[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.
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    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\
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     \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.
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    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\
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     \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.
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    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.
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     \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.
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    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.
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     \6\ For additional details, see Appendix 3.
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    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.
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    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).
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    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\
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     \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.
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    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 
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    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.
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     \8\ http://www.clevelandfed.org/research/policydis/pdp19.pdf
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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\
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     \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. 
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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.
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    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