[Senate Hearing 113-364]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 113-364
 
    EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT FOR BANK HOLDING
                               COMPANIES

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
             FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS

                             SECOND SESSION

                                   ON

EXAMINING THE GAO'S REPORT ON THE GOVERNMENT'S EXTRAORDINARY ASSISTANCE
 TO LARGE BANK HOLDING COMPANIES AND EXPLORING THE AUTHORITIES FEDERAL
 FINANCIAL REGULATORS HAVE TO PREVENT FUTURE ASSISTANCE AT THE COST TO
                               TAXPAYERS

                               __________

                            JANUARY 8, 2014

                               __________

  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              MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York         RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon                 MARK KIRK, Illinois
KAY HAGAN, North Carolina            JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia       TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts      DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota

                       Charles Yi, Staff Director

                Gregg Richard, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                       Taylor Reed, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

     Subcommittee on Financial Institutions and Consumer Protection

                     SHERROD BROWN, Ohio, Chairman

       PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         DAVID VITTER, Louisiana
ROBERT MENENDEZ, New Jersey          MIKE JOHANNS, Nebraska
JON TESTER, Montana                  JERRY MORAN, Kansas
JEFF MERKLEY, Oregon                 DEAN HELLER, Nevada
KAY HAGAN, North Carolina            BOB CORKER, Tennessee
ELIZABETH WARREN, Massachusetts

               Graham Steele, Subcommittee Staff Director

       Tonnie Wybensinger, Republican Subcommittee Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------

                       WEDNESDAY, JANUARY 8, 2014

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Toomey...............................................     3
    Senator Manchin..............................................     4

                               WITNESSES

Lawrance L. Evans, Jr., Director, Financial Markets and Community
  Investment, Government Accountability Office...................     5
    Prepared statement...........................................    34
    Responses to written questions of:
        Senator Vitter...........................................   128
Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship
  and Finance, University of Chicago Booth School of Business....     7
    Prepared statement...........................................    45
Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT
  Sloan School of Management.....................................     8
    Prepared statement...........................................   117
Harvey Rosenblum, Adjunct Professor of Finance, Cox School of
  Business, Southern Methodist University, and Retired Director
  of Research, Federal Reserve Bank of Dallas....................    10
    Prepared statement...........................................   123
Allan H. Meltzer, The Allan H. Meltzer University Professor of
  Political Economy, Carnegie Mellon University Tepper School of
  Business.......................................................    12
    Prepared statement...........................................   126

              Additional Material Supplied for the Record

Statement of the Independent Community Bankers of America,
  submitted by Chairman Brown....................................   134

                                 (iii)


    EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT FOR BANK HOLDING
                               COMPANIES

                              ----------


                       WEDNESDAY, JANUARY 8, 2014

                                       U.S. Senate,
Subcommittee on Financial Institutions and Consumer
                                        Protection,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 10:04 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.

          OPENING STATEMENT OF CHAIRMAN SHERROD BROWN

    Chairman Brown. This hearing will come to order. Thank you
for joining us, Senator Toomey. I particularly appreciate your
cooperation in working with this. Senator Reed, I appreciate
his being here. He has to go to the floor to manage the
unemployment insurance legislation and will return for
questioning.
    Today's topic is how Government policies support too-big-
to-fail megabanks. I often said my vote in 2008 for the TARP,
for the Trouble Asset Relief Program, was both the best vote of
my career and the worst vote of my career. It was the best vote
because we simply could not allow the economy to be destroyed,
and most of us, I think, in the House and Senate thought that
is what would have happened. It was the worst vote because we
allowed Wall Street to run wild for too long, and the only
option presented to us was a $700 billion bailout, with few
instructions, frankly.
    Five years later, according to the firm SNL Financial, the
four largest banks control more than 40 percent of the banking
industry, up from less than 10 percent in 1990. What happened?
Between 1990 and 2009, 37 financial institutions merged 33
times to become the Nation's four largest bank holding
companies. Three of 1990's top five banks are now part of our
Nation's largest bank. In 1995, the top six banks had assets
equal to 17 percent of GDP. Today they are more than 60--six-
zero--percent of GDP.
    While many megabank supporters point out the benefits of
large banks, a 2011 IMF report also shows that Governments bail
out bigger banks. So it should come as no surprise that the
Congressional Oversight Panel for TARP found that the six
biggest Wall Street banks received a total of $1.27 trillion--
1.27 thousand billion dollars--in Government support, including
accounting for 63 percent of the Fed's average daily lending.
    There are important lessons in this first Government
Accountability Office report. First, megabanks borrowed at a
discounted rate against assets that the market was not
accepting. The result is a subsidy for the megabanks. CEOs of
the largest banks understood this. According to Secretary
Paulson, the Treasury Secretary under President Bush, two of
these bank CEOs called it ``cheap capital.'' In 2011, Bloomberg
estimated that the terms of the Fed loans provided the six
largest banks with a $4.8 billion profit, an amount equal to 23
percent of their combined net during the life of the loans. The
GAO report we will discuss today also confirms that Treasury
paid substantially more than market value for the assets that
it purchased. The Congressional Oversight Panel estimated this
provided the six biggest megabanks with a subsidy of $25
billion. These are only small parts of the benefits they have
gotten because of their size.
    Second, megabanks borrowed more than small banks because
they used more volatile and short-term funding sources, not
just deposits that community banks tend to rely upon. Support
for the three largest banks averaged more than 10 percent of
their total assets, much higher than their capital ratios at
the time.
    Finally, we see that walls that were supposed to separate
and protect traditional banking were ignored, and the safety
net was stretched as far as possible. With all these benefits,
it is no wonder the CEO of our Nation's largest banks said that
2008 was ``the finest year ever.''
    Since then, our banking industry has become even more
consolidated, not less consolidated. Today the four largest
bank holding companies are about $2 trillion larger--$2
trillion larger--than they were before the financial crisis.
The four most complex institutions each have more than 2,000
subsidiaries, only 12 of which are commercial banks. More than
11,000--several thousand are nonbanks. The first report shows
that the largest Wall Street banks borrow on favorable terms
directly from the Federal Government during turbulent times. I
expect the second report will show that the Government's
implicit support enables Wall Street banks to borrow on
favorable terms from the market in ordinary times.
    Two things are clear: The largest Wall Street banks are so
much larger and more concentrated than they have ever been, and
because of their size, both their economic clout and their
political clout are enhanced. And because of their size, they
receive financial benefits that are not available to regional
and community banks like Huntington Bank in Columbus and the
First National Bank of Sycamore, Ohio.
    There is broad agreement that this is unacceptable. Senator
Vitter and I offered an amendment to the Senate budget calling
on Congress to eliminate this subsidy. It was approved 99-0.
However, it was stripped from the recent budget deal without
explanation. If we agree that no institution should be too big
to fail, if we agree that all bailouts must end, then we must
agree that we must do something about this. I look forward to
hearing the witnesses' views on what that should be.
    Senator Toomey, thank you.

             STATEMENT OF SENATOR PATRICK J. TOOMEY

    Senator Toomey. Thanks, Mr. Chairman, and thanks for
holding this hearing. I cannot help but comment briefly on one
observation that you made, which is the concentration within
the banking sector, and I think any such observation should
include a really extraordinary fact, which is the complete--
essentially the end of the creation of new community banks in
America which we are recently living through. After many, many
years in which it was common to have dozens or scores,
sometimes even hundreds of community banks launched across the
country, we went 5 years without a single new community bank. I
am happy to report that a bank in Lancaster County,
Pennsylvania, broke that trend just a few months ago, but the
massive, excessive overregulation, including on the smallest
banks that have absolutely no systemic importance really to the
economy, are nevertheless burdened so much that it is just not
feasible to launch a community bank and provide the credit that
communities need. And I think that is a terrible development
that we need to address.
    But I digress, Mr. Chairman. The point of this hearing, of
course, is to consider especially the GAO report on the
Government support that occurred during the financial crisis,
and I do think that is a very important topic. We need to
understand that. I think it would be helpful to understand and
quantify the Government support for other industries as well.
It would be interesting to look at the cost to taxpayers, for
instance, of the automakers' bailout. Some of that, of course,
the taxpayer never recovered and never will.
    And it is important that we understand that, but it is also
important to remember that is historical. As you point out, we
have got a report coming out soon that will look at whether or
not and to what extent there is an ongoing subsidy, whether it
is implied or not.
    I am really looking forward to that report. I think we do
not yet know the answer. I am looking forward to what light the
GAO study will shed on this. But I want to talk a little bit
about this because that is what we can still address. We cannot
change history, but we could address this.
    So if there is an ongoing subsidy to big banks, the first
question is how is it manifested, and presumably it is
manifested in a lower cost of funding. So if that is the case,
it will be interesting to see how GAO attempts to quantify
that, because funding costs are, of course, a function of many,
many things, and it will be interesting to see how those
various factors are separated out. Size itself confers benefits
like an economy of scale that has nothing to do with the
Government, and all industries tend to have lower funding costs
for larger institutions than smaller institutions across
different sectors. The quality of management affects the
perception of creditworthiness, and so that affects funding
costs. The amount of capital obviously affects funding costs.
So there are a lot of factors, and it will be interesting to
see the analysis as to what their relative contributions are to
different funding costs.
    But I am going to suggest, Mr. Chairman, that if there is
an ongoing subsidy to the big banks, I think there is a very
significant likelihood that it arises mostly from Title II of
Dodd-Frank. And the reason I say that is because Title II of
Dodd-Frank, the Orderly Liquidation Authority, explicitly
grants the power to the FDIC to go to the Treasury and to take
taxpayer money and use it for the support of the creditors of
the failing institution. And whether or not the purpose of the
Orderly Liquidation Authority is to ultimately execute the
failing financial institution, the fact that there is money
made available explicitly in Title II of Dodd-Frank to support
creditors, it seems to me, creates some of the moral hazard and
some of the dangers of the subsidies that we would want to
avoid.
    In addition, Title II of Dodd-Frank gives the FDIC
authority in how similarly situated creditors will be treated.
Depending on whether or not the FDIC determines that some of
the creditors may have somehow contributed to the failure of
the institution more than other creditors, how they would
determine that is not at all clear.
    This I think is very, very problematic, and it is one of
the biggest flaws, in my view, with Dodd-Frank, the mechanism
by which the legislation contemplates the liquidation of a
failed financial institution. And so I know you have got a bill
that addresses this in one way. I have got a bill that repeals
Title II of Dodd-Frank and make the necessary amendments to the
Bankruptcy Code so that if a large, complex financial
institution were to fail, we could manage the resolution
through a legal process that would be transparent, based on
clear laws, that would be objective rather than subject, and
creditors would know exactly what their risks were and would
not be subject to the discretion of some potentially
politically influenced organization. And you could do it with
an absolute prohibition on using taxpayer funds, which is what
my bill would do.
    So I think that is one way to address a number of problems,
not the least of which is the possibility that there is some
ongoing subsidy.
    So, with that, Mr. Chairman, I appreciate your having this
hearing and look forward to hearing from our witnesses.
    Chairman Brown. Thank you, Senator Toomey.
    Senator Manchin.

                STATEMENT OF SENATOR JOE MANCHIN

    Senator Manchin. Mr. Chairman, thank you very much. I am
not a Member of the Subcommittee, but I am a Member of the
Committee on Banking, and I am very interested in the health
and wellness of the banking system in this country but, most
importantly, in West Virginia. We are a small State made up
mostly of community banks. We did not suffer through the
mortgage crisis, and we had strong banking laws in our State,
and still do.
    With that being said, I am just trying to learn as much as
possible to understand how we could subsidize some of the
largest banks that cause the problems that we have in this
country and be able to be subsidized by the banks or the people
that were not affected and are being affected now because of
the laws that are coming down with Dodd-Frank. So we are just
trying to find that balance, and I am here anxiously to try to
learn, so thank you.
    Chairman Brown. Thank you, Senator Manchin.
    Let me just begin by introducing the panel. Then we will
hear from each of them, and then I will begin the questions,
then Senator Toomey, and we will work our way through the
panel.
    Lawrance Evans, Jr., is Director of Financial Markets and
Community Investment for the Government Accountability Office,
the GAO. Mr. Evans, thanks for your service. Thanks for joining
us.
    Luigi Zingales is the Robert C. McCormack Professor of
Entrepreneurship and Finance and the David Booth Faculty Fellow
at the University of Chicago Booth School of Business. Dr.
Zingales, welcome.
    Simon Johnson is the former chief economist at the
International Monetary Fund, currently the Ronald Kurtz
Professor of Entrepreneurship at MIT Sloan School of
Management. Dr. Johnson, welcome.
    Harvey Rosenblum is an adjunct professor at Southern
Methodist University's Cox School of Business. He is the former
executive vice president and director of research at the
Federal Reserve Bank of Dallas, where he worked for some 40
years. Dr. Rosenblum, welcome.
    And Allan H. Meltzer is, appropriately, the Allan Meltzer
University Professor of Political Economy, quite a coincidence,
at Carnegie Mellon University Tepper School of Business.
Welcome, Dr. Meltzer.
    And, Mr. Evans, if you would begin.

   STATEMENT OF LAWRANCE L. EVANS, JR., DIRECTOR, FINANCIAL
  MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY
                             OFFICE

    Mr. Evans. Chairman Brown, Ranking Member Toomey, and
Members of the Subcommittee, it is my pleasure to be here today
to discuss Government support for financial institutions.
    During the most recent crisis, that support included more
than $1 trillion in loans and hundreds of billions of dollars
in capital and guarantees. While these actions were credited
with stabilizing the financial system, they also raised
concerns about moral hazard and the weakening of market
discipline. Specifically, such interventions could create
expectations of future support that may reduce investors'
incentives to monitor and price risk taking appropriately.
    Whether firms receive benefits due to investor perceptions
of loss protection is largely an empirical question. To those
ends, GAO will conduct an empirical analysis of any funding
costs or other economic advantages large banks may enjoy as a
result of expectations of public support. Those results will be
included in the report to be released later this year.
    My remarks today are based on GAO's November report, which
focused on actual support provided to institutions over the
2007-09 period to address disruptions in important funding
markets.
    From participation in these crisis-driven programs, bank
holding companies and their subsidiaries experienced individual
benefits, including liquidity benefits from programs that
allowed them to borrow at lower interest rates, in greater
quantities, and at longer maturities than potential market
alternatives. For example, we found program prices were 22 to
92 basis points lower than market alternatives, depending on
the program and market rates examined. This finding is
consistent with the financial stability goals of these
programs.
    Assistance was generally made available to institutions of
various sizes. However, at the end of 2008, program use on
average was higher for banking organizations with $50 billion
or more in total assets than for smaller firms. The six largest
bank organizations were significant participants in emergency
programs, particularly those targeting short-term funding
markets. Some also benefited from institution-specific actions,
including additional capital injections and guarantees.
    Additionally, the Federal Reserve granted a number of
exemptions to allow banks to channel funding support to
subsidiaries and for other purposes. The Fed also granted bank
holding company status to several nonbank financial companies
to provide those firms greater access to Government support,
and also extended a credit to the London subsidiaries of a few
of the largest banking organizations.
    Government assistance to prevent the failures of large
financial institutions like Fannie Mae and AIG also benefited
bank holding companies and other firms that had large exposures
to these institutions. It is important again to emphasize all
these actions were undertaken to promote stability and
confidence in the financial system.
    While the emergency response may have enhanced investor
expectations about public support, the Dodd-Frank Act contained
provisions intended to restrict future emergency assistance and
prompt other regulatory changes that will alter the landscape
for large financial institutions. For example, key provisions
of the act are designed to reduce the probability of failure of
systemically important firms and the risk they pose to the
economy. These include provisions that restrict proprietary
trading and swap transactions, among other activities, and
require the Federal Reserve to subject the largest financial
firms to heightened prudential standards and regulatory
oversight. The act places new restrictions on the Federal
Reserve and FDIC's emergency authorities. While the act allows
the Federal Reserve to use its authority to authorize programs
with broad-based eligibility, it sets forth new restrictions
and requirements for such programs, including a prohibition on
lending to insolvent firms.
    As a first step to ensure any future emergency lending
complies with Dodd-Frank, the Fed recently issued a draft rule
and a request for public comment. The act requires resolution
planning by large firms and grants FDIC new resolution
authority to resolve a large failing firm outside of the
bankruptcy process. FDIC continues to work to implement this
authority and has acknowledged a number of challenges to its
effectiveness. The viability and credibility of the resolution
process is a critical part of removing market expectations of
future extraordinary Government assistance.
    The effectiveness of many of the relevant provisions of the
act will depend in large part on how agencies implement them.
As implementation is incomplete, effectiveness is uncertain.
Some aspects of the act, such as resolutions through Title I or
Title II, may require a market event to fully gauge their
efficacy. As such, many observers, some of them here, have
continued to debate the merits of Dodd-Frank in addressing
threats to financial stability and market discipline.
    Members of the Subcommittee, this concludes my opening
statement. I look forward to any questions you might have.
    Chairman Brown. Thank you, Mr. Evans.
    Dr. Zingales, welcome.

 STATEMENT OF LUIGI ZINGALES, ROBERT C. MCCORMACK PROFESSOR OF
   ENTREPRENEURSHIP AND FINANCE, UNIVERSITY OF CHICAGO BOOTH
                       SCHOOL OF BUSINESS

    Mr. Zingales. Chairman Brown, Ranking Member Toomey,
Members of the Subcommittee, thank you for inviting me.
    I have been asked to comment on the GAO study on the
Government support of bank holding companies and in particular
on my estimates of the financial benefits enjoyed by the bank
holding companies as a result of the extraordinary Government
actions during the financial crisis, and on my views of how to
address the issues identified in the GAO report using the
authorities provided in the Dodd-Frank Act.
    Regarding the estimate of the financial benefits, it is
important to distinguish two components: pure transfer of value
from taxpayers to bank's investors and value created as a
result of a reduction in the probability of a costly
bankruptcy.
    Veronesi and Zingales (2010) calculate the expected
Government cost of the two main programs--the CPP and the
TLGP--to be roughly $40 billion. By using this estimate and by
making reasonable assumptions on the cost of the other
programs, I obtain that the total expected cost of these
programs was between $60 billion and $90 billion. This
represents the pure transfer of value from taxpayers to bank
holding companies' financial claim holders.
    Veronesi and Zingales also estimate that in case of
bankruptcy, 22 percent of the enterprise value of a bank
holding company vanishes. Thus, we can assess the value saved
by computing the changes in the probability of bankruptcy
triggered by the Government interventions. These estimates,
however, will depend crucially on what counterfactual
hypothesis we are willing to entertain, i.e., what we assume
would have happened to the bank holding companies had the
Government not intervened.
    I present two extreme scenarios. The lower bound, analyzed
in Veronesi and Zingales, only considers the differential
benefit of the set of interventions announced Columbus Day
weekend 2008. Since even before that weekend the market was
expecting the Government to intervene, these estimates only
capture the effect of an increase in the probability of a
Government intervention. Overall, this set of Government
interventions saves roughly $100 billion, setting the total
financial benefit enjoyed by the bank holding companies at
between $158 billion and $188 billion.
    To obtain an upper bound, I make the Jamie Dimon's
hypothesis that without Government intervention all the top 10
bank holding companies would have failed. In this case the
value saved overall would be $1.4 trillion with a total
financial benefit by bank holding companies between $1.5 and
$1.6 trillion. The wide range of these estimates shows how
dependent the results are on the counterfactual used.
    On the second issue, I would like to classify the Dodd-
Frank's interventions in three groups:
    Number one, restrictions to interventions in case a bank
holding company is in trouble, such as restrictions on the
Federal Reserve 13(3) authority;
    Two, reduction in the potential cost in case of bankruptcy,
such as living wills;
    Three, restrictions to risk taking in normal conditions,
such as liquidity requirements and debt to equity ratios.
    I regard the first set of tools to be not only useless but
also harmful. As the ``no bailout clause'' of the European
Union Maastricht Treaty has shown, these restrictions are
routinely bypassed when the need arises. If they are not, it
can be dangerous, since by the time a major holding company is
in trouble, the cost of not intervening becomes very high. This
is exactly the type of tradeoff that Senator Brown was
describing when he voted for TARP.
    I regard the second set of tools as wishful thinking. A
bank holding company's incentive to design a proper ``living
will'' equals the desire of a man, sentenced to death by
hanging, to find the right tree at which to be hanged.
    The only effective tool to eliminate a subsidy to large
bank holding companies is to design a mechanism of prompt
intervention, which is triggered much before a bank holding
company becomes insolvent. Such mechanism, described in Hart
and Zingales (2012), can be implemented using the authorities
provided in Dodd-Frank. It is sufficient that, by using its
authority to set leverage standards, the Fed imposes a maximum
price for the credit default swap of bank holding companies'
junior debt. A CDS price subsumes both the leverage position
and the riskiness of the underlying assets. Every time the CDS
price exceeds the predetermined threshold for, let us say, 30
days, the bank should be required to issue equity. If it does
not, it should be taken over by the regulator and liquidated
using the Ordinary Liquidation Authority under Dodd-Frank. The
system works like a margin loan, which is made safe by the
occasional margin calls. This is the most effective way to
eradicate the too-big-to-fail problem.
    Chairman Brown. Thank you, Dr. Zingales.
    Dr. Johnson, welcome.

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

    Mr. Johnson. Thank you, Senator. Let me make three points.
    First of all, I agree, roughly speaking, with the findings
of the GAO report. There was a large amount of support provided
to bank holding companies, the very largest banks in the
country, during the crisis. I have some caveats I would attach
to their estimates. I put those in my written testimony, but I
think, roughly speaking, the GAO has got this right. It was a
huge amount, unprecedented amount of support that was provided.
    The second point is building on what you said, Senator,
about the cost and the cost to the budget of having a dangerous
financial system, which I would emphasize has two components.
One is the direct amount of the subsidy, for example, the kinds
of numbers that Luigi was talking about, how much are you
transferring from the official sector to the private sector.
But there is also a much bigger cost, which is what happens to
the budget, what is the damage done to public accounts as a
result of the crisis.
    Now, you can back that out from some of the work that the
Congressional Budget Office has done. Roughly speaking, over
the cycle, based on their estimates, the severity of this
crisis will end up increasing public debt by about 50 percent--
five-zero percent--of GDP. So call that $7 or $8 trillion in
today's money. And I completely agree with you, Senator Brown,
that this should be an integral part of our budget thinking,
and we should aim to eliminate not just the direct subsidy
along the lines that you identify, but also worry about the
broader hit that can potentially come at us through our fiscal
accounts again. And I think the Senate and others should call
on the Congressional Budget Office to make this kind of
analysis much more central to what they present to you when
they provide you with their standard analysis, both the
baseline scenarios and when they think about various reforms,
including the ones that you propose, and including the ones
that Senator Toomey is proposing.
    And that is my third point, which is I think it is self-
evident that the problem of too big to fail was exacerbated by
the crisis and by the bailout measures, and I think both of you
are acknowledging and recognizing and emphasizing that in a
completely appropriate way with the legislation that you are
putting forward.
    I would also emphasize, at least from my perspective, that
you are agreeing--Senator Brown, you are emphasizing the crazy
increase in concentration in the financial system we have seen
over the past 20 or 30 years. Senator Toomey, I completely
agree with you that the independent community banks have had a
very rough deal, partly as a result of the increasing
concentration, but also as a result of what happened in the
crisis and some of the measures that came out of the crisis.
    I completely support, for example, the positions of Cam
Fine of the Independent Community Bankers of America on this
issue, and Mr. Fine emphasizes repeatedly the way in which the
biggest banks, these very large bank holding companies, and the
forms of implicit Government support they continue to enjoy,
the ways that have damaged--and continues to damage community
banks.
    What should we do about it? Well, I think we have three
ideas on the table from the two of you. I completely support
Senator Brown's proposed Safe Banking Act that would limit the
size of the banks, particularly the size of their nondeposit
liabilities as a percentage of GDP. And I am heartened, as I
say in my testimony, by indications that Dan Tarullo, a
Governor at the Federal Reserve Board, and perhaps some other
Federal Reserve staff are coming around to this way of
thinking. I think it is a little late. Hopefully they can speed
up that process of moving in that direction.
    I also fully support the proposal of Senator Brown and
Senator Vitter, the TBTF Act, which would impose a more
dramatic, drastic sliding scale of capital requirements,
increasing beyond what is currently in the Basel framework or
currently envisaged by the official sector for these very large
bank holding companies because they pose very big risks.
    Now, I also would like, Senator Toomey, to support you on
the point of background, and I do completely agree with the
point that what we need in this economy is for every firm to be
able to go bankrupt. The idea that somebody is exempt from
bankruptcy I think is completely unacceptable.
    I also do not find it very appealing that a certain set of
firms should have their own piece of the Bankruptcy Code. I
would prefer that everyone go through the same Bankruptcy Code.
I recognize that the financial sector has built various poison
pills into their structures that create some difficulties and
some concerns.
    I share, by the way, a lot of reservations about the
resolution powers of the FDIC, and I am on their Systemic
Resolution Advisory Committee. We can talk more about that if
you want.
    I worry, though, about one piece of your proposal, which is
the lack of a debtor-in-possession financing mechanism, a
backup. Obviously, you want that provided by the private sector
ideally. There is nothing, I think, in your proposal that
provides a backup. And when I have talked to people from the
Hoover Institution, for example, recently at an FDIC meeting
and also at a Richmond Fed meeting, they made it very clear
that, without that kind of backup debtor-in-possession
financing, they, the Hoover people who are generally supporting
this bankruptcy idea, would worry a lot about contagion effects
and the way in which a single firm can become a systemic
crisis.
    Thank you, Senator.
    Chairman Brown. Thank you, Dr. Johnson.
    I would like to ask the Subcommittee unanimous consent that
the written statement of the Independent Community Bankers of
America be included in the report. Dr. Johnson had referred to
Cam Fine and the ICBA report's too-big-to-fail subsidies
exacerbate regulatory burden. Without objection, thank you, so
ordered.
    Dr. Rosenblum, thank you. Welcome.

 STATEMENT OF HARVEY ROSENBLUM, ADJUNCT PROFESSOR OF FINANCE,
  COX SCHOOL OF BUSINESS, SOUTHERN METHODIST UNIVERSITY, AND
  RETIRED DIRECTOR OF RESEARCH, FEDERAL RESERVE BANK OF DALLAS

    Mr. Rosenblum. Chairman Brown, Ranking Member Toomey, and
Members of the Subcommittee, I am pleased to be here to testify
on this very important subject.
    On the subject of the too-big-to-fail subsidies, let me
just say that it is big. Most estimates put it between $50 to
$100 billion per year. It is persistent. It will go on in
perpetuity if changes are not made in the incentives driving
the giant banks. It distorts economic behavior. It is difficult
to measure. It is one of the problems we have to face, and
mainly because there is no line item on any bank holding
company's balance sheet or income statement that says this is a
too-big-to-fail subsidy.
    But most important, it is a subsidy that is really an
expenditure made by the Congress that charges the public
taxpayers, and it has never been voted on. I repeat, never been
voted on by the Congress, unlike most other subsidies.
    Furthermore, the attempt to reduce the subsidy in the Dodd-
Frank Act has really not altered the perception that too-big-
too-fail banks are any less likely to receive extraordinary
governmental assistance in the future. As a result, the subsidy
remains. It will be here in perpetuity, as I mentioned before.
    To address the subsidy, we have to recognize two
principles:
    First of all, incentives matter, and Dodd-Frank is putting
the incentives in the wrong places. It has not changed the
perception of future additional Government assistance, number
one, and it has perpetuated the subsidy.
    The other principle is that initial conditions matter, and
as you have already pointed out, Senator Brown, we have very
high concentration in the banking industry, and it has been
getting worse. Moreover, the compliance cost of dealing with
Dodd-Frank has caused a merger wave among the small to medium-
size banks. And as you pointed out, Senator Toomey, there has
been virtually no new entry into the banking industry in the
last 5 years. So the competitive situation gets worse.
    As I think about the subsidy, it relates to something that
is even more important to me, and that is, what was the cost of
the banking crisis, the financial crisis that we just went
through as a Nation? We have been talking about the subsidies
here, the too-big-too-fail subsidy, and using the word
``billions.'' When I look at the costs of the crisis to the
United States, we have to measure it in trillions, not
billions. My own estimates and that of my coauthors at the
Dallas Fed put the cost of the crisis somewhere between $15 and
$30 trillion per year. That is 1 to 2 years of output down the
drain.
    To put that into words that the ordinary person on the
street can understand, the crisis cost a typical household
somewhere between $50,000 and $120,000. That is no small change
indeed.
    The saddest thing is that, unless the incentives are
changed in the banking industry, we are going to repeat this
same scenario again. Same tune, second verse. So the issue is:
How do we get rid of this distortion called the ``too-big-too-
fail subsidy''?
    President Richard Fisher of the Dallas Fed and I came up
with a plan about a year ago, recently labeled the ``Dallas Fed
Plan,'' that would put in place a three-part system that would
reduce the subsidy, and reduce moral hazard. It would involve
restricting the safety net to commercial banks and other
depository institutions, traditional commercial banks. It would
require counterparties of the nonbank subsidiaries of the
financial holding companies to acknowledge in writing that they
have no Government guarantee or backstop in their dealings with
the nonbank entities. And it would call for Government policies
to get management to streamline and right-size the giant
institutions. To some extent, the giant institutions have been
doing that, but it has been proceeding at a snail's pace. As a
result, moral hazard is increasing, not decreasing.
    So the issue is, beyond the Dallas Fed Plan, what else can
be done? There are two other things I would recommend. One is
the Subsidy Reserve Plan, put forward by Professor Hurley at
Boston University, which would bottle up the subsidy and not
allow management to squander it. My other recommendation is the
Brown-Vitter bill, which would put the incentives in the right
place and get the capital of the largest institutions up to
where it should be, given their systemic risk.
    These three provisions--Brown-Vitter, the Subsidy Reserve
Plan, and the Dallas Fed Plan--could probably be written into
legislation that would take less than ten pages. The
implementing regulations could be written in fewer than ten
pages, and I think that would go a long way to driving out some
of the complexity that is perverting the way our banking system
is distorting economic activity.
    Chairman Brown. Thank you, Dr. Rosenblum.
    Dr. Meltzer, welcome. We look forward to your testimony.

STATEMENT OF ALLAN H. MELTZER, THE ALLAN H. MELTZER UNIVERSITY
  PROFESSOR OF POLITICAL ECONOMY, CARNEGIE MELLON UNIVERSITY
                   TEPPER SCHOOL OF BUSINESS

    Mr. Meltzer. Thank you, Senator. I am very happy to be
here.
    Let me start with two statements, one that I have made many
times, which I will repeat: that capitalism without failure is
like religion without sin. It does not work.
    The second is a disclaimer. I worked with Senator Vitter
and his staff when they were writing the Brown-Vitter bill
following my testimony here several times in 2008 and 2009.
    I am very pleased to testify today. Much has changed since
the financial crisis of 2008. I will comment on the adequacy of
some of these measures and propose some more effective
procedures, including passage by the Congress of the Brown-
Vitter legislation.
    Let me begin by stating two principles that should, indeed
must, guide your efforts if they are going to be successful.
    The first principle: Legislation should increase the
incentives by bankers and financial firms to act prudently. In
an uncertain world, we cannot always know the prudent course.
But the owners and managers are most likely to act prudently if
they bear the cost of the errors that they make, the mistakes--
from mistakes and from unforeseen events. They will be more
willing to cushion risks and uncertainties if they bear the
cost.
    Second principle: Regulation must provide rules that
prevent single bank failures from threatening the financial
system. More than a century ago, careful analysts understood
that the public responsibility was to protect the payments
system because a breakdown of the payments system stops all or
most economic activity. That is where the heavy costs that Dr.
Rosenblum talked about came from. Fear and uncertainty cause
banks to refuse to accept payments drawn on other banks.
    That is what happened in the Great Depression. That was
what started to happen in 2008 after Lehman Brothers failed.
Timely, aggressive action by the Federal Reserve prevented the
payments breakdown.
    The second principle has wrongly devolved--wrongly
devolved--into actions to protect banks. There is no economic
justification for that as a public responsibility. I repeat:
The public responsibility is to protect the payments system,
not the banks or bankers. The proper way to separate the two is
to impose procedures that prevent a failing bank from
threatening the payment system. That requires four or five
definite actions.
    One, a clearly stated announced rule for the lender of last
resort. A well-known rule that has been successfully used calls
for the Federal Reserve to lend freely on good collateral at a
penalty rate. In its first 100 years, the Federal Reserve has
often discussed its lender-of-last-resort policy internally,
but it has never announced a policy. Announcement is important,
indeed crucial. It tells potential users well in advance how to
prepare their balance sheets and to hold collateral against
which they can borrow from the Federal Reserve in a crisis. It
avoids panic by enforcing its announced rule. I have been
around this issue for 30 or 40 years. I can tell you with great
certainty there is never a time that a Secretary of the
Treasury, as under Article 2 of Dodd-Frank, in the midst of a
crisis, is going to decide not to do the bailout. That is the
wrong time to be making the decision. The right time is in
advance by making rules which tell the banks how they should be
prepared to act in a crisis and require them to do so.
    Second, it does not wait to choose action until the panic
is upon us.
    Third, the lender-of-last-resort policy prevents crises
from spreading and stopping the payments system. It does not
save or help troubled banks that lack acceptable collateral.
    Fourth, require equity capital at banks sufficient to
absorb all anticipated losses. The Brown-Vitter bill requires a
minimum of 15 percent equity capital for all banks that hold
$500 billion in assets. Capital is assessed against all assets,
no exceptions or adjustments for risk. This avoids
circumvention.
    Fifth, if a bank's equity percentage falls to 10 percent
due to losses, it must cease paying dividends--and, I would
add, bonuses--until the 15 percent equity ratio is reached.
    Sixth, all money market funds should be marked to market.
Recent reform required mark-to-market for institutional funds
but exempted individual funds. That does not solve the problem.
The problem of runs is not avoided unless all money market
funds are covered by a mark-to-market rule. The purpose is to
prevent depositor runs against institutions.
    Let me add, community banks and all banks with less than
$500 billion in assets should hold a lower equity capital
percentage, say 8 percent, because they are protected by
deposit insurance, which is paid for collectively by bankers.
    Thank you.
    Chairman Brown. Thank you, Dr. Meltzer. I remember a
conversation back in maybe 2011 with Dr. Johnson prior to the
Fed's decision to allow these banks to pay dividends, and your
recommendation, similar to what Dr. Meltzer said, so thank you
for that.
    I will ask Dr. Zingales this question, but after he
answers, I would like to just start with Mr. Evans and work
your way down and answer this. You know, he estimated the
banks' financial benefits conservatively somewhere between $158
billion and $188 billion, the cost to taxpayers somewhere
between $59 and $89 billion. So the banks benefited,
financially benefited somewhere upwards of $150 billion, the
cost to taxpayers somewhere $60, $70, $80 billion.
    The Treasury Department says it made a profit of more than
$28 billion in its investment of banks. We have heard that a
number of times.
    How do we reconcile these two positions? And how can a
subsidy exist even when the Government profits? If you would
clear that up and reconcile that for this Committee, this
Subcommittee, and then each of you give us your thoughts.
    Mr. Zingales. Sure. If you buy a lottery ticket and you
win, it is a great investment. But ex ante it is a bad
investment. So there is a difference between calculating the
cost on an expected basis and looking at the final outcome. So,
yes, things turn out the right way, and so the cost might have
turned ex post a profit. It depends on the way you properly
calculate that. But it was not like a large cost. But on an ex
ante basis, if you had to sort of insure that in the market or
pay out of your pocket to get that kind of insurance, that
would be the cost.
    Chairman Brown. Mr. Evans, the Government made that profit,
but the banks got those subsidies. Discuss that.
    Mr. Evans. I agree completely with Professor Zingales. I
think some of it is a measure of accounting. If we are looking
just at the loans and guarantees that were provided to
institutions, then you look at the fees that you generated as a
result of that, and the interest, and that gives you an
indication of what was received back to the Government. But
that is different than a subsidy cost, which is an estimation
that is done based on expected benefits and costs. More
specifically the subsidy costs reflect the expected lifetime
cost of these programs on a present value basis, rather than
just the cash flows as they occur. It also reflects an
adjustment for market risk--or what the market would have
charged for the support.
    Chairman Brown. Dr. Johnson.
    Mr. Johnson. Just to restate but slightly different words
from what Luigi said, when the Treasury says or when the
discussion of returns comes from Treasury and from the Fed,
they do not discuss risk-adjusted returns. In other words, if
you do this 20 times, would you expect to make money 20 times?
Or will you make money once or twice out of the 20? And on a
forward-looking basis, of course, that is what you care about.
There is a lot of risk in this investment, and typically, if
you look across a broad cross-section of experiences around the
world with financial crises and with capital injections,
including into banks, treasuries do not generally make money on
those investments.
    So we got lucky, congratulations to us, but it should not
make us feel at all reassured with regard to the future risks.
    Chairman Brown. Dr. Rosenblum.
    Mr. Rosenblum. Here we have to distinguish between the
micro and the macro. The subsidy drives micro behavior. It
makes banks run risky--giant banks run risky balance sheets.
They get the profits; the public gets the losses. It drives the
behavior of creditors and other counterparties of the giant
institutions. That drives micro behavior.
    On a macro basis, we have to look at the subsidy in a
different way, and we also have to look at the costs that the
GAO measured of the rescues during the crisis, and we have to
think of the alternative cost or the opportunity cost. What if
the bailouts had not been there and we had gone into another
1930s-style Great Depression?
    So the sense in which the Treasury profited is they have
tax revenues now that they would not otherwise have if we were
still in a Great Depression. So we have to distinguish the
micro, which drives individual, personal, and firm behavior,
from the macro and the economics versus the accounting
identities. They are very different.
    Chairman Brown. Dr. Meltzer.
    Mr. Meltzer. I agree with this last statement. The
important thing was that we avoided a Great Depression. That
was a social benefit. The social cost, quite apart from the
accounting, the social cost is we are--you gave the numbers
yourself. We are making the banking system much more rigid. We
are eliminating the role of community banks. They are very
important for American capitalism because that is where little
businesses startup. They are being eliminated. Medium-size
banks are almost all gone. They have been absorbed by the
larger banks. Why were they absorbed by the larger banks?
Because the larger banks--the largest banks have an advantage
of being too big to fail, so they borrow at lower risk. That is
what it is doing to the social structure of the U.S. economy,
and that is not a good thing. And that is where the real costs
are.
    Chairman Brown. Thank you.
    Senator Toomey.
    Senator Toomey. Thanks, Mr. Chairman.
    I am wondering if actually each of you could just comment
briefly, maybe we will start with Dr. Meltzer and work back. If
you believe that Dodd-Frank perpetuates a perception that these
banks are too big to fail, and if you believe that there is any
implicit subsidy that is associated with that, do you believe
that Title II in Dodd-Frank particularly contributes to that?
    Mr. Meltzer. Absolutely. I can honestly say I have been
around this problem for a number of times, talked to various
Secretaries of the Treasury over the years. Imagine--put
yourself in the position, eight Assistant Secretaries or
somebody like that are going to come to you and they are going
to tell you what the crisis will be if you do not do the
bailout. You cannot wait until the last minute to decide
whether you are going to do the bailout. You have got to set up
a structure which is going to discourage that sort of behavior.
If you do not do that, there is not a person in the world--you
know, I have been there. When eight Secretaries of the Treasury
tell the Secretary all the things that can happen, what can you
say to them? ``Take the risk''?
    Senator Toomey. OK. If we could go down real quickly,
because I have several other questions I hope to get to. Dr.
Rosenblum, do you believe that Title II contributes to this
problem?
    Mr. Rosenblum. The short answer is yes. If you think of the
three words--orderly liquidation authority--when I first
started reading about that, I asked a person who was trying to
write some of the regulations for the Treasury Department at
the time, what was the operational word there? Was it
``orderly''? Was it ``liquidation''? Was it ``authority''? I
was hoping he would say ``liquidation.'' His answer was the
emphasis was on ``orderly,'' the second most important word was
``authority,'' and the least important word was
``liquidation.''
    Then you think about how it is going to work. The debtor-
in-possession financing is going to come from the Government,
not from the private sector. That automatically has subsidies
implicit in it.
    And last of all, the fact that these institutions are going
to be labeled ``systemically important'' financial
institutions--in Washington they are called ``sif-fees.'' In
Dallas I call them ``sci-fis.'' It is like something out of
science fiction. But the fact that they have got that
``systemically important'' label already tells all of their
counterparties that they are special, that there will be
extraordinary Government assistance, or at least a good chance
of it, should that institution get in trouble. I think it
compounds the problem. It does not solve the problem.
    Senator Toomey. All right. Dr. Johnson.
    Mr. Johnson. Senator, I think there are some scenarios in
which the single point of entry strategy proposed by the FDIC
could help. I do not think it will help with the very largest
bank holding companies, the subject of today's hearing, because
they are inherently cross-border, very global, huge businesses,
and we do not have a cross-border resolution authority. We have
a specific liquidation authority in the United States.
    And, by the way, the last FDIC hearing made it clear that
the plans do not call for liquidation in the sense of closing
down the business and selling off the assets. It is a legal
liquidation in which a failing entity has so-called good assets
transferred to a new legal entity. They might well continue the
brand name. They might well continue with the management in
that scenario. And I share my colleague's concerns that it is
possible, particularly for the largest category of megabanks,
that Title II will not help and may even, as you are
suggesting, create more difficulties.
    Senator Toomey. Thank you. Dr. Zingales.
    Mr. Zingales. I agree that Title II contributes to too big
to fail. However, I think it is important to understand that
the solution to this problem is not to prevent by legislation
any possibility of rescue, because when push comes to shove,
eventually everybody will do as Senator Brown did in front of
TARP. So what we need to do is prevent us from reaching that
point. It is like with small kids. We want them to learn from
their mistakes, but we do not want them to go into danger, then
take away their life. And so in front of a danger, the only way
to do it is prevent them from going there, not sort of saying,
``I am not going to rescue you if you get on fire.''
    Senator Toomey. So I wanted to follow up with your
proposal, which, if I understood it correctly, is intriguing
and I had not heard this articulated before. But if I
understood what you are suggesting as an alternative, it is a
process by which the Fed would monitor the price of credit
default swaps or subordinated debt, set a ceiling essentially
that would, as you point out, amount to a margin call, right,
new capital, and use that as the mechanism by which we judge
the creditworthiness of the entity? Do I have that about right?
    Mr. Zingales. Yes, that is absolutely right.
    Senator Toomey. OK. Now, you know, the appealing thing
about that is that we do not have politicians arbitrarily
setting a capital level. Instead, we have the market telling us
something. But we still have the Fed arbitrarily deciding what
the ceiling is on the price of the CDS. So you still end up in
the same place in terms of, you know, what is the criteria by
which you decide what the right capital is. So that is one
question.
    The second one is: If you have solved the problem with a
mechanism like that, then is there a need for all the
restrictions on activities? I mean, I find it ironic that, in
an interest of presumably reducing risk, we adopt a Volcker
Rule that, for instance, forbids banks from engaging in
profitable activity. The last time I checked, profitable
activity actually enhanced the stability of the institution,
and we forbid that.
    Would that sort of thing be necessary if you had a
mechanism to ensure adequate capital?
    Mr. Zingales. I think that if this mechanism were
implemented, the need for restricting activities would be much,
much less, because the riskiness of this activity would be
reflected in the measure of capital requirements. So the
problem today is that we have a measure of capital requirements
that only looks at one aspect of the problem, and we want to
look at both. We want to look at leverage, we want to look at
riskiness of assets, and the CDS does exactly that. On the
level, of course, there is some arbitrariness in that, but we
can look at the past and say what would it have taken during
the crisis to recapitalize--or when we should have
recapitalized these banks enough so that we would not reach the
crisis? And so we can easily determine what that threshold
should be.
    Senator Toomey. Thanks, Mr. Chairman.
    Chairman Brown. Thank you, Senator Toomey.
    Senator Reed.
    Senator Reed. Well, thank you very much, Mr. Chairman. I
want to commend the Chairman and Senator Toomey for assembling
a very impressive panel about a very important topic, and let
me ask just a few questions.
    Dr. Johnson, again, thank you for not only being here but
for your very perceptive commentary constantly, so thanks.
    Part of this discussion was about TARP. It has been both
assailed and commended for what it did in terms of stabilizing
the banking industry. There was one aspect of TARP, though,
which I think has to be sort of looked at and emphasized, in my
view, and maybe because I was involved and put in a provision,
and that is, the warrants, which has resulted in about $9
billion of proceeds going back to taxpayers because they were
included in the legislation.
    Dr. Johnson, from your perspective can you comment on just
the warrant provision and its effect? And, also, was it well
managed? Could we have done better? And, frankly, is that
something that has to be the template for any other type of
sort of public engagement in a financial operation like TARP?
    Mr. Johnson. Yes, Senator, I think it was entirely sensible
and a very good idea to include the warrant provision in TARP.
I understand Treasury was not enthusiastic about it initially,
and, frankly, subsequently they did not seem to really pursue
this, as they could have, as a way to get upside for the
taxpayer. And I think, for example, given the discussion that
we are having today, it is entirely reasonable that when the
Government provides this sort of backstop support to the
financial system in an emergency to prevent a systemic
collapse, there should be some upside for the taxpayer, and the
warrant program is a good way to do it. And I would recommend
everyone go and review the terms that Mr. Buffett got for his
support, for example, to Goldman Sachs. If we could have done
just as well as Warren Buffett, we would have done much better
than under what the Treasury actually chose to do.
    Senator Reed. No, I think that is an excellent point. In
fact, that was one of the things that struck us at the time, is
that any serious business person investing in a risky
enterprise with a potential upside would have taken warrants
and would have--you know, directors on the board would have
done a lot of things, and at least we got some of the warrants
in. My recollection is like yours, too. It was
unenthusiastically embraced, that we probably could have set
better terms a la Warren Buffett. And, third, in retrospect, it
looks better and better. So I think the more--you know, as
President Kennedy said, you know, failure is an orphan, but
success has lots of parents. So there is a big collection of
parents today about the warrants provision.
    Just one other quick question. You know, we are really
talking today about emergency assistance, but there is a built-
in support system to the Tax Code for assistance to major
financial institutions and major institutions in general. We
have tried to take some steps in the past. For example, we
limited the deductibility of chief executives' compensation.
What we found is that they have been very good about getting
around that by bonus compensation, and we are putting in
legislation. So could you again, Dr. Johnson, comment on the
notion of tax supports and tax provisions that really are not
helpful to the economy overall and are simply another form of
subsidy to these institutions?
    Mr. Johnson. Senator, I am familiar with your proposal on
this topic, and I think it is a good one. I think to the extent
that the Tax Code is encouraging either excessive levels of
compensation or compensation that encourages too much risk
taking, as my colleagues have been talking about, I think that
is a bad idea. And it is entirely appropriate, as you
suggested, to limit how much of that compensation is deductible
because it is a form of subsidy through the Tax Code, as you
said.
    Senator Reed. Well, thank you. Again, just let me open up
that line of questions to anyone else who might want to
comment, which is that, you know, some of this risk-based
behavior is because we incentivize it through the Tax Code and
through other provisions, and it would be very helpful for me
particularly if there are specific provisions that you think--
and you can respond in writing and answer--are not helpful at
all but do encourage excessive risk taking, and if we could
have a two-fer, if you will, you know, not subsidizing risk and
actually raising revenue through a process that helps in other
ways. So let me open that question up and ask you perhaps in
writing to respond as my time is expiring.
    Thank you, gentlemen, for your testimony.
    Chairman Brown. Would anyone care to comment now on that?
Or you certainly are free to--Dr. Meltzer, yes?
    Mr. Meltzer. Yes, yes. The capital requirements are really
crucial. Banks got down to where many of them had 2 percent
equity capital or less. They had more capital bonds, and they
insured the bonds, so they had no skin in the game. The way to
get the change is not by doing it piecemeal on each part of
their compensation, because they will find ways to circumvent
it. They will get airplanes. They will get cars. They will do
other things that you do not regulate.
    The way to get it is make them bear the cost of the errors.
That is what the Brown-Vitter bill does, and I am convinced
that that is--if you do it so that there is no exception, if
you hold an asset, you have to hold 15 percent against it if
you are of that size. If you do not think it is worth 15
percent, sell it. That is what markets do. And that way you get
the incentives on them, and that is what you want to think
about. You want to think about what are the procedures which
are going to give them the incentives that are hard to
circumvent.
    Senator Reed. Thank you.
    Chairman Brown. Thank you.
    Dr. Rosenblum.
    Mr. Rosenblum. Let me put a slightly different twist on it.
I think of Economics 101. If you want more of something, you
subsidize it. If you want less of it, you tax it. And when we
think about the too-big-too-fail subsidies, it is subsidizing
that which we do not want. So we know it is perverse.
    But if we want to think about too-big-too-fail subsidies,
we want a stable financial system, and we may have to, you
know, think about what is the cost of having that stability and
what is the backup system you need it for.
    The other place where I think you may want a too-big-too-
fail subsidy of some kind is for national defense. You know, we
cannot have the production lines that are going to be used to
produce the material that is going to defend our country go
through bankruptcy. And when I think about General Motors'
bankruptcy, nobody ever talked about the national defense. And
if you go back to World War II, where were the tanks produced?
Converted auto production lines, produced airplanes, tanks,
boats, and all those sorts of things.
    So we have to think about those critical infrastructure
needs that we must have--a payments system, a national defense
system, et cetera, et cetera. And there may be some need to
have some subsidies there and the moral hazard that it
engenders. Moral hazard is the cost we pay for living in a
civilized society. Anybody who has raised children knows about
the moral hazards of raising children and the moral hazard of
taking care of our next-door neighbor when our next-door
neighbor is out of work. It is just something that we must do,
but that is something the United States has done reasonably
well.
    But getting back to the too-big-to-fail subsidy, it is
something we do not want. Yet, it is there. The other subsidies
that we ought to have are those which Congress wants and votes
on politically. If we want to subsidize food supply or make
sure we have a stable food production, maybe a corn subsidy or
a sugar subsidy is warranted. Whatever it is, it may be
something you want. But at least it ought to be voted on
directly. The problem with the too-big-too-fail subsidy, it
happened by happenstance. It was never voted on, and it keeps
getting bigger and bigger in a self-reinforcing mechanism. And
that I find unconstitutional.
    Senator Reed. Thank you.
    Chairman Brown. Thank you.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair, and thank
you to the panel.
    One of my colleagues a few minutes ago said, ``Why would
you ban an activity that is profitable, like proprietary
trading?'' Mr. Johnson, is proprietary trading always
profitable?
    Mr. Johnson. No, Senator, it is not. Well, perhaps it is
profitable to the people undertaking it, so this is the issue
of compensation and the issue of incentives. But it is also
possible to lose a great deal, and we are obviously talking
about companies in this context. When an individual company
incurs losses, there are big spillover effects both directly to
the Government in terms of various kinds of support provided
and, as we are saying, indirectly to the budget and to the real
economy. And those costs are huge relative to the amounts of
money that people were going to gain in terms of their personal
compensation. So I think the Volcker Rule is a very sensible
part of our current regulatory approach.
    Senator Merkley. My memory is the commercial banks lost
about half a trillion dollars in proprietary trading, and, of
course, you have this complex challenge on repurchase
agreements in which a fire sale at one firm can devalue the
asset and create a series of dominoes that affects the entire
market. One of you spoke to the contagion issue. So I just
wanted to go back to that point for a moment and note that if
indeed proprietary trading was risk-free or always profitable,
we would not have been having that discussion. But it posed
such a systemic risk to the entire order.
    One of the issues that we have struggled with is cross-
border resolution, the complexity of international firms,
American firms with foreign subsidiaries, foreign firms with
American operations, and that is a key piece of the puzzle. Can
anyone who would like speak to how satisfied are we with where
we have gotten to? Yes, Mr. Johnson.
    Mr. Johnson. So cross-border resolution remains a huge
problem, both for the existing FDIC approach to a single point
of entry, I think it is the Achilles heel of the entire
approach. And when we talk about any of the big companies, the
subject of today's hearing, they are all so big across borders
that this is going to be the entire ball game, and this is what
will create the pressure for the Secretary of the Treasury and
Congress to provide a bailout in the future.
    I would also say--and I am sorry Senator Toomey is not in
the room at the moment--that this is a key problem for
bankruptcy. And when you talk to the experts, the proponents,
the people who would rather get rid of Title II and stick with
bankruptcy, for example, at this Richmond Fed conference that I
talked about, which is a public conference so people can review
the tape, it is very clear that while cross-border issues are a
big problem under Title II, the resolution authority, they are
an insurmountable obstacle if you are going through the
bankruptcy courts, because bankruptcy courts absolutely cannot
and never will cooperate in the fashion that will be necessary
to have an orderly liquidation, winding down, unraveling, call
it what you want, if you go in through the bankruptcy-only
route.
    So cross-border is a huge problem that we have not dealt
with resolution. It is an insurmountable obstacle for
bankruptcy.
    Senator Merkley. Does anyone else want to chime in? Yes,
Mr. Meltzer.
    Mr. Meltzer. Senator, let me suggest to you a way to think
about that problem. Separate the bank from the holding company.
Let the holding company incorporate all its subsidiaries in the
countries of origin so they are subject to the rules of the
country of origin, not to the U.S. rules, but they are owned by
the holding company, not by the bank. So the bank can be
structured, restructured here. The holding company is a
separate entity subject to whatever laws are applicable in the
foreign countries where the subsidiaries are operating.
    Senator Merkley. Do you feel, Mr. Meltzer, that that
creates a sufficient firewall from the risks incurred abroad
flowing back into the U.S. economy?
    Mr. Meltzer. I have not studied it carefully enough to say
definitively, but I believe it certainly moves in that
direction; that is, you want to keep the problems of the
foreign banks out of the domestic banks so that you can
regulate the domestic banks and regulate the holding company
separately. And if the holding company is taking sufficiently
large risks, then it wants more capital requirement.
    Senator Merkley. Anyone else want to jump into that? Mr.
Rosenblum.
    Mr. Rosenblum. Yes, I want to underscore what Professor
Meltzer said and come back to what I said earlier about the
Dallas Fed Plan, which hives off the safety net to the
commercial bank and legitimate traditional commercial banking
activities. Everything else in these holding companies is
separate, and every counterparty of those nonbank institutions
has to sign off and say there is no Government guarantee. I get
it. Two simple sentences. That puts the onus of responsibility
on the marketplace and on these counterparties to worry about
what happens if this company gets into trouble. Our deposit
insurance system and the lender of last resort is really there
for the bank, the domestic company, and that is where it should
be, and everything else, the market, has to have incentives to
watch over and regulate in its own way with threat of losses,
be it domestic or be it foreign. But we have to let market
forces reinforce the limited effectiveness of regulations that
we have.
    Senator Merkley. Thank you all very much.
    Chairman Brown. Thank you, Senator Merkley.
    Senator Warren.
    Senator Warren. Thank you very much, Mr. Chairman. Thank
you, Mr. Evans, for the work you and your staff have put in to
put this report together.
    The GAO report concludes that it is too early to declare
victory on the too-big-too-fail problem, and I agree. The four
largest banks are nearly 40 percent bigger today than they were
just 5 years ago. The six largest banks now control two-thirds
of the banking assets in this country, a 37-percent increase
over where they were just in the last 5 years. These banks, in
other words, are a whole lot bigger now than they were when we
bailed them out in 2008 because they were too big to fail.
    So I get it. Size is not everything, but basically the
bigger these banks get, the harder it is for the U.S.
Government to declare with any credibility that it will not
bail them out if they get into trouble again.
    Now, the GAO report does not consider the impact of the
Volcker Rule because it was not passed until after the report
was issued. I think the Volcker Rule is an important step in
the right direction if it is strongly enforced. But I am
interested in your take, Dr. Johnson. Does the Volcker Rule
solve the too-big-too-fail problem?
    Mr. Johnson. The Volcker Rule is helpful in the current
context, steps in the right direction, as you said, Senator
Warren. It, unfortunately, by itself or even if implemented in
the most forceful fashion possible, I think is not going to
completely end too big to fail. Those problems, those
subsidies, the systemic risk and the way it can damage the
budget and the economy, that is going to remain.
    Senator Warren. So let me just see if I can do this as
maybe yes/no so we can get on to other questions. Would you
agree with that, Dr. Zingales?
    Mr. Zingales. Yes.
    Senator Warren. And, Dr. Rosenblum, do you think that the
Volcker Rule solves the too-big-too-fail problem?
    Mr. Rosenblum. No.
    Senator Warren. And, Dr. Meltzer.
    Mr. Meltzer. No, and I think it has the added difficulty
that you will never find a clear-cut definition of what is a
hedge and what is a speculation.
    Senator Warren. Good. All right.
    Mr. Zingales. Sorry. To be precise, I said no, I do not--
you understood.
    Senator Warren. I had asked the question backwards. That
was entirely my fault, Dr. Zingales. I should have been
consistent in how I asked it.
    But let me put it this way. The four of you agree the
Volcker Rule does not solve the too-big-too-fail problem even
if it is vigorously enforced. So let me do the next question on
that. Even if the regulatory agencies issue all of the Dodd-
Frank rules that remain and then rigorously enforce all of
those rules, do you believe that would solve the too-big-too-
fail problem? And perhaps I could start with you, Dr.
Rosenblum.
    Mr. Rosenblum. So let me be blunt and do something I should
never do here when the TV is going. I am going to answer your
question by saying, ``No,'' and, ``Hell, no.''
    Senator Warren. And tell me about if you feel strongly
about this.
    [Laughter.]
    Mr. Rosenblum. Well, if we have 14,000 pages of proposed
regulations written to implement less than half of the Dodd-
Frank provisions, we do not have anything going on that can be
enforced. It is mind-boggling. It is unenforceable. It is
inscrutable. It does more harm than good. We need rules that
are simple, straightforward. If they are to be enforced, they
have to be observable. The enforcement has to be observable. As
Dr. Meltzer has said, a capital-to-asset ratio is measurable,
observable, can be looked at sort of in real time. It is a
beginning. We cannot have this Dodd-Frank--which is 850 pages,
roughly, probably will be 30,000 pages of regulations to
implement it. It is not workable. And when something is not
workable, you have to admit it and go back to the drawing board
and try to come up with something simpler and better.
Complexity is the enemy, as I said in my written testimony, and
we have to find some way of addressing it.
    Senator Warren. So----
    Mr. Rosenblum. Let me add one thing, if I may. When I
started in the Federal Reserve System 44 years ago, in 1970, I
was hired to help write the Bank Holding Company Act amendment
regulations, and we were sat down in a room, and they told us
we could write no more than one page of regulations to
implement one page of statutes. We were held accountable to
that criteria. The legislation itself that we had to work on
was only a few pages long, and our regulations were fewer. It
is doable, and it was enforceable, and it worked very, very
well. And I think we have to get back to the drawing board and
realize the social costs of what we are doing. If we cannot
understand the rules that we have to follow, nobody is going to
follow the rules, whether it is driving at the speed limit or
whether it is something else, or getting back to health care,
which is another situation, we have to--we cannot write rules
this way. And I think if Congress were to give a gift to
America for 2014, the greatest New Year's gift they could give
would be to write legislation in a few pages, with regulations
that were an equal number of pages, so that every Senator and
every Congressman can sign off to their constituents and say,
``I read every word of this legislation, and I am proud that I
signed off on it.''
    Senator Warren. From your mouth to God's ears.
    Could I have your indulgence for just a minute, Mr.
Chairman?
    Chairman Brown. There will be a second round, too.
    Senator Warren. Actually, I will finish up, if that is OK,
because I just want to ask--and I will do it the right way, Dr.
Zingales. So if all of Dodd-Frank were implemented and if it
were vigorously enforced, do you believe that would solve the
too-big-too-fail problem? And maybe we can do these with just
yes or no answers to the extent possible. Dr. Zingales.
    Mr. Zingales. No, it would not solve it.
    Senator Warren. Dr. Johnson.
    Mr. Johnson. Yes. If vigorously enforced, Title I says that
the living wills lay out how your firm is going to go bankrupt,
and if that plan is not credible--and I am confident those
plans are not credible and will not be credible, with the
current level of complexity, then the Federal Reserve and other
authorities should take remedial actions, including much higher
capital requirements, including breaking up the banks, as you
proposed, along the new Glass-Steagall lines. All of those
possibilities are contained within Dodd-Frank, but I agree that
is not the current interpretation of the law, particularly from
the Board of Governors of the Federal Reserve.
    Senator Warren. So if amended my question to be ``as
currently interpreted,'' then you answer would be----
    Mr. Johnson. Then the answer is no.
    Senator Warren. Then the answer would be no. And, Dr.
Meltzer.
    Mr. Meltzer. No, it certainly does not, and I believe when
you said we have not won the battle, I think we have lost the
battle against too big to fail because--mainly because we put
the burden on the regulators instead of putting it on the
people who make the loans and make the mistakes. And if you do
that, you know, look what happened before the regulation--
before 2008. The SEC cut the requirement for capital in the
investment banks to 3 percent, allowed them to leverage 30
times. The Federal Reserve allowed banks to incorporate
subsidiaries without capital to hold mortgages. I mean, I had a
meeting here----
    Senator Warren. Dr. Meltzer, I am going to have to cut you
off. Thank you very much. The Chair has been very indulgent.
But if the Chair will indulge me one more minute, I just want
to ask one very quick question because I wanted that time, and
that is, so does it make sense to wait until all of the Dodd-
Frank rules have been put in place and are vigorously enforced
before we consider further legislative actions to address the
too-big-too-fail problem? And if I could just have a yes or no
on that, does it make sense to wait? Dr. Zingales.
    Mr. Zingales. No.
    Senator Warren. Dr. Johnson.
    Mr. Johnson. No.
    Senator Warren. Dr. Rosenblum.
    Mr. Rosenblum. No.
    Senator Warren. Dr. Meltzer.
    Mr. Meltzer. No.
    Senator Warren. Good. So I just want to say thank you very
much, Mr. Chairman, and conclude with the notion, back in July
Secretary of the Treasury Lew said that if we got to the end of
2013 and could not say that we had ended too big to fail, it
was time, in his words, ``to look at other options to end it.''
Then in December, he said we had met the test, that existing
reforms were enough to address too big to fail.
    I think the Secretary laid out the right timeline, but
based on this GAO report and the testimony we have heard today,
I just do not think we can declare confidence that too big to
fail is over. I believe it is time to start looking seriously
at other options. Too big to fail is just too dangerous for us
to cross our fingers and hope for the best.
    So thank you very much for having this hearing, and thank
you for your indulgence on the time.
    Chairman Brown. Thank you, Senator Warren.
    Let me start a second round. I appreciate the comments. One
of the things that has come through in this hearing in so many
ways, especially on capital requirements, is the simplicity of
your proposals and the simplicity of your explanations, and I
thank all five of you for that.
    Dr. Rosenblum, I appreciate also the Dallas Fed Plan, Mr.
Fisher working with us and his office working with us on Brown-
Vitter and a host of other issues, and I want to sort of focus
on one of those.
    You propose restricting the so-called Government safety net
to traditional depository institutions, but rather than
narrowing the scope, as you know, the bailouts and Dodd-Frank
have expanded that safety net by bringing in nonbanks and
companies like clearinghouses into the system. I want to talk
for a moment about Section 23A of the Federal Reserve Act. It
was supposed to protect insured depositories and prevent
institutions from transferring that safety net subsidy to
nonbanks. 23A, while perhaps not written as succinctly as you
called for from your graduate studies and since, 23A was
ineffective during the crisis because of the routine exemption
that regulators granted to too many of these institutions. My
legislation with Senator Vitter strengthens 23A by enacting
legal firewalls between banks and nonbanks and prohibits
Federal assistance to those nonbanks.
    Give me your views--and then after you answer, Mr.
Rosenblum, I will start with Mr. Meltzer and work my way down.
What are your views on the importance and the effectiveness of
23A? How do we strengthen those firewalls between banks and
nonbanks?
    Mr. Rosenblum. You hit on a point that I have not written
about extensively. When Richard Fisher and I came up with the
Dallas Fed Plan, we wanted to keep it down to three points. If
we allowed ourselves a fourth point, 23A would have been the
fourth point. The ability of a nonbank sub to put bad assets
into the bank and, therefore, put it into the FDIC safety net
and/or the discount window borrowing provisions I find
abhorrent. So that would have been the fourth point that I
would have made. So I would toughen up 23A and say that any
exception to 23A that is made has to be done in advance with
written notice and absolute complete transparency on the part
of the Federal Reserve that it is making an exception. Every
one of those assets has to be listed in public, and, therefore,
I think it is much less likely to happen if you have those
kinds of restrictions there.
    There may be some cases when an exception needs to be made,
but it should be few and far between, extremely rare, and I
believe that the General Counsel of the Federal Reserve Board
needs to have some restrictions on the ability to grant those
special provisions in private.
    Chairman Brown. Could you work with us on what--or let me
ask it this way: Are you satisfied with the provisions in
Brown-Vitter that the restrictions are tight enough but the
discretion is given to the Fed for extraordinary cases but
cannot be abused, for want of a better term, or more liberally
given by the Fed than we would want?
    Mr. Rosenblum. I think we have to realize what the Federal
Reserve is, and one of the things it was created to be is a
lender of last resort, which has taken on new meaning in the
21st century. You need that safety valve there, and people have
to recognize that there is a safety valve; otherwise, panic
takes over. What the Federal Reserve's job is to do in times
like that is when everybody in the private sector is trying to
take the sell side, somebody in the Government or in the
Federal Reserve has to take the buy side; otherwise, prices go
to zero. That is what the Federal Reserve was created to do.
That is what the Bagehot Principle is all about. And I would
not like to see the Federal Reserve's hands totally tied from
being able to exercise its prerogative to use lending as a
means to saving the system at the right time. I would like to
see more checks and balances. I agree with Professor Meltzer.
We need rules clearly stated in advance that are
comprehensible. And I agree that the Federal Reserve has never
really put those rules forward on how the lender of last resort
is going to work. But if nobody knows what the rules are, that
is when panic really can set in. So those rules have to be
specified.
    My criticism to Professor Meltzer is--he has been advising
the Fed to write those rules. Those are tough rules to write,
and neither I nor Professor Meltzer have actually written out
what that rule should be that would be clearly there in
advance. But I think it is something the Federal Reserve does
need to work on. But you do need some political checks and
balances to make sure that the Federal Reserve is not exceeding
its authority, but there can be provisions written in so that
would not happen.
    Chairman Brown. Before--Dr. Meltzer, I know you want to
answer this, too, and I want you to. Before answering the 23A
question, I want to put another part of the safety net in this
question and then answer them together, the rest of you, if you
would. Section 716 of Dodd-Frank requires banks to move their
derivatives out of their insured banks, but the GAO report
notes that regulators have given large banks an extension.
Right now the four bank holding companies that are most active
in derivatives hold more than 90 percent of their derivatives
in their insured bank. Two of these companies plan to move more
derivatives into their insured banks in response to a credit
downgrade, asking taxpayers to subsidize their risk. Clearly
that suggests a problem.
    So if you would comment on both of those, Dr. Meltzer, and
then----
    Mr. Meltzer. Sure. Let me step back and say the economics
literature is full of things about capture, how the regulator
gets captured by the regulated. So you are not going to make
effective rules that way. If you think that there is a problem
with derivatives or with these loans or subsidiaries, put on a
cash requirement for banks. Add to the capital requirement a
requirement which says you have to hold cash, negotiable
assets, short term, that you can discount at the Fed when you
need to. That is a way to go.
    Think not about what rules can you put on the regulator to
get them to do the right thing, because that does not seem to
work. Put the rules on the regulated, which makes them want to
do. The essence of regulation, if we strip it way back to
simple economics, is there is a social cost and a private cost.
You want to drive the private cost up to where it is clearly
close to the social cost. That means you want to make them see
what the social benefits are, not what the private benefits
are. They see the private benefits. You have to make them want
to behave in a way, in a simple, direct, observable,
transparent, and enforceable way that sees those costs.
    Chairman Brown. And the simplest and most workable is
capital requirements on real assets----
    Mr. Meltzer. Absolutely.
    Chairman Brown. ----risk weighting and all of that.
    Mr. Meltzer. Right. Now, they will say that is going to
reduce lending. That is baloney. The Federal Reserve decides
how much lending there is in the economy, and they can easily
make it more or less, and do. So we do not need banks to decide
that. Banks decide who gets the credit. The Federal Reserve
decides how much credit there is.
    Chairman Brown. And I have certainly heard that said many
times in response to Brown-Vitter, and much we work on here----
    Mr. Meltzer. It just is not true.
    Chairman Brown. ----we will not lend, there will not be
capital available.
    Mr. Meltzer. Baloney.
    Chairman Brown. OK. We will quote you on that. Thank you.
    Dr. Johnson, your thoughts?
    Mr. Johnson. Well, I certainly agree, Senator Brown, that
23A has become a problem, and I think the problem is located on
the staff of the Federal Reserve Board of Governors,
particularly in the Office of the General Counsel. I think they
have been allowing these bank holding companies to move risky
assets, problematic assets into the bank and, therefore,
benefit from the safety----
    Chairman Brown. Does that--sorry to interrupt. Does that
follow with Dr. Meltzer's comments about regulatory capture? Is
that primarily the reason? Or are there other reasons that
these waivers and these exceptions tend to be the matter of
course?
    Mr. Johnson. That is a great question. You should ask the
Federal Reserve staff, Senator, not me. Certainly there has
been a history of capture in our regulatory agencies with which
you are very familiar, and the Board of Governors has not been
exempt from that in the past.
    Chairman Brown. People at the Peterson Institute called
it--one day we were talking about this with Sheila Bair and
some others, and Governor Huntsman called it ``cognitive
capture,'' that it is a little bit different but it is sort of
the culture of many of these regulatory bodies.
    Mr. Johnson. Yes, it is exactly in the tradition of George
Stigler and the Chicago School. Cognitive capture is just one
application of that. You are captivated by the mystique of Wall
Street--sorry, not you, Senator, but a lot of other people are
captivated by that mystique and, therefore, think that what
these large bank holding companies want to do is somehow, if it
is good for them, they want to do it, it is good for the
economy. I think that that is an extension, very
straightforward extension of the Stigler capture idea.
    But just also to go on to the point you made about Dodd-
Frank and the point about moving derivatives around within the
bank holding company structure, I do worry, Senator, that in
addition to the 23A problem you are identifying, there is a
problem emerging that will emerge from the Title II resolution
application of the single point of entry, because through this
mechanism the FDIC--if it is believed that this is going to
work and that support will be provided, it is ultimately
backing up the entire portfolio of the bank holding company,
and it is transferring losses that would be incurred, for
example, in an operating subsidiary that loses big money on
derivatives. Those losses get pushed up to the holding company
level where the FDIC gets involved in deciding who gets the
losses, deciding who gets--what kind of debt gets converted to
equity or gets wiped out, and also providing backstop
financing.
    So I think we are in danger of enlarging this problem
beyond the scale that already exists, and it is already
problematic.
    Chairman Brown. Dr. Zingales, comments?
    Mr. Zingales. I very much agree with what Meltzer and
Rosenblum said. I think that the problem is all these rules are
very complex and they give ample space for regulators to do
what the regulated want. So I think that we need to simplify
these rules to make it more difficult for this to happen and to
give less discretion to the regulatory authorities, because I
think that they have too much discretion, and this discretion
is always used in one direction, and it is generally the wrong
one.
    Chairman Brown. Mr. Evans, comments?
    Mr. Evans. I think I will take a little bit of time just to
plug our ongoing work, because at the end of the day this is
about investor perceptions or investor expectations about how
regulators, will behave in the instance of distress. In our
work, we will be looking at how any subsidy that we estimate
might change over time, because, again, it is, I think, an
empirical question to ask whether investors' expectations have
been changed as a result of Dodd-Frank. And we will also be
talking to large investors and other market participants. So
there are a lot of things in Dodd-Frank, including 23A, but our
question that we are going to concern ourselves with is whether
it changes investor expectations.
    Chairman Brown. OK. Thank you, Mr. Evans.
    We talk about capital and leverage. In July, the OCC, FDIC,
and the Fed, as you all know, proposed a special higher
leverage ratio for the largest banks, not as high as I would
have liked, not as high, I assume from my conversations with
some of you and my staff's conversation, as some of you would
have liked. Even that said, the New York Times noted just 3
days ago that the Federal Reserve has said we should not
finalize this rule until foreign regulators have finished their
capital rules. Give me your comments on what that means to our
financial system. Should we finish our supplemental leverage
ratio now? Should we wait for other countries? What impact will
waiting have? What should we do? Mr. Evans, do you feel free to
comment on that?
    Mr. Evans. I will punt mostly to my colleagues here. I
think there are pros and cons to both approaches. You know, we
are good at laying out those pros and cons. As you noticed, we
were only an inch deep in the report. We talk about the intent
of the various provisions and the challenges they face, but we
do not have an opinion at this time on that.
    Chairman Brown. OK. Dr. Zingales, I bet you do.
    Mr. Zingales. Yes, I do, and I would like to stress the
example of Switzerland. Nobody doubts that Switzerland is a
capitalist country and a country that generally has been sort
of quite interested in the welfare of banks. But because banks
in Switzerland are too big to be saved, because they are bigger
than what the fiscal authority of the country can do, the
regulatory approach in that country has been much more severe
in terms of capital requirements. So I think that we should
follow the Swiss example as fast as possible because nobody can
say that this is not a legislation done against the banks. It
is simply a legislation done without banks pressuring to have
an implicit guarantee, because in Switzerland they do not
bother to pressure because they know that it would not be
there. So this is the example to follow.
    So if the Fed and Treasury want to follow a lead, they
should follow the Swiss lead.
    Chairman Brown. Dr. Johnson.
    Mr. Johnson. Well, Senator, I am very much disconcerted by
the news that we are going to wait for the Basel Committee--and
that means most immediately for the Europeans--before we decide
on a supplemental leverage ratio. I agree with you that the
leverage ratio should be higher, more strict. We should require
more equity relative to debt for these large bank holding
companies, more than currently proposed. The Basel framework
and this entire mechanism through which we there to unify or
agree or harmonize with our European friends has not been
helpful over the past 30 years, and it is not helpful at the
moment. Secretary Lew said back in the summer--and I believe he
reiterated this also in the fall--that we are supposedly not
going to wait for other countries, that we are going to impose
rules that make sense for ourselves. And I do not see how this
deferral to the Basel community on the supplemental leverage
ratio is helpful in that regard.
    Chairman Brown. It does make you wonder if Secretary Lew's
comments in the summer that if we have not fixed too big--about
fixing too big to fail, then saying we have by December, if he
was including in that these higher capital requirements, which
have not been finalized. To be continued.
    Dr. Rosenblum, your thoughts?
    Mr. Rosenblum. Somebody has to be the leader and the
exemplar, and in this instance I think the leader and the
exemplar should be the United States. We are the largest
economy and the most important economy in the world with the
financial system that the rest of the world depends upon, and
we need the healthiest and safest banking and financial system
in the world in order to lead the world. And, therefore, I do
not think we should wait on the least common denominator coming
up with what they think is right. We ought to do what we think
is right, and the others I think will have to follow.
    Chairman Brown. Thank you.
    Dr. Meltzer, a comment?
    Mr. Meltzer. I agree with what the others have said. The
United States should lead and not follow. The argument that the
bankers make is that it will put them at a competitive
disadvantage. That is hard to accept. They have subsidiaries
overseas, so if the rules in the United States are strict and
prevent them from making loans overseas, they can make them
from their overseas subsidiaries. So it is hard to see how they
are going to be--why that should be a critical reason why we
should not lead the world toward a better solution. As
Professor Zingales said, the Swiss have already taken, I
believe, 19 percent capital requirements on assets.
    Chairman Brown. Thank you.
    A comment and then I wanted to do two more sort of quick
rounds. Dr. Rosenblum's written testimony compared megabanks to
semi-trucks that need lower speed limits than passenger
vehicles, something we are familiar with. If people would look
at the chart to your right, to my left, Government assistance
exceeds banks' capital. The Government's investments, loans,
and guarantees to the three largest banks were significantly
higher than the banks' equity. However, if they had had 15
percent equity, they could have suffered--as Mr. Meltzer has
said over and over and over again, to his credit, they could
have suffered deep losses and still been solvent. So I think
that speaks for itself.
    Mr. Evans, Professor Johnson notes that the GAO weights all
so-called expert opinion equally regardless of whether the work
is being produced in the public interest or Wall Street's
behest. You may remember--I think we are all fairly familiar
with that--after Dodd-Frank was signed by the President of the
United States, one of the leading lobbyist for the financial
service industry said, ``Now it is half time.'' So you know the
influence that Wall Street has. Their economic power has been
enhanced. Their political power has been enhanced.
    So the question is--Professor Johnson said we need to sort
out sensible analysis from sophisticated lobbying, his words.
How is GAO doing that?
    Mr. Evans. Thank you very much. I am happy to be able to
address that particular issue. I do not think, first of all,
that is a fair criticism based on this report because where we
draw from some of the experts is just in identifying some of
the challenges to implementing some of the provisions of Dodd-
Frank. But how are we doing that? We do it how we typically do
it. We are balanced, and fact-based in our approach. We reach
out to all stakeholders. We talk to all affected parties. We do
speak with banks about how they fund themselves. We speak with
investor groups.
    And so our objective scope and methodology sections for all
of our reports are clear about how we go about doing our work.
And at the end of the day, we have to be able to make
conclusions that are based on facts. And if we cannot do that,
then we do not attach a GAGAS statement to our reports. So,
again, we talk to everyone. Now, we are looking at academic
research. Our economists are being quite rigorous in terms of
which ones would qualify as reasonable estimates or reasonable
approaches to estimating any subsidy that exists.
    We are aware of lobbying power. We are aware of conflicts
of interest. In fact, when we reached out to academics to look
at our model and our model specification, one of the things
that we explored was conflicts of interest. We wanted to make
sure that these individuals were free from those type of
influences.
    Chairman Brown. Well, I think some of you saw an article
recently, I think a front-page piece in the New York Times in
the last couple of weeks, about the conflicts of interest so
often from academicians who speak with authority----
    Mr. Evans. That is right.
    Chairman Brown. ----but that so often do not disclose their
conflicts. And I hope that GAO will be acutely aware of that.
    Mr. Evans. For sure. That is why we did that rigorous
exercise. And to be fair, you know, there are folks who believe
they know whether a subsidy exists on both sides. In fact, some
of the research assumes it and then estimates--or assumed that
it does not exist and then comes out with estimates.
    Chairman Brown. Dr. Johnson, a comment on that?
    Mr. Johnson. Well, just an observation to you, Senator. I
have talked to the GAO. They reached out to me. They asked me
my opinion and my assessment of the numbers and the work
involved. They did not ask me if I have a conflict of interest.
They did not ask me who pays for various parts of my activity.
I mean, I would be happy to tell them. In fact, I put a lot of
disclosures on my Web site. I hope that that was an exception,
an aberration. I hope that they are ascertaining this
information when they speak to other people. Maybe they will
call me up tomorrow and get that part of the record straight.
It does worry me that a lot of people work for the industry
explicitly. I think that is not so problematic. But I know
quite a few people who work for the industry without
necessarily fully volunteering in all instances the full extent
of the income and other benefits they derive from those
interactions.
    Chairman Brown. Some may be setting themselves up for
future employment, to be cynical for a moment.
    Mr. Evans, you would like to comment on Dr. Johnson's
comment?
    Mr. Evans. Yes. To be fair, certain folks we reach out to
have an existing large body of work, like Professor Johnson. We
do not always, you know, do it ahead of time. But ex post we
know where folks are coming from. But, again, that is for our
interview purposes. We reach out to a wide range of
stakeholders. We are interested in their opinions. Those
opinions do not influence what we saw or what we think at the
end of the day. And, again, the academic studies have clear
methodologies, so you can tell when they are using untoward
assumptions or undertaking methodologies that raise questions
about the validity of the estimates. So I think that is my
response to Dr. Johnson. No, we did not ask him, but he has a
body of research that we look at.
    Chairman Brown. I hope that--and, again, thank you for your
evenhandedness, Mr. Evans, and your public service and for the
report and the report to come. I do hope that you heard loud
and clear from me, from Dr. Johnson, and from others--and I
think we cannot certainly speak for the public, but I think it
is pretty clear that people want to make sure who these people
are that are talking to you and who is paying whom and that you
work even harder at doing that. But thank you for that.
    Mr. Evans. I think that is fair. Thank you.
    Chairman Brown. The last question to all of you is about
investor disclosures. Section 50106C of the SEC's codification
of financial reporting policies requires that any financial
assistance ``that has materially affected or are reasonably
likely to have a material future effect upon financial
condition or results of operations should provide disclosure of
the nature, amounts, and effects of such assistance.'' It is
difficult to argue that loans from the Fed, guarantees from the
FDIC, capital injections from Treasury, it is hard to argue
that they do not materially affect the future financial
conditions of these institutions. But during the bailouts, many
large financial firms made representations about their
financial conditions, failing to disclose, or they made vague
disclosures regarding assistance provided to them by the Fed or
Treasury or FDIC. This appears to be another example of
regulatory forbearance, not requiring them to disclose what
they should have, the regulatory forbearance that benefited the
large banks, this time at investors' expense.
    Just give me thoughts on how that needs to be--I assume you
all think disclosure--I mean, that kind of goes without saying.
How do we build accountability in this so there is not this
lack of disclosure for investors? Dr. Zingales, do you want to
start?
    Mr. Zingales. Yes. I think that I can see an argument for
delayed disclosure. I can see that in some moments disclosing
help in the moment as help takes place might create more
financial instability, but I do not see any argument for not
disclosing, let us say, 2 years later what the problem is. And
I think that this delayed disclosure should be much more
pervasive. For example, the Fed rates banks with some internal
ratings called CAMELS ratings. Again, I think it is very useful
not to disclose them at the time, but I do not see any reason
why not disclose to the public subsequently so that we can
assess how good the Fed is in disclosing--in measuring the
solvency of banks, and we can improve if we find mistakes.
    Chairman Brown. Dr. Johnson.
    Mr. Johnson. Senator, I think we should be trying to
disclose as much as possible, subject to not destabilizing the
world's economy, obviously. And in this context, I would flag
living wills for you. Now, some of these living wills are
reportedly in the tens of thousands of pages--and those are the
short ones--and we learn very little about what is in those
living wills, either immediately or with some time delay. So I
would reinforce Luigi's suggestion just now that, with some
time delay, the Fed should make more of that information public
so we can go back and look and have some additional assessment
of whether those living wills were indeed realistic plans that
would lay out a road map through which bankruptcy could take
place without causing global financial instability, which is
the mandate.
    Chairman Brown. Dr. Rosenblum.
    Mr. Rosenblum. I would agree with Simon on this
accountability issue and a lot of information being disclosed
with a lag. In real time, however, it can exacerbate the
financial crisis to disclose too much. That is one of the
dangers when you have to go to the lender of last resort. It is
called the lender of last resort for a reason. Again, we have
to take two steps back and put it into everyday language. If
one of my children comes to me for help, they usually do not
want their sibling knowing about it. They had to go to the Bank
of Mom and Dad. That is what the Federal Reserve is, the lender
of last resort, or we can think of it as the pawnbroker for the
Nation. It is a collateralized loan. Nobody really wants it
revealed in real time that they had to go there. But when you
do go there, I agree--and the law is now explicit--it does have
to be acknowledged and made public, but with a lag.
    So there is a delicate balance there, but I come back to
what Professor Zingales also said. I think there is a lot of
bank examination information that is valuable that should be
disclosed with a 2-year lag, maybe a 3-year lag. I am not sure
what the right number is, but if the Comptroller of the
Currency and the FDIC and the Fed are going to do their job, it
has to be--I think disclosure and transparency would make them
more accountable and have them do a better job than they are
doing now and make capture, which is a word we were using
before, less likely.
    Chairman Brown. Dr. Meltzer.
    Mr. Meltzer. I will be very brief. I agree with what
Professor Zingales said.
    Chairman Brown. Thank you. That was very brief. You were
always very brief, Dr. Meltzer. Thank you.
    Mr. Meltzer. Thank you.
    Chairman Brown. Thank you all for your testimony and for
your candor. Some Subcommittee Members may have written
questions for you. Please answer those as quickly as possible.
I appreciate the service that all of you have provided.
    The Subcommittee is adjourned.
    [Whereupon, at 11:48 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
              PREPARED STATEMENT OF LAWRANCE L. EVANS, JR.
   Director, Financial Markets and Community Investment, Government
                         Accountability Office
                            January 8, 2014

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                  PREPARED STATEMENT OF LUIGI ZINGALES
    Robert C. McCormack Professor of Entrepreneurship and Finance,
             University of Chicago Booth School of Business
                            January 8, 2014
    Chairman Brown, Ranking Member Senator Vitter, Members of the
Committee, thank you for inviting me.
    I have been asked to comment on the GAO study on the Government
support of bank holding companies (BHCs)and in particular (1) on my
estimates of the financial benefits enjoyed by the BHCs as a result of
the extraordinary Government actions during the financial crisis; (2)
on my views of how to address the issues identified in the GAO report
using the authorities provided in the Dodd-Frank Act.
    Regarding the estimate of the financial benefits it is important to
distinguish two components: pure transfer of value from taxpayers to
bank's investors and value created as a result of a reduction in the
probability of a costly bankruptcy.
    Veronesi and Zingales (2010) calculate the expected Government cost
of the two main programs (CPP and TLGP) to be $39.9bn. \1\ By using
this estimate and by making reasonable assumptions on the cost of the
other programs, I obtain that the total expected cost of these programs
was between $59bn and $89bn (see Table 1). This represents the pure
transfer of value from taxpayers to BHC financial claimholders.
---------------------------------------------------------------------------
     \1\ Pietro Veronesi and Luigi Zingales, ``Paulson's Gift'',
Journal of Financial Economics, 2010: 97(3):339-368.
---------------------------------------------------------------------------
    Veronesi and Zingales (2010) also estimate that in case of
bankruptcy, 22 percent of the enterprise value of a BHC vanishes. Thus,
we can assess the value saved by computing the changes in the
probability of bankruptcy triggered by the Government interventions.
These estimates, however, will depend crucially on what counterfactual
hypothesis we are willing to entertain, i.e., what we assume would have
happened to the BHCs had the Government not intervened.
    I present two extreme scenarios. The lower bound, analyzed in
Veronesi and Zingales (2010), only considers the differential benefit
of the set of interventions announced Columbus day weekend 2008. Since
even before that weekend the market was expecting the Government to
intervene, these estimates only capture the effect of an increase in
the probability of a Government intervention. Overall, this set of
Government interventions saves $99bn, setting the total financial
benefit enjoyed by BHCs at between $158bn and 188bn.
    To obtain an upper bound, I make the Jamie Dimon's hypothesis that
without Government intervention all the top ten BHCs would have failed
(see Ross Sorkin (2009)). \2\ In this case the value saved overall
would be $1,461bn, with a total financial benefit enjoyed by BHCs
between $1,520bn and $1,550bn. The wide range of these estimates shows
how dependent the results are on the counterfactual used.
---------------------------------------------------------------------------
     \2\ Andrew Ross Sorkin, ``Too Big To Fail'', Penguin Books,
October 20, 2009.
---------------------------------------------------------------------------
    On the second issue, I would like to classify the Dodd-Frank's
interventions in three groups:

   Restrictions to interventions in case a BHC is in trouble
        (such as restrictions on the Federal Reserve 13(3) authority);

   Reduction in the potential cost in case of bankruptcy (such
        as Living Wills);

   Restrictions to risk taking in normal conditions (such
        Liquidity Requirements and Debt to Equity Ratio).

    I regard the first set of tools to be not only useless, but also
harmful. As the ``no bailout clause'' of the European Union Maastricht
Treaty has shown, these restrictions are routinely bypassed when the
need arises. If they are not, it can be dangerous, since by the time a
major BHC is in trouble, the cost of not intervening becomes very high.
    I regard the second set of tools as wishful thinking. A BHC's
incentive to design a proper ``living will'' equals the desire of a
man, sentenced to death by hanging, to find the right tree at which to
be hung.
    The only effective tool to eliminate a subsidy to large BHCs is to
design a mechanism of prompt intervention, which is triggered much
before a BHC becomes insolvent. Such mechanism, described in Hart and
Zingales (2012), can be implemented using the authorities provided in
Dodd-Frank. \3\ It is sufficient that, by using its authority to set
leverage standards, the Fed imposes a maximum price for the Credit
Default Swap of BHC's junior debt. A CDS price subsumes both the
leverage position and the riskiness of the underlying assets. Every
time the CDS price exceeds the predetermined threshold for, let's say,
30 days, the bank should be required to issue equity. If it does not,
it should be taken over by the regulator and liquidated using the
Ordinary Liquidation Authority under Dodd-Frank. The system works like
a margin loan, made safe by the occasional margin calls. This is the
most effective way to eradicate the ``Too Big To Fail'' problem.
---------------------------------------------------------------------------
     \3\ Oliver Hart and Luigi Zingales, ``A New Capital Regulation for
Large Financial Institutions'', American Law and Economic Association
Review, 2012.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                  PREPARED STATEMENT OF SIMON JOHNSON
    Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of
                               Management
                            January 8, 2014
A. Summary \1\
---------------------------------------------------------------------------
     \1\ Simon Johnson is also a member of the Systemic Risk Council, a
member of the Congressional Budget Office's Panel of Economic Advisers,
and a member of the FDIC's Systemic Resolution Advisory Panel. All
views expressed here are personal. For additional affiliations and
disclosures, please see this page: http://BaselineScenario.com/about/.
---------------------------------------------------------------------------
  1. The U.S. Government Accountability Office Report ``Government
        Support for Bank Holding Companies: Statutory Changes to Limit
        Future Support Are Not Yet Fully Implemented'' (GAO-14-18)
        provides some useful detail on the wide variety of support
        provided by the official sector to large bank holding companies
        during the financial crisis of 2007-10. The GAO is also correct
        that, even under the most favorable interpretation, there has
        been slow implementation of various key measures designed
        subsequently to make the financial system less risky. More than
        5 years after the worst crisis since the 1930s, it is
        remarkable how little has been achieved by regulators.

  2. The GAO report makes it clear that official sector support was
        provided disproportionately to some of the largest bank holding
        companies (and other large financial institutions) in the
        United States, because these firms faced very large (relative
        to firm size and relative to the macroeconomy) liquidity and
        solvency issues.

  3. However, the report has seven prominent limitations that should be
        considered when we reflect on potential policy for the future:

    a. There is insufficient consideration given to risk-adjusted
        returns. The GAO seems to accept at face value the Federal
        Reserve and Treasury position that ``all of the Federal Reserve
        and FDIC assistance was fully repaid with interest.'' But
        evaluating any such support as an investment should also
        involve consideration of the risks involved. For example, we
        could reasonably ask--what would the private sector have
        charged to provide this amount of funding under such terms, and
        on a risk-adjusted basis, what was the effective subsidy
        provided to big banks?

    b. It does not consider the full scope of support provided by the
        Federal Reserve System, including the dollar value of allowing
        some financial sector firms to convert to bank holding
        companies at the height of the crisis. \2\
---------------------------------------------------------------------------
     \2\ This point is mentioned in the report, but there is no attempt
to provide a quantitative value for this important dimension of
support. The firms involved, including Goldman Sachs and Morgan
Stanley, may well have failed without this change in their legal
status, which signaled that it would now be much easier for them to
borrow from the Fed.

    c. It is also mostly silent on the ways in which monetary policy
        has become a mechanism for transferring wealth from savers to
---------------------------------------------------------------------------
        financial intermediaries, through very low interest rates.

    d. There were alternative ways for the Government to support the
        economy, including through ``liquidity loans'' to households
        who were underwater on mortgages. Was it cost effective for the
        Government support banks directly and not provide substantial
        assistance to homeowners--many of whom would have experienced a
        recovery in asset values if they had been afforded loans on the
        kinds of terms available to large complex financial
        institutions?

    e. It does not fully explore the full scope of U.S. official
        support provided more indirectly to large foreign banks (e.g.,
        through ensuring that AIG counterparties were paid in full),
        and the ways in which this did or did not help parts of the
        U.S. financial sector.

    f. It does not integrate a full analysis of the fiscal costs of the
        crisis, i.e., how much the Government's debt increased as a
        result of lost revenue and other impacts. \3\ The GAO report
        should therefore be read as measuring some ``direct'' costs of
        intervening to help large financial institutions, rather than
        as measuring the full cost to the taxpayer of the downside
        insurance provided by the official sector.
---------------------------------------------------------------------------
     \3\ In fairness, the GAO has attempted to deal with this broader
issue in other work (e.g., see http://www.gao.gov/products/GAO-13-180).

    g. Perhaps most worryingly for the validity of future analysis, the
        GAO seems to weight all ``expert'' opinion equally,
        irrespective of whether the work in question was undertaken by
        people who work for big banks. In this context, I would flag
        the specific mention of work by the Bipartisan Policy Center on
        p. 51, but this issue seems to come up throughout the report.
        If the GAO cannot sort out sensible analysis from sophisticated
        lobbying, then its important follow-up report on the current
        value of implicit subsidies to large banks is unlikely to have
        much value. The negative reputational effect on the credibility
        of the GAO, Congress, and the executive branch (including the
---------------------------------------------------------------------------
        Fed) would be considerable and most unfortunate.

  4. To understand the full fiscal impact of the deep finance-induced
        recession, look at changes in the CBO's baseline projections
        over time. In January 2008, the CBO projected that total
        Government debt in private hands--the best measure of what the
        Government owes--would fall to $5.1 trillion by 2018 (23
        percent of GDP). As of January 2010, the CBO projected that
        over the next 8 years debt will rise to $13.7 trillion (over 65
        percent of GDP)--a difference of $8.6 trillion. Over the cycle,
        therefore, these CBO projections imply that debt relative to
        GDP will be 50 percentage points higher than it would be
        otherwise, as a direct result of the severity of the crisis.
        \4\
---------------------------------------------------------------------------
     \4\ Most of this fiscal impact is not due to the Troubled Assets
Relief Program--and definitely not due to the part of that program
which injected capital into failing banks. Of the change in CBO
baseline, 57 percent is due to decreased tax revenues resulting from
the financial crisis and recession; 17 percent is due to increases in
discretionary spending, some of it the stimulus package necessitated by
the financial crisis (and because the ``automatic stabilizers'' in the
United States are relatively weak); and another 14 percent is due to
increased interest payments on the debt--because we now have more debt.

  5. Excessive risk taking by large financial firms--including but not
        limited to U.S. bank holding companies--was a central element
        of both the global credit boom in the years prior to 2008 and
        why the U.S. (and the world) experienced such a severe crisis
---------------------------------------------------------------------------
        after the collapse of Lehman Brothers.

  6. Bailouts and myriad forms of downside protection extended to
        creditors, shareholders, and executives of large bank holding
        companies--and to nonbanks that were allowed to become bank
        holding companies during the crisis--confirmed that some of
        these firms have become ``too big to fail.'' In the fall of
        2008, top officials became convinced that allowing these firms
        to default on their obligations and potentially go bankrupt
        would worsen the global panic and damage the U.S. real economy.

  7. Measures taken subsequently--including the Dodd-Frank financial
        reform legislation and actions by regulators--have been
        intended to reduce systemic risk and end the phenomenon of
        ``too big to fail.'' Unfortunately, as the GAO points out,
        relatively little progress has been made even within the
        framework of Dodd-Frank.

  8. The remainder of this testimony assesses what should be done
        within or beyond the Dodd-Frank framework. Specifically, what
        we have learned over the past decade suggests that:

    a. Requiring that all failing financial institutions go through
        bankruptcy, without any form of Government support, is
        appealing but not likely to work with the current scale, scope,
        and complexity of large international financial institutions.
        Changing the bankruptcy code is unlikely to provide the kind of
        systemic stability that is desirable in a crisis--unless the
        official sector is again willing to step in with financing.

    b. The Federal Deposit Insurance Corporation has made some progress
        with its Single Point of Entry approach to bank resolution.
        This could be helpful in some situations, but the FDIC is also
        likely to encounter serious implementation problems due to the
        difficulties of cross-border cooperation.

    c. The living wills provision of Dodd-Frank has so far been
        interpreted very narrowly by regulators. The intent of the law
        is that every financial institution should be able to go
        bankrupt within the existing code, without that destabilizing
        the world economy. This is already the case for small and
        medium-sized financial institutions in the U.S.; the problem is
        the largest handful of banks.

    d. The logical requirement is that these banks should be limited in
        their scale, with a cap on the size of their nondeposit
        liabilities as a percent of GDP. There are some encouraging
        indications that the Federal Reserve is moving in this
        direction, but the pace of sensible change remains glacial.
B. The Problem With Bankruptcy
    It is very appealing to simply say: we will never provide support
to a failing financial company; all such companies must go through
bankruptcy, just as nonfinancial companies do. And this is exactly the
intent of Title I in Dodd-Frank.
    Unfortunately, with the current scale, scope and complexity of very
large financial institutions in the United States, this threat is not
credible--meaning that it will likely not be carried out because it is
not ``time consistent.'' Promises made today will not be implemented in
a serious crisis because the consequences of following through would be
too severe--and therefore officials will seek alternatives that involve
some form of bailout.
    These points became clear beyond a reasonable doubt at a public
meeting at of the Federal Deposit Insurance Corporation's Systemic
Resolution Advisory Committee on December 11, 2013. Proponents of
bankruptcy-as-a-viable-option acknowledged that this would require
substantial new legislation, implying a significant component of
Government support (or what would reasonably be regarded as a form of
``bailout'' to a failing company and its stakeholders). \5\
---------------------------------------------------------------------------
     \5\ I'm a member of the committee, and these points were covered
in the first session of the committee's discussion on that day.
---------------------------------------------------------------------------
    In other words, as matters currently stand--under the existing code
or under any potential version of a ``Chapter 14'' that would preclude
official financial support--bankruptcy for a big financial company
would imply chaotic disaster for world markets (as happened after
Lehman Brothers failed).
    The proponents of bankruptcy readily acknowledged that handling the
collapse of such a company in an ``orderly'' fashion--i.e., without
causing global panic--would require a large amount of credit being made
available to the relevant bankruptcy judge (or to some form of a court-
appointed trustee).
    But who could possibly provide the amount of credit necessary to be
stabilizing, particularly at a moment of systemic nervousness or
potential panic? The only potential credit source available would be
the United States Government, either through the Treasury Department or
the Federal Reserve.
    Under current legislation, providing such funding to a specific
firm would be illegal. It would also be very awkward politically.
Remember the justifiable resentment when Congress was asked to fund the
$700 billion Troubled Asset Relief Program in September 2008, to be run
with the Treasury--initially with very little accountability. Now we
are being asked to fund activities that are being overseen by
bankruptcy judges (and trustees), who could decide, for example, to
keep on current management. How would that play politically?
    One argument is that such official loans would be ``safe'' because
the Government will definitely not lose the principal of its loan. But
such assertions are not justified. Sometimes Government emergency
financial support can earn a decent risk-adjusted return, if troubled
assets sufficiently recover their value. More often, the Government
ends up handing over a very large subsidy.
    Bankruptcy cannot work for big banks--the largest half-dozen or
so--at their current scale and level of complexity. It is not a viable
option under current law. And changing the law to add a bailout
component to bankruptcy--but only for very large complex financial
institutions--does not pass the laugh test.
    It is completely unrealistic to propose ``fixing'' this problem
with legislation that would create a new genre of bailouts (or the
pretense of ``no bailout'', until the next crisis, where there would
again be bailouts of the Paulson-Bernanke-Geithner variety).
    Under current law--and as a matter of common sense--the Federal
Reserve should take the lead in forcing megabanks to become smaller and
simpler.
    The legal authority for such action is clear. Under Section 165 of
the 2010 Dodd-Frank financial reform legislation, large nonbank
financial companies and big banks are required to create and update
``the plan of such company for rapid and orderly resolution in the
event of material financial distress or failure.'' The design is that
this plan--known now as a ``living will''--should explain how the
company could go through bankruptcy (i.e., reorganization of its debts
under Chapter 11 or liquidation under Chapter 7 of the Bankruptcy Code)
without causing the kind of collateral damage that occurred after the
failure of Lehman Brothers.
    This bankruptcy should not involve any Government support. It is
supposed to work for these large financial companies just as it would
for any company, with a bankruptcy judge supervising the treatment of
creditors. Existing equity holders, of course, are typically ``wiped
out''--the value of their claims is reduced to zero.
    The full details of these living wills are secret, known only to
the companies and the regulators. (The Systemic Risk Council, chaired
by Sheila Bair, has called for greater disclosure of important details.
I am a member of that Council.)
    The discussion at the FDIC in December helped make clear that these
living wills cannot be credible--either from a bankruptcy or resolution
perspective--because the big banks are incredibly complex, with cross-
border operations and a web of interlocking activities.
    When one legal entity fails, this leads to cross-defaults--and then
the seizure of assets around the world by various authorities and
enormous confusion regarding who will be paid what. When any single
megabank starts to go down, others will certainly come under intense
market pressure, in part because the value of their assets will fall
and in part because a sense of panic will spread--this is how such
crises become ``systemic.''
    All of these effects are exacerbated by the fact that these
companies are also highly leveraged, with much of this debt structured
in a complex fashion (including through derivatives). The bankruptcy
experts at the FDIC meeting stressed these points in fascinating
detail.
    What then are the implications? The Dodd-Frank Act has some
specific language about what happens if the resolution plan of a
nonbank financial company supervised by the Board of Governors or a
bank holding company described in subsection (a) is not credible or
would not facilitate an orderly resolution of the company.
    Cross-border issues would be an insurmountable obstacle for
bankruptcy with the current structure of large global financial firms.
They would likely also create a major problem for any attempt to apply
the FDIC's preferred Single Point of Entry approach. \6\
---------------------------------------------------------------------------
     \6\ The FDIC has received an expression of potential cooperation
from the Bank of England. Unfortunately, this and other vague
statements are unlikely to hold up under the pressure of many real
world situations. Only a binding treaty on cross-border resolution
could really make a difference and this is unlikely for the foreseeable
future.
---------------------------------------------------------------------------
    Not unreasonably, under Section 165 of Dodd-Frank, the Fed and the
FDIC may jointly impose more stringent capital, leverage, or liquidity
requirements, or restrictions on the growth, activities, or operations
of the company, or any subsidiary thereof, until such time as the
company resubmits a plan that remedies the deficiencies. \7\
---------------------------------------------------------------------------
     \7\ For the FDIC's approach to resolution to work, there has to be
enough ``bailinable debt'' and equity at the holding company level. The
Federal Reserve has yet to issue proposed rules for comment on this key
topic--and their slowness on this issue is a matter for grave concern.
It is also remains to be seen what is really ``bailinable debt''--what
kinds of investors can own this without raising concerns of contagion
and systemic risk when and if this debt is converted to equity (or is
just wiped out) in a crisis.
---------------------------------------------------------------------------
    The company may also be required ``to divest certain assets or
operations identified by the Board of Governors and the corporation, to
facilitate an orderly resolution.''
    The retort of the big banks is, ``We can skip bankruptcy and go
directly to Title II resolution,'' which allows the FDIC to step in and
take charge of a failing financial company. But the Title II (of Dodd-
Frank) authority is intended as a back-up--to be used only if, contrary
to expectations, bankruptcy does not work or chaos threatens.
    If it is clear ex ante that bankruptcy cannot work--and this is now
completely clear--then the implications of the statute are not
controversial. The Fed and the FDIC must require remedial action,
meaning that something about the size, structure, and strategy of the
megabanks must change.
    This is the logic of our current situation. Section 165 is
potentially valuable, but only if the relevant officials recognize this
reality and act on it--precisely with the goal of making bankruptcy
under the existing code into a feasible option for all firms in the
U.S. economy.
C. Assessment of the Volcker Rule
    The announcement in December 2013 of the Volcker Rule, restricting
proprietary trading and limiting other permissible investments for very
large banks, is a major step forward. Almost exactly 4 years after the
general idea was first proposed by Paul A. Volcker, the former chairman
of the Federal Reserve, and nearly 3\1/2\ years since it became law,
the regulators have finally managed to produce a rule.
    This rule could be meaningful, and this is why there has already
been so much pushback from the big banks. Their main strategy so far--
denial that there is a problem to be addressed--has failed completely.
Their legal challenges are also unlikely to succeed. The main issue now
is whether the regulators force enough additional transparency so that
it is possible to see the new ways that proprietary bets are hidden.
    The Volcker Rule is intended to impact only the very largest
banks--the material impact will be mostly on JPMorgan Chase, Bank of
America, Citigroup, Goldman Sachs, and Morgan Stanley. The goal is
simple and sensible. Given that these banks are supported by large
implicit Government backstops (e.g., from the Federal Reserve), they
should be more careful in their activities and should not engage in
large-scale bets that have the potential to cause insolvency for them
and disruption for the rest of the global financial system.
    These companies could choose to become smaller, with the
constituent pieces operating under fewer restrictions. But their
managements want to stay big, so they should face additional
constraints.
    The first pushback strategy--and the main focus of big bank efforts
to date--is to deny that the Volcker Rule is needed at all. This line
has been pushed hard over the last 4 years, including at a Senate
hearing in February 2010.
    Barry Zubrow, then chief risk officer at JPMorgan Chase, testified
that the Volcker Rule was not needed, as risk controls in big banks
were sufficient to the task. (I also testified at the hearing, in favor
of the rule.) The extent to which JPMorgan Chase subsequently managed
its own risks--including proprietary trading-type activities run out of
its chief investment office--has been called into question. Mr. Zubrow
retired at the end of 2012, telling his colleagues, ``We have learned
from the mistakes of our recent trading losses.''
    I hope that is true, but it seems unlikely, because the name of the
game for very large banks is leverage, i.e., taking big bets using a
lot of borrowed money and very little equity. \8\ This is how to boost
your return on equity, unadjusted for risk, which is what financial
analysts (and the related news coverage) focus on. Most regulators now
have this point much more clearly in their minds.
---------------------------------------------------------------------------
     \8\ On this point, see Anat Admati and Martin Hellwig, ``The
Bankers' New Clothes: What's Wrong With Banking and What To Do About
It'', Princeton University Press, 2013. A close reading of this book
suggests that the recently proposed supplemental leverage ratio is a
step in the right direction--but only a small step that is likely to
prove insufficient. The increase in capital requirements under Basel
III is also unlikely to make much difference--one senior official
recently described this as moving maximum permissible leverage (debt
relative to total assets) from 98-99 percent pre-2008 to around 97
percent for the future.
---------------------------------------------------------------------------
    At the same time, Mr. Zubrow and others asserted that the
introduction of any kind of Volcker Rule would have a big negative
effect on financial markets and the economy. But as the adoption of the
rule has approached, financial markets have taken that news completely
in stride. Yes, we have lower employment levels than we would like, but
that's primarily due to the large financial crisis since the Great
Depression, brought on by excessive risk-taking (for example, at
Citigroup).
    The conceptual fight against the Volcker Rule has been lost by the
big banks, at least in part because of the London Whale losses overseen
by Mr. Zubrow and his colleagues--but also because enough regulators
have finally wised up to how the big banks really operate and why that
can damage the real economy.
    Treasury Secretary Jack Lew also deserves credit for pushing the
rule toward the finish line and for insisting that top management be
held accountable for whether companies comply with the law.
    The second pushback strategy is legal--to bring one or more cases
through the courts that will challenge key aspects of the Volcker Rule.
Eugene Scalia, the son of Supreme Court Justice Antonin Scalia, has had
some success with this strategy on other financial regulatory matters.
    But, as former Congressman Barney Frank has pointed out, the new
Senate rules mean that we should expect confirmation of three new
judges on the U.S. Court of Appeals for the District of Columbia
Circuit, which is where the Volcker Rule would need to be challenged.
The chances of a successful legal case have therefore receded, although
what happens when and if such a matter reaches the Supreme Court
remains unclear.
    The third strategy is to find new ways to hide the essence of
proprietary trading--and this is an important open issue. Will there be
enough disclosure and observable behavior for either the regulators or
people on the outside to see whether the spirit of the Volcker Rule is
being followed? For example, how exactly will traders be compensated
and how much of this will be disclosed? Will data be available on
trading activities, allowing independent researchers to look for
patterns that might otherwise elude officials?
    The Volcker Rule could be a major contribution to financial
stability. Or it could still flop. The devil now is in the details of
implementation and compliance--and how much of this becomes public
information and why what time lag.
D. Some Limited Grounds for Optimism
    There are some recent indications of changes in thinking at the
most senior levels of the Federal Reserve System.
    Specifically, beginning in October 2012, Governor Daniel K. Tarullo
has articulated the potential case for limiting the size of our largest
banks, measured in terms of their nondeposit liabilities as a percent
of GDP. \9\
---------------------------------------------------------------------------
     \9\ See http://www.federalreserve.gov/newsevents/speech/
tarullo20121010a.htm. He made similar points in a speech at the
Brookings Institution in December 2012 and in testimony before the
Senate Banking Committee in February 2013.
---------------------------------------------------------------------------
    First and foremost, the Fed has begun to recognize and discuss
publicly the implicit subsidies that large banks continue to receive,

        To the extent that a growing systemic footprint increases
        perceptions of at least some residual too-big-to-fail quality
        in such a firm, notwithstanding the panoply of measures in
        [the] Dodd-Frank [Act] and [Federal Reserve] regulations, there
        may be funding advantages for the firm, which reinforces the
        impulse to grow. There is, then, a case to be made for
        specifying an upper bound [on size].

    The implication is that we should not allow the size of our largest
bank holding companies to increase further, although Mr. Tarullo seems
to want to pass the buck back to Congress.

        In these circumstances, however, with the potentially important
        consequences of such an upper bound and of the need to balance
        different interests and social goals, it would be most
        appropriate for Congress to legislate on the subject. If it
        chooses to do so, there would be merit in its adopting a
        simpler policy instrument, rather than relying on indirect,
        incomplete policy measures such as administrative calculation
        of potentially complex financial stability footprints. The idea
        along these lines that seems to have the most promise would
        limit the nondeposit liabilities of financial firms to a
        specified percentage of U.S. gross domestic product, as
        calculated on a lagged, averaged basis. In addition to the
        virtue of simplicity, this approach has the advantage of tying
        the limitation on growth of financial firms to the growth of
        the national economy and its capacity to absorb losses, as well
        as to the extent of a firm's dependence on funding from sources
        other than the stable base of deposits. While Section 622 of
        Dodd-Frank contains a financial sector concentration limit, it
        is based on a somewhat awkward and potentially shifting metric
        of the aggregated consolidated liabilities of all `financial
        companies.' [emphasis added]

    Hopefully, there will be support for legislation along exactly
these lines--as proposed by Senator Sherrod Brown and by Senator Brown
with Senator David Vitter. \10\
---------------------------------------------------------------------------
     \10\ See the proposed SAFE Banking Act proposal and TBTF Act.
---------------------------------------------------------------------------
    The Federal Reserve could help articulate the case for such
legislation with greater clarity.
    It would also be most helpful if a vice chairman for supervision
could be appointed to the Federal Reserve Board. The creation of this
position is a requirement of the Dodd-Frank Act that, rather
inexplicably, remains completely unaddressed by the Obama
administration.
                                 ______

                 PREPARED STATEMENT OF HARVEY ROSENBLUM
    Adjunct Professor of Finance, Cox School of Business, Southern
Methodist University, and Retired Director of Research, Federal Reserve
                             Bank of Dallas
                            January 8, 2014
    Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee: I am pleased to testify on Too Big to Fail (TBTF)
subsidies and related issues stemming from the 2008-09 Financial
Crisis. In doing so, I will indirectly comment on some of the more
glaring inadequacies of the Dodd-Frank Act which, though well-
intentioned, simply will not end TBTF. \1\ Dodd-Frank leaves the U.S.
and global financial systems more crisis-prone than previously. To end
TBTF and the financial instability it engenders, it is necessary that
Congress amend the laws and incentives governing the provision of
financial services by following a few basic principles.
---------------------------------------------------------------------------
     \1\ The views expressed are my own and are not necessarily those
of the Federal Reserve Bank of Dallas or the Federal Reserve System
where I worked for over 40 years before retiring on Nov. 1, 2013.
---------------------------------------------------------------------------
    First, incentives matter. Dodd-Frank has done little to alter the
widespread perception that the U.S. Treasury and the Federal Reserve
will once again provide extraordinary Government assistance to giant
financial institutions that get themselves into financial trouble.
Promises to end TBTF are easy to make, but like all promises, are
difficult to keep in the face of a financial crisis. The stockholders,
creditors, and other counterparties of giant financial institutions
know this--and act accordingly. This perception enables giant financial
institutions to grow faster, larger and more dangerously than smaller
institutions and provides a distinct cost advantage to the giants. This
is the source of a huge $50-100 billion annual subsidy that flows to
the giant financial institutions in perpetuity [Bank for International
Settlements, 2012].
    Congress has never voted to approve this annual expenditure; it
came about inadvertently as technology changed, Congress allowed
interstate banking, and Congress ended the separation between
investment banking, insurance and commercial banking. The net result is
that public policy now subsidizes the growth of large, risky, and
unmanageable financial institutions that create systemic financial
instability, the opposite of what public policy professes to seek to
achieve.
    Second, initial conditions matter. Fewer than a dozen giant banking
institutions control around 70 percent of industry assets, up
considerably from the years just prior to the financial crisis. Our
financial services industry has gotten more concentrated; the playing
field is less level; and Government policy, perhaps unintentionally,
will continue to foster ever more consolidation, concentration, and
reduced competition in financial services. To believe otherwise
requires a willful blindness to what should be obvious to observers of
our financial system. As Yogi Berra once said: ``Sometimes you can
observe a lot, just by looking.''
    Competition is being further reduced by a merger and acquisition
wave among small-to-medium size banking institutions in response to the
enormity of the regulatory compliance costs of dealing with Dodd-Frank.
In addition, new entry into banking has been at a near-standstill for
the last 5 years. In these circumstances, it would be wishful thinking
on my part to believe that the normal forces exerted by capitalism and
free markets are capable of reversing these competitive imbalances.
    Economics 101 teaches us that proper incentives and competition
allow market forces to solve most economic problems. Banking is plagued
by the perverse incentives of TBTF, combined with ever-diminishing
competition.
    When all of the costs of the 2008-09 Financial Crisis are added up,
the costs to the United States will amount to $15-30 trillion
[Atkinson, Luttrell, and Rosenblum, 2013]. Yes, I said trillion. This
is 1-to-2 years of U.S. output down the drain. Allow me to translate
this into everyday language the average person can understand; a
conservative estimate is that the crisis cost $50 thousand to $120
thousand for every U.S. household [Luttrell, Atkinson, and Rosenblum,
2013]. Many of these costs were largely avoidable. What is worse,
unless Government policies and incentives on TBTF subsidies are
changed, another financial crisis, likely worse than the last one, may
occur in the not-too-distant future.
    The TBTF Subsidy. I commend the recent GAO study of the TBTF
subsidy [GAO, 2013]. As you know, the GAO's study is part one of a two-
part study quantifying the subsidy received by the surviving TBTF
firms. The study quantifies the financial benefits conferred on the
TBTFs during the financial crisis. Part two, the more important study,
will measure the ongoing subsidy received by the TBTFs postcrisis.
    This subsidy is large, though its exact size varies from year-to-
year and business cycle to business cycle. The subsidy grossly distorts
normal market forces. As one observer has noted, the subsidy serves as
a ``shadow poison pill'' not only making the TBTF firm immune to
corporate threats but degrading the customary governance forces that
would lead to the rightsizing of the firm [Roe, 2013].
    The subsidy, moreover, enables the giant banks to grow larger and
more dangerous to our economic system; but it is difficult to measure
precisely. There is no line item on a bank's balance sheet or income
statement labeled ``TBTF Subsidy''. But it exists and it is pernicious
in its impact. It is legal; the giant financial institutions are merely
responding to the incentives presented to them, not necessarily
violating any laws.
    The TBTF subsidy, in theory, should accrue to the equity
shareholders of the giant banking institutions. In practice, a
substantial portion of the TBTF subsidy is dissipated away in the form
of higher management salaries, bonuses, and perquisites; inefficient
operations; and corporate waste. Unlike other industries, hostile
takeovers by corporate raiders, hedge funds, and private equity firms
are impossible in the case of giant banking institutions. Short of a
Government-ordained merger in the face of an impending failure, there
is simply no market mechanism to effectuate a change in corporate
control at the largest banking institutions.
    Restoring Competition and Reducing TBTF Subsidies. Recently, I was
the coauthor of a plan that sought to utilize market forces to reduce
the TBTF subsidy, level the competitive playing field in banking, and
most importantly, lessen the likelihood of incurring another round of
horrendous costs from another avoidable financial crisis [Fisher and
Rosenblum, 2013a]. As a Nation, we simply cannot afford to repeat
previous mistakes.
    The reform plan we advocated--which has since become known as ``the
Dallas Fed Plan''--would: (1) restrict the Federal safety net of
deposit insurance and access to the Federal Reserve's lender of last
resort facilities to traditional depository institutions; (2) require
every customer of nonbank financial institutions to acknowledge in
writing that the U.S. Government provides absolutely no backstop or
financial guaranty for their transactions; and (3) call for Government
policies that strongly encourage the managements of the Nation's
largest banking institutions to streamline, simplify, and downsize
their companies so that any and all banking affiliates of the financial
holding company would be certified by the FDIC as ``Too Small to Save''
in the event of failure. These three steps would realign incentives
away from the current perverse TBTF mindset and would reestablish a
more competitive framework within the banking industry. Dallas Fed
President Richard Fisher continues to advocate the Dallas Fed Plan. To
some extent, several of the giant institutions have begun downsizing
and streamlining, but at a snail's pace [Fisher and Rosenblum, 2013b],
a process that the stock market, by way of price-to-tangible book value
ratios, is urging management to pursue [Fisher and Rosenblum, 2013c].
    Would the Dallas Fed Plan end banking and financial crises?
Probably not; financial crises have characterized the global banking
and financial system for over three centuries and will likely continue
to do so. However, I firmly believe that the Dallas Fed Plan, which
operationally could be thought of as a plan to mitigate moral hazard,
would considerably reduce the frequency and severity of financial
crises in the United States. No financial reform plan is perfect, but
we should not let our quest for perfection distract us from making
significant improvements to the architecture of our financial system.
    Alternative Means to Reduce the Impact of TBTF Subsidies. I believe
the Dallas Fed Plan is the best financial reform plan. But there are
several other good reform plans worthy of consideration. I will mention
two that would reinforce the virtues of the Dallas Fed Plan by helping
to get the incentives right and by having the additional benefit of
enforceability due to their transparency and simplicity.
    One is the Subsidy Reserve Plan advocated by Boston University
Professor Cornelius Hurley. This plan is the subject of legislation
(H.R. 2266) filed by Congressman Michael Capuano in 2013.
    Professor Hurley's plan would require the GAO, together with the
Federal Reserve and the Office of Financial Research to determine the
size of the TBTF subsidy for each of the giant banking institutions,
and then lock up that amount so that it could only be distributed to
shareholders and other stakeholders in connection with the downsizing
of the TBTF firms [Hurley, 2013]. The appeal of this plan is its
reliance on market discipline as opposed to arbitrary break-up plans
and caps on growth.
    While I can imagine intense debate over determining the acceptable
methodology for measuring the TBTF subsidy, I still believe the Subsidy
Reserve Plan has a lot of merit. Part two of the GAO's study due later
this year may be an important milestone in advancing our understanding
of the TBTF subsidy.
    In any event, recent-day banking regulation is plagued by endless
debate over how much bank capital is ``adequate,'' as well as which
categories of capital qualify for covering losses. After more than a
century, measuring the adequacy of bank capital remains a continuing
debate. As with capital requirements, the most important thing is not
that we measure the subsidy with scientific precision but that we
ensure that our quantification of the subsidy is directionally
accurate.
    In this context, I should mention the Brown-Vitter Bill, which
seeks to impose a 15 percent capital-to-assets ratio on all giant
banking institutions, a ratio much higher than has been imposed or
voluntarily adhered to by banking institutions for over half a century,
if not longer [Brown and Vitter, 2013]. For most banking institutions,
a 15 percent capital-to-assets ratio seems to me to be too high. For
the giant banking institutions, however, a 15 percent capital-to-assets
ratio seems to be barely adequate given the systemic repercussions that
would follow the failure of such a giant banking institution.
    We sometimes set different highway speed limits for 18-wheelers
carrying hazardous substances than we do for automobiles carrying a few
passengers. We also do not encourage self-regulation of speed limits by
drivers. Perhaps this analogy provides some lessons for the necessary
transparency, simplicity, and enforceability of capital regulations for
banks. Let me conclude with a sweeping but appropriate generalization:
when it comes to regulation of the banking industry in general, and
capital in particular: complexity is the enemy. Complexity makes
regulation unintelligible and thereby unenforceable; it can sometimes
be worse than no regulation at all. Let me be more specific--the Basel
rules on bank capital regulation and Dodd-Frank have caused more harm
than good. Basel rules have encouraged institutions to load up on
``safe'' assets like mortgage securities and sovereign debt, and Dodd-
Frank, 3\1/2\ years after being signed into law, is only about halfway
through its regulation-writing phase and has already produced more than
14,000 pages of proposed regulations.
    Back to the Drawing Board: If It Is Not Workable, It Simply Will
Not Work. I know it is difficult for those who supported Dodd-Frank to
acknowledge its largely unworkable nature. Delegating rulewriting
responsibility to more than a dozen agencies has produced irrational
unaccountability. The perverse incentives of TBTF have been perpetuated
and hidden within thousands of pages of inscrutable regulations
confounded by conflicts and complexity. The regulations are simply a
kaleidoscopic reflection of the underlying statutes.
    There is a simpler and better alternative. The Dallas Fed Plan,
perhaps combined with the Subsidy Reserve Plan and the Brown-Vitter
Bill, could postpone the next financial crisis for a decade or two.
This would require, however, that the resulting statute is no more than
about 10 pages long, with the added requirement that its resulting
regulations must be written using fewer words than the statute.
References
Atkinson, Tyler, David Luttrell, and Harvey Rosenblum, ``How Bad Was
    It? The Costs and Consequences of the 2007-09 Financial Crisis'',
    Federal Reserve Bank of Dallas, Staff Papers, July 2013.
Bank for International Settlements, BIS Annual Report 2011/12, June 24,
    2012, pp. 75-76.
Brown, Sherrod, and David Vitter, ``Terminating Bailouts for Taxpayer
    Fairness Act (TBTF Act)'', S.798, 2013.
Fisher, Richard, and Harvey Rosenblum (2013a), ``Vanquishing Too Big to
    Fail'', Federal Reserve Bank of Dallas, 2012 Annual Report.
Fisher, Richard, and Harvey Rosenblum (2013b), ``Why We Must Downsize
    Banking Behemoths Into `Too Small To Save' Entities'', Dallas
    Morning News, Sept. 12, 2013.
Fisher, Richard, and Harvey Rosenblum (2013c), ``A Credible Path for
    Ending Too Big to Fail'', Business Economics, Vol. 48, No. 3, pp.
    167-73.
GAO, ``Government Support for Bank Holding Companies: Statutory Changes
    To Limit Future Support Are Not Yet Fully Implemented'', GAO-14-18,
    November 2013.
Hurley, Cornelius, ``End `Too Big to Fail' by Making It Shareholders'
    Problem'', American Banker, January 23, 2013.
Luttrell, David, Tyler Atkinson, and Harvey Rosenblum, ``Assessing the
    Costs and Consequences of the 2007-09 Financial Crisis and Its
    Aftermath'', Federal Reserve Bank of Dallas, Economic Letter, Vol.
    8, No. 7, September 2013.
Roe, Mark J., ``Structural Corporate Degradation Due to Too-Big-To-Fail
    Finance'', University of Pennsylvania Law Review, forthcoming,
    (Draft dated November 7, 2013).
                                 ______

                 PREPARED STATEMENT OF ALLAN H. MELTZER
    The Allan H. Meltzer University Professor of Political Economy,
          Carnegie Mellon University Tepper School of Business
                            January 8, 2014
    I am very pleased to testify on financial soundness before this
Committee. Much has changed since the financial crisis of 2008. I will
comment on the adequacy of some of the measures and propose some more
effective procedures including passage by the Congress of the Brown-
Vitter legislation.
    Let me begin by stating two principles that should guide your
efforts.
    First principle: legislation should increase incentives by bankers
and financial firms to act prudently. In an uncertain world, we cannot
always know the prudent course. Owners and managers are most likely to
act prudently, if they bear the cost of errors, mistakes, and
unforeseen events. They will be more willing to cushion risks and
uncertainties.
    Second principle: regulation must provide rules that prevent single
bank failures from threatening the financial system. More than a
century ago, careful analysts understood that the public responsibility
was to protect the payments system because a breakdown of the payments
system stops all or most economic activity. Fear and uncertainty cause
banks to refuse to accept payments drawn on other banks.
    That is what happened in the Great Depression. That was what
started to happen in 2008 after Lehman Brothers failed. Timely,
aggressive action by the Federal Reserve prevented the payments
breakdown.
    The second principle has wrongly devolved into actions to protect
banks. There is no economic justification for that as a public
responsibility. I repeat: The public responsibility is to protect the
payments system, not the banks or bankers. The proper way to separate
the two is to impose procedures that prevent a failing bank from
threatening the payment system. That requires four or five actions.

  1. A clearly stated announced rule for the lender-of-last resort. A
        well-known rule that has been used successfully calls for the
        Federal Reserve to lend freely on good collateral at a penalty
        rate. In its first hundred years, the Federal Reserve has often
        discussed its lender-of-last-resort policy internally, but it
        has never announced its policy. Announcement is important,
        indeed crucial. It tells potential users well in advance how to
        prepare their balance sheets and to hold collateral against
        which they can borrow from the Federal Reserve in a crisis. It
        avoids panic by enforcing it announced rule.

  2. It does not wait to choose action until the panic is upon us.

  3. The lender-of-last-resort policy prevents crises from spreading
        and stopping the payments system. It does not save or help
        troubled banks that lack acceptable collateral.

  4. Require equity capital at banks sufficient to absorb all
        anticipated losses. The Brown-Vitter bill requires a minimum of
        15 percent equity capital for all banks that hold $500 billion
        in assets. Capital is assessed against all assets, no
        exceptions or adjustments for risk. This avoids circumvention.

  5. If a bank's equity percentage falls to 10 percent due to losses,
        it must cease paying dividends until the 15 percent equity
        ratio is reached.

  6. All money market funds should be marked to market. Recent reform
        required mark-to-market for institutional funds but exempted
        individual funds. The problem of runs is not avoided unless all
        money market funds are covered by a mark to market rule. The
        purpose is to prevent depositor runs.

    Community banks and all banks with less than $500 billion in assets
should hold a lower equity capital percentage, say 8 percent, because
they are protected by deposit insurance.
    Banks as a group pay the cost of deposit insurance. It has worked
well for all but the largest banks.
    The Brown-Vitter bill recognizes that the way to prevent bailouts
using taxpayer funding is to make the bankers have an incentive to be
prudent. The 15 percent equity requirement is based on the minimum
equity capital ratio held by major New York City banks during the worst
financial crisis in our history, 1929-32. By requiring banks to pay for
their mistakes, the system gave bankers strong incentives to lend
prudently. No major New York bank failed.
    Bankers make two principal arguments against this proposal. They
say it would reduce credit availability and would encourage greater
risk taking to restore earnings. Both claims are wrong. The Federal
Reserve determines the volume of lending; banks decide who gets the
credit. As to increased risk taking, the banks bear the cost of bad
decisions, not the public. Large stockholders would quickly replace
managers who caused them heavy losses and jeopardized their dividend.
    Dodd-Frank gives the Treasury Secretary the power to decide too-
big-to-fail. Since TBTF started, it has always been the Treasury
Secretary. The mistake in Dodd-Frank is that the Treasury Secretary
makes the decision in the midst of a crisis. That's much too late. No
one should believe that any Treasury Secretary will risk a bigger
crisis at that time. The only way to end too-big-to-fail is to adopt
and enforce rules that give the bankers much greater incentives to be
prudent and avoid failure. The Brown-Vitter bill does just that.
    Finally, consider the complex Volcker rule that requires regulators
to decide what is a hedge done to reduce risk and what is a speculation
that banks choose to increase risk. Compare that to the much simpler
Brown-Vitter requirement that makes the bankers pay for their mistakes
and gives them a strong incentive to avoid making them. Which do you
think is mostly likely to prevent crises and to reward safety and
soundness?
        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                  FROM LAWRANCE L. EVANS, JR.

Q.1. One of the criticisms of this study is despite the fact
that there are a number of tables in the back, there are not
easy top line numbers as to how much economic assistance each
large financial institution (over $500 billion in assets)
received and what discount of the market rate was provided to
those large financial institutions by the taxpayers. Why did
you not provide those top line numbers in the study and can you
do so now for the record?

A.1. Our decisions about how to present data on the amount and
pricing of the emergency Government assistance reflect our
judgments about how best to present informative measures while
being mindful of the limitations of these types of measures.
Appendix IV of our report contains data tables and figures
intended to facilitate a comparison of the amount of assistance
received by banking organizations of various sizes. For the six
largest bank holding companies (over $500 billion in assets),
table 7 shows the total dollar amount outstanding at year-end
for 2008 through 2012 for programs administered by the Federal
Reserve System, the Federal Deposit Insurance Corporation
(FDIC), and the Department of the Treasury (Treasury). For
these dates, this table also shows this total amount
outstanding under each program as a percentage of the
institution's total consolidated assets. This percentage
calculation provides a measure of assistance that is more
comparable across institutions of different sizes by showing
how much of the institution's balance sheet was assisted by
each program. In table 7 and other figures in this appendix, we
did not sum program totals across the different programs to
arrive at a ``top line'' measure. Such an aggregate measure,
presented on its own, would obscure important differences in
the composition of assistance across firms and the value
provided by different forms of assistance (i.e., loans,
liabilities guaranteed, and capital investments). Accordingly,
in figures 3, 4, and 5 in appendix IV, we aggregated measures
of total assistance from programs that provided similar forms
of assistance, but not measures of the total assistance from
all of the programs.
    In response to your request for more information on the
total assistance provided to the largest bank holding
companies, in Table 1 below, we show the total term-adjusted
assistance provided to these six firms through selected
programs. These term-adjusted measures account for differences
in the time period over which assistance was outstanding by
multiplying the dollar amount of the assistance by the number
of days it was outstanding and dividing this amount by the
number of days in a year (365). While the term-adjusted amounts
provide one measure of the total assistance received under
these programs, they have limitations. For example, they do not
account for differences in firm size that could have
contributed to differences in the dollar amounts firms received
and therefore do not allow for a fair comparison of the
relative amounts of assistance received by firms of different
sizes. In addition, as with the measures shown in our report,
totaling these measures across programs that provided very
different forms of assistance would give an incomplete picture
of the composition and value of assistance received by
different firms.
    With respect to our analyses of emergency program pricing,
these analyses cannot be used to calculate a ``top line''
estimate of the total dollar value benefit for individual bank
holding companies. For selected programs, we compared program
pricing to indicators of pricing for market alternatives. The
market interest rates we used as benchmarks provide a general
indication of market alternatives that could have been
available to program participants. As our report notes,
however, these market rates are unlikely to reflect available
alternatives for all participants at all points in time during
the crisis and cannot be used to produce a precise
quantification of the benefits that accrued to individual
participating institutions. In addition, pricing data were not
available for market alternatives to all programs, such as
interest rates for many types PDCF and TSLF collateral. To
soundly estimate the benefits to individual institutions, we
would need to know the individual counterfactual prices for
each institution for each program, and that information is not
observable.

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Q.2. How have you explored whether these studies and reports
you are relying on been ``sponsored'' by entities that,
directly or indirectly, have a financial interest in the
outcome of the Part II study?

A.2. GAO operates under strict professional standards that
require our staff to exercise objectivity and professional
skepticism in all the work that they do. Simon Johnson's
written statement and opinions expressed during the hearing
reflect a fundamental misunderstanding of how GAO does its
work. To be clear, GAO adheres to generally accepted Government
auditing standards (GAGAS) in developing its products. \1\
Among other things, these standards require GAO staff working
on audit engagements to consider possible bias in the sources
of the evidence collected. We take steps to identify and
address bias and other threats to independence throughout all
of our audits--including threats resulting from undue external
influence from interested parties.
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     \1\ See Government Auditing Standards: 2011 Revision, GAO-12-331G.
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    It is important to emphasize that GAO is relying
principally on its own empirical research for the Part II
study. We plan to supplement our analyses with documentary
evidence (studies) and testimonial evidence (interviews). To
the extent we leverage outside research, quality, validity, and
reliability will determine whether a study is included in our
findings. As we indicated during the hearing, rigorous review
of methodologies, assumptions, and limitations of each study
allows us to distinguish high-quality studies from weaker ones.
Any review will be conducted in accordance with our
professional standards that require us to plan and perform the
audit to obtain sufficient, appropriate evidence that would
provide a reasonable basis for our findings and conclusions.
The staff assigned to the Part II study collectively possesses
adequate professional competence and technical skill needed to
undertake this difficult study, including exercising judgment
on the quality of external research. The exercise of this
professional judgment allows us to review the relevant
literature including studies conducted by interested parties
and eliminate those where bias compromises the validity of the
study.
    The same is true with respect to stakeholders we identify
for interview purposes. For example, Mr. Johnson--who does not
have an empirical study relevant to Part II of our engagement
and is not among those experts reviewing our model--is among a
number of interested parties we have approached who are
knowledgeable and have strong views on one side of the issue.
We routinely engage such interested parties to gather
information and opinions on any number of matters. Meeting with
interested parties that span the ideological spectrum helps to
ensure that we are balanced and objective in our approach,
while our professional standards and ethical principles assure
that we retain professional skepticism and weigh evidence
appropriately.

Q.3. You have indicated that with respect to persons consulted
in connection with the study, ``one of the things that we
explored was conflicts of interest.'' Please describe for the
Committee how you went about the task of unearthing potential
conflicts of interest involving those individuals with which
you and your staff have interacted.

A.3. To be clear, these interactions refer to external experts
we sought out to review aspects of our model and identify
threats to validity or otherwise opine on ways to improve the
robustness of our methodological approach. Utilizing experts in
this manner is an important quality assurance step we take when
appropriate. When external experts contribute to the planning
and conducting of our engagement, in accordance with our
professional standards, we are required to assess their
independence and apply and document any safeguards deemed
necessary to mitigate any threats. In this specific case, we
reviewed the external experts' affiliations, activities, and
research where appropriate. We also asked the academic experts
to raise any potential conflicts of interest that might impinge
upon their ability to render impartial conclusions about our
empirical work.
    When we interview individuals and they are used as sources
of testimonial or other evidence, GAO's standards of evidence
also apply. Among other things, these standards require that we
consider possible bias in the source of the evidence. While we
do background research on the individuals we contact for
interviews, we do not necessarily ask the external sources
questions about funding or sources of income. In most cases,
their biases and interests are quite clear. As discussed above,
in cases where we are merely seeking views or opinions,
information from these individuals is used in ways that does
not require a rigorous evaluation of independence. In fact we
may reach out to interested parties to ensure we heard
perspectives from a balanced group of experts.

Q.4. Are any of the members of your staff who are working on
the Part II study customers of or investors in any of the
financial institutions with assets in excess of $500 billion?

A.4. As mentioned above, GAO adheres to GAGAS in developing its
audit products, including this engagement. These standards
require that GAO staff working on audits maintain both
independence of mind and independence in appearance.
Correspondingly, none of the staff working on the Part II study
have direct investments in bank organizations. We do note,
however, that a GAO employee with direct investments in banks
with assets below $500 billion or even in nonbank financial
companies could also have a threat to independence. As a
result, no employee on this engagement has any reported direct
investment in any financial company, and employees working on
GAO's financial markets work are generally prohibited from
holding any asset in the financial sector. As a result of these
and other actions we take to preserve our independence, we
believe our opinions, findings, conclusions, judgments, and
recommendations are impartial and can be viewed as impartial by
reasonable and informed third parties.
    GAO is not only concerned with actual independence but also
how others might perceive our independence. However, it is
important to emphasize that the reference point for
``independence in appearance'' is a reasonable objective third
party. We don't believe that maintaining a customer
relationship with a financial institution on the same terms as
are available to the general public threatens the independence
of auditors assigned to this engagement or should be perceived
to be a threat by a reasonable, objective third party.

Q.5. Does GAO have a policy in place that would preclude anyone
working on the Part II study from accepting employment at an
institution with assets in excess of $500 billion?

A.5. Although there are no postemployment restrictions on our
employees that would prevent GAO's auditors from seeking
private employment with one of these institutions, no employee
who is seeking employment with one of these institutions would
be permitted to work on the Part II study. Our policies require
employees who are seeking employment with an entity that could
be affected by an engagement to notify management so that any
threat to independence can be evaluated and if significant, an
appropriate safeguard applied--often the reassignment of the
employee to other duties. In addition, most senior GAO
employees are required by law to file a statement within three
calendar days after beginning job negotiations or after
entering into an employment agreement with a private employer.
              Additional Material Supplied for the Record
STATEMENT OF THE INDEPENDENT COMMUNITY BANKERS OF AMERICA, SUBMITTED BY
                             CHAIRMAN BROWN

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