial 
institutions. Any insights on that issue?
    Mr. Volcker. Well, when I sat at this table many times when 
I was Chairman of the Federal Reserve, the complaint that I 
would hear all the time was American banks are at a 
disadvantage to foreign banks because they are too small and we 
want to be big like Japanese banks. That was the favorite 
example that was taken. We want to be big like Japanese banks 
because we are at a disadvantage and we have to carry more 
capital than Japanese banks.
    I would rather have smaller banks and stronger banks, and 
we see what happened in Japan with their big banks. It was not 
all a great treat.
    So my answer is very simple. If we want to make some rules 
that are consistent with banks doing their basic job, I would 
not worry that foreign banks can do some things that we think 
do not contribute to a safe and sound banking system.
    And I--you know, the English authorities, the U.K. 
authorities, are always told by their banks, you cannot do 
this, you cannot do that because we will be at a disadvantage 
to American banks. You are told all the time, you cannot do 
this or that because you are going to be disadvantaged with the 
English banks. Well, the fact is, the approaches are not that 
different and capital requirements should not be that 
different. And there is a lot of effort to make sure the 
capital requirements are not that different.
    Now, in this trading operation, the British looked at what 
we are doing and at one point they expressed sympathy, and now 
they are at the same point with a different law. They say no 
investment banking, no trading, no proprietary trading, no 
hedge funds, no equity funds in a bank, in a commercial bank. 
You can have it in the same holding company, but it has got to 
be in a separate part of the holding company and we are going 
to make a great wall between one side of the holding company 
and the other side of the holding company.
    I do not know whether that is any easier. The banks, 
obviously, do not like that. I do not know what they like 
least. But they are after the same problem and they have a 
somewhat different approach. You could argue their approach is 
much more rigorous than what we have. So, the banks can choose 
whether they like that poison or our poison, but there is not--
I do not think either of them are poison, frankly, but we found 
it difficult in the Federal Reserve and it became even more 
difficult in the midst of the crisis to maintain a distinction 
between parts of the holding company, because when you are in 
crisis, everybody leaps over those boundaries and the 
authorities say, OK, we have had a crisis. Go ahead and leap.
    I would like to think of this ring fencing. That is the 
favorite British term. You are going to ring fence the--I do 
not know if the commercial bank is going to ring fence both of 
them. My experience with ring fences is the gophers go 
underneath and the deer jump over----
    [Laughter.]
    Mr. Volcker.----and you have got a lot of lawyers to help 
them.
    But the point I am making is they are somewhat different 
approaches to the same problem, and you could argue all day as 
to which is better or which is worse from the standpoint, more 
restrictive from the standpoint of the banks.
    Senator Merkley. Well, both are focused on the same issue 
of insured deposits and access to discount windows being 
separated from the hedge fund-style investing.
    I am out of time. Thank you very much for your commentary 
and your leadership. Thank you.
    Mr. Volcker. Well, the British proposal, fiercely contested 
by the banks, is to separate it by putting the hedge funds away 
from the banks. Never should there be any contact between them. 
We say you can have limited--it turned out to have limited 
ability to sponsor hedge funds and equity funds. The original 
proposal was not to have any sponsorship. So it is limited, but 
it is pretty much under control. And I think the banks--my 
impression is, during the process, pretty much giving up their 
hedge funds, equity funds.
    Senator Merkley. Thank you.
    Senator Brown. Thank you, Senator Merkley.
    Senator Johanns.
    Senator Johanns. Mr. Chairman, good to see you again.
    Mr. Volcker. Thank you.
    Senator Johanns. One of the last times you appeared before 
the Banking Committee, the full Committee, was prior to the 
passage of Dodd-Frank and it was at a point in time where the 
Volcker Rule was just kind of unveiled, if you will, the 
concept, at least. I remember during that hearing, and I do not 
have the exactly language in front of me, but we were kind of 
debating back and forth, all of us, what is this going to 
involve? What is going to be covered by the Volcker Rule? What 
is proprietary trading, et cetera? And I remember you, maybe 
somewhat exasperated with me at the time, said, you know, if 
you do not do something, this will haunt you. And then the 
second thing you said----
    [Laughter.]
    Senator Johanns.----which is fine. The second thing you 
said was that, even though it is hard to define, we will know 
it when we see it. And again, those are not your exact words, 
but very clearly, that was the impression I had.
    Mr. Volcker. I recall both of those.
    Senator Johanns. Yes. Now, we have the 300-page rule--go 
ahead. Did I misstate that?
    Mr. Volcker. You have got a 35-page rule accomplished in 
300 pages of explanation, questions, comments----
    Senator Johanns. Yes. I was getting to the fact that I 
think there are 1,300 questions, and it just kind of goes on 
and on and on.
    Really, on both sides of the aisle, there has been concern 
about its complexity. You have expressed concern about its 
complexity. As I have talked to those kind of at the ground 
floor level who have got to administer this thing, they are 
kind of saying, gee, how do we administer this? How do we take 
whatever is here and put this in a real life situation and 
administer it?
    And here is what I am concerned about. My concern is, 
number one, it is going to be very difficult for the people in 
the field to say, you have violated the rule or you have not 
violated the rule.
    Number two, it seems to me that the very goal here was to 
try to deal with these very large institutions that were doing 
irresponsible things, but at the end of the day were making 
this so complicated that I think we are forcing more 
consolidation, not less.
    And I would like your opinion on those two points. Are we 
making this so complicated that the big are going to get bigger 
and the small are just going to sell out?
    Mr. Volcker. This is a matter that, with some exceptions, 
broadly, these prohibitions apply to six, seven, eight 
institutions. The typical regional banks, certainly the 
particular community bank, is not doing proprietary trading. If 
they doing it, it is a very rare kind of transaction.
    So you are talking about a very concentrated number of 
banks, very sophisticated. They have trading desks. They do 
have, as I said before, their own interests, I am sure, strict 
controls over their trading desks, maybe not as strict as they 
should be sometimes, but they have them, because once in a 
while, even with those controls, they found out some rogue 
trader fell into a ditch and cost the bank $9 million, billion 
dollars or something, which has happened on a number of 
occasions either here or abroad.
    I think you do not have to trace every transaction in real 
time. I do not think that is the purpose of regulation, at 
least not the way I would write it. The regulation should 
describe generally a characteristic of proprietary trading. 
Then it should have some very sophisticated, but I do not think 
all that complex, measures of the bank activity.
    Now, all these banks will have daily reports on their 
trading activity anyway. If they do not, they ought to be put 
in jail for having unsafe and unsound banking practices. These 
trading desks are all controlled, daily. You know, in general, 
what the characteristics are of proprietary trading. You can 
look at those reports weekly, monthly, whatever you want to 
look at them, as set down by the Federal Reserve or whoever is 
doing it. If you see characteristics of those trading patterns 
that suggest proprietary trading, then you go look at it.
    In the last extreme, go to the trading desk and see what 
they are doing. If they say it is a customer trade, who is the 
customer? Why were you buying all these securities? You were 
not making a market when you are in the market buying the same 
security all morning. You are not in the market if there is no 
customer on the other side, or you are not market making for a 
customer. You do not have to look at it in that detail unless 
you were very suspicious, and I assume that, in good faith, 
with the management understanding what is at stake, that their 
reputation is at stake with the regulator, they will take due 
care.
    Senator Johanns. I am out of time. Thank you, Mr. Chairman.
    Senator Brown. Thank you, Senator----
    Mr. Volcker. I have had traders, people who ran trading 
desks in the past, tell me--in effect, they said, do not 
believe all this stuff. I ran a trading desk. It was the policy 
of the institution not to do proprietary trading. We were an 
active trader, but we did not do proprietary trading and our 
daily reports showed it.
    Senator Brown. Thank you.
    With the fact there are two other panels after you in mind, 
I have one question I want to ask. Certainly, the other Members 
of the Subcommittee can ask a question or two in addition, if 
you want, maybe not a whole second round. But Senator Merkley 
asked the question that you answered in terms of British banks 
tell their regulators that the Americans will have the 
advantage, and the American banks tell their regulators the 
British banks will have an advantage. In light of that, we know 
that the Swiss and the U.K. financial sector was significantly 
larger, their concentration, and banks in both nations were 
bailed out with billions of dollars from their governments and 
from others, including us, too. Both have taken dramatic 
action.
    I would just like your brief comment on, or your comments 
generally on what you think about Switzerland's considering 19 
percent capital requirements. U.K. has established firewalls, 
as you said, between banks' risky activities and traditional 
banking. Give me your thoughts on those two approaches.
    Mr. Volcker. Well, I will make one point. Those countries, 
their banks are no bigger than our banks, but the countries are 
smaller so they are more concentrated, much more concentrated 
than we are. So they feel even more vulnerable than we feel, I 
think, to these problems.
    Switzerland was obviously very concerned because they have 
two big banks. Both were in trouble. One was in severe trouble. 
They took strong measures, including exceptionally high capital 
standards and other measures, and my understanding is, and you 
can find out more directly, my understanding is that the 
biggest of those banks has practically given up proprietary 
trading. Whatever the law said, I am sure that they were under 
pressure from the central bank. And they have moved away from 
some of these activities to nonrisky activities, to 
investment--basically, toward investment banking, traditional 
banking on the one side, investment management on the other 
side. And they have been de-risked substantially.
    There has been some reaction along the same lines at some 
of the British banks. The British are still open as to how they 
apply the proposed regulation. It may be not insignificant. I 
was invited, and I will go, to have a little session with the 
European Parliament, with the British regulators and the 
commission. I say the British regulators. Mr. Vickers, who made 
the proposal about the British banking system. So we are going 
to have a better feel for how coordinated we are next month. I 
think the obvious purpose of the invitation was to try to get a 
maximum amount of coordination.
    Senator Brown. Thank you.
    Senator Corker, any comment?
    Senator Corker. In your written testimony, you alluded to 
the Government-Sponsored Enterprises, in particular, Fannie and 
Freddie. As you know, it has been 4 years and 95 percent of the 
mortgages originated today are dependent upon them. How 
important is it, in your opinion, that we move away from that 
reliance, and should they exist in their current forms?
    Mr. Volcker. Well, it is important if you think the free 
market financial system is important. Here we are sitting here 
with half of the capital market under the control of the two 
institutions, both of which at this point are Government owned. 
It is kind of ridiculous when you look at it.
    Senator Corker. I assume you think having a free market 
system is----
    Mr. Volcker. Well, I think not only you, but I think some 
other people are, too. So right now, unfortunately, the 
residential mortgage market is dependent on two de facto 
governmental institutions, Fannie Mae and Freddie Mac. So how 
do we wean away from that? It is going to take years, frankly. 
But, please, let us not make the same mistake of having these 
quasi-governmental institutions, half private, half public--
they are public when they get in trouble and they are private 
when they are making money.
    Senator Corker. That is right.
    Mr. Volcker. And that is a recipe for a not very 
disciplined, effective mortgage market, in my opinion. And that 
is a big issue of how we reconstruct the mortgage market. And, 
literally, it will take years.
    Senator Corker. Thank you very much.
    Senator Brown. Senator Merkley.
    Senator Merkley. Thank you, Mr. Volcker. The group of 
regulatory agencies working on the Volcker regulations, those 
30 pages that you referred to, have indicated that they might 
not be prepared to implement them in July, the 2-year time 
period after the passage of Dodd-Frank. Should they hold their 
deadline solid and get those rules implemented in July?
    Mr. Volcker. Well, I am not clear, frankly, on just what 
their attitude is. I have seen a couple of statements that 
confused me a little bit, and my understanding of the basic 
situation is they are aiming to get the final rule out by July, 
whatever the date is. They recognize it will take some time to 
adapt. They recognize that over a 2-year period, you may find 
particular things in the regulation you want to change. But the 
law also says after July whatever it is, no proprietary 
trading. So, I do not know, somebody told me, some law firm 
said if they do not carve out, they can do proprietary trading. 
That is a very strange reading of the law, but I--it is a 
very--I do not know. I will not get into the legal profession 
at this point. It does seem to me a rather strange, contrived 
reading. I do not even see how it is contrived, but there we 
are.
    Senator Merkley. Thank you.
    Senator Brown. Senator Johanns.
    Senator Johanns. It just occurs to me with the passage of 
Dodd-Frank, it incorporates the Volcker Rule and a whole host 
of other things--it is a very lengthy, complex piece of 
legislation--that at the end of the day, we still have a very 
small number of financial institutions that control an enormous 
amount of the capital of the United States and we just have not 
impacted that very much. Do you disagree with my assessment of 
that?
    Mr. Volcker. No. No. We do have a much more concentrated 
financial system than we used to have. I do think that 
skepticism about dealing with institutions outside of the 
banking organization itself, the protected sector of the 
market, I think the idea that they can and will fail is totally 
credible to me. When you talk about the biggest banking 
institutions, they get a lot of Government support in the 
ordinary course of business. I think they should be regulated 
to the point, including what we are talking about in 
derivatives and proprietary trading, that the risk of those 
institutions failing will be very remote. But they, you know, 
you say they have gotten quite concentrated. I agree with you.
    Senator Johanns. Yes. Thank you, Mr. Volcker.
    Senator Brown. Thank you very much for your testimony----
    Mr. Volcker. Thank you.
    Senator Brown.----and for your service for so many years.
    Mr. Volcker. I do appreciate you took this initiative. 
Thank you.
    Senator Brown. Thank you.
    The Chair will call up Tom Hoenig and Randall Kroszner, if 
you would join us.
    [Pause.]
    Senator Brown. Tom Hoenig--perhaps there is no stronger 
advocate for America's community banks than Thomas Hoenig. Dr. 
Hoenig is a Member of the Board of Directors of the Federal 
Deposit Insurance Corporation. For two decades, he has served 
as President and Chief Executive Officer of the Federal Reserve 
Bank of Kansas City. He spent 18 years as a bank supervisor at 
the Kansas City Fed.
    Randall Kroszner is the Norman R. Bobins Professor of 
Economics at the Booth School of Business at the University of 
Chicago. Dr. Kroszner served as Governor of the Federal Reserve 
System from 2006 until early 2009. During his time as a member 
of the Federal Reserve Board, he chaired the Committee on 
Supervision and Regulation of Banking Institutions and the 
Committee on Consumer and Community Affairs.
    Dr. Hoenig, you first. Thank you again for joining us.

 STATEMENT OF THOMAS M. HOENIG, VICE CHAIRPERSON AND MEMBER OF 
 THE BOARD OF DIRECTORS, FEDERAL DEPOSIT INSURANCE CORPORATION

    Mr. Hoenig. Well, thank you very much, Chairman Brown and 
Ranking Member Corker and Senator Johanns. Thank you for the 
opportunity to testify on issues relating to improving the 
safety and soundness of the Nation's banking system.
    Having joined the Board of the FDIC less than a month ago, 
it is a privilege to serve and to be part of a board that can 
draw from the depth of collective experiences and diverse 
backgrounds that I think will inform our discussions and our 
decisions going forward.
    This Subcommittee has asked me to discuss a paper titled, 
``Restructuring the Banking System to Improve Safety and 
Soundness'' that I prepared with my colleague Chuck Morris in 
May of 2011 when I was President of the Federal Reserve Bank of 
Kansas City. I welcome this opportunity to explain the 
recommendations in that paper.
    One note--while I am a Board member of the FDIC, on this, I 
speak for myself today.
    First, banking organizations should be allowed to conduct 
the following activities: commercial banking, underwriting 
securities and advisory services, and asset and wealth 
management services. Most of these latter services are 
primarily fee-based and do not disproportionately place a 
firm's capital at risk. They are similar to the trust services 
that have long been part of banking itself.
    But in contrast, dealing and market making, brokerage, and 
proprietary trading extend the safety net's coverage and yet do 
not have much in common with core banking services. Under the 
safety net and the incentives that follow from it--risks are 
created that are difficult for management and the markets to 
assess, to monitor, and to control.
    Thus, under the proposal, banking organizations would not 
be allowed to do trading, either proprietary or for customers, 
or make markets which requires the ability to do trading. 
Allowing customer trading makes it easy to game the system by 
concealing proprietary trading as part of the customer trading. 
Also, prime brokerage services require the ability to trade and 
essentially allow companies to finance their activities with 
highly unstable, uninsured deposits.
    This combination of factors, as we have recently witnessed, 
leads to unstable markets, financial crises, and Government 
bailouts. Furthermore, these actions alone would provide 
limited benefits if the newly restricted activities migrate to 
the shadow banks without that sector also being reformed. We 
need to change the incentives within the shadow banking system 
through reforms of money market funds and the repo market.
    The first change to the shadow banking system addresses 
potential disruptions coming from money market funding of 
shadow banks to fund long-term assets. Money market mutual 
funds and other investments that are allowed to maintain a 
fixed net asset value of a dollar should be required to have a 
floating net asset value. Shadow banks' reliance on this source 
of short-term funding would be greatly reduced by requiring 
share values to float with their market values.
    The second recommendation is to change the bankruptcy law 
to eliminate the automatic stay exemption for mortgage-related 
repurchase agreement collateral. This exemption allowed all of 
the complicated and often risky mortgage securities to be used 
as repo collateral just when the securities were growing 
rapidly and just prior to the busting of the housing price 
bubble. One of the sources of instability during the crisis was 
the repo runs, particularly on repo borrowers using subprime 
mortgage related assets as collateral. Essentially, these 
borrowers funded long-term assets of relatively low quality 
with very short-term liabilities.
    The proposal would not eliminate risk in the financial 
system. It would shift it away from the incentives of the 
safety net. This plan would return U.S. banks to a position of 
financial clarity and strength from which the country enjoyed 
decades of its greatest global economic advantage. It would 
improve the stability of the financial system by clarifying for 
management and regulators where risks reside; improving the 
pricing of risk; and, thus, enhancing the allocation of 
resources within our economic system. It would promote a more 
competitive financial system as it levels the playing field for 
all financial institutions in the United States.
    Finally, it will raise the bar of accountability for 
actions taken, and to an important degree give further 
credibility to the supervisory authorities' commitment to place 
these firms into bankruptcy or FDIC receivership when they 
fail, thus reducing the likelihood of future bailouts.
    I am pleased to provide you these comments and I am happy 
to take your questions. Thank you.
    Senator Brown. Thank you, Dr. Hoenig.
    Dr. Kroszner, thank you for joining us.

   STATEMENT OF RANDALL S. KROSZNER, PROFESSOR OF ECONOMICS, 
        UNIVERSITY OF CHICAGO, BOOTH SCHOOL OF BUSINESS

    Mr. Kroszner. Thank you very much. I am delighted to be 
here, Chairman Brown, Ranking Member Corker, Senator Johanns.
    My general approach to these very important issues that you 
have convened this hearing on is to try to clearly state 
objectives what regulation and regulatory reform are about and 
then try to weigh the costs and benefits of alternatives in 
order to decide which regulations and which reforms are most 
effective in trying to address those objectives. My priorities 
and objectives, I think, are very much shared by the Committee 
and in the discussion that we heard earlier, enhance the 
stability of the financial system and its resilience to shocks 
since its shocks are going to be inevitable. In other words, we 
can talk about it as trying to make the markets more robust to 
those shocks, and I go into much more detail in the 
contribution to the book that I have with Bob Shiller on 
reforming U.S. financial markets, on trying to make markets 
more robust.
    Second, obviously, we have to mitigate taxpayer exposure 
and moral hazard incentives, as was discussed in the previous 
panel, and I certainly applaud and share the objectives of the 
recent regulatory reforms, but I perhaps want to raise some 
questions about whether some of the proposed means are the most 
effective means possible to try to achieve those ends. Would 
they be the ones that would be the highest in a cost-benefit 
test?
    I think it is extremely important to identify the 
fragilities in the system and address those as directly as 
possible rather than rely too much on any one regulatory 
instrument or one regulatory intervention because I think that 
opens up the greatest possibilities for unintended 
consequences. I think some of the greatest fragilities in the 
system are leverage, liquidity, and interconnectedness. Our 
focus today seems to be primarily on interconnectedness issues, 
too big or, as I would like to characterize it, too 
interconnected to fail. Chairman Volcker in his testimony also 
characterized things that way.
    And so what we need to do is think about exactly where are 
those fragilities in the markets and address them directly. One 
of those fragilities which Dodd-Frank takes steps toward is 
trying to clarify contracts and contract enforcement, something 
that is very important in thinking about resolution of the 
large, complex financial institutions. New authority is given 
to the Treasury and the FDIC, but that authority has not really 
been clarified yet by the regulators. I think that is of the 
utmost importance. One of the challenges that we saw during the 
crisis was the uncertainty about contract enforcement, 
uncertainty about what is mine and what is thine in customers' 
accounts, and that is a recipe for an implosion of the business 
model and for just uncertainty where people in general pull 
back. So I urge greater clarity on that.
    Second, as has already been discussed, over-the-counter 
derivatives markets, trying to migrate those to cleared 
platforms, providing more information to market participants, 
more information to supervisors, and better incentives to avoid 
risk concentrations, as we saw in AIG.
    Third, I wanted to think about activity restrictions. And 
interestingly, Chairman Volcker in his testimony says that his 
first principle is that risk of failure of large interconnected 
firms must be reduced, whether by reducing their size, 
curtailing their interconnectedness, or limiting their 
activities. So it is interesting that he sees those as 
alternatives, and I think in thinking about it from a cost-
benefit perspective, that is the appropriate way to think about 
it. What is the best way to try to limit those kinds of risks 
to both the taxpayer and to the system overall?
    I am not 100 percent convinced that trying to draw the 
lines on what is and is not different types of trading 
activities will be the most effective way of getting there. As 
was discussed in earlier questioning, there is a lot of 
uncertainty about where the line should be drawn, and I think 
the greater clarity, the better. I was very heartened that 
former Chairman Volcker said that he did not want to exclude 
market making. I think it is very important not to exclude that 
very important function that provides liquidity and robustness 
to the markets in general. We would not want to have the 
unintended consequence of producing rules that actually make 
markets less robust rather than more robust. But I think it is 
very difficult to draw those lines clearly and crisply and 
ensure that we do not have unintended consequences of pushing 
activities off balance sheet or into the shadows, and so I 
think it is incumbent upon the supervisors and regulators to 
have much greater clarity when it comes to those issues.
    Also, something that has been mentioned is the culture of 
institutions and the culture of risk taking if these activities 
are there. I think it is important to remember that there were 
many institutions that were much more narrowly focused, 
primarily on mortgage lending, institutions like Washington 
Mutual, Countrywide, Indy Mac, that were not engaged in 
proprietary trading, not engaged in these other activities that 
may involve risks. But we are reminded that even their core 
activity of mortgage lending was extremely risky and brought 
these institutions down. So it is not clear to me that simply 
removing these activities will be things to change the culture 
or make institutions more stable. In some cases, as we have 
seen, very focused institutions actually could be quite 
unstable.
    Thank you very much.
    Senator Brown. Thank you, Dr. Kroszner.
    Dr. Hoenig, let me begin with you. I want to follow up on 
the concentration question that we discussed with Chairman 
Volcker. You and I have talked in the past about the importance 
of manufacturing. Your region was obviously a major 
manufacturing center and other things. The last 35 years, the 
share of GDP of manufacturing and financial services basically 
flipped. Thirty years ago, manufacturing was 25 percent plus of 
GDP and financial services about 10. Those numbers have more or 
less reversed in more modern days.
    To what do you attribute this growth of finance versus 
manufacturing in the real economy? Has this benefited our 
country? Give me thoughts on sort of how it happened and how 
Federal policy may have contributed to it.
    Mr. Hoenig. Well, relative to the manufacturing side, there 
are a whole host of considerations in terms of international 
competitiveness and all these sorts of things. But in terms of 
the growth of the financial industry, I think it is clear that 
if you provide a subsidy to an industry, as we have the 
financial industry in terms of these largest institutions, that 
is, when we passed the Gramm-Leach-Bliley Act, we allowed these 
high-risk activities, broker-dealer activities, into the safety 
net, which is a subsidy.
    We allowed them to, number one, leverage up and to become 
larger than they otherwise would have because they could take 
on, number one, greater risk with less capital required. 
Therefore, they could balloon their balance sheets, and they 
did. And I think those are the kinds of things that contributed 
to their very rapid growth and very strong drive toward 
mergers, consolidation--and the effect was concentration in the 
industry.
    It is partly the subsidy that is provided through the 
protection of the safety net that contributed to their 
advantage. You did not have the same, and, I think, wisely so, 
subsidies going into necessarily these other industries, 
although subsidies is a big issue in the United States, I 
realize, for other industries, as well. But I think for the 
financial industry, it was a big factor allowing them to grow 
and take on greater risk.
    Senator Brown. Thank you. Before I move on, Dr. Hoenig, I 
would like to submit for the hearing record a speech that Dr. 
Hoenig gave in Prague in 1999. You talked about the wave of 
mega-mergers and the problem of too-big-to-fail. Your 
prescience, unfortunately, was pretty accurate there, and 
without objection, I would like to submit that for the record, 
the speech.
    Senator Brown. Three years ago or so, Dr. Hoenig, you said 
that when Gramm-Leach-Bliley passed in 1999--this was now 10 
years later, you said this in 2009--the five biggest banks held 
38 percent of the assets in the financial industry. That, by 
then, had grown to 52 percent. I would like to ask you both, 
each of you, a three-part question. I will start with Dr. 
Hoenig.
    Tell me what this growth and consolidation has meant in 
three ways. One, for the management seeking to understand the 
companies they are running, so this huge growth, what it means 
to people actually in charge of running these institutions. 
Second, to the authorities monitoring these risks, how the 
regulators have been able to both understand and regulate these 
much larger entities. And, third, what it has meant to the 
community banks that are competing with these ever-growing 
mega-banks.
    Dr. Hoenig, I will start with you on the three-part 
question, then Dr. Kroszner.
    Mr. Hoenig. If I can, Senator, I would go back to my 
confirmation hearing when it was pointed out that if a bank is 
well capitalized, well managed, and well supervised, it will 
not fail. And if you think about the decade following Gramm-
Leach-Bliley, allowing these institutions, these broker-dealer 
activities and institutions to be brought into the safety net, 
it encouraged through the safety net, enormous increases in 
leverage and debt. We saw the capital levels of our financial 
institutions decline, or the leverage increase, and so we had 
weaker capital, very thin capital levels when the crisis 
emerged in 2007 and 2008.
    Second, we allowed the scope, if you will, of management 
to, I think, go beyond its capacity. It was not just these very 
important activities of lending and payment system 
intermediation that were there. Now you had all these new high-
risk-oriented broker-dealer activities. So the scope of 
management had to be able to cross over and manage these 
activities. That was an enormous additional level of 
responsibility that clearly was beyond management's ability to 
monitor and to control the risk. Had they been able to, we 
would not have had the crisis. So it was outside their bounds.
    And I think in terms of bank supervision, if it is beyond 
the management and directors' ability to control this risk and 
monitor this risk, I think it is a lot to ask the supervisors 
to fill the gap when you are pushing this risk off balance 
sheet and other ways of doing it. It is a lot to ask the 
supervisor.
    So what is the effect on the community bank? It is 
important because when you give one sector an advantage of this 
very significant too-big-to-fail safety net. Then, where are 
you going to put your funds as a major or as a medium-sized 
company or corporation? You are going to put it with the 
institution that will not be allowed to fail, and that is a 
nice advantage if you want to grow and become more, I would 
say, dominant in the industry.
    And the other thing about it is--in that sense, it is 
unfair because it does make consolidation even more important 
to the largest institutions--maintains too-big-to-fail--and 
that is a disadvantage to the regional banks and, I think, to 
the community banks, as well. That is how I have judged it over 
the last decade watching this emerge.
    Senator Brown. Dr. Kroszner.
    Mr. Kroszner. I will try to be brief. On the management 
issue, going back to the examples I had given of institutions 
that were very focused on a narrow set of activities, mortgage 
lending, that did not necessarily make them better managed or 
less risky, and there are some very large complex institutions 
that seem to have done well in the crisis internationally, both 
in the United States and outside of the United States, banks 
that have been more universal banks.
    We can find examples on either side. So I am not saying 
that it is consistent that diverse banks are always better 
managed and focused banks are always worse managed. That is 
certainly not the case. But I think it is very hard to 
generalize. I really think it depends upon the structure of the 
institution itself and the supervisory process over it.
    Senator Brown. So these banks are not necessarily--sorry to 
interrupt, but----
    Mr. Kroszner. Sure.
    Senator Brown. These banks, as I think Dr. Hoenig implied, 
if not said directly, in your mind are not by nature of their 
size too big to manage, if I could----
    Mr. Kroszner. Not necessarily, because we could see that 
there were some smaller institutions that were more focused 
that I think were very poorly managed and badly managed. So 
there are certainly some institutions that were not very well 
managed that were very large, so I do not want to say that in 
all cases they have gotten it right. In most--I should not say 
most, but in many cases they got it right.
    Senator Brown. In essence, they are not too big to manage.
    Mr. Kroszner. Not in principle too big to manage, that is 
right. But they certainly could be. Just the small institutions 
could be very poorly managed. Focused institutions like the 
ones that we are focused on, the mortgage market, many examples 
where they were, unfortunately, very poorly managed.
    That brings us to the next step about the authorities and 
the regulators, and this gets back to one of the issues that I 
had mentioned in my oral remarks about pushing things off into 
the shadows. So in principle, if you can make things very 
transparent, very simple, they are easier for the regulators to 
monitor. The challenge is that even if we try to do that for 
one set of organizations, that does not mean that the risks 
disappear.
    As Tom Hoenig made very clear in, I think, his very 
interesting proposal, he wanted to focus on not just the 
banking system, but also the shadow banking system, because 
when you put restrictions on one piece, there is a natural 
tendency for some of those activities to occur elsewhere. We 
sometimes would joke about the whack-a-mole problem, that you 
push down the mole that pops up from this game in one spot, but 
it pops up somewhere else. The risk does not disappear even if 
you get it out of one particular set of institutions because of 
the interconnections. Those activities typically are done 
either off balance sheet or very close to the bank as other 
funders are funded by the banks.
    So it is not clear to me that we actually can make the 
system easier for the regulators if one set of institutions may 
have fewer activities but a lot of those other activities do 
not actually disappear but are taking place in the shadows.
    The issue of the community banks. I very much share Tom 
Hoenig's view that we should not be having subsidies to one 
type of institution versus another institution. To use the 
public fisc to try to unbalance the competitive landscape is 
inappropriate, inconsistent with free markets, unfair, and not 
good policy. So we certainly want to try to rein in any 
particular subsidies that are being given to one type of 
institution versus the other to maintain the robustness of the 
6,000 community banks that continue to exist in the United 
States today.
    Senator Brown. And do you agree--I was not clear on how far 
your agreement with Dr. Hoenig was in terms of the advantages 
that large banks get over small banks in terms of the way the 
system has been built, that the less expensive the financial 
market, the advantages they get that way, in borrowing and 
other things.
    Mr. Kroszner. Well, I think the community banks are largely 
in different markets than the largest five or six institutions, 
or three or four institutions, that are really focused 
internationally on very large lending. So there is a lot of 
separation in the activities that they undertake. There are 
concerns on both sides that there are some subsidies on the 
smaller bank side from some of the safety net as well as on the 
larger bank side, and I think a careful cost-benefit analysis 
should be done to identify where those subsidies may be and, as 
much as possible, eliminate them, because I think both it is 
unfair and not good policy.
    Senator Brown. And do you agree that there are different 
consequences if a small bank fails versus a larger bank fails?
    Mr. Kroszner. There may well be different consequences. The 
key is whether you have correlation of the risk. So if it is 
just an isolated institution, just that there is a problem with 
that one institution, that is one issue. But if you have 1,000 
institutions that are all doing the same business, exposed to 
the same risks, and if one goes down, that is effectively the 
same as a thousand of them going down, then it may not make 
that much of a difference whether we have a few larger 
institutions or a thousand that may go down simultaneously.
    Senator Brown. Thank you.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and thank both of 
you for being here, and Dr. Hoenig, thank you for the time we 
spent yesterday. I appreciate it and am looking forward to the 
Hoenig Rule someday.
    [Laughter.]
    Senator Corker. But, look, you had made some comments 
earlier on. We had gone back, talking about Dodd-Frank itself, 
and I want to get to the model that you propose to have. It is 
really Glass-Steagall on steroids in many ways. But you talked 
about Dodd-Frank and the fact that it actually made our banking 
system, our financial system, less safe, and I am just--and you 
went on to say, ``I do not see a system that is more safe. I 
see it as less safe. What about it has made it more safe?'' 
When you say that, what is it in particular that you are 
referring to, if you can generalize?
    Mr. Hoenig. OK. What I am saying is if we have the elements 
of the resolution, which I think is extremely important, we 
also have the view that this new legislation will eliminate 
future crises that we have out there. And I think--I said I am 
skeptical, and I think skeptical is healthy in the sense that 
30 years of asserting that we have no institution too-big-to-
fail and then bailing them out is something that we need to be 
aware of. But, the real advantage is it makes us more resolute 
to make sure that we do take them into either bankruptcy or 
receivership going forward, and I think that is extremely 
important.
    Now, Dodd-Frank does give us the mechanism to do that. It 
is whether we have the will going forward. Now we have even 
larger institutions accumulating greater risk and 
concentration, so the ``will'' part will be even more difficult 
come forward.
    What the proposal I put forward says is, let us take these 
high-risk activities and let us move them out into the market 
and let the market be the judge there, and the part that was 
meant to be protected by the safety net--the payment system, 
the settlement system, the intermediation process--let us allow 
that to continue to be protected, but we take these others 
where the subsidy has allowed the leverage to move up and take 
that away. Then Dodd-Frank becomes even more, I think, powerful 
in the sense of resolving institutions that, in fact, fail with 
the next crisis. And I think that is where we have an 
opportunity to strengthen our hand going forward.
    And I want to comment on the fact that if, as some people 
say, if you take this away, we will not be as competitive. But 
in the 1980s and 1990s before the repeal of Glass-Steagall, the 
United States had the most vibrant banking and capital markets 
in the world. People came to us to get the financing, every bit 
as much as anywhere else in the world. When I say move them 
out, I do not mean let us eliminate market making. I do not 
mean, let us eliminate trading. I am saying, let us put it into 
the market where it can meet the market test, where it can be 
competitive and where the greatest innovation will come from. 
By putting them together and putting that subsidy around it, I 
think you inhibit our ability to compete in the world today in 
a vigorous and in a capitalistic sort of way, and that is my 
whole point for this proposal.
    Senator Corker. I know we had a lot of discussion around 
the Federal Reserve Rule 23(a), and I know we are going to talk 
about that some more later----
    Mr. Hoenig. Right.
    Senator Corker.----because there is a firewall that is 
being created there from the standpoint of money flowing back 
and forth and I look forward to future conversations there.
    But your approach is--what you are saying is you do not 
think Congress should even consider arbitrarily limiting the 
size of an institution. You think that separating one type of 
activity from the basic activities that banks did originally, 
you think separating those two is probably the best route to 
take, and over time, because of that separation, the size issue 
will resolve itself, is that correct?
    Mr. Hoenig. Yes. I am saying that if you try and resolve it 
by arbitrarily putting a size limit on, what is your principle 
for that? Is it antitrust? What is it? When you say, let us 
move these out, if you take these high-risk activities and move 
them out and make them subject to the market where they can 
fail, I think that becomes its own, if you will, control 
system.
    In commercial banking, now, we are going to have large 
institutions. We always have. But at least it allows the 
regional bank and the community bank to compete on a more equal 
footing. And this country has always had a range of very large 
institutions to very small in the financial side and it has 
paralleled our industrial side--large industrial to small. And 
we have been able to have a broad cross-section of each.
    We are now moving this into fewer and fewer institutions 
where everything has to take place and I think that 
disadvantages the vibrance of the United States, our 
entrepreneurial spirits that come from local financing, and I 
think it compromises that because it focuses everything on 
fewer and fewer banks over time, and that is what we want to 
avoid. I think we will always have large institutions, but when 
you level the playing field, I think you also allow for 
continuation of having small to medium to regional institutions 
competing and providing credit in the market. I think that not 
separating out the subsidy to the largest institutions 
handicaps the rest of the industry and, I think, handicaps, if 
you will, Main Street America.
    Senator Corker. Well, listen, thank you, and again, I 
really enjoyed the time and look forward to furthering our 
conversations. I know the last two witnesses have referred to 
the resolution piece, and while it did not end up perfectly, 
that is certainly an area that I know myself and Senator Warner 
spent a lot of time on, and hopefully, officials will have the 
courage to put a bank out of its misery if it fails. I know the 
tools certainly have been given there. And I think there are 
some more evolutions that need to occur. I mean, some of the 
bankruptcy components that we were not able to get into the 
bill should be there.
    Dr. Kroszner, you spoke about--in your testimony, you made 
comments about cost-benefit analysis. I am hearing out there in 
sort of the world of people dealing with regulators that there 
really are not appropriate cost-benefit analyses being done on 
these rules and there are many people who are predicting a 
plethora of lawsuits down the road as these rules actually come 
into play because the regulators are not adhering to 
Congressional mandates of ensuring that there are cost-benefit 
analyses. I am wondering if you are hearing the same thing.
    Mr. Kroszner. Well, I think it is extremely important to 
focus on cost-benefit analysis. I mean, if you--and it has 
bipartisan support. I was actually recently reviewing the 
Executive Orders from President Reagan and from President Obama 
on exactly this issue and it is really quite surprising how 
similar they look. So I think there is agreement across the 
aisle that to make good policy, you have to think about the 
cost and the benefits.
    Obviously, there have been a number of lawsuits that some 
regulators have lost recently because they have not properly 
done economic analysis. I think it is very important to do 
that. I think that should be the focus of both thinking about 
what the objectives are, thinking about what the relevant 
alternatives are, and then doing as best a job as possible. It 
is never going to be perfect because you are trying to predict 
the future. You do not have the future data. But you can draw 
on historical analogies, international analogies, and different 
economic theories to try to get a feeling for what would make 
the most sense to try to address the objective you have.
    And I think that is very important, because one of the 
disciplines that cost-benefit analysis does, it asks you, what 
are you trying to achieve? Sometimes people just have various 
objectives that are not well specified, not well focused. But 
it forces the policy process to address that. And so the more 
that they do, the better it will be.
    Senator Corker. Let me ask you this. What is driving many 
of the regulators that are promulgating these rules? What is 
driving them, especially around Dodd-Frank, not to be doing 
what they have been mandated to do as it relates to cost-
benefit analysis? And, Dr. Hoenig, if you want to weigh in on 
that, because I do think these rules are going to be on their 
way for years. We have done anything but create 
predictability----
    Mr. Kroszner. Yes.
    Senator Corker.----at a time when people talk about 
predictability. As a matter of fact, you would have to wonder 
what Congress's intent was with all of Dodd-Frank when it was 
put in place from that standpoint. But what do you think is 
driving regulators to ignore this cost-benefit analysis and set 
themselves up for major setbacks down the road?
    Mr. Kroszner. Well, I am hoping that they are not. I am not 
privy to the internal processes, so I do not want to say 
anything specific about any particular process. But I think a 
lot of regulations--a lot of regulatory processes, more than 
100, I believe, were set in train by Dodd-Frank with a 
relatively tight time table. And so that perhaps may have put 
some constraints on the ability to take as much time to gather 
the data and do the analysis that is necessary.
    This is one of the issues, I think, that has come up with 
the many questions that were in the Volcker Rule proposal. A 
lot of them involved requests for data, which I think is 
exactly the right thing for the regulators to do. And if it 
need be that it takes a little bit more time to do the 
analysis, to be able to draw the lines appropriately to really 
try to minimize unintended consequences and increase the 
robustness of the system, I would be very sympathetic to 
allowing more time for that.
    Mr. Hoenig. I would offer this. I am only getting involved 
in it in the last month, but I would share this observation, 
that there are two complaints that I see coming forward, that 
they are not moving fast enough and that they are moving----
    Mr. Kroszner. Too fast.
    Mr. Hoenig.----too fast.
    [Laughter.]
    Mr. Hoenig. I do think that they are being very careful, 
because I think most of the regulatory authorities understand 
the law of unintended consequences, have seen it and are 
worried about it, and, therefore, are trying to be very 
deliberate. And I know from experience that cost-benefit 
analysis is very time consuming and very slow and I think that 
is one of the reasons that, for some, this has been going 
slower than people would like.
    So I think there is a sincere effort to get this right, but 
it is a big piece of legislation. There are a lot of moving 
parts in it. And it is probably going to be hard to satisfy 
everyone when we get through with this.
    Senator Corker. Thank you both very much.
    Senator Brown. Thank you both for joining us. Dr. Hoenig, 
thank you and thanks for your service. And Dr. Kroszner, thank 
you very much for joining us.
    Mr. Kroszner. Thank you.
    [Pause.]
    Senator Brown. The third and final panel--thank you for 
joining us. Thank you very much for your patience and for 
waiting through two panels. They were interesting. I know we 
all learned--at least, I think, Senator Corker and I learned 
some things.
    Tom Frost is a lifelong banker, the fourth generation of 
his family to oversee the Frost Bank, which was founded in 1868 
in San Antonio, Texas. He is the Chief Executive of the Board 
of Frost National, with 78 financial centers across Texas.
    Marc Jarsulic is no stranger to this Committee. He worked 
as an economist on the JEC, the Joint Economic Committee, and 
was a senior staffer for the Senate Committee on Banking under 
Chairman Dodd during the crafting of Dodd-Frank. Mr. Jarsulic 
currently serves as Chief Economist at Better Markets, an 
organization that promotes the public interest in the capital 
and commodities markets.
    James Roselle is the Executive Vice President and Associate 
General Counsel of Northern Trust Corporation, a global 
financial services firm based in Chicago. He is focused on 
regulatory changes resulting from Dodd-Frank and briefs his 
firm's Board of Directors on these issues.
    And Mr. Anthony Carfang is the Director of Treasury 
Strategies. Mr. Carfang has helped some of the world's largest 
banks and securities firms to position their services in the 
marketplace. He has advocated for the interests of his clients 
with regard to regulatory issues and liquidity management.
    Thanks to all four of you. Mr. Frost, would you begin.

 STATEMENT OF TOM C. FROST, CHAIRMAN EMERITUS, FROST NATIONAL 
                              BANK

    Mr. Frost. Well, thank you for inviting me. It is a real 
honor for you to have me here, and I especially note that 
except for my compatriot from Northern Trust, we are the only 
people who are actually practicing in the industry that you are 
listening to. And I would hope that you would, in the future, 
hear more from us who are in the business than just listen to 
educators and regulators, many of whom I agree with, but I 
think to hear practitioners--banking has been in my DNA, as you 
said, for now 5 years [sic].
    I am from San Antonio, Texas, and I served for 57 years, 26 
of them as Chief Executive Officer of a commercial bank 
established by my Great-Grandfather. The institution grew and 
prospered through money panics, wars, and depressions, now with 
$20 billion in assets and now 115 offices, all of them in 
Texas. The Frost Bank did not take Government funds from the 
issuance of preferred stock in 1933 and was one of the first 
banks to refuse TARP money in 2008.
    I personally survived the very difficult times of Texas in 
the 1980s where many lessons were learned and the Frost Bank 
was the only one of the top 10 commercial banks in Texas to 
survive through a period when a significant number of banks 
failed and most of the savings and loans were closed.
    I will start out with my first days as a young college 
graduate and a fresh employee of the institution I have just 
described, and I want to say as an aside, one of the things I 
am going to be talking about here is a difference in cultures, 
and I want you to focus on that. We have all talked about where 
people came from, how big they are, what kind of people, where 
we have not talked about the culture in which they lived and 
worked.
    My Great Uncle Joe, who was then CEO--this is 1950 when I 
got out of college--I was a young, inexperienced banker. I had 
been there in the summers. He told me that the very first goal 
we had was to be able to return the deposits received from the 
customers--the first goal we had. Our obligation was to take 
care of the community's liquid assets and to manage them in a 
safe and sound fashion for the use--loans--of the community to 
grow.
    Uncle Joe told me in 1950 that we were not big enough to be 
saved by the Government, that we would need to always maintain 
strong liquidity, safe and sound assets, and adequate capital. 
I was impressed by the fact that the need to make money was not 
high on this list but does occur if sound banking practices are 
observed.
    Uncle Joe was not a fan of the FDIC. He told me it took his 
money to subsidize his inefficient competition. I personally 
support the FDIC as a protector for the depositor, but want to 
suggest that this safety net apply only to banks which receive 
FDIC-insured deposits. I am convinced that offering the safety 
net to other financial institutions which provide services not 
deemed appropriate for deposit loan commercial banking 
institutions is not sound public policy.
    The deposit facilities of financial institutions which 
provide primarily investment, hedging, and speculative services 
should have no taxpayer safety net. These institutions should 
be governed by market forces with investors understanding what 
can be earned and what can be lost. This would involve the need 
to separate two cultures, the one which Uncle Joe articulated 
and our family has followed for 144 years, by establishing 
long-term customer relationships and building our community and 
preserving its liquid assets. Other financial institutions can 
provide the other services that are not authorized to insured 
deposit banks at a potential good profit, but without a 
taxpayer risk through a Federal safety net.
    I would suggest that the two types of institutions have 
separate ownership, separate management, and separate 
regulation. My conviction comes after seeing both systems, 
which were separated but now have been joined to create a 
situation which in 2008 brought bout the near catastrophe of 
collapse of the world financial systems. Following the path 
that we are on currently will not only provide opportunity for 
the same occurrence to be--consequences to be repeated, but 
also mean the end of a banking system consisting of many 
providers.
    It seems we are rapidly approaching a system which will be 
an oligopoly of a few major institutions whose management will 
not only have the same concerns and dedications as emphasized 
by Uncle Joe. So if both cultures are separated, the clients of 
both will prosper, but without the inordinate risk of a 
potential massive cost to the taxpayer.
    I thank you for giving me the opportunity to express my 
opinion, which has been developed over a half a century's 
experience and has led me to the conviction that the insured 
deposit banking system we had was effective, worked well, and 
did not require any significant Federal support until 2008 when 
other activities of large institutions involved in so-called 
investment activities nearly destroyed the financial system and 
imposed enormous costs on taxpayers to the present day.
    Gentlemen, what we are talking about is a conflict of 
cultures, and I would like to ask you to even stop and talk 
about doing something differently than what is proposed to you 
in Dodd-Frank and talking about the separation of the cultures, 
the absence of a Federal safety net for one, different 
regulation, different ownership, and the market activity 
organized--supported by one, and to take a look at a different 
way to do things, because if we keep things doing the same way 
over and over and expecting different results, I think, 
facetiously, that is called insanity, and I think we are on the 
level of going to do the same thing over and over and over 
again with what we are proposing.
    Thank you.
    Senator Brown. Thank you, Mr. Frost. We appreciate your 
comments.
    Mr. Jarsulic, welcome again back to the Committee.

 STATEMENT OF MARC W. JARSULIC, CHIEF ECONOMIST, BETTER MARKETS

    Mr. Jarsulic. Thank you, Chairman Brown, Ranking Member 
Corker. Thank you for the invitation to Better Markets to 
testify today.
    Let me start with the observation that the very largest 
bank-holding companies, which for convenience we can think of 
as the 10 largest, are now distinctly different from the rest 
of the banking industry. They are more highly leveraged than 
other banks. They are far more likely to operate large and 
complex broker-dealers. And they are more likely to be directly 
dependent on unstable sources of short-term financing. Each of 
these characteristics made the large bank-holding companies 
vulnerable during the financial crisis and each of these 
characteristics needs to be addressed by effective 
implementation of relevant sections of the Dodd-Frank Act.
    During the crisis, high leverage, that is, a high ratio of 
assets-to-equity, increased the likelihood that the large bank-
holding companies would become insolvent if asset prices 
declined significantly. During the period 1990 to 2000, the 10 
large bank-holding companies had a leverage ratio of about 20-
to-1, which in itself is fairly high. By the end of 2000, the 
leverage ratio had risen to 34, and this put the large bank-
holding companies at approximately the same level of the five 
largest stand-alone investment banks, who had a leverage ratio 
of 36.
    Thus, in 2007, large bank-holding companies, like the large 
investment banks, could see their equity wiped out by a 3-
percent decline in asset values. Their funding sources and 
assets were not identical to the investment banks, but on the 
important dimension of leverage, they were in the same 
ballpark.
    Proprietary trading made them less safe because the 
speculative positions can quickly produce large unexpected 
losses which may not be backed up by sufficient capital. I 
think the trading losses at Citigroup are a case in point. As 
part of its trading operations, Citigroup was one of the 
largest issuers and traders of CDOs in the world, many of them 
backed by subprime mortgage-backed securities. But Citigroup 
was unwilling to sell the so-called super senior tranches of 
these CDOs at market clearing prices, so between 2003 and 2007, 
they accumulated $43 billion worth of these securities which 
they held in conduits and in the trading book. But in 2007, 
when the subprime mortgage market tanked, Citigroup had to 
start writing things down, and by the end of 2008, they lost 
$39 billion on these CDO-related positions. So very early in 
the crisis, proprietary trading did significant damage to a big 
bank-holding company.
    A final area of instability comes from the dependence of 
the large bank-holding companies on short-term very unstable 
financing. This makes the banks less safe because creditor runs 
can force asset sales and realization of losses. And during the 
crisis, there were runs on both repo borrowing and asset-backed 
commercial paper. The trading operations of the large bank-
holding companies and investment banks are often highly 
dependent on repo funding, which is collateralized short-term 
borrowing, often for periods as short as a day. It is estimated 
that in 2007, the five largest investment banks funded as much 
as 42 percent of their assets on repo funding. That is, they 
were borrowing every day to support their book, and I do not 
think there is a good reason to believe that bank traders were 
operating differently.
    Second, the banks commonly use conduits, which issue short-
term commercial paper backed by a pool of assets, because it 
allows them to increase their leverage at a relatively low 
cost. But again, there was a run on asset-backed commercial 
paper during the crisis and ultimately the Federal Reserve had 
to step in to rescue this market.
    Given the scale of the large bank-holding companies, these 
vulnerabilities also threaten the financial stability of the 
system as a whole. No large bank-holding company failed, but I 
think if you look back to the scale and scope of the rescue 
effort at Citigroup, we can see that it was a very close thing.
    So to prevent the recurrence of near catastrophes in the 
future, regulators need to use the tools created by Dodd-Frank 
to eliminate the threats to financial stability that are caused 
by large bank-holding companies. In particular, we need, one, 
effective leverage limits for the largest bank-holding 
companies. Section 165 of the Dodd-Frank Act gives the Federal 
Reserve the option to impose much higher capital requirements 
on the banks. The Fed is imposing Basel III requirements, and 
these, for reasons we could talk about, seem relatively 
inadequate.
    Second, effective implementation of the Volcker Rule would 
do a lot to reduce the risk created by bank trading operations, 
and I think that there are two parts to this. One is a well 
defined definition of market banking so that it cannot be gamed 
and cannot become a source of risk. But of equal importance are 
significant leverage limits on trading operations because they 
are based on a funding model which is highly leveraged and 
highly unstable.
    And finally, there needs to be an effective regulation of 
shadow banking activity, in particular, aspects of the shadow 
banking industry that cause potential creditor runs on these 
big bank-holding companies, for example, the behavior of the 
conduit market.
    Taking these steps, I think, will go a long way to 
containing the risk posed by the size and complexity of the 
largest bank-holding companies. Thank you.
    Senator Brown. Thank you.
    Mr. Roselle, thank you for joining us.

  STATEMENT OF JAMES E. ROSELLE, EXECUTIVE VICE PRESIDENT AND 
     ASSOCIATE GENERAL COUNSEL, NORTHERN TRUST CORPORATION

    Mr. Roselle. Thank you, Chairman Brown, Ranking Member 
Corker. I appreciate the opportunity to testify before you 
today on behalf of Northern Trust.
    Northern Trust supports the very positive efforts of 
Congress and this Committee to put in place reforms that reduce 
risk to the financial system, and many of those are included in 
the Dodd-Frank Act. Those are all very good reforms. However, 
it is essential that efforts to reduce risk are carefully 
calibrated so they do not inadvertently restrict or harm core 
banking activities that serve the needs of customers in the 
United States and around the world, that provide employment for 
our citizens, and that promote the economy.
    I would like to focus my testimony on specific provisions 
contained in the Volcker Rule to show why it is so important to 
consider the full impact of regulatory reforms in order to 
avoid unintended negative consequences for individual banks and 
for the economy more generally.
    Northern Trust does not engage in the types of activities 
the Volcker Rule intended to prohibit. In fact, we heard from 
Chairman Volcker earlier that he thought the proprietary 
trading rules would only impact maybe six to eight 
institutions. I wish that were true. Specifically, Northern 
Trust does not engage in high-risk proprietary trading and 
investment activities. Because of the traditional nature of our 
core banking business, we anticipated the Volcker Rule would 
have little or no impact on our business. The rules as 
currently proposed, however, will adversely impact 
traditionally low-risk business activity that investors rely on 
for investment management purposes. If not corrected in the 
rulemaking process, a core banking business of Northern Trust 
and other banking companies will be adversely impacted, which 
may ultimately impair the competitiveness of U.S. banks in a 
business where we are the acknowledged global leaders.
    Today, I want to summarize three parts of the proposed rule 
to implement Volcker that go beyond what the law requires and 
that may significantly impact Northern Trust and our clients. 
First, the proposed rule unnecessarily includes a broad range 
of funds that banking entities will be restricted from 
sponsoring or investing in. The definition of a covered fund 
would capture nearly all foreign funds, as well as many other 
entities that do not have traditional hedge fund or private 
equity fund characteristics. This definition is important, 
because if a bank is deemed to be a sponsor or an advisor to a 
covered fund, then the proposed rule--then under the proposed 
rule, the bank is prohibited from providing any credit 
whatsoever to the fund under the super 23(a) provisions.
    Ordinary custodial and administrative services provided to 
our clients must include the provision of intra-day or short-
term extensions of credit to facilitate securities settlement, 
dividend payments, and similar custody-related transactions. 
These payment flows are expected in order for transaction 
settlements to operate smoothly and they have been encouraged 
by global financial supervisors. Nevertheless, these low-risk 
extensions of credit appear to be considered as prohibited 
covered transactions under the proposed rule.
    Second, the proposed inclusion of foreign exchange swap and 
forward transactions within the proprietary trading 
prohibitions will result in damage to a traditional and low-
risk activity with no offsetting benefit to the U.S. financial 
system. As a significant global custodian and asset manager, 
Northern Trust carries on an active foreign exchange trading 
operation that is directly related to our core client services. 
In essence, these currency transactions are simple cash 
management transactions used by our clients to efficiently 
manage cross-currency needs. The agencies should exclude these 
transactions from the trading restrictions for the same reason 
that the Treasury Secretary proposed to exclude them from Title 
VII of Dodd-Frank.
    Third, the compliance requirements in the proposed rule are 
unduly burdensome and will unnecessarily increase compliance 
costs for banks with little or no offsetting benefit. The 
proposed rule essentially requires the bank to prove that each 
transaction does not fall within the prohibited category and 
requires banks to produce a large number of compliance metrics 
which will result in considerable systems expenditures and 
ongoing costs of compliance. We believe the agencies could 
carry out the intent of Congress more effectively and with less 
cost to the banking system with a simpler rule that is 
supplemented by a few key metrics and active supervision of 
bank trading risks and practices.
    We urge this Committee to encourage the agencies to adopt 
final regulations that carry out Congressional intent to 
prohibit high-risk trading and investment activities but not to 
adversely impact those traditional business activities that 
played no role in causing the financial crisis. Preserving our 
business models will ensure that U.S. banks can operate 
effectively and competitively while protecting against negative 
impacts on the broader economy and U.S. employment.
    Thank you, Chairman Brown, Ranking Member Corker, for 
allowing me to present Northern Trust's views on this 
critically important topic.
    Senator Brown. Thank you, Mr. Roselle.
    Mr. Carfang, welcome. Thank you for joining us.

STATEMENT OF ANTHONY J. CARFANG, PARTNER AND DIRECTOR, TREASURY 
  STRATEGIES, INC., ON BEHALF OF THE U.S. CHAMBER OF COMMERCE

    Mr. Carfang. Thank you, Chairman Brown, Ranking Member 
Corker. I am delighted to be here today on behalf of the U.S. 
Chamber of Commerce, the three million members, each of whom 
are customers of banks. So we are representing the customer 
side this afternoon, as well.
    My name is Tony Carfang and I am partner with Treasury 
Strategies. We are a leading consulting firm in the area of 
Treasury and cash management. We help corporate treasurers day 
in and day out manage their risk, raise their capital, fund 
their accounts, and meet their payrolls. We also work with the 
financial institutions, large and small, in fact, around the 
globe, who provide services to businesses to make productive 
use of their capital.
    I would like to leave you with four messages today. Number 
one is that the U.S. economy is the most capital efficient in 
the world. None comes close, and I will share with you some 
statistics in a second. But I want to say that this is a 
delicate balance and we need to make sure as we move to the 
next generation of financial services we do not destroy the 
capital efficiency that we have worked two centuries to 
achieve.
    Number two is that the U.S. financial system is a very 
delicate mosaic of banks, money market funds, securities firms, 
institutions large and small serving corporations large and 
small who have needs that in some cases are regional, in some 
cases are global, some are industry specific, and what we have 
is actually a very beautiful mosaic of all of this coming 
together, and we need to understand how this all works before 
we begin changing it.
    The third point I would like to make today is that risk is 
like energy in that it can neither be created nor destroyed. It 
can only be transferred. So please do not be lulled into 
thinking that if you eliminate a risk in a particular 
institution that that risk goes away. It goes somewhere else 
and we need to understand where it goes. So, for example, if a 
bank is unable to help a client hedge commodities, let us say, 
and there is a farmer out there somewhere whose profit, whose 
crop is at risk, so we have taken the risk out of the bank and 
put it back on the farm. We need to be careful about that. 
Similarly, a manufacturer who cannot hedge foreign exchange may 
choose not to export and may actually shrink the size of the 
company. There is an interconnectedness here that we need to be 
very careful to preserve.
    The fourth point I would like to make is that we are in the 
midst of an uncontrolled experiment. Now, we are not arguing 
against regulation at all, but what is happening is that there 
are a number of regulations being promulgated around the world 
right now that are directed at financial institutions, things 
like Basel III, things like derivative regulation, new talk of 
another round of money market fund regulations. All of these 
are untested and they are all designed, oriented toward 
financial institutions, but, frankly, they all land on the desk 
of the corporate treasurer. The financial institutions are the 
intermediaries. It is the consumer, it is the business person, 
it is the corporate treasurer that is dealing with all of these 
simultaneously.
    Senator, you raised the question of cost-benefit analysis 
earlier, and frankly, not only do each of these need to have a 
much more thorough cost-benefit analysis, but they need to be 
analyzed in the context of their interrelationship and what it 
means to simultaneously change a liquidity requirement, add a 
capital requirement, eliminate a trading business, and throw in 
a little bit of risk management or whatever you want. We have 
an experiment that is moving out of control.
    I would like to go back to the point of capital efficiency 
because that is a hallmark of American business. U.S. companies 
are sitting on a record amount of corporate cash, and I am sure 
you see those headlines, $2.2 trillion at the end of the last 
quarter. That represents 14 percent of U.S. GDP. A similar 
ratio in Europe is 21 percent. That is, European corporations 
hold cash on their balance sheets equal to 21 percent of the 
total GDP of the Euro zone. You might say we are 50 percent 
more efficient. Should we lose this capital efficiency and 
companies move to this 21 percent range as a result of some 
regulations that are not totally thought through, that $2.2 
trillion on Americans' balance sheets at 14 percent, 21 
percent, that translates to $3.3 trillion.
    We are, in effect, taking $1.1 trillion out of the U.S. 
economy, putting it in cash on balance sheets and effectively 
sidelining it. So we have the potential here of destroying 
capital efficiency that has a magnitude that is greater than 
the entire stimulus program, $1.1 trillion. That is more than 
QE II. That is more than the entire TARP program. So I think we 
are playing with fire here and we need to be very, very 
careful, hence the point on an appropriate cost-benefit 
analysis not only on one regulation but across the board.
    We want to make sure that America's businesses can continue 
to have access to the capital markets and raise capital as 
efficiently as possible so that they can grow their businesses, 
so that they can create jobs, so that they can manage their 
risk.
    And I would say to you the real threshold question and what 
we are putting at risk here is when a business's treasurer 
calls a bank to raise capital or to manage risk, is there going 
to be a U.S. banker there to answer the call?
    Thank you very much.
    Senator Brown. Thank you, Mr. Carfang.
    I am a little confused. I was going to go in a different 
place, but I want to follow up with your last statement there.
    Mr. Carfang. Sure.
    Senator Brown. The $2.2 trillion, the 14 percent of GDP 
that sits as cash reserves, these are not just banks. These 
are--you are talking about all American companies? You are 
talking about Alcoa, any large manufacturers that sit on large 
cash reserves?
    Mr. Carfang. I am talking about all of America's 
nonfinancial corporations. This is published each quarter----
    Senator Brown. Yes. I guess--that seems--I know of that. I 
think we hear that often----
    Mr. Carfang. Yes.
    Senator Brown.----and I guess I do not think that it is a 
regulatory issue as much as it is these companies do not see, 
for reasons of uncertainty or reasons of lack of demand, do not 
see it as good economics for their companies, good policies for 
their companies to invest back in job creation, invest in 
capital equipment. That is my understanding.
    Mr. Carfang. Well, and they also need that for working 
capital and precautionary needs, as you just pointed out. And 
my point is that the comparable number in Europe is 50 percent 
higher----
    Senator Brown. Right. I got that, the 14 versus 21. I guess 
when I talk to--and my State, Ohio, has a large number of major 
manufacturers. They tell me, 5 years ago, that a company might 
have had $100 million in cash reserves, now has $400 million. 
That is not a question of they need more in order to 
potentially protect themselves as much as it is they do not see 
the demand in the marketplace for them to reinvest in the 
company, or they use those dollars to buy other companies or 
stockpayer--stocks, whatever. OK. Let me go somewhere else with 
this, and thank you for that insight, Mr. Carfang.
    Mr. Frost, you had mentioned, I thought, importantly so, 
that you and Mr. Roselle are the only people that are working 
actually in banks on any of three panels of the seven of you 
here today. Let me ask you a question based on that. You are 
$20 billion in assets, 48th largest bank in the United States. 
That is one-one-hundred-fifteenth the size of the largest bank 
in the United States. The former executive of a trillion-dollar 
bank told the Financial Crisis Inquiry Commission that it is 
impossible for executives to understand the balance sheet of an 
institution of that size--that size, 115 times your size--on a 
daily basis.
    I asked Mr. Kroszner and Mr. Hoenig about that. Do you 
think those institutions, those five, six, seven, those 
institutions that are a $1.5, $2 trillion in assets, are they 
too big to manage? We had that question on the last panel. In 
your mind, from your experience of 60 years at the bank and 
your family's experience, are these too big to manage?
    Mr. Frost. I think, because of the cultures, they are 
impossible to both be managed by the same manager. Now, you 
have read, maybe, about Built to Last and Good to Best [sic], 
the books, and those books say that the most effective 
corporations in all of America that were built to last did not 
have profit as a major objective of the company, and the ones 
that went from good to best reduced the level of profit making. 
So you have got a culture with the large investment financial 
firms that deal only with transactions, where the transactions 
work out to a direct impact on the pocket of the person who is 
dealing with the customer. That is what investment banking 
does, and they do it beautifully.
    When you talk about Uncle Joe and talking to me, profit was 
down at the bottom of the list, and our present mission 
statement is we will grow and prosper by building long-term 
relationships based on good service and high ethical standards 
and safe and sound assets. But I want to tell you, the reason 
our mission statement is that way has nothing to do with 
profit. It tells everybody what to do when they come to work 
every day. Build relationships. We build them with each other 
to have the ability to take care of customers. We build the 
customers to take care of us.
    So I do not think when you have the transactional 
businesses that we are--Mr. Volcker talked all about them, the 
man from the Federal Reserve of Kansas City later on talked 
about it. When you have a manager that is basically thinking 
about his own pocketbook and what he is going to gain by the 
dollars and cents that are coming down and not thinking of the 
customer, you have a different culture than the one that I have 
grown up in, the Kempers in St. Louis--I mean, in Missouri, 
there are two of them in Kansas City, run beautiful banks, 
there is a man in Oklahoma who runs the Bank of Oklahoma, same 
way. When you are working to take care of the relationships 
with your customers for what will be of value and benefit to 
them and taking care of them and great value to the whole 
economy, the whole community, and profit comes if you do that 
well without starting out and saying, I am making a deal today 
because it is going to bring $500,000 into my pocket at the end 
of this year by the bonus I am going to get.
    So my answer is you cannot have the two cultures in one 
entity. They have got to be in separate entities. And I am, in 
all due deference to the U.S. Chamber of Commerce, we had big 
financial institutions, Goldman Sachs and others, that were 
doing very well taking care of big companies internationally 
and we had big banks that we could take care of and compete 
with very satisfactorily, even though we are in different 
markets with the smaller entities, and that system worked.
    So in answer to your question, I think if we have the 
cultures that do not understand, that operate differently, I 
think you cannot possibly succeed, and that is what 2008 
brought us. Two-thousand-eight brought us the disaster of the 
culture that had profit at the top of what they wanted to do. 
They did not care who ended up with those mortgage bonds. They 
only cared about the interest to them. And every single step 
felt that way in those mortgage things, right down to the last 
poor dumb guy that bought them without doing anything but 
looking at the ratings, and what we had was a disaster because 
everybody down the line was just making some money off of it 
and had no vigorish in the game.
    So, to me, your answer--my answer is, you cannot put the 
two together. That is what we have demonstrated by getting away 
from Glass-Steagall. You cannot put them together. You will 
have a disaster. You will keep doing the same thing over again, 
and that is the definition--and expecting a different result, 
and that is the definition of insanity.
    Senator Brown. Thank you, Mr. Frost. A 144 years of success 
is hard to argue with.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank all of 
you for your testimony.
    If I understand you, Mr. Frost, what you are, I think, 
advocating, generally speaking--I know it is a very general 
statement--but basically, Dodd-Frank did everything but address 
the core issue from your perspective. It went around the world 
trying to address all these little things that at the end of 
the day you think best could be resolved by sacking Dodd-Frank 
and just going back to Glass-Steagall, or maybe what Mr. Hoenig 
was referring to, Glass-Steagall on steroids. Is that a 
generalization of what you are saying?
    Mr. Frost. Well, yes, both of them are, but Dodd-Frank, of 
course, had a big package of things that, I think, were a big 
mistake and ought to have been dealt with separately, and I am 
only talking about one of them and the one of them is the 
separation of the two financial systems, the one with the 
safety net which worked and we had--we solved in this country 
every single commercial bank failure, including all the large 
banks in Texas. And I do not care what Governor Perry said 
running for President. Texas has had a few things that were not 
exactly perfect--not very many, but the banks were one. And 
what we have done is we had a system that worked and not a 
single penny of taxpayer money went to solve one of those 
banks. The taxpayer money went to take care of those savings 
and loans that you allowed to go in and do things that--you, 
the Congress, allowed to go in and take interest in entities to 
which they were lending.
    So what I am saying is we had a system that worked. It can 
continue to work regardless of the size of the two if you 
separate the cultures. Let one have a safety net and have a 
regulation that does not allow it to do certain things and the 
other has no Government safety net, but has different 
regulation that makes them lose money and not ruin the system.
    Right now, the Dodd-Frank is just a real mish-mash of 
things to do, including protect consumers, protect mortgages, 
manage big banks, and let me tell you, we have all been hearing 
today about how to handle the big banks, and the unintended 
consequences which many people here mention is what is 
happening to us in the smaller banks. We are getting killed by 
this thing because you are not paying attention, Mr. Chamber of 
Commerce, to the mosaic and the change in the mosaic. It ain't 
the mosaic that we saw before we took away Glass-Steagall. It 
is a different mosaic.
    We have got 52 percent of the banking assets inside about 
four or five banks, and if we make separate businesses of them, 
about one-half the assets of those two large banks are at the 
at risk part of investment banking and only one-half are in 
deposit insured things, and why do you have the taxpayer 
insuring deposits to give to somebody to go out and use it for 
something else. That does not make any sense at all. We made a 
big mistake in putting these two things together. I supported 
it. I have made a few mistakes in my life and that is one of 
them I will admit, and I will make some more, I am sure.
    But we are on the wrong path. That is my message to you 
all. And we are on the wrong path because the cultures are 
different and you are trying to regulate them together with a 
thing that no human being can either manage or regulate, in my 
opinion.
    Senator Corker. Mr. Roselle, you run a really boring 
operation yourself and it does a different--is involved in 
different kinds of activities than was just described, and you 
are the other true practitioner that is here, although the 
others obviously have a lot of wisdom. How would you respond to 
what Mr. Frost just said?
    Mr. Roselle. That is a challenge, Senator. Let me say this. 
I think we are not going down the wrong path. I believe that 
Dodd-Frank has a lot of very positive aspects to it. I think 
improvement of capital ratios, capital planning, resolution 
planning, liquidation authority, improvements in governance and 
risk management, those are all very positive aspects of the 
Dodd-Frank Act and I think the financial system is much better 
off for many of those.
    There are a lot of details in the Act that do create issues 
for us, and----
    Senator Corker. What about--and I----
    Mr. Roselle. Sure.
    Senator Corker.----and you did a great job in your 
testimony of laying out some of those, but from the standpoint 
of Mr. Frost's real solution to this, I mean, I just wonder if 
your point of view--if you share his point of view regarding 
the total separation and really returning to Glass-Steagall.
    Mr. Roselle. I do not share that point of view. I----
    Senator Corker. I thought you might not. That is why I 
asked the question.
    [Laughter.]
    Mr. Roselle. But even though we are not in a lot of those 
businesses, Senator, I think it is a mistake to try to put in 
place a separation that is based on a decision made at a point 
in time that becomes immutable. Things change. Financial 
markets change. Client needs change. And I think we as 
institutions and as the financial system need to be in a 
position to meet those changes.
    I will give you an example. Northern Trust used to be 
primarily almost exclusively in the wealth management area. We 
serviced private clients, and out of that we found a lot of 
those clients needed us to keep custody of their assets. We 
started doing that. We started doing that around the world as 
they invested globally. That emerged, or that evolved into the 
need for foreign exchange transactions to support those 
clients. Securities lending came out of custody. Things evolve, 
and I think it is a mistake to try to have an artificial 
separation.
    Absolutely, we should have tight controls and good 
oversight, and that is why I referred to a lot of the good 
parts of Dodd-Frank that I think do that. But I think to have 
an artificial separation that says, this one set of activities 
are going to be here and another are going to be over there 
does not make sense, and frankly, I do not know that it really 
does anything to reduce risk. It drives those activities, 
perhaps, into a less regulated environment that may create much 
higher risk as we go down the road. So I would be very careful 
about any kind of separation like that.
    Mr. Frost. May I make one comment on that?
    Senator Brown. Very brief, Mr. Frost.
    Mr. Frost. All right. I want to make clear that I did not 
say that there would be total separation. There would be 
overlaps of things that those banks can do. We did that with 
Glass-Steagall. So I think a lot of the things he is talking 
about could be done by the commercial banks and they could be 
done by the investment banks and there could be overlaps.
    One of the very significant things we all did years ago was 
the banks did--underwrote and handled the markets on Government 
bonds and tax supported municipals and so did the investment 
bankers. So I am not talking about where you would take a total 
separation of everything. I am talking about only those things 
that we have had to pay for and the taxpayer should not have to 
pay for and should be done by markets instead of by an 
underwriting that we now have on deposits and using the Federal 
underwriting. That is why people go to the big banks. They have 
got the Federal underwriting of money, that if they want, they 
can take it and put it in these other things.
    I am saying too much. I know that it is a thing that we all 
feel very strongly about and you do, too, and thank you for 
listening to me.
    Senator Brown. Thank you all. Mr. Frost, thank you, and Mr. 
Roselle, thank you, and Mr. Carfang, thank you very much.
    Before calling the hearing to a close, I would like to make 
one comment about a program that is especially important to 
community banks that are forced to compete with Government, in 
my mind, subsidized mega-banks. The FDIC's Transaction Account 
Guarantee, or TAG program, expires at the end of the year. It 
has been a valuable tool for America's community banks and it 
has not cost taxpayers a dime. I believe we must extend this 
program. I look forward to working with both the Chairman and 
the Ranking Member of the full Committee and with Senator 
Corker to extend the TAG program so community banks can 
continue to compete.
    Thank you all for joining us. Some Members of the 
Subcommittee may have questions for any of the four of you or 
the three on the first two panels. We may send you questions, 
and they will be submitted within a few days and we would like 
your answer within a week if they do that.
    So thank you very much for being with us. The hearing is 
adjourned.
    [Whereupon, at 4:04 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
                 PREPARED STATEMENT OF PAUL A. VOLCKER
       Chair, President's Economic Recovery Advisory Board, and 
    Former Chairman, Board of Govenors of the Federal Reserve System
                              May 9, 2012
``Too Big To Fail''--the Key Issue in Structural Reform
    The greatest structural challenge facing the financial system is 
how to deal with the wide-spread impression--many would say 
conviction--that important institutions are deemed ``too large or too 
interconnected'' to fail. During the crisis, creditors--and to some 
extent stockholders--were in fact saved by injection of official 
capital and liquidity in the aggregate of trillions of dollars, 
reinforcing the prevailing attitudes.
    Few will argue that the support was unwarranted given the severity 
of the crisis, and the danger of financial collapse in response to 
contagious fears, with the implication of intolerable pressures on the 
real economy. But there are real consequences, behavioral consequences 
of the rescue effort. The expectation that taxpayers will help absorb 
potential losses can only reassure creditors that risks will be 
minimized and help induce risk-taking on the assumption that losses 
will be socialized, with the potential gains all private. 
Understandably the body politic feels aggrieved and wants serious 
reforms.
    The issue is not new. The circumstance in which occasional official 
rescues can be justified has long been debated.\1\ What cannot be in 
question is that the prevailing attitudes and uncertainties demand an 
answer. And that answer must entail three elements:
---------------------------------------------------------------------------
    \1\ Alan Greenspan, 1996.

    First, the risk of failure of ``large, interconnected firms'' must 
be reduced, whether by reducing their size, curtailing their 
interconnections, or limiting their activities.
    Second, ways and means must be found to manage a prompt and orderly 
financial resolution process for firms that fail (or are on the brink 
of failure), minimizing the potential impact on markets and the economy 
without massive official support.
    Third, key elements in the approach toward failures need to be 
broadly consistent among major financial centers in which the failing 
institutions have critical operations.
    Plainly, all that will require structural change embodied in 
legislation. Various approaches are possible. Each is difficult 
intellectually, operationally, and politically, but progress in these 
areas is the key to effective and lasting financial reform.
    I think it is fair to say that in passing the Dodd-Frank 
legislation, the United States has taken an important step in the 
needed directions. Some elements of the new law remain controversial, 
and the effectiveness of some of the most important elements are still 
subject to administrative rule writing. Most importantly, a truly 
convincing approach to deal with the moral hazard posed by official 
rescue is critically dependent on complementary action by other 
countries.
    In terms of the first element I listed to deal with ``too-big-to-
fail''--minimizing the size and ``interconnectedness'' of financial 
institutions--the U.S. approach sets out limited but important steps. 
The size of the major financial institutions (except for ``organic'' 
growth) will be constrained by a 10 percent cap on their share of bank 
deposits and liabilities. That cap is slightly higher than the existing 
size of the largest institutions, and is justified as much to limit 
further concentration as by its role as prudential measures.
    The newly enacted prohibitions on proprietary trading and strong 
limits on sponsorship of hedge and equity funds should be much more 
significant. The impact on the sheer size of the largest U.S. 
commercial banking organizations and the activities of foreign banks in 
the United States may be limited. They are, however, an important step 
to deal with risk, conflicts of interest, potentially compensation 
practices and, more broadly, the culture of banking institutions.
    The justification for official support and protection of commercial 
banks is to assure maintenance of a flow of credit to businesses and 
individuals and to provide a stable, efficient payment system and safe 
depository. Those are both matters entailed in continuing customer 
relations and necessarily imply an element of fiduciary responsibility. 
Imposing on those essential banking functions a system of highly 
rewarded--very highly rewarded--impersonal trading dismissive of client 
relationships presents cultural conflicts that are hard--I think really 
impossible--to successfully reconcile within a single institution. In 
any event, it is surely inappropriate that those activities be carried 
out by institutions benefiting from taxpayer support, current or 
potential.
    Similar considerations bear upon the importance of requiring that 
trading in derivatives ordinarily be cleared and settled through strong 
clearing houses. The purpose is to encourage simplicity and 
standardization in an area that has been rapidly growing, fragmented, 
unnecessarily complex and opaque and, as events have shown, risk prone.
    There is, of course, an important legitimate role for derivatives 
and for trading. The question is whether those activities have been 
extended well beyond their economic utility, risking rather than 
promoting economic growth and efficient allocation of capital.
    There is one very large part of American capital markets calling 
for massive structural change that so far has not been touched by 
legislation. The mortgage market in the United States is dominated by a 
few Government agencies or quasi-governmental organizations. The 
financial breakdown was in fact triggered by extremely lax, Government-
tolerated underwriting standards, an important ingredient in the 
housing bubble. The need for reform is self-evident and the direction 
of change is clear.
    We simply should not countenance a residential mortgage market, the 
largest part of our capital market, dominated by so-called Government-
Sponsored Enterprises. Collectively, Fannie Mae, Freddie Mac and the 
Home Loan Banks had securities and guarantees outstanding that exceed 
the amount of marketable U.S. Treasury securities. The interest rates 
on GSE securities have been close to those on Government obligations.
    That was possible because it was broadly assumed, quite accurately 
as it has turned out, that in case of difficulty those agencies would 
be supported by the Treasury to whatever extent necessary to maintain 
their operations. That support was triggered in 2008, confirming the 
moral hazard implicit in the high degree of confidence that Government-
Sponsored Enterprises would not be allowed to fail.
    The residential mortgage market today remains almost completely 
dependent on Government support. It will be a matter of years before a 
healthy, privately supported market can be developed. But it is 
important that planning proceed now on the assumption that Government-
Sponsored Enterprises will no longer be a part of the structure of the 
market.
    It is evident that there is not yet full international agreement on 
elements of the basic structural framework for banking and other 
financial operations. Some jurisdictions seem content with what is 
termed ``universal banks'', whatever the conflicts, risks and cultural 
issues involved. In the United States, there are restrictions on the 
activities of commercial banking organizations, particularly with 
respect to trading and links with commercial firms.
    Financial institutions not undertaking on commercial banking 
activities will be able to continue a full range of trading and 
investment banking activities, even when affiliated with commercial 
firms. When deemed ``systemically significant'', they will be subject 
to capital requirements and greater surveillance than in the past. 
However, there should be no presumption of official support--access to 
the Federal Reserve, to deposit insurance, or otherwise. Presumably, 
failure will be more likely than in the case of regulated commercial 
banking organizations protected by the official safety net. Therefore, 
it is important that the new resolution process be available and 
promptly brought into play.
    In the U.K., another approach has been supported by the current 
government: a ``pure'' deposit taking and lending bank would be 
separated from an investment bank within the holding company. A ``ring 
fence'' would strictly limit contact between the two businesses.
    As an operational matter, some interaction between the retail and 
investment banks is contemplated in the interest of minimizing costs 
and facilitating full customer service. American experiences with 
``fire walls'' and prohibitions on transactions between a bank and its 
affiliates have not been entirely reassuring in practice. Ironically, 
the philosophy of U.S. regulators has been to satisfy itself that a 
financial holding company and its nonbank affiliates should be a 
``source of strength'' to the commercial bank. That principle has not 
been highly effective in practice, and does not appear to be a part of 
the U.K. approach.
    More broadly, a comprehensive approach internationally is seen to 
be developing in which systemic oversight is coupled with resolution 
authority for both banks and nonbanks. A dividing line between those 
activities worthy of government support and those that are not is 
common to both the U.S. and U.K. approaches.
    The Volcker Rule is a part of this formula, and should not be 
considered in isolation against the total task at hand. Coupled with 
increased capital requirements, the Dodd-Frank legislation, if fully 
enforced, is a solid step toward reigning in ``too-big-to-fail''.
    The regulators are still hard at work completing the important 
rulemaking, and will soon turn their attention to constructing the 
supervisory manuals and other tools of enforcement. After the 
transition period when the legislation and new capital requirements are 
a functioning part of our financial and supervisory system, not only 
should risk be reduced but important cultural issues will begin to be 
addressed.
    Unfinished business remains. Money Market Mutual funds are another 
example of moral hazard, and seem to me more amenable to structural 
change. By grace of an accounting convention, shareholders in those 
funds are permitted to meet requests for withdrawals upon demand at a 
fixed dollar price so long as the market valuation of fund assets 
remains within a specified limit around the one dollar ``par'' (in the 
vernacular ``the buck''). Started decades ago essentially as regulatory 
arbitrage, money market mutual funds today have trillions of dollars 
heavily invested in short-term commercial paper, bank deposits, and 
notably recently, European banks.
    Free of capital constraints, official reserve requirements, and 
deposit insurance charges, these MMMFs are truly hidden in the shadows 
of banking markets. The result is to divert what amounts to demand 
deposits from the regulated banking system. While generally 
conservatively managed, the funds are demonstrably vulnerable in 
troubled times to disturbing runs, highlighted in the wake of the 
Lehman bankruptcy after one large fund had to suspend payments. The 
sudden impact on the availability of business credit in the midst of 
the broader financial crisis compelled the Treasury and Federal Reserve 
to provide hundreds of billions of dollars by resorting to highly 
unorthodox emergency funds to maintain the functioning of markets.
    The time has clearly come to harness money market funds in a manner 
that recognizes both their structural importance in diverting funds 
from regulated banks and their destabilizing potential. If indeed they 
wish to continue to provide on so large a scale a service that mimics 
commercial bank demand deposits, then strong capital requirements, 
official insurance protection, and stronger official surveillance of 
investment practices is called for. Simpler and more appropriately, 
they should be treated as an ordinary mutual funds, with redemption 
value reflecting day by day market price fluctuations.
    I call your attention to another piece of unfinished business. It 
should be simpler because it has already been passed into law: 
specifically a member of the Federal Reserve Board should be designated 
as Vice Chairman for Supervision. Supervision of the banking and 
financial system should have a strong and visible place on the agenda 
at the Federal Reserve. It should have a proper focus in Congressional 
oversight. That the position remains unfilled, 2 years after its 
authorization and in the midst of financial uncertainty, is a mystery 
to me.
                                 ______
                                 
  The ``Volcker Rule'', Sovereign Debt, and International Cooperation
                            February 8, 2012
                           By Paul A. Volcker
    I confess total surprise about the vehement complaints by some 
European and other foreign officials about the restrictions on 
proprietary trading by American banks embedded in the Dodd-Frank Act--
now dubbed the ``Volcker'' Rule.
    It made me think--think all the way back to my years in the U.S. 
Treasury and Federal Reserve, years when the Glass-Steagall Act was in 
full force. The practical effect was to ban all securities trading by 
American banks--not just ``proprietary'' trading, but also ``market 
making'' and ``underwriting'' (except when involving U.S. Government 
and certain municipal securities). I do not recall, and I am morally 
certain it never happened, receiving a single complaint that that 
American law was discriminatory, that it damaged other sovereign debt 
markets, or that it limited the ability of foreign governments to 
access capital markets.
    There is a certain irony in what I read. In Europe, there are plans 
to introduce a financial transaction tax, justified in part by 
officials because it puts ``sand in the wheels'' of overly liquid, 
speculation prone securities markets. For reasons analogous to the 
Volcker Rule, the U.K. is planning to ``ring fence'' trading and 
investment banking from retail banking, attempting to create airtight 
subsidiaries of larger organisations. The commercial banks responsible 
for what is deemed essential services to the economy will be insulated 
from all trading and only then be protected by the official safety net 
of access to the central bank, deposit insurance, and perhaps 
assistance in emergencies.
    That approach, as a matter of regulatory philosophy and policy, 
resembles the seemingly less draconian U.S. restrictions on proprietary 
trading.
    The simple fact is that Dodd/Frank specifically permits both 
``market making'' in response to customer needs and ``underwriting''. 
No doubt American banks will, upon request, be happy to provide those 
services to the U.K. and other governments. They can continue to 
purchase foreign sovereign debt for their investment portfolios--should 
I say a la MF Global? What would be prohibited would be ``proprietary'' 
trading, usually labeled as ``speculative''. How many times in the past 
have we heard complaints by European governments about speculative 
trading in their securities, particularly when markets are under 
pressure?
    Is there really a case that proprietary trading is of benefit to 
the stability of commercial banks, to their risk profile, and to their 
compensation practices and desirably fiduciary culture? I think not, 
and we need to look no further than Canada for a system in which its 
large banks have been much less committed to proprietary trading than a 
few American giants. In any event, there are and should be thousands of 
hedge funds and nonbank institutions ready, willing and able to 
undertake proprietary trading in unrestricted securities in large 
volumes. The point is those traders should not have access to the 
taxpayer support implicit in the safety net of commercial banks.
    In addressing liquidity, can it really be of concern that some of 
the largest banks in Europe, in Japan, in China, and indeed in Canada 
cannot maintain effective markets in their own sovereign debt? U.S.-
chartered commercial banks could remain participants ``making markets'' 
for their customers wherever they are.
    Let's get serious.
    National regulatory (and at least as important, accounting and 
auditing) authorities should, to the extent practical, seek common 
understanding and common approaches. In the past, I participated in 
that process, helping to initiate the effort to achieve common capital 
standards for banks. I am today encouraged by efforts underway by the 
United States, the United Kingdom, and other authorities to reach the 
needed degree of consensus with respect to resolution authority--in 
plain English how to practically end the ``too-big-to-fail'' syndrome. 
That's really complex. The major banks are international, and managing 
their orderly merger or liquidation will necessarily involve 
cooperation among jurisdictions. That is a key challenge, arguably the 
key challenge for banking reform. It needs to be dealt with.
    Meanwhile, let us not be swayed by the smoke screen of lobbyists 
dedicated to protecting the interests of some highly compensated 
traders and their risk-prone banks.
    The American regulators are now considering what adjustments should 
be made in their preliminary rules with respect to market-making and 
proprietary trading, while hopefully reducing the inevitable 
complications imposed by the very complexity of modern finance. I 
regret that the effect, if not the intent, of much of the lobbying has 
been to add complications rather than to clarify the principles 
involved. As with any new regulation, there will be, with experience, 
opportunities to deal with unnecessary frictions or unintended 
consequences. But I certainly take comfort with the stated confidence 
of the authorities that the rule adopted will be both workable and 
effective.
                                 ______
                                 
                PREPARED STATEMENT OF THOMAS M. HOENIG *
         Vice Chairperson and Member of the Board of Directors
                 Federal Deposit Insurance Corporation
                              May 9, 2012
Restructuring the Banking System to Improve Safety and Soundness

---------------------------------------------------------------------------
     Co-authored by Charles S. Morris Vice President and Economist, 
Federal Reserve Bank of Kansas City in May 2011.
    This document does not represent the views of the Board of 
Governors of the Federal Reserve or the Federal Reserve System. Michal 
Kowalik, an Economist in the Banking Research Department at the Bank, 
contributed substantially to the proposal. The authors would like to 
thank Viral Acharya, Matt Richardson, Larry White, Richard Sylla, 
Thomas Philippon, Lasse Pedersen, Jacob Goldfield, and Nada Mora for 
helpful comments and suggestions.
---------------------------------------------------------------------------
    Over the past 30 years, the U.S. banking system has changed 
dramatically from the stylized view of banking that arose from the 
banking panics of the early 1930s. The structure of the banking 
industry that emerged from the 1930s separated investment banking and 
other financial services from ``traditional'' commercial banking--
making loans and taking deposits to provide payment, liquidity, and 
credit intermediation services. Because these core banking services are 
a critical part of the economic infrastructure and banks are 
susceptible to disruptions from depositor runs, the structure also 
included a public safety net to protect depositors and their banks.
    The current financial structure is vastly different. Leading up to 
the financial crisis, the financial system had become dominated by a 
handful of large, complex financial organizations and it is even more 
so since the crisis. These companies combine traditional banking 
activities with a variety of nonbank activities. Banks benefit from 
additional activities, for example, if they increase the 
diversification of their assets and revenue streams. However, 
additional activities can also increase banks' riskiness and create 
complexity that makes it more difficult for the market, bank 
management, and regulators to assess, monitor, and/or contain risk 
taking that endangers the public safety net and financial stability. 
Thus, the social costs of additional activities and the associated 
complexity can greatly exceed the private benefits to an individual 
bank.
    This paper offers a proposal to reduce the costs and risks to the 
public safety net and financial system and reintroduce accountability 
by restricting bank activities. The designation of allowable activities 
is based on the principle that banks should not engage in activities 
beyond their core services of loans and deposits if those activities 
disproportionately increase the complexity of banks such that it 
impedes the ability of the market, bank management, and regulators to 
assess, monitor, and/or control bank risk taking. Such activities are 
not essential for conducting the socially valuable core banking 
activities and lead to unnecessary risk to the safety net and financial 
system.
    Specifically, in addition to their traditional business of 
providing payment and settlement services, granting loans, and offering 
deposits, banks also would be allowed to underwrite securities, offer 
merger and acquisition advice, and provide trust and wealth and asset 
management services. They would not be allowed to conduct broker-dealer 
activities, make markets in derivatives or securities, trade securities 
or derivatives for either their own account or customers, or sponsor 
hedge or private equity funds.
    The benefits of prohibiting banks from engaging in high-risk 
activities outside of their core business, however, would be limited if 
those activities continue to threaten stability by mostly migrating to 
the ``shadow'' banking system. Shadow banks are financial companies not 
subject to prudential supervision and regulation that use short-term or 
near-demandable debt to fund longer-term assets. In other words, shadow 
banks essentially perform the same critical, core functions as 
traditional banks, but without an explicit safety net or prudential 
regulation. As a result, the shadow banking system is susceptible to 
disruptions that threaten financial and economic stability and lead to 
additional implicit Government guarantees and the associated moral 
hazard to take greater risks.
    To mitigate the potential systemic effects and moral hazard of 
shadow banks or other financial companies, this paper makes two 
additional recommendations. First, money market mutual and other 
investment funds that are allowed to maintain a fixed net asset value 
of $1 should be required to have floating net asset values. Second, 
bankruptcy law for repurchase agreement collateral should be rolled 
back to the pre-2005 rules, which would eliminate mortgage-related 
assets from being exempt from the automatic stay in bankruptcy when the 
borrower defaults on its repurchase obligation.
Evolution of current financial structure
    The 1930s financial structure that lasted largely until the 
        end of the century was shaped by three major legislative and 
        regulatory changes: the Glass-Steagall Act, creation of Federal 
        deposit insurance, and Federal Reserve's Regulation Q.

      The Glass-Steagall Act refers to four provisions of the 
        Banking Act of 1933 that separated commercial and investment 
        banking. Deposit (i.e., commercial) banks were prohibited from 
        conducting securities activities (underwriting and dealing) or 
        affiliating with companies that conducted securities 
        activities. The rationale was that banks are crucial for a 
        well-functioning economy because they settle payments, provide 
        deposits that are available at par value on demand, and are the 
        primary source of credit for vast majority of businesses and 
        individuals. These functions are a critical part of the 
        economy's financial infrastructure.

      Banks are provided access to a public safety net because 
        of their importance and susceptibility to runs from using 
        demand deposits to fund longer-term, illiquid loans. Prior to 
        the 1930s, the Federal Reserve's discount window provided a 
        limited safety net for solvent banks.\1\ The public safety net 
        was significantly enhanced in 1933 by passage of the Federal 
        Deposit Insurance Act and the associated provision of limited 
        deposit insurance because it protected depositors of banks that 
        failed.
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    \1\ Also, only members of the Federal Reserve could borrow from the 
discount window until the Monetary Control and Depository Institutions 
Deregulation Act of 1980.

      Access to a safety net, however, increases the incentive 
        for banks to take greater risks. Given the importance of a 
        stable banking system, the necessity of a public safety net to 
        provide the stability, and an incentive to take greater risk, a 
        mechanism is needed to prevent banks from taking excessive 
        risks and endangering the safety net. The market cannot be 
        solely relied upon to prevent the risk taking because some 
        deposits are insured and banks are inherently opaque. As a 
        result, prudential supervision and regulation must be used to 
---------------------------------------------------------------------------
        prevent excessive risk taking.

      One of the key regulations of the Banking Act of 1933 was 
        the prohibition of paying interest on demand deposits and the 
        authority to impose ceilings on savings deposit rates, which 
        was implemented through the Federal Reserve's Regulation Q. The 
        rationale for Regulation Q was to prevent competition for 
        deposits from causing instability in the banking system.

      The combined effect of the Glass-Steagall Act, bank 
        access to a Government safety net, prudential supervision and 
        regulation, and deposit rate ceilings was a fairly stable, 
        profitable banking industry with a positive franchise value for 
        many years. The franchise value was protected to the extent 
        banks were protected from outside competition and competition 
        among themselves.

    Over time, banks faced increasing competition on both the 
        liability and asset sides of the balance sheet. The increase in 
        competition was spurred by advancements in portfolio theory, 
        investment and money management techniques, and information 
        technology combined with greater volatility of the economic 
        environment.

    On the liability side, banks had to compete with money 
        market mutual funds (MMMFs) and savings association NOW 
        accounts that paid interest on close substitutes for bank 
        demand deposits. They also faced greater competition for 
        household savings from mutual funds, pension funds, and 
        insurance companies.

      MMMFs started in 1971 as a competitive alternative to 
        bank deposits because they paid a market interest rate and were 
        allowed to maintain a net asset value (NAV) of $1 a share as 
        long as they met certain accounting (net asset value has to be 
        greater than 99.5 cents) and investment (quality and maturity) 
        requirements. They allow investors to withdraw funds on demand 
        and have limited check-writing privileges. MMMF shares are held 
        by individuals, institutional investors, and corporate and 
        noncorporate businesses as an alternative to bank deposits for 
        cash management and payments purposes. MMMFs started out 
        investing in highly rated financial and nonfinancial company 
        commercial paper (CP) and short-term Treasury securities, and 
        then over the years expanded to other money market instruments 
        (MMIs), such as asset-backed commercial paper (ABCP), and 
        short-term repurchase agreements (repo).

      It is important to note that although an MMMF investor 
        technically owns equity shares of the fund (i.e., there is zero 
        leverage), the investor is more like a depositor because the 
        expectation is that funds can be withdrawn at a par value of $1 
        a share (i.e., there is no equity and leverage is infinite). As 
        a result, MMMF investors act more like depositors and will run 
        whenever they are concerned about a fund's safety so they can 
        redeem their shares for $1 before the fund ``breaks the buck'' 
        and reduces the value of the shares.

      NOW accounts were developed by savings and loans in the 
        early 1980s as a competitive alternative to demand deposits 
        that paid interest. NOW accounts essentially were just like 
        demand deposits--funds were available upon demand and had 
        unlimited checkwriting privileges--but they could pay interest 
        because the depository institution reserved the right to 
        require notice before allowing funds to be withdrawn or 
        transferred by check.

    On the asset side, banks faced competition in making loans 
        from investment banks (junk bonds, securitization and 
        nonfinancial commercial paper), mortgage brokers, and specialty 
        lenders such as unaffiliated finance companies (primarily 
        consumer lending), captive lenders (auto financing, retailers), 
        and factors (trade receivable lending).

      Banks have long faced competition in making loans from 
        unaffiliated and captive finance companies and factors. 
        Commercial paper became a competitive alternative to bank 
        operating loans for large, highly rated nonfinancial companies 
        in the late 1960s and early 1970s.

      Competition for bank loans increased substantially 
        beginning in the 1980s with the growth of junk bonds and an 
        ability to originate and distribute loans through the 
        development of mortgage-backed securities (MBS), followed by 
        other types of asset-backed securities (ABS), which are 
        typically backed by consumer loans (credit cards, auto, 
        student).

    The combination of alternatives to bank deposits and loans 
        created an alternative system for providing complete end-to-end 
        banking--from gathering funds to making loans--which 
        collectively comprises the so-called shadow banking system.\2\
---------------------------------------------------------------------------
    \2\ The description of the shadow banking system and the process 
described below is largely from ``Shadow Banking'' by Zoltan Pozsar, 
Tobias Adrian, Adam Ashcraft, and Hayley Boesky, Staff Report no. 458, 
Federal Reserve Bank of New York, July 2010.

      In contrast to a typical bank that conducts the entire 
        process of borrowing funds from savers, making loans to 
        ultimate borrowers, and holding the loans to maturity, credit 
        intermediation through the shadow banking system is a vertical 
        process that takes place through a series of entities--
        collectively called shadow banks--similar to a supply chain 
---------------------------------------------------------------------------
        manufacturing process.

      Funding for each of the entities takes place in wholesale 
        markets. Money market instruments--specifically CP, ABCP, and 
        short-term repos--are a major source of funds at virtually each 
        step in the process.\3\ The major investors in the MMIs are 
        MMMFs and other short-term investment funds that have a fixed 
        NAV of $1.\4\ At some steps of the process, major funding 
        sources also include medium-term notes and ABS that are 
        purchased by long-term investors, such as mutual funds, pension 
        funds, and insurance companies.
---------------------------------------------------------------------------
    \3\ The one exception is the step that actually securitizes loans 
into MBS/ABS.
    \4\ There are also direct investors in these money market 
instruments, such as securities lenders.

      A typical example of the shadow banking intermediation 
---------------------------------------------------------------------------
        process is as follows:

      1.  A loan is made by either a nonbank financial company or a 
        bank. The nonbank companies finance the initial loans with CP 
        or medium-term notes (MTN).

      2.  The loan is sold to a bank or broker-dealer conduit, which is 
        an intermediate entity that temporarily warehouses the 
        individual loans until it has enough to package together as an 
        MBS or ABS. The conduits are funded with ABCP.

      3.  The loan warehouse sells the package of loans to a 
        securitization sponsor that sets up a trust to hold the loans, 
        which is financed by selling MBS/ABS backed by the loans. This 
        is the only step in the process not financed by MMIs.

      4.  The ABS are purchased by a variety of entities that are 
        funded by a variety of sources.

        a.  Entities that tend to fund ABS with longer-term sources of 
        funds include mutual funds, pension funds, and insurance 
        companies.

        b.  BHCs may purchase ABS and hold them on bank balance sheets 
        funded by deposits. However, prior to the financial crisis, 
        they generally held them in off-balance-sheet entities, such as 
        structured investment vehicles (SIVs) or other conduits, that 
        were funded by CP or ABCP. The CP or ABCP, in turn, was 
        typically funded by MMMFs and other MMI funds with $1 NAVs.

        c.  Investment banks and FHCs purchased ABS for a variety of 
        reasons. They may have been held by a securities subsidiary as 
        a proprietary trading asset, in inventory for filling customer 
        trades, or warehoused for creating collateralized debt 
        obligations (CDOs). The ABS were typically funded with repo and 
        sometimes ABCP, which again were funded by MMMFs and other MMI 
        funds with $1 NAVs.

    Increased competition for banks from the shadow banking 
        organizations combined with regulatory capital requirements 
        (stemming from the first Basel Accord) that were higher than 
        for their competitors led to reduced profits and declining 
        franchise values. As a result, banking organizations looked for 
        alternative activities, revenue streams, and business models, 
        which included the originate-to-distribute shadow banking 
        business model. Whereas the traditional banking model of making 
        loans and holding them to maturity earned profits from loan-
        deposit rate spreads, the shadow banking model earned profits 
        from fees and trading gains.

    Some banks responded to the increased competition by 
        focusing first on being able to engage in investment banking 
        and securities activities and later more broadly on broker-
        dealer and shadow banking activities.

      Banks were able to whittle away at the Glass-Steagall Act 
        restriction on investment banking activities in the 1990s by 
        creating Section 20 securities subsidiaries and through Federal 
        Reserve Board approvals of higher thresholds for being 
        ``principally engaged'' in securities activities.\5\
---------------------------------------------------------------------------
    \5\ One of the Glass-Steagall Act provisions was Section 20 of the 
Banking Act of 1933. Section 20 prohibited Federal Reserve member banks 
from affiliating with organizations that ``engaged principally in the 
issue, floatation, underwriting, public sale, or distribution of 
stocks, bonds, debentures, notes, or other securities.'' For many 
years, the administrative limit for not being ``principally engaged'' 
was that underwriting and dealing accounted for 5 percent or less of a 
subsidiary's gross revenue. As banks became larger, underwriting and 
dealing became cost effective even with the 5 percent revenue limit. 
Overtime, banking organizations began petitioning for larger limits, 
which the Federal Reserve agreed to based on assessments of the risks 
and benefits to the economy, with the limit eventually rising to 25 
percent in 1997.

      To fully participate, however, banks needed the Glass-
        Steagall Act prohibition on affiliation with securities 
        companies to be repealed, which was achieved with the passage 
        of the Gramm-Leach-Bliley Act (GLBA) in 1999. The GLBA allowed 
        the formation of financial holding companies (FHCs), which were 
        BHCs engaged in certain nonbanking activities, such as 
        securities underwriting, broker-dealer activities, and 
---------------------------------------------------------------------------
        insurance underwriting, not permitted for BHCs.

    Significant changes in the investment banking industry also 
        occurred to take full advantage of the opportunities of the 
        shadow banking industry. With the growth of bond markets and 
        the development of MBS securities in the 1980s, investment 
        banks moved from partnership structures to public corporate 
        structures. The corporate structures essentially allowed the 
        investment banks to engage in riskier activities that put the 
        firm's capital at risk, such as proprietary trading, leveraged 
        lending, and hedge fund sponsorship, that the partners were not 
        willing to do when their own money was at risk. In addition, 
        the risks were exacerbated by relying on debt financing, i.e., 
        leverage, much of which was short-term repo. In fact, it became 
        much easier to use debt after 2004 when the SEC allowed broker-
        dealers to use their internal risk management models to compute 
        the haircuts for calculating their net capital.\6\
---------------------------------------------------------------------------
    \6\ Prior to the 2004 SEC ruling, the SEC determined the haircuts 
used to calculate the leverage ratios of broker-dealers. The 2004 
ruling allowed the broker-dealers to use their internal risk management 
models to compute these haircuts. The ruling followed a similar change 
to the Basel I Accord from 1996, under which commercial banks could 
compute their capital requirements for trading positions using their 
own models.
---------------------------------------------------------------------------
Implications for financial structure, risk, and stability
    The sharp line between commercial and investment banks is 
        significantly blurred as each has engaged in shadow banking 
        activities.

      The larger banking organizations engage in activities 
        traditionally limited to investment banks, which exposes them 
        to investment bank risks. Traditional banks that take in 
        deposits and make and hold loans to maturity have to manage 
        credit and interest rate risk. As FHCs have expanded activities 
        to earning fees from trading and ABS underwriting, their risk 
        exposures expanded to include market risk from trading and the 
        risk from having to roll over uninsured wholesale money market 
        funding risks.

      Similarly, the larger investment banks now engage in 
        activities traditionally limited to commercial banks, which 
        exposes them to commercial bank risks. By switching from a 
        partnership to public corporate structure, taking on leverage, 
        and making direct investments and loans that were held on the 
        balance sheet, investment banks expanded their risk exposures 
        beyond market risk to credit and funding risk.

    With the largest financial companies--both banking and 
        investment banking organizations--being the key players in 
        shadow banking activities, both types of organizations play a 
        special role in the economy that once was limited to commercial 
        banks. Through shadow banking activities, both types of 
        organizations ultimately provide the same credit intermediation 
        function of traditional banks--lending long term using funds 
        available to creditors upon demand.

    The expansion of activities by commercial and investment 
        banks has led to a less stable financial system because it is 
        dependent on wholesale, money market funding without an 
        explicit safety net of insurance and access to central bank 
        lender-of-last-resort facilities.

      Just like banks were subject to depositor runs that 
        created liquidity crises before deposit insurance was 
        available, virtually every step of the shadow banking process 
        is dependent on uninsured investments in MMMFs and other MMI 
        funds with NAVs of $1.

      Investors in these money market funds have full access to 
        their money as long as the underlying NAV is $1 or more, so 
        once concerns arise about the quality of the underlying assets, 
        i.e., that the underlying NAV will drop below $1, investors 
        have an incentive to withdraw their funds before others. A loss 
        in funding at any step of the process will cause the system to 
        break down just like a loss in funding at a traditional 
        commercial bank.

    The heavy involvement of large banking organizations (in 
        the form of FHCs) and investment banks in shadow banking 
        activities exposes them to similar risks that previously had 
        been eliminated by deposit insurance in retail banking.

      Bank subsidiaries are still protected from insured 
        depositor runs, but the holding companies and banks are now 
        exposed to money market fund runs.

      The bank subsidiaries are exposed to the money market 
        runs because the banks often provide credit lines on the ABCP 
        that fund ABS held by affiliated holding company subsidiaries, 
        such as off-balance-sheet conduits and SIVs. The ABCP often 
        needs a credit line or guarantee so that it has the AAA rating 
        needed to make it an eligible investment for MMMFs. So if MMMFs 
        decide not to roll over their ABCP investments in an SIV and 
        the underlying ABS had fallen below par value, the SIV would 
        sell the ABS to the bank guarantor at par, which means the bank 
        takes the loss and has to fund the ABS on balance sheet. In 
        other words, the credit and funding risk to the bank from 
        guaranteeing the off-balance-sheet funding of ABS with ABCP is 
        the same as if it held the underlying ABS on its own balance 
        sheet.

      To make matters worse, even though the risks to the bank 
        of holding assets on balance sheet or guaranteeing them off 
        balance sheet are the same, FHCs had an incentive to move the 
        assets off balance sheet because it can fund those assets with 
        much less capital.\7\ Specifically, the risk-based capital 
        requirements of FHCs had a much higher risk weight for holding 
        the loans or ABS on balance sheet than for guaranteeing the 
        ABCP funding of an off-balance-sheet entity. As a result of 
        this arbitrage of regulatory capital requirements, FHCs are 
        much riskier because they can fund the credit risk with much 
        higher leverage.
---------------------------------------------------------------------------
    \7\ In a September 2010 working paper ``Securitization Without Risk 
Transfer,'' Viral Acharya, Philipp Schnabl, and Gustavo Suarez provide 
evidence consistent with regulatory arbitrage being a reason for the 
use of ABCP programs by banks. They also document changes in regulatory 
rules that enabled banks to perform this type of regulatory arbitrage. 
In July 2004, the OCC, Federal Reserve, FDIC, and OTS exempted assets 
in ABCP programs from the calculation of risk-weighted assets. As a 
result, assets moved from banks' balance sheets to ABCP programs did 
not have to be considered when calculating risk-weighted assets for 
capital requirements. Moreover, under the Basel I and Basel II Accords, 
assets placed in ABCP programs carried lower capital charges than the 
same assets carried on balance sheets.

      FHCs also are exposed to runs by money market investors 
        even if the MMIs are not fully guaranteed because of 
        reputational risk. Although subsidiary conduits and SIVs that 
        hold ABS are technically bankruptcy remote, FHCs either 
        purchase assets and bring them on balance sheet or provide 
        capital to avoid the negative reputational effects of 
---------------------------------------------------------------------------
        defaulting on the securities funding the subsidiaries.

      Finally, the broker-dealer subsidiaries of investment 
        banks and FHCs also are exposed to MMI runs. As already noted, 
        broker-dealers use repo and ABCP to fund ABS held as part of 
        their proprietary trading business, as inventory for filling 
        customer trades, or for creating CDOs.

    Overall, the largest financial companies conduct a variety 
        of traditional and nontraditional banking activities, many of 
        which have increased the complexity of their operations and 
        portfolios. These companies benefit from additional activities, 
        for example, if they increase the diversification of their 
        assets and revenue streams. However, these benefits are 
        outweighed by the significant complications it poses for the 
        market, bank management, and regulators to assess, monitor, 
        and/or contain risk taking that endangers the public safety net 
        and financial stability. Specifically, as explained below, 
        combining banking and nonbanking activities makes it more 
        difficult to supervise and regulate banks, to price deposit 
        insurance, and for bank management to manage risks. It also 
        reduces market discipline by making banks less transparent.

    Some activities make it more difficult to supervise banks.

      The goal of prudential supervision is to control bank 
        risk taking so that they are safe and sound and do not endanger 
        the safety net. This is done by monitoring a bank's financial 
        condition, lending, operational, risk management, and other 
        practices and enforcing regulatory rules. Due to the periodic 
        nature of bank supervision, supervisors are able to get only a 
        snapshot of bank processes, risk exposure, and capital 
        positions at a given point in time. These snapshots are useful 
        only as long as they are able to predict the bank's processes, 
        risk exposure, and capital positions between the supervisory 
        examinations. The flexibility to adjust risk profiles between 
        exams depends to some extent on the activities banks engage in 
        and the nature of the risks.

      Many of the nontraditional activities that the large, 
        complex banking organizations engage in are difficult to 
        supervise effectively because they are very risky in the short 
        term and can be used to quickly change a bank's risk profile. 
        For example, trading and market-making are high frequency 
        activities that can take place between exams with little 
        evidence that they ever occurred. As a result, a snapshot of 
        positions of these activities on one day has no predicative 
        value for the positions, for example, a week later. Monitoring 
        these activities on a high-frequency basis would be very costly 
        for banks and supervisors. Moreover, it requires substantial 
        transparency that banks are likely to strongly oppose. Thus, 
        while examiners may err in their judgment on the riskiness of 
        any activity, they do not have the tools to monitor the 
        riskiness of many traditional nonbanking activities.

    Banks with a variety of activities require much more 
        complex regulations.

      The history of the Basel capital requirements provides a 
        good example of the difficulty in effectively regulating 
        complex financial companies. The increased variety and 
        complexity of bank activities required much more complex 
        capital standards, which the financial crisis showed were not 
        very effective. Complex capital requirements are very difficult 
        to monitor and understand for banks, supervisors, and the 
        market.

      One problem is that the various capital requirements 
        under Basel are essentially relative prices, which generally 
        will be incorrect when they are administratively set. As a 
        result, the regulatory capital requirements did not adequately 
        align bank risks with capital levels. In particular, it created 
        opportunities for regulatory arbitrage that was a major 
        contributor to the risk taking of the large, complex banking 
        companies and the financial crisis. For example, the capital 
        charge for an MBS based on a pool of subprime loans was lower 
        than that for a portfolio of mortgages held on the balance 
        sheet. Capital charges were also lower for an MBS held in off-
        balance-sheet conduits than on the balance sheet.

      The difficulty in determining appropriate requirements is 
        even more difficult when banks face a variety of risks, such as 
        credit, market, and interest risk. Understanding and formally 
        modeling these risks and their relationships is very difficult, 
        especially after a systemic shock or during a financial crisis. 
        In addition, the variety of assets held by the complex banks 
        meant regulators had to rely on bank internal models, which 
        provided banks opportunities to game the capital regulations. 
        The incentive to game regulations is a problem particularly for 
        banks suffering large losses because it buys them more time to 
        find a way out of their problems.

    Complexity of activities makes it difficult to price 
        deposits insurance: Deposit insurance would not create moral 
        hazard if the premiums were priced appropriately to reflect a 
        bank's risk. However, pricing deposit premiums correctly is 
        difficult for the same reasons that it is difficult to 
        determine capital requirements.

    To the extent it is possible, resolving large, complex 
        banks is much more difficult and costly.

      Complex financial institutions are hard to resolve in a 
        quick and orderly manner. Lehman Brothers is a good example of 
        the difficulty in resolving a complex company. The number of 
        transactions and complexity of interconnections made it very 
        difficult to determine the company's value over a weekend, 
        which made it difficult to find a buyer. And Lehman Brothers 
        was a relatively simple company as compared to a bank like 
        Citigroup, which has more than 2,000 majority-owned 
        subsidiaries that include a ``Lehman Brothers'' equivalent. It 
        would be much harder to wind down or find the number of 
        separate buyers necessary to transfer Citigroup's operations to 
        third parties.

      In addition to the difficulty in resolving complex banks, 
        the fallout from the Lehman Brothers failure shows that complex 
        institutions are more likely to be bailed out in the future. 
        The probability of an implicit Government guarantee from a 
        bailout creates additional moral hazard. Moreover, if the 
        market and banks expect bailouts, banks have an increased 
        incentive to become more complex, and it will be supported by a 
        lack of market discipline.

    Banks with a variety of activities are less transparent. 
        Relative to nonfinancial companies, it is difficult for 
        investors to evaluate the condition of banks and their 
        riskiness because their balance sheet assets and activities are 
        opaque and easily changed.\8\ Traditional banking is opaque 
        because only the bank knows the risk and quality of its loans. 
        Banks that engage in nontraditional activities such as trading, 
        hedge funds, private equity, and market making are even less 
        transparent because the success of these strategies depend on 
        the confidentiality of the positions and speed with which the 
        banks are able to change their exposures. Given the lack of 
        transparency, regulators must play a larger role relative to 
        the market in monitoring and disciplining banks. However, as 
        already discussed, regulators are also at a disadvantage when 
        dealing with banks engaging in complex activities.
---------------------------------------------------------------------------
    \8\ Donald Morgan provides evidence on the increased opacity of 
banks from combining lending and trading activities in ``Rating Banks: 
Risk and Uncertainty in an Opaque Industry,'' American Economic Review, 
September 2002.

    Complexity makes risk management much more difficult.\9\
---------------------------------------------------------------------------
    \9\ All aspects of managing a large, complex financial company is 
difficult, but given the context of this paper, the focus is on risk 
management.

      Risk management is particularly difficult when there are 
        many different operation and activities divisions in a bank. 
        Examples include understanding all of the different business 
        lines and their interactions, having appropriate management 
        information systems, and appropriately allocating and pricing 
---------------------------------------------------------------------------
        capital across activities.

      The risk management of a complex institution will also 
        vary with the background of the senior leadership. For example, 
        the risk tolerance is likely to be lower if the senior 
        leadership of a large, complex bank has a commercial banking 
        background than a trading background.

      To the extent that a bank's senior management has 
        difficulty understanding and managing its risks, it is even 
        more difficult for supervisors to scrutinize and monitor its 
        risks.

    In summary, the financial system has become less stable 
        over the past 30 years as banks and other financial companies 
        have expanded into more complicated activities that are not 
        supported by a public safety net or subject to prudential 
        supervision. The root of the problem is that large, complex 
        financial companies are funding long-term, illiquid assets with 
        liabilities available upon demand. In addition, after the 
        crisis, the concentration of the industry and complexity of 
        activities at the largest banks have increased. The industry is 
        dominated by a handful of companies that combined are as large 
        as half of annual U.S. economic output, of which the failure of 
        any could cause financial instability. Finally, because these 
        companies are so large and complex, they and other institutions 
        that could be deemed systemically important receive an implicit 
        Government guarantee on their debt--and sometimes on their 
        equity--they have an incentive to take extra risk, which 
        further increases systemic risk (the too-big-to-fail problem).
Proposal to Reduce Costs and Risks to the Safely Net and Financial 
        System
    This proposal to reduce costs and risks to the safety net and 
financial system has two parts. The first part proposes to restrict 
bank activities to the core activities of making loans and taking 
deposits and to other activities that do not significantly impede the 
market, bank management, and regulators in assessing, monitoring, and/
or controlling bank risk taking. However, prohibiting banks from 
engaging in activities that do not meet these criteria and that 
threaten financial stability would provide limited benefits if those 
activities migrate to shadow banks. The second part proposes changes to 
the shadow banking system by making recommendations to reform money 
market funds and the repo market. Following the proposal, alternative 
proposals are discussed and critiqued.
Restricting activities of banking organizations
    The financial activities of commercial, investment, and 
        shadow banks can be categorized in the following six 
        groups:\10\
---------------------------------------------------------------------------
    \10\ This categorization of financial activities is from Matthew 
Richardson, Roy Smith, and Ingo Walter in Chapter 7 of Regulating Wall 
Street: The Dodd-Frank Act and the New Architecture of Global Finance, 
edited by Viral V. Acharya, Thomas F. Cooley, Matthew Richardson, Ingo 
Walter, New York University Stem School of Business, John Wiley & Sons, 
Inc., 2010.

      Commercial banking--deposit taking and lending to 
---------------------------------------------------------------------------
        individuals and businesses.

      Investment banking--underwriting securities (stocks and 
        bonds) and advisory services.

      Asset and wealth management services--managing assets for 
        individuals and institutions.

      Intermediation as dealers and market makers--securities, 
        repo, over-the-counter (OTC) derivatives.

      Brokerage services--retail, professional investors, and 
        hedge funds (prime brokerage).

      Proprietary trading--trading for own account, internal 
        hedge funds, private equity funds, and holding unhedged 
        securities and derivatives.

    Based on the criterion that permissible activities should 
        not significantly impede the market, bank management, and 
        regulators in assessing, monitoring, and/or controlling bank 
        risk taking, banking organizations should be able to conduct 
        the following activities: commercial banking, investment 
        banking as defined above, and asset and wealth management 
        services. Investment banking and asset and wealth management 
        services are mostly fee-based services that do not put much of 
        a firm's capital at risk. In addition, asset and wealth 
        management services are similar to the trust services that have 
        always been allowable for banks.

    In contrast, the other three categories of activities--
        dealing and market making, brokerage, and proprietary trading--
        do not have much in common with core banking services and 
        create risks that are difficult to assess, monitor, and/or 
        control. Banking organizations would not be allowed to do any 
        trading, either proprietary or for customers, or make markets 
        because it requires the ability to do trading.''\11\ In 
        addition, allowing customer but not proprietary trading would 
        be conducive to ``concealing'' proprietary trading as part of 
        the inventory necessary to conduct customer trading. Prime 
        brokerage services not only require the ability to conduct 
        trading activities, but also essentially allow companies to 
        finance their activities with highly unstable uninsured 
        ``deposits.''
---------------------------------------------------------------------------
    \11\ Banking organizations would be allowed to purchase and sell 
derivatives to hedge their assets and liabilities.

      Prohibiting these activities would make banks more 
        transparent and would enable better market discipline, 
---------------------------------------------------------------------------
        supervision, regulation, and resolution.

      Because these activities involve taking positions that 
        can be continuously adjusted and manipulated, they are 
        inherently opaque and difficult for supervisors to monitor and 
        regulate and for investors to understand.

      Moreover, regulatory arbitrage between balance-sheet and 
        off-balance-sheet activities and between banking and trading 
        books is difficult to prevent with regulation.

    The proposed activity restrictions also will improve the 
        management of banks by focusing their activities solely on the 
        traditional banking business with exposure only to risks 
        inherent in these activities.

      There is an inherent difference in the underlying factors 
        that make commercial banking and securities firms successful. 
        Banking is based on a long-term customer relationship where the 
        interests of the bank and customer are the same. Both the bank 
        and loan customers benefit if borrowers do well and are able to 
        pay off their loans. In contrast, trading is an adversarial 
        zero-sum game--the trader's gains are the customer's losses. 
        Thus, restricting these activities removes a conflict of 
        interest between a bank and its customers, which could produce 
        a more stable, less risky company.

      The inherent riskiness of securities trading, dealing, 
        and market-making attracts, and in fact requires, people who 
        are predisposed to taking short-term risks rather than lenders 
        with a long-term perspective. The combination of securities 
        with commercial banking activities in a single organization 
        provides opportunities for the senior management and boards of 
        directors to be increasingly influenced by individuals with a 
        short-term perspective. As a result, the increased propensity 
        of these corporate leaders to take risk leads to more of a 
        short-term-returns culture throughout the organization.

    Historically, bank investments were restricted to loans and 
        investments in investment-grade securities. As demonstrated in 
        the financial crisis, the complexity of many asset-backed 
        securities made it very difficult to determine their credit 
        quality. As a result, banking organizations should be 
        prohibited from holding ``complicated'' securities, such as 
        multilayer structured securities (e.g., CDOs) because it is 
        difficult to determine and monitor their credit quality.

    Off-balance-sheet holdings and exposures should be 
        supervised and regulated as if they were on-balance-sheet 
        because, as was also demonstrated in the crisis, they 
        ultimately put a bank's capital at risk.

    Restricting banks to the activities mentioned above will 
        allow capital regulation to be simplified and improved. As 
        noted in the previous section, the complexity of Basel capital 
        regulation is necessary but still ineffective because there is 
        no ability to satisfactorily model the wide range of complexity 
        and risk characteristics of current allowable activities. 
        Capital regulation will be simpler and more effective because 
        there is less need for complicated risk-based requirements if 
        the balance sheet is largely limited to loans and investment 
        grade securities, i.e., a relatively high simple leverage ratio 
        would be effective.\12\
---------------------------------------------------------------------------
    \12\ Anat R. Admati, Peter M. DeMarzo, Martin R. Heliwig, and Paul 
Pfleiderer provide an excellent discussion of the reasons for 
substantially increasing bank capital requirements in ``Fallacies, 
Irrelevant Facts, and Myths in the Discussion of Capital Regulation: 
Why Bank Equity is Not Expensive,'' August 2010, Rock Center for 
Corporate Governance at Stanford University Working Paper No. 86, 
Stanford Graduate School of Business Research Paper No. 2065. Martin 
Hellwig provides arguments for abandoning risk-sensitive capital 
requirements in ``Capital Regulation after the Crisis: Business as 
Usual?'' Reprints of Max Planck Institute for Research on Collective 
Goods 2010/31.

    Critics of restricting bank activities argue it would 
        reduce the economies of scale and scope that are critical for 
        the largest banks to be successful in global markets and that 
        large corporations want one-stop shopping for their financial 
---------------------------------------------------------------------------
        services. These arguments, however, are not persuasive.

      First, there is no strong evidence of economies of scale. 
        There are many conceptual and empirical problems with studies 
        of economies of scale.\13\ Nevertheless, older studies from the 
        1990s show that there are no economies of scale when banks are 
        larger than about $250 million in assets, although the 
        threshold is likely to be higher in today's economy because of 
        inflation and advancements in information technology. In fact, 
        a more recent study from the mid-2000s suggests there are 
        economies of scale for the largest banking organizations, but 
        the results are highly questionable because there are so few 
        banks at the sizes in question and the study uses data prior to 
        the problems that banks had during the financial crisis.
---------------------------------------------------------------------------
    \13\ Robert DeYoung comments in the Federal Reserve Bank of 
Minneapolis Region (2010) that it is not really possible to provide 
empirical evidence for or against existence of economies of scale in 
large and complex financial institutions because there are too few of 
them for a meaningful statistical analysis to be conducted.

      Second, there is even less evidence of economies of 
        scope.\14\ In fact, there is evidence that multiple functions 
        of large, complex banks actually increase systemic risk and 
        anecdotal evidence that if bank activities are restricted as 
        suggested here, a nonbank financial industry would emerge and 
        thrive.
---------------------------------------------------------------------------
    \14\ A survey of empirical studies on economies of scale is 
provided by Matthew Richardson, Roy Smith, and Ingo Walter in Chapter 7 
of Regulating Wall Street: The Dodd-Frank Act and the New Architecture 
of Global Finance, edited by Viral V. Acharya, Thomas F. Cooley, 
Matthew Richardson, Ingo Walter, New York University Stern School of 
Business, John Wiley & Sons, Inc., 2010.

      Third, large corporations would still be able to do one-
        stop shopping for commercial and traditional investment banking 
        services, although they would have to go to securities dealers 
---------------------------------------------------------------------------
        to purchase swaps and other derivatives for hedging purposes.

      Finally, even if there are economies of scale or scope, 
        it does not necessarily mean that banks should be allowed to 
        continue to conduct all of their current activities. Whether 
        they should depends on comparing the marginal benefits from the 
        reduced private costs of operation to the social costs 
        associated with financial crises. Given the large costs of the 
        2007-9 crisis, the efficiencies and cost benefits of size and 
        scope would need to be extremely large.

    Critics of restricting activities also question how we 
        would go about divesting the prohibited activities. The 
        divestitures that were required by the Glass-Steagall Act and 
        the breakup of AT&T in the 1980s suggest that divestitures can 
        be conducted in an orderly manner in a relatively short period 
        of time.

    Critics of restricting activities also are concerned that 
        it would cause two major problems for U.S. banks because they 
        would face a competitive disadvantage relative to universal 
        banks, mostly from Europe, that are allowed to conduct the full 
        range of activities.

      One problem is it would drive U.S. banks to move to other 
        countries. However, it seems highly improbable that any other 
        country would be willing or able to expand its safety net to 
        new large and complex banking organizations.

      Second, the competitive disadvantage of U.S. banks would 
        lower their franchise values, which would provide an incentive 
        to take even greater risks to raise lost revenues and maintain 
        ROEs. However, the virtue of restricting activities is that it 
        is easier for the supervisors and the market to detect and 
        punish excessive risk taking.
Reforming the shadow banking system
    Restricting the activities of banking organizations alone, 
        however, does not completely address the stability of the 
        financial system. In fact, it could worsen the risk of 
        financial instability by pushing even more activities from the 
        regulated banking sector to large, interconnected securities 
        firms, which would expand the sector that was an integral part 
        of the financial crisis.

    As previously discussed, the source of this instability is 
        the use of short-term funding for longer-term investment in the 
        shadow banking market, i.e., the maturity and liquidity 
        transformation conducted by a lightly regulated/unregulated 
        sector of the financial system. We believe this source of 
        systemic risk can be significantly reduced by making two 
        changes to the money market.

    The first recommendation addresses potential disruptions 
        coming from money market funding of shadow banks--money market 
        mutual and other investment funds that are allowed to maintain 
        a fixed net asset value of $1 should be required to have 
        floating net asset values.

      The primary MMIs today are MMMFs and repo (ABCP has 
        largely disappeared as a funding instrument for financial 
        companies since the financial crisis). Individuals, 
        institutional investors, and nonfinancial companies are the 
        primary holders of MMMF and other MMI funds with a $1 NAV, 
        which in turn are major investors in repo along with other 
        financial companies.

      Some have suggested that MMMFs should be backed by 
        Government guarantees. We see no reason why the safety net 
        should be extended and the taxpayer put at risk when other 
        solutions are feasible. In addition, providing Government 
        guarantees would require prudential supervision to prevent 
        excessive risk taking, but it would not be effective because of 
        the ability of funds to rapidly shift their risk profiles.

      The runs during the crisis on MMMFs occurred because of 
        concerns about the quality of their investments and because of 
        the promise to maintain a $1 NAV. MMMF investment rules have 
        been strengthened by increasing the minimum average quality and 
        decreasing the maximum average maturity of their 
        investments.\15\ However, because of the difficulty in 
        calibrating these requirements, it is not clear that the 
        vulnerability of MMMFs to runs in a systemic event would be 
        significantly reduced as long as the $1 NAV is maintained. We 
        believe reliance on this source of short-term funding and the 
        threat of disruptive runs would be greatly reduced by 
        eliminating the fixed $1 NAV and requiring MMMFs to have 
        floating NAVs.
---------------------------------------------------------------------------
    \15\ Some of the new rules for MMMFs are: 30 percent of assets must 
be liquid within 1 week, no more than 3 percent of assets can be 
invested in second-tier securities, the maximum weighted-average 
maturity of a fund's portfolio is 60 days, and MMMFs have to report 
their holdings every month.

    Critics of eliminating a $1 NAV for MMMFs argue that this 
        limits cash management options for large corporations. However, 
        MMMFs were first introduced to evade interest rate ceilings on 
        deposits, and the only remaining Regulation Q deposit rate 
        ceiling--the prohibition of paying interest on business 
        transactions deposits--was eliminated by the Dodd-Frank Act. 
        Some may be concerned that their deposits will be largely 
---------------------------------------------------------------------------
        uninsured, but they were uninsured when invested in MMMFs.

    The second recommendation addresses potential disruptions 
        stemming from the repo financing of shadow banks--the 
        bankruptcy law for repurchase agreement collateral should be 
        rolled back to the pre-2005 rules. This change would eliminate 
        mortgage-related assets from being exempt from the automatic 
        stay in bankruptcy when a borrower defaults on its repurchase 
        obligation.

      One reason for the runs on repo during the crisis was 
        because of the prevalence of repo borrowers using subprime 
        mortgage-related assets as collateral. Essentially, these 
        borrowers funded long-term assets of relatively low quality 
        with very short-term liabilities. The price volatility of 
        subprime MBS rose sharply when subprime defaults started 
        reducing MBS income flows. As a result, haircuts on subprime 
        repo rose sharply or the repo was not rolled over.

      The eligibility of mortgage-related assets as collateral 
        exempt from the automatic stay in bankruptcy in case of default 
        by the borrower is relatively recent. The automatic stay 
        exemption allows the lender to liquidate the collateral upon 
        default as opposed to having to wait for the bankruptcy court 
        to determine payouts to secured creditors.

      Prior to 2005, collateral in repo transactions eligible 
        for the automatic stay was limited to U.S. Government and 
        agency securities, bank certificates of deposits, and bankers' 
        acceptances. The Bankruptcy Abuse Prevention and Consumer 
        Protection Act of 2005 expanded the definition of repurchase 
        agreements to include mortgage loans, mortgage-related 
        securities, and interest from mortgage loans and mortgage-
        related securities. This meant that repo collateralized by MBS, 
        CMOs, CMBS, and CDOs backed by mortgage-related assets were 
        exempt from the automatic stay.

      We believe the threat of runs by repo lenders would be 
        significantly reduced by rolling back the bankruptcy law for 
        repurchase agreement collateral to the pre-2005 rules.

    Overall, these two changes to the rules for money market 
        funds and repo would increase the stability of the shadow 
        banking system because term lending would be less dependent on 
        ``demandable'' funding and more reliant on term funding. Term 
        wholesale funding would continue to be provided by 
        institutional investors such as mutual funds, pension funds, 
        and life insurance companies. While this might increase the 
        cost of funds and, therefore, the cost of mortgages and other 
        consumer loans, it would be less risky and more reflective of 
        the true costs.
Alternative proposals
    A variety of alternative policy reforms, which are not 
        necessarily mutually exclusive, have been proposed to improve 
        the stability of the financial system. These proposals address 
        the structure of banking organizations (size limitations), bank 
        regulation and supervision (stronger resolution authority, 
        stronger capital regulation, systemic risk fees, improved 
        supervision) and institutional changes (Government guarantees 
        for repo similar to deposit insurance).

    Size limit

      Banking organizations have been prohibited from merging 
        if the new company would hold more than 10 percent of national 
        deposits since 1994, and the Dodd-Frank Act prohibits mergers 
        of financial companies if the new company would hold more than 
        10 percent of financial industry liabilities. These provisions 
        do not limit organic growth.

      We are not in favor of a strict size limit because it is 
        not clear what the size limit should be or how it should change 
        over time.

    Resolution authority (would only address the too-big-to-
        fail problem and not systemic risk more generally)--the Dodd-
        Frank Act includes a provision for resolving systemically 
        important companies.

      We believe resolution authority is necessary but it may 
        not be sufficient for very large, complex financial 
        institutions. The resolution authority is too political because 
        the Treasury secretary makes the final decision to close a 
        failing company as opposed to independent supervisory 
        authorities.

      But even if it were up to the supervisory authorities, it 
        is not clear they would use it when faced with the failure of a 
        systemically important company. Liquidating a large and complex 
        financial company will always impose costs and disruptions even 
        under ideal circumstances, but is more likely to cause systemic 
        problems. Given the tradeoff between costs and economic 
        disruption that are large, highly visible, and immediate versus 
        benefits that may take years to be recognized, the more likely 
        scenario is that regulators will choose to bail out the 
        company. This decision is even more skewed to avoiding the 
        short-run costs because of pressures on regulators from 
        politicians and the big banks.

    Improve capital regulation--this is the approach taken by 
        the Basel Committee in developing the Basel III capital 
        requirements. The Dodd-Frank Act also has provisions to improve 
        capital regulation.

      Basel III attempts to correct the problems with Basel II 
        and is an improvement. It increases the minimum capital 
        requirement (capital to risk-weighted assets), introduces a 
        leverage ratio and capital conservation buffer, tightens 
        restrictions on what counts as capital so that common equity is 
        the predominant source of capital, improves the treatment of 
        off-balance-sheet exposures and funding, and includes a 
        proposal for counter-cyclical capital requirements.

      Some countries require an even higher minimum capital 
        requirement than the recommended 7 percent (Tier 1 common 
        equity base plus capital conservation buffer) in Basel III. For 
        example, Switzerland is requiring a 10 percent Tier 1 equity 
        risk-based ratio and a 19 percent total capital risk-based 
        ratio. The preliminary report of the U.K.'s Independent 
        Commission on Banking, the Vickers report, also recommends a 10 
        percent Tier 1 common equity risk-based capital requirement for 
        British banks.

      Nevertheless, we do not believe Basel III capital rules 
        will be effective largely because of the complexity of the 
        largest financial companies and the variety of their 
        activities. The complexity and variety of activities requires 
        complex, risk-based capital rules, which were reflected in the 
        1996 revision to Basel I and the 2004 Basel II requirements. 
        However, the requirements depend on regulators setting relative 
        prices in the form of risk weights for the various asset 
        classes, or for the firms to set their own requirements based 
        on internal model risk calculations. Basel III is an extension 
        of these previous standards, and the underlying problems 
        causing instability remain. In addition, the leverage ratio is 
        based on Tier 1 capital instead of common equity and is only 3 
        percent. Stronger minimum leverage ratios have been recommended 
        by economists and some regulators.

      The Dodd-Frank Act requires regulators to set more 
        stringent capital requirements for BHCs and FHCs with more than 
        $50 billion in assets and nonbank financial companies 
        determined to be systemically important than for other banking 
        organizations. The capital requirements, however, are based off 
        the Basel III requirements.

    Systemic risk fee

      These proposals are based on the traditional economic 
        policy of taxing externalities. Market data on financial 
        companies and historical data on financial crises are used to 
        assess the expected cost of financial crises and the individual 
        contributions of financial institutions to these costs. Based 
        on these estimates, a fee is charged so that financial 
        institutions internalize the systemic impact of their 
        decisions.\16\ Presumably, the fee would also account for the 
        increased systemic risk of being too-big-to-fail. By charging 
        the appropriate fee, companies would reduce or even divest 
        activities that are no longer profitable.
---------------------------------------------------------------------------
    \16\ The New York University Stern School of Business V-Lab project 
proposes a method to assess the systemic relevance of financial 
institutions.

      Charging a fee clearly is an appropriate policy option, 
        but we believe it would be very hard to implement in practice 
        for the same reasons as implementing the risk-based capital 
        requirements along the lines of Basel II. It is extremely hard 
        in practice to calibrate the risk-weights and fees in such a 
        way that the banks are not able to arbitrage them away. In 
        addition, because it is impossible to always charge the right 
        fee on a continuous basis, some firms will still end up taking 
        too much risk. While the likelihood of a crisis would be 
---------------------------------------------------------------------------
        reduced, the cost of a crisis may still be too large.

    Improve supervision

      The Dodd-Frank Act made the Federal Reserve the 
        consolidated supervisor for BHCs and FHCs with more than $50 
        billion in assets and nonbank financial companies determined to 
        be systemically important. The Act also requires the Federal 
        Reserve to establish more stringent prudential standards for 
        these organizations than for other banking organizations.

      We do not believe enhanced supervision will be effective 
        without restricting the activities of the largest financial 
        companies. First, there is evidence that the largest financial 
        companies did not fully understand the extent of their risk 
        exposures for a variety of reasons.\17\ If the organization 
        does not fully understand the risks, it is infeasible for the 
        regulatory authority to understand the risks and effectively 
        supervise the organization.
---------------------------------------------------------------------------
    \17\ The Senior Supervisors Group provides a number of reasons for 
poor risk management practices in complex financial institutions in the 
March 2008 report ``Observations on Risk Management Practices during 
the Recent Market Turbulence.''

      Second, many of the activities that pose the greatest 
        risks to the organization and to the broader financial system 
        and economy are not conducive to prudential supervision because 
        of the short-term nature of the risks. As noted earlier, 
        activities that have high short-term risks cannot be 
        effectively monitored because supervision and regulation occurs 
---------------------------------------------------------------------------
        periodically at potentially irregular intervals.

      Essentially, the overall regulatory system for the 
        largest financial companies broke down by not keeping up with 
        the evolution of the financial system. Commercial and 
        investment banking organizations began engaging in activities 
        that the market, bank management, and regulators cannot assess, 
        monitor, and/or control very well. As a result, expanding 
        supervision to the same activities that cannot be supervised 
        well will not fix the problem.

    Guaranteeing repo--a variety of proposals have been made, 
        many of which include provisions to limit Government liability, 
        such as limiting collateral to very safe securities and 
        charging a fee.\18\
---------------------------------------------------------------------------
    \18\ Gary Gorton and Andrew Metrick propose a system of insurance 
for money market mutual funds combined with strict regulation of 
securities used as collateral in repo transactions in ``Regulating the 
Shadow Banking System.''

      The idea behind this approach is that repo is a primary 
        source of funds for much of the shadow banking system, but also 
        provides value to large financial and nonfinancial companies 
        that have a demand for repo because they want a risk-free asset 
        for cash management purposes and bank deposits are only insured 
---------------------------------------------------------------------------
        up to $250,000.

      We see no reason why the Government and taxpayer should 
        step in and insure positions taken by sophisticated investors 
        with abilities to analyze the risk of securities that back 
        their loans. Therefore, there is no rationale for the 
        Government to provide guarantees even in exchange for heavier 
        regulation and supervision of repo markets.

        [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
                                 
                   PREPARED STATEMENT OF TOM C. FROST
                 Chairman Emeritus, Frost National Bank
                              May 9, 2012
    My name is Tom Frost. I am from San Antonio, Texas and served for 
57 years, 26 of these as Chief Executive Officer of a commercial bank 
established by my great-grandfather. The institution grew and prospered 
through money panics, wars and depressions. Now with $20.3 billion in 
assets at year end 2011 and 115 offices all in Texas, the Frost Bank 
did not take Government funds from the issuance of preferred stock in 
1933 and was one of the first banks to refuse TARP money in 2008. I 
personally survived the very difficult times in Texas of the 1980s 
where many lessons were learned. The Frost Bank was the only one of the 
top 10 commercial banks in Texas to survive through a period when a 
significant number of the banks failed and most of the savings and 
loans were closed.
    But, I will start out with my first days as a young college 
graduate and a fresh employee of the institution I have just described. 
My great Uncle Joe, then CEO, told me that the very first goal we had 
was to be able to return the deposits received from customers. Our 
obligation was to take care of the community's liquid assets and to 
manage them in a safe and sound fashion for the use (loans) of the 
community to grow. Uncle Joe told me in 1950 that we were not big 
enough to be saved by the Government. That we would need to always 
maintain strong liquidity, safe and sound assets, and adequate capital. 
I was impressed by the fact that the need to make money was not high on 
this list, but did occur if sound banking principles were observed. 
Uncle Joe was not a fan of the FDIC saying that it took his money to 
subsidize his inefficient competition. I, personally, support the FDIC 
as a protection for the depositor, but want to suggest that this safety 
net apply only to banks which receive FDIC insured deposits. I am 
convinced that offering this safety net to other financial institutions 
which provide services not deemed appropriate for deposit/loan 
commercial banking institutions, is not sound public policy. The 
deposit facilities of financial institutions which provide primarily 
investment, hedging and speculative services should have no taxpayer 
safety net. These institutions should be governed by market forces with 
investors understanding what can be earned and what can be lost.
    This would involve the need to separate two cultures. The one which 
Uncle Joe articulated our family has followed for 144 years by 
establishing long-term customer relationships, building our community 
and preserving its liquid assets. Other financial institutions can 
provide the other services that are not authorized to insured deposit 
banks at a potential good profit, but without a taxpayer risk through a 
Federal safety net.
    I would suggest that the two types of institutions have separate 
ownership, separate management, separate regulation. My conviction 
comes after seeing both systems which were separate, but now have been 
joined, to create a situation which in 2008 brought about the near 
catastrophe of collapse of the world financial systems. Following the 
path that we are on currently will not only provide opportunity for the 
same consequences to be repeated, but also mean the end of a banking 
system consisting of many providers. It seems we are rapidly 
approaching a system which will be an oligopoly of a few major 
institutions whose management will not have the same concerns and 
dedication as evidenced by my Uncle Joe. If both cultures are 
separated, the clients of both will prosper, but without the inordinate 
risk of a potential massive cost to the taxpayers.
    I thank you for giving me the opportunity to express my opinion 
which has developed through over half a century experience and has led 
me to the conviction that the insured deposit banking system we had was 
effective, worked well, and did not require any significant direct 
Federal support until 2008 when the other activities of large 
institutions involved in so called investment activities nearly 
destroyed the financial system and imposed enormous costs on taxpayers 
to the present day.
                                 ______
                                 
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                 PREPARED STATEMENT OF JAMES E. ROSELLE
         Executive Vice President and Associate General Counsel
                       Northern Trust Corporation
                              May 9, 2012
    Good afternoon Chairman Brown, Ranking Member Corker, and Members 
of the Committee:

    My name is James Roselle; I am the Associate General Counsel for 
Northern Trust Corporation, a global financial services firm that 
provides investment management services, asset and fund administration, 
and fiduciary and banking solutions to corporations, institutions, and 
individuals worldwide. As of March 31, 2012, Northern Trust has over 
$4.6 trillion in assets under custody and $700 billion in assets under 
management. I appreciate the opportunity to testify before you today on 
behalf of Northern Trust.
    Northern Trust supports the very positive efforts of Congress and 
this Committee to put in place reforms that reduce systemic risk to the 
financial system and prohibit high-risk activities that contributed to 
the financial crisis. As regulators and market participants continue 
work on implementing and complying with the new financial reform law 
(``Dodd-Frank Act''), I would like to focus my testimony on specific 
provisions contained in the Proposed Rule \1\ issued pursuant to the 
so-called ``Volcker Rule.''\2\
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    \1\ Prohibitions and Restrictions on Proprietary Trading and 
Certain Interests in, and Relationships with, Hedge Funds and Private 
Equity Funds, 76 Fed. Reg. 68,846 (Nov. 7, 2011).
    \2\ Section 619 of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (Section 13 of the Bank Holding Company Act of 1956, as 
amended).
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    The restrictions and prohibitions set forth in the Volcker Rule 
were intended to limit banking organization exposure to high risk 
proprietary trading and investment activities. As a global custody bank 
and asset manager, Northern Trust does not engage in the types of 
activities that the Volcker Rule intended to prohibit. Specifically, 
Northern Trust does not engage in high-risk proprietary trading and 
investment activities. Because of the traditional nature of our core 
banking business, we anticipated that the Volcker Rule would have 
little or no impact on our business. Before the Dodd-Frank Act was 
passed, former Federal Reserve Board Chairman Volcker stated that 
``[c]ustody and safekeeping arrangements for securities and valuables'' 
are among the core banking functions that must remain permissible under 
the Volcker Rule.\3\
---------------------------------------------------------------------------
    \3\ See Prohibiting Certain High-Risk Investment Activities by 
Banks and Bank Holding Companies before the S. Comm. On Banking, 
Housing & Urban Affairs, 111th Cong. 2 (February 2, 2010)(testimony of 
the Honorable Paul Volcker, Chairman, President's Economic Recovery 
Advisory Board).
---------------------------------------------------------------------------
    The rules as currently proposed, however, will adversely impact 
traditionally low-risk business activity that investors rely upon for 
investment management purposes. This impact is contrary to the stated 
intention of Congress; it will not promote the safety and soundness of 
the U.S. financial system and may in fact increase systemic risk. If 
not corrected in the rulemaking process, a core banking business of 
Northern Trust and other U.S. banking companies will be adversely 
impacted, which may ultimately impair the competitiveness of U.S. banks 
in a business where we are the acknowledged global leaders.
    Today I will discuss three parts of the Proposed Rule to implement 
the Volcker Rule that may significantly affect Northern Trust and our 
clients. Our key concerns are: (1) the overly broad definition of 
``covered fund'' and the impact that so-called ``Super 23A''\4\ 
prohibitions will have on custody-related transactions with many 
clients; (2) the proposed inclusion of foreign exchange swaps and 
forwards in the proprietary trading restrictions; and (3) the 
unnecessary and onerous proposed compliance requirements.
---------------------------------------------------------------------------
    \4\ Section 13(f) of the Bank Holding Company Act, as amended.
---------------------------------------------------------------------------
    First, the Proposed Rule unnecessarily includes a broad range of 
funds that banking entities will be restricted from sponsoring or 
investing in. The definition of ``covered fund'' would capture nearly 
all foreign funds (including those that are similar to U.S. regulated 
mutual funds that are exempt from the Volcker Rule), all funds that 
trade futures, swaps or other commodity interests to any extent 
(including U.S. mutual funds) \5\, as well as many other entities that 
do not have traditional hedge fund or private equity fund 
characteristics. This definition is important because, if a bank is 
deemed to be a ``sponsor'' or ``adviser'' to a ``covered fund,'' then 
under the Proposed Rule the bank is prohibited under the Super 23A 
requirements from providing any credit whatsoever to the fund.
---------------------------------------------------------------------------
    \5\ See attached comment letter from Vanguard dated February 13, 
2012, on prohibitions and restrictions on proprietary trading and 
certain interests in, and relationships with, hedge funds and private 
equity funds. http://1.usa.gov/IrG535.
---------------------------------------------------------------------------
    Custody banks such as Northern Trust are among the leading global 
providers of asset management and custody services to the many foreign 
funds that do not share the characteristics of hedge funds or private 
equity funds but nevertheless fall within the proposed definition of 
``covered fund.'' Moreover, our custody services often include 
ancillary services that may cause us to be deemed a ``sponsor'' for a 
client's fund under the Proposed Rule. If large numbers of sponsored or 
advised foreign funds become subject to the Volcker Rule, the custody 
banks will be prohibited from providing traditional operational 
extensions of credit and will need to satisfy onerous compliance 
requirements that in some cases may conflict with laws in certain non-
U.S. jurisdictions.
    Such a sweeping approach is inconsistent with Congressional intent 
as well as the findings and recommendations of the Financial Stability 
Oversight Committee (``FSOC'') in its study on the Volcker Rule. The 
legislative history of the Volcker Rule indicates that Congress 
intended and expected the Agencies to use their rulemaking authority to 
implement the Volcker Rule in a way that focuses its prohibitions and 
restrictions on traditional hedge funds and private equity funds. The 
Proposed Rule expands the universe far beyond the intended scope of the 
law.
    To compound the problem, the Proposed Rule adopts an extremely 
rigid interpretation of the Super 23A restriction that will put at risk 
traditional payment and settlement services that custody banks provide 
for their clients. Ordinary custodial and administrative services 
provided to our clients of necessity must include the provision of 
intra-day or short-term extensions of credit to facilitate securities 
settlement, dividend payments and similar custody-related transactions. 
These payment flows are expected in order for transaction settlements 
to operate smoothly and they have been encouraged by global financial 
supervisors. Northern Trust and other banks have a robust risk 
framework to deal with these types of payments, and our risk framework 
and exposure limits are regularly examined by bank supervisors. 
Nevertheless, even these low-risk extensions of credit appear to be 
considered as prohibited ``covered transactions'' under the Proposed 
Rule. It is unfortunate that the Proposed Rule has not followed the 
framework of Section 23A of the Federal Reserve Act \6\ and Regulation 
W, which contain provisions that permit these low-risk operational 
exposures subject to well-established risk management standards.
---------------------------------------------------------------------------
    \6\ 12 U.S.C. Section 371c.
---------------------------------------------------------------------------
    These custody-related transactions simply do not give rise to the 
type of risk that the Volcker Rule was intended to address. Prohibiting 
them will encourage covered fund clients to make alternative 
arrangements for custodial and administrative services with non-U.S. 
banks, which will damage the competitive position of Northern Trust and 
other U.S. banks. Moreover, prohibiting these transactions could result 
in market disruption and elevated levels of risk in global payment and 
settlement systems, with no corresponding systemic or firm-specific 
risk reduction.\7\ Northern Trust believes the agencies have ample 
authority to craft a rule that does not have these unintended and 
adverse consequences for a traditional core banking activity.
---------------------------------------------------------------------------
    \7\ See comment letter from BNY Mellon, Northern Trust, and State 
Street dated February 13, 2012, on proposed rulemaking implementing the 
Volcker Rule-Hedge Funds and Private Equity Funds. http://1.usa.gov/
Jjgh9b.
---------------------------------------------------------------------------
    Second, the proposed inclusion of foreign exchange swap and forward 
transactions within the proprietary trading prohibitions will result in 
damage to a traditional and low-risk activity, with no offsetting 
benefit to the U.S. financial system.\8\ As a significant global 
custodian and asset manager, Northern Trust carries on an active 
foreign exchange trading operation that is directly related to our core 
client services. Foreign exchange transactions typically are generated 
as a result of the routine purchase or sale of securities, or the 
receipt or payment of income, dividends or redemptions, by or for our 
clients. In essence, these currency transactions are simple cash 
management transactions used by our clients to efficiently manage cross 
currency needs.
---------------------------------------------------------------------------
    \8\ See attached comment letter from Northern Trust dated February 
13, 2012, on proposed rulemaking implementing the Volcker Rule--
Proprietary Trading. http://1.usa.gov/IJVcsd.
---------------------------------------------------------------------------
    Secretary Geithner cited the key differences between foreign 
exchange transactions and other types of derivatives in his proposed 
determination to exclude foreign exchange swaps and forwards from the 
clearing and settlement requirements of Title VII of the Dodd-Frank 
Act.\9\ The proposed determination correctly concluded that foreign 
exchange swaps and forwards ``already reflect many of Dodd-Frank's 
objectives for reform including high levels of transparency, effective 
risk management, and financial stability.'' Foreign exchange swaps and 
forwards have fixed payment obligations, are physically settled, and 
are predominately short-term instruments; therefore the risk profile is 
different from other derivatives. This is a traditional banking 
activity that is clearly not required by statute to be included in the 
Volcker Rule's proprietary trading ban and, for the reasons stated 
above, should be excluded from the Rule's trading restrictions.\10\
---------------------------------------------------------------------------
    \9\ ``Determination of Foreign Exchange Swaps and Foreign Exchange 
Forwards under the Commodity Exchange Act'' issued by the Department of 
the Treasury on April 29, 2011.
    \10\ With respect to the proprietary trading portions of the 
Volcker Rule, Northern Trust concurs with the attached comment letter 
submitted by SIFMA's Asset Management Group dated February 13, 2012, on 
restrictions on proprietary trading and certain interests in and 
relationship with hedge funds and private equity funds. http://
1.usa.gov/IB2ldf.
---------------------------------------------------------------------------
    Third, the compliance requirements of the Proposed Rule are unduly 
burdensome and will unnecessarily increase compliance costs for banks 
with little or no offsetting benefit. The Proposed Rule essentially 
requires the bank to prove that each transaction does not fall within 
the prohibited category. At Northern Trust, a very high percentage of 
trading assets reported on our Call Report are foreign exchange 
transactions that, for the reasons given above, should be excluded from 
the trading restrictions. We have very small mark-to-market exposures 
in ``plain vanilla'' derivatives and securities. Yet, under the 
Proposed Rule, we would be required to produce a large number of 
compliance metrics, many of which are poorly designed to reveal 
evidence of prohibited proprietary trading, resulting in considerable 
systems expenditures and ongoing costs of compliance. We believe these 
costs have not adequately been considered by the Agencies in issuing 
the Proposed Rule. We believe the Agencies could carry out the intent 
of Congress more effectively and with less cost to the banking system 
with a simpler rule that is supplemented by active supervision of bank 
trading risks and practices.
    Northern Trust has submitted comments on the Proposed Rule to 
implement the Volcker Rule restrictions, and we have had meetings with 
the Agencies to discuss our concerns. I am confident that the Agencies 
will seriously consider the comments received, and that the final rule, 
or a re-proposal of the Proposed Rule, will deal more effectively with 
the intended purpose of the Volcker Rule and avoid adverse unintended 
consequences.
    We believe that our conservative and highly focused business model 
is one that contributes to financial stability and long-term benefits 
for our clients, shareholders and employees. As the rulemaking phase 
continues, we urge this Committee to encourage the Agencies to adopt 
final regulations that do not adversely impact those traditional 
business activities that played no role in causing the financial 
crisis. These activities provide market participants with efficient and 
safe investment management services. Preserving such business models 
will ensure that U.S. banks can operate competitively while protecting 
against negative impacts on the broader economy and U.S. employment.
    Thank you Chairman Brown, Ranking Member Corker, and Members of the 
Committee, for allowing me to present Northern Trust's views on this 
critically important topic.
                                 ______
                                 
                PREPARED STATEMENT OF ANTHONY J. CARFANG
            Partner and Director, Treasury Strategies, Inc.
               on behalf of the U.S. Chamber of Commerce
                              May 9, 2012
        The U.S. Chamber of Commerce is the world's largest business 
        federation, representing the interests of more than 3 million 
        businesses of all sizes, sectors, and regions, as well as State 
        and local chambers and industry associations.

        More than 96 percent of the Chamber's members are small 
        businesses with 100 or fewer employees, 70 percent of which 
        have 10 or fewer employees. Yet, virtually all of the nation's 
        largest companies are also active members. We are particularly 
        cognizant of the problems of smaller businesses, as well as 
        issues facing the business community at large.

        Besides representing a cross-section of the American business 
        community in terms of number of employees, the Chamber 
        represents a wide management spectrum by type of business and 
        location. Each major classification of American business--
        manufacturing, retailing, services, construction, wholesaling, 
        and finance--is represented. Also, the Chamber has substantial 
        membership in all 50 States.

        The Chamber's international reach is substantial as well. It 
        believes that global interdependence provides an opportunity, 
        not a threat. In addition to the U.S. Chamber of Commerce's 115 
        American Chambers of Commerce abroad, an increasing number of 
        members are engaged in the export and import of both goods and 
        services and have ongoing investment activities. The Chamber 
        favors strengthened international competitiveness and opposes 
        artificial U.S. and foreign barriers to international business.

        Positions on national issues are developed by a cross-section 
        of Chamber members serving on committees, subcommittees, and 
        task forces. More than 1,000 business people participate in 
        this process.
                                 ______
                                 
    Good afternoon Chairman Brown, Ranking Member Corker, and Members 
of the Subcommittee. Thank you for the opportunity to testify, on 
behalf of the U.S. Chamber of Commerce, at today's hearing: ``Is 
Simpler Better? Limiting Federal Support for Financial Institutions''. 
This is a timely hearing and is a unique opportunity to discuss the 
capital markets that fuel business expansion and the concurrent 
economic growth and job creation that occurs as a result.
    I am Anthony J. Carfang, a founding partner of Treasury Strategies, 
Inc. Treasury Strategies is one of the world's leading consultancies in 
the area of treasury management, payments and liquidity. Our clients 
include the CFOs and treasurers of large and medium sized corporations 
as well as State and local governments, hospitals and universities. We 
also consult with the major global and regional banks that provide 
treasury and transaction services to these corporations. In thirty 
years of practice, we have consulted with businesses and financial 
institutions of every size and complexity on a global basis.
    Last year, the Chamber of Commerce issued a report, Sources of 
Capital and Economic Growth: Interconnected and Diverse Markets Driving 
U.S. Competition, a copy of which is attached as part of this testimony 
for today's hearing. The purpose of the report was to demonstrate the 
wide variety and diversity of capital needed to fuel business expansion 
and job growth. This diverse quilt includes debt markets, equity 
markets, bank loans, trade finance, angel investing, venture capital, 
credit cards, home equity loans and the list goes on and on.
    It has been my experience that all of these capital raising methods 
are needed as options for businesses because flexibility will allow 
them to meet their needs depending on the maturity of the firm, 
business cycle, regulatory pressures and counterparty positions. Global 
financial systems are needed for large corporations, but also small 
businesses that engage in international trade. Community banks assist 
small businesses, while credit cards help fuel the entrepreneurial 
spirit that continually reinvigorates the economy.
    So while the premise of the hearing is that our financial systems 
need to be plainer and simpler, the fact is that we need a mosaic of 
interconnected products of varying size and complexity to meet the 
capital needs of a 21st century economy. Constraining our financial 
systems to look plainer and simpler would be as beneficial as 
reestablishing the horse and buggy as the foundation of our 
transportation systems. There is no guarantee that plainer and simpler 
translates to safer. The opposite, because of lack of diversification, 
might well be true. Furthermore, the loss of productivity, speed and 
communication would cause our economy to shrink and businesses to 
disappear.
    Consideration of financial systems and products cannot be divorced 
from the way that the markets work and the purposes they serve. Viewed 
from this practical perspective, financial institutions and systems are 
a conduit--a means of transferring capital from investors to the 
businesses that need it. A well-regulated conduit will efficiently and 
reliably provide businesses with the resources needed to grow and 
thrive. Inappropriately restricting that conduit is analogous to 
blocked blood vessels that deprive the heart of needed oxygen, causing 
a heart attack and coronary disease.
    Many aspects of our financial system are in fact already being 
circumscribed by legislators and regulators today. Just consider the 
rapid succession of far-reaching regulations that have flowed from the 
Dodd-Frank Act and other responses to the 2008 financial crisis--the 
Volcker Rule, new derivatives regulations, potential money market 
regulations, Basel III capital standards, systemic risk mandates, to 
name a few, all have one thing in common--they will impact the ability 
of businesses to raise capital and the ability and willingness of 
investors to provide it.
    If we judge these regulatory initiatives in light of my earlier-
stated premise that businesses need access to a mosaic of financial 
products and systems to raise capital number of questions must be 
considered: How do these initiatives impact that mosaic? How would 
placing artificial caps on these systems or institutions impact 
capital-raising for companies and the return that investors expect to 
receive? How would restricting diversification reduce risk? Ultimately, 
how could U.S. businesses compete and hire workers in a global 
marketplace, if their ability to raise capital is impaired?
Economic Consequences
    Up to now, businesses operating in the United States have been the 
most capital efficient and productive in the world. Thanks to our 
financial institutions and existing banking frameworks, businesses and 
the U.S. economy benefit greatly from:

    The broadest, deepest and most resilient capital markets,

    The best risk management products and tools,

    The most robust and liquid markets,

    The most technologically advanced cash management services, 
        and

    The most efficient and transparent payment systems.

As a result, U.S. businesses are extremely efficient. Consider the 
following Treasury Strategies analysis: companies doing business in the 
United States operate with approximately $2.2 trillion of cash 
reserves. That represents only 14 percent of U.S. gross domestic 
product. In contrast, corporate cash in the Eurozone is 21 percent of 
Eurozone GDP. In the UK, the ratio is even higher at 50 percent.
    The availability of highly liquid capital pools allows Treasurers 
to keep less cash on hand and use a just-in-time financing system that 
allows companies to pay their bills and raise the capital needed to 
expand and create jobs.
    Using this analysis to look at just two items posed by today's 
hearing--placing caps on the size of financial institutions or the 
imposition of the Volcker Rule as currently drafted--shows that 
America's capital efficiency will decline. This will result in 
corporations having to maintain larger cash buffers. Were cash reserves 
to rise to the Eurozone level of 21 percent of GDP, that new level 
would be in excess of $3 trillion.
    Stated differently, CFOs and Treasurers would need to set aside and 
idle an additional $1 trillion of cash that could otherwise be used for 
expansion and hiring. $1 trillion dollars of idle cash is a staggering 
number. By way of comparison:

    It is greater than the entire TARP program.

    It is more than the Stimulus program.

    It is even greater than the Federal Reserve's quantitative 
        easing program, QE II.

This would seriously slow the economy to the detriment of businesses, 
workers and consumers. To raise this extra $1 trillion cash buffer, 
companies may have to downsize and lay off workers, reduce inventories, 
postpone expansion and defer capital investment. Obviously, the 
economic consequences would be huge.
    Why would treasurers have to idle so much more cash?
    Artificial caps and the Volcker Rule, as currently proposed, will 
create a subjective regulatory scrutiny of trades, making a company's 
ability to raise capital more expensive and time consuming. They will 
increase administrative expenses for banks which will translate into a 
higher cost of capital for businesses. Real-time financing will no 
longer be possible for many companies. This will raise costs for most 
companies and make foreign capital markets more attractive for some 
companies, while shutting other companies out of debt markets entirely.
    This is also not happening in a vacuum.
    Corporate treasurers must also contend with looming money market 
fund regulations that may imperil 40 percent of the commercial paper 
market, Basel III capital and liquidity requirements and expected 
derivatives regulations.
    As I said earlier all of these efforts simultaneously converge on 
the desk of the corporate treasurer, adversely impacting business's 
ability to raise capital and mitigate risk. It is unclear how well 
these proposals have been vetted and the extent to which their 
cumulative impacts have been considered and analyzed. Never before have 
so many unproven, high stakes regulations been imposed simultaneously. 
This is a dangerous experiment.
    In January, Federal Reserve Governor Tarullo testified before the 
House Financial Services Committee that the regulators did not know or 
understand what normal market making or underwriting practices are. 
Market making and underwriting are used by nonfinancial firms to raise 
money. Yet the regulators admit that they don't understand the activity 
or products they are attempting to regulate--three months after the 
three hundred page Volcker Rule regulation has been proposed.
    Similarly, no economic analysis has been performed regarding the 
potential impacts on our economy and job growth that may flow from 
capping the size of financial institutions. For instance, where will 
community banks go for liquidity?
    There is a very close relationship between large banks and 
community banks that could be jeopardized by ill-considered, arbitrary 
regulations. Large banks are a major source of liquidity for community 
banks and their business and consumer customers.
    For example, large banks lend to community banks via the fed funds 
market so that community banks will have funds to invest locally. 
Often, large banks will participate in loans originated by community 
banks, allowing that bank to better serve the community. Typically, 
community banks will access services of larger banks in order to meet 
occasional customer needs such as international wire transfers, foreign 
currency orders or letters of credit. Breaks in this chain can have 
direct adverse consequences for Main Street businesses and the smaller 
financial firms that service them. If community banks lose access to 
liquidity, by extension, Main Street businesses lose access to capital.
    Similarly, if a company must go to multiple institutions to raise 
capital for a deal, rather than one institution, market efficiency and 
capital formation are impaired. Economies of scale must be considered 
for the ease and efficiency of the overall economy.
The nature of financial risk
    I would like to add a statement about managing financial risk. A 
common understanding among our clients is that, like energy, risk can 
neither be created nor destroyed but only transferred. So when you 
consider ways to reduce banking system risk, do not be tricked into 
thinking that risk disappears. It simply moves elsewhere. Our system 
relies on the presence of actors who view the potential rewards of 
accepting this risk as sufficient to prompt them to do so. If they 
should come to view the costs and risks as outweighing any potential 
reward, the flow of capital will come to a standstill.
    To truly minimize the probability of future financial crises, we 
must understand how this risk moves and where it will show up next. 
Risk is managed most efficiently when it is transparent, properly 
understood and the market responds with robust, efficient and liquid 
hedging solutions.
    A corporate CFO whose company imports a raw material from the Far 
East, for example, must manage currency risk, commodity price risk, 
interest rate risk and operational shipping risks. By simply precluding 
a bank from helping a company to hedge these risks, the Volcker Rule or 
size limitations does not make those risks go away.
    CFOs and Treasurers will undoubtedly conclude that some risk 
management techniques and some heretofore efficient transactions will 
no longer be available, or, if they are available, they will no longer 
be cost effective. They will decide to ``go naked'' and retain more 
risk internally. The upshot of this is that they will hold even more 
precautionary cash on their balance sheets as a buffer. This will take 
money out of the real economy, stall economic growth, stunt the 
creation of new jobs, and destroy existing jobs.
    The corporate treasury is the financial nerve center of a business, 
which must make countless decisions on a daily basis to identify and 
manage the complexities of the company's cash-flow in global as well as 
local markets. To assist them in this critical and ongoing task, some 
companies require a bank that can deliver global economies of scale. 
Other companies require a broad array of services that only a full 
service bank can provide. Still others require specific knowledge of 
local markets that regional and community banks best provide. Most 
companies required all of the above at some point in their life cycle. 
The Volcker Rule and size caps would virtually eliminate U.S. banks 
from offering both the scale services, scope services and localized 
specialties that today's U.S. businesses need.
    Many companies have recently engaged Treasury Strategies to assist 
in upgrading their treasury technology. Their intent is to get a real 
time view of their cash, and implement automated tools to easily move 
that cash around the globe. In this frictionless environment, cash can 
easily move to the most favorable jurisdictions.
    Thus, regulations that limit a financial institution's ability to 
provide a full range of services erode the dominance of the U.S. banks. 
Many companies have already established regional treasury centers for 
functions traditionally housed in the United States. All of this leads 
to capital flowing out of the United States and competitiveness 
declining.
    Let me also state that Treasury Strategies and our clients fully 
support well thought out efforts to improve economic efficiency and to 
reduce the likelihood of another systemic failure. The U.S. Chamber's 
position is the same and it has advocated for stronger capital rules, 
rather than a unilateral ban on proprietary trading, as a pro-growth 
means of stabilizing the financial system and avoiding systemic 
failure.
    However, we are in danger of developing an overly complex 
hodgepodge of unproven regulations that will be extraordinarily vague 
and create regulatory risk and legal uncertainty. In short we may 
deprive the American economy of one extraordinary advantage--the 
efficiency associated with predictability and legal certainty in the 
rules governing our financial systems.
    We could deprive our economy of competitive advantages at the same 
time that it must become more globally competitive to grow our economy 
and put America back to work.
Conclusion
    I appreciate the opportunity to appear before you today on behalf 
of the U.S. Chamber of Commerce.
    Financial regulatory reform is an unfinished project that must take 
into account the needs of treasurers and businesses to meet the demands 
needed to grow and operate in an increasingly competitive and global 
environment. Proposals to impose artificial and arbitrary caps on the 
financial industry, or the Volcker Rule (as currently proposed), or 
additional money market regulation will not reduce systemic risk. 
Instead they will only shift that risk. They will force the 
nonfinancial companies that are the engines of our economy to retrench, 
enhance their cash positions and face a much tougher time raising the 
capital needed to operate, grow and create jobs.
    This is about a grand tradeoff: are we willing to jeopardize 
America's capital raising and job creating engine in exchange for a 
vague, unproven hope of reducing financial risk? As stated earlier, 
risks can only be shifted, not eliminated. We believe that these 
regulations will make U.S. capital markets less robust, U.S. business 
less competitive and ultimately harm all Americans by slowing America's 
economic activity.
    In thinking through these difficult problems, I would respectfully 
suggest that policymakers ask this question before proposing new laws 
or approving new regulations governing America's financial system:
    When a business' treasurer calls a U.S. bank or financial firm to 
raise the cash needed to meet the pay bills or fund expansion, will 
someone be there to answer that phone call?
    If not, the business will suffer, as will the economy and job 
creation.
    I am delighted to discuss these issues further and answer any 
questions you may have.

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