    [Senate Hearing 113-481]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 113-481

                   WHAT MAKES A BANK SYSTEMICALLY IMPORTANT?

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

                                    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 CHARACTERISTICS OF BANKS THAT MAKE SOME OF THEM
                             SYSTEMICALLY IMPORTANT

                                   __________

                                 JULY 16, 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, JULY 16, 2014

                                                                       Page

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

    Opening statements, comments, or prepared statements of:
        Senator Toomey...............................................     9

                                   WITNESSES

    Richard J. Herring, Jacob Safra Professor of International
      Banking, The Wharton School, University of Pennsylvania........     3
        Prepared statement...........................................    30
    James B. Thomson, Professor and Finance Chair, University of
      Akron..........................................................     5
        Prepared statement...........................................   110
    Robert DeYoung, Capitol Federal Distinguished Professor in
      Financial Markets and Institutions, University of Kansas School
      of Business....................................................     6
        Prepared statement...........................................   115
    Paul H. Kupiec, Resident Scholar, American Enterprise Institute..     8
        Prepared statement...........................................   116

                  Additional Material Supplied for the Record

    Letter from Paul Saltzman, President, The Clearing House
      Association L.L.C., Executive Vice President and General
      Counsel of The Clearing House Payments Company L.L.C.,
      submitted by Chairman Brown....................................   135
    Statement submitted by Christy L. Romero, Special Inspector
      General for the Troubled Asset Relief Program..................   138

                                     (iii)

                   WHAT MAKES A BANK SYSTEMICALLY IMPORTANT?

                                  ----------

                            WEDNESDAY, JULY 16, 2014

                                           U.S. Senate,
           Subcommittee on Financial Institutions and Consumer
                                                    Protection,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Subcommittee met at 10:24 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. Welcome. The Subcommittee will come to
    order. First, apologies to the witnesses and those in
    attendance for the sort of truncated way we are doing this
    today. There was a vote called late yesterday to be held at
    10:15 today. So we have at least two Members of the
    Subcommittee who I think will join us. Senator Toomey, the
    Ranking Member, will have--normally he would do an opening
    statement after I would, and because he was not able to vote
    and come back as quickly, at the conclusion of the testimony of
    the four of you, Senator Toomey will certainly be given the
    right to do an opening statement, as any other Senators who
    join us will.
        Three regional banks are headquartered in my home State of
    Ohio, one in each of the three biggest cities--Cleveland,
    Cincinnati, and Columbus. They serve customers throughout the
    State with other regionals located/headquartered in other
    States obviously serving Ohio, too.
        These banks operate under a very traditional banking model.
    The CEO of one of them talked about her bank as a ``core funded
    bank,'' the term she used. They take deposits, they lend
    lending to families and small businesses. Each has assets of
    over $50 billion, making them subject to enhanced supervision
    by the Federal Reserve.
        While nonbanks are judged based upon a specific set of
    criteria, the Dodd-Frank Act requires all banks, as we know,
    with more than $50 billion in assets to automatically be viewed
    as systemically important.
        Each of these three Ohio banks serves an important role in
    the communities they serve, but from what I can tell, none of
    these regional institutions would threaten the United States or
    global financial system or economy if they were to fail.
        Many in Washington attack the Financial Stability Oversight
    Council, or FSOC, for designating institutions as systemic. Let
    us be clear: the $50 billion line was created by Congress, not
    by FSOC.
        Some Washington politicians say that this systemically
    important designation means that all of these banks are, in
    parlance we used, ``too big to fail.''
        But financial regulators say that the failure of a $50 or a
    $60 or a $100 billion bank would not, in fact, threaten the
    financial system.
        This group of 33 banks contains banks with diverse business
    models--universal banks, regional banks, trust banks, and
    foreign banks--and diverse geographic footprints--Columbus,
    Ohio; Pittsburgh, Pennsylvania; Montreal; Salt Lake City, Utah;
    Santander, Spain.
        They range in size from $2.4 trillion, the largest, in
    assets, those that have been designated, to $56 billion; from
    operating in 100 countries to operating in just one. Clearly,
    these banks are not the same.
        That is why other rules use different thresholds. For
    example, banks with $250 billion are subject to a liquidity
    coverage ratio; banks with more than $700 billion in assets
    must meet a supplementary leverage ratio.
        It is clear that regulators believe that these institutions
    present different levels of risk. In May, Governor Tarullo said
    that banks between $50 and $250 billion--which all three of
    these Ohio banks are, incidentally--are ``overwhelmingly
    recognizable as traditional commercial banks (though a few do
    have significant capital market or other activities).''
        So today we are exploring what makes a bank systemically
    important by looking at issues like size and leverage and
    business model and funding sources.
        We will consider what the failure of a $100 billion bank, a
    $300 billion bank, or a $1 trillion bank might mean for the
    financial system and the economy.
        We will look at tools that regulators have--or should have,
    or your suggestions need to have--to prevent the failure of a
    systemically important bank, or to protect taxpayers and the
    economy if one does, in fact, fail.
        It is important that we strike the right balance between
    identifying the institutions and activities that present the
    most risk while not becoming complacent and not taking our eyes
    off of potential sources of risk.
        I thank the witnesses, and let me introduce each of you,
    and we will begin the testimony. As I said, at the conclusion
    of your remarks, if other Senators want to make opening
    statements, they certainly can.
        Dr. Richard Herring is the Jacob Safra Professor of
    International Banking at the University of Pennsylvania's
    Wharton School, codirector of the Wharton Financial
    Institutions Center. Professor Herring is a member of the
    Systemic Risk Council at the FDIC's Systemic Resolution
    Advisory Committee. Welcome, Dr. Herring.
        Dr. James Thomson is the finance chair at the University of
    Akron's College of Business Administration. Prior to joining
    the University of Akron, Professor Thomson held multiple roles
    at the Federal Reserve Bank of Cleveland, including vice
    president and financial economist. He worked as a financial
    economist at the independent General Accounting Office. He
    calls Mentor, Ohio, his home. Welcome, Dr. Thomson.
        Dr. Robert DeYoung is the Capitol Federal Professor in
    Financial Markets and Institutions at the University of Kansas
    School of Business. In addition to his work with the
    university, Professor DeYoung is a visiting scholar at the
    Federal Reserve Bank of Kansas City and a senior research
    fellow at the FDIC's Center for Financial Research. Prior to
    joining the faculty, Professor DeYoung was an Associate
    Director of Research at the FDIC, Economic Adviser at the
    Federal Reserve Bank of Chicago, and a Senior Financial
    Economist at the Office of the Comptroller of the Currency.
        Dr. Paul Kupiec is a resident scholar at the American
    Enterprise Institute. He joined AEI from the FDIC where he held
    multiple roles, including Director of the Center for Financial
    Research. His past experience includes positions at the IMF,
    Freddie Mac, the Board of Governors of the Fed, the Bank for
    International Settlements, and JPMorgan's Risk Metrics Group.
    From 2010 to 2013, Dr. Kupiec served as Chair of the Basel
    Committee on Bank Supervision Research Task.
        Welcome to the four of you. Dr. Herring, if you would
    begin, keep your comments as close to 5 minutes as you can, and
    after your conclusion, we will move on. Dr. Herring.

       STATEMENT OF RICHARD J. HERRING, JACOB SAFRA PROFESSOR OF
       INTERNATIONAL BANKING, THE WHARTON SCHOOL, UNIVERSITY OF
                              PENNSYLVANIA

        Mr. Herring. Thank you very much, Chairman Brown. I am
    grateful for the opportunity to testify this morning on what I
    think is a very important issue.
        Interestingly, the very question of whether and whether it
    is possible to identify systemically important banks still
    divides experts. Some people feel that it is both impossible
    and dangerous to categorize such institutions. I think this is
    actually unrealistic because we know they exist. We have seen
    how they benefit from Government intervention. And instead the
    question should be how we, in fact, limit the category, perhaps
    reduce it, and try to devise procedures to make these
    institutions safe to fail.
        There has been considerable effort to actually try to
    devise indicators that would help us understand what this
    category looks like. The most refined set have been produced by
    the Financial Stability Board and, of course, amended and
    revised by FSOC. They include size, and I quite agree with you
    that size is by no means the only distinguishing feature, and
    the $50 billion threshold is way too low. They would included
    interconnectedness, which involves certainly capital market
    interconnections; cross-border activity; complexity; and the
    lack of substitutes for the services they provide in the global
    economy.
        These all give you different dimensions. I think they are
    all important, but I think they are not sufficient in and of
    themselves.
        In addition, there have been considerable efforts in both
    the official world and the academic world to model sources of
    interaction and to try to understand the drivers of systemic
    risk. I think both of these activities are worthwhile. I
    certainly think they will give us better insights into what
    actually drives this problem. But I think in some sense they
    miss the point.
        As a practical matter, what makes an institution systemic
    is the decision of regulators to intervene and support. And I
    think it is pretty easy to understand the process.
        When you are standing on the brink of what you fear may be
    a crisis because you do not know the reactions, I think the key
    determinant for regulators is whether they have resolution
    tools that they think are reliable. And during the crisis, they
    did not. So time after time we saw sleepless weekends in which
    regulators devised really desperate bailout measures that, in
    the end, probably undermined safety and soundness of the
    system, but bought it at a very high price in the short term.
        The one time they failed to do so with regard to Lehman
    Brothers indicated why they have taken such pains. Although
    some people would regard that as a useful application of
    bankruptcy policy in the United States, I think there is no
    doubt in the rest of the world it was hugely damaging. And, in
    fact, we are still trying to deal with the pieces in something
    like 60 to 70 different bankruptcy proceedings around the
    world.
        While Dodd-Frank, I think, deserves a lot of credit for
    trying to deal with this problem, part of it simply tries to
    reduce the probability of failure by increasing the quality and
    quantity of capital, which I think is very worthwhile. There
    are other measures which also may be important, but I think we
    should recognize that it never will and never should make these
    institutions fail-safe, because, in fact, banks add value to
    the economy by taking prudent risks--by intermediating between
    borrowers and savers, by buying and selling risk, and providing
    reliable payment systems.
        But I think the most important part of Dodd-Frank and, in
    fact, the most remarkable change in the regulatory landscape is
    the attempt to provide better resolution tools. It begins with
    living wills, which are supposed to describe the plans that a
    bank has for rapid solution and the unwinding of the bank,
    without creating crisis situations for others. These are
    massive plans. I think there is a danger that some of them are
    too big to understand, which is a whole new category, at 10,000
    pages. But also I think there is a huge lost opportunity in
    public disclosure. If we want them really to work, we need to
    inform the public about what the priorities will be and exactly
    how the authorities will intervene.
        In addition, we need better resolution tools. There is a
    huge effort underway at Stanford Hoover to provide better
    bankruptcy proceedings. It has just been put on the Web site.
    There is a Chapter 14 proposal that has been the result of an
    enormous amount of work by a group of academics. And, of
    course, there is the Title II resolution procedure by the FDIC.
    This involves putting the FDIC in a whole new role trying to
    cope with the unwinding, actually the surgical intervention in
    a large, sick institution, literally over a weekend. They need
    to pull the trigger. They need to intervene over the weekend,
    stabilize, provide capital and liquidity, and open up the
    systemically important operations.
        There are several obstacles that all three of these--both
    of these resolution procedures face. One of them is how to
    override ipso facto clauses that could undermine it all. Two is
    how to provide sufficient liquidity to maintain confidence.
    Three is how to sustain international cooperation. And four is
    something actively considered by the Fed just now: how much
    debt to require at the holding company level.
        I would argue, finally--and this is the end--that not only
    the level of debt is important but also the kind of debt. I
    think that if we do not take the opportunity to think about
    this carefully, we will have missed an important opportunity to
    improve incentives for banks to manage their risk more
    effectively and to recapitalize more promptly. But this would
    require, I think, looking very carefully at the Tax Code
    because the main hurdle to adopting something like a CoCo
    appears to be the IRS' reluctance to permit interest payments
    on CoCos to count as deductions in looking at taxable income.
        Thank you very much.
        Chairman Brown. Thank you very much, Dr. Herring.
        Dr. Thomson.

      STATEMENT OF JAMES B. THOMSON, PROFESSOR AND FINANCE CHAIR,
                          UNIVERSITY OF AKRON

        Mr. Thomson. Thank you, Senator Brown and Members of the
    Committee, for the opportunity to speak here today. The focus
    of this hearing, identifying the factors that make a financial
    institution systemically important, is the first step in
    designing an institutional and legal framework to rein in the
    risk of these systemic firms post to the financial markets and
    ultimately the macroeconomy.
        Viewing systemic spillovers as market failure, we need to
    identify the source, severity, and whether the failure merits
    Government intervention, and if so, the most economically
    effective way to structure that intervention.
        During a 30-year career as a financial economist, I have
    studied financial markets, banking, payment systems, failed
    bank resolution, and the Federal financial safety net from a
    public policy perspective. The ideas I express today are
    informed by reading and research I have done in these areas,
    especially papers on systemically important financial
    institutions, the need for an asset salvage agency, and
    systemic banking crises.
        One of the things I want to sound today is that ``too big
    to fail'' is a misleading term. Size is not the only
    distinguishing characteristic that makes financial firms
    systemic. Through my research in this area, I have identified
    four characteristics, what I call the four C's of systemic
    importance: contagion, correlation, concentration, and context
    or conditions.
        The factors that lead to institutions being treated as
    systemically important tend to be prevalent in the larger
    firms, and that is why size shows up on the list.
        In my written statement, I stress how each of these four
    C's has been part of the rationale for generous Government
    treatment of the creditors, managers, and stockholders of
    troubled financial firms. It is important to emphasize that the
    decisions on how we handle economically failed institutions are
    themselves an important source of systemic risk. We need to
    understand whether an institution authorities label as systemic
    in the handling of its economic insolvency are truly systemic
    or merely politically expedient.
        The Dodd-Frank Wall Street Reform and Consumer Protection
    Act, enacted in 2010 in response to the recent financial
    crisis, contains numerous reforms to the financial system and
    supervisory infrastructure. In my written statement, I provide
    my thoughts on Dodd-Frank's provisions dealing with
    systemically important institutions. In the interest of time, I
    will skip over that section of my written statement and spend
    my remaining time on the need for supervisory contingency or
    disaster plans--a missing element of reform.
        Systemic importance reflects constraints faced by financial
    market supervisors in enforcing timely closure rules. It does
    not matter what powers Congress gives financial supervisors to
    conduct orderly resolutions of financial companies if the
    regulators remain reluctant to use them. A major step forward
    to limiting systemic importance is requiring financial system
    supervisory agencies to develop and to commit to contingency
    plans for handling the failure of one or more systemically
    important financial firms.
        These contingency plans should contain a series of options,
    actions taken to contain systemic spillovers, with blanket
    guarantees of all creditor/counterparty claims to be, without
    exception, the last option on the list. Scenario analysis
    should be used to test and refine these disaster plans. Much as
    Dodd-Frank Section 165 resolution planning by systemically
    important firms is intended to promote the orderly resolution
    of these firms--whether it be through bankruptcy or through
    FDIC receivership--supervisory disaster plans should allow for
    resolution of systemic firms with the least impact on long-term
    incentives facing these firms.
        Dodd-Frank was hailed by its drafters as the antidote to
    too big to fail. While provisions in this important reform
    legislation move us toward the goal of reining in the effects
    of systemic importance in the financial system, much remains to
    be done.
        Thank you.
        Chairman Brown. Thank you, Dr. Thomson.
        Dr. DeYoung.

      STATEMENT OF ROBERT DEYOUNG, CAPITOL FEDERAL DISTINGUISHED
    PROFESSOR IN FINANCIAL MARKETS AND INSTITUTIONS, UNIVERSITY OF
                       KANSAS SCHOOL OF BUSINESS

        Mr. DeYoung. Thank you, Senator Brown, for inviting me to
    address the Committee today.
        When you invite four economists to address the Committee
    and the first three of them tell you virtually the same thing,
    I think you will be happy. My remarks are quite consistent with
    what Professor Thomson and Professor Herring had to say.
        The Dodd-Frank Act contains new measures aimed at reducing
    systemic risk at U.S. financial institutions. From my
    perspective, these measures can be divided relatively neatly
    into two different categories.
        On the one side, we have ex ante measures that try to make
    banks' balance sheets resilient to systemic macroeconomic
    events. Some key examples of this, of course, are higher
    minimum capital ratios, liquidity ratios, and regulatory stress
    tests.
        On the other side, we have ex post measures that try to
    limit the amplification of systemic events--contagion--caused
    when banks default on their financial obligations. This
    approach centers on the FDIC's orderly liquidation authority
    and the information made available to the FDIC in living wills.
        It has been my observation that we pay most of our
    attention to the ex ante systemic risk prevention measures--
    they are important measures--setting rules and limits for
    banks; and we tend to have less confidence in ex post measures
    designed to contain systemic risk once it rears its head.
        In 2006, just a year before the financial crisis began, the
    average U.S. banking company had nearly double the risk-
    weighted capital ratios necessary to be deemed ``well
    capitalized'' by bank regulators; 95 percent of all banking
    companies at that time cleared the adequately capitalized
    threshold by at least 300 basis points. As we know, these large
    stores of equity capital were not by themselves large enough to
    prevent hundreds of bank insolvencies in the years that
    followed. Accordingly, Dodd-Frank and Basel III require higher
    levels of capital for banks. As I said, this is clearly
    important and a step that we must take. But we cannot forget
    that restrictions like these impose costs on banks that
    ultimately result in fewer financial services being provided.
        Now, in the shadow of the financial crisis, this may seem
    like a very wise tradeoff. We accept less lending and slower
    economic growth in exchange for a reduction in the severity of
    the next systemic financial event. But the orderly liquidation
    powers in Dodd-Frank provide us with a historic opportunity to
    avoid having to accept this tradeoff. OLA should allow us to
    not only limit the contagious aftereffects of a systemic
    crisis, but also to establish a newly credible regulatory
    regime that is devoid of the too-big-to-fail incentives that
    have so long fostered risk in our financial system.
        The economic logic is a straightforward story. When
    investors become convinced that large complex banks will, in
    fact, be seized upon insolvency--with shareholders losing
    everything and bondholders suffering losses--then credit
    markets and equity markets will more fully price bank risk
    taking; profit-seeking banks will then face clear incentives to
    reject high-risk investments ex ante.
        That is the economic story, but the political story is far
    from straightforward. OLA requires bank regulators to credibly
    establish that they can and will seize, unwind, and eventually
    liquidate large complex insolvent banks. The FDIC's ``single
    point of entry'' plan I think is a workable plan. Nevertheless,
    in my discussions with scores of banking and regulatory
    economists across the country, I meet with a near uniform
    skepticism that the FDIC will be permitted to fully exercise
    its new resolution authorities during a financial crisis when
    multiple large banking companies are nearing insolvency.
    Essentially, their belief is that the deeper the financial
    crisis, the greater the probability that OLA will be suspended.
        So, in my opinion, the most important actions that Congress
    and the administration could take to limit systemic risk in the
    financial system is to strongly and repeatedly enunciate their
    support of orderly liquidation authority and to pledge that
    they will not stand in the way of its implementation during a
    deep financial crisis. Our banking system is most effective
    when scarce economic resources are moved from poorly managed
    banks to well-managed banks. Hence, we do not want a banking
    system that is devoid of bank failure; rather, we want a
    banking system that is resilient to bank failure. And I think
    orderly liquidation authority is essential to establishing this
    resiliency.
        Thanks again for inviting me, and I look forward to any
    questions you might have.
        Chairman Brown. Thank you, Dr. DeYoung.
        Dr. Kupiec.

        STATEMENT OF PAUL H. KUPIEC, RESIDENT SCHOLAR, AMERICAN
                          ENTERPRISE INSTITUTE

        Mr. Kupiec. Thanks, Chairman Brown, Ranking Member Toomey,
    and distinguished Members of the Subcommittee. My written
    testimony addresses the specific questions posed in the
    Subcommittee's letter of invitation. In my oral testimony, I am
    going to skip over the details for the most part and provide an
    overall perspective on the issues that are raised in this
    hearing.
        The Dodd-Frank Act made sweeping changes in the way U.S.
    banks and financial markets are regulated. Four years on,
    required rulemaking continues, and the implications of the
    legislation are only still being discovered.
        The overarching Dodd-Frank goal is to prevent another
    financial crisis, and I doubt anyone would speak against this
    goal. But in attempting to achieve the goal, Dodd-Frank
    includes a large body of poorly balanced legislation. It grants
    regulatory agencies vast new powers to regulate and allows
    these powers to be exercised with almost no checks and
    balances.
        The power and discretion granted by the act are problematic
    because the duties and responsibilities assigned by the act are
    vague and ambiguous. The agencies and the FSOC are directed to
    exercise new powers to ensure financial stability and mitigate
    systemic risk. But financial stability and systemic risk are
    never defined in the legislation.
        The mix of new unchecked powers and vague, ambiguous goals
    is a toxic for economic growth. For example, what does ``ensure
    financial stability'' mean? Does it mean regulators need only
    focus on preventing another financial crisis? Is that the only
    job?
        The duties and responsibilities assigned by the act never
    recognize a link between economic growth and financial
    intermediation. Financial intermediation is necessary for
    economic growth, and if intermediation is restricted, economic
    growth will suffer. Financial crises devastated economic growth
    because the crises interrupt financial intermediation. Similar
    forces operate in noncrisis times. If regulations impede
    financial intermediation, they will also reduce economic
    growth.
        The Dodd-Frank Act does not recognize this tradeoff.
    Instead, it builds in a bias for overregulation. There is no
    regulatory reward for preventing a financial crisis, but
    regulators will certainly be disgraced, if not punished, should
    there be another financial crisis. So what are their
    incentives?
        The issue is analogous to monetary policy where decades ago
    it was recognized that price stability cannot be the only goal
    of the Federal Reserve. It must balance price stability against
    goals of encouraging employment and economic growth. The Dodd-
    Frank Act lacks this balance and instead directs agencies to
    use their new powers to stop bad intermediation. But do
    regulators, councils, or even us economists have the judgment
    and ability to identify and stop only bad financial
    intermediation? And is this ability so trusted that we should
    be able to carry out this vague assignment without supervision
    and review?
        History suggests not, but this is what the Dodd-Frank Act
    does. Section 113 of the Dodd-Frank Act provides a concrete
    example. It grants the FSOC the power to designate nonfinancial
    intermediaries for enhanced prudential supervision and
    regulation by the Board of Governors. The standard for
    designation is vague. It puts very few constraints on the
    FSOC's designation ability. For example, the FSOC is not
    required to identify specific issues or features that mandate
    designation or demonstrate how an FSOC designation will
    mitigate risk. And so the FSOC has not provided these details.
        There is no link to Title I orderly resolution plans in
    that statute even though a key standard for designating a firm
    involves the risk that failure of the firm generates systemic
    risk. Why isn't a firm required to submit a resolution plan as
    part of the designation process? Would a good review preclude
    designation? Perhaps. But then the adequacy of the orderly
    resolution plan is determined solely by the regulators'
    subjective judgments, so maybe the added work would not amount
    to much.
        In my written testimony, I discuss many specific examples
    where underlying imbalances of the Dodd-Frank Act lead to
    overregulation. Other specific examples of overregulation
    include designating all bank holding companies larger than $50
    billion for heightened supervision and prudential standards.
        Another example is the Board of Governors' stress test and
    the power for regulators to restrict the use of short-term
    debt.
        I have also discussed instances where the new Dodd-Frank
    Act powers will not achieve intended goals. In particular, I
    identify missed opportunities regarding duties assigned under
    the Title I orderly resolution plan process, and I also point
    out serious shortcomings in Title II orderly resolution
    authority.
        Under the FDIC's single point of entry resolution strategy,
    Title II creates new uncertainties for the resolution of large
    financial institutions, and it potentially extends the
    Government's safety net beyond the guarantees provided under
    the deposit insurance resolution system.
        Thank you, and I look forward to your questions.
        Chairman Brown. Thank you, Dr. Kupiec.
        Senator Toomey is recognized for an opening statement.
    Thank you.

                 STATEMENT OF SENATOR PATRICK J. TOOMEY

        Senator Toomey. Thank you, Chairman Brown. I want to thank
    our witnesses for joining us today. This is an important topic.
        Dodd-Frank obviously deals with the whole too-big-to-fail
    issue in a number of ways. One of the major ways is through the
    SIFI designations, which I would argue then precipitate the
    micromanagement of these financial institutions by a host of
    regulators in what will, in my view, ultimately be a futile
    attempt to make failure impossible.
        I see a lot of problems with this approach. One is that
    institutions end up being designated as SIFIs, despite the fact
    that they are not systemically dangerous to our economy.
        The second problem is that the layers of regulations impose
    real costs. There are direct costs of compliance, and then
    there are all the indirect costs of a reduction in innovation
    and dynamism that comes when regulators have the power to run
    these financial institutions like public utilities, which is
    really where we pretty much are.
        And, finally, of course, the regulators themselves, as we
    know, are not omniscient. They are not going to be perfect.
    They are not going to always get it right, and in the end,
    eventually institutions will fail anyway.
        Dodd-Frank deals with the failure itself, of course,
    through the orderly liquidation authority, the failure of a
    SIFI, and I have major, major reservations about this. Some of
    the problems that worry me is, number one, the highly
    subjective nature of this process; the extensive discretion
    that is given to the regulators in implementing it; the fact
    that there is no real option for restructuring when; in fact;
    that might be the best solution for an institution; the fact
    that creditors have no certainty because we grant discretion to
    the regulator to decide which of the various equally standing
    creditors are more equal than others; and, finally, there is an
    explicit bailout mechanism that is written into the statute in
    the orderly liquidation authority, and I thought we wanted to
    move in a direction where we would not permit taxpayers to have
    to be bailing out these institutions.
        So I will now blatantly and shamelessly plug my bill, Mr.
    Chairman, which repeals the orderly liquidation authority and
    instead makes the necessary reforms to our Bankruptcy Code so
    that in the event of the failure of a large complex financial
    institution, we would have a rules-based, transparent, credible
    way to resolve that institution without all of these problems
    that I think are inherent in the orderly liquidation authority.
    But I digress, and I appreciate your indulgence.
        The issue more at hand I think for this hearing is some of
    the problems that Dodd-Frank imposes, particularly on regional
    banks. This goes right to the issue of designations. In my
    view, there is nothing magic about a $50 billion threshold
    above which we ought to automatically assume every institution
    is systemically important and significant and dangerous. That
    threshold, of course, gives no consideration to the activity of
    the bank, the nature of the bank's activities and whether or
    not it gives rise to these risks. And then the overregulation
    that comes with the enhanced prudential standards are
    enormously problematic.
        A couple of issues that I would like to hear about today
    that concern me as they affect regional banks is the liquidity
    coverage ratio. Again, it seems to me that this rule will treat
    regional banks as though they were very large, complex,
    internationally active, money center Wall Street-type banks,
    when, in fact, the nature and activity of these regional banks
    is nothing like that of the large, complex, money center banks.
        The comprehensive capital analysis and review and the
    supervisory stress tests, another very, very onerous regulation
    that we could debate whether or not it makes sense for the
    biggest of banks. I do not see how we can defend the
    proposition that small regional banks with a simple business
    model should be subject to the same kinds of tests.
        So these would be some of the things I hope we can discuss,
    Mr. Chairman. I do oppose the overall framework of Dodd-Frank,
    but it seems to me a couple of the most egregious laws are
    subjecting financial institutions that are not, in fact,
    systemically risky to these very onerous regulations imposes a
    real cost. At the end of the day, it means credit is less
    available and less affordable for American consumers and
    businesses, and that is what is happening today that I believe
    is a direct result of Dodd-Frank. And so I am looking for ways
    to relieve that problem that we have created.
        I thank you for your indulgence.
        Chairman Brown. Thank you, Senator Toomey. Let us begin the
    questions.
        Observers note the financial system was generally able to
    absorb in 2007 and 2008 the failures of regional banks and
    thrifts. Perhaps one of the most notable was in Dr. Thomson's
    home State, Cleveland, with National City absorbed by PNC out
    of Pittsburgh, causing certain hardship in that city, in our
    State, and job loss. But the system absorbed it without great
    damage, obviously, to the stability of the system. FDIC sold a
    $307 billion Washington Mutual at no apparent loss to U.S.
    taxpayers.
        So my question to all four of you, and I will start, Dr.
    Herring, with you: What would happen today if a $250 billion or
    a $150 billion or a $50 billion systemically important bank,
    SIFI-designated bank, were to fail? Would we need a megabank
    like JPMorgan to absorb it, to rescue it? As you answer that,
    each of the four of you, talk to us about industry
    concentration, if that would be the logical outcome of more
    concentration as we saw between 2007 and 2010. Dr. Herring.
        Mr. Herring. I certainly agree that the legislation sets
    the threshold way too low. There is nothing magical about $50
    billion. I would argue that--well, if you take a look at the
    Financial Stability Board's list of global systemically
    important institutions, it contains 8 American banks out of 29
    international. And that range of eight banks ranges in size
    from JPMorgan Chase, which is about $2.4 trillion, down to
    State Street Bank, which is about $220 billion. So the current
    criteria do have a nuanced effect. They do rely on much more
    than just size. And I think it is highly unlikely that any bank
    that has a strictly regional footprint should really be
    regarded in the same rubric at all. And I quite agree that
    overregulation is a tremendous threat, that, in fact, the
    biggest growth in the banking industry over the last 3 years
    has been in the employment of compliance officers. Having some
    is good, but certainly that should not be the main thrust of
    bank growth these days.
        On the other hand, I think it is dangerous to rely on
    forced mergers that are arranged over a weekend as a way out. I
    think one of the huge mistakes that was made during the crisis
    was relying on really Government-assisted concentration in the
    system. I think we have ended up with the result where we
    started with banks that were too big to fail and ended with
    banks that are emphatically too big to fail, which is a
    terrible mistake.
        I think the resolution process should make sure that the
    bank that emerges from the resolution process is no longer too
    big to fail in any dimension. If that means breaking it up into
    smaller banks, I think that is a good thing to do. We do not
    want these institutions rattling around that can cause the
    regulators to take destructive actions in the belief that they
    are saving the system in the short run but actually undermining
    long-term discipline.
        So I have enormous sympathy with the thought that you
    should treat these smaller banks and the larger regionals quite
    differently, but I am not sympathetic to the thought we should
    merge them with the giants.
        Chairman Brown. So, Dr. Thomson, what would happen if one
    of them failed?
        Mr. Thomson. I do not think the implications of one of them
    failing other than the impact on the region itself is going to
    be that great. It is not going to send the shock through the
    financial system that taking down a very large institution
    would, because quite simply they are not as interconnected,
    they are not carrying as much of the off-balance-sheet types of
    risks that are more difficult to trace. And I think from the
    standpoint of employment in the region, the failure of a large
    regional bank is an issue, but it is not a threat to the
    national financial system. You will get some local impacts on
    credit availability, and I think the big trick here is the way
    we have always dealt with large company failures is to find a
    larger company to put them into, creating larger and larger
    companies. So we go from a financial system where the top 10 or
    15 banks had about half the assets to one where the top 4 have
    something on order of like 70 percent of the assets?
        So I agree with Dr. Herring that we need to find a way to
    do this that does not just assemble these megabanks and that
    takes into consideration that the end product will not be a
    bigger bank that is a bigger problem than what we had to begin
    with.
        Chairman Brown. Dr. DeYoung.
        Mr. DeYoung. Well, I also agree with Professor Herring that
    a blanket $50 billion threshold for SIFIs is too low. FSOC has
    the authority to declare a bank a SIFI regardless whether it is
    a larger or smaller than that. So the blanket at $50 billion is
    too low.
        You asked about concentration. I want to make clear that
    the concentration of power and influence among a smaller number
    of financial institutions is far more dangerous than any
    pricing or market power concentration that would happen. The
    banking system in the U.S. is far from concentrated in a
    pricing standpoint. We have high levels of competition.
    Concentration of large banks together is more of a question of
    whether they gain influence.
        And to your question about what would happen if a $200 or
    $300 billion bank failed, a systemically important bank failed,
    well, I am going to line up with Dodd-Frank and say that the
    FDIC would then exercise its orderly liquidation authority, if
    allowed to do so. The question is--there are two questions
    here. One is whether they are allowed to do so, and I have no
    horse in this race. I know Senator Toomey favors a rewriting of
    the bankruptcy laws to allow us to handle bank insolvencies
    that way. The issue is that we actually do it and we actually
    are able to resolve these systemically important institutions
    without disrupting financial markets. And I believe we can do
    it within the OLA authority within the Government. We can do it
    through a rewriting of the banking laws. Either way, the
    crucial thing is we actually do it and establish credibility
    that it will be done. And I have had occasion to speak with the
    folks at the FDIC a couple of times about how they would do it,
    and specifically how quickly this process would run. And I
    myself would prefer a slow process in which contracts are
    allowed to run off, the bank is allowed to stabilize. Yes, we
    have losses, but we do not race in order to find a buyer for
    that bank, that we use the word ``liquidation'' and that we
    take that word seriously, that we stabilize the bank, we
    liquidate it if possible into pieces, and not resolve that at
    the end through some kind of a large purchase and assumption
    merger.
        Chairman Brown. Thank you.
        Dr. Kupiec.
        Mr. Kupiec. Thank you very much, Chairman Brown. This is a
    very important question, and it is actually a question that is
    at the heart of the whole SIFI designation Dodd-Frank process.
        When you say would a bank of this size be systemically
    important and should it be designated, well, if it fails in
    isolation, certainly not. What happens if it fails in a real
    crisis when many banks are failing? That is the problem. And
    the problem in Dodd-Frank, Dodd-Frank is ambiguous. It does not
    say when a failure is supposed to cause systemic risk. And this
    is a real ambiguity, so you do not know how the FSOC or anybody
    else is actually evaluating the circumstances surrounding the
    failure, and that is an ambiguity that really should be taken
    care of. We need to specify under what conditions it will be a
    problem.
        I have suggested in my written testimony--I have a pretty
    lengthy part on it, on this issue, about regional banks, and I
    agree with my colleagues that a regional bank should be broken
    up, and that--if it could be broken up in a resolution, that
    means it is not systemic.
        What I think this needs to mean--and this is my reference
    to the lost opportunity under the Title I authority--is that
    when you do an orderly resolution plan and submit it to the
    FDIC and the Federal Reserve Board, the FDIC should be required
    to figure out that if that bank were to be taken into a regular
    FDIC resolution, not a Title II resolution but through the
    normal FDIC resolution process, how would the FDIC break that
    bank apart?
        Now, there are a lot of problems with breaking a bank
    apart. Historically, when the FDIC gets a big bank, it sells
    the bank in a whole-bank transaction. And there is a legal
    reason for that. Under FDICIA, the FDIC is required to resolve
    a bank in a way that is least costly to the Deposit Insurance
    Fund. And a whole-bank resolution is almost always the least
    costly way to resolve a bank. So, legally, if there is a whole-
    bank bid for a very large bid, under current law if it is an
    FDIC resolution, an FDI Act resolution, the FDIC does not have
    a choice. They cannot take the bank into a bridge bank and take
    all the time to break it apart if it will cost more. And it
    almost certainly will cost more. But the time taken to bridge a
    bank in the resolution process and break it apart is the price
    we have to pay to reduce systemic risk. But to do that, you do
    not need Title II. You just need to use Title I, the plan, the
    planning part, and change the law so that the FDIC is required
    to break large banks up when it resolves them.
        In that case, there would be no reason to treat--in my
    opinion, at least most of the things that we would call
    regional banks now, $250 billion or less that mostly do
    commercial banking in a region, most of those do not have any
    business being designated at all.
        Now, again, if all of them are in trouble at the same time,
    we have a problem. You cannot--unless you are willing to let
    the FDIC bridge all these banks and run them until they can
    sell them. And even under Title II we have a problem because
    you have still got the FDIC bridging banks and breaking them
    apart.
        So the problem is not really solved in the context of a
    true financial crisis when there is a problem and lots of banks
    get in trouble at once.
        So I think there is still a lot to work on here. I think
    that is when contingent capital--although it is not a
    resolution, it is a reorganization, but contingent capital has
    a lot more promise in a systemic crisis when many large
    institutions would be in danger of a Title I or a Title II or
    direct Government guarantee.
        So I could speak more about the Title II and why the bank--
    why the FDIC needs to take over the holding company. There is
    the whole case of NexBank in 2002 that was a horrible
    resolution experience for them. I am happy to talk about that
    at length, but I think I should stop now.
        Chairman Brown. Thank you, Dr. Kupiec.
        Senator Toomey.
        Senator Toomey. Thanks, Mr. Chairman.
        A quick follow-up on some of the points that Dr. DeYoung
    made, which I thought were some thoughtful and interesting
    points on managing a resolution through Title II. But it
    strikes me that parts of Title II are problematic in the way
    they are written, problematic in doing a slow process. It seems
    that Title II is effectively mostly an execution order. The
    bank gets executed. I mean, that is the purpose as a practical
    matter. Management has to be all fired regardless of which
    managers are actually at fault. That does not distinguish--and,
    frankly, I would really seriously question the competence of
    the FDIC to run JPMorgan Chase or to run Lehman Brothers. The
    FDIC is competent at rolling up small banks over a weekend.
    There is no question about that. But running a $2 trillion
    multinational that is enormously complex, I really rather doubt
    it. But this is probably a better topic for a different time,
    if we could.
        I want to go back to observing a very interesting agreement
    that I discerned, I think, which is I think every single
    panelist here said that it does not make sense to have an
    automatic SIFI designation at $50 billion by virtue of that
    criteria alone. That is an important agreement because, of
    course, the law does exactly that.
        So I share that view, but rather than trying to guess what
    the right number is, because, frankly, I do not think $75
    billion is the right number either, I wonder if each of you
    would comment briefly on whether we should have qualitative
    criteria instead of an arbitrary dollar value of assets, things
    like funding sources, capitalization, liquidity, the
    composition of assets, other criteria that we might use rather
    than pick some other arbitrary number above which we would
    designate everybody for this very expensive, in my view,
    overregulation. Dr. Herring, if you would begin.
        Mr. Herring. Yes, I think that the international agreement
    on identifying global systemically important institutions
    actually does speak to your point. They do have five
    quantitative indicators, but there is a clear role for a
    judgmental override that must be clearly stated. And that is
    how, in fact, we get some smaller banks, and some of the bigger
    banks that actually do not have systemic implications are not
    included.
        Senator Toomey. Could I just suggest, adding a subjective
    element would be one way to get away from a numerical hard and
    fast----
        Mr. Herring. A judgmental, a qualitative----
        Senator Toomey. Right. But we could also have other
    quantitative measures.
        Mr. Herring. You could.
        Senator Toomey. Like liquidity and capitalization and off-
    balance-sheet----
        Mr. Herring. Those are included.
        Senator Toomey. ----activity here they may or not be
    subjective. They could be fairly----
        Mr. Herring. No, those are all included in the quantitative
    indicators. Each of those----
        Senator Toomey. Not under Dodd-Frank, right?
        Mr. Herring. Not under Dodd-Frank, but under the FSB, which
    I think had the benefit of coming after Dodd-Frank.
        Senator Toomey. Right.
        Mr. Herring. And, frankly, did a more sophisticated job of
    looking at this question. Congress did this in an immense rush,
    and I do not think it was a very thoughtful solution.
        I would also add that I share your interest in having sort
    of better procedural clarity, and I think better bankruptcy
    laws could be helpful. I would commend the work of the Hoover
    Stanford group. I must confess that I played a minor role in
    it, but it has just been published, a Chapter 14 proposal, that
    would, in fact, amend the Bankruptcy Act to deal with
    financial----
        Senator Toomey. I would just point--their work very
    significantly informed my judgment as we developed our
    legislation.
        Dr. Thomson.
        Mr. Thomson. I do not think that having a hard and fast
    number, a bright-line rule in legislation like the $50 billion
    or $250 billion, is useful for making the designation. Now, it
    may be useful to have a rule where you automatically review a
    company for that designation, but not designate them until you
    look at the number of factors, liquidity, their
    interconnectedness, their importance in a particular financial
    market, and if somebody clears 40 percent of the derivative
    contracts of a certain type, that should probably go into your
    consideration as to whether or not they are systemically
    important or not.
        So I think having some benchmark but being just a guideline
    we will automatically review for this would be the way to go,
    but then to dig deeper and understand what are the very things
    that are going to prevent us from either in isolation as a
    single institution or as a group of institutions take them
    down, which is part of the reason why I mentioned in my
    remarks, we should be developing these contingency plans by the
    regulatory agencies on how would we actually take these
    institutions down.
        Now, the living wills that are in Dodd-Frank is a piece of
    the information of how do we go about that. When we develop
    these plans, that would tell us where the pressure points in
    the system are, ones we need to address in identifying which
    institutions are the problem.
        Senator Toomey. But what I understood you to say is that
    you agree with the premise that the actual activities of the
    bank ought to be given more weight than an arbitrary dollar
    value of assets?
        Mr. Thomson. Yes, any threshold set using the dollar value
    of assets is inherently arbitrary, my work shows size is not
    the determining factor. It is the activities themselves. And it
    just turns out that really large banks tend to be in all the
    activities that leads us to consider them systemically
    important.
        Senator Toomey. All right. Thank you.
        Dr. DeYoung.
        Mr. DeYoung. Yes, you have put your finger on one of the
    potential weaknesses of orderly liquidation authority, and that
    is, who will run these institutions after we excuse the board
    and the top management?
        A couple of things. One is, of course, at that point the
    bank will be run in a very different way with a very different
    objective function. The objective will be not to grow the bank,
    not to look for risk opportunities, not to look for growth
    opportunities, but to service the customers, to allow financial
    contracts to run their course, and to stabilize the finances of
    the bank. So the challenges are a little bit different. We
    would need to know where all the bodies are buried, of course,
    and hopefully the orderly--the living will would do that. But
    it may not be as big a challenge as one would think. This does
    speak to the concept, to the question of credibility. This is
    all part of what we will find out when we allow the FDIC or a
    bankruptcy court under a different set of rules to resolve one
    of these large banks in a slow and thoughtful way. Credibility
    has to be established, and as we do that, of course, we will
    make mistakes. But, you know, the first time we go through
    this, it is not going to be perfect. Losses do have to be taken
    somewhere.
        Senator Toomey. Dr. Kupiec.
        Mr. Kupiec. Yes, thanks. I think this whole thing is a
    fundamental problem because systemic risk is not really a very
    well developed science. It really became popular, a popular
    thing to talk about, to write papers about, after the crisis.
    The economics and the science really are not sound and there
    yet. Of course, we all know we think systemic risk exists
    because we saw the crisis.
        Now, in terms of size alone as a cutoff, I agree with you
    that any arbitrary size is--there is no science that supports a
    $50 billion--I have that in my testimony, I agree. It doesn't
    support any number. But if the pure economics of it is,
    especially in the case of a bank, size is related to the damage
    it would cause to the economy if you were to lock it up and
    shut it down and freeze everybody that uses that bank for
    financial intermediation.
        Now, the reason we do not see size mattering in modern
    times is because we already had in place mechanisms to prevent
    the bank intermediation function from getting locked up. The
    FDIC stepped in, and it sold the bank to another bank. And so
    there was a small disruption and some problems there. But more
    or less the economics smoothed out because the FDIC had already
    stepped in.
        Back in the 1930s, when you did not have that process, it
    was a really bad time. You lost access to credit, financial
    intermediation, deposits got locked up. It was really bad for
    the economy.
        So the reason we do not see large bank failures per se
    having an effect on the economy is largely because we had
    things in place for a long time that helped fix that. So size
    clearly does matter for systemic risk, pure and simple, but we
    have things that can handle the systemic risk associated with
    many of these things. It is only when you get to the very large
    banks that either the things we have in place now make bigger
    banks--that is the way we fix it, we put a failing big bank
    into another big bank, and we create another bigger bank. You
    can only play that game for so long, and we are kind of at the
    end of that route. Or we do something else.
        And this breaking apart of the bank--and I am on board with
    Bob in that, but I do not think you run the bank's business
    down. I think you have to run it as a bank, but you have to
    split it up and sell it, because if the bank really does have
    important functions and you really take over that bank and you
    say, OK, now we are in lockdown mode, all these things have to
    stop, you have to stop lending, it is just run off contracts,
    but then you are going to impose financial losses.
        So I think you have to run the bank, but you have to plan
    to break it up in the resolution process if you get there. And
    I think that should be through Title I and deposit insurance.
    The holding company issues I think should be solved through the
    Title I process, and I think about it that way. But I think
    there is a tradeoff here, and we do know from history that, you
    know, just holding onto the bank and running it down, you know,
    is not going to be as smooth as a whole-bank resolution has
    been in the past.
        Thanks.
        Chairman Brown. Senator Warren.
        Senator Warren. Thank you, Mr. Chairman. Thank you all for
    being here.
        I want to focus on another part about SIFIs. Last week, the
    new Vice Chair of the Fed, Stanley Fischer, spoke about the
    Fed's role in financial reform, and he made some claims about
    the too-big-to-fail problem that I would like to be able to get
    your comments on, and I am just going to kind of break it apart
    into the different claims he made.
        His first claim was that the evidence was basically mixed
    on whether bigger banks take on more risk than their smaller
    counterparts. And I find that hard to believe, particularly for
    banks in the United States.
        Professor DeYoung, you have noted that four out of ten of
    the biggest U.S. banks in 2008 either failed or had to be
    bailed out. That is a 40-percent failure rate. By contrast,
    only 6 percent of smaller banks failed during the crisis.
        So, Dr. DeYoung, given those data, is it fair to conclude
    that bigger banks, say those over $500 billion in assets, tend
    to take on more risk than their community bank and regional
    bank counterparts?
        Mr. DeYoung. Well, thank you for reading my research, or
    thank you to your staff for reading my research. I appreciate
    that.
        I think it is unquestionably true that, on average, larger
    banks are involved in riskier activities. And in the end, at
    least over the most recent distress we have gone through, they
    are failing in larger proportions, and I think you have to be
    blind to conclude otherwise.
        Senator Warren. OK. Good. We have got a point one.
        Mr. DeYoung. That is point one.
        Point two, though--point two, though, is have we done
    things to--is it size alone that is causing these banks to take
    more risk?
        Senator Warren. Well, we are going to come there.
        Mr. DeYoung. Yes.
        Senator Warren. We are going to come there; I promise.
        Mr. DeYoung. Very good. OK.
        Senator Warren. OK? Because we are just going to do these,
    though, by pieces because I want to make sure I am getting
    them.
        Mr. DeYoung. Very good. I am going to hold you on that.
        Senator Warren. All right.
        Mr. DeYoung. OK.
        Senator Warren. The second one is about the question about
    economies of scale for big financial institutions.
        Vice Chair Fischer addressed the economies of scale, saying
    whether or not banks become more efficient and reduce their
    marginal costs as they grow bigger, and he pointed to recent
    studies that say that such economies of scale exist even for
    the largest banks.
        So I am a little skeptical on the point, but I want to open
    it up to the panel. Does JPMorgan, for example, really become
    more efficient when it grows from $2.4 trillion to $2.5
    trillion, or we will do an even bigger leap, when it grows from
    $1.5 trillion to $2.5 trillion?
        And I will just go down the list here. Dr. Herring.
        Mr. Herring. I think that is--oh, excuse me, I think that
    is a very difficult issue.
        All the evidence until very, very recently has indicated
    that economies of scale peter out at a level well below the
    $250 billion mark. And, in fact, if you look at banks of any
    given scale, the difference in efficiency between the most
    efficient bank and the least efficient bank is much, much
    greater than anything you could get out of scale and scope.
        There has been some very recent research actually done by
    the new President of the Cleveland Fed that suggests otherwise.
        What concerns me about this is that I do not feel
    comfortable that it has taken into account the too-big-to-fail
    advantages, nor do I think that it has taken into account the
    obvious diseconomies of management. It is very, very difficult
    to manage one of these institutions. It is humanly impossible
    to understand everything that is going on. And I think there is
    a limit to our ability to actually exercise effective control
    over such huge, complicated institutions.
        That really needs to be taken serious.
        Senator Warren. OK. Good.
        Dr. Thomson, did you want to add anything to that?
        Mr. Thomson. Yes. Along with the funding advantages that
    these institutions enjoy because, obviously, you do not have to
    pay as much for liabilities if people credibly believe that you
    will never be closed and have losses imposed on them.
        There are all sorts of activities where massive size gives
    these banks an advantage over smaller ones. And I think that
    these advantages show up as cost efficiencies in studies of
    scale and scope economies in banks, where in fact, it is an
    artificial efficiency.
        If you look at some of the things like lines of credit,
    standby letters of credit and all these sorts of things,
    customers take those from banks they think who can perform on
    them.
        If you are a bank that is considered too big to fail, you
    are considered somebody who is a good credit, who will be able
    to perform on that contract going forward.
        And, I think this aspect of systemic advantage is why
    studies pick up cost efficiencies in the largest institutions.
        I do not believe in the credibility of economies of scale
    literature that find cost efficiencies above the $250 billion
    mark.
        Senator Warren. OK. Anything you want to add to that, Dr.
    DeYoung, on the efficiency point.
        Mr. DeYoung. Yeah, on the efficiency part.
        Senator Warren. I promise we are coming to the third one.
        Mr. DeYoung. On the efficiency, yeah, scale economies. We
    do not have any idea whether there are scale economies of large
    banks.
        I published--I am editor of the Journal of Money, Credit
    and Banking. Two of the most recent three important scale
    economy studies have been published in my journal. The most
    recent--and all three of those--all three of these important
    studies find different results. All right.
        So we do not know. No disparagements toward the
    researchers; these are incredibly different things to be trying
    to estimate.
        I will point out that the most recent of the three papers
    does adjust, or attempts to adjust for, the financial
    advantages that too-big-to-fail banks have, as James has
    mentioned.
        Senator Warren. Yes.
        Mr. DeYoung. Puts those into the cost functions that they
    are estimating. And when they control for the too-big-to-fail
    advantage, the scale economies go away.
        So this is one out of three studies. We cannot draw any
    firm conclusions on this, but it does suggest that--and this is
    to the point earlier--large banks are more risky; however, they
    have lower costs of financing due to too-big-to-fail, and this
    gives them a different set of profitable opportunities to
    chase.
        Senator Warren. So I will tell you what; instead of asking
    the same question a fourth time, what I will do is I will now
    cut to the one that intersects the pieces.
        And that is so we have the problem of the increased
    riskiness of the largest financial institutions, no evidence
    that they are more efficient, some evidence that what they are
    doing is taking advantage of the benefits of too-big-to-fail.
        I want to hit the very last part of this, and that is the
    intersection of size with risk with cost.
        And, that is if two banks have an equal chance of failure--
    let's set it up that way--is there anyone who thinks that the
    failure of a $2.5 trillion bank poses a smaller risk to the
    economy than the failure of a bank that is half that size or a
    quarter that size?
        I want to see the intersection here.
        Why don't I start with you, Dr. Kupiec, and we will come
    back down the other direction.
        Mr. Kupiec. No, I clearly think that size does create
    bigger spillover effects, and at the very largest institutions
    it would be a bad thing if one of those institutions fails.
    There is no--I think there is no doubt about that. Even under
    the best Title II Dodd-Frank thing we could come up with, it
    still would not be pretty.
        But where this kicks in, in the size range, is, I think, a
    pretty difficult question to know. So, if a $250 billion bank
    is 10 times smaller and not doing the same activities as
    JPMorgan Chase, a $100 billion bank is not doing anything like
    that probably.
        So, I mean, there is a big range here, and I think, for
    sure, the systemic risk is related to size. I have published
    papers that show that, using historical data from 1900s, before
    we had any safety nets. It is pretty clear that if you have a
    lot of little banks fail, you have got a problem. You have one
    big bank failing; you have got a problem if the little banks
    fail at the same time.
        But where this line crosses, I cannot pick a number.
        Senator Warren. OK, cannot pick a number, but we are sure
    that the end is somehow different here--the furthest point out
    on it.
        Mr. Kupiec. I would agree with that.
        Senator Warren. Dr. DeYoung.
        Mr. DeYoung. Yes, I agree with Paul; there is no way we can
    draw a brightline.
        I will point out that some of these large banks were using
    the same business models as the large banks that became
    insolvent and came through the crisis with flying colors. In
    fact, some of them came through so well that we asked them to
    buy some of the large failed banks.
        I would not draw any lessons and apply them to all banks.
    The best of all cases is we remove the too-big-to-fail
    subsidies and then let the market determine which bankers are
    good, smart bankers and which bankers are not.
        Senator Warren. Dr. Thomson.
        Mr. Thomson. Yes. I am in agreement with my two colleagues.
        An element of this is not only would a large institution
    have a much bigger impact because it is just going to affect so
    many more markets and so many more activities, but there is
    also the aspect of anticipation.
        We can imagine a $250 billion bank being taken down and
    failed. We cannot imagine this happening to a $2.4 trillion
    institution. And the expectations of what is going to happen
    and how that will be handled is important. If the failure is
    handled differently than the market expects it to be handled,
    as we saw with Lehman Brothers, that is going to create the
    dislocation.
        Senator Warren. Good point.
        Dr. Herring.
        Mr. Herring. I agree with all three of the panelists.
        Let me make one additional point about economics of scale,
    and that is that there are elements that clearly do have
    economies of scale. If technology is involved, we know that
    running larger batches of things is going to give you lower
    cost.
        And what we need to figure out is a way for the whole
    industry to participate in those economies of scale rather than
    concentrating them in a single institution and tying up a
    systemically important function with the fate of one
    institution.
        The other issue that is giving rise to economies of scale
    that is very worrisome about the current regulatory system is
    that the fixed costs of running a bank--having the systems in
    place, having compliance officers in place--is becoming a very
    large barrier to entry, and it is something that actually will
    make it more efficient to be larger.
        Senator Warren. Oh, yes, and again, talking about where we
    are on that continuum.
        Mr. Herring. Yeah.
        Senator Warren. But it is a very good point, Dr. Herring.
        So, thank you. I appreciate it.
        I think we have agreement that size matters, that it would
    not be smart just to limit the size of banks and sit back and
    say we have solved every problem, but that the combination of
    adding risk, of banks that are more complex, that there is a
    greater impact if they do fail--and I would add that they have
    more political power and that permits them to pull in
    additional subsidies--all matter, and that happens because they
    get big.
        So we cannot win the battle against too-big-to-fail just by
    attempting to make banks safer. I think the battle for a safer
    banking system is also a battle over size.
        Thank you.
        Thank you, Mr. Chairman.
        Chairman Brown. Thank you, Senator Warren.
        Dr. DeYoung, I think before you were able to get here
    Senator Warren spoke about the advantage of size, that
    competition is not so much price and the failure of the market
    there or the advantages they have, but the advantages in
    political power that you spoke of. And I think that was good
    insight.
        I found your answers to the economies of scale issue pretty
    interesting, that Senator Warren brought up, even in contrast
    with the study, as one of you pointed out, by the new Cleveland
    Fed President. And I think your comments were pretty
    compelling.
        I want to ask Dr. Thomson one question about that and then
    shift to something else.
        You mentioned you are all familiar with IMF and Bloomberg
    and the estimates of 60-80 basis point advantage on the capital
    markets--$80 billion. You all, of course, are familiar with
    those studies and those contentions.
        But, Dr. Thomson, you said it is much more, though, the
    advantages they have because of size are greater than just the
    capital market cost of capital. Could you expand on those for a
    couple of minutes?
        Mr. Thomson. Yes. I mean----
        Chairman Brown. Delineate as much as you can on that.
        Mr. Thomson. Yeah. So Dr. Herring mentioned one thing;
    compliance is much easier for large firms. If you have to add 1
    person to a staff of 50, that is a much smaller cost than
    adding 1 person to a staff of 2.
        There are a lot of contracts where the perception of being
    too big to fail gives a bank a competitive advantage.
        There was some research that was done in the late 80s early
    90s looking at whether loans made through lines of credit or
    loans extended through standby letters of credit or other types
    of guarantees, whether they were riskier or not. And what they
    were finding is they were not.
        And what some of the research was finding was, in fact,
    that safer banks were the ones who were writing these types of
    contracts, they were the ones doing the business, and that this
    was a form of market discipline on them because customers do
    not buy contracts that require performance by somebody if they
    do not think you can perform.
        Well, if you are too big to fail, if you are thought of as
    somebody who will never be closed, then I will feel safer
    entering into a contract with you than somebody else who I
    think there is a chance that next year when I need that credit
    that they will not be there to perform.
        And so it is these types of aspects that are within the
    businesses of these institutions that give them an advantage
    that you will not pick up by just looking at a funding cost,
    but it gives them a fundamental advantage in the business
    because they have--they are competing with--a guarantee that
    other people do not have.
        Chairman Brown. And you think customers--is there evidence
    in studies that customers sense that, know that and act upon
    that?
        Mr. Herring. Yes. There are, in fact, services that advise
    corporations on banks they should establish a relationship with
    because those banks are more likely to be able to perform on
    the contracts. It is a very good point.
        Chairman Brown. Good. Well said. Thank you.
        A housekeeping issue, I ask unanimous consent the following
    two documents be included in the record--a letter from the
    Clearing House Association, a statement from the Special
    Inspector General for the Troubled Asset Relief Program,
    SIGTARP.
        Without objection, we will enter that in the record.
        In a statement just submitted to the record--and this is a
    question I want to ask all of you--the Special Inspector
    General for TARP says that nine institutions that were given
    capital injections. The four largest banks, three large
    investment banks and two custodial banks ``were chosen for
    their 'perceived' importance to the markets in the greater
    financial system.''
        The Government conducted stress tests after TARP but also
    announced that FDIC would guarantee the debt of all banks with
    at least $100 billion in assets.
        And, according to the GAO, the Government offered banks
    with $50 billion or more financial support of around 10 to 11
    percent of their assets; for banks with between $10 and $50
    billion, the support percentage was about half of that amount.
        So, two questions for each of you, and I will start with
    you, Mr. Kupiec:
        Why were these decisions made in 2007 and '08; what do you
    think?
        And how important are market perceptions, and what does the
    market expect today?
        Mr. Kupiec. Well, the TARP decisions were clearly made in a
    crisis mode, and they wanted to ensure or inject confident in
    the public on the largest institutions.
        When it came to picking and choosing among the smaller
    institutions who got money in TARP, there was an application
    process. It went through review.
        I am not particularly--I was not privileged to be involved
    in those discussions. So I do not know exactly, you know, why
    they got less money, but certainly the headline institutions
    were the first to take; they were taken care of.
        Chairman Brown. So, Dr. DeYoung, how important are market
    perceptions, and what does the market expect today?
        Mr. DeYoung. Well, for the smaller banks, market
    perceptions are pretty much moot. There were many, many small
    banks who are not publicly traded that received TARP.
        And the market perceptions--I mean, you are talking about
    financial markets, correct? This is your question?
        Chairman Brown. Yes.
        Mr. DeYoung. Yes, financial markets are not important
    there.
        I would say as long as the subsidies here were done in a
    transparent fashion there would be no uncertainty to investors,
    and therefore, I think that the pricing of the risk of these
    firms would be very efficient.
        The minute these subsidies start to go--start to happen
    with some lack of transparency, then I think market perception
    becomes very important because then if there is any risk, any
    uncertainty, about whether a bank is being supported or not
    supported or the degree of their support I think the markets
    will discount the price or increase the risk of those
    institutions.
        So I think your question depends on how transparent the
    process was, and with TARP it seems to have been relatively
    transparent.
        Chairman Brown. Dr. Thomson.
        Mr. Thomson. All right, so one comment on the TARP at the
    large side. Institutions at the top end, of course, were not
    given a choice. They were going to take the TARP money although
    we know two of them decided that they needed extra TARP money
    in the process. Again, that application process for the smaller
    institutions was a bit different.
        I think whenever you, during a crisis period, signal that
    you are going to stand behind institutions without setting any
    type of thing in place that says this is it, this is the only
    time, you condition market expectations for those types of
    bailouts to become forthcoming the next time.
        And this is a self-reinforcing process. The more markets
    believe, the greater the potential dislocation and the more you
    are going to tie the hands of the bank regulators and Congress
    to provide the subsidies to these institutions until you can
    put in place something credible that says, going forward, this
    is what is going to happen. And then you have to be able to
    follow up and do it when that happens.
        Otherwise, you are just going to perpetuate the very same
    sorts of risk-taking through the subsidies that is going to
    drive the next crisis.
        Chairman Brown. Dr. Herring.
        Mr. Herring. I very much agree with those points.
        I think that the TARP episode is exactly what Dodd-Frank is
    trying to prevent and it is a very important point of market
    expectations.
        I think probably the best example of that was the bailout
    of Bear Stearns which, unquestionably, made the Lehman Brothers
    crisis much greater. The markets expected that if Bear Stearns
    received a subsidy and it was half as complex, half as large as
    Lehman Brothers, Lehman Brothers surely would.
        And when markets are disappointed in something that they
    have come to believe because of the behavior of officials over
    time, they react very badly. When people think the rules of the
    game have changed, they rush for quality. We saw that in
    markets with pressure bills from one point even going negative.
    And they tend to sit on the sidelines until they think they
    know the rules of the game again.
        That means that if we want a new regime to work, we have
    got to be very consistent in applying it. Sadly, that probably
    means that we need a crisis of just the right size, something
    that will show these tools work, whether they be bankruptcy or
    the Title II authority, and work effectively so that people
    will have confidence that we have a new regime in place.
        But I think, until then, there are going to be very
    troublesome questions about whether we, in fact, have the
    ability to do what we say we are going to do.
        And the willingness, I think, has been a good point made
    before, too.
        Chairman Brown. Thank you.
        Talk about FSOC and ask for your thoughts and
    recommendations about what they might consider.
        Dodd-Frank authorized FSOC to make recommendations to the
    Fed regarding enhanced prudential standards and adjusting the
    applicability of those standards to different kinds and
    different sizes of institutions.
        FSOC, for example, may set an asset threshold that is
    higher than $50 billion for the applicability of certain
    enhanced prudential standards under Section 165, such as
    resolution plans or concentration limits.
        Should FSOC do that?
        What would you recommend that FSOC do in making those
    judgments, Dr. Herring?
        Mr. Herring. I think this question is very much parallel to
    the question of identifying SIFIs. Just as we have said that
    size is not a magic number for a SIFI designation, I think it
    surely should have enhanced supervision as well.
        That, of course, takes you into some uncomfortable
    judgmental grounds because you need multiple kinds of
    indicators and you probably need some sort of judgment overlay.
    It should be transparent, but I think it would be a mistake to
    base it on size alone.
        Chairman Brown. Dr. Thomson.
        Mr. Thomson. Yes, I concur. I think we----
        Chairman Brown. We have kind of established that for all
    four of you on size.
        So, speak elsewhere, what else that they should have. What
    else they should consider as they make suggestions, make
    statements, make rules?
        Mr. Thomson. Well, I think one of the things that we need
    is more information transparency, more granularity of
    information. One of the big things we see is concerns about
    transmission over payment systems or through common asset
    holdings or through derivatives markets.
        We are starting to get more information collected on this.
    Some of it is an outgrowth or direct result of Dodd-Frank.
        We do not collect all of the information we need,
    particularly for the institutions we think are systemically
    important. We do not collect the types of information at the
    level of detail--collecting such information from large
    institutions would not pose an undue burden on them, while it
    would for a small one--that would allow us to really see what
    these connections are.
        Now, in Europe, we do see this information being collected,
    and we see this information being used to understand what the
    connections are, what the pressure points are and what the
    danger points are.
        And I think until we start putting more information in
    place the process for labeling financial firms as systemic is
    going to be more judgmental than what I would be comfortable
    with.
        Chairman Brown. Dr. DeYoung, thoughts?
        Mr. DeYoung. I will pass on this question. I will let Paul
    go.
        Chairman Brown. OK, Dr. Kupiec.
        Mr. Kupiec. The FSOC--it sounds like a good idea, and the
    section gives the FSOC the power to sort of designate a
    different set of criteria. But in the end the FSOC is not very
    transparent, and it is all judgment-based.
        And the FSOC is dominated by bank regulators, by far and
    away, and it is not clear to me that the bank regulators would
    want to give up some of the smaller banks.
        I think they very much like, according to Governor
    Tarullo's speeches, their stress-testing approach. They want to
    replace the capital requirements, in fact. Governor Tarullo is
    on record of saying he would like to replace Basel with stress
    test as the primary, and it is the primary tool right now in
    which the Fed determines capital.
        But the whole system of designation by the FSOC--because
    there is really no hard and fast science about systemic risk,
    when does the failure of a firm cause financial instability?
        Is it if it fails by itself in isolation during good times
    or if it fails by itself in isolation during not so good times,
    or is it when it fails with other firms at the same time and
    times are not good?
        These are all different circumstances, and the law in no
    way speaks to what the situation needs to be for the FSOC to
    consider. It is very vague and ambiguous, and it is entirely
    then left up to the judgment of the FSOC.
        So I do agree that a $50 billion automatic designation for
    bank holding companies is way too low.
        I also agree that I do not know the right number that that
    should be raised to, but I do not think turning it all over to
    the judgment of the FSOC, the way it operates today and without
    any real constraints and transparency, is something that I
    would recommend.
        Once the FSOC determines that a company is systemically
    important, how does it get out of that?
        It does not tell you when it designates it. The insurance
    companies that have been designated do not have a list of
    things they have to do to become undesignated.
        There are property rights involved. When you are
    designated, all of a sudden you have to satisfy a whole bunch
    of rules. This slams profitability and shareholders, and pretty
    soon you have got Fed regulators crawling over you, you know,
    once a year. And you are an insurance company. You never had
    this before.
        There are real issues associated with this decision, and
    yet, the firm that is getting evaluated does not have a whole
    lot of say.
        They do not, for example, have to file an orderly Title I
    resolution plan to the FSOC before they get designated, where
    one of the criteria for designation is the fact that if they
    were to fail in bankruptcy it would cause a problem. Well, you
    do not even give them the right to file that report.
        There is none of that that has been done in any of the
    designations.
        So, right now, until we really tune up the FSOC designation
    process, and put some structure on it and some controls on it,
    I feel very uncomfortable in recommending that they get any
    additional powers, frankly.
        Chairman Brown. OK, understanding. Thank you.
        Dr. Kupiec, understanding your reluctance, your concern
    about empowering FSOC further, I want you--I want all of you--
    to be more specific about sort of where we go.
        And this panel has all said making this determination based
    on size alone, especially the size being $50 billion, does not
    make sense. It is costly. It is onerous. It is a burden on
    these banks that should not be there just by that criterion
    alone. I understand that.
        We know a number of things.
        We know banks above $50 billion have a whole different--as
    I mentioned in my opening statement, and Senator Toomey, and a
    number of us have, that banks above $50 billion have a whole
    different range of business models, some way less risky than
    others.
        We know that banks with less than $100 billion, on average,
    hold just 6 percent of the assets of all the banks over that
    are SIFI-designated.
        We know that the large--that the banks above $100 billion
    average less than 1 percent of the largest banks' over-the-
    counter derivatives.
        They engage in just 1 percent of repo and security lending.
        So we can see where the risk mostly is concentrated. It is,
    obviously, not in the smaller banks.
        So my question--a series of questions on this:
        Should regulators focus on particular business models or
    activities?
        Should regulators think about physical commodities?
        We did a couple of hearings in this Subcommittee on banks'
    ownership of everything from oil tankers to aluminum and
    electricity generation. Should contending--I think the
    conclusions in these hearings were, one, big banks have an
    advantage that in the real economy is perhaps unfair and that
    it brings more risk to the financial system, their involvement
    that way in the real economy, all those issues.
        So, be as specific as you can, and I will start with you,
    Dr. Kupiec. And I think this probably will be the last
    question.
        Mr. Kupiec. OK.
        Chairman Brown. And one more thing, how specific you can be
    on what kinds of determinants we should make, we should use,
    whether it is FSOC or somebody else, as regulators.
        Mr. Kupiec. Looking at the practical side of things, that
    probably nobody is willing to open up Dodd-Frank very broadly
    at least and you want to make a few adjustments around the
    edges to make it better, if I had to propose something, I
    suppose I would still use a dollar cutoff as the simplest
    thing.
        I would look--looking at the list of holding companies and
    recognizing what I think they do--and I have not analyzed every
    one of them in detail--the cutoff would be somewhere between
    today, to allow for growth, maybe $250 billion.
        And I would add some requirements that they not be involved
    in any critical specialized activity, perhaps like, you know,
    asset custody--be a big asset custody manager or have too big a
    capital markets operation.
        I do not think that is perfect, and I do not--and it is
    certainly not right in any scientific way. But if I had to come
    up with a specific solution, based on what I know today, I
    would not turn it over to a subjective assessment to the FSOC,
    bank by bank. I think there is no control there.
        I would think, second best, I would be forced to stick with
    a dollar number and a few caveat criteria, and it would look
    something like that, I think.
        Chairman Brown. Dr. DeYoung.
        Mr. DeYoung. Yeah, none of us are willing to commit to a
    number. I guess Paul came pretty close there.
        Chairman Brown. I would say he did.
        Mr. DeYoung. He got pretty close. He actually said an
    integer.
        Business models are important. You do not want to name a
    business model, but I will point to two places we should be
    looking.
        Traditional banks originate and hold--originate loans and
    hold them. They do the financing of the loan. They underwrite
    the credit risk of the loan, and they bear the risk from the
    loan.
        Other banks have a business model in which they originate
    the sell, they make some fees, and they get rid of the risk.
    They do not do any financing. And although they have
    underwritten the loan, you are not sure about how they have
    basically handed over the bond raters to tell investors how
    risky these credits are.
        Most banks do a mixture of these two types of underwriting
    and financing. So that is one dimension.
        Unfortunately, you would have to draw a line someplace--
    what percentage of your activities originate in hold; what
    percentage originate in sell? But the more originate and sell
    the bank does, the more systemic risk this is generating within
    the economy.
        The other place to look is whether the bank is funding
    itself with deposits or funding itself with market finance.
        And you know market finance. If you go down the list of
    firms that we look at as being particularly systemically
    crucial to what happened in the crisis, they all were funding
    their long-term assets with short-term market finance. So that
    would be the other place to look.
        Now these are functions. These are not necessarily business
    models, but this is where I would look.
        Chairman Brown. Fair enough.
        Dr. Thomson, before you answer this, you had said in, I
    believe, your opening testimony, maybe it was in response to a
    question, that we should--you acknowledge that $50 billion is
    probably too low a number, but you said perhaps if it is $50
    billion and up you automatically review their other activities.
        But if I heard you right, $50 billion would sort of be the
    trigger. Let's review the activities of every bank over $50
    billion, not designate them SIFI--I am reading a bit into what
    you said--perhaps not designate them as SIFI unless they have
    other high-risk activities or high-risk activities.
        Is that--do you want to----
        Mr. Thomson. Yes however, I do not think $50 billion is the
    right number. I would go higher, somewhere on the order of $250
    billion for an automatic review, with the proviso that there
    are institutions that are under $250 billion we may also want
    to look at because of the nature of their activities.
        But I think that setting a threshold for where you look and
    then apply some judgment is the answer--maybe that is where
    FSOC gets involved.
        Chairman Brown. So set a lower threshold, 50 or 100 for
    automatic review, but then look for the other, but at 250 it is
    automatic designation.
        Mr. Thomson. No, I would set a higher threshold, and I
    would set the higher threshold and have automatic review for
    designation above that dollar amount with, on a case-by-case
    basis, review of institutions below that dollar amount and
    maybe have a second threshold below which you just do not
    really look because I think there is little risk those
    institutions below a certain size are engaged in the activities
    that get larger institutions reviewed.
        In your opening remarks, you talked about the traditional
    regional banks that are in Ohio, Pennsylvania, Illinois, and
    Indiana that do a very sort of classic, what you might call a
    Glass-Steagall type banking business. They lend. They provide
    trust services for customers. They raise most of their funding
    through their retail branch networks.
        And that is a very, very different type of business than
    someone who is doing proprietary trading or a lot of trade on
    behalf of customers.
        I think if you want to point to activities associated with
    systemic importance, I would look at activities that go beyond
    what we think of this traditional retail-focused banking model.
        Chairman Brown. Thank you.
        Dr. Herring.
        Mr. Herring. I do think that this analysis should be very
    congruent with the analysis for designation of SIFIs.
        And I think the Financial Stability Board has actually
    developed a reasonable analytical approach that weights size.
    It weights interconnectedness, which would include involvement
    in capital markets activities and commodities. It evaluates
    cross-border activity, complexity, the lack of substitutes for
    the services the firm funds and liquidity profile.
        And all of these things are weighted. One can argue about
    the subjectivity of the weights, but it gives you something to
    start from.
        Then I think if you are going to apply judgment, it should
    be very transparent. If you pick somebody up that is lower on
    this list and put it in, you should be very explicit about why
    you are doing it. If somebody on that list at a higher order is
    taken out, you should be very explicit about what you are
    doing.
        I think that is the best we can do with our current state
    of knowledge.
        Chairman Brown. Thank you. Thank you all.
        Some Members of the Subcommittee may send you written
    questions in the next few days. Please answer them as quickly
    as you can if that happens.
        And thanks very much for your candor today and your good
    answers. The Subcommittee is adjourned.
        [Whereupon, at 11:51 a.m., the hearing was adjourned.]
        [Prepared statements and additional material supplied for
    the record follow:]
                    PREPARED STATEMENT OF RICHARD J. HERRING
      Jacob Safra Professor of International Banking, The Wharton School,
                           University of Pennsylvania
                                 July 16, 2014
        Chairman Brown, Ranking Member Toomey, and distinguished Members of
    this Subcommittee, I am grateful for the opportunity to address you
    today at this hearing entitled, ``What Makes a Bank Systemically
    Important?''
        I am Jacob Safra Professor of International Banking at the Wharton
    School, Codirector of the Wharton Financial Institutions Center,
    Cochair of the U.S. Financial Regulatory Subcommittee, Executive
    Director of the Financial Economists Roundtable, a member of the
    Systemic Risk Council and the FDIC Systemic Resolution Advisory
    Committee as well as the Hoover Institution Stanford Resolution
    Project. Although my views have certainly been influenced by
    discussions with my colleagues in these groups, the views I express
    today are my own.
        The question of what makes a bank systemically important continues
    to divide experts. Some believe that recognition that some banks are
    systemically important will exacerbate moral hazard, leading to
    competitive inequities and the misallocation of resources. The concern
    is that institutions designated as systemically important benefit from
    implicit Government guarantees that will give them an unwarranted
    competitive advantage. This is a legitimate concern, but, of course,
    much of the Dodd-Frank Act aims to eliminate the category of too-big-
    to-fail institutions and extinguish the implicit guarantee. I think
    this is the correct approach, although disagreement continues about
    whether the goal has been accomplished.
        Experience during the recent crisis indicates that the authorities
    are unlikely to refrain from bailouts if an institution which they
    regard as systemic encounters extreme financial stress. Thus I think it
    is pointless to deny that some institutions will be considered
    systemic. Rather we should aim to find ways to resolve them without
    creating intolerable spillovers for other institutions, financial
    markets and, most importantly, the real economy. If we succeed, it will
    end the implicit benefits banks derive from being regarded as systemic.
        Since the crisis, officials have undertaken major efforts to
    identify the factors that make some institutions ``systemic.'' The
    Financial Stability Board has developed criteria for making the
    designation based on several different indicators. \1\ These indicators
    include the size of banks, their interconnectedness, their cross-
    jurisdictional activity, their complexity and the lack of readily
    available substitutes for the services they provide. Each November the
    FSB publishes a list of G-SIBs. Currently 29 institutions are
    designated as G-SIBs. These 29 banks accounts for the bulk of activity
    in equity and bond underwriting, loan syndication, derivatives, foreign
    exchange and custody. Eight of the G-SIBs are headquartered in the
    United States and they range in size from nearly $2.5 trillion to $222
    million indicating that factors in addition to size matter.
    ---------------------------------------------------------------------------
         \1\ The Financial Stability Oversight Council (FSOC) has refined
    these criteria and applied them to a broader range of financial
    institutions in the United States.
    ---------------------------------------------------------------------------
        Substantial efforts are underway to refine the indicators and to
    model the interactions among institutions that create systemic
    concerns. Although these efforts may help us better understand the
    interconnectedness of financial institutions and markets, I think that
    they focus on the wrong question. In practice, the authorities treat an
    institution as systemic if they fear that a loss to uninsured
    depositors and creditors would damage the financial system and the real
    economy. When faced with the prospect of a disorderly resolution,
    officials have too often improvised bailouts over frantic, sleepless
    weekends. If the authorities cannot make a credible commitment to
    abstain from bailouts, Systemically Important Banks (SIBs) will grow
    larger, more complex and more dangerous.
        I believe that the authorities have granted bailouts so frequently
    because they lacked reliable resolution tools. They relied instead on a
    policy of constructive ambiguity, believing they could limit moral
    hazard by asserting that access to the safety net was uncertain. This
    policy seems naive and ineffectual. It can work only if market
    participants believe that bailouts will be random. But market
    participants do not believe that bailout policy is determined by a spin
    of a roulette wheel. They expect that the authorities will behave
    rationally and provide bailouts to institutions that are regarded as
    systemic. \2\
    ---------------------------------------------------------------------------
         \2\ This is, of course, a prime example of a time inconsistency
    problem: what the authorities say ex ante is quite different from what
    they can expect to do ex post.
    ---------------------------------------------------------------------------
        The Dodd-Frank Act can be viewed as a multipronged attempt to
    eliminate bailouts and neutralize the threat posed by SIBs. Many of
    these measures are designed to reduce the likelihood that institutions
    will fail. The most important of these is the imposition of higher,
    better quality capital requirements with differentially higher capital
    requirements for SIBs. This is a welcome reversal of the policy before
    the crisis of giving SIBs differentially lighter capital requirements.
    While strengthened capital requirements will ensure that SIBs have
    better shock absorbers, they cannot prevent failures--nor should they.
    Banks are in the business of taking risks and so long as they do so
    prudently they provide substantial benefits to the economy by
    intermediating between savers and investors, buying and selling risk
    and operating the payments system.
        If banks cannot be made fail-safe, they must be made safe to fail.
    This requires resolution policies and procedures that will ensure that
    investors and creditors bear the cost of bank failures, not taxpayers.
    The Dodd-Frank Act addresses this problem in Titles I and II. This is a
    major enhancement of the regulatory framework. Before the Dodd-Frank
    Act, most institutions paid no attention to how they might be resolved
    in the event of severe financial distress or what measures they might
    take to minimize the damage to the financial system. Lehman Brothers
    illustrated the problem starkly. It entered bankruptcy with no
    preparation. Indeed, the managers were uncertain about how many legal
    entities the holding company controlled and employees were unclear
    about which legal entity they worked for.
        Title I requires rapid resolution plans for all SIBs. These so-
    called living wills show how the SIB could be resolved under bankruptcy
    without causing damaging spillover effects on other institutions and
    financial markets. Living wills must include: (1) an executive summary
    with a strategic analysis describing the firm's plan for a rapid and
    orderly resolution (without, however, defining what period of time
    qualifies as ``rapid''); (2) a description of how resolution planning
    is incorporated in the firm's corporate governance structure; (3) a
    description of the group's overall organizational structure that
    includes a hierarchical list of all material entities, as well as
    jurisdictional and ownership information and mapping of core business
    lines and critical operations into corporate entities; (4) a
    description of management information systems that support the covered
    company and its material entities, including a detailed inventory and
    description of key applications along with identification of the legal
    owner or licensor and related service level agreements; (5) a
    description of interconnections and interdependencies among a covered
    company and its material entities and the covered company's critical
    operations and core business lines along with a description of how
    service levels would be sustained during a material financial distress
    or insolvency; and (6) identification of supervisory authorities and
    regulators that oversee the covered company.
        For the largest and most complicated banking groups that have
    thousands of subsidiaries, the third requirement has been onerous. It
    demands not only a mapping of lines of business into corporate
    entities, but also details regarding material entities, critical
    operations and core business that, at a minimum, describe types and
    amounts of liabilities. It also requires details about the booking of
    trading and derivatives activities, as well as an identification of
    major counterparties including descriptions of any interconnections or
    interdependencies among them. Finally, it requires that covered
    companies list all material trading, payment, clearing, and settlement
    systems in which they participate.
        Most of these requirements can be seen as attempts to minimize the
    prospect of a Lehman Brothers-like disorderly bankruptcy by ensuring
    that both covered companies and regulators have thought through the end
    game in advance. Although this will not ensure an orderly resolution,
    it increases the likelihood that SIBs can be made safe to fail. Not
    only will the authorities have a more accurate view of the SIB and its
    interactions with the rest of the financial system, but also the
    process and costs of drawing up rapid resolution plans and responding
    to regulatory evaluations, may give institutions an incentive to reduce
    their complexity. Moreover, the authorities have the authority to
    compel a SIB to simplify its structure if it is not sufficiently
    responsive to regulatory reviews of its resolution plan over an
    extended period.
        While the D-F Act generally supports greater market discipline, it
    does not address the issue of public disclosure of resolution plans.
    The FRB and FDIC, however, have required disclosure of a public section
    of the plan containing an executive summary that describes the business
    of the covered company including: ``(i) the names of material entities;
    (ii) a description of core business lines; (iii) consolidated or
    segment financial information regarding assets, liabilities, capital,
    and major funding sources.'' This could have been an effective way of
    harnessing market discipline to support the simplification of SIBs, but
    unfortunately, the FRB and FDIC chose to permit institutions to limit
    their disclosures to publicly available information.
        If the information is already publicly disclosed, it's not clear
    what value this disclosure requirement adds. This timid approach
    represents a significant lost opportunity. If the authorities had been
    serious about enhancing market discipline, they should have required
    disclosure of information that would enable potential creditors of the
    covered company to understand the statutory hierarchy of claims on the
    various entities in resolution, and precisely how the authorities
    propose to conduct a resolution. In the absence of such information,
    creditors cannot be expected to price claims efficiently. Moreover,
    some of the information in the first rounds of disclosures falls short
    of the more modest goal of helping the public understand the business
    of the covered company because it is difficult to reconcile with other
    publicly available information. \3\
    ---------------------------------------------------------------------------
         \3\ For additional details, see Carmassi and Herring (2013) in
    Appendix 1 and The Systemic Risk Council Jetter (2013) re: ``Improving
    the Public Disclosure of Large Complex Financial Institutions'' in
    Appendix 2.
    ---------------------------------------------------------------------------
        Living wills must assume that resolution takes place under
    bankruptcy. But current bankruptcy procedures are not sufficiently
    swift and flexible to ensure an orderly resolution. \4\ The Hoover
    Resolution Project has devoted considerable effort to developing a new
    proposal for a Chapter 14 to the Bankruptcy Code that would be able to
    deal with the special demands of complex financial institutions. See
    http://www.hoover.org/sites/default/files/rp-14-july-9-tom-jackson.pdf
    for a description of the proposal and an analysis of how it would
    improve current bankruptcy procedures. This is a particularly important
    initiative because bankruptcy is the default option under Title I of
    the Dodd-Frank Act.
    ---------------------------------------------------------------------------
         \4\ The current bankruptcy process is thought to be too slow and
    cumbersome to deal with an institution that trades 24 hours a day, 7
    days a week and must rely on the confidence of its counterparties and
    creditors to maintain its operations. Moreover, a series of amendments
    to the Bankruptcy Code has increasingly immunized counterparties in
    qualified financial contracts from major aspects of the bankruptcy
    process, especially the imposition of automatic stays.
    ---------------------------------------------------------------------------
        At the same time, the FDIC has refined plans for implementing its
    stand-by authority to act as receiver under Title II of the Dodd-Frank
    Act. Although the FDIC has performed this role for banks of moderate
    size, it has never had to face the challenge of acting as receiver for
    a SIB. Indeed, before passage of the Dodd-Frank Act its authority was
    limited to the insured depository institution within the SIB holding
    company.
        The FDIC has proposed to resolve SIBs by (1) placing the parent
    holding company under the control of FDIC as receiver and (2)
    transferring to a new ``bridge'' financial company most of the assets
    and secured liabilities, leaving behind much of the unsecured debt.
    Regardless of where the losses occurred in the SIB, only the holding
    company would be taken into bankruptcy. This approach has been termed a
    ``single point of entry'' (SPOE).
        In principle, the new financial company would be strongly
    capitalized (after shedding a large amount of its prior debt), would
    have the capacity to recapitalize operating subsidiaries when
    necessary, and would have the confidence of other market participants.
    This would enable it to continue its critical operations in the
    financial system. Since the bankruptcy would be confined to the holding
    company, spillover effects should be avoided.
        The success of both the Chapter 14 proposal and the SPOE strategy
    depend on three issues that remain unresolved. First is that the bridge
    company have all of the assets, rights and liabilities of the holding
    company that has entered bankruptcy. This is crucial for maintaining
    business as usual in the operating entities and would require
    overriding ``ipso facto'' clauses that permit contracts to be
    terminated based on a change of control, bankruptcy proceedings or a
    change in agency credit ratings. This is particularly a problem with
    regard to qualified financial contracts. Currently counterparties may
    liquidate, terminate, or accelerate qualified financial contracts of
    the debtor and offset or net them out. This can result in a sudden loss
    of liquidity and, potentially, the forced sale of illiquid assets in
    illiquid markets that might drive down prices and transmit the shock to
    other institutions holding the same asset. Qualified financial
    contracts should be transferred in their original form to the bridge
    company so long as the debtor and its subsidiaries continue to perform
    payment and delivery obligations.
        Second, both approaches depend on cooperation from the relevant
    authorities in countries where the SIB has operations. Virtually all
    SIBs have substantial cross-border operations and so an orderly
    resolution depends on cooperation in the transfer of assets and
    contracts to the bridge. The FDIC has taken a leading role in trying to
    forge an international agreement regarding harmonization of resolution
    policies. It participates in crisis resolution groups that review
    resolution plans for GSIBs and it has published a paper with the Bank
    of England supporting the SPOE. Nonetheless, agreements and
    understandings tend to unravel in a crisis and countries may try to
    ring-fence the assets they control. The recent crisis did not provide
    much evidence of cross-border cooperation in resolution.
        Third, both approaches require that ``sufficient'' long-term
    unsecured debt be left behind in the bankrupt holding company to
    recapitalize the bridge company. \5\ Although it is relatively easy to
    compute an amount of loss absorption capacity that would be sufficient
    under conventional stressful conditions, tail risks are crucial and
    inherently very difficult to measure.
    ---------------------------------------------------------------------------
         \5\ In principle, if losses at a subsidiary exceed the long-term
    unsecured debt at the holding company, the additional loss could be
    imposed on creditors of the subsidiary. But, once the prospect of
    creditors bearing loss in subsidiary is introduced, subsidiaries may be
    subject to a run by creditors and counterparties.
    ---------------------------------------------------------------------------
        I would like to conclude with a somewhat different point, however.
    I believe that how the long-term debt is structured can also be
    important. Long-term debt matters not only because of its ability to
    absorb loss, but also because it has the potential to incentivize banks
    to manage their risks more prudently and to issue new equity before
    they reach the brink of insolvency.
        Charles Calomiris and I have argued that a properly designed
    contingent convertible debt (CoCo) requirement can provide strong
    incentives for the prompt recapitalization of banks after significant
    losses of equity or for the proactive raising of equity capital when
    risk increases. \6\ Correspondingly, it can provide strong incentives
    for effective risk governance and help limit regulatory
    ``forbearance,'' the tendency of supervisors to delay recognition of
    losses. We show that, to be effective, a large amount of CoCos
    (relative to common equity) should be required. CoCo conversion should
    be based on a market-value trigger that is defined by a moving average
    of a quasi-market-value-of-equity ratio. All CoCos should convert if
    conversion is triggered and the conversion ratio should be dilutive of
    preexisting shareholders. Unfortunately, this proposal has not received
    serious consideration in the U.S. because the Internal Revenue Service
    appears unlikely to permit interest paid on CoCos to be deducted in the
    computation of taxable income and so banks would prefer to issue
    conventional, long-term debt. In view of the enormous costs of a
    financial crisis and the potential for a properly structured CoCo to
    create incentives that would reduce the probability of a crisis, this
    tax policy should be reviewed.
    ---------------------------------------------------------------------------
         \6\ For additional details, see Appendix 3.
    ---------------------------------------------------------------------------
        Thank you for the opportunity to testify on this important topic.

                     PREPARED STATEMENT OF JAMES B. THOMSON
                Professor and Finance Chair, University of Akron
                                 July 16, 2014
        I would like to thank Senator Brown and the Members of the Senate
    Committee on Banking, Housing, and Urban Affairs and Consumer
    Protection Subcommittee on for the opportunity to speak here today. The
    issue of systemically important financial institutions is of critical
    importance to the stability of financial markets and the ultimately the
    macro economy. Understanding what makes a financial firm systemic is
    the first step in designing an institutional and legal framework to
    rein in systemic firms. Viewing systemic spillovers as market failure
    we need to identify the source of that market failure, the severity of
    the market failure, whether the market failure merits Government
    intervention and if so, the most economically effective way to
    structure that intervention.
        United States financial history over the past 40 years is littered
    with examples of Government interventions into financial markets in
    response to lobbying by particular sectors (esp. housing) to the
    pending failure of large financial institutions. Early on we referred
    to these intuitions as too big to fail and the public policy issue as
    the too big to let fail problem. One of the themes I want to sound
    today is that too big to fail is a misleading term. Size is not the
    distinguishing characteristic that makes financial firms systemic.
    Section 113 of the Dodd-Frank Wall Street Reform and Consumer
    Protection Act of 2010 (hereafter called ``Dodd-Frank'') lists 11 such
    characteristics. However, the factors that lead to institutions ``being
    treated'' as systemically important also tend to be prevalent in larger
    firms. It is important to emphasize that decisions on how we handle
    economically failed financial institutions are themselves an important
    source of systemic risk. We need to understand whether an institution
    authorities label as systemic in the handling of its economic
    insolvency are truly systemic, or merely politically expedient.
        During a 30-year career as a financial economist I have studied
    financial markets, banking, payments systems, failed bank resolution,
    and the Federal financial safety net from a public policy perspective.
    The ideas I express today observations below are informed by reading
    and research I have done in these areas, especially papers on
    systemically important financial institutions, the need for an asset
    salvage agency, and systemic banking crises. \1\
    ---------------------------------------------------------------------------
         \1\ James B. Thomson, ``On Systemically Important Financial
    Institutions and Progressive Systemic Mitigation'', DePaul Business &
    Commercial Law Journal 8 no. 2 (Winter 2010), 135-150; James B.
    Thomson, ``Cleaning up the Refuse From a Financial Crisis: The Case for
    a Resolution Management Corporation'', The Florida State University
    Business Review 10 no. 1 (Spring 2011), 1-23; Ozgur E. Ergrungor and
    James B. Thomson, ``Systemic Banking Crises'', Research in Finance 23
    (2006), Elsevier Ltd., Amsterdam, 279-310.
    ---------------------------------------------------------------------------
        As I mentioned above, the past 40 years of U.S. financial history
    is replete with examples of economically failed financial firms whose
    solvency resolution involved systemic considerations or were handled
    through regulatory forbearance (that is, were allowed to continue
    operations with the hope that they would recover). Examining a number
    of these cases and the stated rationale for how they were handled
    allowed me to identify four sources of systemic importance. It is
    important to note systemic importance in these cases was based on a
    judgment call in the face of a potentially disruptive event in
    financial markets and not hard evidence the firms were indeed
    systemically important.
    Sources of Systemic Importance
        Obviously size, an imperfect measure of systemic importance, is
    correlated with systemic importance because large financial firms are
    more likely to have characteristics of systemic importance. The $50
    billion threshold set by Title I Sec 121 of Dodd-Frank is probably
    sufficiently low that it captures the lion's share of banking companies
    that would be flagged under one or more of the systemic criteria
    discussed below. However, just relying on size does not give us an
    understanding of how to design laws and regulatory infrastructure to
    deal effectively with systemically important institutions. Along with
    size I would stress what I call the ``4 C's'' of systemic importance:
    Contagion, Correlation, Concentration, and Context/Conditions, and
    discuss how each of the 4 C's has been part of the rationale for
    generous treatment of the creditors, managers and stockholders of
    troubled financial firms.
        In the systemic context, Contagion is a metaphoric way to describe
    the transmission of losses across the financial system or the locking
    up of financial markets from the insolvency of one or more major
    financial firms. Contagion as a source of systemic importance appears
    on the scene in 1974 with the failure of Bankhaus I.G. Herstatt AG,
    which failed coincidentally as the United States authorities were
    dealing with the largest protracted U.S. bank failure resolution to
    date, Franklin National Bank, 1974, and the 1984 FDIC rescue of the
    Continental Illinois Bank and Trust Company. \2\ Contagion would also
    seem to be a factor in the 2008 Federal Reserve Bank of New York's
    assisted acquisition of Bear Stearns by JPMorgan Chase. The `breaking
    of the buck' by Reserve Primary Money Fund in September 2008 following
    the Lehman Brothers bankruptcy filing in is another example of
    contagion. Contagion is a fundamental consequence of the degree of a
    megafirm's interconnectedness, be it through the payments system, a
    clearing, and settlement system, asset holdings, or off-balance sheet
    contracts (such as derivatives).
    ---------------------------------------------------------------------------
         \2\ Walker F. Todd and James B. Thomson, ``An Insider's View of
    the Political Economy of the Too Big to Fail Doctrine'', Congressional
    Record, vol. 138 (no. 102), S9978-9987 (July 20, 1992), 102nd Congress,
    2nd session. Reprinted from ``Public Budgeting and Financial
    Management: An International Journal'', vol. 3 (no. 3), pp. 547-617
    (1991). Also published as Working Paper 9017, Federal Reseve Bank of
    Cleveland (December 1990).
    ---------------------------------------------------------------------------
        Currently we do not collect information with sufficient granularity
    for us to understand the potential for contagion in the market place or
    how to aggregate what information exists in ways that would let us
    measure, monitor and police this risk. Information and clearing
    requirements in the over the counter (OTC) market under Title VII
    Sections 725, 728, 729, 742, 763, and 764 of Dodd-Frank could produce
    some of the information needed. However, much more needs to be done to
    identify the dealer's counterparties. Congress should direct the Office
    of Financial Research (OFR) to collect International Swap Dealers
    Association (ISDA) master agreements for the purpose of constructing
    measures of exposure in the OTC derivative markets. Moreover, financial
    institutions with assets in excess of the $50 billion threshold for
    systemic banking companies should be required to report to Federal
    financial market supervisors and to their Boards of Directors any
    exposures to another financial firm in excess of 10 percent of their
    tier-I capital. Such exposure should be broken down by type--funding
    market, clearing and settling, interfirm balances (including
    correspondent balances), lending and security holdings, and off-balance
    sheet exposure. Collecting this information would allow the Federal
    Reserve to determine if the limits to be set on exposure should below
    the 25 percent of capital under Section 165 of Dodd-Frank. It would
    also promote the orderly resolution of a failed financial firm as
    regulators could work to limit the spillover effects of the firm's
    failure without automatically resorting to blanket guarantees of the
    financial firm's creditors.
        Correlation can create a too-many-to-fail problem. It occurs when
    many institutions hold similar balance-sheet positions. \3\ Correlating
    one's risk taking enhances political clout to resist closure should the
    firm become insolvent. Financial supervisors will face pressures to
    forbear as the cost of dealing with an insolvent industry will be high
    from a fiscal and political standpoint. \4\ When risky bets go bad the
    odds of survival are increased if a firm is one of many facing ruin.
    Examples of this phenomenon in U.S. financial history include the 1980s
    savings and loan debacle (correlated interest rate risk), the 1980s
    international debt crisis (correlated sovereign risk), and more
    recently the subprime mortgage crisis. \5\
    ---------------------------------------------------------------------------
         \3\ See Janet Mitchell, 1988, ``Strategic Creditor Passivity,
    Regulation, and Bank Bailouts'', CEPR discussion paper no. 1780.
         \4\ See Edward J. Kane, 1989, The S&L Insurance Mess, How Did It
    Happen? Washington DC: The Urban Institute Press.
         \5\ See Alessandro Penati and Aris Protopapadakis, 1988, ``The
    Effect of Implicit Deposit Insurance on Banks' Portfolio Choices With
    an Application to International Overexposure'', Journal of Monetary
    Economics, 21: 107-126.
    ---------------------------------------------------------------------------
        Today, measurement of correlation across Dodd-Frank classified
    systemic financial firms is being addressed through the Comprehensive
    Capital Analysis and Review (CCAR) stress tests conducted by the
    Federal Reserve. These tests are mandated under Title I Section 121 of
    Dodd-Frank. While the results of the stress tests are scrutinized at
    the institution level as part of the capital planning review,
    information on the extent of loss exposure across firms subject to the
    stress tests under the various shock scenarios would give a clear
    picture of the extent to which these firms are taking on correlated
    risks. The stress tests should include specific industry shocks such as
    a decline in commercial real estate prices for financial market sectors
    that represent a growing share of the risk exposure of the financial
    services industry. Again, aggregation of risks across firms is the
    problem. This may require the reporting of asset exposure by 3 digit
    Standard Industrial Classification (SIC) codes for all CCAR firms and
    nonbank financial firms that meet the conditions to be considered
    systemically important by the Financial Services Oversight Council
    (FSOC).
        The third source of systemic importance is Concentration. Here we
    are referring to market concentration, the presence of a few big
    players in a key market or activity and the degree of contestability
    (the ease with which new firms can enter). Concentration becomes a
    source of systemic importance when the failure of a firm causes a major
    disruption or the locking up of a key financial market or activity. Two
    prime examples of this are in the set of financial contracts that are
    not subject to the trust-avoidance provisions of United States
    bankruptcy law. Currently, the seven largest U.S. banks account for 98
    percent of OTC derivative contracts written by U.S. banks. Reportedly
    JPMorgan Chase has had as much as 40 percent share of the plain vanilla
    interest-rate swap market. It is hard to imagine that the impact of a
    JPMorgan Chase failure on the SWAPS market would not influence how its
    insolvency would be handled. \6\ The other example is the triparty repo
    market, a $1.6 trillion market where hundreds of billions of dollars of
    intraday credit is extended by the two large depository institutions
    (Bank of New York Mellon and JPMorgan Chase) that serve as the
    intermediaries (clearing banks) in that market. \7\
    ---------------------------------------------------------------------------
         \6\ For the over the counter derivatives markets the reforms to
    that market under Title VII of Dodd-Frank may lessen the systemic
    importance large banking companies may derive from the SWAPS market.
         \7\ http://libertystreeteconomics.newyorkfed.org/2011/04/
    everything-you-wanted-to-know-about-the-tri-party-repo-market-but-
    didnt-know-to-ask.html#.U8FZVLFwV2M
    ---------------------------------------------------------------------------
        The fourth source of systemic importance for a financial firm is
    context/conditions, that is, the economic or financial market
    conditions at the time the firm becomes insolvent. Firms that come
    under financial distress during a period of market fragility are more
    likely to be treated as systemic than firms that run aground during
    more normal market conditions. Context/conditions explains why Drexel
    Burnham Lambert filed for bankruptcy in 1990 but Bear Stearns was put
    through a Federal Reserve Bank of New York assisted merger in early
    2008. It also partially explains why the Federal Reserve Bank of New
    York intervened to broker a deal for Long Term Capital Management. \8\
    Context/conditions includes the exercise of political clout, something
    Members of your Committee are very familiar with.
    ---------------------------------------------------------------------------
         \8\ http://www.clevelandfed.org/research/policydis/pdp19.pdf
    ---------------------------------------------------------------------------
    Dodd-Frank Reforms
        Dodd-Frank was enacted in 2010 in response to the financial crisis.
    It is a massive piece of legislation--848 pages and 16 Titles. The Act
    contains a number of provisions dealing with systemically important
    institutions. Below are my thoughts on Sections 113, 115, 121, and 165
    and Title II of Dodd-Frank. I will also discuss the need for
    supervisory contingency/disaster plans so as to facilitate orderly
    resolution of systemically important financial institutions in a time-
    consistent manner.
    Factors for Systemic Determination Under Section 113 of Dodd-Frank
        The period leading up the financial crisis saw the emergence of
    ``Shadow Banks''--nonbank financial intermediaries engaged in
    activities that mirror banking. These shadow entities resemble banks in
    that they tend to employ a high degree of leverage and financed opaque
    assets with short-term liabilities. Shadow banks and shadow banking
    activities are a form of regulatory arbitrage as activities move from
    the more heavily regulated banking sector into a less regulated sector.
    Hence, it is important to identify nonbank financial firms that are
    systemically important.
        The general criteria outlined in Section 113 of the Dodd-Frank for
    determining the systemic importance of a nonbank financial firm are
    consistent with what would be suggested by my the 4 C's above. In fact,
    the 11 factors the FSOC is to use go beyond what I identified in my
    research. Setting so many characteristics that FSOC must use in
    determining whether nonbank firms are deemed systemically important
    financial institutions creates unnecessary discretion that invites
    political manipulation. Measuring systemic risk by the value of a
    firm's taxpayer put provides a more concrete and accountable way for
    FSOC to determine who is and is not systemically important.
    FSOC's Authority Under Section 115 of Dodd-Frank
        Section 115 of the Dodd-Frank provides FSOC a consultative role in
    the supervision of systemic financial firms. That is the FSOC can make
    recommendations on the Federal Reserve Board concerning regulations,
    supervisory standards and disclosure requirements applicable to
    systemic firms supervised by the Federal Reserve. It is unclear whether
    the FSOC's role under Section 115 will have much of an impact. The
    Board of Governors and other agencies are not required to follow FSOC
    recommendations and other avenues exist for financial supervisors to
    provide input into new regulations and supervisory policies and
    procedures.
        It may be the case however, that public and political pressure that
    would come with the issuance of guidance by the FSOC to the Board would
    influence the Board's decisions with respect to supervision of
    systemically important financial firms. Congress could increase the
    influence of the FSOC by holding hearings where the Federal Reserve
    Chairman must explain how the Board implemented FSOC recommendations
    and if it did not, why not.
    Section 121 of Dodd-Frank
        Section 121 largely clarifies powers the Federal Reserve likely had
    under existing banking law and extends this authority to nonbank firms
    subject to supervision by the Federal Reserve. To the extent that
    financial system supervisors failed to act because they were uncertain
    as to their authority under U.S. law, Section 121 of the Dodd-Frank
    could improve the effectiveness of the Federal Reserve in its oversight
    of systemically important financial institutions. I question, however,
    whether clarity of authority to act is constraint on financial
    supervisors. The Bear Stearns and AIG rescues, along with the extension
    of the financial safety net through aggressive use of 13(3) lending
    authority by the Federal Reserve and the FDIC's Temporary Liquidity
    Guarantee Program, suggest a willingness of financial supervisors to
    act when statutory authority is unclear.
        Under a liberal reading one can argue that Section 121 directs the
    Federal Reserve Board to take into account systemic risk when reviewing
    mergers and acquisitions by systemically important financial companies
    under Federal Reserve supervision. I believe that systemic risk should
    be a consideration by the Federal Reserve when reviewing any proposed
    merger or acquisition, and in any proposed restructuring of a financial
    company under its regulatory purview. Furthermore, I believe that
    systemic risk should be part of the Justice Department's antitrust
    guidelines.
    Section 165 of the Dodd-Frank Act (2010)
        Section 165 of the Dodd-Frank has five provisions of particular
    note. First is the limit on the leverage ratio, setting the minimum
    amount of equity a systemically important company must hold. Second are
    the resolution plan provisions (living wills) that systemically
    important companies must file detailing how they would dismantle the
    company under Chapter 11 of the Bankruptcy Code. Third are the limits
    on exposure to a single counterparty which we discussed above. Fourth
    is the authority for the Federal Reserve to set limits on short-term
    debt. Finally, there is the requirement of annual stress tests.
        Section 165 more than doubles the minimum leveraging standard from
    33 to 1 to 15 to 1 for systemically important financial institutions.
    While on paper this seems like a material increase in capital
    standards, the 6.5 equity to assets under Section 165 of the Act is
    below the tier-I capital ratio for U.S. banking firms over the past two
    decades. Even during the financial crisis tier-I capital for the
    industry never fell below 10 percent of assets. Bank of America which
    required a second capital infusion under the Troubled Asset Relief
    Program (TARP), would have exceeded the minimum 6.5 capital standard at
    the end of 2008 without the TARP infusions. Leveraging standards are
    likely to fail because they are based on book value of capital and not
    market values. The average loss on assets for banks closed from 2007
    through 2009--despite the presence of prompt corrective action
    provisions which also relied on book capital valuations under the
    Federal Deposit Insurance Corporation Improvement Act of 1991
    (FDICIA)--was around 36 percent of assets.
        Resolution plans should improve the management of the systemic
    firms and reduce their complexity. This may indeed be happening. For
    instance, the number of CitiGroup's nonbank subsidiaries fell from 1378
    at the end of 2012 to 993 currently. Part of this decline was due to a
    decline in foreign nonbank subsidiaries from 375 to 322 over the same
    time period. Properly implemented, these ``funeral plans'' should
    improve the management of systemic firms by having management
    explicitly consider worst-case scenarios. These plans should provide
    financial market supervisors a blueprint on how to dismantle a systemic
    company, including which financial markets might be affected by the
    demise of the firm thus allowing for a more orderly resolution of the
    firms. Taking a more macro view of these plans, financial market
    supervisors can compare plans across the major systemic firms. The
    macro view of the funeral plans could provide information on potential
    stress points in the financial system during periods of market
    fragility. That is how the living wills should work in principle. In
    practice it is too early to see if the resolution plans will have the
    desired impact. Beyond the review of submitted plans for their
    compliance with the final rule adopted by the Federal Reserve and FDIC,
    these two supervisory agencies need to conduct audits of these plans,
    analogous to the stress tests for capital planning, to determine their
    feasibility.
        Limits on short term debt authorized under Section 165 are being
    implemented as part of the liquidity requirements under the Basel III
    international capital requirements. Specifically they would be embodied
    by the Net Stable Funding Ratio, one of the two Basel III liquidity
    ratios (the other being the liquid asset ratio). Minimum requirements
    for liquidity should help improve financial system stability and the
    resiliency of individual financial companies. Whether the Basel III
    approach to liquidity is the economically most desirable way to
    regulate liquidity is something that needs careful study.
        The annual Comprehensive Capital Analysis and Review (CCAR)
    involves stress tests of systemic financial companies and possibly is
    the most important of the Section 165 reforms. It is the closest thing
    to assessing systemic institution solvency on a market value basis.
    Care must be taken that stress scenarios are calibrated over a
    sufficiently long period of financial history to ensure the results
    remain meaningful as the 2007-2009 financial crisis gets farther back
    in our rearview mirror. With the implementation of the CCAR it is
    unclear that the CCAR coupled with a straight leveraging ratio would
    not be sufficient and, hence, that model-based capital requirements as
    in Basel II and III are no longer necessary. \9\
    ---------------------------------------------------------------------------
         \9\ A sentiment expressed in a recent speech by Federal Reserve
    Board Governor Tarullo. See p. 15 of the Governor Tarullo's speech,
    which can be found at http://www.federalreserve.gov/newsevents/speech/
    tarullo20140508a.pdf.
    ---------------------------------------------------------------------------
    Dodd-Frank's Title II Orderly Liquidation Authority
        Orderly liquidation authority (OLA) under Title II of Dodd-Frank is
    a misnomer. The character of this new resolution authority is not new.
    It is modeled after and extends the bridge bank authority created by
    the Competitive Equality Banking Act (1987). Experience suggests that
    the expectation is restructuring and reorganization, with liquidation
    being the last resort. The resolution powers under Title II of Dodd-
    Frank also incorporate features of the Bankruptcy Code. Two general
    observations about OLA: First, the main use of OLA is likely to be to
    handle the failure of a large bank holding company. The prospect of a
    disorderly resolution of the parent holding company and its nonbank
    subsidiaries under bankruptcy was a source of systemic uncertainty
    prior to Dodd-Frank. Second, there are efficiencies in having a single
    entity, the FDIC, handle both the bank and nonbank parts of the estate
    of a bank holding company.
        In Title II of Dodd-Frank Congress grants the FDIC the ability to
    impose a one-day automatic stay on qualified financial contracts (QFC),
    allowing it time to decide which contracts to bring into the bridge
    institution and which ones to place into part of the estate to be
    liquidated. This 1-day stay can effectively be a 3-day stay if the
    resolution is triggered on a Friday. Cherry picking of contracts is
    reduced by requiring all the contracts of a single counterparty be
    treated the same way. Congress should revisit the safe-harbor
    provisions for QFCs passed as part of the 2005 bankruptcy reforms. I
    believe the collateral runs by QFC counterparties on Bear Stearns and
    Lehman Brothers are an unintended consequence of the special treatment
    of QFC counterparties in bankruptcy. A limited stay and the anti-cherry
    picking provisions of Title II should be incorporated into the
    Bankruptcy Code.
        It is curious that the firms exempt from bankruptcy are not subject
    to OLA, in particular insurance companies. AIG and Prudential have been
    designated as systemically important nonbank financial firms and
    MetLife is a bank holding company. Hence, major parts of three large
    systemically important financial institutions cannot be resolved under
    OLA, an important gap in the coverage of this authority.
        Another gap in OLA is it does not extend to the foreign activities
    of systemically important financial firms. So international
    subsidiaries of systemic banks and nonbank subsidiaries of foreign
    banks in the U.S. complicate the resolution of these companies and
    remain a source of systemic importance. One might observe the movement
    of activities off-shore in response to OLA. A possible example of such
    regulatory arbitrage is the growth of CitiGroup's foreign nonbank
    assets. CitiGroup as a whole grew 1.60 percent from the end of 2012
    through the first quarter of 2014. Its nonbank assets grew at a rate of
    8.60 percent over the same period while its nonbank foreign assets grew
    at a rate of 29.25 percent. The reason for CitiGroup's shifting of
    assets offshore is unclear. However, it is consistent with regulatory
    arbitrage in response to OLA.
    Additional Steps Needed To Address Systemic Risk
        Systemic importance reflects constraints faced by financial market
    supervisors in enforcing timely closure rules. It doesn't matter what
    powers Congress gives financial supervisors to conduct orderly
    resolutions of financial companies if regulators remain reluctant to
    use them. A major step forward to limiting systemic importance (ending
    too big to fail) is requiring financial system supervisory agencies to
    develop and commit to contingency plans akin to the firm's living wills
    for handling the failure of one or more systemically important
    financial institutions. These plans should contain a series of options,
    actions taken to contain systemic spillovers, with blanket guarantees
    of all creditor/counterparty claims to be, without exception, the last
    option on the list. \10\ Scenario analysis should be used to test and
    refine these disaster plans. Much as the intent of Section 165
    resolution planning by systemically important firms is intended to
    promote the orderly resolution of these firms (whether through
    bankruptcy or FDIC receivership), supervisory disaster plans should
    allow for resolution of systemic firms with the least impact on long-
    term incentives facing these firms.
    ---------------------------------------------------------------------------
         \10\ For a discussion of contingency or disaster planning see,
    Joseph G. Haubrich, James B. Thomson, and O. Emre Ergrungor, ``Central
    Banks and Crisis Management'', Federal Reserve Bank of Cleveland 2007
    Annual Report and Edward J. Kane, 2001. ``Using disaster Planning To
    Optimize Expenditures on Financial Safety Nets'', Atlantic Economic
    Journal 29(3): 243-253.
    ---------------------------------------------------------------------------
        Dodd-Frank was hailed by its drafters as the antidote to Too Big to
    Fail. While provisions in this important reform legislation move us
    towards the goal of reining in the effects of systemic importance in
    the financial system, much remains to be done.
                                     ______

                      PREPARED STATEMENT OF ROBERT DEYOUNG
       Capitol Federal Distinguished Professor in Financial Markets and
             Institutions, University of Kansas School of Business
                                 July 16, 2014
        Thank you for the opportunity to address the Committee this
    morning. The Dodd-Frank Act contains many well-considered prudential
    standards aimed at reducing the systemic risk of U.S. financial
    institutions and by extension the systemic risk of the U.S. financial
    system. Some of these safeguards tighten up existing prudential
    standards, while others impose brand new prudential standards. These
    measures touch on nearly every risk function at modern banking
    companies, and the list is a long one.
        From my perspective, these measures can be dividing relatively
    neatly into two separate categories.
        On one side we have ex ante measures that try to limit banks'
    exposures to and/or contributions to systemic macroeconomic events.
    Some salient examples include higher capital and liquidity ratios aimed
    at making bank balance sheets more resilient to systemic events, and
    regulatory stress tests designed to monitor the resiliency of bank
    balance sheets. On the other side we have ex post measures that try to
    limit the amplification of systemic events (contagion) caused when
    banks default on their financial obligations to creditors, borrowers,
    other banks or financial counterparties. This approach centers on the
    FDIC's orderly liquidation authority, which is complemented by new
    stores information made available to the FDIC via resolution plans
    (living wills) and price discovery via exchange traded derivatives
    positions.
        It is my observation that we pay most of our attention to the ex
    ante systemic risk prevention measures--i.e., setting rules and limits
    for banks--and we tend to have relatively less confidence in ex post
    measures to contain systemic risk. The explanation for this, I think,
    is two-fold. First, we understand intuitively that for every dollar of
    risk that we can prevent beforehand, we will have one less dollar of
    risk to contain afterwards. And second, we are skeptical that
    regulators will take strong actions to seize and liquidate large
    insolvent banks during a deep recession or financial crisis. Given our
    intuition and our skepticism, we tend to stress ex ante risk
    prevention.
        Minimum equity capital standards are the backbone of our ex ante
    risk prevention framework. The idea is that by increasing a bank's
    capital buffer, it will have enough resources to continue operating
    during an economy wide financial event and to emerge from the crisis
    financially solvent. But such a world requires extremely high levels of
    bank capital. My research (with Allen Berger, Mark Flannery, David Lee,
    and Ozde Oztekin) shows that in 2006, the average U.S. commercial
    banking company had nearly double the risk-weighted capital ratios
    necessary to be deemed well-capitalized by bank regulators, and that 95
    percent of all banking companies cleared the adequately capitalized
    threshold by at least 300 basis points. As we know, these outsized
    stores of equity capital were not large enough to prevent hundreds of
    bank insolvencies in the years that immediately followed. The lesson
    here is that relying on ex ante regulations to reduce bank failure
    risk--whether this means more capital, more liquidity, more lending
    restrictions, etc.--will impose nontrivial costs on banks, and these
    costs will in turn result in nontrivial reductions in financial
    services.
        In the shadow of the financial crisis, this may seem like a wise
    tradeoff--less lending and slower economic growth in exchange for a
    reduction in the severity of the next systemic financial event. But the
    orderly liquidation powers in Dodd-Frank provide us with an historic
    opportunity to avoid having to accept this tradeoff. OLA should allow
    us to not only limit the contagious after-effects of a systemic crisis,
    but also to establish a newly credible regulatory regime devoid of the
    too-big-to-fail that have for so long fostered systemic risk in our
    financial system.
        Indeed, this is a big claim. But the economic story is
    straightforward: when investors become convinced that large complex
    banks will be seized upon insolvency--with shareholders losing
    everything and bondholders suffering losses--then credit markets and
    equity markets will more fully price bank risk-taking; profit-seeking
    banks will then face clear incentives to reject high-risk investments
    ex ante.
        The political story, however, is far from straightforward. OLA
    requires bank regulators to credibly establish that they can and will
    seize, unwind and eventually liquidate large complex insolvent banks.
    The FDIC's ``single point of entry'' plan for implementing OLA is a
    workable plan. Nevertheless, in my discussions with scores of banking
    and regulatory economists across the U.S., I meet with a near uniform
    skepticism that the FDIC will be permitted to exercise its resolution
    authority during a financial crisis in which multiple large banking
    companies are nearing insolvency. Essentially, their belief is that the
    deeper is the financial crisis, the greater is the probability that OLA
    will be suspended.
        In my opinion, the most important actions that Congress and the
    Administration can take to limit systemic risk in the U.S. financial
    system is to strongly and repeatedly enunciate their support of OLA and
    to pledge that they will not stand in the way of its implementation
    during a deep financial crisis. Our banking system is most effective
    when scarce economic resources are moved from poorly managed banks to
    well-managed banks. Hence, we don't want a banking system that is
    devoid of bank failure. Rather, we want a banking system that is
    resilient to bank failure. OLA is the key to this resiliency.
        Thank you for your time this morning. I hope that my remarks have
    been useful. I look forward to your questions.
                                     ______

                      PREPARED STATEMENT OF PAUL H. KUPIEC
                Resident Scholar, American Enterprise Institute
                                 July 16, 2014
        Chairman Brown, Ranking Member Toomey, and distinguished Members of
    the Subcommittee, thank you for convening today's hearing, ``What Makes
    a Bank Systemically Important?'' and thank you for inviting me to
    testify. I am a resident scholar at the American Enterprise Institute,
    but this testimony represents my personal views. My research is focused
    on banking, regulation, and financial stability. I have years of
    experience working on banking and financial policy as a senior
    economist at the Federal Reserve Board, as a Deputy Director at the IMF
    and most recently for almost 10 years as Director of the FDIC Center of
    Financial Research where I served a 3-year term as chairman of the
    Research Task Force of the Basel Committee on Bank Supervision. It is
    an honor for me to be able to testify before the Subcommittee today.
        I will begin with a high-level summary of my testimony:

        There is a trade-off between financial intermediation and
            economic growth. When prudential regulations reduce financial
            intermediation, they will restrict economic growth. The Dodd-
            Frank Act (DFA) does not recognize this trade-off.

        The DFA does not define systemic risk, and this ambiguity
            allows regulators wide discretion to interpret DFA new DFA
            powers.

        When designated nonbank financial firms, DFA criteria is
            unclear. Should the firm be designated if its isolated failure
            causes financial instability, or is the criterion that the
            firm's failure in the midst of crisis and many other financial
            failures will cause financial instability? These two cases
            represent very different standards for designation.

        Because DFA assigns regulators with the (impossible) task
            of ensuring financial stability without recognizing and
            limiting regulators' ability to slow economic growth by
            overregulating the financial system, DFA builds in a bias
            toward overregulation of the financial system.

        DFA gives regulators many powers to meet vague objectives.
            There are few controls over the exercise of regulators' powers
            and extremely limited ability to appeal regulatory decisions to
            judicial review. In many cases these regulatory powers can be
            exercised arbitrarily resulting in limiting or even canceling
            investor property rights without compensation or due process.

        Designating bank holding companies larger than $50 billion
            for enhanced prudential supervision and regulation is arbitrary
            and a clear case of over regulation.

        The imposition of explicit enhanced prudential regulations
            for the largest institutions creates a two-tiered system of
            regulation that will have long run negative implications for
            the structure of the financial industry.

        The provision of enhanced prudential power to limit the use
            of short-term debt does not recognize that a substantial
            finance literature finds that the use of short-term (uninsured)
            debt is a method investors use to control risk-taking by
            borrowers. Short-term debt is cheaper, in part, because of this
            risk control mechanism and the imposition of binding short-term
            debt restrictions will lead to higher borrowing costs.

        Mandatory Board of Governor stress tests have many negative
            side effects. They involve highly intrusive and detailed
            modeling of individual bank operations. Stress loss estimates
            are not the output of pure modeling exercises, but loss
            estimates depend to a substantial degree on judgments made by
            the Board of Governors. Along with enhanced prudential
            regulations for the largest institutions, the stress test
            process creates investor perceptions that the largest
            institutions are too-big-to-fail. Since the historical track
            record of stress-test based regulation is checkered at best, it
            is likely that there may be a time when the Board of Governors
            has the largest financial firms fully prepared for the wrong
            crisis.

        A Title II resolution using the FDIC's single point of
            entry (SPOE) strategy does not fix the too-big-to-fail problem.
            In order to keep subsidiaries open and operating to avoid
            creating financial instability, in many cases, SPOE will
            require the extension of Government guarantees that are far
            larger than those that would be provided under a bankruptcy
            proceeding and Federal Deposit Insurance Act (FDIA) resolution.

        The Title II and SPOE create new uncertainty regarding
            which investors will be forced to bear losses when a bank
            holding company fails.

        When Title II is used on a bank holding company because a
            subsidiary bank failed, it creates a conflict of interest
            between contributors to the deposit insurance fund and
            contributors to the orderly liquidation fund.

        Title II and SPOE alter investor property rights without
            prior notice, compensation, or due process and with little
            scope for judicial protection.

        Contingent capital is a more attractive means for address
            the consequences of the distress of a large and important
            financial intermediary. Its benefits are even more apparent in
            a crisis, when multiple financial institutions may be in
            distress.

        The FDIA resolution process should be improved to avoid
            creating too-big-to-fail banks. Title I orderly resolution plan
            powers can be used to require the FDIC to plan to break up
            large institutions in an FDIA resolution rather than use a
            whole bank purchase. This may require legislation to amend the
            FDIC's least cost mandate if favor of requiring large
            institutions to be broken up in the resolution process even if
            it imposes a larger loss on the insurance fund.

        Improvements in the FDIA resolution process can be a
            substitute for mandatory enhanced supervision and prudential
            standards that apply to many institutions that exceed the
            Section 165 size threshold.
    I. Financial Intermediation, Economic Growth, and Systemic Risk
        It is has long been recognized that banks play a special role in
    capitalist economies. Today, the idea that ``banks are special'' is
    such a cliche that many may have forgotten what underlies this belief.
    Since Government regulations are designed around the idea that banks
    are special, it is useful to briefly review the economic functions of
    banks and highlight the link between bank regulation and economic
    growth.
        In many capitalist economies, banks are the only intermediaries
    that collect consumer savings and channel them into private sector
    investments. In bank-centric economies, if banks make sound investment
    decisions, the economy grows, banks profit, and consumers earn interest
    and their deposits are safe. If banks make poor investment choices,
    their investments fail, consumers lose their savings and economic
    growth plummets.
        Some economies, including the U.S. economy, also benefit from
    nonbank financial intermediation, sometimes called ``shadow banking.''
    Nonbank financial intermediation occurs when consumers channel their
    savings into private sector investments without the intermediation of a
    bank.
        In the most common form of nonbank intermediation, firms issue
    publicly traded securities that consumers can purchase and own
    directly, but savers may also purchase and own securities indirectly
    through collective investment vehicles like mutual funds, insurance
    companies, private equity, hedge funds, or other nonbank financial
    institutions. These intermediaries along with broker-dealers are part
    of the financial infrastructure that makes it possible for consumers to
    purchase and sell securities and thereby channel their savings into
    investments without using the banking system as the investing
    intermediary.
        The ability to invest saving using nonbank forms of intermediation
    generally gives savers more control over their investment decisions as
    well as the ability retain a larger share of the profit (or the loss)
    generated by their investment decisions. Nonbank intermediation is
    typically a cheaper source of funding for firms that have achieved a
    good reputation among investors by repeatedly honoring the financial
    claims they have issued in the past and through public disclosures that
    help to make their operations and financial condition as transparent as
    possible to investors.
        Banks also play a key role in creating the supply of money that
    consumers use as a store of value and medium of exchange. Transferable
    bank deposits are an important part of the money supply. Money is an
    extremely important economic invention. It allows consumers to
    specialize in their most productive labor activity in exchange for
    receiving compensation in the form of a widely accepted medium of
    exchange (money) they can use to purchase the goods and services they
    choose to consume or to save using bank or nonbank intermediation.
        Without money, consumers would have to barter. Without money,
    consumers must find someone offering the goods or services they want,
    and at the same time, the counterparty must want the output their own
    labor services. Making an investment is even more difficult because a
    saver must also trust that the counterparty will be willing and able to
    provide the promised service in a future period. When an economy lacks
    money, it must satisfy ``a double coincidence of wants,'' and economic
    output and growth are severely limited.
        Money facilities trade, but it is costly for firms and consumers to
    hold money. Cash pays no interest. Bank deposits offer minimal yield,
    and banks may impose costs to transfer deposit balances. If firms and
    consumers can find ways to minimize their holding of cash and bank
    deposits, they are better off because they have more control over where
    their savings are invested, they have the potential to earn higher
    returns, and they save on bank transactions costs. However, because
    transactions in real goods and services require the transfer of cash or
    bank deposits, firms and consumers either need to own money balances
    before transacting or be able to borrow them from somewhere. But most
    firms and consumers do not have established reputations that allow them
    to borrow based only on their pledge to repay in the future.
        The market solution to the borrower reputation problem is to use
    liquid long-term debt securities issued by reputable firms as
    collateral for borrowing. \1\ Liquid long-term debt securities that are
    perceived to have stable values that are largely insensitive to new
    information are ideal collateral for borrowing. These securities can be
    traded among savers without the need to spend a large amount of effort
    to collect information and evaluate the likelihood that they will
    maintain their value in the near term. Firms and consumers may purchase
    these securities not for their ultimate cash payoffs, but to use them
    to secure borrowing when they are unable to borrow based on their
    promise of repayment alone.
    ---------------------------------------------------------------------------
         \1\ Other securities can also be used as collateral but high
    quality information insensitive long-term debt securities like U.S.
    Government securities and highly rated corporate debt are preferred
    collateral.
    ---------------------------------------------------------------------------
        Securities that are widely perceived as having a stable predictable
    value function as so-called inside-money. They are held by firms and
    consumers as a temporary store of value in lieu of bank deposits
    because they offer higher yields and can be quickly converted into cash
    and deposit money at minimal cost. When firms or consumers need to
    transact, they exchange the securities for cash. A real world example
    of inside money is the market for repurchase agreements for Government,
    agency and high-quality structured and corporate credits. The stock of
    inside money is an important component of the economy's effective money
    supply.
    Defining Systemic Risk
        Against this background, it is useful to consider a definition for
    systemic risk. My preferred definition of systemic risk is that it is
    the possibility that a disruption in the financial intermediation
    process could cause a significant reduction in real economic growth.
        In the simple stylized economy have I described in the prior
    section, financial intermediation can be disrupted in two ways. The
    first is that the failure of a financial intermediary or many financial
    intermediaries will disrupts financial intermediation. To take an
    extreme example, if the economy has only a single bank and it fails,
    consumers can no longer use it to channel their savings into
    investments, its bank deposits are no longer acceptable as money, and
    economic growth will clearly decline.
        The nonbank intermediation process can also be disrupted and cause
    systemic risk. The failure of a key intermediary could make it very
    difficult for savers to purchase or sell securities. An important
    failure or series of intermediary failures could cause important
    disruptions in this form of intermediation.
        Nonbank intermediation can also be interrupted without an
    intermediary failure. Events or new information can make savers
    reluctant to purchase existing securities making it difficult or
    impossible for investors to sell the securities they own. When the
    value of existing securities is materially diminished, the agents
    holding securities for use as collateral have a diminished ability to
    borrow or may be unable to borrow at all and this will restrict their
    ability to transact in goods and services.
    The Dodd-Frank Act and Systemic Risk
        The Dodd-Frank Act uses the phrase ``systemic risk'' 39 times in
    directing the financial regulatory agencies to identify, mitigate, and
    minimize ``systemic risk.'' But the Dodd-Frank Act never defines
    systemic risk. Because the term is ambiguous, the law allows the
    regulatory agencies wide discretion to interpret the powers it conveys.
    The DFA directs agencies to draft and implement rules to control and
    minimize ``systemic risk'' without requiring the agencies to identify
    specifically what they are attempting to control or minimize.
        Another troubling aspect of the Dodd-Frank Act is that the law does
    not recognize that rules and regulations that reduce systemic risk will
    have an impact on economic growth. The necessity of such a relationship
    is easiest to see in a bank-centric economy. If systemic risk reduction
    is accomplished by imposing regulations that limit the risk of bank
    investments, regulation will also limit economic growth. A fundamental
    principle of finance is that risk and return are positively related.
    Regulations that limit the risk of bank investments, if they are
    effective, will necessarily constrain banks to low-risk, low-return
    investments. Very stringent bank regulation may ensure that bank
    deposits remain safe, but they will also force banks to channel
    consumer saving into low-risk, low-return investments, and the economy
    will grow more slowly than it otherwise would.
        The Dodd-Frank Act takes a very naive approach toward controlling
    systemic risk. Instead of clearly identifying what it is trying to
    accomplish and legislating appropriate measures, it defines financial
    stability as the absence of systemic risk and grants regulators an
    extensive set of new powers while assigning them the responsibility of
    ensuring U.S. financial stability.
        One way to ensure financial stability and remove systemic risk is
    to restrict financial intermediation. If there is little or no
    financial intermediation, then it cannot be a source of systemic risk.
    Unfortunately this solution has very serious consequences for economic
    growth.
        An alternative solution is to restrict the kinds of financial
    intermediation that cause systemic risk. This is the Dodd-Frank
    approach. It requires regulators to separate ``good'' financial
    intermediation from ``bad'' financial intermediation and to impose
    rules to stop bad intermediation. The problem is that is unclear that
    any person or agency has the capacity to distinguish good
    intermediation from bad intermediation, and stopping intermediation has
    negative consequences for economic growth. While this problem is
    inherent to some degree in any form of financial regulation, Dodd-Frank
    grants regulators extensive new powers to identify and stop ``bad''
    financial intermediation as the means to achieve an ultimate (and
    impossible goal) of ensuring financial stability without any
    requirement that regulators recognize the implicit cost on economic
    growth.
        Post Dodd-Frank, if we do not achieve financial stability, then
    easiest conclusion is that the regulators failed because they did not
    stop enough ``bad'' intermediation since regulators had been given
    sweeping powers to stop bad intermediation. Whether the conclusion is
    true or not does not matter. The fact that the conclusion will be made
    by some builds in a clear bias encouraging regulators to overregulate
    in their pursuit of financial stability. Clear constraints on
    regulatory power are necessary, or regulators will overregulate and
    economic growth will suffer.
        I will now discuss in detail some of the specific issues that were
    raised in the invitation to testify at today's hearing.
    Section 113 Designation
        Section 113 of the DFA provides the FSOC guidelines that should be
    followed when designating nonbank financial firms to be supervised by
    the Board of Governors and subjected to heightened prudential
    standards. The standard for designation is ``if the Council determines
    that material financial distress at the U.S. nonbank financial company,
    or the nature, scope, size, scale, concentration, interconnectedness,
    or mix of the activities of the U.S. nonbank financial company, could
    pose a threat to the financial stability of the United States.''
    Issues Associated With Section 113
        Section 113 includes a laundry list of factors that the Council can
    consider in making the designation, but the language merely identifies
    factors the Council can consider; it does not include any quantitative
    standards to guide the designation process. The characteristics that
    may be considered for designation are very broad, but without
    quantitative guidance, the guidelines are arbitrary and impose little
    rigor on the designation process. For example, the guidelines never
    mention whether the firms' distress should be considered in isolation
    in an otherwise well-functioning financial market, or whether the
    threat to financial stability engendered by firm distress should be
    assessed in the context of a dysfunctional financial market under the
    assumption that many other banks and nonbank financial institutions are
    also failing. Clearly, the financial stability consequence of a firm
    failure in an otherwise quiescent financial market is far less severe
    than a failure under stressed financial market conditions.
        In practice, Section 113 guidelines merely restrict the FSOC's
    designation discussion and the case (if any) it makes to support its
    decision, but the designation outcome is completely governed by the
    Council vote. Moreover, since the directive lacks objective standards
    for designation, the criterion used to designate firms will almost
    certainly across administrations as different politically appointed
    officials are represented on the Council. Without objective minimum
    quantitative standards for designation, there is little scope for
    continuity over time or for a designated firm to use data, analysis, or
    case precedent to overturn an opinion rendered by the Council.
        One especially telling feature of Section 113 is that the
    designation guidelines do not require the Council to simultaneously
    recommend specific heightened prudential standards for the designated
    firm to mitigate systemic risk or consider whether the heightened
    prudential standards that otherwise apply (set by the Board of
    Governors) will reduce the probability that the firm's financial
    distress would pose a material threat to the financial stability of the
    United States. Indeed all of the Council's designations to date have
    been made without any Council recommendations for specific heightened
    prudential standards and before the Federal Reserve has revealed how it
    will supervise the nonbank financial institutions or what heightened
    prudential standards the designated firms must satisfy.
        There is no requirement in Section 113 that the Council specify
    what specific characteristics or activities of the nonbank financial
    firm lead the Council make a designation. The justifications for all of
    the Council's designations made thus far are vague and lack any
    specific information that would inform the designated firm or other
    potential designees of the actions they might take to avoid
    designation. Should the council take an interest in designating an
    institution, there is little or no objective information the
    institution might use to proactively modify its operations, capital, or
    organizational structure to reduce its ``systemic risk'' to acceptable
    levels.
        In summary, the legislation that guides the designation process for
    nonbank financial institutions gives financial firms little or no
    ability to protect themselves against an arbitrary designation by the
    Financial Stability Oversight Council. Moreover, the criterion used to
    designated financial firms will likely vary as administrations and
    their politically appointed FSOC representatives change. Since
    designation has the potential to materially change an institution's
    regulatory framework as well as the potential to restrict its
    investments options and business processes, the designation process
    should be amended to include minimum quantitative standards for
    designation and a requirement that the Council credibly establish that
    Federal Reserve supervision and the enhanced prudential standards that
    will apply reduce the potential for the firm's distress to create
    financial instability.
    Sections 115: FSOC Recommendations for Enhanced Regulation
        Section 115 empowers the FSOC to recommend specific enhanced
    prudential standards for designated financial institutions. The FSOC
    has authority to recommend that the Board of Governors impose
    heightened prudential standards on designated firms. These
    recommendations can require firm-specific standards and may include
    enhanced leverage ratio and risk-based capital requirements, liquidity
    requirements, short-term debt and concentration limits, contingent
    capital requirements, enhanced risk management requirements, resolution
    planning and credit exposure reports, and enhanced public disclosure.
    Issues Relate to Section 115 Powers
        Section 115 includes no guidelines or requirements to constrain the
    heightened prudential standards that the FSOC may recommend. Indeed
    Section 115 does not even discuss a process that must be followed to
    issue a recommendation. For example it is unclear whether the issuance
    of an FSOC recommendation requires an FSOC vote or the voting majority
    need for approval. Section 115 lacks any requirement that the FSOC
    support its recommendation for heightened prudential standards with
    objective evidence that shows that the recommended standards will
    successfully limit the firm's ability to destabilize the U.S. financial
    system should the firm become distressed.
    Sections 121: FSOC Discretion To Grant Board of Governors Additional
            Corrective Powers
        Section 121 gives the Board of Governors the authority to request
    FSOC approval for additional powers that enable it to restrict the
    activities of a specific designated firm including preventing the
    institution from entering into mergers, barring it from specific
    investment activities or offering specific financial products,
    requiring changes to its business practices, and even requiring
    divestures if the Council determines that the institution poses a grave
    threat to U.S. financial stability that cannot be mitigated by other
    means.
        The primary issue raised by Section 121 powers is that Section 121
    does not require that FSOC produce specific evidence to demonstrate
    that its restriction recommendation will curtail systemic risk or
    improve the stability of U.S. financial markets. Section 121 requires
    no objective criteria to limit or constrain the FSOC's powers and
    protect the property rights of the designated financial firm's
    shareholders and creditors.
    Section 165: Enhanced Supervision and Prudential Standards
        Section 165 directs the Board of Governors to establish heightened
    prudential standards that apply to bank holding companies in excess of
    $50 billion and nonbanks financial firms designated by the Council. The
    Board of Governors is required to set heightened prudential standards
    for risk-based capital requirements, liquidity requirements,
    concentration limits, risk management requirements and resolution plans
    and credit exposure reports. The Board of Governors is also empowered
    to set standards for short-term debt limits, contingent capital
    requirements, enhanced public disclosure, or other standards the Board
    of Governors deems appropriate to mitigate or prevent risks to
    financial stability that may arise from the distress of a designated
    company.
        Section 165 also requires the Board of Governors to administer
    annual stress test to bank holding companies with consolidated assets
    in excess of $50 billion and designated nonbank financial institutions
    and to publicly report on the results. The Board of Governors may use
    the results of the stress test to require designated institutions to
    modify their orderly resolution plans. In addition, Section 165
    requires that all financial institutions or holding companies larger
    than $10 billion with a primary Federal regulator must conduct annual
    stress tests similar to the Board of Governors stress test and report
    the results to their primary Federal regulator.
        Section 165 also provides the Board of Governors and EDIC with the
    powers to impose heightened prudential standards on designated firms
    that do not submit resolution plans that provide for a rapid and
    orderly resolution under Chapter 11 Bankruptcy in the event the
    designated firm suffers material financial distress or failure.
    Issues Raised by Section 165 Requirements
                When does a bank become systemic and require heightened
                        prudential standards?
        There is no science evidence that supports a threshold of $50
    billion for subjecting bank holding companies to heightened prudential
    standards. While the factors that are mentioned in Section 165 as
    potential indications that an institution may be a source of systemic
    risk--size, leverage riskiness, complexity, interconnectedness, and the
    nature of the institutions financial activities--are reasonable
    features to consider, there is no economic research that supports the
    use of a specific thresholds for any of these individual factors to
    indicate a need for heightened prudential regulation.
        As of March 2014, the U.S. has 39 bank holding companies with
    consolidated assets in excess of $50 billion. Of these, 4 had
    consolidated assets greater than $1 trillion, 4 had assets between $500
    billion and $1 trillion (and none of the 4 are primarily commercial
    banks), 8 had assets between $200 and $500 billion (5 of these are
    specialty banks), and 23 had assets less than $200 billion. Of the 23
    banks with under $200 billion in consolidated assets, most are almost
    exclusively involved in commercial banking and many might be
    characterized as ``regional'' banks.
        There are huge differences in the characteristics of the 39 bank
    holding companies that are subjected to enhanced prudential supervision
    by the $50 billion limit imposed under Section 165. Very few of these
    institutions can truly be considered systemically important. Moreover,
    for the vast majority of these institutions, their failure could be
    handled using an FDI Act resolution if the appropriate planning were
    undertaken using Title I orderly resolution planning authority. There
    should be no need to invoke Title II. Thus, in my opinion, the $50
    billion threshold set for enhanced prudential standards in Section 165
    has erred on the side of excessive caution.
                Enhanced capital and leverage requirements for designated
                        bank holding companies
        The enhanced bank capital and leverage standards required by
    Section 165 have been enthusiastically supported by many economists and
    policy makers, and I agree that higher bank capital requirements are
    appropriate for institutions that are truly systemic. But the class of
    institutions that is truly systemic is far more restricted than the
    class prescribed in Section 165.
        The enhanced capital and leverage requirements that have been
    implemented by the Board of Governors are associated with the U.S.
    implementation of Basel III. These requirements have been designed for
    use by banks and bank holding companies. They are not appropriate for
    nonbank designated firms who are also subject to the heightened
    prudential requirements under Section 165.
                Enhanced capital and leverage requirements for designated
                        nonbanks
        Section 165 seems to give the Board of Governors the discretion to
    modify these enhanced prudential requirements and tailor them to more
    closely fit the businesses of nonbank designated firms. Thus far, the
    Board of Governors has not modified any of these enhanced prudential
    standards and argued that the Collins amendment imposes Basel I capital
    requirements as a minimum standard on all designated companies.
    Legislation clarifying that the DFA Collins amendment does not apply to
    insurance companies has passed the Senate and been introduced in the
    House of Representatives.
        Still, the issue of the applicability of Section 165 enhanced
    prudential standards highlights fundamental weakness in the drafting
    and implementation of the Dodd-Frank Act. The Financial Stability
    Oversight Council has designated a number of nonbank financial
    institutions without either knowing what enhanced prudential standards
    will apply or assuming that nonbanks will have to meet the same
    standards as bank holding companies. In either case, it is doubtful
    that the Council's deliberations considered how designation would
    improve U.S. financial sector stability.
                A two-tiered system of bank regulations will stimulate the
                        growth of large institutions
        A second issue raised by the imposition of enhance prudential
    standards on the largest institutions in the banking system is that a
    two-tiered system of regulations officially recognizes two distinct
    types of banks: (1) those that are small and can be allowed to fail
    without social cost; (2) those that are very large and create large
    failure costs that must be avoided by stricter regulation. Under this
    system, the smaller banks may benefit from less burdensome regulation.
    But investors understand that these institutions will be allowed to
    fail and softer regulations seemingly makes their failure more likely.
    In contrast, large banks have added regulatory burden, but they also
    have been explicitly identified by the Government as so important that
    they need additional regulation to ensure their continued existence.
        The differences in capital and leverage regulations between small
    and large banks mandated by Section 165 and implemented as Basel III
    are mechanical and may not be the decisive factor that differentiates
    the largest banks. However, the Board of Governors stress test and the
    resolution plans (joint with the FDIC) mandated by Section 165 include
    very intrusive correctional powers where the Fed or the FDIC can
    require extensive operational changes or additional capital at the
    largest institutions. For the largest institutions, post Dodd-Frank, it
    is not hyperbole to say the Board of Governors (and to a far lesser
    extent the FDIC) now have a direct and important role managing the
    largest bank holding companies.
        When the Government is intimately involved in planning and
    approving large bank operations, why wouldn't investors believe that
    their investments were safer in the largest banks? The enhanced
    prudential standards imposed by Section 165 contribute to investor
    perceptions that the largest banks are too big to fail.
        Over time, the two-tiered approach to banking regulation will erode
    the ability of small banks to compete for uninsured deposits and reduce
    their ability to issue unsecured liabilities. Since Dodd-Frank also
    prohibits the use of trust preferred securities, small bank options to
    fund growth beyond their retail deposit bases will be severely limited.
    As a consequence, Section 165 requirements are likely to encourage
    additional consolidation in the U.S. banking system as large deposits
    and assets further migrate into the institutions that are required to
    meet enhanced prudential standards.
                Limits on the use of short-term debt
        Section 165 short-term debt limits give the Board of Governors the
    power to require designated financial firms to extend the maturity of
    their funding debt (except for deposits, which are exempted from the
    rule) and restrict the use of short-term collateralized funding
    including the use of repurchase agreements. Curiously, the deposit
    exemption is not restricted to fully insured deposits. Banks may issue
    uninsured deposit without restrictions even though this source of
    funding is among the most volatile and the first to run.
        Short-term debt restrictions limit one of the most visible symptoms
    of a financial crisis--the inability of financial firms to roll-over
    their maturating debt. They try to alleviate this problem by requiring
    that firms have, on average, a longer time buffer before they face the
    inevitable maturing debt roll-over. But all going-concern debt
    eventually becomes short-term and must be refinanced.
        The idea for short-term debt restrictions is also popular in many
    postcrisis academic papers that argue that there is an underlying
    market failure that can be fixed by short-term debt limits. Banks gain
    private benefit from funding short term because they have a monopoly on
    issuing demandable deposits and an implicit guarantee advantage in
    issuing other short-term deposit-like liabilities. The bank benefit is
    that short-term funding is usually the cheapest source of finance.
        The market failure arises when there is a liquidity shock and
    investors for some reason become unwilling to roll-over banks' short-
    term liabilities and banks are forced to sell assets to meet redemption
    requirements. Because many banks are using ``excess'' short-term
    funding because of the apparent interest cost savings, they must all
    shed assets, and this depresses the market price of assets, causing a
    so-called ``fire-sale'' decline is asset prices. The decline is asset
    prices must be recognized by all institutions, even ones that may not
    be funding with excess short term-debt. And so the lesson from these
    models is that ``asset fire sales'' are an externality attached to the
    overuse of short-term debt, and if regulators restrict bank's ability
    is fund short term, then the externality can be controlled. Well maybe,
    but there will be real economic costs that are not recognized in these
    models.
        First, all debt eventually become short term, so limiting the
    amount of banks and other financial firms short term debt does not
    remove the issue that all debt must eventually be rolled over
    regardless of maturity. The economic models that demonstrate ``fire
    sale'' externalities are highly stylized and static. In these models,
    if banks fund long term (in the third and final model period) they do
    not have to refinance in the second period when the fire sale occurs.
    By forcing banks to issue claims in the ``last'' period of the model,
    the claims magically never have to be refunded in the horizon of
    interest. While this solves the fire sale problem in these economic
    models, it does not fix the real life problem that seemingly far-off
    future periods have a habit if turning into tomorrow, and debt that was
    once long-term, becomes short term and must be rolled over.
        The ``fire sale'' models of short-term debt also ignore a large
    literature in corporate finance that argues that short-term debt is
    cheaper because it is a mechanism for controlling the risk that the
    managers of a financial institution (or any corporation for that
    matter) take. If the manager of a corporation is forced with the
    discipline of continuously rolling over a significant share of the
    corporation's funding, then the manager must ensure that the
    corporations finances are always sound and its debt holders are never
    surprised by the firm's is investments.
        Short-term debt is a bonding device. The need to roll over debt
    helps to keep the manager from investing in longer-term risky
    investments with uncertain payoffs unless debt holders are fully aware
    and approve (i.e., are already compensated) for such investments. If
    the manager conveys that the firm investments in short term and
    relatively safe activities, should debt holders learn otherwise, the
    manager's debt holders may refuse to roll over the debt at existing
    rates and the manager will be forced to abandon longer term investments
    before they can (possibly) produce the desired high payoff.
        When short-term debt controls the risks the manager takes,
    investors can charge lower rates. Thus, short-term debt provides
    cheaper funding in part because it limits borrower risk-taking. Indeed
    academic many papers argue that, before deposit insurance, banks funded
    themselves with demandable deposits because depositors required the
    demandable feature to discipline the bank, since the soundness of the
    bank's assets could not otherwise be verified by depositors. Deposit
    insurance largely destroys the risk control benefits of demandable
    deposits. I say largely because there is evidence that some insured
    deposits still run.
        Thus, there are sound economic reasons for arguing that short-term
    debt restrictions on designated financial firms may be less advantages
    than they might seem. Short-term (noninsured deposit) debt controls
    risk taking, and the current wave of theoretical economic models that
    produce ``asset fire sales'' do not consider the risk control benefits
    of short-term debt. If financial firms are forced to fund themselves
    longer-term debt, their cost of debt will increase, and either the
    institutions will absorb these costs and be less profitable or pass
    these cost on to customers in the form of higher loan rates and lower
    returns on deposits. Section 165, and indeed the current wave of
    macroprudential economic models, do not recognize that short-term debt
    restrictions are likely to have real economic costs on borrowers.
                Mandatory Board of Governors annual stress tests
        Section 165 Board of Governor stress tests are perhaps the most
    problematic form of enhanced prudential supervision required by the
    Dodd-Frank Act. The value of these exercises for identifying and
    mitigating financial sector excesses is highly questionable, and yet
    the Federal Reserve System spends an enormous amount of resources on
    this activity. Indeed senior Federal Reserve officials have argued that
    Basel regulatory capital rules should be suspended, and the Board of
    Governors annual stress test should be formally recognized as the means
    for determining minimum capital requirements for large bank holding
    companies.
        Aside from the confidence of senior Federal Reserve officials,
    there is no evidence that coordinated macroeconomic stress tests will
    be effective in preventing future financial crisis. Already, these
    stress tests have missed the ``London Whale'' at JPM Chase and a
    multibillion dollar hole in Bank of America's balance sheet. Fannie Mae
    and Freddie Mac both passed severe Government-designed macroeconomic
    stress test right before they failed in September 2008. Even before the
    financial crisis, many countries produced financial stability reports
    that included bank stress tests and none anticipated or prevented the
    crisis. Prior pan-European EBA stress tests failed to identify a number
    institutions that become problematic in short order. Based on the track
    record to date, stress tests have a pretty poor record for detecting
    ``problem'' institutions.
        A stress-test based approach for setting bank capital has two
    gigantic measurement problems. First, the macroeconomic scenario must
    actually anticipate the next financial crisis. And secondly, regulators
    must be able to translate the macroeconomic crisis scenario into
    accurate predictions about actual bank profits and losses.
        Few regulators possess the prescience necessary to accomplish this
    first step. Rewind your clock to 2006 and ask yourself if the Board of
    Governors would have used a scenario that predicted the housing crisis.
    It was less than 2 years away, but the Fed did not see it coming. The
    New York Fed's staff was publishing papers that dismissed the idea of a
    housing bubble and the Federal Reserve Chairman's speeches argued--
    worst case--there may be some ``froth'' in local housing markets. Even
    as the subprime bubble burst, the new Fed Chairman publicly opined that
    the economy would suffer only minor fallout.
        Even if the Board of Governors stress scenario correctly
    anticipates a coming crisis, the crisis must be translated into
    individual bank profits and losses. The problem here is that bank
    profits and losses are not very highly correlated with changes in
    macroeconomic indicators. Quarter-to-quarter bank profits do not
    closely follow quarterly changes in GDP, inflation, unemployment, or
    any other macroeconomic indication. The best macroeconomic stress test
    models explain only about 25 percent of the quarterly variation in
    individual bank profits and losses, meaning that more than 75 percent
    of the variation in bank profit and losses cannot be predicted using
    GDP, unemployment, or other business cycle indicators.
        Because of these measurement issues, bank loss predictions from
    macroeconomic stress tests have very little objective accuracy. Even
    using the best models, there remains a great deal of uncertainty
    surrounding how each bank may actually perform in the next crisis,
    presuming the stress scenario anticipates the crisis.
        These issues are real and serious and they make macroeconomic
    stress testing more of an art than a science. There is no formula or
    procedure that will lead to a single set of stress test bank loss
    estimates that can be independently calculated by different stress test
    modelers. Thus, it is not surprising that the Board of Governors and
    the U.S. banks rarely agree on stress test results. The Fed uses its
    artistic judgment to produce large losses while the banks' aesthetics
    favor smaller loss estimates. Both the bank and the Fed are probably
    wrong, but the Fed's judgment always prevails when it comes to the
    stress test capital assessment.
        The stress test process requires the Board of Governors to be
    intimately involved in modeling the operations and exposures of each
    large banking institution. It also requires the Federal Reserve Board
    to use its own judgment to set each large bank holding company's
    ``stress tested'' capital plan. What if the Board of Governors is
    wrong? How can they let an institution that they are essentially
    managing fail? When regulations get so intrusive that the regulator
    virtually ``runs the bank,'' it becomes difficult for the Government to
    impose losses on the institution's shareholders and bondholders if the
    institution fails. This precarious situation could easily encourage the
    Board of Governors to over regulate the largest institutions to ensure
    that there is never a failure on its watch. This outcome is a recipe
    for permanently slower economic growth and stagnant financial
    institutions.
        It may not be widely appreciated, but the coordinated macroeconomic
    stress test approach to regulation encourages a ``group think''
    approach to risk management that may actually increase the probability
    of a financial crisis. Stress test crisis scenarios have to be specific
    so that banks and regulators can model the same event. Moreover, the
    Board of Governors imposes some uniformity in loss rates across all
    designated banks by using its own stress test estimates. The Board of
    Governors is very much like a coach or a central planner that tries to
    ensure some coherence in each designated firms estimates and capital
    plans. Unintentionally perhaps, by requiring all firms to approach the
    stress test problem the Board of Governors approve way, the process is
    encouraging all large institutions to think and operate the same way.
    What happens when all the largest banks are steeled against the wrong
    crisis scenario? Could the financial losses generated by a different an
    unexpected crisis actually be made worse by the coordinated stress test
    exercise?
        The finial Section 165 issue I will discuss is related to the
    requirement that designated firms file an annual orderly resolution
    plan. Section 165 directs the Board of Governors and the FDIC to
    determine whether designated firms' orderly resolution plans are
    credible or whether they would fail to facilitate an orderly resolution
    of the company under title 11 of United States Code. However, Section
    165 does not provide any specific guidance that constrains the
    agencies' judgment. There are no specific criteria specified that can
    be used to identify a credible plan; there are no objective standards
    that must be met. The credibility of a plan is entirely based on
    subjective judgments by the Board of Governors and the FDIC.
    Title II: Orderly Liquidation Authority
        Title II creates a special administrative process similar to the
    Federal Deposit Insurance Act (FDIA) administrative process for
    resolving failed banks. Title II also creates a special funding
    mechanism that can be used to ``liquidate failing financial companies
    that pose a significant risk to the financial stability of the United
    States in a manner that mitigates such risk and minimizes moral hazard.
    (Sec. 204 (a))''
        Title II is invoked when two-thirds of the serving members of the
    Federal Reserve Board and FDIC \2\ board of directors make a written
    recommendation for the use of Title II to the Secretary of the
    Treasury. The recommendation must include:
    ---------------------------------------------------------------------------
         \2\ If the SIFI is primarily a broker-dealer, The FDIC plays a
    consultative role and is replaced in its primary role by two-thirds of
    the sitting members of the Securities and Exchange Commission. If the
    SIFI is primarily an insurer, the FDIC has a consultative role and the
    case is made by the FRB and the Director of the Federal insurance
    Office.

        A determination that that the financial firm is endanger of
    ---------------------------------------------------------------------------
            default

        A determination that default under the Bankruptcy Code
            would have a serious destabilizing impact on the financial
            system

        A summary of the effect of default on financial conditions

        An assessment of the likelihood of a private sector
            solution

        An evaluation of why a normal Bankruptcy process would be
            problematic

        A recommendation for Title II actions to be taken

        An evaluation of likely impacts on counterparties,
            creditors, shareholders, and other market participants.

        Based on this recommendation, the Secretary of the Treasury in
    consultation with the President of the United States makes the final
    determination to use Title II powers.
        When Title II is invoked, the Secretary of the Treasury notifies
    the distressed financial firm's board of directors that the FDIC will
    be appointed receiver under Title II of the DFA. Should the board of
    directors not consent to the appointment, the Secretary of the Treasury
    can petition the United States District Court for the District of
    Columbia for an order that appoints the FDIC as receiver. The Court has
    24 hours to object to the petition as arbitrary and capricious and
    provide a reason supporting this determination. Faced with an
    objection, the Treasury Secretary can amend and refile the petition and
    continue this process until the Court appoints the FDIC as receiver.
        Once a petition is filed, the Court must decide within 24 hours or
    the FDIC is appointed receiver. Once the FDIC is appointed as receiver,
    the special resolution process cannot be stayed by the courts. The FDIC
    has three years to complete its receivership duties, but the time limit
    can be extended to 5 years with Congressional approval.
        Title II assigns the FDIC specific responsibilities that must be
    satisfied in the resolution process. These responsibilities are
    summarized in Table 1. Title II allows the FDIC to treat similarly
    situated creditors differently if it improves recovery values or limits
    disruptions to the financial system. However, any disadvantaged
    claimants must receive a recovery at least as large as they would
    receive in a Chapter 7 bankruptcy. The FDIC also has the power to
    charter a bridge financial institution to affect the resolution and it
    can make use of an Orderly Liquidation Fund (OLF) to fund the
    resolution. \3\
    ---------------------------------------------------------------------------
         \3\ The FDIC can move any assets and liabilities of its choosing
    from the receivership into the bridge financial companies. The bridge
    financial company is exempt from regulatory capital requirements and
    all taxes: U.S., State, county, territory, municipality, or other local
    taxing authority. The bridge company charter is for 2 years but can be
    extended to up to 5 years.
    ---------------------------------------------------------------------------
        The OLF is an FDIC line of credit with the U.S. Treasury that can
    be used to fund Title II resolutions. The FDIC can pledge receivership
    assets to secure funding. Within the first 30 days of the appointment
    of the FDIC as receiver, Title II limits the amount of OLF funding to
    10 percent of the consolidated assets of the distressed holding company
    as reported on its last available financial statement. After 30 days,
    the FDIC can borrow up to 90 percent of the fair value of the total
    consolidated assets of each covered financial company that are
    available for repayment.
        To access OLF funds, the FDIC must secure the Secretary of the
    Treasury's approval of an orderly liquidation plan, a specific plan for
    the liquidation of the receivership that demonstrates an ability to
    amortize OLF loan balances and pay interest consistent with the
    repayment schedule agreement. The interest rate on the OLF loan will be
    set by the Secretary of the Treasury, but it must be at least as large
    as the prevailing interest rate on similar maturity corporate loans.
    \4\
    ---------------------------------------------------------------------------
         \4\ The DFA says the interest rate must be at least as large as
    the prevailing rate on U.S. Government obligations of a similar
    maturity plus and interest rate premium at least as large as the
    different between the prevailing rate in a corporate bond index of
    similar maturity and the prevailing rate on U.S. Government securities
    of a similar maturity. The DFA does not specify the credit quality of
    the corporate bonds that should be used to set a lower bound on the
    credit spread.
    ---------------------------------------------------------------------------
        Should the projected repayment schedule from the receivership be
    unable to discharge the OLF loan terms within 60 months of the loan
    origination, the FDIC must follow a prescribed assessment protocol to
    collect the additional funds needed to discharge the debt. In the
    protocol, the FDIC first recovers any additional benefits that it paid
    out to similarly situated creditors in order to maximize the recovery
    value of the receivership or attenuate systemic risk (Section
    210(o)(D)). If this recovery is insufficient, the FDIC then must impose
    a risk-based assessment on all financial firms with consolidated assets
    in excess of $50 billion. Title II includes an extensive list of
    criteria the FDIC must consider in setting the assessment rate \5\ and
    it requires the Council to produce a ``risk matrix'' for criteria that
    the FDIC must take into consideration when setting OLF repayment
    assessment rates.
    ---------------------------------------------------------------------------
         \5\ The criteria are given in Section 210(o)(4). Among the
    criteria for setting assessment rates is a particularly striking
    catchall criterion: ``any risks presented by the financial company in
    the 10-year period immediately prior to the appointment of the
    Corporation as receiver for the covered financial company that
    contributed to the failure of the covered financial company (p. 1511).

        Title II clearly states that distressed financial firms should be
    resolved through the normal judicial bankruptcy process unless the
    bankruptcy destabilizes the financial system. To increase the
    probability that a financial firm can be resolved through a normal
    bankruptcy process, DFA Title I Sec. 165 requires designated financial
    firms to submit annual plans that outline a strategy to affect their
    orderly reorganization under a chapter 11 bankruptcy. The plan must be
    approved by the Board of Governors and the FDIC, and should objections
    be raised, designated firms are required to remedy objections and the
    Board of Governors and FDIC have the power to require any needed
    changes.
    The FDIC Single Point of Entry Title II Resolution Proposal
        Title II creates a new Orderly Resolution Authority, assigns the
    task to the FDIC, and imposes some broad guidelines the FDIC must
    follow but it does not dictate exactly how the FDIC must resolve a
    company put into Title II receivership. Title II leaves the FDIC with
    significant discretion to manage a receivership. To provide clarity to
    the Title II process, the FDIC has released a proposed strategy for
    executing a Title II resolution. The strategy envisions taking the top
    holding company of the distressed financial firm into receivership.
    This objectives of this ``Single Point of Entry'' strategy (SPOE) \6\
    are summarized in the FDIC Federal Register release,
    ---------------------------------------------------------------------------
         \6\ http://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-
    b_fr.pdf

            The SPOE strategy is intended to minimize market disruption by
            isolating the failure and associated losses in a SIFI to the
            top-tier holding company while maintaining operations at the
            subsidiary level. In this manner, the resolution would be
            confined to one legal entity, the holding company, and would
            not trigger the need for resolution or bankruptcy across the
            operating subsidiaries, multiple business lines, or various
    ---------------------------------------------------------------------------
            sovereign jurisdictions. p. 76623.

        Under a SPOE Title II resolution, the FDIC will be appointed
    receiver of the failing institution's top holding company. The FDIC
    will then charter a bridge financial institution, fire the existing
    management, hire new management, transfer all holding company assets
    into the bridge bank (p. 76617), and the bridge institution would
    function as the new top holding company. The holding company
    shareholders and most of its liabilities will remain in the
    receivership to absorb the failed institutions losses.
        The FDIC has the power to treat similarly situated creditors of the
    receivership differently if disparate treatment is necessary to
    maximize the return to creditors left in the receivership or to
    maintain essential operations of the bridge financial holding company.
    Using this power, vendors and liabilities related to retained employees
    would be transferred to the bridge holding company so they could
    maintain continuity in essential vendor and employee services. Also,
    secured holding company claims would be transferred to the bridge bank
    along with the collateral assets.
        Most of the liabilities of the distressed financial firm's top
    holding company would be converted into receivership certificates.
    Since most holding company liabilities would not be transferred into
    the bridge holding company, the new bridge company would be
    predominately equity funded. With the help of Government guarantees
    using the OLF if necessary, the bridge bank will issue new debt
    instruments and downstream the proceeds to recapitalize any
    subsidiaries that suffered losses or replace lost funding so that
    subsidiaries do not have to shed assets in a ``fire sale'' to meet
    redemption demands.
        The SPOE is designed to have the equity and debt holders of the
    parent company absorb all of the losses of holding company
    subsidiaries, but the FDIC anticipates circumstances when this may not
    be possible:

            if there are circumstances under which the losses cannot be
            fully absorbed by the holding company's shareholders and
            creditors, then the subsidiaries with the greatest losses would
            have to be placed into receivership, exposing those
            subsidiary's creditors, potentially including uninsured
            depositors, to loss. An operating subsidiary that is insolvent
            and cannot be recapitalized might be closed as a separate
            receivership. Creditors, including uninsured depositors, of
            operating subsidiaries therefore, should not expect with
            certainty that they would be protected from loss in the event
            of financial difficulties (p. 76623).

    Issues Raised by a Title II SPOE Resolution
                Most large financial firms that might be subject to Title
                        II are primarily banks
        Most of the large financial institutions that might be candidates
    for a Title II resolution are bank holding companies. For the majority
    of these institutions, their primary asset is a bank or a subsidiary
    bank holding company. Figure 1 shows the share of each parent holding
    company's equity that is invested in a subsidiary, affiliated bank, or
    a subsidiary bank holding company for all bank holding companies larger
    than $10 billion in consolidated assets. For most of these
    institutions, their primary asset is a bank, and even in cases where
    these institutions have multiple banks or subsidiary bank holding
    companies, they usually have one large depository institution that
    holds most of the holding company's consolidated assets and issues most
    of the holding company's consolidated liabilities. This feature is
    important because if the bank holding company's largest asset is a big
    bank, the holding company will only be in financial distress when the
    largest bank is in distress.
                For most Title II candidate firms, parent equity =
                        consolidated holding company equity
        To understand how well the SPOE might work in practice, it is
    instructive to take a closer look at the equity and liability
    characteristics of bank holding companies larger than $100 billion,
    banks that might require a Title II resolution. Table 2 reports March
    2014 data on all holding companies larger than $100 billion. Two of
    these holding companies are savings and loan holding companies which
    have less detailed disclosures reported in the Federal Reserve public
    data base. The first important point to recognize in Table 2 is that
    when the equity in the parent holding company is exhausted by losses in
    its subsidiaries, then there is, at best, only a tiny amount of equity
    remaining in the consolidated institution.
        Table 2 shows that, for most of these institutions, once the parent
    is facing insolvency because losses exhaust its equity, any equity in
    its remaining solvent subsidiaries would be consumed by the losses in
    the holding company's insolvent subsidiaries. So if the parent's equity
    is exhausted or nearly exhausted when it is taken into a Title II
    receivership, then parent liability holders must be relied on to bear
    the receivership losses.

                In many cases Title II and SPOE will provide larger
                        Government guarantees than bankruptcy
        To keep a financial firm's subsidiaries open and operating, the
    FDIC will have to guarantee all the subsidiary liabilities so that
    counterparties do not undertake additional insolvency proceedings that
    would suspend subsidiary operations and tie up their assets in
    additional (potentially foreign) legal proceedings. If the FDIC
    guarantees subsidiary liabilities, then only the parent holding
    company's liabilities remain to absorb losses and recapitalize and fund
    subsidiaries.
        The final column of Table 2 shows that, in most cases, the parent's
    liabilities comprise only a small fraction of the consolidated
    liabilities of these financial firms. This pattern is most pronounced
    when the holding company's largest assets are held in subsidiary banks.
    The implication is that a Title II SPOE resolution will extend
    Government guarantees to the largest majority of the financial firm's
    liabilities and impose the losses on only a small share of liabilities
    issued by the consolidated financial firm. This feature creates a
    Government guarantee that is, in many cases, much larger than the
    Government guarantee that would arise when a bank fails and the holding
    company goes into a commercial bankruptcy proceeding.

                Holding company minimum debt regulations will be as
                        complicated as Basel capital regulations
        If the FDIC plans to keep subsidiary entities open and operating to
    maintain financial stability, and the SPOE is the resolution strategy,
    then Title II is likely to expand the Government safety net beyond what
    would happen in a bankruptcy proceeding. The FDIC and Board of
    Governors position on this critique is that the agencies will in time
    craft new debt requirements for the parent holding company to ensure
    that it has an adequate stock of senior and subordinated debt to absorb
    substantial losses. But crafting holding company minimum debt
    requirements is a process that is analogous to the process of
    calculating regulatory capital requirements. The development of
    regulatory capital requirements has taken tremendous regulatory and
    bank resources, not to mention more than 15 years of development time.
    Moreover, holding company minimum debt requirements will also have
    international competitive implications if large foreign banks do not
    face similar requirements. This sets up the case for another yet
    another Basel process to set international requirements for holding
    company debt issuance.
                The OLF is a new guarantee fund that conflicts with the
                        deposit insurance fund
        If the parent holding company liabilities are insufficient to
    support receivership losses and distressed subsidiary recapitalization
    needs, the FDIC will have to use the OLF to fund the receivership. This
    will require an FDIC assessment of all financial firms with
    consolidated assets larger than $50 billion to fund the receivership.
        While it has not been widely discussed since the passage of the
    DFA, the OLF Title II mechanism sets up a new Government guarantee
    fund. Under the SPOE, it will guarantee all but the parent holding
    company liabilities of the failing financial firm unless the FDIC
    decides to put some subsidiaries into default. Unless there are some
    operational details yet to be released, resources from the OLF will be
    available to guarantee deposits at a bank subsidiary. Consequently,
    Title II creates a conflict of interest between banks that support the
    deposit insurance fund and larger institutions that will be assessed to
    fund the OLF. This conflict becomes transparent when considering a SPOE
    resolution for a bank holding company whose primary asset is a single
    large bank.
        Among bank holding companies with consolidated assets greater than
    $50 billion, there are 13 institutions that own a single bank
    subsidiary. Selected characteristics of these institutions are reported
    in Table 3. Of these institutions, only Goldman Sachs and Ally
    Financial have significant investments in nonbank subsidiaries.
    Investments in the operating subsidiaries in the remaining 11 holding
    companies are concentrated in the holding company's single bank. If any
    of these holding companies is in distress, their bank must also be
    failing. If any of these designated institutions becomes distressed and
    imperils the financial stability of the U.S. financial system, then the
    Secretary of the Treasury and the President must make a decision
    whether to put the distressed firm through an FDIA resolution, or
    invoke Title II and use a SPOE resolution. This decision has important
    consequences.
        An FDIA bank resolution resolves the bank using the FDIC's long
    standing administrative resolution process. Under this process, the
    failed bank's shareholders and senior and subordinated debt holders
    bear the institution's losses. Deposit protection, if needed, is
    provided by the deposit insurance fund, a fund that is built from
    assessments on all insured banks. Under an FDIC bank resolution, the
    holding company equity holders will suffer very large losses, and the
    holding company is often forced to reorganize in bankruptcy. Holding
    company senior and subordinated debt holders may have a better
    experience, and indeed they may even suffer no loss in bankruptcy. \7\
    ---------------------------------------------------------------------------
         \7\ For example, the senior and subordinated debt holders in WAMU
    bank suffered large losses while the senior and subordinated debt in
    the holding company had a 100 percent recovery on their securities.
    ---------------------------------------------------------------------------
        Under a Title II resolution, the investors that own senior and
    subordinated debt in the bank will be fully protected under the SPOE
    strategy. Bank deposits, insured and uninsured, will also be fully
    protected under a Title II resolution. The SPOE will impose losses on
    investors in senior and subordinated holding company debt holders if
    the receivership losses cannot be fully absorbed by the holding
    company's equity. Any additional losses and recapitalization needs that
    cannot be covered by the holding company debt will be borrowed from the
    OLF. Repayment of these OLF funds will be assessed against any
    financial firm with assets greater than $50 billion.
                With Presidential approval, Title II empowers the Secretary
                        of the Treasury to change property rights without
                        prior notice, public debate, or Congressional
                        action
        The decision to use an FDIC Act resolution versus a Title II SPOE
    resolution has important consequences for investors. While holding
    company bankruptcy and FDIA resolutions are the presumed status quo
    where bank debt holders bear losses and bank holding company debt
    holders have a better chance of recovery, the Secretary of the Treasury
    and the President can, quickly and without public debate or
    Congressional approval, change the rules.
        If Title II is invoked, losses are shifted onto holding company
    debt holders, and bank deposits, investors in bank debt, and the
    deposit insurance fund are fully protected against any losses. Title II
    allows the President and his appointed Secretary of Treasury to
    completely change property rights and shift losses among distinctly
    different investors without prior notice, public debate, or any vote
    from Congress.

        Unless the holding company has specific characteristics that are
    uncommon among the largest holding companies, invoking Title II has the
    potential to provide Government guarantees far in excess of those that
    might be in force under an FDI Act resolution. The last column of Table
    3 reports the liabilities of the parent holding company as a percentage
    of the subsidiary bank liabilities. Except for Goldman Sachs and Ally
    Financial, a Title II SPOE resolution would impose losses on only a
    very small fraction of liabilities issued by the consolidated holding
    company. If the bank subsidiary liabilities were protected by the SPOE,
    it is probable that a large share of the holding company's losses would
    be borne by the firms that must contribute to the OLF.
                Title II provides inadequate funding to prevent asset
                        ``fire sales''
        The SPOE raises a few additional issues. Under Title II, access to
    OLF funds are limited to 10 percent of the value consolidated assets of
    the failed financial firm as reported on its last financial statement.
    After 30 days, or when the FDIC completes an assessment of the market
    value of the receiverships' assets, OLF funding can increase to up to
    90 percent of the market value of assets available to fund the
    receivership. The 10 percent cap on SPOE funding raises some important
    issues.
        It is highly unlikely that a large financial institution fails
    because it prepares its financial statements and discovers that it is
    undercapitalized. Instead, long before financial statements reflect
    true distressed values, market investors lose confidence and withdraw
    funding from the firm. The firm ultimately suffers a liquidity crisis
    that forces it to find a buyer or to reorganize. In the case of
    Wachovia and WAMU, somewhere close to 10 percent of their depositors
    ``ran'' in the weeks before they failed. Thus, history suggests that a
    large financial institution that is in danger of failing will have
    losses that require capital injections, but they will also face funding
    withdrawals that must be replaced if they are to avoid asset ``fire
    sales.''
        When the FDIC is required to quickly replace funding withdrawals
    and inject capital using the OLF, the 10 percent funding cap could
    become an important impediment. To avoid the cap, the FDIC may have to
    revalue the receivership assets quickly and then request funds in
    excess of 10 percent of holding company's initial consolidated assets.
    In reality, the FDIC does not have the capacity to value receivership
    assets that quickly, especially if the failure is a surprise. While I
    believe that the 10 percent funding cap is an example of good
    Congressional governance on paper, in practice, the FDIC will likely be
    forced into a speedy and less than rigorous revaluation because it will
    have access additional OLF funding in the early days of a Title II
    receivership.
                How will Title II work when and a bank subsidiary is
                        simultaneously being resolved under the FDI Act?
        Some of my criticisms of the SPOE have been anticipated in the FDIC
    Federal Register proposal where the FDIC reserves the right to take the
    subsidiary bank or nonbank subsidiaries into separate receiverships:

            if there are circumstances under which the losses cannot be
            fully absorbed by the holding company's shareholders and
            creditors, then the subsidiaries with the greatest losses would
            have to be placed into receivership, exposing those
            subsidiary's creditors, potentially including uninsured
            depositors, to loss. An operating subsidiary that is insolvent
            and cannot be recapitalized might be closed as a separate
            receivership. Creditors, including uninsured depositors, of
            operating subsidiaries therefore, should not expect with
            certainty that they would be protected from loss in the event
            of financial difficulties (p. 76623).

        It is unclear how this policy would work when a large financial
    holding company is predominately comprised of a large bank, especially
    of the bank is internationally active. The overarching goal of the
    SPOE's is too keep critical subsidiaries of the holding company open
    and operating to facilitate global cooperation, prevent ``ring-
    fencing,'' multiple competing insolvencies, and counterparty reactions
    that create operational difficulties and systemic risk. The resolving
    the large bank subsidiary would certainly create the problems SPOE
    tries to avoid.
        The FDIC's SPOE proposal does not explain how a Title II resolution
    would work when it is paired with a FDIA resolution of a bank
    subsidiary. It is unclear how losses will be allocated between bank and
    holding company creditors and between contributors to the deposit
    insurance fund and the OLF. It is also difficult to envision how the
    FDIC might be able to close a very large internationally active bank
    subsidiary, and impose losses on its creditors, while keeping it open
    and operating and out of extranational bankruptcy proceedings.
                Does Title II work in a true financial crisis?
        The last and biggest issue is how Title II and the SPOE would work
    when multiple large financial firms are simultaneously in distress.
    Would SPOE be used to simultaneously to resolve multiple large
    financial institutions through bridge banks? How different is this from
    nationalizing these banks which could comprise a large part of the
    banking system?
        Title II and SPOE do not fix the too-big-to-fail resolution problem
    in a true financial crisis when the distress of large financial
    institutions is mostly likely to arise. In my judgment, Title II
    complicates and compounds the too-big-to-fail issue at times when a
    single large institution fails in isolation without providing a
    practical solution in a financial crisis when many large financial
    firms are likely to be distressed simultaneously.
    If Not Title II and SPOE, Then What?
        I have argued that Title II implemented using SPOE does not fix the
    too-big-to-fail problem and instead introduces many new complications
    into the resolution process. There may be better policies available to
    deal with the distress of a large systemically important financial
    institutions and I briefly discuss some of these options.
                Mandatory contingent capital
        I would argue that a requirement for large institutions to fund
    themselves with an adequate buffer of contingent capital is probably a
    better solution than SPOE. First, it is useful to realize that SPOE
    operates similarly to a contingent capital buffer, only the Secretary
    of the Treasury decides when to trigger the conversion of debt into
    equity, and to date, no requirements have been issued that force
    designated holding companies to issue a minimum amount of senior or
    subordinated debt that might be converted.
        Under Title II and the SPOE, neither investors in holding company
    debt nor investors in the senior and subordinated debt of the
    subsidiary bank know whether they will be called on to convert their
    debt claims into an equity claim against the receivership. As a
    consequence, both groups of investors will demand a risk premium for
    the additional uncertainty.
        Contingent capital, or a requirement to issue so-called ``co-cos''
    would solve many of the problems associated with SPOE. Its issuance
    would be required by all designated firms ex ante and not just required
    ex post in a Title II resolution. Presumably co-cos would be required
    at the holding company level so that all designated firms are treated
    through the same recapitalization mechanism. Conversion triggers should
    be explicit and written into the contingent capital contract terms
    before bonds are sold, so that investors have the best available
    information to price the securities correctly. Provided issuance
    requirements are sufficient, co-cos would avoid the need to use of the
    OLF.
        To the best of my knowledge, European approaches for requiring
    contingent capital do not require immediate management removal.
    Managers may continue to serve (or not) according to the preferences of
    the shareholders after conversion. DFA requires managers and directors
    to be fired and replaced in a Title II resolution. To satisfy this
    requirement, the FDIC claims it will have a collection of vetted
    managers waiting to run a SPOE bridge institution. This claim seems a
    bit of a stretch. There are probably few people with such a capability,
    and my guess is that they are already fully employed and well
    compensated.
        Unlike the SPOE, it is easy to envision how contingent capital
    might work in a financial crisis when many designated firms
    simultaneously approach distress. Multiple conversions would
    recapitalize designated institutions without the need to resort to
    simultaneous Title II resolutions.
        There are still many unresolved issues related to the use of
    contingent capital to solve the too-big-to-fail problem. Foremost among
    these is the design of appropriate conversion triggers. Triggers should
    be based on objective criteria and not left to the discretion of
    regulators. A second issue is what happens if you need a resolution
    mechanism after conversion is triggered? Even allowing that open issues
    remain, still I think that contingent capital is a more practical
    solution relative to Title II and a SPOE resolution.
                Using Title I to fine-tune FDIC large bank resolutions
        Historically, when large banks fail, the FDIC arranges a whole bank
    transaction in which a larger, typically healthier bank, assumes all
    the deposits and most if not all of the institutions assets. Sometimes
    the FDIC uses a loss share agreement to partially cover losses on the
    failed bank assets that are of questionable quality. A whole bank
    transaction was used to resolve WAMU, the largest bank failure in U.S.
    history, without cost to the deposit insurance fund.
        The problem with whole bank resolutions is that there needs to be a
    bigger healthier bank to purchase the failing institution, and even
    when one exists, if a sale is successful, it creates a new larger
    institution. One step toward fixing the too-big-to-fail problem, is to
    require the FDIC to break up failing banks when they sell them in a
    normal FDI Act resolution.
        There are costs associated with changing the public policy
    priorities in an FDIC resolution. Whole bank purchases often impose the
    least cost on the deposit insurance fund because bidders value
    acquiring the entire franchise intact. It may be costly and require
    significant time and resources to separate and market large failing
    banks piecemeal. For example, it may be difficult to identify all bank
    operations associated with a single customer relationship, and more
    difficult yet to package these customer relationships into
    subfranchises that are readily marketable. But the added resolution
    costs are costs that must be born to avoid creating too-big-to-fail
    banks through the resolution process. Indeed the FDIC SPOE envisions a
    similar process in a Title II resolution.
        There may be practical ways to reduce the cost of requiring the
    FDIC to break up large banks in an FDIA resolution. For example, the
    FDIC could be required to use Title I orderly resolution planning
    powers to require organizational changes within the depository
    institution that would allow the institution to be more easily broken
    apart in a resolution. This may involve organizational changes to
    information systems, employee reporting lines or other process to
    ensure that the bank has the capacity to conduct key operations in
    house and is not relying on venders or consultants in a manner that
    would inhibit the break-up of the institution in a resolution process.
        There are many complicated, complex, and potentially costly issues
    that must be solved before a large bank could be successfully
    dismantled and sold in pieces in an FDIC resolution. However, these
    issues are a subset of the issues the FDIC must solve if it is to
    undertake a Title II resolution of the largest, most complex and
    internationally active institutions and downsize them in the resolution
    process.
        Once large regional banks can be managed and downsized in the
    course of a normal bank resolution, there would no longer be a case to
    require these banks to meet heightened prudential capital, leverage,
    stress test, or other regulatory standards prescribed by Section 165
    (excepting the requirement to submit a satisfactory orderly resolution
    plan). Improvements in the resolution process can substitute for overly
    rigorous prudential regulations that limit economic growth.
                  Additional Material Supplied for the Record
     LETTER FROM PAUL SALTZMAN, PRESIDENT, THE CLEARING HOUSE ASSOCIATION
     L.L.C., EXECUTIVE VICE PRESIDENT AND GENERAL COUNSEL OF THE CLEARING
           HOUSE PAYMENTS COMPANY L.L.C., SUBMITTED BY CHAIRMAN BROWN

    STATEMENT SUBMITTED BY CHRISTY L. ROMERO, SPECIAL INSPECTOR GENERAL FOR
                       THE TROUBLED ASSET RELIEF PROGRAM