[Senate Hearing 113-481]
[From the U.S. Government Publishing Office]
S. Hrg. 113-481
WHAT MAKES A BANK SYSTEMICALLY IMPORTANT?
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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 /
______
U.S. GOVERNMENT PUBLISHING OFFICE
91-384 PDF WASHINGTON : 2015
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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
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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?
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WEDNESDAY, JULY 16, 2014
U.S. Senate,
Subcommittee on Financial Institutions and Consumer
Protection,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 10:24 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
Chairman Brown. Welcome. The Subcommittee will come to
order. First, apologies to the witnesses and those in
attendance for the sort of truncated way we are doing this
today. There was a vote called late yesterday to be held at
10:15 today. So we have at least two Members of the
Subcommittee who I think will join us. Senator Toomey, the
Ranking Member, will have--normally he would do an opening
statement after I would, and because he was not able to vote
and come back as quickly, at the conclusion of the testimony of
the four of you, Senator Toomey will certainly be given the
right to do an opening statement, as any other Senators who
join us will.
Three regional banks are headquartered in my home State of
Ohio, one in each of the three biggest cities--Cleveland,
Cincinnati, and Columbus. They serve customers throughout the
State with other regionals located/headquartered in other
States obviously serving Ohio, too.
These banks operate under a very traditional banking model.
The CEO of one of them talked about her bank as a ``core funded
bank,'' the term she used. They take deposits, they lend
lending to families and small businesses. Each has assets of
over $50 billion, making them subject to enhanced supervision
by the Federal Reserve.
While nonbanks are judged based upon a specific set of
criteria, the Dodd-Frank Act requires all banks, as we know,
with more than $50 billion in assets to automatically be viewed
as systemically important.
Each of these three Ohio banks serves an important role in
the communities they serve, but from what I can tell, none of
these regional institutions would threaten the United States or
global financial system or economy if they were to fail.
Many in Washington attack the Financial Stability Oversight
Council, or FSOC, for designating institutions as systemic. Let
us be clear: the $50 billion line was created by Congress, not
by FSOC.
Some Washington politicians say that this systemically
important designation means that all of these banks are, in
parlance we used, ``too big to fail.''
But financial regulators say that the failure of a $50 or a
$60 or a $100 billion bank would not, in fact, threaten the
financial system.
This group of 33 banks contains banks with diverse business
models--universal banks, regional banks, trust banks, and
foreign banks--and diverse geographic footprints--Columbus,
Ohio; Pittsburgh, Pennsylvania; Montreal; Salt Lake City, Utah;
Santander, Spain.
They range in size from $2.4 trillion, the largest, in
assets, those that have been designated, to $56 billion; from
operating in 100 countries to operating in just one. Clearly,
these banks are not the same.
That is why other rules use different thresholds. For
example, banks with $250 billion are subject to a liquidity
coverage ratio; banks with more than $700 billion in assets
must meet a supplementary leverage ratio.
It is clear that regulators believe that these institutions
present different levels of risk. In May, Governor Tarullo said
that banks between $50 and $250 billion--which all three of
these Ohio banks are, incidentally--are ``overwhelmingly
recognizable as traditional commercial banks (though a few do
have significant capital market or other activities).''
So today we are exploring what makes a bank systemically
important by looking at issues like size and leverage and
business model and funding sources.
We will consider what the failure of a $100 billion bank, a
$300 billion bank, or a $1 trillion bank might mean for the
financial system and the economy.
We will look at tools that regulators have--or should have,
or your suggestions need to have--to prevent the failure of a
systemically important bank, or to protect taxpayers and the
economy if one does, in fact, fail.
It is important that we strike the right balance between
identifying the institutions and activities that present the
most risk while not becoming complacent and not taking our eyes
off of potential sources of risk.
I thank the witnesses, and let me introduce each of you,
and we will begin the testimony. As I said, at the conclusion
of your remarks, if other Senators want to make opening
statements, they certainly can.
Dr. Richard Herring is the Jacob Safra Professor of
International Banking at the University of Pennsylvania's
Wharton School, codirector of the Wharton Financial
Institutions Center. Professor Herring is a member of the
Systemic Risk Council at the FDIC's Systemic Resolution
Advisory Committee. Welcome, Dr. Herring.
Dr. James Thomson is the finance chair at the University of
Akron's College of Business Administration. Prior to joining
the University of Akron, Professor Thomson held multiple roles
at the Federal Reserve Bank of Cleveland, including vice
president and financial economist. He worked as a financial
economist at the independent General Accounting Office. He
calls Mentor, Ohio, his home. Welcome, Dr. Thomson.
Dr. Robert DeYoung is the Capitol Federal Professor in
Financial Markets and Institutions at the University of Kansas
School of Business. In addition to his work with the
university, Professor DeYoung is a visiting scholar at the
Federal Reserve Bank of Kansas City and a senior research
fellow at the FDIC's Center for Financial Research. Prior to
joining the faculty, Professor DeYoung was an Associate
Director of Research at the FDIC, Economic Adviser at the
Federal Reserve Bank of Chicago, and a Senior Financial
Economist at the Office of the Comptroller of the Currency.
Dr. Paul Kupiec is a resident scholar at the American
Enterprise Institute. He joined AEI from the FDIC where he held
multiple roles, including Director of the Center for Financial
Research. His past experience includes positions at the IMF,
Freddie Mac, the Board of Governors of the Fed, the Bank for
International Settlements, and JPMorgan's Risk Metrics Group.
From 2010 to 2013, Dr. Kupiec served as Chair of the Basel
Committee on Bank Supervision Research Task.
Welcome to the four of you. Dr. Herring, if you would
begin, keep your comments as close to 5 minutes as you can, and
after your conclusion, we will move on. Dr. Herring.
STATEMENT OF RICHARD J. HERRING, JACOB SAFRA PROFESSOR OF
INTERNATIONAL BANKING, THE WHARTON SCHOOL, UNIVERSITY OF
PENNSYLVANIA
Mr. Herring. Thank you very much, Chairman Brown. I am
grateful for the opportunity to testify this morning on what I
think is a very important issue.
Interestingly, the very question of whether and whether it
is possible to identify systemically important banks still
divides experts. Some people feel that it is both impossible
and dangerous to categorize such institutions. I think this is
actually unrealistic because we know they exist. We have seen
how they benefit from Government intervention. And instead the
question should be how we, in fact, limit the category, perhaps
reduce it, and try to devise procedures to make these
institutions safe to fail.
There has been considerable effort to actually try to
devise indicators that would help us understand what this
category looks like. The most refined set have been produced by
the Financial Stability Board and, of course, amended and
revised by FSOC. They include size, and I quite agree with you
that size is by no means the only distinguishing feature, and
the $50 billion threshold is way too low. They would included
interconnectedness, which involves certainly capital market
interconnections; cross-border activity; complexity; and the
lack of substitutes for the services they provide in the global
economy.
These all give you different dimensions. I think they are
all important, but I think they are not sufficient in and of
themselves.
In addition, there have been considerable efforts in both
the official world and the academic world to model sources of
interaction and to try to understand the drivers of systemic
risk. I think both of these activities are worthwhile. I
certainly think they will give us better insights into what
actually drives this problem. But I think in some sense they
miss the point.
As a practical matter, what makes an institution systemic
is the decision of regulators to intervene and support. And I
think it is pretty easy to understand the process.
When you are standing on the brink of what you fear may be
a crisis because you do not know the reactions, I think the key
determinant for regulators is whether they have resolution
tools that they think are reliable. And during the crisis, they
did not. So time after time we saw sleepless weekends in which
regulators devised really desperate bailout measures that, in
the end, probably undermined safety and soundness of the
system, but bought it at a very high price in the short term.
The one time they failed to do so with regard to Lehman
Brothers indicated why they have taken such pains. Although
some people would regard that as a useful application of
bankruptcy policy in the United States, I think there is no
doubt in the rest of the world it was hugely damaging. And, in
fact, we are still trying to deal with the pieces in something
like 60 to 70 different bankruptcy proceedings around the
world.
While Dodd-Frank, I think, deserves a lot of credit for
trying to deal with this problem, part of it simply tries to
reduce the probability of failure by increasing the quality and
quantity of capital, which I think is very worthwhile. There
are other measures which also may be important, but I think we
should recognize that it never will and never should make these
institutions fail-safe, because, in fact, banks add value to
the economy by taking prudent risks--by intermediating between
borrowers and savers, by buying and selling risk, and providing
reliable payment systems.
But I think the most important part of Dodd-Frank and, in
fact, the most remarkable change in the regulatory landscape is
the attempt to provide better resolution tools. It begins with
living wills, which are supposed to describe the plans that a
bank has for rapid solution and the unwinding of the bank,
without creating crisis situations for others. These are
massive plans. I think there is a danger that some of them are
too big to understand, which is a whole new category, at 10,000
pages. But also I think there is a huge lost opportunity in
public disclosure. If we want them really to work, we need to
inform the public about what the priorities will be and exactly
how the authorities will intervene.
In addition, we need better resolution tools. There is a
huge effort underway at Stanford Hoover to provide better
bankruptcy proceedings. It has just been put on the Web site.
There is a Chapter 14 proposal that has been the result of an
enormous amount of work by a group of academics. And, of
course, there is the Title II resolution procedure by the FDIC.
This involves putting the FDIC in a whole new role trying to
cope with the unwinding, actually the surgical intervention in
a large, sick institution, literally over a weekend. They need
to pull the trigger. They need to intervene over the weekend,
stabilize, provide capital and liquidity, and open up the
systemically important operations.
There are several obstacles that all three of these--both
of these resolution procedures face. One of them is how to
override ipso facto clauses that could undermine it all. Two is
how to provide sufficient liquidity to maintain confidence.
Three is how to sustain international cooperation. And four is
something actively considered by the Fed just now: how much
debt to require at the holding company level.
I would argue, finally--and this is the end--that not only
the level of debt is important but also the kind of debt. I
think that if we do not take the opportunity to think about
this carefully, we will have missed an important opportunity to
improve incentives for banks to manage their risk more
effectively and to recapitalize more promptly. But this would
require, I think, looking very carefully at the Tax Code
because the main hurdle to adopting something like a CoCo
appears to be the IRS' reluctance to permit interest payments
on CoCos to count as deductions in looking at taxable income.
Thank you very much.
Chairman Brown. Thank you very much, Dr. Herring.
Dr. Thomson.
STATEMENT OF JAMES B. THOMSON, PROFESSOR AND FINANCE CHAIR,
UNIVERSITY OF AKRON
Mr. Thomson. Thank you, Senator Brown and Members of the
Committee, for the opportunity to speak here today. The focus
of this hearing, identifying the factors that make a financial
institution systemically important, is the first step in
designing an institutional and legal framework to rein in the
risk of these systemic firms post to the financial markets and
ultimately the macroeconomy.
Viewing systemic spillovers as market failure, we need to
identify the source, severity, and whether the failure merits
Government intervention, and if so, the most economically
effective way to structure that intervention.
During a 30-year career as a financial economist, I have
studied financial markets, banking, payment systems, failed
bank resolution, and the Federal financial safety net from a
public policy perspective. The ideas I express today are
informed by reading and research I have done in these areas,
especially papers on systemically important financial
institutions, the need for an asset salvage agency, and
systemic banking crises.
One of the things I want to sound today is that ``too big
to fail'' is a misleading term. Size is not the only
distinguishing characteristic that makes financial firms
systemic. Through my research in this area, I have identified
four characteristics, what I call the four C's of systemic
importance: contagion, correlation, concentration, and context
or conditions.
The factors that lead to institutions being treated as
systemically important tend to be prevalent in the larger
firms, and that is why size shows up on the list.
In my written statement, I stress how each of these four
C's has been part of the rationale for generous Government
treatment of the creditors, managers, and stockholders of
troubled financial firms. It is important to emphasize that the
decisions on how we handle economically failed institutions are
themselves an important source of systemic risk. We need to
understand whether an institution authorities label as systemic
in the handling of its economic insolvency are truly systemic
or merely politically expedient.
The Dodd-Frank Wall Street Reform and Consumer Protection
Act, enacted in 2010 in response to the recent financial
crisis, contains numerous reforms to the financial system and
supervisory infrastructure. In my written statement, I provide
my thoughts on Dodd-Frank's provisions dealing with
systemically important institutions. In the interest of time, I
will skip over that section of my written statement and spend
my remaining time on the need for supervisory contingency or
disaster plans--a missing element of reform.
Systemic importance reflects constraints faced by financial
market supervisors in enforcing timely closure rules. It does
not matter what powers Congress gives financial supervisors to
conduct orderly resolutions of financial companies if the
regulators remain reluctant to use them. A major step forward
to limiting systemic importance is requiring financial system
supervisory agencies to develop and to commit to contingency
plans for handling the failure of one or more systemically
important financial firms.
These contingency plans should contain a series of options,
actions taken to contain systemic spillovers, with blanket
guarantees of all creditor/counterparty claims to be, without
exception, the last option on the list. Scenario analysis
should be used to test and refine these disaster plans. Much as
Dodd-Frank Section 165 resolution planning by systemically
important firms is intended to promote the orderly resolution
of these firms--whether it be through bankruptcy or through
FDIC receivership--supervisory disaster plans should allow for
resolution of systemic firms with the least impact on long-term
incentives facing these firms.
Dodd-Frank was hailed by its drafters as the antidote to
too big to fail. While provisions in this important reform
legislation move us toward the goal of reining in the effects
of systemic importance in the financial system, much remains to
be done.
Thank you.
Chairman Brown. Thank you, Dr. Thomson.
Dr. DeYoung.
STATEMENT OF ROBERT DEYOUNG, CAPITOL FEDERAL DISTINGUISHED
PROFESSOR IN FINANCIAL MARKETS AND INSTITUTIONS, UNIVERSITY OF
KANSAS SCHOOL OF BUSINESS
Mr. DeYoung. Thank you, Senator Brown, for inviting me to
address the Committee today.
When you invite four economists to address the Committee
and the first three of them tell you virtually the same thing,
I think you will be happy. My remarks are quite consistent with
what Professor Thomson and Professor Herring had to say.
The Dodd-Frank Act contains new measures aimed at reducing
systemic risk at U.S. financial institutions. From my
perspective, these measures can be divided relatively neatly
into two different categories.
On the one side, we have ex ante measures that try to make
banks' balance sheets resilient to systemic macroeconomic
events. Some key examples of this, of course, are higher
minimum capital ratios, liquidity ratios, and regulatory stress
tests.
On the other side, we have ex post measures that try to
limit the amplification of systemic events--contagion--caused
when banks default on their financial obligations. This
approach centers on the FDIC's orderly liquidation authority
and the information made available to the FDIC in living wills.
It has been my observation that we pay most of our
attention to the ex ante systemic risk prevention measures--
they are important measures--setting rules and limits for
banks; and we tend to have less confidence in ex post measures
designed to contain systemic risk once it rears its head.
In 2006, just a year before the financial crisis began, the
average U.S. banking company had nearly double the risk-
weighted capital ratios necessary to be deemed ``well
capitalized'' by bank regulators; 95 percent of all banking
companies at that time cleared the adequately capitalized
threshold by at least 300 basis points. As we know, these large
stores of equity capital were not by themselves large enough to
prevent hundreds of bank insolvencies in the years that
followed. Accordingly, Dodd-Frank and Basel III require higher
levels of capital for banks. As I said, this is clearly
important and a step that we must take. But we cannot forget
that restrictions like these impose costs on banks that
ultimately result in fewer financial services being provided.
Now, in the shadow of the financial crisis, this may seem
like a very wise tradeoff. We accept less lending and slower
economic growth in exchange for a reduction in the severity of
the next systemic financial event. But the orderly liquidation
powers in Dodd-Frank provide us with a historic opportunity to
avoid having to accept this tradeoff. OLA should allow us to
not only limit the contagious aftereffects of a systemic
crisis, but also to establish a newly credible regulatory
regime that is devoid of the too-big-to-fail incentives that
have so long fostered risk in our financial system.
The economic logic is a straightforward story. When
investors become convinced that large complex banks will, in
fact, be seized upon insolvency--with shareholders losing
everything and bondholders suffering losses--then credit
markets and equity markets will more fully price bank risk
taking; profit-seeking banks will then face clear incentives to
reject high-risk investments ex ante.
That is the economic story, but the political story is far
from straightforward. OLA requires bank regulators to credibly
establish that they can and will seize, unwind, and eventually
liquidate large complex insolvent banks. The FDIC's ``single
point of entry'' plan I think is a workable plan. Nevertheless,
in my discussions with scores of banking and regulatory
economists across the country, I meet with a near uniform
skepticism that the FDIC will be permitted to fully exercise
its new resolution authorities during a financial crisis when
multiple large banking companies are nearing insolvency.
Essentially, their belief is that the deeper the financial
crisis, the greater the probability that OLA will be suspended.
So, in my opinion, the most important actions that Congress
and the administration could take to limit systemic risk in the
financial system is to strongly and repeatedly enunciate their
support of orderly liquidation authority and to pledge that
they will not stand in the way of its implementation during a
deep financial crisis. Our banking system is most effective
when scarce economic resources are moved from poorly managed
banks to well-managed banks. Hence, we do not want a banking
system that is devoid of bank failure; rather, we want a
banking system that is resilient to bank failure. And I think
orderly liquidation authority is essential to establishing this
resiliency.
Thanks again for inviting me, and I look forward to any
questions you might have.
Chairman Brown. Thank you, Dr. DeYoung.
Dr. Kupiec.
STATEMENT OF PAUL H. KUPIEC, RESIDENT SCHOLAR, AMERICAN
ENTERPRISE INSTITUTE
Mr. Kupiec. Thanks, Chairman Brown, Ranking Member Toomey,
and distinguished Members of the Subcommittee. My written
testimony addresses the specific questions posed in the
Subcommittee's letter of invitation. In my oral testimony, I am
going to skip over the details for the most part and provide an
overall perspective on the issues that are raised in this
hearing.
The Dodd-Frank Act made sweeping changes in the way U.S.
banks and financial markets are regulated. Four years on,
required rulemaking continues, and the implications of the
legislation are only still being discovered.
The overarching Dodd-Frank goal is to prevent another
financial crisis, and I doubt anyone would speak against this
goal. But in attempting to achieve the goal, Dodd-Frank
includes a large body of poorly balanced legislation. It grants
regulatory agencies vast new powers to regulate and allows
these powers to be exercised with almost no checks and
balances.
The power and discretion granted by the act are problematic
because the duties and responsibilities assigned by the act are
vague and ambiguous. The agencies and the FSOC are directed to
exercise new powers to ensure financial stability and mitigate
systemic risk. But financial stability and systemic risk are
never defined in the legislation.
The mix of new unchecked powers and vague, ambiguous goals
is a toxic for economic growth. For example, what does ``ensure
financial stability'' mean? Does it mean regulators need only
focus on preventing another financial crisis? Is that the only
job?
The duties and responsibilities assigned by the act never
recognize a link between economic growth and financial
intermediation. Financial intermediation is necessary for
economic growth, and if intermediation is restricted, economic
growth will suffer. Financial crises devastated economic growth
because the crises interrupt financial intermediation. Similar
forces operate in noncrisis times. If regulations impede
financial intermediation, they will also reduce economic
growth.
The Dodd-Frank Act does not recognize this tradeoff.
Instead, it builds in a bias for overregulation. There is no
regulatory reward for preventing a financial crisis, but
regulators will certainly be disgraced, if not punished, should
there be another financial crisis. So what are their
incentives?
The issue is analogous to monetary policy where decades ago
it was recognized that price stability cannot be the only goal
of the Federal Reserve. It must balance price stability against
goals of encouraging employment and economic growth. The Dodd-
Frank Act lacks this balance and instead directs agencies to
use their new powers to stop bad intermediation. But do
regulators, councils, or even us economists have the judgment
and ability to identify and stop only bad financial
intermediation? And is this ability so trusted that we should
be able to carry out this vague assignment without supervision
and review?
History suggests not, but this is what the Dodd-Frank Act
does. Section 113 of the Dodd-Frank Act provides a concrete
example. It grants the FSOC the power to designate nonfinancial
intermediaries for enhanced prudential supervision and
regulation by the Board of Governors. The standard for
designation is vague. It puts very few constraints on the
FSOC's designation ability. For example, the FSOC is not
required to identify specific issues or features that mandate
designation or demonstrate how an FSOC designation will
mitigate risk. And so the FSOC has not provided these details.
There is no link to Title I orderly resolution plans in
that statute even though a key standard for designating a firm
involves the risk that failure of the firm generates systemic
risk. Why isn't a firm required to submit a resolution plan as
part of the designation process? Would a good review preclude
designation? Perhaps. But then the adequacy of the orderly
resolution plan is determined solely by the regulators'
subjective judgments, so maybe the added work would not amount
to much.
In my written testimony, I discuss many specific examples
where underlying imbalances of the Dodd-Frank Act lead to
overregulation. Other specific examples of overregulation
include designating all bank holding companies larger than $50
billion for heightened supervision and prudential standards.
Another example is the Board of Governors' stress test and
the power for regulators to restrict the use of short-term
debt.
I have also discussed instances where the new Dodd-Frank
Act powers will not achieve intended goals. In particular, I
identify missed opportunities regarding duties assigned under
the Title I orderly resolution plan process, and I also point
out serious shortcomings in Title II orderly resolution
authority.
Under the FDIC's single point of entry resolution strategy,
Title II creates new uncertainties for the resolution of large
financial institutions, and it potentially extends the
Government's safety net beyond the guarantees provided under
the deposit insurance resolution system.
Thank you, and I look forward to your questions.
Chairman Brown. Thank you, Dr. Kupiec.
Senator Toomey is recognized for an opening statement.
Thank you.
STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thank you, Chairman Brown. I want to thank
our witnesses for joining us today. This is an important topic.
Dodd-Frank obviously deals with the whole too-big-to-fail
issue in a number of ways. One of the major ways is through the
SIFI designations, which I would argue then precipitate the
micromanagement of these financial institutions by a host of
regulators in what will, in my view, ultimately be a futile
attempt to make failure impossible.
I see a lot of problems with this approach. One is that
institutions end up being designated as SIFIs, despite the fact
that they are not systemically dangerous to our economy.
The second problem is that the layers of regulations impose
real costs. There are direct costs of compliance, and then
there are all the indirect costs of a reduction in innovation
and dynamism that comes when regulators have the power to run
these financial institutions like public utilities, which is
really where we pretty much are.
And, finally, of course, the regulators themselves, as we
know, are not omniscient. They are not going to be perfect.
They are not going to always get it right, and in the end,
eventually institutions will fail anyway.
Dodd-Frank deals with the failure itself, of course,
through the orderly liquidation authority, the failure of a
SIFI, and I have major, major reservations about this. Some of
the problems that worry me is, number one, the highly
subjective nature of this process; the extensive discretion
that is given to the regulators in implementing it; the fact
that there is no real option for restructuring when; in fact;
that might be the best solution for an institution; the fact
that creditors have no certainty because we grant discretion to
the regulator to decide which of the various equally standing
creditors are more equal than others; and, finally, there is an
explicit bailout mechanism that is written into the statute in
the orderly liquidation authority, and I thought we wanted to
move in a direction where we would not permit taxpayers to have
to be bailing out these institutions.
So I will now blatantly and shamelessly plug my bill, Mr.
Chairman, which repeals the orderly liquidation authority and
instead makes the necessary reforms to our Bankruptcy Code so
that in the event of the failure of a large complex financial
institution, we would have a rules-based, transparent, credible
way to resolve that institution without all of these problems
that I think are inherent in the orderly liquidation authority.
But I digress, and I appreciate your indulgence.
The issue more at hand I think for this hearing is some of
the problems that Dodd-Frank imposes, particularly on regional
banks. This goes right to the issue of designations. In my
view, there is nothing magic about a $50 billion threshold
above which we ought to automatically assume every institution
is systemically important and significant and dangerous. That
threshold, of course, gives no consideration to the activity of
the bank, the nature of the bank's activities and whether or
not it gives rise to these risks. And then the overregulation
that comes with the enhanced prudential standards are
enormously problematic.
A couple of issues that I would like to hear about today
that concern me as they affect regional banks is the liquidity
coverage ratio. Again, it seems to me that this rule will treat
regional banks as though they were very large, complex,
internationally active, money center Wall Street-type banks,
when, in fact, the nature and activity of these regional banks
is nothing like that of the large, complex, money center banks.
The comprehensive capital analysis and review and the
supervisory stress tests, another very, very onerous regulation
that we could debate whether or not it makes sense for the
biggest of banks. I do not see how we can defend the
proposition that small regional banks with a simple business
model should be subject to the same kinds of tests.
So these would be some of the things I hope we can discuss,
Mr. Chairman. I do oppose the overall framework of Dodd-Frank,
but it seems to me a couple of the most egregious laws are
subjecting financial institutions that are not, in fact,
systemically risky to these very onerous regulations imposes a
real cost. At the end of the day, it means credit is less
available and less affordable for American consumers and
businesses, and that is what is happening today that I believe
is a direct result of Dodd-Frank. And so I am looking for ways
to relieve that problem that we have created.
I thank you for your indulgence.
Chairman Brown. Thank you, Senator Toomey. Let us begin the
questions.
Observers note the financial system was generally able to
absorb in 2007 and 2008 the failures of regional banks and
thrifts. Perhaps one of the most notable was in Dr. Thomson's
home State, Cleveland, with National City absorbed by PNC out
of Pittsburgh, causing certain hardship in that city, in our
State, and job loss. But the system absorbed it without great
damage, obviously, to the stability of the system. FDIC sold a
$307 billion Washington Mutual at no apparent loss to U.S.
taxpayers.
So my question to all four of you, and I will start, Dr.
Herring, with you: What would happen today if a $250 billion or
a $150 billion or a $50 billion systemically important bank,
SIFI-designated bank, were to fail? Would we need a megabank
like JPMorgan to absorb it, to rescue it? As you answer that,
each of the four of you, talk to us about industry
concentration, if that would be the logical outcome of more
concentration as we saw between 2007 and 2010. Dr. Herring.
Mr. Herring. I certainly agree that the legislation sets
the threshold way too low. There is nothing magical about $50
billion. I would argue that--well, if you take a look at the
Financial Stability Board's list of global systemically
important institutions, it contains 8 American banks out of 29
international. And that range of eight banks ranges in size
from JPMorgan Chase, which is about $2.4 trillion, down to
State Street Bank, which is about $220 billion. So the current
criteria do have a nuanced effect. They do rely on much more
than just size. And I think it is highly unlikely that any bank
that has a strictly regional footprint should really be
regarded in the same rubric at all. And I quite agree that
overregulation is a tremendous threat, that, in fact, the
biggest growth in the banking industry over the last 3 years
has been in the employment of compliance officers. Having some
is good, but certainly that should not be the main thrust of
bank growth these days.
On the other hand, I think it is dangerous to rely on
forced mergers that are arranged over a weekend as a way out. I
think one of the huge mistakes that was made during the crisis
was relying on really Government-assisted concentration in the
system. I think we have ended up with the result where we
started with banks that were too big to fail and ended with
banks that are emphatically too big to fail, which is a
terrible mistake.
I think the resolution process should make sure that the
bank that emerges from the resolution process is no longer too
big to fail in any dimension. If that means breaking it up into
smaller banks, I think that is a good thing to do. We do not
want these institutions rattling around that can cause the
regulators to take destructive actions in the belief that they
are saving the system in the short run but actually undermining
long-term discipline.
So I have enormous sympathy with the thought that you
should treat these smaller banks and the larger regionals quite
differently, but I am not sympathetic to the thought we should
merge them with the giants.
Chairman Brown. So, Dr. Thomson, what would happen if one
of them failed?
Mr. Thomson. I do not think the implications of one of them
failing other than the impact on the region itself is going to
be that great. It is not going to send the shock through the
financial system that taking down a very large institution
would, because quite simply they are not as interconnected,
they are not carrying as much of the off-balance-sheet types of
risks that are more difficult to trace. And I think from the
standpoint of employment in the region, the failure of a large
regional bank is an issue, but it is not a threat to the
national financial system. You will get some local impacts on
credit availability, and I think the big trick here is the way
we have always dealt with large company failures is to find a
larger company to put them into, creating larger and larger
companies. So we go from a financial system where the top 10 or
15 banks had about half the assets to one where the top 4 have
something on order of like 70 percent of the assets?
So I agree with Dr. Herring that we need to find a way to
do this that does not just assemble these megabanks and that
takes into consideration that the end product will not be a
bigger bank that is a bigger problem than what we had to begin
with.
Chairman Brown. Dr. DeYoung.
Mr. DeYoung. Well, I also agree with Professor Herring that
a blanket $50 billion threshold for SIFIs is too low. FSOC has
the authority to declare a bank a SIFI regardless whether it is
a larger or smaller than that. So the blanket at $50 billion is
too low.
You asked about concentration. I want to make clear that
the concentration of power and influence among a smaller number
of financial institutions is far more dangerous than any
pricing or market power concentration that would happen. The
banking system in the U.S. is far from concentrated in a
pricing standpoint. We have high levels of competition.
Concentration of large banks together is more of a question of
whether they gain influence.
And to your question about what would happen if a $200 or
$300 billion bank failed, a systemically important bank failed,
well, I am going to line up with Dodd-Frank and say that the
FDIC would then exercise its orderly liquidation authority, if
allowed to do so. The question is--there are two questions
here. One is whether they are allowed to do so, and I have no
horse in this race. I know Senator Toomey favors a rewriting of
the bankruptcy laws to allow us to handle bank insolvencies
that way. The issue is that we actually do it and we actually
are able to resolve these systemically important institutions
without disrupting financial markets. And I believe we can do
it within the OLA authority within the Government. We can do it
through a rewriting of the banking laws. Either way, the
crucial thing is we actually do it and establish credibility
that it will be done. And I have had occasion to speak with the
folks at the FDIC a couple of times about how they would do it,
and specifically how quickly this process would run. And I
myself would prefer a slow process in which contracts are
allowed to run off, the bank is allowed to stabilize. Yes, we
have losses, but we do not race in order to find a buyer for
that bank, that we use the word ``liquidation'' and that we
take that word seriously, that we stabilize the bank, we
liquidate it if possible into pieces, and not resolve that at
the end through some kind of a large purchase and assumption
merger.
Chairman Brown. Thank you.
Dr. Kupiec.
Mr. Kupiec. Thank you very much, Chairman Brown. This is a
very important question, and it is actually a question that is
at the heart of the whole SIFI designation Dodd-Frank process.
When you say would a bank of this size be systemically
important and should it be designated, well, if it fails in
isolation, certainly not. What happens if it fails in a real
crisis when many banks are failing? That is the problem. And
the problem in Dodd-Frank, Dodd-Frank is ambiguous. It does not
say when a failure is supposed to cause systemic risk. And this
is a real ambiguity, so you do not know how the FSOC or anybody
else is actually evaluating the circumstances surrounding the
failure, and that is an ambiguity that really should be taken
care of. We need to specify under what conditions it will be a
problem.
I have suggested in my written testimony--I have a pretty
lengthy part on it, on this issue, about regional banks, and I
agree with my colleagues that a regional bank should be broken
up, and that--if it could be broken up in a resolution, that
means it is not systemic.
What I think this needs to mean--and this is my reference
to the lost opportunity under the Title I authority--is that
when you do an orderly resolution plan and submit it to the
FDIC and the Federal Reserve Board, the FDIC should be required
to figure out that if that bank were to be taken into a regular
FDIC resolution, not a Title II resolution but through the
normal FDIC resolution process, how would the FDIC break that
bank apart?
Now, there are a lot of problems with breaking a bank
apart. Historically, when the FDIC gets a big bank, it sells
the bank in a whole-bank transaction. And there is a legal
reason for that. Under FDICIA, the FDIC is required to resolve
a bank in a way that is least costly to the Deposit Insurance
Fund. And a whole-bank resolution is almost always the least
costly way to resolve a bank. So, legally, if there is a whole-
bank bid for a very large bid, under current law if it is an
FDIC resolution, an FDI Act resolution, the FDIC does not have
a choice. They cannot take the bank into a bridge bank and take
all the time to break it apart if it will cost more. And it
almost certainly will cost more. But the time taken to bridge a
bank in the resolution process and break it apart is the price
we have to pay to reduce systemic risk. But to do that, you do
not need Title II. You just need to use Title I, the plan, the
planning part, and change the law so that the FDIC is required
to break large banks up when it resolves them.
In that case, there would be no reason to treat--in my
opinion, at least most of the things that we would call
regional banks now, $250 billion or less that mostly do
commercial banking in a region, most of those do not have any
business being designated at all.
Now, again, if all of them are in trouble at the same time,
we have a problem. You cannot--unless you are willing to let
the FDIC bridge all these banks and run them until they can
sell them. And even under Title II we have a problem because
you have still got the FDIC bridging banks and breaking them
apart.
So the problem is not really solved in the context of a
true financial crisis when there is a problem and lots of banks
get in trouble at once.
So I think there is still a lot to work on here. I think
that is when contingent capital--although it is not a
resolution, it is a reorganization, but contingent capital has
a lot more promise in a systemic crisis when many large
institutions would be in danger of a Title I or a Title II or
direct Government guarantee.
So I could speak more about the Title II and why the bank--
why the FDIC needs to take over the holding company. There is
the whole case of NexBank in 2002 that was a horrible
resolution experience for them. I am happy to talk about that
at length, but I think I should stop now.
Chairman Brown. Thank you, Dr. Kupiec.
Senator Toomey.
Senator Toomey. Thanks, Mr. Chairman.
A quick follow-up on some of the points that Dr. DeYoung
made, which I thought were some thoughtful and interesting
points on managing a resolution through Title II. But it
strikes me that parts of Title II are problematic in the way
they are written, problematic in doing a slow process. It seems
that Title II is effectively mostly an execution order. The
bank gets executed. I mean, that is the purpose as a practical
matter. Management has to be all fired regardless of which
managers are actually at fault. That does not distinguish--and,
frankly, I would really seriously question the competence of
the FDIC to run JPMorgan Chase or to run Lehman Brothers. The
FDIC is competent at rolling up small banks over a weekend.
There is no question about that. But running a $2 trillion
multinational that is enormously complex, I really rather doubt
it. But this is probably a better topic for a different time,
if we could.
I want to go back to observing a very interesting agreement
that I discerned, I think, which is I think every single
panelist here said that it does not make sense to have an
automatic SIFI designation at $50 billion by virtue of that
criteria alone. That is an important agreement because, of
course, the law does exactly that.
So I share that view, but rather than trying to guess what
the right number is, because, frankly, I do not think $75
billion is the right number either, I wonder if each of you
would comment briefly on whether we should have qualitative
criteria instead of an arbitrary dollar value of assets, things
like funding sources, capitalization, liquidity, the
composition of assets, other criteria that we might use rather
than pick some other arbitrary number above which we would
designate everybody for this very expensive, in my view,
overregulation. Dr. Herring, if you would begin.
Mr. Herring. Yes, I think that the international agreement
on identifying global systemically important institutions
actually does speak to your point. They do have five
quantitative indicators, but there is a clear role for a
judgmental override that must be clearly stated. And that is
how, in fact, we get some smaller banks, and some of the bigger
banks that actually do not have systemic implications are not
included.
Senator Toomey. Could I just suggest, adding a subjective
element would be one way to get away from a numerical hard and
fast----
Mr. Herring. A judgmental, a qualitative----
Senator Toomey. Right. But we could also have other
quantitative measures.
Mr. Herring. You could.
Senator Toomey. Like liquidity and capitalization and off-
balance-sheet----
Mr. Herring. Those are included.
Senator Toomey. ----activity here they may or not be
subjective. They could be fairly----
Mr. Herring. No, those are all included in the quantitative
indicators. Each of those----
Senator Toomey. Not under Dodd-Frank, right?
Mr. Herring. Not under Dodd-Frank, but under the FSB, which
I think had the benefit of coming after Dodd-Frank.
Senator Toomey. Right.
Mr. Herring. And, frankly, did a more sophisticated job of
looking at this question. Congress did this in an immense rush,
and I do not think it was a very thoughtful solution.
I would also add that I share your interest in having sort
of better procedural clarity, and I think better bankruptcy
laws could be helpful. I would commend the work of the Hoover
Stanford group. I must confess that I played a minor role in
it, but it has just been published, a Chapter 14 proposal, that
would, in fact, amend the Bankruptcy Act to deal with
financial----
Senator Toomey. I would just point--their work very
significantly informed my judgment as we developed our
legislation.
Dr. Thomson.
Mr. Thomson. I do not think that having a hard and fast
number, a bright-line rule in legislation like the $50 billion
or $250 billion, is useful for making the designation. Now, it
may be useful to have a rule where you automatically review a
company for that designation, but not designate them until you
look at the number of factors, liquidity, their
interconnectedness, their importance in a particular financial
market, and if somebody clears 40 percent of the derivative
contracts of a certain type, that should probably go into your
consideration as to whether or not they are systemically
important or not.
So I think having some benchmark but being just a guideline
we will automatically review for this would be the way to go,
but then to dig deeper and understand what are the very things
that are going to prevent us from either in isolation as a
single institution or as a group of institutions take them
down, which is part of the reason why I mentioned in my
remarks, we should be developing these contingency plans by the
regulatory agencies on how would we actually take these
institutions down.
Now, the living wills that are in Dodd-Frank is a piece of
the information of how do we go about that. When we develop
these plans, that would tell us where the pressure points in
the system are, ones we need to address in identifying which
institutions are the problem.
Senator Toomey. But what I understood you to say is that
you agree with the premise that the actual activities of the
bank ought to be given more weight than an arbitrary dollar
value of assets?
Mr. Thomson. Yes, any threshold set using the dollar value
of assets is inherently arbitrary, my work shows size is not
the determining factor. It is the activities themselves. And it
just turns out that really large banks tend to be in all the
activities that leads us to consider them systemically
important.
Senator Toomey. All right. Thank you.
Dr. DeYoung.
Mr. DeYoung. Yes, you have put your finger on one of the
potential weaknesses of orderly liquidation authority, and that
is, who will run these institutions after we excuse the board
and the top management?
A couple of things. One is, of course, at that point the
bank will be run in a very different way with a very different
objective function. The objective will be not to grow the bank,
not to look for risk opportunities, not to look for growth
opportunities, but to service the customers, to allow financial
contracts to run their course, and to stabilize the finances of
the bank. So the challenges are a little bit different. We
would need to know where all the bodies are buried, of course,
and hopefully the orderly--the living will would do that. But
it may not be as big a challenge as one would think. This does
speak to the concept, to the question of credibility. This is
all part of what we will find out when we allow the FDIC or a
bankruptcy court under a different set of rules to resolve one
of these large banks in a slow and thoughtful way. Credibility
has to be established, and as we do that, of course, we will
make mistakes. But, you know, the first time we go through
this, it is not going to be perfect. Losses do have to be taken
somewhere.
Senator Toomey. Dr. Kupiec.
Mr. Kupiec. Yes, thanks. I think this whole thing is a
fundamental problem because systemic risk is not really a very
well developed science. It really became popular, a popular
thing to talk about, to write papers about, after the crisis.
The economics and the science really are not sound and there
yet. Of course, we all know we think systemic risk exists
because we saw the crisis.
Now, in terms of size alone as a cutoff, I agree with you
that any arbitrary size is--there is no science that supports a
$50 billion--I have that in my testimony, I agree. It doesn't
support any number. But if the pure economics of it is,
especially in the case of a bank, size is related to the damage
it would cause to the economy if you were to lock it up and
shut it down and freeze everybody that uses that bank for
financial intermediation.
Now, the reason we do not see size mattering in modern
times is because we already had in place mechanisms to prevent
the bank intermediation function from getting locked up. The
FDIC stepped in, and it sold the bank to another bank. And so
there was a small disruption and some problems there. But more
or less the economics smoothed out because the FDIC had already
stepped in.
Back in the 1930s, when you did not have that process, it
was a really bad time. You lost access to credit, financial
intermediation, deposits got locked up. It was really bad for
the economy.
So the reason we do not see large bank failures per se
having an effect on the economy is largely because we had
things in place for a long time that helped fix that. So size
clearly does matter for systemic risk, pure and simple, but we
have things that can handle the systemic risk associated with
many of these things. It is only when you get to the very large
banks that either the things we have in place now make bigger
banks--that is the way we fix it, we put a failing big bank
into another big bank, and we create another bigger bank. You
can only play that game for so long, and we are kind of at the
end of that route. Or we do something else.
And this breaking apart of the bank--and I am on board with
Bob in that, but I do not think you run the bank's business
down. I think you have to run it as a bank, but you have to
split it up and sell it, because if the bank really does have
important functions and you really take over that bank and you
say, OK, now we are in lockdown mode, all these things have to
stop, you have to stop lending, it is just run off contracts,
but then you are going to impose financial losses.
So I think you have to run the bank, but you have to plan
to break it up in the resolution process if you get there. And
I think that should be through Title I and deposit insurance.
The holding company issues I think should be solved through the
Title I process, and I think about it that way. But I think
there is a tradeoff here, and we do know from history that, you
know, just holding onto the bank and running it down, you know,
is not going to be as smooth as a whole-bank resolution has
been in the past.
Thanks.
Chairman Brown. Senator Warren.
Senator Warren. Thank you, Mr. Chairman. Thank you all for
being here.
I want to focus on another part about SIFIs. Last week, the
new Vice Chair of the Fed, Stanley Fischer, spoke about the
Fed's role in financial reform, and he made some claims about
the too-big-to-fail problem that I would like to be able to get
your comments on, and I am just going to kind of break it apart
into the different claims he made.
His first claim was that the evidence was basically mixed
on whether bigger banks take on more risk than their smaller
counterparts. And I find that hard to believe, particularly for
banks in the United States.
Professor DeYoung, you have noted that four out of ten of
the biggest U.S. banks in 2008 either failed or had to be
bailed out. That is a 40-percent failure rate. By contrast,
only 6 percent of smaller banks failed during the crisis.
So, Dr. DeYoung, given those data, is it fair to conclude
that bigger banks, say those over $500 billion in assets, tend
to take on more risk than their community bank and regional
bank counterparts?
Mr. DeYoung. Well, thank you for reading my research, or
thank you to your staff for reading my research. I appreciate
that.
I think it is unquestionably true that, on average, larger
banks are involved in riskier activities. And in the end, at
least over the most recent distress we have gone through, they
are failing in larger proportions, and I think you have to be
blind to conclude otherwise.
Senator Warren. OK. Good. We have got a point one.
Mr. DeYoung. That is point one.
Point two, though--point two, though, is have we done
things to--is it size alone that is causing these banks to take
more risk?
Senator Warren. Well, we are going to come there.
Mr. DeYoung. Yes.
Senator Warren. We are going to come there; I promise.
Mr. DeYoung. Very good. OK.
Senator Warren. OK? Because we are just going to do these,
though, by pieces because I want to make sure I am getting
them.
Mr. DeYoung. Very good. I am going to hold you on that.
Senator Warren. All right.
Mr. DeYoung. OK.
Senator Warren. The second one is about the question about
economies of scale for big financial institutions.
Vice Chair Fischer addressed the economies of scale, saying
whether or not banks become more efficient and reduce their
marginal costs as they grow bigger, and he pointed to recent
studies that say that such economies of scale exist even for
the largest banks.
So I am a little skeptical on the point, but I want to open
it up to the panel. Does JPMorgan, for example, really become
more efficient when it grows from $2.4 trillion to $2.5
trillion, or we will do an even bigger leap, when it grows from
$1.5 trillion to $2.5 trillion?
And I will just go down the list here. Dr. Herring.
Mr. Herring. I think that is--oh, excuse me, I think that
is a very difficult issue.
All the evidence until very, very recently has indicated
that economies of scale peter out at a level well below the
$250 billion mark. And, in fact, if you look at banks of any
given scale, the difference in efficiency between the most
efficient bank and the least efficient bank is much, much
greater than anything you could get out of scale and scope.
There has been some very recent research actually done by
the new President of the Cleveland Fed that suggests otherwise.
What concerns me about this is that I do not feel
comfortable that it has taken into account the too-big-to-fail
advantages, nor do I think that it has taken into account the
obvious diseconomies of management. It is very, very difficult
to manage one of these institutions. It is humanly impossible
to understand everything that is going on. And I think there is
a limit to our ability to actually exercise effective control
over such huge, complicated institutions.
That really needs to be taken serious.
Senator Warren. OK. Good.
Dr. Thomson, did you want to add anything to that?
Mr. Thomson. Yes. Along with the funding advantages that
these institutions enjoy because, obviously, you do not have to
pay as much for liabilities if people credibly believe that you
will never be closed and have losses imposed on them.
There are all sorts of activities where massive size gives
these banks an advantage over smaller ones. And I think that
these advantages show up as cost efficiencies in studies of
scale and scope economies in banks, where in fact, it is an
artificial efficiency.
If you look at some of the things like lines of credit,
standby letters of credit and all these sorts of things,
customers take those from banks they think who can perform on
them.
If you are a bank that is considered too big to fail, you
are considered somebody who is a good credit, who will be able
to perform on that contract going forward.
And, I think this aspect of systemic advantage is why
studies pick up cost efficiencies in the largest institutions.
I do not believe in the credibility of economies of scale
literature that find cost efficiencies above the $250 billion
mark.
Senator Warren. OK. Anything you want to add to that, Dr.
DeYoung, on the efficiency point.
Mr. DeYoung. Yeah, on the efficiency part.
Senator Warren. I promise we are coming to the third one.
Mr. DeYoung. On the efficiency, yeah, scale economies. We
do not have any idea whether there are scale economies of large
banks.
I published--I am editor of the Journal of Money, Credit
and Banking. Two of the most recent three important scale
economy studies have been published in my journal. The most
recent--and all three of those--all three of these important
studies find different results. All right.
So we do not know. No disparagements toward the
researchers; these are incredibly different things to be trying
to estimate.
I will point out that the most recent of the three papers
does adjust, or attempts to adjust for, the financial
advantages that too-big-to-fail banks have, as James has
mentioned.
Senator Warren. Yes.
Mr. DeYoung. Puts those into the cost functions that they
are estimating. And when they control for the too-big-to-fail
advantage, the scale economies go away.
So this is one out of three studies. We cannot draw any
firm conclusions on this, but it does suggest that--and this is
to the point earlier--large banks are more risky; however, they
have lower costs of financing due to too-big-to-fail, and this
gives them a different set of profitable opportunities to
chase.
Senator Warren. So I will tell you what; instead of asking
the same question a fourth time, what I will do is I will now
cut to the one that intersects the pieces.
And that is so we have the problem of the increased
riskiness of the largest financial institutions, no evidence
that they are more efficient, some evidence that what they are
doing is taking advantage of the benefits of too-big-to-fail.
I want to hit the very last part of this, and that is the
intersection of size with risk with cost.
And, that is if two banks have an equal chance of failure--
let's set it up that way--is there anyone who thinks that the
failure of a $2.5 trillion bank poses a smaller risk to the
economy than the failure of a bank that is half that size or a
quarter that size?
I want to see the intersection here.
Why don't I start with you, Dr. Kupiec, and we will come
back down the other direction.
Mr. Kupiec. No, I clearly think that size does create
bigger spillover effects, and at the very largest institutions
it would be a bad thing if one of those institutions fails.
There is no--I think there is no doubt about that. Even under
the best Title II Dodd-Frank thing we could come up with, it
still would not be pretty.
But where this kicks in, in the size range, is, I think, a
pretty difficult question to know. So, if a $250 billion bank
is 10 times smaller and not doing the same activities as
JPMorgan Chase, a $100 billion bank is not doing anything like
that probably.
So, I mean, there is a big range here, and I think, for
sure, the systemic risk is related to size. I have published
papers that show that, using historical data from 1900s, before
we had any safety nets. It is pretty clear that if you have a
lot of little banks fail, you have got a problem. You have one
big bank failing; you have got a problem if the little banks
fail at the same time.
But where this line crosses, I cannot pick a number.
Senator Warren. OK, cannot pick a number, but we are sure
that the end is somehow different here--the furthest point out
on it.
Mr. Kupiec. I would agree with that.
Senator Warren. Dr. DeYoung.
Mr. DeYoung. Yes, I agree with Paul; there is no way we can
draw a brightline.
I will point out that some of these large banks were using
the same business models as the large banks that became
insolvent and came through the crisis with flying colors. In
fact, some of them came through so well that we asked them to
buy some of the large failed banks.
I would not draw any lessons and apply them to all banks.
The best of all cases is we remove the too-big-to-fail
subsidies and then let the market determine which bankers are
good, smart bankers and which bankers are not.
Senator Warren. Dr. Thomson.
Mr. Thomson. Yes. I am in agreement with my two colleagues.
An element of this is not only would a large institution
have a much bigger impact because it is just going to affect so
many more markets and so many more activities, but there is
also the aspect of anticipation.
We can imagine a $250 billion bank being taken down and
failed. We cannot imagine this happening to a $2.4 trillion
institution. And the expectations of what is going to happen
and how that will be handled is important. If the failure is
handled differently than the market expects it to be handled,
as we saw with Lehman Brothers, that is going to create the
dislocation.
Senator Warren. Good point.
Dr. Herring.
Mr. Herring. I agree with all three of the panelists.
Let me make one additional point about economics of scale,
and that is that there are elements that clearly do have
economies of scale. If technology is involved, we know that
running larger batches of things is going to give you lower
cost.
And what we need to figure out is a way for the whole
industry to participate in those economies of scale rather than
concentrating them in a single institution and tying up a
systemically important function with the fate of one
institution.
The other issue that is giving rise to economies of scale
that is very worrisome about the current regulatory system is
that the fixed costs of running a bank--having the systems in
place, having compliance officers in place--is becoming a very
large barrier to entry, and it is something that actually will
make it more efficient to be larger.
Senator Warren. Oh, yes, and again, talking about where we
are on that continuum.
Mr. Herring. Yeah.
Senator Warren. But it is a very good point, Dr. Herring.
So, thank you. I appreciate it.
I think we have agreement that size matters, that it would
not be smart just to limit the size of banks and sit back and
say we have solved every problem, but that the combination of
adding risk, of banks that are more complex, that there is a
greater impact if they do fail--and I would add that they have
more political power and that permits them to pull in
additional subsidies--all matter, and that happens because they
get big.
So we cannot win the battle against too-big-to-fail just by
attempting to make banks safer. I think the battle for a safer
banking system is also a battle over size.
Thank you.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Warren.
Dr. DeYoung, I think before you were able to get here
Senator Warren spoke about the advantage of size, that
competition is not so much price and the failure of the market
there or the advantages they have, but the advantages in
political power that you spoke of. And I think that was good
insight.
I found your answers to the economies of scale issue pretty
interesting, that Senator Warren brought up, even in contrast
with the study, as one of you pointed out, by the new Cleveland
Fed President. And I think your comments were pretty
compelling.
I want to ask Dr. Thomson one question about that and then
shift to something else.
You mentioned you are all familiar with IMF and Bloomberg
and the estimates of 60-80 basis point advantage on the capital
markets--$80 billion. You all, of course, are familiar with
those studies and those contentions.
But, Dr. Thomson, you said it is much more, though, the
advantages they have because of size are greater than just the
capital market cost of capital. Could you expand on those for a
couple of minutes?
Mr. Thomson. Yes. I mean----
Chairman Brown. Delineate as much as you can on that.
Mr. Thomson. Yeah. So Dr. Herring mentioned one thing;
compliance is much easier for large firms. If you have to add 1
person to a staff of 50, that is a much smaller cost than
adding 1 person to a staff of 2.
There are a lot of contracts where the perception of being
too big to fail gives a bank a competitive advantage.
There was some research that was done in the late 80s early
90s looking at whether loans made through lines of credit or
loans extended through standby letters of credit or other types
of guarantees, whether they were riskier or not. And what they
were finding is they were not.
And what some of the research was finding was, in fact,
that safer banks were the ones who were writing these types of
contracts, they were the ones doing the business, and that this
was a form of market discipline on them because customers do
not buy contracts that require performance by somebody if they
do not think you can perform.
Well, if you are too big to fail, if you are thought of as
somebody who will never be closed, then I will feel safer
entering into a contract with you than somebody else who I
think there is a chance that next year when I need that credit
that they will not be there to perform.
And so it is these types of aspects that are within the
businesses of these institutions that give them an advantage
that you will not pick up by just looking at a funding cost,
but it gives them a fundamental advantage in the business
because they have--they are competing with--a guarantee that
other people do not have.
Chairman Brown. And you think customers--is there evidence
in studies that customers sense that, know that and act upon
that?
Mr. Herring. Yes. There are, in fact, services that advise
corporations on banks they should establish a relationship with
because those banks are more likely to be able to perform on
the contracts. It is a very good point.
Chairman Brown. Good. Well said. Thank you.
A housekeeping issue, I ask unanimous consent the following
two documents be included in the record--a letter from the
Clearing House Association, a statement from the Special
Inspector General for the Troubled Asset Relief Program,
SIGTARP.
Without objection, we will enter that in the record.
In a statement just submitted to the record--and this is a
question I want to ask all of you--the Special Inspector
General for TARP says that nine institutions that were given
capital injections. The four largest banks, three large
investment banks and two custodial banks ``were chosen for
their 'perceived' importance to the markets in the greater
financial system.''
The Government conducted stress tests after TARP but also
announced that FDIC would guarantee the debt of all banks with
at least $100 billion in assets.
And, according to the GAO, the Government offered banks
with $50 billion or more financial support of around 10 to 11
percent of their assets; for banks with between $10 and $50
billion, the support percentage was about half of that amount.
So, two questions for each of you, and I will start with
you, Mr. Kupiec:
Why were these decisions made in 2007 and '08; what do you
think?
And how important are market perceptions, and what does the
market expect today?
Mr. Kupiec. Well, the TARP decisions were clearly made in a
crisis mode, and they wanted to ensure or inject confident in
the public on the largest institutions.
When it came to picking and choosing among the smaller
institutions who got money in TARP, there was an application
process. It went through review.
I am not particularly--I was not privileged to be involved
in those discussions. So I do not know exactly, you know, why
they got less money, but certainly the headline institutions
were the first to take; they were taken care of.
Chairman Brown. So, Dr. DeYoung, how important are market
perceptions, and what does the market expect today?
Mr. DeYoung. Well, for the smaller banks, market
perceptions are pretty much moot. There were many, many small
banks who are not publicly traded that received TARP.
And the market perceptions--I mean, you are talking about
financial markets, correct? This is your question?
Chairman Brown. Yes.
Mr. DeYoung. Yes, financial markets are not important
there.
I would say as long as the subsidies here were done in a
transparent fashion there would be no uncertainty to investors,
and therefore, I think that the pricing of the risk of these
firms would be very efficient.
The minute these subsidies start to go--start to happen
with some lack of transparency, then I think market perception
becomes very important because then if there is any risk, any
uncertainty, about whether a bank is being supported or not
supported or the degree of their support I think the markets
will discount the price or increase the risk of those
institutions.
So I think your question depends on how transparent the
process was, and with TARP it seems to have been relatively
transparent.
Chairman Brown. Dr. Thomson.
Mr. Thomson. All right, so one comment on the TARP at the
large side. Institutions at the top end, of course, were not
given a choice. They were going to take the TARP money although
we know two of them decided that they needed extra TARP money
in the process. Again, that application process for the smaller
institutions was a bit different.
I think whenever you, during a crisis period, signal that
you are going to stand behind institutions without setting any
type of thing in place that says this is it, this is the only
time, you condition market expectations for those types of
bailouts to become forthcoming the next time.
And this is a self-reinforcing process. The more markets
believe, the greater the potential dislocation and the more you
are going to tie the hands of the bank regulators and Congress
to provide the subsidies to these institutions until you can
put in place something credible that says, going forward, this
is what is going to happen. And then you have to be able to
follow up and do it when that happens.
Otherwise, you are just going to perpetuate the very same
sorts of risk-taking through the subsidies that is going to
drive the next crisis.
Chairman Brown. Dr. Herring.
Mr. Herring. I very much agree with those points.
I think that the TARP episode is exactly what Dodd-Frank is
trying to prevent and it is a very important point of market
expectations.
I think probably the best example of that was the bailout
of Bear Stearns which, unquestionably, made the Lehman Brothers
crisis much greater. The markets expected that if Bear Stearns
received a subsidy and it was half as complex, half as large as
Lehman Brothers, Lehman Brothers surely would.
And when markets are disappointed in something that they
have come to believe because of the behavior of officials over
time, they react very badly. When people think the rules of the
game have changed, they rush for quality. We saw that in
markets with pressure bills from one point even going negative.
And they tend to sit on the sidelines until they think they
know the rules of the game again.
That means that if we want a new regime to work, we have
got to be very consistent in applying it. Sadly, that probably
means that we need a crisis of just the right size, something
that will show these tools work, whether they be bankruptcy or
the Title II authority, and work effectively so that people
will have confidence that we have a new regime in place.
But I think, until then, there are going to be very
troublesome questions about whether we, in fact, have the
ability to do what we say we are going to do.
And the willingness, I think, has been a good point made
before, too.
Chairman Brown. Thank you.
Talk about FSOC and ask for your thoughts and
recommendations about what they might consider.
Dodd-Frank authorized FSOC to make recommendations to the
Fed regarding enhanced prudential standards and adjusting the
applicability of those standards to different kinds and
different sizes of institutions.
FSOC, for example, may set an asset threshold that is
higher than $50 billion for the applicability of certain
enhanced prudential standards under Section 165, such as
resolution plans or concentration limits.
Should FSOC do that?
What would you recommend that FSOC do in making those
judgments, Dr. Herring?
Mr. Herring. I think this question is very much parallel to
the question of identifying SIFIs. Just as we have said that
size is not a magic number for a SIFI designation, I think it
surely should have enhanced supervision as well.
That, of course, takes you into some uncomfortable
judgmental grounds because you need multiple kinds of
indicators and you probably need some sort of judgment overlay.
It should be transparent, but I think it would be a mistake to
base it on size alone.
Chairman Brown. Dr. Thomson.
Mr. Thomson. Yes, I concur. I think we----
Chairman Brown. We have kind of established that for all
four of you on size.
So, speak elsewhere, what else that they should have. What
else they should consider as they make suggestions, make
statements, make rules?
Mr. Thomson. Well, I think one of the things that we need
is more information transparency, more granularity of
information. One of the big things we see is concerns about
transmission over payment systems or through common asset
holdings or through derivatives markets.
We are starting to get more information collected on this.
Some of it is an outgrowth or direct result of Dodd-Frank.
We do not collect all of the information we need,
particularly for the institutions we think are systemically
important. We do not collect the types of information at the
level of detail--collecting such information from large
institutions would not pose an undue burden on them, while it
would for a small one--that would allow us to really see what
these connections are.
Now, in Europe, we do see this information being collected,
and we see this information being used to understand what the
connections are, what the pressure points are and what the
danger points are.
And I think until we start putting more information in
place the process for labeling financial firms as systemic is
going to be more judgmental than what I would be comfortable
with.
Chairman Brown. Dr. DeYoung, thoughts?
Mr. DeYoung. I will pass on this question. I will let Paul
go.
Chairman Brown. OK, Dr. Kupiec.
Mr. Kupiec. The FSOC--it sounds like a good idea, and the
section gives the FSOC the power to sort of designate a
different set of criteria. But in the end the FSOC is not very
transparent, and it is all judgment-based.
And the FSOC is dominated by bank regulators, by far and
away, and it is not clear to me that the bank regulators would
want to give up some of the smaller banks.
I think they very much like, according to Governor
Tarullo's speeches, their stress-testing approach. They want to
replace the capital requirements, in fact. Governor Tarullo is
on record of saying he would like to replace Basel with stress
test as the primary, and it is the primary tool right now in
which the Fed determines capital.
But the whole system of designation by the FSOC--because
there is really no hard and fast science about systemic risk,
when does the failure of a firm cause financial instability?
Is it if it fails by itself in isolation during good times
or if it fails by itself in isolation during not so good times,
or is it when it fails with other firms at the same time and
times are not good?
These are all different circumstances, and the law in no
way speaks to what the situation needs to be for the FSOC to
consider. It is very vague and ambiguous, and it is entirely
then left up to the judgment of the FSOC.
So I do agree that a $50 billion automatic designation for
bank holding companies is way too low.
I also agree that I do not know the right number that that
should be raised to, but I do not think turning it all over to
the judgment of the FSOC, the way it operates today and without
any real constraints and transparency, is something that I
would recommend.
Once the FSOC determines that a company is systemically
important, how does it get out of that?
It does not tell you when it designates it. The insurance
companies that have been designated do not have a list of
things they have to do to become undesignated.
There are property rights involved. When you are
designated, all of a sudden you have to satisfy a whole bunch
of rules. This slams profitability and shareholders, and pretty
soon you have got Fed regulators crawling over you, you know,
once a year. And you are an insurance company. You never had
this before.
There are real issues associated with this decision, and
yet, the firm that is getting evaluated does not have a whole
lot of say.
They do not, for example, have to file an orderly Title I
resolution plan to the FSOC before they get designated, where
one of the criteria for designation is the fact that if they
were to fail in bankruptcy it would cause a problem. Well, you
do not even give them the right to file that report.
There is none of that that has been done in any of the
designations.
So, right now, until we really tune up the FSOC designation
process, and put some structure on it and some controls on it,
I feel very uncomfortable in recommending that they get any
additional powers, frankly.
Chairman Brown. OK, understanding. Thank you.
Dr. Kupiec, understanding your reluctance, your concern
about empowering FSOC further, I want you--I want all of you--
to be more specific about sort of where we go.
And this panel has all said making this determination based
on size alone, especially the size being $50 billion, does not
make sense. It is costly. It is onerous. It is a burden on
these banks that should not be there just by that criterion
alone. I understand that.
We know a number of things.
We know banks above $50 billion have a whole different--as
I mentioned in my opening statement, and Senator Toomey, and a
number of us have, that banks above $50 billion have a whole
different range of business models, some way less risky than
others.
We know that banks with less than $100 billion, on average,
hold just 6 percent of the assets of all the banks over that
are SIFI-designated.
We know that the large--that the banks above $100 billion
average less than 1 percent of the largest banks' over-the-
counter derivatives.
They engage in just 1 percent of repo and security lending.
So we can see where the risk mostly is concentrated. It is,
obviously, not in the smaller banks.
So my question--a series of questions on this:
Should regulators focus on particular business models or
activities?
Should regulators think about physical commodities?
We did a couple of hearings in this Subcommittee on banks'
ownership of everything from oil tankers to aluminum and
electricity generation. Should contending--I think the
conclusions in these hearings were, one, big banks have an
advantage that in the real economy is perhaps unfair and that
it brings more risk to the financial system, their involvement
that way in the real economy, all those issues.
So, be as specific as you can, and I will start with you,
Dr. Kupiec. And I think this probably will be the last
question.
Mr. Kupiec. OK.
Chairman Brown. And one more thing, how specific you can be
on what kinds of determinants we should make, we should use,
whether it is FSOC or somebody else, as regulators.
Mr. Kupiec. Looking at the practical side of things, that
probably nobody is willing to open up Dodd-Frank very broadly
at least and you want to make a few adjustments around the
edges to make it better, if I had to propose something, I
suppose I would still use a dollar cutoff as the simplest
thing.
I would look--looking at the list of holding companies and
recognizing what I think they do--and I have not analyzed every
one of them in detail--the cutoff would be somewhere between
today, to allow for growth, maybe $250 billion.
And I would add some requirements that they not be involved
in any critical specialized activity, perhaps like, you know,
asset custody--be a big asset custody manager or have too big a
capital markets operation.
I do not think that is perfect, and I do not--and it is
certainly not right in any scientific way. But if I had to come
up with a specific solution, based on what I know today, I
would not turn it over to a subjective assessment to the FSOC,
bank by bank. I think there is no control there.
I would think, second best, I would be forced to stick with
a dollar number and a few caveat criteria, and it would look
something like that, I think.
Chairman Brown. Dr. DeYoung.
Mr. DeYoung. Yeah, none of us are willing to commit to a
number. I guess Paul came pretty close there.
Chairman Brown. I would say he did.
Mr. DeYoung. He got pretty close. He actually said an
integer.
Business models are important. You do not want to name a
business model, but I will point to two places we should be
looking.
Traditional banks originate and hold--originate loans and
hold them. They do the financing of the loan. They underwrite
the credit risk of the loan, and they bear the risk from the
loan.
Other banks have a business model in which they originate
the sell, they make some fees, and they get rid of the risk.
They do not do any financing. And although they have
underwritten the loan, you are not sure about how they have
basically handed over the bond raters to tell investors how
risky these credits are.
Most banks do a mixture of these two types of underwriting
and financing. So that is one dimension.
Unfortunately, you would have to draw a line someplace--
what percentage of your activities originate in hold; what
percentage originate in sell? But the more originate and sell
the bank does, the more systemic risk this is generating within
the economy.
The other place to look is whether the bank is funding
itself with deposits or funding itself with market finance.
And you know market finance. If you go down the list of
firms that we look at as being particularly systemically
crucial to what happened in the crisis, they all were funding
their long-term assets with short-term market finance. So that
would be the other place to look.
Now these are functions. These are not necessarily business
models, but this is where I would look.
Chairman Brown. Fair enough.
Dr. Thomson, before you answer this, you had said in, I
believe, your opening testimony, maybe it was in response to a
question, that we should--you acknowledge that $50 billion is
probably too low a number, but you said perhaps if it is $50
billion and up you automatically review their other activities.
But if I heard you right, $50 billion would sort of be the
trigger. Let's review the activities of every bank over $50
billion, not designate them SIFI--I am reading a bit into what
you said--perhaps not designate them as SIFI unless they have
other high-risk activities or high-risk activities.
Is that--do you want to----
Mr. Thomson. Yes however, I do not think $50 billion is the
right number. I would go higher, somewhere on the order of $250
billion for an automatic review, with the proviso that there
are institutions that are under $250 billion we may also want
to look at because of the nature of their activities.
But I think that setting a threshold for where you look and
then apply some judgment is the answer--maybe that is where
FSOC gets involved.
Chairman Brown. So set a lower threshold, 50 or 100 for
automatic review, but then look for the other, but at 250 it is
automatic designation.
Mr. Thomson. No, I would set a higher threshold, and I
would set the higher threshold and have automatic review for
designation above that dollar amount with, on a case-by-case
basis, review of institutions below that dollar amount and
maybe have a second threshold below which you just do not
really look because I think there is little risk those
institutions below a certain size are engaged in the activities
that get larger institutions reviewed.
In your opening remarks, you talked about the traditional
regional banks that are in Ohio, Pennsylvania, Illinois, and
Indiana that do a very sort of classic, what you might call a
Glass-Steagall type banking business. They lend. They provide
trust services for customers. They raise most of their funding
through their retail branch networks.
And that is a very, very different type of business than
someone who is doing proprietary trading or a lot of trade on
behalf of customers.
I think if you want to point to activities associated with
systemic importance, I would look at activities that go beyond
what we think of this traditional retail-focused banking model.
Chairman Brown. Thank you.
Dr. Herring.
Mr. Herring. I do think that this analysis should be very
congruent with the analysis for designation of SIFIs.
And I think the Financial Stability Board has actually
developed a reasonable analytical approach that weights size.
It weights interconnectedness, which would include involvement
in capital markets activities and commodities. It evaluates
cross-border activity, complexity, the lack of substitutes for
the services the firm funds and liquidity profile.
And all of these things are weighted. One can argue about
the subjectivity of the weights, but it gives you something to
start from.
Then I think if you are going to apply judgment, it should
be very transparent. If you pick somebody up that is lower on
this list and put it in, you should be very explicit about why
you are doing it. If somebody on that list at a higher order is
taken out, you should be very explicit about what you are
doing.
I think that is the best we can do with our current state
of knowledge.
Chairman Brown. Thank you. Thank you all.
Some Members of the Subcommittee may send you written
questions in the next few days. Please answer them as quickly
as you can if that happens.
And thanks very much for your candor today and your good
answers. The Subcommittee is adjourned.
[Whereupon, at 11:51 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF RICHARD J. HERRING
Jacob Safra Professor of International Banking, The Wharton School,
University of Pennsylvania
July 16, 2014
Chairman Brown, Ranking Member Toomey, and distinguished Members of
this Subcommittee, I am grateful for the opportunity to address you
today at this hearing entitled, ``What Makes a Bank Systemically
Important?''
I am Jacob Safra Professor of International Banking at the Wharton
School, Codirector of the Wharton Financial Institutions Center,
Cochair of the U.S. Financial Regulatory Subcommittee, Executive
Director of the Financial Economists Roundtable, a member of the
Systemic Risk Council and the FDIC Systemic Resolution Advisory
Committee as well as the Hoover Institution Stanford Resolution
Project. Although my views have certainly been influenced by
discussions with my colleagues in these groups, the views I express
today are my own.
The question of what makes a bank systemically important continues
to divide experts. Some believe that recognition that some banks are
systemically important will exacerbate moral hazard, leading to
competitive inequities and the misallocation of resources. The concern
is that institutions designated as systemically important benefit from
implicit Government guarantees that will give them an unwarranted
competitive advantage. This is a legitimate concern, but, of course,
much of the Dodd-Frank Act aims to eliminate the category of too-big-
to-fail institutions and extinguish the implicit guarantee. I think
this is the correct approach, although disagreement continues about
whether the goal has been accomplished.
Experience during the recent crisis indicates that the authorities
are unlikely to refrain from bailouts if an institution which they
regard as systemic encounters extreme financial stress. Thus I think it
is pointless to deny that some institutions will be considered
systemic. Rather we should aim to find ways to resolve them without
creating intolerable spillovers for other institutions, financial
markets and, most importantly, the real economy. If we succeed, it will
end the implicit benefits banks derive from being regarded as systemic.
Since the crisis, officials have undertaken major efforts to
identify the factors that make some institutions ``systemic.'' The
Financial Stability Board has developed criteria for making the
designation based on several different indicators. \1\ These indicators
include the size of banks, their interconnectedness, their cross-
jurisdictional activity, their complexity and the lack of readily
available substitutes for the services they provide. Each November the
FSB publishes a list of G-SIBs. Currently 29 institutions are
designated as G-SIBs. These 29 banks accounts for the bulk of activity
in equity and bond underwriting, loan syndication, derivatives, foreign
exchange and custody. Eight of the G-SIBs are headquartered in the
United States and they range in size from nearly $2.5 trillion to $222
million indicating that factors in addition to size matter.
---------------------------------------------------------------------------
\1\ The Financial Stability Oversight Council (FSOC) has refined
these criteria and applied them to a broader range of financial
institutions in the United States.
---------------------------------------------------------------------------
Substantial efforts are underway to refine the indicators and to
model the interactions among institutions that create systemic
concerns. Although these efforts may help us better understand the
interconnectedness of financial institutions and markets, I think that
they focus on the wrong question. In practice, the authorities treat an
institution as systemic if they fear that a loss to uninsured
depositors and creditors would damage the financial system and the real
economy. When faced with the prospect of a disorderly resolution,
officials have too often improvised bailouts over frantic, sleepless
weekends. If the authorities cannot make a credible commitment to
abstain from bailouts, Systemically Important Banks (SIBs) will grow
larger, more complex and more dangerous.
I believe that the authorities have granted bailouts so frequently
because they lacked reliable resolution tools. They relied instead on a
policy of constructive ambiguity, believing they could limit moral
hazard by asserting that access to the safety net was uncertain. This
policy seems naive and ineffectual. It can work only if market
participants believe that bailouts will be random. But market
participants do not believe that bailout policy is determined by a spin
of a roulette wheel. They expect that the authorities will behave
rationally and provide bailouts to institutions that are regarded as
systemic. \2\
---------------------------------------------------------------------------
\2\ This is, of course, a prime example of a time inconsistency
problem: what the authorities say ex ante is quite different from what
they can expect to do ex post.
---------------------------------------------------------------------------
The Dodd-Frank Act can be viewed as a multipronged attempt to
eliminate bailouts and neutralize the threat posed by SIBs. Many of
these measures are designed to reduce the likelihood that institutions
will fail. The most important of these is the imposition of higher,
better quality capital requirements with differentially higher capital
requirements for SIBs. This is a welcome reversal of the policy before
the crisis of giving SIBs differentially lighter capital requirements.
While strengthened capital requirements will ensure that SIBs have
better shock absorbers, they cannot prevent failures--nor should they.
Banks are in the business of taking risks and so long as they do so
prudently they provide substantial benefits to the economy by
intermediating between savers and investors, buying and selling risk
and operating the payments system.
If banks cannot be made fail-safe, they must be made safe to fail.
This requires resolution policies and procedures that will ensure that
investors and creditors bear the cost of bank failures, not taxpayers.
The Dodd-Frank Act addresses this problem in Titles I and II. This is a
major enhancement of the regulatory framework. Before the Dodd-Frank
Act, most institutions paid no attention to how they might be resolved
in the event of severe financial distress or what measures they might
take to minimize the damage to the financial system. Lehman Brothers
illustrated the problem starkly. It entered bankruptcy with no
preparation. Indeed, the managers were uncertain about how many legal
entities the holding company controlled and employees were unclear
about which legal entity they worked for.
Title I requires rapid resolution plans for all SIBs. These so-
called living wills show how the SIB could be resolved under bankruptcy
without causing damaging spillover effects on other institutions and
financial markets. Living wills must include: (1) an executive summary
with a strategic analysis describing the firm's plan for a rapid and
orderly resolution (without, however, defining what period of time
qualifies as ``rapid''); (2) a description of how resolution planning
is incorporated in the firm's corporate governance structure; (3) a
description of the group's overall organizational structure that
includes a hierarchical list of all material entities, as well as
jurisdictional and ownership information and mapping of core business
lines and critical operations into corporate entities; (4) a
description of management information systems that support the covered
company and its material entities, including a detailed inventory and
description of key applications along with identification of the legal
owner or licensor and related service level agreements; (5) a
description of interconnections and interdependencies among a covered
company and its material entities and the covered company's critical
operations and core business lines along with a description of how
service levels would be sustained during a material financial distress
or insolvency; and (6) identification of supervisory authorities and
regulators that oversee the covered company.
For the largest and most complicated banking groups that have
thousands of subsidiaries, the third requirement has been onerous. It
demands not only a mapping of lines of business into corporate
entities, but also details regarding material entities, critical
operations and core business that, at a minimum, describe types and
amounts of liabilities. It also requires details about the booking of
trading and derivatives activities, as well as an identification of
major counterparties including descriptions of any interconnections or
interdependencies among them. Finally, it requires that covered
companies list all material trading, payment, clearing, and settlement
systems in which they participate.
Most of these requirements can be seen as attempts to minimize the
prospect of a Lehman Brothers-like disorderly bankruptcy by ensuring
that both covered companies and regulators have thought through the end
game in advance. Although this will not ensure an orderly resolution,
it increases the likelihood that SIBs can be made safe to fail. Not
only will the authorities have a more accurate view of the SIB and its
interactions with the rest of the financial system, but also the
process and costs of drawing up rapid resolution plans and responding
to regulatory evaluations, may give institutions an incentive to reduce
their complexity. Moreover, the authorities have the authority to
compel a SIB to simplify its structure if it is not sufficiently
responsive to regulatory reviews of its resolution plan over an
extended period.
While the D-F Act generally supports greater market discipline, it
does not address the issue of public disclosure of resolution plans.
The FRB and FDIC, however, have required disclosure of a public section
of the plan containing an executive summary that describes the business
of the covered company including: ``(i) the names of material entities;
(ii) a description of core business lines; (iii) consolidated or
segment financial information regarding assets, liabilities, capital,
and major funding sources.'' This could have been an effective way of
harnessing market discipline to support the simplification of SIBs, but
unfortunately, the FRB and FDIC chose to permit institutions to limit
their disclosures to publicly available information.
If the information is already publicly disclosed, it's not clear
what value this disclosure requirement adds. This timid approach
represents a significant lost opportunity. If the authorities had been
serious about enhancing market discipline, they should have required
disclosure of information that would enable potential creditors of the
covered company to understand the statutory hierarchy of claims on the
various entities in resolution, and precisely how the authorities
propose to conduct a resolution. In the absence of such information,
creditors cannot be expected to price claims efficiently. Moreover,
some of the information in the first rounds of disclosures falls short
of the more modest goal of helping the public understand the business
of the covered company because it is difficult to reconcile with other
publicly available information. \3\
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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.
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\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.
---------------------------------------------------------------------------
\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\
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\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).
---------------------------------------------------------------------------
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\
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\6\ For the over the counter derivatives markets the reforms to
that market under Title VII of Dodd-Frank may lessen the systemic
importance large banking companies may derive from the SWAPS market.
\7\ http://libertystreeteconomics.newyorkfed.org/2011/04/
everything-you-wanted-to-know-about-the-tri-party-repo-market-but-
didnt-know-to-ask.html#.U8FZVLFwV2M
---------------------------------------------------------------------------
The fourth source of systemic importance for a financial firm is
context/conditions, that is, the economic or financial market
conditions at the time the firm becomes insolvent. Firms that come
under financial distress during a period of market fragility are more
likely to be treated as systemic than firms that run aground during
more normal market conditions. Context/conditions explains why Drexel
Burnham Lambert filed for bankruptcy in 1990 but Bear Stearns was put
through a Federal Reserve Bank of New York assisted merger in early
2008. It also partially explains why the Federal Reserve Bank of New
York intervened to broker a deal for Long Term Capital Management. \8\
Context/conditions includes the exercise of political clout, something
Members of your Committee are very familiar with.
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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.
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\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.
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\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.
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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:
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\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
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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\
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\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.
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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\
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\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.
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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.
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\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,
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\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\
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\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.
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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