[Senate Hearing 113-551]
[From the U.S. Government Publishing Office]
S. Hrg. 113-551
EXAMINING THE GAO REPORT ON
EXPECTATIONS OF GOVERNMENT SUPPORT FOR BANK HOLDING COMPANIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING WHETHER THE ERA OF TOO BIG TO FAIL IS FINALLY OVER
__________
JULY 31, 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
93-180 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
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
Geoffrey Okamoto, Republican Subcommittee Staff Director
Megan Cheney, Legislative Assistant
(ii)
C O N T E N T S
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THURSDAY, JULY 31, 2014
Page
Opening statement of Chairman Brown.............................. 1
Opening statements, comments, or prepared statements of:
Senator Toomey............................................... 3
Senator Vitter............................................... 4
WITNESSES
Lawrance Evans, Director, Financial Markets and Community
Investment, Government Accountability Office................... 6
Prepared statement........................................... 34
Responses to written questions of:
Chairman Brown........................................... 198
Deniz Anginer, Assistant Professor of Finance, Pamplin School of
Business, Virginia Tech........................................ 8
Prepared statement........................................... 50
Edward Kane, Professor of Finance, Boston College................ 10
Prepared statement........................................... 124
Anat Admati, George G.C. Parker Professor of Finance and
Economics, Graduate School of Business, Stanford University.... 13
Prepared statement........................................... 130
Douglas Holtz-Eakin, President, American Action Forum............ 15
Prepared statement........................................... 195
Responses to written questions of:
Chairman Brown........................................... 199
Additional Material Supplied for the Record
Charts submitted by Chairman Sherrod Brown....................... 201
Report submitted by the Government Accountability Office......... 202
Statement submitted by the American Bankers Association.......... 296
Comments regarding the ``GAO Report on Large Bank Holding
Companies'', by Allan H. Meltzer............................... 303
(iii)
EXAMINING THE GAO REPORT ON EXPECTATIONS OF GOVERNMENT SUPPORT FOR BANK
HOLDING COMPANIES
----------
THURSDAY, JULY 31, 2014
U.S. Senate,
Subcommittee on Financial Institutions and Consumer
Protection
Committee on Banking, Housing, and Urban Affairs
Washington, DC.
The Subcommittee met at 2:02 p.m., in room 538, Dirksen
Senate Office Building, Senator Sherrod Brown, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
Chairman Brown. The Subcommittee will come to order.
Thank you, Senator Toomey, for working with us on so many
issues, including your cooperation in this hearing. Thank you.
Thank you, Senator Vitter, for joining us.
There will be other Members here, too.
And thanks to the witnesses whom I will introduce in a
moment.
Too big to fail is the Government policy that ensures that
certain financial institutions cannot be allowed to fail
because their failures would cause too much damage to our
Nation's financial system and our Nation's economy.
This is the Subcommittee's sixth hearing since 2011 on the
issue of too-big-to-fail banks. We are here to ask again
whether too big to fail is finally over.
Some Wall Street institutions and their paid consultants
and lobbyists argue that no bank is too big to fail.
Upton Sinclair, the American writer, once said, ``It is
difficult to get a man to understand something, when his salary
depends on his not understanding it.''
But most objective observers agree with Federal Reserve
Chair Janet Yellen who said that ``Our work is not finished.''
When the four largest U.S. banks are 25 percent larger today
than they were in 2007, before the implosion of the economy, it
is hard to disagree with her statement.
Yesterday, Christy Romero, the Special Inspector General
for TARP, released a report in which she concluded the six
largest U.S. bank holding companies ``remain interconnected to
each other in 2013 as they were in 2008.'' She agreed we have
more to do.
Too big to fail distorts incentives and encourages
excessive growth and leverage and complexity.
Today we are here to examine one effect of too-big-to-fail
policies--the financial benefits enjoyed by the largest banks.
The GAO report shows that megabanks' funding advantage varies
based upon how one measures it. Unfortunately, this estimate
contains many limitations and is clouded by both extraordinary
interest rate policies and a number of subsidies that are
difficult to quantify.
But this report has some valuable lessons about too big to
fail and shows that right now the subsidy may have been reduced
but could be about 50 basis points. GAO also says the subsidy
may have been reduced not because we ended too big to fail but
because of, their words, ``improvements in banks' holding
companies' financial conditions.''
Unfortunately, market perceptions of financial conditions
change quickly. For example, banks' credit default swap spreads
increased suddenly and not until well into 2008.
Secretary Lew told this Committee last month that the only
real moment when you know for sure is when there is a crisis.
We rarely have the foresight to know when a financial
crisis is about to happen. GAO's report, though, gives us a
glimpse of the next crisis. It estimates that the funding
advantage would return to levels similar to those in 2008 as
investors and depositors flock--and that word, flock, is
exactly right--as depositors and investors flock to the
megabanks because they believe the U.S. Government will rescue
them.
In another crisis, the biggest banks' advantages
potentially rise to as much as 500 basis points. Taking an
estimate from one of the most conservative models of this
scenario, the 6 largest banks would get an annual subsidy of
about $13 billion in all of their liabilities. Using some of
the higher estimates, it could be 10 times that.
This suggests that under Secretary Lew's test, the largest
banks are still too big to fail; taxpayers are still supplying
them with an implicit guarantee.
Whether you view the Government support as a form of
catastrophic insurance or a stock option or a nontransparent
contingent liability for the Federal budget, we know that
taxpayers really, in the end, never receive full value for it.
The first GAO report issued in November, when Dr. Evans
joined us before, showed that Government programs underprice
support during a crisis.
As a second report shows, we have not taken the necessary
steps to ensure that we will not have to prop up the largest
banks again.
Unless you think that we can eliminate financial crises
forever, the GAO report is another reminder we have more work
to do to eliminate too-big-to-fail policies and the advantages
and the distortions which they create.
When we think about the costs and benefits of too-big-to-
fail policies, industry wants us to think only about their
costs.
Steel companies dump waste into a river. They then argue it
will be costly to clean it up, but it has a higher human cost
to the miners and the children who get sick from the pollution.
It passes more health care costs onto our society. The same
with damage done by policies on too big to fail.
Those who believe in a society with rules understand that
auto safety might cost car companies to install seatbelts and
airbags, but those protections save lives.
And financial rules might cost bank executives a little
smaller bonuses, somewhat smaller dividends perhaps, but they
will help prevent a repeat of what we had 5 years ago with
millions of foreclosures and millions of lost jobs.
Senator Toomey, thank you.
STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thank you very much, Chairman Brown, and
thanks for having this hearing.
I want to also thank Senator Vitter for requesting the GAO
report and thank the GAO for their contribution to this
discussion.
It seems to me the GAO report on whether or not big banks
get a subsidy is inconclusive, but in any case the real work
that we ought to be focused on, the real issue here, is the
extent to which Dodd-Frank has codified too big to fail.
The way I see it, what Dodd-Frank does is it looks at
banks, designates them as SIFIs and then attempts to
micromanage them so massively and so completely that failure
is, theoretically, not possible. I think that is the basic
mentality of Dodd-Frank.
Well, there are some problems with this approach.
One is we have institutions designated as SIFIs who
absolutely are not systemically important, and we have had
hearings where we have had that discussion. There is no
question in my mind about that.
We also have the massive direct and indirect costs of
complying with the overregulation and the micromanagement,
which I would suggest goes well beyond a slightly diminished
dividend to shareholders. It means there is less credit
available, and the credit that is available is available at
higher prices. So that is a problem for our entire economy.
I would also suggest that the premise that regulators, as
long as they have enough power, will make it impossible for an
institution to fail; that is based on the mistaken notion that
these regulators are omniscient, or have greater wisdom or
intuition than they did before 2008, because there was no
absence of regulators at the time that the financial crisis
hit.
Finally, I would simply argue that failure has to be an
option. In a market-based economy, in a capitalist system, in a
free society, you have to be free to fail. And that is without
a taxpayer bailout.
And so that is what we ought to be looking to achieve--a
system where we can have a failure that is not catastrophic and
that does not involve taxpayers being forced to make a bailout.
So my suggestion is that what we ought to do--and I am open
and looking forward to having your support on my legislation,
Mr. Chairman--is let's repeal Title II. To the extent that
anybody thinks there is a subsidy or there is a codification of
too big to fail, it must reside in Title II, which is where the
orderly liquidation authority is.
And rather than have this subjective process, which is what
Title II is, where there is no option for restructuring, there
is no certainty about creditor rights and there is an explicit
mechanism for taxpayers to come in and be forced to make a
bailout, rather than all of that, why not do this in
bankruptcy, which is what bankruptcy is supposed to be all
about?
If you have a properly designed bankruptcy code, which I
think does require some modifications, creditors would be on
the hook for losses, not taxpayers; you could allow for either
a liquidation or a reorganization, whichever makes sense;
creditors of equal standing would be treated equally rather
than the subjective treatment that Title II of Dodd-Frank
contemplates; and you have a bridge bank mechanism that would
allow for a resolution to occur without systemic problems.
So I think that too big to fail is a real concern. I think
the real solution is to go to the heart of where the problem
is. The problem is in Dodd-Frank, and so I hope we will be able
at some point to address that.
Again, I thank you for having this hearing, Mr. Chairman.
Chairman Brown. Thanks, Senator Toomey.
Senator Warren? No opening statement.
Senator Vitter.
STATEMENT OF SENATOR DAVID VITTER
Senator Vitter. Thank you, Chairman Brown, for holding this
hearing today and for partnering with me in requesting the
study from the GAO that was released today on the expectation
of Government support for megabanks-large bank holding
companies.
Chairman Brown and I started our work together based on a
shared belief that Dodd-Frank had not ended too big to fail. We
began by writing the regulators in 2012, urging them to use
their statutory authority to deal with the too-big-to-fail
problem and end bailouts once and for all. Unfortunately, they
were not as aggressive as they needed to be.
We then introduced our legislation requiring prior capital
standards, and in January 2013, we asked the GAO to study and
report to Congress on the perks of a megabank being considered
too big to fail.
I guess I disagree somewhat with my colleague, Senator
Toomey, that this report is completely inconclusive. I think it
is very helpful, and I think it moves the debate significantly.
Not long ago, a lot of folks led by the megabanks were
denying any funding advantage, any too-big-to-fail subsidy. Now
I think that debate is over. Everyone agrees it exists, and we
are debating how big it is and for what reasons it is here or
here or wherever.
I think that is a significant shift in the debate and we
are approaching a consensus on this. From this report, I think
it supports that consensus.
Let me just point to a couple of quotes.
``Remaining market assumptions about Government support can
give rise to advantages for the largest bank holding companies
in three broad categories to the extent these assumptions
affect decisions by investors, counterparties and customers of
these firms. Those categories are funding costs, financial
contracts that reference ratings and an ability to attract
customers.''
And then in addition, out of this GAO report, it says that
if today's megabanks had the same environment and credit risk
as in 2008 the market would expect bailouts and their funding
advantage would increase to between 102 and 495 basis points.
So that is significant.
Finally, let me point to one other key metric that I am
very concerned about. It is outside of this report, but it is a
key metric that is unassailable, and that is the accelerating
pace since the crisis of consolidation.
The megabanks have gotten much bigger. Smaller community
banks have gotten far fewer in number. That was a preexisting
trend, but that trend has been put on steroids through the
crisis and Dodd-Frank. That trend is unassailable, beyond
debate.
And I think that is very worrisome for our banking system
and sadly ironic, given that on the private side--Government
was certainly responsible for the crisis in terms of many
policies, but on the private side it was very large
institutions, not smaller community banks. They have
essentially benefited in terms of where they are in the market,
benefited through the crisis and, in light, benefited by our
response in terms of Dodd-Frank.
Those smaller institutions that had nothing to do with the
crisis have receded and in a much more vulnerable position than
they were before the crisis and the legislative response.
I look forward to our witnesses today and to an informed
discussion based on what they have to say.
Thank you.
Chairman Brown. Thank you, Senator Vitter. Thank you for
your work on requesting this report and as Senator Toomey said,
too.
Dr. Lawrance Evans is a Director in the Financial Markets
team at the GAO, where he has also served as an economist and
led engagements in the GAO's International Affairs and Trade
Team. Prior to his service there, Dr. Evans was a research
fellow at Amherst College and a research assistant at the
Center for Economic Policy and Analysis.
Welcome back, Dr. Evans.
Mr. Evans. Thank you.
Chairman Brown. Dr. Deniz Anginer is an assistant professor
of finance at Virginia Tech's Pamplin School of Business and is
currently on leave from the position as a financial economist
with the Development Research Group at the World Bank. Prior to
joining the World Bank, Dr. Anginer worked as a risk and
finance consultant at Oliver Wyman.
Dr. Edward Kane is a research professor of finance at
Boston College. In addition to his more than 50-year career in
banking and economic teaching and research, Professor Kane
served as a consultant to private companies and Government
agencies including the Office of the Comptroller of the
Currency, the General Accounting Office and the Federal Reserve
Banks of Boston and Chicago. He currently serves as a research
associate at the National Bureau of Economic Research and is a
member of the Shadow Financial Regulatory Committee.
Welcome.
Dr. Anat Admati is the George Parker Professor of Finance
and Economics at Stanford University's Graduate School of
Business. Professor Admati spent more than 30 years studying
and teaching finance and economics and has written extensively
about the function and regulation of financial markets.
Thank you, Dr. Admati, for being here.
Douglas Holtz-Eakin is President of the American Action
Forum. Dr. Eakin was a member of the Financial Crisis Inquiry
Commission and served as Director of the Congressional Budget
Office and Chief Economist of the President's Council of
Economic Advisors. In addition to his appointments across
multiple Administrations, Dr. Holtz-Eakin was a senior fellow
at the Peterson Institute for International Economics, Director
of the Maurice Greenberg Center for Geoeconomic Studies and the
Volcker Chair of International Economics at the Council on
Foreign Relations.
Welcome back to one of your many times to testify, Dr.
Holtz-Eakin.
Dr. Evans, if you would begin.
STATEMENT OF LAWRANCE EVANS, DIRECTOR, FINANCIAL MARKETS AND
COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY OFFICE
Mr. Evans. Thank you. Chairman Brown, Ranking Member
Toomey, and Members of the Subcommittee, it is my pleasure to
appear before you today to discuss the existence of any funding
advantages the largest banks may have received due to perceived
Government support.
The report we released today reflects GAO's extensive work
on this issue. When I appeared before the Subcommittee in
January, I noted that the question of whether or not banks
receive benefits because of investor expectations of loss
protection was largely an empirical one. As a result, my
remarks today will focus on our original quantitative analysis.
It is important to note up front that this was a difficult
task, particularly because measuring investor perceptions is
complicated. The very nature of our exercise necessitated a
number of methodological choices and raised a number of issues
over which reasonable people may disagree.
Consumers of this research should know that precise and
firm conclusions likely reflect key assumptions and confident
decisions on difficult methodological issues that would benefit
from professional skepticism and full disclosure. As a result,
our report carries a heavy dose of caution and nuance and
reflects the uncertainty underpinning our modeling effort.
There are many funding sources one could analyze. We
selected senior unsecured bonds.
Bond yield spreads are a direct measure of what actual
investors charge banks to borrow money in the market and are
sensitive to credit risk and, thus, investor expectations.
Senior unsecured debt is among the most important sources of
nondeposit funding and intended to absorb losses under FDIC's
resolution authority.
While there are many approaches to examining potential
funding cost advantages, we chose an econometric methodology.
This allows us to examine the relationship between size and
bond funding costs and take into account other factors that
might drive funding cost differences, like credit risk and bond
liquidity.
Specifically, our model allows the funding cost-risk
relationship to be influenced by bank holding company size and
for that influence to change from year to year.
Our time period covers 2006 to 2013, which captures many
important changes in the regulatory environment and any impact
this may have had on market expectations.
Because uncertainty is inherent in modeling, it is best
practice to analyze and report its effects. We directly
incorporate sensitivity analysis into our findings by
estimating 42 models for each year. The multiple model
specifications reflect the various defensible ways to
incorporate credit risk, bond liquidity and size into the
analysis.
For example, there is no agreement in the literature on
which institutions may be considered too big to fail.
Therefore, we capture systemic importance using different
measures, including total assets and indicators for banks
designated as G-SIBs and those designated as SIFIs by Dodd-
Frank.
Our analysis suggests a funding cost advantage for large
banks during the financial crisis but provides mixed evidence
of such advantages in recent years. For example, most models in
2013 suggest that funding cost advantages have declined or
reversed, but there were a few models that found lower funding
costs for large banks.
Because we are agnostic about which models are the right
ones, GAO remains cautious against strong conclusions. The
weight of the evidence, though, suggests progress has been
made, but it is still too soon to declare victory as funding
cost advantages might resurface should crisis conditions
reemerge.
This is an important possibility to consider because
changes over time in our estimates of the funding cost-size
relationship may reflect changes in investors' belief about,
one, the likelihood that a bank will fail, two, the likelihood
that it will be rescued by the Government if it fails, and
three, the size of the losses the Government may impose on
investors if it rescues the bank. However, we cannot precisely
identify the influence of each of these factors.
In a hypothetical scenario, when we assume credit risk
returned to financial crisis levels in 2013, most of our models
suggest, again, lower funding costs for larger banks.
The hypothetical scenarios we examined did not provide the
same overwhelming type of evidence of advantages we found in
2008 and 2009, and Dodd-Frank and other financial reforms could
make financial crisis risk scenarios less likely.
But the outcome of these scenarios suggests that in
addition to changes in expectations of Government support some
of what we see is likely related to balance sheet repair and,
therefore, a lower probability of failure.
To be frank, it may take another crisis to truly test the
effectiveness of financial reforms.
We detail important limitations associated with our
econometric analysis in the written statement and full report.
Suffice to say here that our work is not perfect, and we have
not exhausted the many ways one might investigate funding cost
advantages. Users of the report should give our cautionary
notes serious attention before moving from our findings to
public policy.
Now we understand that stakeholders are invested on both
sides of this issue. We encourage interested parties to base
their examination of our work on an objective and thorough
reading of the actual report.
Shortly, you will hear from Professor Kane, who likely only
had a limited time to review our report. Professor Kane's
written testimony contains a number of statements that are
either inaccurate, mischaracterize our methodology or result
from the application of inappropriate criteria to assess the
validity of our study.
GAO will welcome an opportunity to respond as we believe we
have made an important contribution to the literature and the
public policy debate.
Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee, this concludes my prepared statement. I look
forward to any questions you might have.
Chairman Brown. Thank you, Dr. Evans.
Dr. Anginer.
STATEMENT OF DENIZ ANGINER, ASSISTANT PROFESSOR OF FINANCE,
PAMPLIN SCHOOL OF BUSINESS, VIRGINIA TECH
Mr. Anginer. Mr. Chairman and the distinguished Members of
the Subcommittee, thank you for convening today's hearing and
inviting me to testify.
My name is Deniz Anginer. I am an assistant professor at
Pamplin Business School and Virginia Tech.
Along with my colleagues, Viral Acharya and Joe Warburton,
I have examined market expectations of implicit Government
guarantees to so-called too-big-to-fail institutions. Most of
my testimony is based on this research.
The too-big-to-fail doctrine holds that the Government will
not allow large financial institutions to fail if their failure
would cause significant disruption to the financial system and
to economic activity.
In our research, we find that large financial institutions
and their investors expect the Government to back the debts of
these institutions should they encounter financial difficulty.
These expectations of Government support are embedded in the
price of bonds issued by major financial firms, allowing them
to borrow at lower rates.
Expectation of Government support by the market also
results in a distortion in how risk is reflected in the debt
prices of large financial institutions.
An explicit Government guarantee dulls market discipline by
reducing investors' incentives to monitor and to price the
risk-taking of large financial firms.
In our analysis, we show that while a positive relationship
exists between risk and cost of debt for medium- and small-
sized institutions, this relationship is 75 percent weaker for
the largest institutions. Changes in leverage and capital
ratios are likewise less sensitive to changes in risk for these
large financial firms.
Because they pay a lower price for risk than other
financial institutions, the perceived guarantee provides too-
big-to-fail firms with a funding advantage. We estimate a
funding cost advantage of approximately 30 basis points over
the years 1990 to 2012, peaking at more than 100 basis points
in 2009.
The total value of the subsidy amounted to about $30
billion per year on average over the same time period, topping
at $150 billion in 2009.
We also examined nonfinancial firms. If bond investors
believe that all of the largest firms, both financial and
nonfinancial, are too big to fail, then large nonfinancial
firms should enjoy subsidies similar to that of large financial
firms. However, we find that this is not the case, suggesting
that the difference is likely due to an expectation of an
implicit Government guarantee.
Compared to the GAO study, we find lower implicit subsidy
values for the years 2007 to 2011 and slightly higher numbers
in 2012. We have not examined the year 2013, the year in which
the GAO finds the greatest decline.
Although most of the attention will be paid to the analyses
that try to quantify the dollar values of the subsidy and its
changes over time, it is important to note that it is very
difficult to directly relate these changes to the introduction
of Dodd-Frank and other regulations.
It is very hard to separate out changes in the probability
of large financial firms experiencing distress from the
probability that they will be bailed out. As the GAO report
points out, this is especially true as the risk premium in the
market has declined in recent years and large financial firms
have seen significant improvements in their balance sheets and
capital ratios, reducing their probability of experiencing
financial distress.
Although it is very difficult to establish a direct link
between regulations and changes in subsidy over time, examining
these changes in subsidy using alternative methods over a short
time window would be more helpful in analyzing the impact of
Dodd-Frank and other regulations.
In our study, we examined changes in risk sensitivities of
cost of debt after the introduction of Dodd-Frank. We examined
changes in subsidies accruing to large financial firms compared
to nonfinancial firms. We also examined the cost of implicitly
guaranteed debt to explicitly guaranteed debt issued by the
same firm under the FDIC's Temporary Liquidity Guarantee
Program.
Using these alternative approaches, we find that Dodd-Frank
did not significantly alter investors' expectations that the
Government will bail out too-big-to-fail financial firms should
they falter.
Despite its no-bailout pledge, Dodd-Frank leaves open many
avenues for future rescues. For instance, the Federal Reserve
can offer a broad-based lending facility to a group of
financial institutions in order to provide a disguised bailout
to the industry or a single firm.
In addition, Congress can sidestep Dodd-Frank by amending
or repealing it or by allowing regulators to interpret their
authority in ways that protect creditors and support large
institutions.
Finally, it is also important to note that the analysis
conducted by us and the GAO only measured the direct subsidy
that may accrue to too-big-to-fail firms. There may be other
indirect effects such as misallocation of capital or excessive
and correlated risk-taking to exploit the implicit guarantees
that are not captured by the analysis.
To conclude, Governments are generally not required to make
any apparent financial commitment or outlay or request funds
from the legislatures or taxpayers when they implicitly
guarantee too-big-to-fail institutions. Implicit guarantees
lack the transparency and accountability that accompany
explicit policy decisions.
Taxpayers' interests could be better served by estimating
on an ongoing basis, both in good times and in bad times, the
accumulated value of the subsidy. Public accounting of
accumulated too-big-to-fail costs might restrain those
Government actions and policies that encourage too-big-to-fail
expectations.
Thank you.
Chairman Brown. Thank you, Dr. Anginer.
Dr. Kane, welcome.
STATEMENT OF EDWARD KANE, PROFESSOR OF FINANCE, BOSTON COLLEGE
Mr. Kane. Thank you, Mr. Chairman, for inviting me to
testify today. I want to congratulate you and the rest of the
Committee for continuing to battle against too big to fail in
the face industry efforts to tell us it has gone away. Finally,
I also want to thank Mr. Evans for making you more eager to
hear what I have to say.
[Laughter.]
Mr. Kane. What I have to say is that GAO bungled the
assignment you gave it. The GAO goes wrong at the outset in how
it defines too big to fail.
The definition of too big to fail offered in the report's
first sentence is incomplete. It describes too big to fail
(TBTF) as an active policy of intervention when the most
important part of TBTF is a passive policy of forbearance,
which allows institutions that are insolvent to continue to
roll over, and even expand, their debt.
Deeply insolvent banks are what I term zombie institutions.
They can only prevail because they are backed by the black
magic of Government implicit guarantees.
The GAO also misunderstands the character of the funding
advantages that your Committee asked them to study. The GAO
treats these guarantees as if they are merely a form of bond
insurance on outstanding bonds.
The character of too-big-to-fail guarantees is richer than
insurance on outstanding bonds because, as long as regulators
forbear from resolving its insolvency, a truly too-big-to-fail
firm can extract further guarantees by issuing endless amounts
of additional debt.
So what is funding cost? Funding cost is the cost of the
funding mix. Being too big to fail lowers both the cost of
debt, which GAO studied, and the cost of equity, which it did
not.
too big to fail guarantees lower the risk that flows
through to holders of both kinds of securities. It chops off
their losses at a certain point and directs the flow of further
losses to taxpayers.
This means that, period by period, the incremental
reduction in interest payments on outstanding bonds, deposits
and repos is only part of the subsidy that the stockholders
enjoy. The missing part is the increase in stock prices that
comes from having investors discount the firm's current and
future cash-flows at an artificially low rate of return on
equity.
Limitless guarantees shift the risk of the deepest possible
losses away from creditors and stockholders. It is as if the
profit flow move through a pipeline with a Y in it. Once a TBTF
becomes insolvent, further losses go to the taxpayers until the
economy recovers.
So the issue is not whether things are better today. The
economy is better; so the banks will be better.
The issue is whether we continue to encourage them to take
on too much tail risk.
The value of these incentives is the greatest part of what
the GAO missed. We must recognize that guarantee contracts have
two components. The first allows the guarantee party to put
responsibility for covering losses that exceed the value of the
assets of the bank holding company to the guarantor. No
guarantor wants to expose itself to unlimited losses on this
put.
For this reason, all guarantee contracts incorporate a
stop-loss provision that gives the guarantor a call on the
assets of the firm. Ordinarily, the stop-loss kicks in just as
insolvency is approached or breached.
In the FDIC Improvement Act of 1991, efforts to exercise
the Government's call is termed prompt corrective action. We
did not see prompt corrective action in 2008 for TBTF
institutes.
By definition, the Government's right to take over a firm's
assets will never be exercised in a financial institution that
is truly too big to fail. Nonexercise means that the Government
has effectively ceded the value of its loss-stopping rights to
the too-big-to-fail BHC's stockholders. The value that
forbearance gives away is what the GAO's measure ignores.
I offer a picture, Figure 2, in my testimony that graphs
the behavior of AIG's stock price before, during and after the
2008 crisis. The only time AIG's stock price approached zero--
and it did so twice--was when the notion of a Government
takeover was seriously under discussion so that the probability
of stockholders' continued rescue was falling. As soon as this
course of action was tabled, the stock price surged again
because, TBTF policies were turning the stop-loss back to the
stockholders.
Also, the designation of systemically important financial
institutions is really not a binary condition; that is, it is
wrong to say that a BHC either is TBTF or it is not. TBTF does
not start at a particular size; it lies on a continuum and is
influenced by several variables. Any firm's access to Senators
and Congresspersons grows with its geographic footprint--this
is part of the problem caused by the ongoing consolidation
among the biggest BHCs--and with the number of employees that
can be persuaded to contribute to reelection campaigns.
To do a proper investigation, one cannot just look at bond
markets. One should be looking also the stock market.
I present in Figure 3 some work that Hovakimian, Luc
Laeven, and I have done to estimate average dividend that
taxpayers ought to have been paid by large banking firms from
1974 to 2010. We can see the cyclical pattern that we have been
talking about. But we can also see secular learning about and
growing exploration of the value of these guarantees.
Prior to each new recession, at the peak, more benefit has
been extracted by too-big-to-fail institutions. I fear what is
apt to happen in the next crisis.
In deciding to ignore studies that use the contingent-claim
approach to evaluate TBTF subsidies, the GAO fell into the trap
of thinking of bailout expenditures as either loans or
insurance. It is important that we understand the difference
between guarantees, insurance, and loan contracts.
An insurance company does not double and redouble the
coverage of drivers it knows to be reckless.
Similarly, lifelines provided to an underwater firm cannot
be thought of as low-interest loans. Loans are just not
available to firms that are in dire straits.
The ability to extract implicit guarantees on new debt and
the hugely below-market character of bailout programs means the
repayment of funds that were actually advanced--i.e., just the
funds that were actually advanced--does not show that a bailout
program is a good deal for taxpayers.
I believe that the politicians who have made that claim are
embarassing everyone in Government. They are causing the
public, who does understand this, to lose confidence in the
policymaking.
So what should we do to sanction reckless pursuit of TBTF
subsidies? That is the second part of my statement: How can we
sanction the exploitation of too-big-to-fail quantities?
I have stressed that in principle the risks in backstopping
these firms cannot be calculated and priced in the
straightforward way that the risks of bonds or insurance
contracts can.
Now I want to convince you to characterize bailout support
as equity funding, as loss-absorbing equity funding, provided
to a zombie firm when no one else will give it a nickel. We
have got to see that managers who adopt risk management
strategies that willfully conceal and abuse taxpayers' equity
stake are sanctioned explicitly by corporate and criminal law
rather than excused by insurance law as inevitable moral
hazard.
I believe the way we frame problems is critically important
in making policy.
If we think of bailout support as a loan, if recipients pay
it back, it is a good loan.
If we think of it as insurance, we would suppose that
actuaries have been able to somehow figure out the risks and
that the Government should be able to price and control its
exposure to moral hazard.
I am saying----
Chairman Brown. Please wrap up.
Mr. Kane. OK. Recklessly pursuing tail risk is an ethical
violation.
Regulatory capture has actually infiltrated the
bureaucratic system that is supposed to limit risk-taking and
sewn loopholes into the rules. Capital requirements in
particular have gone very, very awry.
I believe that genuine reform would compel the Department
of Justice to prosecute megabank holding companies that engaged
in easy-to-document securities fraud. There is value in
documenting the violations and prosecuting these crimes in open
court.
I know that Senator Warren has been pushing a bill that
would make settlement deals much more transparent. We need to
underscore how managers benefit when the fines fall only on the
shareholders.
But BHC managers that have committed theft by safety net
from taxpayers are individuals. If we do not set up sanctions
that punish individuals, we are going to get even more theft in
the future.
Chairman Brown. OK. I am going to cut you off. Thank you,
Dr. Kane.
Dr. Admati, thank you.
STATEMENT OF ANAT ADMATI, GEORGE G.C. PARKER PROFESSOR OF
FINANCE AND ECONOMICS, GRADUATE SCHOOL OF BUSINESS, STANFORD
UNIVERSITY
Ms. Admati. Chairman Brown, Ranking Member Toomey, and
Subcommittee Members, I am very grateful for the opportunity to
speak to you today.
too big to fail is primarily about the collateral damage
from the failure of some very large and complex companies.
The global financial system is highly interconnected,
opaque and fragile, like a set of dominos near one another. The
systemic dominos are particularly large and central. If one of
them fails, or if people fear that it might be unable to
fulfill some of its many promises, the system may collapse. And
the same is true is multiple banks are in trouble at the same
time even if they are not so big.
The trends are not encouraging on this despite the Dodd-
Frank Act, and I can elaborate on that later if you would like.
In this scenario, the Government and the Fed must choose
whether to let the natural process of failure play out or to
intervene and, if so, how.
When Lehman Brothers, a medium-sized investment bank that
did not take deposits, filed for bankruptcy almost 6 years, the
experience was traumatic. Massive interventions supported
numerous other institutions. Some of the largest ones were
among big-time recipients.
Here are some questions:
Is this fragile system the best system we can have?
Must we live with it like we must live with the risk of an
earthquake?
Was the financial crisis the 100-year flood, and it is not
cost-beneficial to build an expensive dam just for the rare
event?
Would making the system safer entail sacrificing its
benefits?
Is the problem just that they are too big and, therefore,
breaking them up would solve the problems?
Is finding a way to make them fail the solution?
The answer to all these questions is no.
We first must diagnose the problems and see which ones are
most solvable and at reasonable cost. This does not happen,
unfortunately. We are still living in a sick system, and we
keep missing the most effective and straightforward medicines,
and we can do something about this.
Let me say, briefly, the failed scenarios are all bad, and
even changing the bankruptcy law will not help that. Bankruptcy
certainly, as it is, is not going to work without collateral
damage. So we can commit to something, but we have to bear the
results of what we decide to do.
I hope the Fed does not need too many iterations with its
living wills to admit this obviously reality. I am glad Senator
Warren pushed Chair Yellen about this recently.
I have further questions to ask, and I did in my statement.
Title I of Dodd-Frank gives the Fed perfect authority to
act not only once it admits that bankruptcy is not a viable
option without harm but, right now, while it is still
iterating. Instead, the Fed is failing the public.
Title II, orderly liquidation authority, is not really
liquidation. It can maintain the firm's infected intents, too.
The FDIC is doing the best it can. This option is better
than bankruptcy right now, certainly, but Title II is also not
the solution of too big to fail, and it is especially not a
solution to the inefficiencies and distortions in the system.
Harm starts much before the fail is reached. In fact, the
system is inefficient and distorted every single day, and much
more can be done to improve it.
This hearing is about implicit supports, and we heard
something about it. I have a lot to say on that, and in fact,
some of the documents that I submitted elaborate a little bit
more on some of what Dr. Kane said over here and more about
what these insidious subsidies really are.
Implicit supports that the banks do not pay for do create a
subsidy. Measuring the size of this subsidy is really
complicated. A lot of assumptions are made, and often bad
assumptions are made.
But it is also besides the point is what I what to say.
Even if you charge the companies every penny of the monetary
cost of this subsidy, even if you did, and that would be
difficult, this is a very bad system.
I cite some papers in my statement that the GAO report and
industry studies do not cite.
And the bottom line is very clear; the subsidies are real,
and they are very large.
The main problem with the guarantees is that they reinforce
an already distorted set of incentives and exacerbate the
inefficiencies of the system. They create perverse incentives,
and they enable excessive growth and other bad decisions. They
intensify the conflict of interest between the banks and the
rest of society.
We are not getting what we want for these subsidies. We are
maintaining a sick system.
The key to the fragility of this system is the fragility of
the institutions in it. This is not about the risk they take or
about micromanaging them. This is about how they fund their
investment.
This is the most immediately fixable disease; banks simply
use too little equity and too much debt. The tough regulations
allow them to fund with 95 percent debt. This is unheard of
anywhere without regulation, and there is nothing good about
it.
Citigroup would have satisfied these requirements in
December 2007. These requirements are outrageously
inappropriate.
At the current levels, this level of indebtedness magnifies
the risk in the system and creates fragility without doing
anything useful for us at all. It works only for those in the
system. The rest of us got talked into allowing it and living
with the bad consequences.
If you care about access to credit, we are not getting it.
We are getting distorted credit. We get too little for some
things that we want funded and too much elsewhere; that is
wasteful.
The key reason is that the lenders themselves have too much
debt. They behave like distressed or zombie borrowers all the
time.
The people in the system are compensated to take risk, and
the regulations are so bad; they distort the incentives further
through a use of a risk weights that favor some investments
over others and are manipulatable and distorted.
We want risk to be taken with the right funding so that
when things go wrong and do not work out there is no collateral
damage.
You may also believe that regulations are automatically bad
and costly, but that is false. Some regulations are essential
and good. Forcing banks to use more equity and less debt, if
done effectively, brings only benefit.
It acts to correct the distortions. It is a correction to
what otherwise is crony capitalism. This is an area where the
markets are not working, and only regulations or laws can
correct this.
We are doing a little bit of it, and they will tell you
that we are doing a lot more. But we are doing it bad and
insufficiently and ineffectively.
The analogy I give is having speed limits that are entirely
inappropriate. The fail is like ambulances and hospitals. We
are not going to allow trucks to drive at 95 miles an hour
through a residential neighborhood and take the chance that
they implode and they burn the engine meanwhile. This is not a
safe speed, and it is not hard to see that.
Similarly, no corporation must live on 95 percent debt.
Nobody does except in banking. Nobody can live like the banks
except for the way they are allowed to and get away with. And
that is without regulating it.
I urge you to engage on these issues and to do what you can
to improve this part of the regulation. The public should own
this place, and the public is not served. Flawed claims that
seem to have outside impact on this important debate are having
that impact and should not.
I look forward to a further discussion.
Chairman Brown. Thank you, Dr. Admati.
Dr. Holtz-Eakin.
STATEMENT OF DOUGLAS HOLTZ-EAKIN, PRESIDENT, AMERICAN ACTION
FORUM
Mr. Holtz-Eakin. Thank you, Chairman Brown, Ranking Member
Toomey, and Members of the Committee, for the privilege of
being here today.
I am going to make four brief points in my oral remarks,
each of which is elaborated on in the written testimony that I
submitted.
Point number one is that any expectation of support for a
bank holding company is, at its root, the result of
discretionary policy actions taken, and the problem begins with
policymakers and ends with policymakers. It is not something
that the banks did. It is not something that the creditors did.
It is something that the policymakers, in a discretionary
fashion, did. And creditors took it into account, charged too
little in their loans to banks. Banks correctly responded to
those incentives and expanded their portfolios inappropriately.
It is a very simple identification of the problem. It is a
policymaking problem.
The second point is that the history of such interventions
in a discretionary fashion is very erratic. It has consisted of
interventions on behalf of large firms and on behalf of some
very small firms. It has been interventions on behalf of
financial firms and nonfinancial firms. Even in the most recent
crisis, we saw both large and small banks receive some
intervention, and we saw auto companies receive intervention.
The nature of the intervention has changed. In some cases,
it is to preserve the financial stake of bondholders. In other
cases, they have been wiped out.
And so it was unsurprising to me, having written my
testimony before I read the GAO report, that when I read the
GAO report they said there was a wide range of expectations
among market participants and monitors about the nature of a
potential Government intervention. Given the history, that
range of expectations is utterly unsurprising to me and
something the GAO should have found.
The third point is that econometric attempts to pull out of
differences in bond yields anything like quantifiable too-big-
to-fail subsidy is a really elusive quest. It is well
established that there are borrowing differentials between
large and small entities in lots of industry, and indeed,
financial services does not stand out as an especially large
differential in the data.
There are good reasons why markets might reward diversified
firms, firms that have greater liquidity, and reward them even
disproportionately in a crisis when liquidity and being able to
move your financial assets is especially important.
As a result, taking apart the differences in those bond
yields is going to be highly sensitive to the nature of the
specification, the nature of the estimation.
And I think what you see in the GAO report is a stark
tribute to exactly that--that we are going to get a different
answer depending on how we do this analysis and you are
unlikely to find a single sign or a single number on which to
hang the analysis.
And the last point is that given that this is an issue that
comes from policymaker interventions it is hardly surprising
that any too-big-to-fail expectation would change over time. We
have seen radically important changes in the policymaking
environment since the most recent financial crisis--Dodd-Frank,
the Federal Reserve's activities, you know, look across all the
regulators, the existence of the FSOC, the activities of the
FSOC.
One would expect this to change. Indeed, the GAO had found
that it had diminished somewhat.
If you want to eliminate it, you have to eliminate the
problem, which is discretion.
And in that regard I am quite sympathetic with the notion
of Senator Toomey and his coauthors, that what you want to do
is eliminate the discretion, put a fixed set of rules in the
hands of a bankruptcy judge, design the rules so that you can
deal with the admitted problem that illiquid financial
institutions can become insolvent in a rapid fashion. So you
have to build the system around that.
But the solution to this is not to be found in changing the
behavior of the creditors or the banks. It is changing the
opportunity for behavior on the part of the policymakers.
And I think the bankruptcy route and things like that are
the most promising way for eliminating this problem in the
future.
Thank you, and I look forward to the chance to answer your
questions.
Chairman Brown. Thank you, Dr. Holtz-Eakin.
I want to start by observing that the GAO used three
industry-funded studies to design this report, and the GAO
arranged meetings with corporate treasurers of companies
suggested exclusively--I believe exclusively--by the U.S.
Chamber of Commerce, the same organization that sent a letter
to the Subcommittee, sort of extolling the virtues of the
largest banks in the country. So, just that observation.
I want to start with Dr. Anginer and then work my way
across the table, about the study.
The GAO said the subsidy may have been reduced because of
``improvements in banks' holding companies' financial
conditions.''
One of the witnesses at our last hearing said that banks
are in the business of taking prudent risks.
Tom Hoenig estimates that the 8 U.S. globally, systemically
important banks, the G-SIBs, have a 6.5 percent leverage ratio
under U.S. accounting rules and a 4.62 percent ratio under
international accounting rules. By comparison, the 10 largest
banks in this country, under $1 billion, have a 9.25 percent
leverage ratio under both measures.
So my question is--and starting with you, Mr. Anginer, and
working across--how do we encourage institutions to engage in
prudent risks useful to our economy, prudent risks without
incenting the kind of reckless behavior that leads to bailouts?
If you would answer that, and then Dr. Kane and Dr. Admati
and Dr. Holtz-Eakin.
Mr. Anginer. I think market discipline is very important.
So the type of policies that encourage greater market
discipline would be very useful in that regard.
One of the things that we show in our analysis is that one
of the effects of this too-big-to-fail doctrine is that it
dulls market discipline. It reduces investors' incentives to
monitor the risk-taking of these financial institutions.
So, to the extent that these policies reduce those
incentives, you would expect greater risk-taking and not only
greater risk-taking but a certain type of risk-taking as well.
So, if you are a bank and you fail and none of the other
banks are failing, you will most likely not get a bailout. If
you fail when everybody else is failing, then you will get a
bailout.
So this sort of incentivizes banks to take on a correlated
risk, or similar risk, to all the other banks. This is also
another important aspect that is often overlooked.
And what we showed in our analysis is that this is usually
penalized in other industries. So, if you are a company and you
take on risk similar to other companies in the industry, the
market will actually penalize you whereas in the financial
sector we do not see this; they actually get a benefit.
So market discipline is very important toward this type of
perverse incentives.
Chairman Brown. Dr. Kane.
Mr. Kane. What I see is a failure of the rule of law.
Corporate and property law needs to recognize that the taxpayer
is given an equity stake in these firms. And by thinking of the
safety net as insurance, we excuse it as moral hazard and say
it is regulators' problem to stop it, even though they do not
have the tools to stop it.
Individual managers are paid to take potentially ruinous
tail risks and rewarded and promoted on the basis of the value
they extract by taking tail risks.
Congress needs to enact offsetting personal and corporate
penalties for willful efforts to pursue risks that recklessly
abuse taxpayers' equity stake and visit problems on
nonfinancial and household sectors in the economy. Corporate
penalties could include forced sales of some or all kinds of
business.
I think it is useful to think of the taxpayers' stake in
each too-big-to-fail firm as if it were a trust fund and
conceive of Government officials as fiduciaries responsible for
managing that fund.
The reforms I propose seek to give regulators and managers
and directors of too-big-to-fail firms an explicit and codified
fiduciary duty to measure, disclose and service taxpayers'
stakeholding fairly and competently.
We have to rework bureaucratic and private incentives to
make this happen. That means regulatory agency and corporate
mission statements must explicitly define, embrace and enforce
fiduciary duties of loyalty, competence, and care to
taxpayers--to taxpayers--who are implicit shareholders and are
being treated unfairly relative to the explicit shareholders.
Chairman Brown. Dr. Admati.
Ms. Admati. Well, corporate governance is broken in banks,
mostly because most of the money they invest is creditors'
money, but the creditors are not really there in the
governance.
And what I am proposing and what is being proposed before
is very complicated to do, but the first thing we have to do is
bring the risk back to the investors. And the investors that
should take the risk are the shareholders, and there should be
more of their money.
It is as if you increase their liability, but instead, you
just have more of them with limited liability because that is
what corporations are.
So partnerships have more liability. Banks should have more
responsibility and liability on their balance sheets. And the
way to do that is not through triggers and through imposing it
on creditors because of the collateral damage of doing that.
That is why the natural place is the way other companies do
it, and the way they do it in other companies is because the
creditors start telling them that they will not stand for it
anymore unless they write incredibly punishing covenants and
conditions and increase the costs.
So if you have more shareholders, then you get more
discipline from them.
If banks were sent to the equity markets, they would be
told by equity investors that they are too opaque. That is what
they are saying. Listen to equity investors say that they
cannot understand the disclosures, that they are uninvestable.
And if they do not give them a high price for their equity,
then we need to know that and we need to know why. And that is
the price of their worth because maybe their balance sheets are
too inflated.
So the point is if they cannot raise equity then--at any
price, then they fail a market stress test, and that is a
stress test much better than the stress test that the Fed
wants.
Chairman Brown. Dr. Holtz-Eakin. Mr. Holtz-Eakin. I will
echo at the outset some of those remarks in that you want
creditors doing their job, which is monitoring the risks that
are embedded in the activities of a bank.
And in addition to that you want the shareholders keenly
aware that their money is at risk and that if, in fact, the
bank is not well-run they will lose it and that it will go
away.
If they do that, if the external forces convey appropriate
appreciation of the risks, something very important will
happen.
One of the things I learned on the Financial Crisis
Commission is that many of these institutions had remarkably
bad internal risk assessment during the course of this period.
I was stunned, but it was really very surprising.
If the outside creditors and shareholders are telling you,
do not worry about risk, you do not devote anything in your
corporate management to controlling those risks. And it conveys
all through these organizations.
So we would get better risk management, not through the
regulatory approach, but just from the outside incentives
permeating the culture of the firm.
Now, to do that, you have to take off the table the
assistance, or expectation of assistance, by the Government in
bad times. And that is the hardest thing because, honestly,
when things go bad policymakers become very risk-averse,
infinitely risk-averse.
And, you know, they have asked many times, is there any
chance this could happen?
You say, well, there is a two-tenths of a billionth of a
probability that something very bad is going to happen.
And they say, OK, well, then let's pull whatever leverage
we have got.
You have to take those levers away to get this to work, and
that should be the focus of the Committee--finding ways to
establish rules that will reorganize or liquidate these
entities. Then the outside forces will do their job.
Chairman Brown. Thank you.
Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman.
Senator Moran. Would the Senator yield just for a second?
Senator Toomey. I would be happy to yield to the Senator
from Kansas.
Senator Moran. Mr. Chairman I am leaving to speak on the
floor. I appreciate the Senator from Pennsylvania allowing me
just a minute of his time, and I hope to return to ask
substantive questions.
But it is troublesome to me that in reading the testimony
and hearing the testimony of the witnesses at least some of
them appear to have known what was in the GAO report before the
GAO report became public.
And I tried recently, yesterday, to see if I could get a
copy of the GAO report so I could be more intelligent in my
asking questions, without success. I do not know whether
something happened here that is inappropriate, but it does seem
to me that there may be a double standard in who has
information about their testimony and who did not.
Senator Toomey. Thank you.
Dr. Holtz-Eakin, I want to follow up.
I think you make a very, very important point here about
where the expectations for bailout come from, which one of the
things you have stressed is previous policy decisions, right?
Mr. Holtz-Eakin. Yes.
Senator Toomey. So if, in fact, the Government comes along
and bails out institutions, then there is obviously some level
of expectation that the Government will do this again in the
future.
But would you agree that in Title II of Dodd-Frank there is
an explicit mechanism by which the regulators are empowered at
their discretion to tap into taxpayer funding and execute a
bailout of sorts.
And so it would seem to me that the codification of that
mechanism also contributes perhaps very significantly to the
expectation that it might, in fact, get used.
Could you comment on that?
Mr. Holtz-Eakin. Yes, I am quite sympathetic to that point
of view.
I mean, you can think of this in many ways as codifying
what has been our experience with Fannie Mae and Freddie Mac,
who we put on taxpayer funds, kept alive for a long time, have
not fundamentally resolved in any way, and now you hear lots of
agitation for them to be simply returned to the private sector.
There is no discipline then, right? They get bailed out,
and they survive.
Senator Toomey. So is it your view that if we repeal Title
II, which is the bailout mechanism of Dodd-Frank, and we made
the reforms necessary for there to be a credible bankruptcy
resolution that would actually be orderly and which would
follow the ordinary rules of bankruptcy to the extent that we
can--and I think you need to make some modifications to the
current code to get there--would that at least diminish the
likely expectations that there would be a taxpayer-funded
bailout?
Mr. Holtz-Eakin. I think so, yes. My reading of the broad
amount of research--and it is not specifically the GAO report--
is that we have already seen a diminishment. That expectation
has dropped dramatically, postcrisis.
This would further diminish it. So I do not think it would
impose a great shock on financial markets.
I do think it would be a step toward sounder policymaking.
It is a sensible thing to do.
Senator Toomey. Would there be--if that were to be the
case, if we had that policy change and the expectations of a
bailout correspondingly diminished, would you be able to
comment on any benefits for taxpayers, for markets, for
allocation of credit? Are there other benefits that come about?
Mr. Holtz-Eakin. Certainly, you would have less of a need
for an elaborate supervisory regime, which is quite costly and
raises the cost of credit and diminishes access to credit for
consumers. I think that would be a tremendous benefit.
You would have the benefit of a set of rules that all
market participants understood rather than guesses at the
discretionary actions of policymakers in a crisis.
And all of those things produce better outcomes.
Senator Toomey. Dr. Kane, if I understood your comment, I
thought at one point you said that your recommendation is for
the Government to impose penalties on the people who would take
excessive risks because the taxpayers are the involuntary
shareholders, effectively.
Mr. Kane. Absolutely.
Senator Toomey. Well, that, of course, supposes that the
Government knows what is excessive, knows what the penalty
ought to be for what somebody decides is excessive.
And I wonder if a better approach is simply to make sure
that the taxpayer is not an involuntary shareholder in the
institution in the first place so that creditors can enforce
behavior by virtue of their decisions on pricing and allocation
of credit.
Mr. Kane. Well, I think the best is often an enemy of the
good; that is, we would like to make sure that authorities did
not make bad policy, but the stresses of a crisis make bailouts
so much easier than resolutions.
We see bailout behavior all around the world. Along with
some colleagues at the World Bank and the IMF, I have studied
what happened to the safety net in 196 countries during this
last crisis.
In country after country, if they did not have deposit
insurance, they created it. If they had deposit insurance, they
extended the coverage and even guaranteed other kinds of debt
of TBTF organizations. It is just so much easier to extend
guarantees than running the risk of disorganizing the system in
crisis circumstances.
To get them to do hard things, we have to change the
incentives of the bankers who play this risky game, and not
just blame the authorities.
What is the purpose of Section II? It responds to the
excuse for inaction that authorities gave. This excuse was:
``Oh, we did not have the powers to resolve TBTF firms.''
So DFA gave regulators more powers, but power is not the
true problem.
The problem is incentives. Top officials are risking their
careers and reputations, if they try to allocate losses. It
resembles the issues in exercising tough love. It is very hard
for parents to show tough love when their child is caught, say,
smoking marijuana or worse. Instead, they hire a lawyer to save
them from the consequences of their bad behavior.
On the other hand, the goal is not to send hordes of
managers to prison. What we want to do is to build a system
where the people who have been abusing the safety net have
better incentives in the future.
Senator Toomey. I think Dr. Admati has something she would
like to add to this.
Ms. Admati. All the benefits that were just mentioned here
to having a bankruptcy code--which, by the way, in the
modification of the bankruptcy code that you would need to have
all the big institutions fail under bankruptcy, and good luck
to all of us in that scenario--you would also need some kind of
backstop.
You yourself said you were going to need some liquidity
support.
It would look--and I heard the FDIC discuss this with
bankruptcy experts. It would look very much like Title II. So
where bankruptcy would change, it would change in the direction
of where Title II is right now. I think the distinctions there
are very minor.
The point is that all the benefits to credit and less
micromanaging are going to happen with more equity. Then there
would be more money if banks retain their earnings, more money
to make loans and better incentives.
And so there is nothing about correcting that distortion
that goes against anything that we want in this system.
Nothing.
Senator Toomey. Well, I see my time is expired, but Mr.
Chairman----
Chairman Brown. If you want to continue with Dr. Anginer,
if you want to.
Senator Toomey. Fine.
Mr. Anginer. Just on the point of whether Dodd-Frank might
have codified too big to fail, actually, there is some
empirical support for that. We looked at risk sensitivity of
cost of debt for these large financial institutions that are
deemed to be too big to fail by Dodd-Frank, and there is
actually a decline in risk sensitivity.
So the cost of debt has become less sensitive to risk after
the introduction, again, suggesting that this too big to fail
might have been codified.
Senator Toomey. Thank you, Mr. Chairman.
Chairman Brown. Senator Reed.
Senator Reed. Well, thank you very much.
This has been a very informative panel. Thank you all.
Dr. Admati, I think you made the point, and you made
several good points, that the size issue is sort of irrelevant
in many respects, that there is no perfect size, right size,
that it goes really more to capital that the company has, the
equity and the leverage ratios.
But a lot of times we have to take very simple approaches,
and there has been a lot of discussion about not letting
institutions grow beyond $250 billion. That seems, to me, to be
treating a symptom and not effective.
Ms. Admati. I am glad you asked about that because about
the size, the size is very large, and you have to wonder why.
My answer to that is because the funding is too easy.
And we saw conglomerates break up on their own weight, on
their own inefficiency.
If the funding gets straightened out, then we might begin
to see it. For example, if it was beginning, if you were
beginning to pass more and more of the down side to the
shareholders, they might begin to see how inefficient these
corporations are, and we might see a natural breakups that just
make more nimble, better pieces of it.
Yes, I think that some of the crude measures of size at
some point by Government, et cetera, at some point, it really
becomes just outsized by any measure at all. And so I can see
that some of the crude rules that say, OK, enough is enough for
size.
These corporations are the largest in the economy by asset
size. The amount that is controlled, sprawling across the
globe, is unfathomable. Every study of governance shows a total
breakdown, and all the repeated scandals are reinforcing that.
This is a reckless industry.
Senator Reed. But we could sort of exclude the larger ones
with the hope that that would solve the problem, but that would
not necessarily help those that sort of get underneath the
limit if they are insufficiently capitalized or overleveraged.
Ms. Admati. Well, you can have a system with tiny, little
pieces all failing at the same time, all interconnected, and it
is not--that is why just size is not going to do it.
Senator Reed. I understand.
And you raised some other issues. It is not just size. It
is two others, which makes this a very challenging problem.
It is management--the inability, because they are so large,
to effectively manage even if the intention is to manage it
well.
And then, the interconnection to other institutions that
might be poorly managed or led, or that take business
approaches that compel the others to follow.
And let me add a third dimension, which is we are in a
global system, and what we do is affected by what other
countries do.
And, in fact, frankly, you have heard it before. One of the
reasons these banks are so big is because they are global and
their global competitors are just as big.
And, oh, by the way and you might comment on this--they
have a too-big-to-fail regime overseas, which is a competitive
advantage that they have.
Can you comment on that?
Ms. Admati. Yes. And, again, I am very thankful for the
question.
That other countries might do worse than us is not a reason
to follow them.
So a huge problem in Europe, in fact, which is misdiagnosed
because the Germans like to protect their banks, and so do the
French, is that they have a sicker banking system than we do,
and very bloated.
And so, yes, we are not here to support a particular
industry on our back. We are not allowing pollution when other
countries allow it, and we should not allow excessive risk even
if other countries allow it.
We should protect our citizens. The foreign banks that are
here, we control what they can do here.
We should worry about what we can worry about and lead the
world as opposed to follow to the lowest common denominator.
Senator Reed. But let me ask Dr. Kane, too, to comment
because Dr. Kane suggested--and I think your testimony together
sort of is sympathetic--in that there are two paths.
One is regulatory forbearance--of not being tough on
capital, on equity, on management skills and things like that,
and the other is the implicit subsidy for debt and for equity.
And those are the two paths.
For the first path there has to be very active regulation
by the Federal Reserve particularly because I must say I do not
think we are in a position to, on a daily basis, pass
legislation to fix this.
And then the second path is a much more structural path
about just the public perception--equity perceptions.
So I have just been very general.
Dr. Kane, do you want to comment on this discussion we have
had?
Mr. Kane. Yes.
First, when you ask why are U.S. firms so active globally,
I would point out two disturbing phenomena.
In the futures markets, we see parent firms ``de-
guaranteeing'' their foreign susidiaries stripping formal
guarantees from foreign affiliates. This lets the parent search
out markets that can least well discipline their risk-taking.
This is exposing the U.S. safety net because distressed subs
are going to be supported by the parent in a pinch and by U.S.
taxpayers in the next crisis.
Second, we are observing what is called ``inversion,''
where, say, a company like Morgan Chase could merge with a
small foreign firm, move the headquarters abroad and not pay
corporate taxes here. In fact, the CEO claimed the right to do
this.
To me, this behavior is an ethical scandal. I am apalled by
the ethical environment of an industry that would thumb its
nose at the Government that rescued it a mere 5 years ago.
I mean, again, in ordinary human relations we would sock
somebody like that in the nose.
You know, it just----
Senator Reed. You must be from Boston.
Mr. Kane. Well, I spent a lot of time there.
No, I am from Northeast Washington, DC. We did a lot of
that, here, too.
[Laughter.]
Senator Reed. I just--may I have one?
Chairman Brown. Sure, go ahead.
Senator Reed. I think this has been terribly useful. And I
will ask, at least, are we better off than we were in 2008 with
some of the provisions we have adopted in Dodd-Frank like those
on derivatives, and the fact that we have actually put emphasis
on higher capital levels?
I think there is a sense like nothing has changed at all,
and my sense is some things have changed, maybe not enough, but
some things have changed.
Mr. Kane. Again, yes, some things have changed, but cross-
country swaps regulation is currently a complete disaster.
In the U.S., we have the SEC and the CFTC trying to divide
responsibility. Swaps and other derivatives are very protean
types of instruments. There are futures now on swaps trading on
exchanges. There is a problem with the capitalization of
central clearing parties. They have taken on much more risk
than before, but none of them has increased its reserve funds
to support that, and no one is compelling them to do so.
So one could say we are not in the same position in the
sense that the details are different, but U.S. taxpayers are
still very exposed. The next crisis threatens to be worse than
the last one.
Ms. Admati. I would say that some of the things that were
done in Dodd-Frank are essential, and they gave authority that
can be used well.
The problem is the implementation. A few of the things that
got written were written in such a way that makes
implementation very difficult, like Volcker. And so in the end
of all of that, you are not sure whether the thousand pages of
rules are really going to do as much as was hoped. So that is
one.
And then Title VII is very important. So this is critical
because the modernization act was an absolute disaster, and we
know that.
So the ability to regulate derivatives is there. However,
CFTC is not getting budgets to do it. And Gensler did a mighty
job of it except, you know, could not.
So in the end the lesson that was learned was that the ones
that did the bailouts extolled them, and the people learned
that there will be more bailouts.
So whether we can try to commit to not do them, it is very
difficult. We should try to prevent it.
Why are we having ambulances when we have speed limits so
dangerous? That is the question we have to first ask.
Senator Reed. Thank you.
Thank you, Mr. Chairman. You are very kind. Thank you.
Chairman Brown. Thanks, Senator Reed.
Senator Vitter.
Senator Vitter. Thank you, again, to all of our panelists.
Let me start with sort of the biggest bottom-line question.
Do any of you think that too big to fail as policy and market
perception has ended, and if so, why?
Anybody?
Ms. Admati. The answer is no.
Senator Vitter. OK. Do you----
Mr. Kane. No, for me, too.
Senator Vitter. OK.
Mr. Holtz-Eakin. Greatly diminished, however. I mean, not
gone but greatly diminished.
Mr. Evans. And, clearly, we show that there is a variation
over time across models, and it may depend on credit risk
conditions. So we would say, no.
Senator Vitter. OK. And do any of you think that firms
perceived as too big to fail do not have a market advantage
because of that?
Mr. Kane. No.
Ms. Admati. They do have a funding advantage.
Mr. Holtz-Eakin. That is not so obvious, I would say, at
this point, honestly.
There would be a funding advantage, but these are also the
same entities that are subject to an enhanced supervisory
regime. They have a much bigger regulatory cost. They have
capital charges. And on balance it is not obvious they have a
competitive advantage against smaller banks.
Senator Vitter. OK.
Mr. Anginer. And just to clarify, I mean, losses to the
taxpayer will depend on two things. One is the probability that
these institutions will fail, as Dr. Evans pointed out, as well
as the likelihood that they will be bailed out.
Senator Vitter. Right.
Mr. Anginer. So some of the regulations actually increase
some of the--made the banks in a much better position than they
were five, 6 years ago.
So the likelihood of failure has come down, but a
likelihood of a bailout still remains. It is good to make that
distinction.
Senator Vitter. So my second question, does anyone else
think--Dr. Holtz-Eakin says it is questionable.
Does anyone else think that a too big to fail does not have
a market advantage as a result?
Mr. Kane. Could I add something? This increased regulatory
burden is scalable, so that it has actually helped big banks.
They can assign someone to fill out all the forms, while
managers of very small banks find this burdening. Smaller banks
are going to have to get bigger in order to spread the costs of
filling out the paperwork.
Senator Vitter. Right. Well, I would certainly agree with
that, and that sort of goes to Dr. Holtz-Eakin's point.
I think the overall new regulatory environment is an
advantage for big firms, not small firms, even though the
burden is bigger for big firms.
But, anyway, I want to use my time efficiently.
Mr. Evans, do you have any response to the criticism that
you all studied too-big-to-fail funding advantage in an overly
narrow way by looking at bond debt?
Dr. Kane talked about the entire equity side. In addition,
a lot of people think that much of the advantage is in short-
term funding of money market liabilities, which you did not
look at. Do you have a response to that broad set of
criticisms?
Mr. Evans. Right. Certainly, we did not exhaust the various
ways institutions might benefit from perceptions of being too
big to fail, but we used the dominant methodology in the
literature, which is to study one particular slice of the
liability stack.
We think bonds are extremely important. You can learn a lot
about bonds. It tells you a lot about what happens below it.
So, if we are talking about trends--and, remember, we did
not try to quantify a subsidy. We are talking about what
happens over time. And if it happens in bonds, it is quite
likely that in places where there is a lower priority you are
seeing it as well.
Now Dr. Kane, when he says equity, he is really referring
to some of these option pricing modeling approaches, which are
highly theoretical. In fact, if I know leverage, if I know
volatility, I can mechanically produce a result, and there is
no room for investor expectation.
So our model was strongly informed by Professor Anginer's
work----
Senator Vitter. OK.
Mr. Evans. ----and an independent review by some highly
respected scholars.
Senator Vitter. OK. And, finally, Dr. Admati, in your
testimony you particularly focus on the significance and
perhaps the potency of capital as a tool to dramatically lessen
risk. Why is that, and can you expand on that a little bit?
Ms. Admati. Well, equity is the most natural loss absorber.
Equity gets the upside. Why should anybody but equity bear more
of the downside?
The fact of the matter is equity bears a downside for most
corporations, first and foremost, and there is no corporation
that has so much debt.
And the banks do not have to have so much debt. They are
not in the right range of equity levels that are reasonable for
corporations. Without regulation, the markets tell them.
And this is related to the point about what do supervisors
need to do. The way to think about that, in my view, is not
that the supervisors and the regulators are like equity
holders. They take the place of the breakdown of credit markets
for these precisely because the banks' ability to borrow comes
with not enough strings attached that usual creditors do. And
that includes insolvency.
Most companies could not live like the banks.
If you erase the labels from the banks and you gave them--
of course, you would have to erase a few zeroes so they are not
recognizable as such, and gave their balance sheets to the
banks, they would--with the disclosures that they have, they
would not be able to borrow.
My hypothetical funding costs for them? Very large, if they
really lived on their own.
In a hypothetical that they really are on their own, if we
surely believe that with all the covenants and the
prioritization that you have to think about, creditors will not
come.
What happens in the banks in reality--and it is easy to
understand. Start with deposits. Start especially with
deposits. Depositors are the most passive creditors. They do
not even know they are creditors. They do not even think of
themselves as creditors. That is where the problem starts.
A bank CEO could say, I have a lot of deposits; therefore,
I do not have a lot of debt.
Right there is the problem. The fact that the bank CEO can
momentarily forget that he owes the deposit shows you the
problem right there.
From that time on--and deposits are unsecured--they can go
and borrow more with the assets they buy with deposits, and the
creditors will let them do it. And then the next creditor will
let them do it.
Companies cannot live like that in the real world, and the
banks should not be allowed to.
So what the regulators are doing is only coming in instead
of the usual credit or covenants that would normally happen to
a company that look like this. They should not live like this.
That is what we have to do. The missing piece of it is that
there is no credit discipline, and there will not be, and it is
not the most effective way to get the discipline.
First, push the rest of the balance sheet. Then there is
obviously corporate governance that has to care about risk
management.
First, it has to be their own money.
Senator Vitter. Thank you.
Chairman Brown. Thank you, Senator Vitter, and thank you
for your assistance on this.
Mr. Kane. May I just say one thing?
Chairman Brown. Dr. Kane, certainly.
Mr. Kane. Mr. Evans said that the GAO used the ``dominant
methodology.''
There are at least two broad methodologies. I believe the
other one is actually dominant because we must be concerned
about the taxpayer put--the ability to put losses to the
taxpayer when they exceed stockholder equity. Equity is the
natural loss-absorbing mechanism. To not look at taxpayer
exposure as an option is conceptually inferior.
The GAO methodology has a lot of people working on it who
do not thoroughly understand option pricing.
Chairman Brown. Dr. Evans, if you would like to speak to
that.
Mr. Evans. Just to quickly say, you would use that approach
if you thought you were sure a subsidy exists and you just
wanted to know how large it is.
I mean, Merton, of Black-Scholes and Merton, used it in a
deposit insurance context where it is most appropriate.
Again, this is a highly theoretical model and makes some
strong and extreme assumptions, and again, there is no room for
investor expectations.
Mr. Kane. Well, that is not true. It is changes in
expectations that cause movements in the stock price that
others use to pull estimates of the option out.
So I am saying you do not quite understand the mechanism
and are downplaying the role of assumptions in other economic
research.
Chairman Brown. Dr. Anginer, conclude on that discussion,
referee for a moment, and then let me move on.
Mr. Anginer. Sure, just a point on the methodology. It
reminds me of the old joke about looking for a lost key under a
lightpost because that is where the light is, not where the key
is lost.
And the reason we study bonds is that is where the data are
available and makes the analysis much easier.
But having said that, it is likely that we are
underestimating risk for a number of reasons.
One is that we are using equity prices.
Also, bonds, publicly traded bonds, are the first ones that
are going to get hit on the balance sheet structure, on the
debt structure, when there is a failure.
So there is good reason to think that most likely we are
underestimating; so these subsidy numbers would be larger.
Chairman Brown. OK. Thank you.
Dr. Admati, you said that we should compare banks' funding
with and without Government support rather than compare bank by
larger banks and smaller banks, if I recall.
One way to do this is to incorporate ratings uplift that
big banks get as a result of that implied support, actually,
that regional community banks do not get.
The GAO report does not do that. They say it is an indirect
measure of the funding advantage.
How important--and feel free, all of you, to comment on
this, too, but it is directed first to you, Dr. Admati.
How important is including or excluding this uplift in
measuring financial benefits for the too-big-to-fail
institutions?
Ms. Admati. Well, I think the credibility of credit rating
agencies, of course, is somewhat diminished after the crisis.
So we should be always skeptical of what they say.
However, they are capturing something real, which is that
investors perceive--and the credit rating agencies know--that
in the hypothetical if the banks are really on their own their
funding costs would be a whole lot higher.
And it has not just the interest rate. It has the whole
conditions that come with it.
Most of what scares companies from becoming highly indebted
is that the creditors will write such restrictive conditions
that will not allow them to move.
And the banks get credit under incredibly comfortable, easy
burdens that are different from other companies.
Credit uplifts are trying to get at the way to do this,
which is not to compare to other companies but to compare the
company as it is to the hypothetical company without support.
That is what we are after, conceptually. The problem is it
is a hypothetical that is counterfactual, that we do not have.
That is why I said in my hypothetical, with really no--with
knowing that the depositor can come in the bank, that other
short-term creditors can come and dilute you as a junior
creditor, the banks will have a very hard time borrowing. And
some of the small banks have a hard time and, in fact, do not
have bonds. So, already, you are biasing the whole discussion.
The point is the banks are funding at an unreal world that
they feel entitled to, that is completely outside the normal
markets.
So I think the credit rating--it is too bad that it was not
included. Some of the studies that include it are informative,
I would say.
Chairman Brown. Dr. Holtz-Eakin, do you have something on
that?
I would just note--and someone can correct me if I am
wrong--recently, most, if not all, the major credit rating
agencies have removed the credit uplifts. So you could not do
that now. If you care about too big to fail now, in 2013 and
'14, it is gone from that perspective.
Chairman Brown. Dr. Anginer and then Dr. Evans.
Mr. Anginer. So just on that, we actually examined the
effect of these ratings on the pricing of debt.
So some rating agencies issue two types of ratings. One is
called a standalone rating, just incorporating the risk of an
institution on its own, without any Government support, and
another rating that incorporates the Government support.
So, if you look at how these two types of ratings are
priced, it is really the Government support that is being
priced, not the standalone rest.
So it is true that some of the rating agencies have
recently downgraded some of the Government support, but we do
not know what the pricing implications of those are.
Chairman Brown. Dr. Evans.
Mr. Evans. And I would say rating agencies are a less
direct measure. In fact, they are indirect. If you can go
straight to the market and study actual investors that
participate in the market, you are going to get a much cleaner
answer.
Now we have interviewed a number of investment firms. Some
of them do their own credit rating analysis. So it is not
necessarily the case that you can go from credit ratings to
actual bond spreads.
Chairman Brown. OK. Dr. Kane, and then I want to move on to
a last question, and then we will wrap up.
Mr. Kane. I do not see why you do not use all the data
possible. Why would you look in just one place when you lost
your keys in your house?
Chairman Brown. Fair enough question.
Mr. Evans. And that would apply to the option pricing
approach, too, which is, again, highly theoretical.
And if the option pricing model is a hammer and the world
is a nail, you will always look there.
But I will point out, in Dr. Kane's written testimony,
Figure 3--which, again, you would expect to see this trend
because volatility is lower, leverage is lower--looks a lot
like the graphics from GAO's report.
Chairman Brown. OK. Dr. Anginer touched on an issue. I want
to ask one question, and all of you feel free to weigh in here.
A lot of the talk is about whether too big to fail
overfocuses on what would happen if one institution got into
trouble and needed to be resolved.
When you look at the last terrible financial crisis and you
look to the future, it seems more likely--I mean it does not
seem so likely that one large institution will fail, and only
one. Large, universal banks, by and large, conduct the same
activities, have the same kind of portfolios, making it
unlikely that there will only be one getting into trouble at a
time.
So two questions, and I guess I will start with you, Dr.
Anginer, since you touched on it earlier, and I just want you
to expand.
How does the universal nature of the largest banks affect
too big to fail, initially?
And then what sort of risk-taking--because, ultimately,
this hearing is about what too big to fail leads to, and that
is incenting risk-taking among these large banks and paying
little price for it, except the price the public pays.
What sort of risk-taking does that sort of universal nature
of the largest banks incent, and does it make it more likely we
have a systemic event rather than just isolated and just an
isolated failure?
So, Dr. Anginer and then anybody else that wants to weigh
in.
Mr. Anginer. Sure. I think large financial institutions are
incentivized to take these type of correlated risks.
As I mentioned before, again, if you are a large financial
institution and you fail when nobody else is failing, you are
less likely to get bailed out. This incentivizes you to take
on--do activities that others are doing.
And just to----
Chairman Brown. So you are saying that if you are a CEO of
a large bank and you understand what you just said, that means
that you are going to want to act like the others. You want to
mimic the other banks; they want to mimic you.
Mr. Anginer. Exactly, exactly.
Chairman Brown. OK, for sort of safety in numbers. So you
are all bailed out because one of you would not be----
Mr. Anginer. Exactly.
Chairman Brown. ----if it were solely one. OK.
Mr. Anginer. Exactly. And we actually do see this in the
data as well.
So, if you are in another industry and you do what
everybody else is doing, taking on similar risk, the investors
in the market actually penalize you.
Why? Because they want to be diversified. They do not want
their company to fail when everybody else is failing because
they are going to suffer greater losses.
We see the opposite effect in the financial sector. They
actually get a benefit when they take on similar risk.
So, again, that is because we have these perverse
incentives, that because of this too-many-to-fail effect, this
universal banking model that you mentioned. And it leads to all
sorts of perverse incentives, actually increasing systemic
fragility.
Chairman Brown. Dr. Admati, next.
Ms. Admati. Yes. I did not talk too much about the report
and did not get into the details, but my commentary goes to a
number of other issues that did not come up here.
And I just want to say--and it is related to your
question--this is something incredibly interconnected. That
means the bailouts are interconnected. When AIG is bailed out,
the banks are bailed out. When you bail out Greece, the German
banks get bailed out. That is why you cannot even look exactly
at one company and isolate these costs.
It is much more complicated because it is not just that
they do the same thing; it is that most of their activities are
with each other. Actually, a small fraction of them come out to
the rest of the economy. There is just so much intersystem
activity in those balance sheets.
And so the bailout issues are very, very complicated. In
terms of measuring the subsidy, a lot of issues come.
I want to say as well that I mentioned at least one op-ed,
and it was specifically about this study here, that says that
that study is underestimated.
And I mentioned studies that are not cited in the GAO
report that go to the return on the equity, not options, but a
study by Kelly, et al., that you did not use, and Lustig and
all of those that were not there, some of which was not
options. And it showed directly that the banks benefit from all
kinds of--in all kinds of ways.
So the subsidy is underrated.
On volatility is low now, credit ratings took the uplift,
all of those things--I want to remind everybody; 2006 was a
great year. Volatility was very, very low. Everybody was making
record profits. OK.
So let's just remember the good times can stop very
quickly, and the euphoria of those good times and the low
volatilities of these good times can change dramatically.
Within less than a year or two, or starting mid-2007,
volatilities have shifted from 10 percent on the VIX sort of
index to 70 percent.
And I was teaching through that time, so I could see it.
Chairman Brown. Thank you.
Dr. Holtz-Eakin.
Mr. Holtz-Eakin. So there is an important difference
between interconnectedness and suffering a common shock. And
what we saw in the last crisis was a worldwide credit and
housing bubble that, when it broke, was a common shock across
all financial institutions.
Institutions that rely on short-term funding and are
heavily leveraged are the recipe for financial problems in
those circumstances, and it is appropriate then to worry about
an enhanced supervisory regime for those big institutions. And
we have that now, and I think that is a sensible thing.
And you should not somehow believe that they are all going
to fall apart in the same instance. Indeed, I believe if you go
back and just reread the history of the evolution of the 2007-
2008 crisis, everyone's remembrance of those awful days when
Lehman went down, AIG, Fannie, Freddie, in close order. But the
lead-up time was well over a year before that, a year and a
half.
I mean, we had early indicators of problems and stresses
and policies that accommodated them, and the importance of the
policy being better could have cut that off at the beginning.
Now we are going to debate forever whether we should have
let Bear Stearns go down along with Lehman or saved them both,
but saving one and not the other was a disaster. That is
inconsistent discretionary policymaking, and that is the
problem.
Ms. Admati. I would characterize the problem differently.
The problem is one of forbearance and of not prompt corrective
action. Fail is not a good option. That is the difficulty here.
You can put all your eggs in the fail option, but we do not
have to. That is why we have supervision that would interfere
before.
And I agree; the signs were there. But the fail allowed
dividends out--dividends that would then have to be plugged in,
or were plugged in, by top money that was actually debt and not
equity, that they did not lend, that they just wanted to return
so they could pay bonuses again.
Chairman Brown. Dr. Kane.
Mr. Kane. I would just like to emphasize the political side
of being interconnected and being subject to common shocks. It
is very hard in our system to say we are going to close, say,
Bank of America and not Citi. That choice would just bring a
tremendous amount of problems.
Mr. Holtz-Eakin. That is why you should not give them a
choice.
Mr. Kane. Well, the----
Ms. Admati. Well, some were not that big, by the way.
Mr. Kane. Yeah, but my point is that if most BHCs are
failing whatever test you run, or if they all are subject to a
common shock, the situation requires choices to be made. The
Government will not have the people in place to sort things
out.
Even with the slower processing of insolvency in 2008-2009,
the FDIC brought people out of retirement to come back to work
to help them. They did not have enough experienced personnel.
Chairman Brown. Thank you all. This was a very helpful
discussion. Thank you.
And you saw a lot of interest from my colleagues. Some, I
assume, will have questions. Some Members of the Subcommittee
perhaps or the full Committee, too, may have questions. If you
would get answers to those within a week, it would be very
helpful.
Special thanks to Graham Steele and Megan Cheney in my
office and Travis Johnson in Senator Vitter's office for the
work they have done for a year leading up to this.
We have done a lot of Subcommittee hearings in this
Subcommittee. This is one of the most important because it is
the one that has such effect on our financial system. And the
input from all of you was quite valuable.
So the Subcommittee is adjourned and thank you.
[Whereupon, at 3:38 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF LAWRANCE EVANS
Director, Financial Markets and Community Investment, Government
Accountability Office
July 31, 2014
PREPARED STATEMENT OF DENIZ ANGINER
Assistant Professor of Finance, Pamplin School of Business, Virginia
Tech
July 31, 2014
Mr. Chairman and the distinguished Members of the Subcommittee,
thank you for convening today's hearing, and inviting me to testify. My
name is Deniz Anginer. I am an assistant Professor at the Pamplin
Business School at Virginia Tech. Along with my colleagues, Viral
Acharya and Joe Warburton, I have examined market expectations of
implicit Government guarantees to so called ``too-big-to-fail''
institutions. \1\ Most of my testimony is based on this research.
---------------------------------------------------------------------------
\1\ Viral V. Acharya, Deniz Anginer, and A. Joseph Warburton,
``The End of Market Discipline? Investor Expectations of Implicit
Government Guarantees'' (available at: http://ssrn.com/
abstract=1961656).
---------------------------------------------------------------------------
The too-big-to-fail (TBTF) doctrine holds that the Government will
not allow large financial institutions to fail if their failure would
cause significant disruption to the financial system and economic
activity. In our research, we find that large financial institutions
and their investors expect the Government to back the debts of these
institutions should they encounter financial difficulty. These
expectations of Government support are embedded in the prices of bonds
issued by major financial institutions, allowing them to borrow at
lower rates.
Expectation of Government support by the market also results in a
distortion in how risk is reflected in the debt prices of large
financial institutions. An implicit Government guarantee dulls market
discipline by reducing investors' incentives to monitor and price the
risk taking of large financial institutions. In our analyses, we show
that while a positive relationship exists between risk and cost of debt
for medium- and small-sized institutions, this relationship is 75
percent weaker for the largest institutions. Changes in leverage and
capital ratios are, likewise, less sensitive to changes in risk for
these large institutions. \2\
---------------------------------------------------------------------------
\2\ Acharya, Anginer, and Warburton (2014).
---------------------------------------------------------------------------
Because they pay a lower price for risk than other financial
institutions, the perceived guarantee provides TBTF institutions with a
funding advantage. We find that the implicit subsidy has provided these
institutions an average funding cost advantage of approximately 30
basis points per year over the 1990-2012 period, peaking at more than
100 basis points in 2009. The total value of the subsidy amounted to
about $30 billion per year on average over the 1990-2012 period,
topping $150 billion in 2009. We have also examined nonfinancial firms.
If bond investors believe that all of the largest firms (both financial
and nonfinancial) are too big to fail, then large nonfinancial firms
should enjoy a size subsidy similar to that of large financial
institutions. However, we find this is not the case.
Compared to the GAO study, we find lower implicit subsidy values
for the years 2007 to 2011 and slightly higher numbers in 2012. We have
not examined 2013, the year in which the GAO finds the greatest
decline. Although most of the attention will be paid to the analyses
that try to quantify the dollar values of the subsidy and its changes
over time, it is important to note that it is very difficult to
directly relate these changes to the introduction of Dodd-Frank and
other regulations.
It is very hard to separate out changes in probabilities of large
financial institutions experiencing distress from the probability that
they will be bailed out. As the GAO report points out, this is
especially true as the risk premium has declined in recent years and
the large financial institutions have seen significant improvements in
their balance sheets and capital ratios reducing their probability of
experiencing financial distress.
Although it is very difficult to establish a direct link between
regulations and changes in subsidy over time, examining these changes
using alternative methods over a short time window would be more
helpful in analyzing the impact of Dodd-Frank and other regulations.
For instance, in our study we examined changes in risk sensitivities of
cost of debt after the introduction of Dodd-Frank. We examined changes
in subsidies accruing to large financial firms compared to nonfinancial
firms. We also examined the cost of implicitly guaranteed debt to
explicitly guaranteed debt issued by the same firm under FDIC's
Temporary Liquidity Guarantee Program.
Using these alternative approaches, we find that Dodd-Frank did not
significantly alter investors' expectations that the Government will
bail out TBTF financial institutions should they falter. Despite its
no-bailout pledge, Dodd-Frank leaves open many avenues for future TBTF
rescues. For instance, the Federal Reserve can offer a broad-based
lending facility to a group of financial institutions in order to
provide a disguised bailout to the industry or a single firm. In
addition, Congress can sidestep Dodd-Frank by amending or repealing it
or by allowing regulators to interpret their authority in ways that
protect creditors and support large institutions. \3\ As former Kansas
City Fed President, Thomas Hoenig, noted: ``The final decision on
solvency is not market driven but rests with different regulatory
agencies and finally with the Secretary of the Treasury, which will
bring political considerations into what should be a financial
determination.''
---------------------------------------------------------------------------
\3\ See, e.g., David Skeel, ``The New Financial Deal:
Understanding the Dodd-Frank Act and Its (Unintended) Consequences''
(2011); Arthur E. Wilmarth, ``The Dodd-Frank Act: A Flawed and
Inadequate Response to the Too-Big-To-Fail Problem'', 89 Oregon Law
Review 951 (2011); Standard & Poor's, ``The U.S. Government Says
Support for Banks Will Be Different `Next Time'--But Will It?'', (July
12, 2011). One aspect of the recent regulations, that our analyses
suggest had a mild impact in reducing market expectations of support,
is the release of the specifics of the FDIC's Single Point-of-Entry
approach to resolving financial institutions under OLA. This is
consistent with the GAO interviews with large investors who point to
the SPOE approach as affecting their expectations of future Government
support.
---------------------------------------------------------------------------
Finally, it is also important to note that the analyses conducted
by us and the GAO only measure the direct subsidy that may accrue to
TBTF institutions. There may be other indirect effects such as
misallocation of capital or excessive and correlated risk-taking (to
exploit the implicit guarantee) that are not captured by the analyses.
Governments are generally not required to make any apparent
financial commitment or outlay, or request funds from legislatures or
taxpayers, when they implicitly guarantee TBTF institutions. Implicit
guarantees lack the transparency and accountability that accompany
explicit policy decisions. Taxpayer interests could be better served,
in both good times and bad, by estimating on an ongoing basis the
accumulated value of this subsidy. Public accounting of accumulated
TBTF costs might restrain those Government actions and policies that
encourage TBTF expectations.
Thank you for your time.
References
Acharya, V., D. Anginer, and A.J. Warburton (2014) ``The End of Market
Discipline? Investor Expectations of Implicit State Guarantees''.
NYU Working Paper.
Skeel, David, (2011), The New Financial Deal: Understanding the Dodd-
Frank Act and Its (Unintended) Consequences (Hoboken, NJ: John
Wiley).
Standard & Poor's, (2011), ``The U.S. Government Says Support for Banks
Will Be Different `Next Time'--But Will It?'' (July 12).
Wilmarth, Arthur E., (2011), ``The Dodd-Frank Act: A Flawed and
Inadequate Response to the Too-Big-To-Fail Problem'', Oregon Law
Review 89, 951-1057.
Appendix
PREPARED STATEMENT OF EDWARD KANE
Professor of Finance, Boston College
July 31, 2014
I want to begin by thanking Chairman Brown for inviting me to
testify today and to congratulate him and the Subcommittee for
continuing to battle against the pernicious and unfair advantages that
panic-driven crisis-management policies confer on mega-institutions,
not only in this country but in financial-center countries around the
world. The claim that the Dodd-Frank Act of 2010 or Basel III can end
these advantages is a dangerous pipe dream. There will always be
institutions that regulators will--especially in crisis circumstances--
find macroeconomically, politically, and administratively too difficult
to fail and unwind. The existence of a powerful propensity to rescue
such too-big-to-fail (TBTF) firms is the central lesson taught both by
the S&L mess and by the Great Financial Crisis.
The GAO Has Bungled Its Assignment
The GAO goes wrong at the outset. The definition of TBTF offered in
the Report's first sentence (lines 9-10) is incomplete. It describes
TBTF as an active policy of ``intervention'' without confronting the
more dangerous additional role played by passive capital forbearance.
The title of this hearing focuses on ``funding advantages'' that
TBTF BHCs receive from expectations of unlimited Government support.
The GAO's estimated 42 statistical models each year seek to explain in
a robust manner only how the interest spreads between bonds issued by
large BHCs and comparable Treasuries relate to BHC size and credit
risk. This conception of TBTF subsidies treats TBTF guarantees as if
they were merely a form of bond insurance and builds in an additional
downward bias by not using volume-based proxies for the extent to which
after-issue trading in individual BHC bonds is less liquid than in
Treasuries.
But even if they were modeled perfectly, spreads on outstanding
bonds capture only part of the impact of TBTF guarantees. TBTF
guarantees are different from bond insurance because, as long as
regulators forbear from resolving a BHC's insolvency, a truly TBTF firm
can extract further guarantees by issuing endless amounts of additional
debt.
Funding Cost Is More Than Debt Costs
A BHC's ``funding cost'' is the cost of its ``funding mix.'' Being
TBTF lowers both the cost of debt and the cost of equity. This is
because TBTF guarantees lower the risk that flows through to the
holders of both kinds of contracts. The lower discount rate on TBTF
equity means that, period by period, a TBTF institution's incremental
reduction in interest payments on outstanding bonds, deposits, and
repos is only part of the subsidy its stockholders enjoy. The other
part is the increase in its stock price that comes from having
investors discount all of the firm's current and future cash flows at
an artificially low risk-adjusted cost of equity. This intangible
benefit generates capital gains for stockholders and shows up in the
ratio of TBTF firms' stock price to book value. Other things equal
(including the threat of closure), a TBTF firm's price-to-book ratio
increases with firm size. For four quarters in 2012-2013, Figure 1
compares the behavior of this ratio for banks in different size ranges.
The comparisons show that on average this ratio increases with size in
all four quarters.
I hope that contemplating the following numerical example can drive
home the need to account for the equity-funding component of annual and
capitalized TBTF subsidies. Let us suppose a TBTF institution is
projected to earn $12 billion a year forever and that $2 billion of its
earnings comes from the reduction in its cost of debt. By hypothesis,
market participants recognize that TBTF guarantees shift a range of the
deepest possible losses away from creditors and stockholders to
taxpayers. If authorities were expected to take over the firm and pay
off guaranteed creditors just as it became insolvent, the debt
component would be the whole story. But because authorities are
expected to leave the stock in play come hell or high water, TBTF
policies give comfort to shareholders, too. This comfort lowers the
risk class of the stock, so that the warranted return on equity falls.
Let us assume that the opportunity cost of equity would be 12
percent without the TBTF guarantee, but--in the presence of the contra-
liability provided by the unlimited guarantee--this cost falls to 10
percent. Then, the capitalized subsidy built into the stock price would
be not $16.7 billion ($2 billion/.12) or even $20 billion (=$2
billion/.10), but $36.3 billion. The capitalized subsidy is the
difference between the $83.3 billion stock-market value of the
unguaranteed firm (=$10 billion/.12) and the $120 billion ($12
billion/.10) in value that develops under TBTF guarantees. The annual
subsidy that would deserve to be passed through the Federal budget
would be $4.4 billion: the $2 billion in interest saving plus another
$2.4 billion (.02 x $120 billion) subsidy on the firm's equity funding.
So, for this hypothetical BHC, the annual subsidy to equity would prove
roughly the same size as the subsidy to debt.
The warranted rate of return on the stock of deeply
undercapitalized firms like Citi and B of A would have been sky high
and their stock would have been declared worthless long ago if market
participants were not convinced that authorities are afraid to force
them to resolve their weaknesses. Had these BHCs' assets and
liabilities been transferred to bridge institutions or put into
resolution, losses that contractually deserved to be incurred by
uninsured creditors and postcrisis increases in the TBTF stock prices
would have accrued to taxpayers.
A simpler way to see what the GAO has missed is to think carefully
about the structure of guarantee contracts. An external guarantee
allows the guaranteed party to put responsibility for covering debts
that exceed the value of BHC assets to the guarantor. No guarantor
wants to expose itself to unlimited losses on this put. For this
reason, all guarantee contracts incorporate a stop-loss provision that
gives the guarantor a call on the guaranteed party's assets.
Ordinarily, this right kicks in just the insolvency threshold is
breached. In the FDIC Improvement Act of 1991, efforts to exercise this
call are termed ``prompt corrective action'' (PCA).
By definition, the Government's right to take over the firm's
assets will never be exercised in a financial organization is truly
TBTF. This means that the Government has effectively ceded the value of
its loss-stopping rights to TBTF stockholders. The value of this
giveaway is what the GAO's measure ignores.
I can clarify this further by examining Figure 2. This figure
graphs the behavior of AIG's stock price before, during, and after the
2008 crisis. The only times AIG's stock price approached zero was when
a Government takeover of the firm was being actively discussed. Each
time that this possibility was tabled, trading picked up and the stock
price soared as new stockholders tried to share in the value of the
unexercised call.
GAO Neglect of Differences in Political Clout
Postcrisis reforms seek to classify particular firms as either
systemically important financial institutions (SIFIs) or not. But TBTF
status is not a binary condition and does not start at a particular
size. A firm's access to Senators and Congresspersons grows steadily
with its geographic footprint and with the number of employees that can
be persuaded to contribute to reelection campaigns. TBTF BHCs give
heavily to candidates in both political parties as Ferguson, Jorgenson,
and Chen (2013) have documented. Holding size constant, the more
organizationally complex and politically influential an institution
becomes, the better the chance that Government examiners will find it
difficult to observe its exposure to tail risk and to discipline such
risk adequately.
Need To Bring in the Behavior of Stock Market Prices
To capture the full extent of TBTF subsidies, it is critical to
make use of stock-market data. Figure 3 of my presentation tracks
annualized estimates that Armen Hovakimian, Luc Laeven, and I (2012)
have made of the average dividend that taxpayers ought to have been
paid on their stake in large BHCs. This Figure plots the mean value of
the credit support in annualized basis points per dollar of assets
supplied to large banking organizations, quarter by quarter between
1974 and 2010. The surge in the third quarter of 2008 is remarkable, as
is its steady fallback afterwards.
Regulators and policymakers persistently misframe bailout
expenditures as either loans or insurance. This false characterization
helps TBTF firms and their creditors to steal wealth from taxpayers. An
insurance company does not double and redouble its coverage of drivers
it knows to be reckless. Similarly, lifelines provided to an underwater
firm should not be thought of as low-interest loans. Loans are simply
not available to openly insolvent firms from conventional sources. The
ability to extract implicit guarantees on new debt and the hugely
below-market character of bailout programs means that the repayment of
funds that were actually advanced does not show that a bailout program
is a good deal for taxpayers.
Bailout funding can more accurately be described as unbalanced
equity investments whose substantial downside deserves to carry at
least a 15 percent to 20 percent contractual return. The Government's
bailout deals compare very unfavorably with the deal Warren Buffet
negotiated in rescuing Goldman-Sachs. Buffet's deal carried a running
yield of 10 percent and included warrants that gave him a substantial
claim on Goldman's future profits. Government credit support
transferred or ``put'' to taxpayers the bill for past and interim
losses at numerous insolvent or nearly insolvent TBTF firms.
Authorities chose this path without weighing the full range of out-of-
pocket and implicit costs of their rescue programs against the costs
and benefits of alternative programs such as prepackaged bankruptcy or
temporary nationalization and without documenting differences in the
way each deal would distribute benefits and costs across the populace
(see Bair, 2012).
In my opinion, it is shameful for Government officials to imply
that TBTF bailouts were good deals for taxpayers. On balance, the
bailouts transferred wealth and economic opportunity from ordinary
taxpayers to much higher-income stakeholders in TBTF firms. Ordinary
citizens understand that this is unfair and officials that deny the
unfairness undermine confidence in the integrity of economic
policymaking going forward.
How To Sanction the Pursuit of TBTF Subsidies
I hope my testimony convinces you that, in principle, the risks in
backstopping TBTF firms cannot be calculated and priced in the
straightforward ways that the risks of a bond or insurance contract
can. Taxpayer guarantees to TBTF creditors provide unlimited loss-
absorbing equity funding to zombie firms at a time when no sensible
private party would even advance them a dime.
I want to convince you further that interpreting bailout support as
equity funding implies that managers who adopt risk-management
strategies that willfully conceal and abuse taxpayers' equity stake
should be sanctioned explicitly by corporate and criminal law rather
than excused by insurance law as inevitable moral hazard.
I find it disgraceful that corporate law legitimizes managerial
efforts to exploit taxpayers' equity position. The norm of maximizing
stockholder value is inappropriate for TBTF firms. In TBTF
institutions, this norm leaves taxpayers' unbooked equity stake
inferior to that of ordinary shareholders in five ways:
1. Taxpayers cannot trade their positions away.
2. Downside liability is not contractually limited, but upside gain
is.
3. Taxpayer Positions carry no procedural or disclosure safeguards.
4. Taxpayer positions are not recognized legally as an ``equitable
interest.'' (This means TBTF firms may exploit them without
fear of lawsuits.)
5. TBTF Managers can and do abuse taxpayers by blocking or delaying
recovery and resolution.
The Problem of Regulatory Capture
In and out of crisis, taxpayer interests are poorly represented by
regulators because politicians and regulators have kept themselves less
than fully accountable for the costs of bailouts and have
simultaneously pursued conflicting political and bureaucratic goals.
Over the years, the financial industry has infiltrated the bureaucratic
system that ought to monitor and regulate aggressive risk-taking and
woven huge loopholes into the fabric of capital requirements that--then
and now--are supposed to keep financial instability in check. The
industry's capture of the regulatory system is politically very well-
defended, because the subsidies are in part shifted forward to
creditors and to customers in various industries (e.g., in realty and
construction).
Capture can be demonstrated in at least four complementary ways:
(1) by enumerating the problems that the Dodd-Frank Act set aside (such
as how to define systemic risk operationally or how to resolve the
Fannie and Freddie mess); (2) by examining the many loose ends left in
the Act's efforts to handle regulation-induced innovation (especially
in swaps) and to deal with institutions that have made or are making
themselves too large, too complex, and too well-connected politically
and bureaucratically to be closed and unwound; (3) by noting that
crisis-management policies have helped the largest BHCs to become even
larger; and (4) by recognizing that postcrisis reforms continue to
feature loophole-ridden measures of accounting capital as the
cornerstone of financial-stability policy.
Why Capital Requirements Can't Adequately Protect Taxpayers From BHC
Shareholders
Besides setting minimums that are far too low, gaping imperfections
exist in weighing risks and measuring capital that open and solidify
avoidance opportunities (see Admati and Hellwig, 2013). Actual and
potential zombie institutions can use accounting tricks, organizational
complexity, and innovative instruments to hide risk exposures and
accumulate losses until their insolvency becomes so immense that they
can panic regulators and command life support from them.
The Basel control framework (see Basel Committee on Banking
Supervision, 2013) is built on the fiction that all or most SIFIs can
be persuaded to forgo individually profitable credit business for the
greater good. This seems awfully naive (see Schelling, ``Strategy of
Conflict''). The naivete lies in a set of unrealistic assumptions about
the regulatory game: (1) that accounting ratios are difficult to
misrepresent; (2) that supervisors are hard to mislead; (3) that
bankers dutifully accept statutory burdens rather than work
aggressively to adjust their risk profile to neutralize the net effect
of capital restrictions on SIFI profits and market capitalization; and
(4) that meritorious commitments to protect unsophisticated depositors
and to keep systemically important markets and institutions from
breaking down in difficult circumstances do not provide convenient
cover that tempts officials to obligate taxpayer funds over-generously
and without revealing the full picture of fiscal and incentive effects.
Capital requirements are merely restraints. Improved capital
requirements increase the difficulty of extracting TBTF subsidies, but
they do not reduce the legitimacy of adopting strategies that willfully
pursue this goal. To do this, I propose that Congress declare that
taxpayers have an equitable interest in any institution that can be
shown to extract a subsidy from the safety net. In common law, an
``equitable interest'' is understood as a balance-sheet position that
gives its owner a right to compensation from damages. I believe that we
should conceive of this compensation as the dividend taxpayers would be
paid on their implicit equity stake in any accounting period if
information asymmetries did not exist. The net value of taxpayers'
stake in a TBTF firm increases with the extent to which creditors and
stockholders are confident that they can hide tail risks and, if
ruinous losses emerge, scare authorities into funding the losses
without extracting due compensation.
Genuine reform would compel the DOJ to prosecute megabank holding
companies that engaged in easy-to-document securities fraud. Numerous
representations and warranties can be shown to be deliberately
deceptive and designed to benefit individual firms at the expense of
the rest of us. As legal persons and convicted felons, guilty BHCs
could be forced to break themselves up. Subsidiaries of felonious
companies could lose the right to take insured deposits or act as
broker-dealer firms and futures merchants. The beauty of such penalties
is that managements and not Governments would have to design the
breakup plan.
Living wills, enhanced resolution authority, clawbacks of
undeserved executive compensation, and an Office of Financial Research
are potentially useful tools. But the failure to prosecute any TBTF
firm or top manager in open court for criminal securities fraud tells
us how easy it is to collect fines (because they are paid by
stockholders) and how hard it can be for regulators to discipline
individual managers of influential and interconnected BHCs. For top
management, corporate-level fines are a nondeterrent slap on the wrist.
Moreover, only a portion of most fines compensate the taxpayer by
flowing through to the Treasury. Sad to say, most of these criticisms
apply to the reform programs that are unfolding in the European Union
as well.
The Problem of Fairness
Fairness is the heart of the Rule of Law. Whether or not enhanced
resolution or contracts with bail-in provisions can be enforced in
difficult circumstances, Corporate and/or Property Law needs: (1) to
recognize that regulators' demonstrated propensity to bail out
creditors and shareholders in TBTF firms (e.g., in AIG, Fannie, and
Freddie) assigns taxpayers' a disadvantaged equity position in each
TBTF firm, and (2) to enact personal and corporate penalties for
willful efforts to pursue risks that abuse taxpayers' equity stake and
pervert the pattern of real investment. Corporate penalties could
include forced sales of some or all lines of business.
It is useful to think of taxpayers' stake in each TBTF firm as if
it were a trust fund and conceive of Government officials as
fiduciaries responsible for managing that fund. The purpose of the
reforms I propose is to give regulators, along with managers and
directors of TBTF firms, an explicit and codified fiduciary duty to
measure, disclose, and service taxpayers' stake-holding fairly. To
overcome short-term benefits from ducking their implicit fiduciary
responsibilities, regulators, managers, and board members need to face
stricter legal liability for neglecting or incompetently performing
these fiduciary duties.
Governments must rework bureaucratic and private incentives to
focus reporting responsibilities for regulators and institutions on
uncovering the value of safety-net support. Regulatory-agency and
corporate mission statements must explicitly define, embrace, and
enforce fiduciary duties of loyalty, competence and care to taxpayers
in operational and accountable ways. Otherwise, it is unreasonable to
hope that managers will--or that regulatory staff can--contain systemic
risk during future rounds of boom and bust.
The report the GAO released today (General Accountability Office,
2014) is a small step in this direction. The downside of the report is
that TBTF firms are going to trumpet GAO's low-ball and conceptually
deficient measurement of the subsidy as if it were gospel.
To support a culture of fiduciary duty, I have long maintained that
we need to strengthen training and recruitment procedures for high-
ranking regulators. If it were up to me, I would establish the
equivalent of a military academy for financial regulators and train
cadets from around the world. The curriculum would not just teach
cadets how to calculate, aggregate, and monitor the costs of safety-net
support in individual institutions and countries. The core of the
curriculum would be to drill students in the duties they will owe the
citizenry and to instruct them in how to confront and overcome the
nasty political pressures that elite institutions exert when and as
they become increasingly undercapitalized.
Politically, a financial crisis is a struggle by financial firms
whose assets have collapsed in value to offload the bulk of their
losses onto creditors, customers, and taxpayers. In the early months of
the 2008 crisis, Fed and Treasury officials assisted economically
insolvent zombie institutions (such as Bear Stearns and AIG) to book
new risks and to transfer their losses onto the Government's balance
sheet. Authorities did this by mischaracterizing the causes of these
institutions' distress as a shortage of market liquidity and helping
insolvent firms to expand and roll over their otherwise unattractive
debt. Far from assisting zombie institutions to address their
insolvency, unwisely targeted and inadequately monitored Government
credit support encouraged troubled firms not only to hold, but even to
redouble the kinds of go-for-broke gambles that pushed them into
insolvency in the first place.
Indiscriminately bailing out giant firms was a mistake that has
hampered, rather than promoted economic recovery. Similarly, prolonged
uncertainty about the future of Fannie and Freddie continues to disrupt
housing-finance activity. Blanket bailouts evoke gambles for
resurrection among zombie and near-zombie beneficiary firms like AIG,
while uncertainty about who will finally bear the extravagant costs of
these programs dampens spending plans in every sector. These problems
divert and restrain the flows of credit and real investment necessary
to trigger and sustain a healthy economic recovery.
References
Admati, A., and Hellwig, M. (2013). ``The Bankers' New Clothes: What's
Wrong With Banking and What To Do About It?'', Princeton University
Press, Princeton.
Bair, S. (2012). ``Bull by the Horns: Fighting To Save Main Street From
Wall Street and Wall Street From Itself'', Free Press, New York.
Basel Committee on Banking Supervision (2014). ``Supervisory Guidelines
for Identifying and Dealing With Weak Banks: Consultative
Document'', Banking for International Settlements, Basel.
Ferguson, T., Jorgenson, P., and Chen, J., (2013). ``Party Competition
and Industrial Structure in the 2012 Elections: Who's Really
Driving the Taxi to the Dark Side?'', International Journal of
Political Economy, 42 (Summer), 3-41.
Hovakimian, A., Kane, E.J., and Laeven, L.A. (2012). ``Variation in
Systemic Risk at U.S. Banks During 1974-2010'', available at SSRN:
http://ssrn.com/abstract=2031798 or http://dx.doi.org/10.2139/
ssrn.2031798 (May 29).
United States Government Accountability Office, July 2014. ``Bank
Holding Companies: Expectations of Government Support'', (GAO-14-
621).
PREPARED STATEMENT OF ANAT ADMATI
George G.C. Parker Professor of Finance and Economics, Graduate School
of Business, Stanford University
July 31, 2014
Chairman Brown, Ranking Member Toomey, and Members of this
Subcommittee, I commend you for holding this hearing and am grateful
for the opportunity to speak to you. I am a Professor of Finance and
Economics at Stanford Graduate School of Business and my recent
research and writings have focused on issues immediately relevant to
today's hearing.
Recent experiences have helped foster the expectations of
Government support mentioned in the title of this hearing. Since 2008,
the Treasury, the Federal Reserve and the FDIC provided through various
programs massive and unprecedented support to the financial system. The
largest bank holding companies, to varying degrees, have had access to
hundreds of billions, even trillions of dollars in relatively cheap
loans and guarantees, and they benefited from bailouts of their
counterparties such as AIG. For some, e.g., Citigroup, the support was
critical. \1\
---------------------------------------------------------------------------
\1\ The banks and the Federal Reserve tried to keep information
about the extent of Fed loans hidden. The information was released
after Bloomberg fought in court. See Phil Kuntz and Bob Ivry, ``Fed
Once-Secret Loan Crisis Data Compiled by Bloomberg Released to
Public'', Bloomberg, December 22, 2011. Citigroup is discussed further
below.
---------------------------------------------------------------------------
Trillions of U.S. taxpayer funds were put at risk. The supports
prevented the collapse of the system and helped many financial
institutions avoid default, bankruptcy, or resolution in which their
shareholders would be wiped out and at least some of their creditors
would suffer losses. Yet, the programs did little to solve the housing
crisis, failed to improve business lending meaningfully, and at times
were excessively generous and inefficient. \2\
---------------------------------------------------------------------------
\2\ Cole (2012) shows that TARP did not help improve business
lending, which is not surprising since the programs did not reduce the
institutions' indebtedness and the resulting debt overhangs (see Admati
and Hellwig, 2013a, chapter 3, and Admati et al., 2014). Barofsky
(2012) and Bair (2012) describe the bailouts programs. Additional
references in the notes to chapter 9 of Admati and Hellwig (2013a),
whose text is attached to this testimony.
---------------------------------------------------------------------------
Implicit guarantees for which banks do not pay create a subsidy,
essentially free insurance for their debts, or at least a partial
insurance that lowers the likelihood of losses in some scenarios.
Because such subsidies are implicit and invisible, determining their
value with any precision is difficult; there is no market in which the
implicit guarantees are being valued (although some have tried to use
credit insurance contracts to try to estimate their value). Any
estimate depends on many variables that change over time, and
estimation requires making many assumptions; such assumptions might or
might not be true in reality. In fact, many of the variables that
affect the size of the subsidy vary across different institution in
complex ways. Moreover, actions by the institutions, by investors, and
by regulators also have important impacts. Later in this document I
will have additional comments on measuring the subsidies.
When implicit-guarantee subsidies are provided to institutions that
have significant discretion about their investments and the risks they
take, the results can be perverse. Policymakers may hope that the
subsidies are passed on to specific investments or people, but the
institutions, as they benefit from the guarantees, may well have
incentives to make different investments altogether.
For example, guarantees may be provided in the hope that the banks
will make certain loans, when in fact, given their compensation
structures and the flawed regulations we have in place (e.g., the use
of risk weights), the banks may only make the loan if it is very safe
or if it is guaranteed by the Government. Instead, banks may prefer to
invest in derivatives markets with more upside.
The institutions benefiting most from the subsidies often deny the
existence of any benefit and claim that they are happy to give up the
implicit subsidies. ``Please,'' they may say, ``let banks fail when
they should.'' \3\ The difficulty is that letting systemic
institutions--or many institutions at the same time--fail may be
disruptive and entail enormous collateral damage. Even if the direct
costs of the failure are covered, the disruptions and inefficiencies
that result are costly for the economy and the harm is borne by
innocent citizens. As I will explain below, we do not have workable
options for the failure of systemic institutions; moreover, the harm
from their distress and even from the fear of their failure creates
instabilities.
---------------------------------------------------------------------------
\3\ For example, in his letter to shareholders in April 2011,
Jamie Dimon, CEO of JPMorgan Chase, denies his bank benefits from
implicit subsidies and suggested that the industry pay any expenses
associated with the failure of ``dumb banks.'' For a response to this
letter, see Anat Admati, ``An Open Letter to JPMorgan Chase Board of
Directors'', reprinted in Huffington Post, June 14, 2011). This letter,
which was sent to at least one person within the bank, did not receive
any acknowledgment and did not appear to affect the banks' strategy.
Misleading comments by bank executives and bank lobbyists as well as
others are discussed in Admati and Hellwig (2013a) and in a number of
short pieces, some of which are cited later in this document.
---------------------------------------------------------------------------
Financial crises are sometimes portrayed as if they were
unpreventable natural disasters, implying that bailouts are similar to
emergency aid after an earthquake. This narrative is misleading. The
crisis of 2007-2009 was an implosion of a system that had become too
fragile, reckless, and distorted. Regulatory failures, including flawed
and ineffectively enforced regulations, must take much of the blame for
the excessive fragility and the buildup of risk. These failures can be
corrected, and regulators have authority to do so under current laws,
but, remarkably, obvious lessons have not been learned, and not enough
has been done to make the system as safe as it can and should be. Some
counterproductive laws have also remained in place. \4\
---------------------------------------------------------------------------
\4\ I am referring, for example, to the distortive corporate tax
code that penalizes equity funding and encourages borrowing, which can
become excessive, and to the sweeping exemptions of repos and
derivatives from stay in bankruptcy, which has likely enabled and
encourage excessive growth in these markets. These issues will come up
briefly below and they are discussed in Admati and Hellwig (2013a,
chapters 5, 9, and 10).
---------------------------------------------------------------------------
The situation in banking is disturbingly similar to allowing heavy
trucks with dangerous cargo to drive recklessly at 95 miles per hour in
residential neighborhoods. If drivers get a bonus for reaching the
destination quickly, and face little risk of injury or death even in an
explosion (imagine that they have a special protective mechanism), they
will drive recklessly and endanger innocent citizens. Authorities can
send firefighters to put out fires and medics to treat the injured if
an explosion occurs, but the public would wonder why truck companies
reward reckless driving and, most importantly, why a safer speed limit
was not set and enforced to prevent harm.
Similar questions must be asked about the failure of financial
regulation. We should have a financial system that supports the economy
as efficiently and consistently as possible without major distortions.
The system we have instead is too dangerous, exposing the public to
unnecessary risk and distorting the economy. Much can be done--even
within existing laws--to improve this situation.
This Committee has an important role in helping bring about
beneficial changes. In the rest of this document, I will elaborate on
the above statements, diagnose the key problems, and outline some
recommendations. Additional materials are attached and referenced; I
will be happy to provide more at your request.
Can/Will Large Bank Holding Companies Ever ``Fail'' and if so, How?
The Dodd-Frank Act (DFA) intended, among other things, to eliminate
bailouts. Yet virtually everyone involved in the financial system--even
if some would not admit it--expects that the Government, possibly
through the Federal Reserve and FDIC, will again provide supports to
large bank holding companies and other institutions considered
``systemic'' if authorities fear that the failure of these institutions
would cause significant harm to the economy. If many small institutions
become distressed at the same time, they too may be supported.
This assessment is based on the realities of today's system and the
state of its regulation. \5\ Whereas regulators receive significant
authority under DFA (some of which they had all along), the
implementation of the law has been messy and uneven. Some of the most
critical rules are insufficient and flawed; others appear wasteful, too
costly relative to the benefit they provide.
---------------------------------------------------------------------------
\5\ The dynamics of contagion are explained in Admati and Hellwig
(2013a, chapter 5), White (2014), and testimony of James Thomson before
this Subcommittee on July 16, 2014.
---------------------------------------------------------------------------
Policymakers who were involved in the bailouts extol the virtues of
their actions while appearing willfully blind to their failure to
reduce the fragility of the system before the crisis and to learn the
lessons since. If anything, investors may reasonably expect that
supports would be forthcoming for fear of another ``Lehman moment''
even with the alternative to bankruptcy offered through the new and
still untested resolution authority by FDIC.
The DFA titles most relevant for this discussion are Titles 1, 2,
and 7. I'd like to focus my discussion mainly on Titles 1 and 2,
although Title 7, which deals with derivatives markets, is also
critical. The still-too-opaque markets in derivatives allow banks to
hide enormous amount of risk from investors and regulators. Ineffective
implementation of Title 7 and poor disclosures can undermine Titles 1
and 2 and the objective of having a healthier financial system.
Stating the obvious (but see more below for nuances), a business
``fails'' when it does not fulfill its debt commitments or is feared to
be unable to pay the debts. For ``normal'' companies in the U.S.,
failure involves filing for bankruptcy or liquidation under Chapter 11
or Chapter 7.
Title 1 of DFA requires, among other things, that large bank
holding companies submit ``living wills'' to regulators. These
documents are meant to play out a scenario in which the holding company
goes through bankruptcy process, presumably under Chapter 11. In her
testimony before your Committee on July 15, 2014, Fed Chair Janet
Yellen was asked some pointed questions about the living-wills process
by Senator Elizabeth Warren. The exchange brings out some key issues.
According to Chair Yellen, the largest bank holding companies have by
now submitted three rounds of living-wills documents, and received
feedback on the first set of submissions. The parts of these documents
that are made public provide little information, often less than is
included in standard financial statements. The full submission,
according to Chair Yellen, goes into tens of thousands of pages.
Senator Warren asked Chair Yellen a critical question: ``Can you
honestly say that JPMorgan could be resolved in a rapid and orderly
fashion as described in its plans with no threats to the economy and no
need for a taxpayer bailout?'' The Senator pointed out that JPMorgan
Chase has $2.5 trillion in assets and 3,391 subsidiaries, compared to
Lehmann Brothers, which had $639 billion in assets and 209 subsidiaries
prior to its failure.
The Lehman Brothers bankruptcy, filed on September 15, 2008, caused
severe disruption and damage to the global financial system. In its
immediate aftermath, stock prices imploded, investors withdrew from
money market funds, money market funds refused to renew their loans to
banks, and banks stopped lending to each other. Banks furiously tried
to sell assets, which further depressed prices. Within 2 weeks, many
banks faced the prospect of default.
To prevent a complete meltdown of the system, Governments and
central banks all over the world provided massive supports to financial
institutions. These interventions stopped the decline, but the downturn
in economic activity was still the sharpest since the Great Depression.
Anton Valukas, the lawyer appointed by the bankruptcy court to
investigate Lehman Brothers, put it succinctly: ``Everybody got hurt.
The entire economy has suffered from the fall of Lehman Brothers . . .
the whole world.'' Within 21 months, American households lost $17
trillion; reported unemployment hit 10.1 percent at its peak in 2009.
\6\
---------------------------------------------------------------------------
\6\ These two paragraphs are adapted from Admati and Hellwig
(2013a, p. 11), and the crisis is described in some detail in chapters
5 and 9 (the latter is attached to this testimony). Mr. Valukas made
the statement here quoted in an interview on CBS 60 Minutes, aired
April 22, 2012. The last fact is included in the 2011 report of the
Financial Crisis Inquiry Commission (p. 390).
---------------------------------------------------------------------------
Chair Yellen stated that Title 1 of DFA only requires the Fed to
give feedback to the companies about their plans. She referred to an
``iterative process'' of submission and feedback. Title 1 apparently
does not require that regulators give a pass/fail grade to the living
wills nor to determine definitively whether bankruptcy is a viable
option. However, the title definitely authorizes regulators to take a
number of strong actions if they find that bankruptcy would entail too
much collateral damage. Such actions include increasing capital
(equity) requirements, requiring that structures be simplified and
assets sold (potentially ``breaking up'' the banks), etc.
The U.S. bankruptcy code to which Lehman Brothers was subjected has
not changed since 2008. Other countries have different processes, which
Lehman Brothers' foreign subsidiaries must follow. The tens of
thousands of pages of living wills JPMorgan Chase has submitted to
regulators might be of some use should it file for bankruptcy, at least
under U.S. law (although they may well be dated by the relevant time,
because banks' counterparties and businesses can change in a matter of
days or months). But the process will not be much faster and simpler
than Lehman Brothers bankruptcy. Moreover, should the numerous
counterparties of JPMorgan Chase become concerned that bankruptcy might
be forthcoming, runs and disruptions similar to those observed in 2007-
08 when Bear Stearns and Lehman Brothers became distressed will likely
start significantly before any filing.
It defies credibility to suggest that, at the current speed of the
``iterative process'' that Chair Yellen described regarding the living
wills, and without major changes to their structure and funding mix,
enormously large and complex institutions like JPMorgan Chase will be
able to go through bankruptcy without major harmful effects. Yet,
regulators may continue to ``iterate'' and fail to use their authority
to act even knowing that bankruptcy is not viable, refusing to admit to
and deal with this reality. I doubt this situation was the intent of
Title 1.
DFA authors, perhaps mindful after the Lehman Brothers experience
that bankruptcy may not be a realistic option for large financial
institutions, included an alternative mechanism in Title 2, which gives
the FDIC authority to deal with the failure of any institution deemed
``systemic'' through a so-called Orderly Liquidation Authority (which
actually doesn't intend to liquidate the company). The FDIC has engaged
in the last few years in a serious effort to make its plans for this
process credible, focusing on an approach called Single Point of Entry
(SPOE).
SPOE represents an important and useful development, but, as
bankruptcy expert David Skeel (2014, p. 3) assesses, ``the technique
also has important vulnerabilities, and some of the claims made on its
behalf are quite exaggerated.'' Among them, SPOE does not work for
institutions that are active globally and that have systemically
important operations in several countries, unless all the countries
that are involved agree to such an approach. A recent coordination
effort between U.S. and UK may allow for SPOE of U.S. authorities in
U.S. holdings companies without intervention of UK authorities in UK
subsidiaries, so the problem of UK authorities entering a Lehman
Brothers subsidiary and finding that there is no cash to keep
systemically important functions going might not arise.
However, the U.S.-UK coordination is the only attempt of this sort,
and it does not seem to be fully symmetric. If Barclays or Deutsche
Bank were to run into trouble, U.S. authorities would probably not be
willing to accept SPOE resolution by the domestic authorities of these
banks, but instead would intervene directly in the holdings companies
that organize these banks' U.S. activities. Multiple-entry resolution,
however, destroys operational procedures that have been managed in
integrated fashion across jurisdictions, for cash management, as in the
case of Lehman Brothers, or, even more importantly, the joint use of
Information Technology systems.
From the perspective of the different countries involved, single-
entry resolution would involve significant conflicts of interest. If
U.S. authorities had been in charge of Lehman Brothers, London, as well
as the parent, would they have paid proper attention to London-specific
concerns, including the systemically important market-making activities
of Lehman Brothers in London? Alternatively, is it acceptable for U.S.
authorities to follow the procedure suggested in the living will of
Deutsche Bank, which argues that damage from resolution would be
minimized if U.S. authorities were willing to trust the German
authorities (Bafin, the supervisor, and FMSA, the resolution
authority)? In a cross-border setting, SPOE resolution leaves too much
room for the authority in charge to shift losses to other countries and
it is therefore hardly workable. \7\
---------------------------------------------------------------------------
\7\ Even the Nordic countries have not been able to agree on an
SPOE procedure for Nordea.
---------------------------------------------------------------------------
Even if we had SPOE resolution for globally systemically important
banks, some of these banks would most likely be ``too big to fail.''
Procedures would be lengthy and cumbersome and, meanwhile, there might
be substantial systemic fallout. Regulators would then be reluctant to
use the procedure if multiple financial institutions face default at
the same time, or if resolution would expose problems at one or more
subsidiaries. In sum, Title 2 is useful, but it is certainly not a
silver bullet for addressing the ``too-big-to-fail'' problem and it
does not eliminate expectations of support for large bank holding
companies. Moreover and importantly, even under the best scenario,
using Title 2 resolution would be costly and entail collateral damage
and, as in the case of bankruptcy, the distress of the corporation, and
the fear or anticipation that Title 2 resolution might be invoked by
its counterparties would likely already cause harm. \8\
---------------------------------------------------------------------------
\8\ See also White (2014) for a discussion of the issues regarding
``fail'' scenarios in ``too big to fail.''
---------------------------------------------------------------------------
The living wills requirements and Title 2 of DFA try to make
palatable the notion that, like other companies, financial institutions
structured as limited liability corporations should fail if they take
risk and become unable to pay their debts, thus wiping out their
shareholders and imposing losses on their creditors through an orderly
legal process. In a vibrant market economy, innovations involve risk,
and failures should be tolerated.
For normal companies, bankruptcy typically follows an actual or
imminent default. Restructuring debts may allow the company to continue
operating. Bankruptcy laws try to control the actions of managers and
shareholders in insolvent companies, who have incentive to benefit
themselves at the expense of creditors by taking out cash or gambling
for survival. Since such problems and the legal and other costs of
bankruptcy are anticipated by creditors, the terms of the debt claims,
including both the interest rate and the conditions the contract puts
on the borrower, are set by prudent lenders to compensate for the
losses in the event of default and bankruptcy, and to control
borrowers' actions that go against the lenders' interests.
A source of great inefficiency in banking is that banking
institutions can persist in a state of distress or even insolvency
without their creditors becoming alarmed and without the institution
experiencing the difficulty of most distressed borrowers to raise funds
and continue operating. One reason for this anomaly is that banks'
creditors include depositors, who are insured and dispersed. Depositors
are particularly passive in their role as lenders to the banks (a
status most of them do not quite realize they have) and do not behave
as normal creditors with standard debt contracts. Depositors rely on
insurance and regulators to protect them.
Banks can use depositors' funds to invest in various loans and
other assets that can sometimes be used as collateral and enable the
bank to borrow even more under attractive terms. Creditors whose debts
are secured by collateral care less than unsecured creditors about the
borrower's solvency. Lending to financial institutions through so-
called repurchase agreements (repos) is even safer than secured
lending, because, under safe harbor laws from 2005, repos, as well as
derivatives, are exempted from the normal stay in bankruptcy. \9\
---------------------------------------------------------------------------
\9\ Skeel and Jackson (2012), and Mark Roe, another bankruptcy
expert, (see, e.g., ``Reforming Repo Rules'', Project Syndicate,
December 21, 2011), call for reexamining these exemptions. Skeel (2014)
also warns with regard to Title 2 resolution that ``it reinforces
problematic incentives for financial institutions to rely on short-term
financing.''
---------------------------------------------------------------------------
For bank holding companies considered too big to fail, even
unsecured bond holders feel reasonably sure they will be paid in full.
In the financial crisis the creditors of numerous banking institutions,
including those whose claims had counted as ``regulatory capital'' and
were meant to absorb losses, were paid in full even as the institutions
received large amounts of bailout funds and other supports. As
discussed above, even today, and despite DFA, it is quite possible and
even likely that the creditors of one of the largest bank holding
companies will be paid in full even if the institution is insolvent.
As long as creditors are paid and do not constrain the borrowing
bank much, it can continue operating. In that case, only regulators are
in a position to intervene even as highly distressed or insolvent
borrowers, including banks, are extremely inefficient and their
decisions are distorted by conflicts of interest with creditor. In
fact, I will argue below that by most standards, the banks are
permanently in a state of financial distress, yet they manage to get
away with it.
Essential, Yet Flawed and Insufficient Regulation
In addition to the living-wills requirement, Title 1 of DFA
authorizes the Federal Reserve, in collaboration with other regulators,
to design prudential regulations meant to maintain the safety and
soundness of the system. The Fed is charged with regulating bank
holding companies as well as all institutions declared systemic by the
Financial Stability Oversight Committee.
As discussed above, the scenarios that involve default and failure
of systemic institutions are complicated, disruptive, and harmful.
There are no good options. It thus appears particularly important to
try to prevent reaching these failure situations through prudent
supervision and regulations. Most important among those safety measures
are capital requirements meant to control the funding mix of these
companies, including to ensure that they fund their investments by
appropriate amount equity--money from owners and shareholders--so that
they can continue making loans and investments and still pay their
debts even if they incur losses. (Note: the jargon that refers to
capital as something banks ``hold'' or ``set aside'' is confusing,
suggesting that capital represents idle funds like cash reserves that
banks cannot use, which is false. \10\)
---------------------------------------------------------------------------
\10\ On this insidious confusion, see Admati and Hellwig (2013a,
chapters 1 and 6), Admati et al. (2013, section 3.1), Claims 1 and 2
Admati and Hellwig (2014), which is attached to this testimony, and my
Tedx Stanford talk http://www.youtube.com/
watch?v=s_I4vx7gHPQ&feature=youtu.be&a.
---------------------------------------------------------------------------
According to its financial statements, on December 31, 2007, the
largest bank holding company at the time, Citigroup, reported that its
shareholder equity or net worth (the difference between its reported
assets and liabilities) was 5.2 percent of its total assets.
Citigroup's assets were valued at almost $2.2 trillion. As Lawrence
White from New York University Stern School notes, however, this
information does not capture some important facts. He writes (White,
2014, p. 7, footnotes omitted): ``Citigroup is best understood as a
(roughly) $1.2 trillion depository institution, on top of which was a
(roughly) $1 trillion holding company (including its nondepository
subsidiaries). The holding company's net worth was smaller than the
depository's net worth; in essence, if the net worth of the depository
(i.e., the capital of the depository, which also counted as an asset
for the holding company) was ignored, the holding company was
insolvent.''
Citigroup proceeded to collapse at the end of 2008 and needed a
series of bailouts and massive other supports. Remarkably, the
Government injected of $25 billion of TARP funds into Citigroup on
October, 8, 2008, and, even with the market value Citigroup stock
falling below $25 billion in November, the company was offered tens of
billions in additional bailouts and hundreds of billions in cheap loans
and guarantees from the Fed. (Citigroup, according to Arthur Wilmarth
from George Washington University Law School is ``a case study in
managerial and regulatory failure.'' \11\)
---------------------------------------------------------------------------
\11\ See Wilmarth (2014). Bair (2012) and Barofsky (2012) include
vivid descriptions of the bailouts.
---------------------------------------------------------------------------
Indeed, regulators often show forbearance and allow insolvent banks
to persist and even hide their losses. Insolvent institutions are
highly dysfunctional and harm the economy. They do not make new loans
and may become reckless, gambling for survival or looting the
institutions. Recklessness was pervasive in the Savings and Loan Crisis
of the 1980, and the dysfunctionality of weak banks is evident in
Europe in recent years. Yet, when banks are supported, their
indebtedness is often maintained because the supports are given in the
form of more loans. \12\ Solvent corporations can in fact raise equity
at some price, although their managers and shareholders are unlikely to
do so voluntarily. Creditors or regulators can bring about reduction of
indebtedness through covenants or regulation. \13\
---------------------------------------------------------------------------
\12\ Onaran (2011) argues that both Citigroup and Bank of America
were insolvent or ``zombies'' even in 2010. Admati and Hellwig (2013a,
chapters 3, 4, and 11) emphasize the harm of allowing weak banks to
persist.
\13\ Admati et al. (2014) discusses in detail how borrower-
creditor conflicts affect funding decisions in highly indebted
corporations, and the analysis is particularly applicable to banks.
---------------------------------------------------------------------------
A glaring failure of regulatory reform efforts across the globe
(not just in the U.S., indeed, the situation is worse in Europe) is
that, even as the largest global financial institutions have grown ever
bigger, more complex, more connected and more dangerous, they continue
to be allowed to operate with dangerously high levels of indebtedness
and much too little equity, and to hide too much risk in opaque markets
and off their balance sheets.
The minimal requirements agreed upon in Basel III allow equity to
be as low as 3 percent of the total assets. Even with the harsher U.S.
requirements, 95 percent of the total assets of the largest bank
holding companies can be funded with debt. Note that this requirement
would have been satisfied by Citigroup in December, 2007. Capital
regulations also rely on an enormously complex and manipulable system
of risk weights that distorts banks' decisions and exacerbates the
fragility of the system, among other things making business lending
relatively unattractive.
Bankers and regulators claim that the new capital regulations are
tough when in fact these reforms amount to a tweak and they have no
valid justification. In the speeding analogy, the reforms are analogous
to reducing the speed limit for loaded trucks from 90 miles per hour to
85 miles per hour in residential neighborhoods, with police unable to
measure the actual speed. The claims made to justify the regulation or
to fight higher equity requirements are fraught with flaws that range
from false statements to misleading claims that divert the discussion.
These statements are discussed in details in many of my writings, with
colleagues, over the last 4 years; a small sample of which is attached
to this testimony. \14\
---------------------------------------------------------------------------
\14\ See Admati (2014), Admati and Hellwig (2013a, 2014), and
Admati et al. (2013, 2014). Admati et al. (2013) was first posted in
August, 2010. These and additional references are available at http://
bankersnewclothes.com/: and (for more academic writing) http://
www.gsb.stanford.edu/news/research/admati.etal.html.
---------------------------------------------------------------------------
A key observation for understanding corporate funding decisions is
that heavy borrowing creates strong conflicts of interest between
borrowers and lenders and potentially distorts the investments and
funding decisions made by borrowers once debt is in place. Overhanging
debts create inefficiencies when borrowers--or managers in an indebted
corporation acting in the interests of shareholders--make decisions in
their own interest and do not take into account the impact of their
actions on creditors or third parties. For example, borrowers may
underinvest in worthy projects if they expect the returns to accrue in
part to their creditors or they may make excessively risky investments
if they expect the downside of the risks to be borne by creditors, or
by deposit insurance institutions and taxpayers. \15\
---------------------------------------------------------------------------
\15\ As discussed in Admati and Hellwig (2013a, chapter 3), the
effects of overhanging debt can be seen in the case of homeowners who
would not invest in the house if its value is low relative to the
mortgage, or who might take a second mortgage even as this may put the
lender of their first mortgage at risk.
---------------------------------------------------------------------------
As a result of these distortions and other costs associated with
distress or bankruptcy, heavy borrowing can actually reduce the total
value of a firm (i.e., the sum of the values of all claims, including
debt and equity). Borrower-creditor conflicts also create an
``addiction'' to debt on the part of heavy borrowers, biasing
subsequent funding decisions towards more debt and away from equity
that makes existing creditors safer. \16\ As mentioned above, the
conflicts are particularly intense when corporations are in a state of
distress or insolvency, which for most corporations are rare but which
in fact are considered normal in banking.
---------------------------------------------------------------------------
\16\ This phenomenon is explores in details in Admati et al.
(2014), which is highly relevant to understanding the rationale for
leverage regulation. See also Admati et al. (2013) and Admati (2014).
---------------------------------------------------------------------------
Without any regulation of their funding, and despite a (distortive)
tax code that subsidizes borrowing and penalizes the use of equity,
most corporations do not borrow heavily. \17\ Even those who tend to
use more debt, including private equity firms or Real Estate Investment
Trusts, rarely have less than 30 percent equity in their funding mix.
As discussed above, prudent creditors write restrictive covenants that
constrain dividend payouts and other decisions by the borrower, and
adjust the cost of borrowing to reflect anticipated legal costs and
delays should the borrower go into bankruptcy, as well as the
possibility that the borrower would take additional debt that might
dilute their claims.
---------------------------------------------------------------------------
\17\ White (2014) provides some comparisons based on book value of
equity. The comparisons of banks and nonbanks on the basis of market
value are starker. The latter have on average 60 percent or more equity
relative to total assets.
---------------------------------------------------------------------------
Banks, however, can persist in distress because they do not
experience the ``dark side of borrowing,'' including the increased
costs and harsh terms that naturally prevent other corporations from
heavy borrowing. Although they use a lot of debt, much of this debt
comes with fewer strings attached than those other borrowers face (and,
indeed, the terms the banks often place those to whom they lend).
Deposit insurance and implicit guarantees lighten the burden of debt,
allowing banks to continue to borrow and take risks without much effect
on the terms of their debts. Supports and guarantees enable, encourage,
and feed this addiction to debt. \18\
---------------------------------------------------------------------------
\18\ Some claim that debt disciplines managers. In banking, this
idea is a myth, as discussed in Admati et al. (2013, section 5), Admati
and Hellwig (2013b) and Admati and Hellwig (2014, Claim 22), attached.
---------------------------------------------------------------------------
Guarantees can also exacerbate the inefficiencies and distortions
in banks' investment decisions. If you could use borrowed money in a
casino, keep the winnings and continue to borrow when you lose, you
would certainly love gambling even if the odds were significantly
against you. Chapter 9 of Admati and Hellwig (2013a), whose text is
attached to this testimony, provides an accessible explanation.
The fact that banks choose to rely so much on debt does not mean
that their indebtedness levels are essential or efficient. These levels
are the result of a failure of internal governance and a failure of
normal credit markets to constrain the love of borrowing by banks and
bankers. Compensation structures that reward return on equity (ROE),
which are pervasive in banking, effectively pay bankers to gamble at
the expense of creditors or taxpayers who are exposed to greater risks.
Even shareholders may be exposed to risks for which they are not
properly compensated. \19\ Few benefit while the rest are harmed by
this situation. When markets fail, effective laws and regulations must
correct the distortions. Otherwise laissez faire can become crony
capitalism.
---------------------------------------------------------------------------
\19\ This is explained in detail in chapter 8 of Admati and
Hellwig (2013a) and in many other writings. See Claim 8 in Admati and
Hellwig (2014), attached.
---------------------------------------------------------------------------
The idea of finding ways for banks to fail, discussed above, is
obviously meant to bring back market discipline into banking. However,
given the collateral damage from the failure of one or more
institutions, and the fact that disruptions and harm start even before
an actual default, the primary focus should be on prevention. Much more
can be done on this front. There is simply no justification for the
current inefficient levels of indebtedness in banking. Reducing it will
achieve major benefits for society at virtually no relevant costs.
The inefficiencies of heavy borrowing in banking also distort the
provision of credit in the economy. Making loans is a critical
contribution banks can make to the economy. \20\ Heavily indebted
banks, however, may make too few worthy (but relatively ``boring'')
business loans that don't have much upside, while at the same time
making too many risky loans, including credit card loans, which may
lead others to borrow too much and suffer the consequences. The
distortions create cycles of booms, busts and crises. Regulations based
on risk weights exacerbate these distortions.
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\20\ Despite the emphasis often placed on banks as sources of
credit for firms, lending is actually a small part of what the largest
bank holding companies do (see Admati and Hellwig (2013a, chapter 6).
On the evolution of business of banking in the U.S., see Omarova
(2013).
---------------------------------------------------------------------------
It is possible and highly beneficial to transition to a system in
which banks use significantly more equity, thus reducing the likelihood
of costly failures or bailouts and at the same time permitting banks to
invests more efficiently on behalf of all its investors, thus
supporting the economy better and with fewer distortions.
Whereas many extol the importance of increasing equity
requirements, the status quo seems to be the benchmark against which
changes are measured. This benchmark is entirely inappropriate. Banks
are as fragile as they are only because those who make decisions in the
banks benefit from the status quo and they have so far gotten away with
maintaining it, even after the most recent crisis.
Requiring that banks use more equity is not a silver bullet, and
much depends on the details of the regulations and its implementation
and enforcement, but effective regulation of banks' indebtedness can
make other, more costly, regulations less important or necessary. \21\
Liquidity breakdowns are less likely if banks can trust each other to
be solvent, and the liquidity offered by deposits and other short term
debt by banks would only be enhanced if banks have more equity. \22\
---------------------------------------------------------------------------
\21\ In chapter 11 of Admati and Hellwig (2013a) we outline
briefly how better regulation can be designed and how to transition to
a better system.
\22\ These issues are discussed in detail in Admati and Hellwig
(2013a, chapter 10).
---------------------------------------------------------------------------
Existing laws still allow regulators to revise capital regulation.
Title 1, specifically in the context of the living wills requirements,
allows significant increases in equity requirements for institutions
deemed systemic, if regulators admit that bankruptcy is not a viable
option.
Comments on Measuring the Value of the Implicit Subsidies
As discussed at the start of this document, it is very difficult to
measure the value of the implicit subsidy associated with guarantees.
Because there are no markets for these guarantees, assumptions must be
made about the underlying forces and the data being used. One can also
try to focus on the cost to taxpayers or in terms of benefits to
banking institutions who receive the subsidies. In fact, these two need
not be the same because of the collateral impact of the banks' choices
of investment and funding, and especially of their distress and failure
scenarios.
In assessing the costs to taxpayers, it is important to realize
that expenses for supporting financial institutions in a systemic
crisis occur at the every moment when the macro-economy is doing
poorly, the country's fiscal situation is very tight and money is
sorely needed in many places. \23\ Similarly, in assessing the benefits
to banks, it is important to realize that Government guarantees are
most useful in times of crisis, when private protection schemes are
breaking down and the very survival of the institution is at stake. As
discussed above, banks' decisions about lending and investments are
most distorted at that time, and bailouts that do not reduce
indebtedness and thus do not alleviate banks' distress may keep banks
going but be unhelpful to the rest of the economy. (Ineffective banking
regulations have caused much harm in Europe in recent years; many
problems can be traced to a weak and bloated banking system and the
politics of banking.)
---------------------------------------------------------------------------
\23\ For example, in the Swedish crisis of 1992-1994, Government
support for the banks necessitated cutbacks in other Government
spending, which greatly contributed to the sharp economic recession.
Citizens in Ireland and Iceland are still suffering.
---------------------------------------------------------------------------
With these caveats, I will make a few observations about attempts
to estimate the size of the subsidy, but I do not wish to focus on this
technical issue. As I will argue below, the size of the subsidy does
not actually matter much to the policy recommendation.
1. There is compelling evidence that the Government provided a
sector-wide collective bailout guarantees to the financial
sector in 2007-2009. \24\
---------------------------------------------------------------------------
\24\ In one example, Kelly, et al. (2014) document the fact that
during the recent financial crisis, (out-of-the-money) index put
options that provide protection against large drops in the value of the
entire financial sector were surprisingly cheap compared to the
individual options of the financial institutions that are part of this
index. This finding is consistent with the notion that the Government
will not tolerate large equity losses for the financial sector as a
whole. As a result, the market underprices the cost of insurance
against these sector-wide losses for financials.
2. The value of the subsidy, if thought of as the amount the banks
would have to pay to receive perpetual (even partial) insurance
for their debts in the private markets, is sensitive to many
variables and can change dramatically over time depending on
the level of uncertainty, the state of the local and global
economy, and various fragilities in the financial system. The
value is highest when uncertainty is large and when the economy
and/or the financial sector are weak, and especially in a
crisis. Boom times, however, when the value of the subsidy
might be thought low, can quickly turn to bust. For example,
uncertainty indicators were low in 2006 and through summer 2007
---------------------------------------------------------------------------
only to explode in late 2008 and 2009.)
3. When focusing on the funding costs of the institutions,
particularly their borrowing costs, the relevant thought
experiment in trying to assess the value of the implicit
subsidies to the institutions who receive them from an ex ante
perspective, i.e., when institutions fund their investments in
light of the expectations of support, is to consider how
institutions would have fared in the hypothetical scenario in
which they tried to raise funding, such as unsecured, junior
debt, without any chance of a guarantee, and specifically in a
world in which the full costs of any failure, including
bankruptcy costs and the distortions of distress and
insolvency, would fall on shareholders and creditors. This
counterfactual scenario cannot be observed, thus comparison
requires many assumptions. One approach is to use credit
ratings uplifts. The approach makes sense if the uplifts
actually capture the true distinctions in the context of an
individual institution and specific bond issuance.
4. None of the approaches takes into account the extreme opacity of
the large banking institutions' and the difficulty in assessing
their risks, including those lurking off their balance sheets
and in derivatives markets. \25\ Many banks use derivatives to
get certain risks off their balance sheets. But then the
counterparties on these derivatives might fail. If the
counterparties have many parallel positions, as was the case
when AIG wrote credit default swaps for $500 billion on
mortgage-backed securities, CDOs, and the like, the risk that
the counterparty might fail is correlated with the underlying
risk, i.e., the attempt to hedge risks through derivatives may
end up being ineffective. In the case of AIG, fear of systemic
fallout from such a failure was a major reason for the bailout.
---------------------------------------------------------------------------
\25\ On the poor disclosures of the banks and investors' inability
to assess their risk, see for example Jesse Eisinger and Frank Partnoy,
``What's Inside America's Banks'', The Atlantic, January 2, 2013.
5. Correlations of risks, i.e., the risk that the same event affects
multiple institutions, are notoriously difficult to measure.
This is especially true of the correlations among the risks
against which derivative contracts are written and the default
risks on these contracts. If these correlations are improperly
measured, however, credit ratings and credit ratings uplifts
are unlikely to be reliable. If these correlations are
neglected, as has been the case in the past (for example the
possibility that housing price declines will affect numerous
mortgages at the same time), the estimates of the total risk in
banks' assets are likely to be too low, and so are all
estimated of the value of Government guarantees protecting
---------------------------------------------------------------------------
against such risks.
6. In this context, it is also important to appreciate the role
played by Government guarantees for counterparties of banking
institutions. In a financial system with a complex network of
inter-institution contracts, the individual institution
benefits not only from Government guarantees protecting its own
creditors but also from Government guarantees protecting the
counterparties of those in which it invested. For example, the
AIG bailout benefited many counterparties of AIG, not the least
of these being the many banks that had purchased credit
insurance from AIG. The benefit of such protection for AIG to,
say, Goldman Sachs, however, cannot be assessed merely by
looking at data for Goldman Sachs and relating the interest
Goldman Sachs must pay to the risks they are taking. The
embeddedness of their activities in a system to which the
Government provides comprehensive support can hardly be
gathered from data about individual institutions.
7. Even a resolution process such as under Title 2 of DFA may offer
guarantees to some of the institutions' debt in order to avoid
disruptions or runs, which would transfer some downside risk to
the Government at least temporarily. \26\
---------------------------------------------------------------------------
\26\ DFA directs the FDIC to cover any shortfall by charging the
surviving institutions, but doing so might be difficult if they too are
experiencing losses.
8. Being able to borrow at below-market rates relative to the risk
taken with the investments provides a subsidy that affects the
institutions' stock price and can favorably affect the terms at
which the institution can raise equity. When an insolvent
institution is given supports and does not fail, its
shareholders are not wiped out. Other things equal, therefore,
a systemic institution's stock price is higher in reality than
in the hypothetical without support. Indeed, raising equity has
been surprisingly cheap for the largest U.S. banks over the
past four decades, but expensive for the smallest banks,
because large bank stocks are priced under the assumption that
they are relative safe while the stocks of small banks are not,
despite the fact that large banks tend to be more heavily
indebted. \27\ The fact that guarantee become an asset, and the
fact that commonly used assumptions about the risks banks are
subject to may well be inappropriate, may lead the value of the
subsidies in some studies to be under-estimated. \28\
---------------------------------------------------------------------------
\27\ Gandhi and Lustig (2014) find that over the past four decades
the stock returns realized on the largest U.S. commercial banks, after
adjusting for risk differences, are abnormally low compared to the
stock returns on the smallest U.S. commercial banks. These differences
are large (around 6 percent per year). The authors also provide
evidence that large bank stocks are significantly less exposed to
losses during recessions and financial crises, even though these large
banks are typically much more heavily indebted. These findings are
consistent with the notion that Government guarantees are perceived by
investors to protect shareholders in large banks, but not in small
banks, in financial disasters.
\28\ See, for example, Stefan Nagel, ``Too Big To Fail Is Bigger
Than You Think'', Bloomberg, March 2, 2014.
9. Comparisons between the interest charged on debt of large and
small banks may not be informative because the large banks may
well have significant risks that are harder to assess due to
their more opaque disclosures. As mentioned earlier, this
applies particularly to banks heavily involved in derivatives
trading. The larger banks also tend to have more complex
structures, more lines of business, and more off-balance sheet
exposures than small banks. These factors would affect funding
costs in the hypothetical scenario without support and thus the
comparison between large and small banks, and they might not be
sufficiently observable to correct for. Similar considerations
apply to comparisons of large banks with other large
corporations, whose disclosures, and business models are often
---------------------------------------------------------------------------
simpler and less opaque.
The challenges in measuring how the banking industry as a whole,
and especially the largest institutions, benefit from the possibility
of future support do not change my bottom line, that the subsidy is
perverse and insidious, rewarding and encouraging recklessness and
excessive use of debt which endangers the public while allowing banks
to make investments of many kinds to maximize their own profits that
may not always benefit society.
Because the public pays for any subsidy, and the result of implicit
supports is a dangerous and distorted system, these subsidies are, on
net, enormously costly for society. Even if banks were to pay in full
for the guarantees, at least collectively--similar to how deposit
insurance works--the impact of the implicit support is harmful and
distortive. The same institutions whose failure would cause significant
collateral damage--individually and when they fail at the same time--
have incentives to borrow too much, take too much risk, and become more
highly interconnected, so as to increase the likelihood of Government
support. In responding to these incentives, they can put us at yet more
harm, unless these incentives are countered effectively by regulations.
\29\
---------------------------------------------------------------------------
\29\ See, for example, Brandao et al. (2013) for evidence on
excessive risk taking as a result of expectations and support. Section
5 in Admati et al. (2014) which discusses the why the leverage ratchet
effect (addiction to borrowing by heavy borrowers) is particularly
relevant in banking and exacerbated by guarantees, and this effect
exacerbates other distortions. Admati and Hellwig (2013a, chapter 9)
provide additional references. See also Anat Admati, ``Bank Immensity
Undermines Responsibility'', New York Times Room for Debate, May 16,
2014.
---------------------------------------------------------------------------
Among the perverse consequences of implicit guarantees is that they
encourage and enable the largest institutions to grow even to
inefficiently large sizes. There is no valid evidence of true scale
economies for banks as they grow to trillions in assets. Such sizes are
unseen in the rest of the economy. \30\ Indeed, the problem of ``empire
building'' by managers to benefit themselves appears particularly
severe in banking. \31\ The largest institutions seem to suffer from
serious governance and control problems, as evidenced by repeated
scandals and fines. \32\ However, because the status of being too big
to fail confers significant benefits and better access to funding, the
largest institutions are unlikely to shrink naturally (as conglomerates
often do).
---------------------------------------------------------------------------
\30\ Davis and Tracey (2014) use estimates of the subsidies based
on credit rating uplifts and argue that, once the effect of subsidies
is controlled for, the largest institutions are ``too large to be
efficient.''
\31\ For example, Mayo (2011) describes excessive growth that
appears inefficient, for example in Citigroup. A recent book (Fraser,
2014) describes the recklessness of the Royal Bank of Scotland and its
CEO, which led to its spectacular failure and bailout by UK taxpayers.
\32\ For example, the report by the Senate Committee on
Investigation chaired by Senator Carl Levin on ``London Whale''
scandal, entitled ``JPMorgan Chase Whale Trades: A Case History of
Derivatives Risks and Abuses'', reveals serious control problems in our
largest banks. Suspicion of fraud and other evasion of laws and
regulations appear routinely in the press.
---------------------------------------------------------------------------
These perverse effects undermine any notion of market discipline
and they breed recklessness, even lawlessness, on the part of those
within the largest institutions who benefit the most from the
guarantees and subsidies, whose compensation reward gambling, and who
rarely pay a personal price when charges for wrongdoings, including
crimes, are settled by authorities or when excessive risks that harm
the public, and even the shareholders of the corporations, are taken.
Both corporate governance and regulations appear to fail. It is
essential to take steps to counter these perverse incentives of the
implicit subsidies and reduce their impact.
Fortunately, there is a straightforward and cost-effective way to
do just that while reaping other critical benefits; that is to reduce
banks' excessive use of debt and requiring significantly more equity
than banks are currently required to have. \33\ There is no reason for
banks to live so dangerously. Importantly, aside from possibly losing
subsidies associated with borrowing, the overall funding costs of banks
would not increase if they use more equity and less debt. \34\ Since
subsidies come from public funds, reducing them does not represent a
social cost.
---------------------------------------------------------------------------
\33\ Additional benefits are outlined in Admati et al. (2013,
section 2) and Admati (2014).
\34\ This is explained in details in Admati et al. (2013, see
especially section 4); see chapter 9 of Admati and Hellwig (2013a)
Claim 11 in Admati and Hellwig (2014), both in attached documents.
Taxes are public funds, and the tax impact of higher equity
requirements can easily be neutralized, as explained in Admati et al.,
(2013, section 4.1).
---------------------------------------------------------------------------
Encouraging and subsidizing banks to fund themselves with as much
debt as is currently allowed (up to 95 percent for the large bank
holding companies) as perverse as encouraging and subsidizing reckless
speed for trucks or rewarding the captains of large oil tankers to go
ever closer to the coast. More equity would force banks to stand more
on their own when they take risk, rather than shift some of the risk
and cost of bearing it to others. Shareholders who benefit from the
upside, and not creditors or taxpayers, should be the ones to bear the
downside.
Whatever else is done to reform the financial system so it works
better for the rest of the economy, bringing banks' indebtedness to
more reasonable levels appears enormously cost-beneficial. With the
perverse incentives banks have, and their ability to get away with
harmful actions, many of the problems will not be corrected by markets.
Making the system safer requires focused and effectively enforced
regulation. If the size of individual banks, or of the banking
industry, shrinks as a result, the resulting size would likely be more
appropriate. The size and structure of firms and industries should be
determined by undistorted markets, but the markets we have are entirely
distorted. Bloated and inefficient, the financial industry may be able
to attract talented workforce that may be more productive elsewhere in
the economy. This system works for few and harms all the rest. When
regulations fail to correct such distortions and harm, the public pays
the price. Because the issues are misunderstood and the harm from
excessive risk in finance, unlike that from exploding trucks, is
abstract, the public may not fully realize the situation, particularly
with the extent of lobbying by the industry.
Summary: If not Now, When?\35\
In March, 2013, the Senate voted unanimously to approve an
amendment proposed by Senators Brown and Vitter to eliminate the too-
big-to-fail subsidies. As discussed above, among the many benefits of
forcing the large banks to use more equity and less debt is that any
subsidy they benefit from is immediately reduced. This benefit is
obtained without having to break up the banks, and is realized in
addition to all the other benefits of preventing their failure and
reducing the distortions in their lending.
---------------------------------------------------------------------------
\35\ This is the title of chapter 11 in Admati and Hellwig
(2013a), whose epigraph is ``time has a trick of getting rotten before
it gets ripe.'' For an excerpt, see Anat Admati and Martin Hellwig,
``Must Financial Reform Await Another Crisis?'' Bloomberg View,
February 6, 2013.
---------------------------------------------------------------------------
The focus on making the failure option palatable is as misguided as
a focus on preparing ambulances for a possible explosion while police
allows loaded trucks to drive at 95 miles an hour in residential
neighborhoods. Whoever pays for the ambulances, explosions harm
innocent people. Requiring that banks fund themselves so that those who
benefit from the upside of risk bear more of its downside brings about
more safety and corrects distortions.
In the exchange on July 15, 2014, between Senator Warren and Chair
Yellen referred to earlier, Senator Warren pointed out that under Title
1 of DFA, the Fed has authority to break up the largest bank holding
companies if it finds that bankruptcy is not a viable option if they
fail. The Fed certainly has authority to ban dividends and other
payouts to shareholders until banks are better prepared to absorb
losses from risks they take without failing or becoming distressed.
As it goes through the ``iterative process'' of the living wills,
and while it is not ready to assert that the failure of the largest
bank holding companies will not harm the economy, the Fed must act
prudently and protect the public. Corporations routinely retain their
profits to fund investments, and banks should do the same. Retained
profits would enable banks to make more worthy loans, and may increase
their incentives to actually make them. The profits from any
investments belong to shareholders as long as debt is paid. \36\
---------------------------------------------------------------------------
\36\ Warren Buffett's company Berkshire Hathaway, for example,
rarely makes payouts to its shareholders, continuing to invest on their
behalf and retained earnings are considered first in the ``pecking
order'' of funding. See Admati et al. (2014), for example.
---------------------------------------------------------------------------
Not only do banks have access to their own profits to become more
resilient, they can sell shares to investors at appropriate prices.
Other companies may be forced by debt covenants or prohibitive
borrowing costs to raise equity when they are distressed. For banks,
action must come from regulators. Banks unable to raise equity at any
price fail a basic market ``stress tests'' and might be too opaque or
not viable without subsidies. Such banks are unhealthy and must be
dealt with promptly.
The Fed justifies allowing banks to make payouts to their
shareholders on the basis of ``stress tests.'' This methodology uses
models to predict regulatory capital levels that mean little in actual
distress and especially in a crisis. The models are incapable of
predicting the within-system dynamics that might follow adverse
scenarios because the Fed does not have sufficient information on the
many layers of interconnectedness that go beyond single counterparty
exposures. Trusting models that should not be trusted has contributed
to the causes of the financial crisis. The lesson from the failures of
these models must be learned, particularly when there is no scarcity of
equity just for banks, and no justification for allowing them to live
as dangerously as they do. \37\
---------------------------------------------------------------------------
\37\ See Claims 13-14 in Admati and Hellwig (2014), attached, for
a brief discussion.
---------------------------------------------------------------------------
If banks deny that they benefit from implicit subsidies, moreover,
they cannot at the same time complain that their funding costs would
increase significantly if they must use more equity. \38\ The fact that
banks are anxious to make payouts to their shareholders rather than use
their profits for making worthy loans, even at their very low equity
levels, calls into question their motives and exposes the disconnect
between claims that higher equity requirements would prevent lending
and making payout to shareholders instead of using the funds to make
loans.
---------------------------------------------------------------------------
\38\ In that case, the only private cost is that banks might have
to pay more corporate taxes, but, as explained in Admati et al. (2013,
section 4.1), this is not a social cost, and the effect can anyway be
neutralized.
---------------------------------------------------------------------------
It is baffling that the Fed finds it appropriate, before it can
assert that the largest bank holding companies would not harm the
economy if they fail, to allow these institutions to make payouts to
shareholders that deplete their most reliable loss-absorbing capacity,
namely their equity. \39\ A significant increase in equity requirements
must be considered the most cost-effective way to make it less likely
that we face difficult choices when institutions become weak, as well
as to reduce the fragility of the system and many distortions. The Fed
has the responsibility and the ability to protect the public, yet as a
regulator, it has failed the public. On behalf of the public, I hope
you will take my comments into consideration and implore it to do
better. \40\
---------------------------------------------------------------------------
\39\ I have written many commentaries on this issue, see Anat
Admati, ``Dividends Can Wait Until the Banks Are Stronger'', Financial
Times, January 19, 2011, ``Only Recapitalized Banks Should Pay
Dividends'', a letter signed by 16 academics, Financial Times, February
15, 2011, Anat Admati, ``Fed Runs Scared With Boost to Bank
Dividends'', Bloomberg View, February 24, 2011, and ``Why the Bank
Dividends Are a Bad Idea'', Reuters, March 14, 2012. Admati and Hellwig
(2011, chapter 11) provide a more detailed explanation.
\40\ Other claims are made in response to such recommendations,
such as concerns about the so-called shadow banking system or about the
competitiveness of our banks. These concerns are invalid excuses, as
explained in Admati and Hellwig (2013a, chapters 12 and 13) and Claims
26-28 in Admati and Hellwig (2014), attached.
---------------------------------------------------------------------------
References\41\
Admati, Anat R. (2014), ``The Compelling Case for Stronger and More
Effective Leverage Regulation in Banking'', Journal of Legal
Studies, forthcoming.
---------------------------------------------------------------------------
\41\ Most of the references (at least in working paper form) are
available online. My own academic papers and other writings on the
topic are posted at http://www.gsb.stanford.edu/news/research/
admati.etal.html.
---------------------------------------------------------------------------
Admati, Anat R., Peter M., DeMarzo, Martin F. Hellwig, and Paul
Pfleiderer (2013), ``Fallacies, Irrelevant Facts, and Myths in the
Discussion of Capital Regulation: Why Bank Equity Is Not Socially
Expensive'', Working paper; and (2014), ``The Leverage Ratchet
Effect'', Working paper.
Admati, Anat R., and Martin F. Hellwig (2013a), ``The Bankers' New
Clothes: What's Wrong With Banking and What To Do about It'',
Princeton University Press. (Excerpts and links available at http:/
/bankersnewclothes.com/.)
Admati, Anat R., and Martin F. Hellwig (2013b), ``Does Debt Discipline
Bankers? An Academic Myth About Bank Indebtedness'', Working paper
(based on a chapter omitted from Admati and Hellwig (2013a).
Admati, Anat R., and Martin F. Hellwig (2014), ``The Parade of Bankers'
New Clothes Continues: 28 Flawed Claims Debunked'', available at
http://bankersnewclothes.com/wp-content/uploads/2014/07/Parade-
continues-July-2014.pdf.
Bair, Sheila (2012), ``Bull by the Horns: Fighting To Save Main Street
From Wall Street and Wall Street from Itself'', Free Press.
Barofsky, Neil (2012), ``Bailout: An Inside Account of How Washington
Abandoned Main Street While Rescuing Wall Street'', Free Press.
Brandao, Luis Marques, Ricardo Correa, and Horacio Sapriza (2013),
``International Evidence on Government Support and Risk Taking in
the Banking Sector'', IMF Working Paper WP/13/94.
Cole, Rebel A. (2013), ``How Did the Financial Crisis Affect Business
Lending in the U.S.?'' Working paper.
Davies, Richard, and Belinda Tracy (2014), ``Too Big To Be Efficient?
The Impact of Implicit Subsidies on Estimates of Scale Economies in
Banking'', Journal of Money, Credit and Banking, 219-253. (Working
paper version dated 2012 available online.)
Fraser, Ian (2014), Shredded: Inside RBS, the Bank That Broke Britain,
Birlinn; ``Too Big To Be Efficient? The Impact of Implicit
Subsidies on Estimates of Scale Economies in Banking'', Journal of
Money, Credit and Banking.
Gandhi, Priyank, and Hanno Lustig (2014), ``Size Anomalies in U.S. Bank
Stock Returns'', Journal of Finance, Forthcoming. (Working paper
dated 2012 available on SSRN.com.)
Kelly, Bryan, Hanno Lustig, and Stijn Van Niewerburgh (2012), ``Too-
Systemic-To-Fail: What Option Markets Imply About Sector-Wide
Government Guarantees'', Working paper.
Mayo, Mike (2011), ``Exile on Wall Street: One Analyst's Fight To Save
the Big Banks From Themselves'', John Wiley and Sons.
Omarova, Saula T. (2013), ``The Merchants of Wall Street: Banking,
Commerce, and Commodities'', Minnesota Law Review, 2-78.
Onaran, Yalman (2011), ``Zombie Banks: How Broken Banks and Debtor
Nations Are Crippling the Global Economy'', Bloomberg.
Skeel, David A., Jr. (2014), ``Single Point of Entry and the Bankruptcy
Alternative'', Working paper.
Skeel, David A., Jr., and Thomas H. Jackson (2012), ``Transaction
Consistency and the New Finance in Bankruptcy'', Columbia Law
Review, 152-202.
White, Lawrence J. (2014), ``The Basics of `Too Big To Fail' '',
Forthcoming in Paul H. Schultz, ed. Dodd-Frank and the Future of
Finance, MIT Press.
PREPARED STATEMENT OF DOUGLAS HOLTZ-EAKIN
President, American Action Forum
July 31, 2014
Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee, I am grateful for the privilege of appearing today. In my
brief testimony today I would like to make four main points:
Any expectations of Government support for bank holding
companies is at root a problem created by policymakers'
discretionary actions;
The history of Federal Government assistance is not a
pattern of consistent intervention on behalf of large firms,
but rather an erratic and unpredictable series of interventions
on behalf of firms large, small, financial, and nonfinancial;
Attempts to measure any ``implicit too-big-to-fail (TBTF)
subsidy'' is an elusive quest due to the many confounding
factors; and
Any market TBTF expectation is hardly fixed, but is
necessarily a changing reality.
To start, I should stipulate that I do not seek in this testimony
to specifically criticize or address the Government Accountability
Office report on Government support for bank holding companies, nor the
several other reports from other institutions on the same topic. Let me
also stipulate that no firm (financial or otherwise) should ever
benefit from an unfair advantage owing to policy-induced bias. Herein I
only hope to provide the Committee with a brief conceptual discussion
of some of the issues surrounding the question too big to fail (TBTF)
and implicit subsidies. \1\
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\1\ A longer discussion of these issues can be found in Satya
Thallam, ``Reconsidering Too Big To Fail'', American Action Forum,
Research, March 12, 2014, http://americanactionforum.org/research/
reconsidering-too-big-to-fail.
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The Policymaker-Creditor Nexus
What is too big to fail? \2\ It is not a market failure, like an
externality; it ``is a rational market response to expectations set by
Government policy.'' \3\ The proximate beneficiaries of any perceived
bailout expectations (the banks) benefit passively--the ultimate source
of any implicit subsidy exists at the nexus of the banks' creditors and
expectations imputed from policymaker choices. As Minneapolis Fed
President Narayana Kocherlakota put it, the proper conception of too
big to fail ``emphasizes the role of creditor beliefs . . . The beliefs
of other parties are much less relevant.'' \4\
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\2\ Here I use the phrase ``too big to fail'' or ``TBTF''.
\3\ Supra, n. 1.
\4\ Narayana Kocherlakota, ``Too-Big-To-Fail: The Role of
Metrics'', Speech delivered at ``Quantifying the `Too Big to Fail'
Subsidy Workshop'', Federal Reserve Bank of Minneapolis, Minneapolis,
Minnesota, November 18, 2013, http://www.minneapolisfed.org/
news_events/pres/speech_display.cfm?id=5203.
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A creditor's belief that an institution will receive Government
support will be rooted in an expectation that policymakers will take
extraordinary steps to prevent contagion from one firm's failure to
spread to others. Financial interdependencies may be the transmission
mechanism for shocks to spread throughout a system, but policymakers
make the ultimate decision to intervene, creating the ex ante
expectation in the first place. Thus policymakers attempting to
eliminate any implicit TBTF subsidy will need to look to themselves--or
more specifically they will need to consider the rules and regulations
which open the door to future intervention, or even lead creditors to
believe intervention is forthcoming.
Unpredictability
The Federal Government has a dubious history of intervening in
times of economic distress to save certain firms or otherwise mitigate
their losses. Unfortunately for analysts and policymakers seeking to
determine the financial effects of these interventions, this history is
inconsistent, not hewing to any rule or regularity. In the most recent
financial crisis, the Federal Government's response swung from pillar
to post, intervening (Bear Stearns), then not (Lehman Brothers),
intermittently providing assistance to investment banks, banks large
and small (TARP), investment funds, and automakers (GM and Chrysler).
If we go further back, we see intervention on behalf of a large,
conventional commercial bank (Continental Illinois), a not particularly
large or major money center institution (Long Term Capital Management),
savings and loans, airlines, and even a city (New York City). \5\ It's
the very breadth and variety of these interventions (not to mention the
extreme infrequency relative to the gross number of large firm failures
during the same period) that should lead one to be skeptical of claims
purporting a robust relationship between certain firms' insolvency and
Government rescue.
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\5\ Jesse Nankin and Krista Kjellman Schmidt, ``History of U.S.
Gov't Bailouts'', ProPublica April 15, 2009, http://www.propublica.org/
special/government-bailouts.
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And yet, even this incomplete list understates the highly
heterogeneous nature of interventions. Loans, loan guarantees, capital
infusions, stock purchases and warrants, direct transfers--all
interventions are not born the same, and more to the point, have
differing effects on different parties.
The larger point is that if, for example, investors in a bank
holding company's bonds are pricing in a discount (lower yield) owing
to some probability of a bailout conditional on insolvency, we must
presume those investors have determined the likelihood not only that
policymakers will in fact intervene, but that they have also correctly
identified the firm that will receive assistance, and that the
intervention will benefit them as opposed to shareholders, executives,
employees, or even other classes of debtholders. Indeed, as we saw in
the Chrysler bailout, some bondholders were in fact made worse off. \6\
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\6\ Todd Zywicki, ``The Auto Bailout and the Rule of Law'',
National Journal, No. 7, Spring 2011, http://www.nationalaffairs.com/
publications/detail/the-auto-bailout-and-the-rule-of-law.
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Confounding Factors
One prevailing line of thinking points to the fact that large
financial institutions can borrow more cheaply relative to smaller
ones, and thus this differential is evidence of TBTF. But there are
many factors that affect the funding costs of various institutions.
This large-small differential in fact exists across most industries,
with the banking industry somewhere near the middle. \7\ Differences in
the liquidity of debt, risk diversification, information limitations,
and other factors may explain much or all of the differential. That
said, there still might be a part of the differential that cannot be
explained by size-dependent factors--a TBTF subsidy may still be
embedded. But any attempt to quantify the TBTF subsidy using cost of
funding will need to successfully separate out the non-TBTF factors,
which is exceedingly difficult and perhaps even impossible.
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\7\ Randall Kroszner, ``A Review of Bank Funding Differentials'',
Presented at ``Too Big to Fail and Its Implications on Bank Funding
Costs'', NYU School of Business, October 8, 2013, http://
www.stern.nyu.edu/cons/groups/content/documents/webasset/
con_044532.pdf.
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If a TBTF subsidy does exist, it stands to reason that it exists on
a continuum, rather than simply as a binary condition between those
firms that are TBTF and those that are absolutely not. Thus properly
determining the subsidy portion of the differential is beside the point
if one cannot properly identify the two categories of institutions.
Changing Expectations
The yield spread between firms may be ever changing; indeed, it has
at times even become negative. \8\ As it changes, one must conclude
either that: (1) the TBTF subsidy is in fact changing and transferring
among institutions over time; \9\ (2) the yield spread attributable to
TBTF is being swamped by other effects; or (3) the yield spread is not
a reliable measure of the TBTF subsidy.
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\8\ Steve Strongin, et al., ``Measuring the TBTF Effect on Bond
Pricing'', Goldman Sachs Global Markets Institute, May 2013, http://
www.goldmansachs.com/our-thinking/public-policy/regulatory-reform/
measuring-tbtf-doc.pdf. See also Kroszner 2013, supra.
\9\ Kenichi Ueda and Beatrice Weder di Mauro, ``Quantifying
Structural Subsidy Values for Systemically Important Financial
Institutions'', IMF Working Paper 12/128, May 2012, http://www.imf.org/
external/pubs/ft/wp/2012/wp12128.pdf.
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Consider what bank investors and creditors must have thought about
the likelihood of rescue following the collapse of Bear Stearns as
compared to after the collapse of Lehman Brothers. In just 1 year,
real-time policy choices must have drastically changed the implied TBTF
subsidy. Thus the outcome of any TBTF study will be directly affected
by the window of time chosen to examine. But the larger point is that
any policy chosen now or in the near future as a TBTF corrective may be
(in the best case scenario) appropriately targeted for some fixed state
of the world, but cannot easily adjust to changing conditions. In the
extreme, would such a policy corrective (such as a tax) become a refund
if and when the TBTF subsidy reverses?
Final Thoughts
Two wrongs do not make a right. Even if we presume the existence of
a consistent and significant TBTF subsidy, one must consider the net
effect of applying another distortion on top of the first. That is,
proposed solutions such as a bank tax or a financial transactions tax
applied to TBTF institutions are attempting to counteract a distorting
dynamic created by policymaker expectations and creditors' response
with a punitive measure which works along a somewhat different channel.
Discretion is the handmaiden of bailouts. Time consistency in
policymaking is an age-old problem and is not limited to financial
crises. \10\ Congress should focus its energy on those mechanisms
which: (1) make bank failures easier and predictable; and (2) limit
policy choices even in a time of crisis.
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\10\ See Finn Kydland and Edward Prescott, ``Rules Rather Than
Discretion: The Inconsistency of Optimal Plans'', Journal of Political
Economy, Vol. 85, Iss. 3, pp. 473-492, June 1977. The difficulty of
time-consistent plans are illustrated by a recent report which stated:
``If the only choices are between bailout and fire-sale liquidations or
value-destroying reorganizations that can result in a contagious panic
and collapse of the financial system, responsible policymakers
typically choose bailout as the lesser of two evils.'' John Bovenzi,
Randall Guynn, and Thomas H. Jackson, ``Too Big to Fail: The Path to a
Solution'', Report of the Failure Resolution Task Force of the
Financial Regulatory Reform Initiative, Bipartisan Policy Center, May
2013, p. 43.
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One particularly promising avenue in this regard is to replace
Title II of the Dodd-Frank Act with a bankruptcy process for banks.
This would place decisions in the hands of a court, and not either an
agency or the Congress. In the process it would limit discretion and
clarify the outlook for creditors.
The Dodd-Frank Act happened. Whether one considers the Dodd-Frank
Act a positive or negative change to financial regulation, there is
little argument that it has a significant effect on financial
institutions. This includes numerous new requirements and restrictions
on the industry, many of them directed specifically at the largest bank
holdings companies. The upshot is that any perceived advantages must be
considered on net with any of these new costs.
Thank you and I look forward to answering your questions.
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
FROM LAWRENCE EVANS
Q.1. GAO used wide-ranging data and a number of models to
estimate the various funding cost differences in its study.
Will GAO make the full documentation of its data, coding,
methodology, etc., available to third parties--either for free
or at cost--so that independent experts can examine the data a
processes to make their own evaluations and draw their own
conclusions?
A.1. While GAO is not subject to the Freedom of Information
Act, its disclosure policy follows the spirit of the act
consistent with GAO's duties and responsibilities to the
Congress. Upon written request, GAO may provide GAO records
associated with this engagement to parties wishing to replicate
our work. However, please be advised that certain exemptions to
disclosure apply and GAO does not release certain information
including proprietary and trade secret data. See 4 CFR 81.5
and 4 CFR 81.6. \1\ Interested parties should submit their
request in writing to GAO's Chief Quality Officer. The request
may be emailed to [email protected], faxed to (202) 512-
5806, or mailed by traditional mail.
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\1\ For information concerning fees and charges, please see 4 CFR
81.7.
Q.2. Has GAO released any information--such as a list of
meetings, conference calls, and other conversations--regarding
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the parties with whom you consulted in preparing this report?
A.2. No, GAO has not released indentifying information on the
parties interviewed for the report. \2\ The Objectives Scope
and Methodology section of the report discloses only that we
conducted interviews with representatives from credit rating
agencies, investment firms, and corporations that are customers
of banks, bank holding companies of various sizes, bank
industry associations, public interest groups, academics, and
other experts.
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\2\ As per our protocols, for any ongoing work--except for
classified work and investigations--GAO will disclose, if asked (e.g.,
by Members, congressional staff, agencies, or the press) the source of
the request and the project's objectives, scope, and methodology.
Additionally, all congressional offices have, through the Senate and
House intranet connections to GAO, access to the background and key
research questions for active GAO assignments, except for those cases
where the reporting of such work would result in disclosing classified
or other sensitive information. The information we volunteer would not
include the detailed information on the parties we selected for
interview.
Q.3. Would you be willing to provide such information,
---------------------------------------------------------------------------
including the party initiating the contact?
A.3. Yes, GAO will grant Members, upon their written request,
access to the available information at GAO offices or will
provide copies of such lists. The Objectives, Scope, and
Methodology Section of the report details the criteria we used
to select parties to interview.
Additional Information To Correct the Record
During the hearing Chairman Brown stated,
GAO used three industry-funded studies to design this
report . . .
For the record, this is inaccurate. To inform our
econometric approach and understand the breadth of results and
methodological approaches, we reviewed 16 studies--1 of which
was conducted by researchers at a large bank holding company
and two others that were sponsored by a trade group
representing large commercial banks. Taking into consideration
the strengths and limitations of different methodologies, we
developed our own econometric approach. We then selected three
experts with relevant expertise to review our methodology and
assess its strengths and limitations. These experts reviewed
our approach before we implemented it and provided comments. In
many instances, we made changes or additions to our models to
address their comments, and in other instances, we disclosed
additional limitations of the models. Before selecting these
experts, we reviewed potential sources of conflicts of
interest, and we determined that the experts we selected did
not have any material conflicts of interest for the purpose of
reviewing our work. Note well, the GAO approach was influenced
most significantly by the research conducted by Dr. and his
colleagues.
During the hearing Chairman Brown stated
. . . and the GAO arranged meetings with corporate
treasurers of companies suggested exclusively--I
believe exclusively--by the U.S. Chamber of Commerce .
. .
GAO--not the Chamber of Commerce--indentified firms we
planned to contact. At GAO's request, the Chamber informed its
members that GAO was reaching out to corporate customers of
banks. GAO then contacted and interviewed four of the member
firms that expressed interest and met our criteria. We
subsequently selected two additional firms to achieve further
diversity across industry sectors. Note, GAO selected U.S.
corporations from different industry sectors and with a range
of banking needs. These corporate treasurers provided a diverse
set of views on the issue.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
FROM DOUGLAS HOLTZ-EAKIN
Q.1. During the hearing, I asked all of the witnesses about the
ratings ``uplift'' given to banks by ratings agencies as a
result of perceived Government support. In response, you said
that ``recently most if not all the major credit agencies have
removed the credit uplifts . . . If you care about `too big to
fail' now and 2013, '14, it's gone from that perspective.''
It is true that Moody's recently removed the uplift for the
holding company debt of the eight U.S. G-SIBs, while
maintaining its assumption of support for bank-level senior
debt. However, S&P released a report on August 4th--after the
Subcommittee hearing--titled ``U.S. Banks: Government Support
Is Fading But Not Gone--Yet.'' In it, they maintain a 1-2 notch
uplift for the U.S. G-SIBs. In March, Fitch Ratings also
released support ratings for some U.S. G-SIBs that ``reflect
Fitch's expectation that there remains an extremely high
probability of support from the U.S. Government (rated `AAA',
Rating Outlook Stable) if required. This expectation reflects
the U.S.'s extremely high ability to support its banks
especially given its strong financial flexibility, though
propensity is becoming less certain.''
Would you care to amend or revise your response to the
question in any way?
A.1. Thank you for bringing these more recent data to my
attention. The Moody's report indicates that the basic trend
toward no Government support remains, but that the pace is
slower than I had estimated and markets may not as yet have
fully reflected these developments as I had anticipated.
Additional Material Supplied for the Record
CHARTS SUBMITTED BY CHAIRMAN SHERROD BROWN
REPORT SUBMITTED BY THE GOVERNMENT ACCOUNTABILITY OFFICE
COMMENTS REGARDING THE ``GAO REPORT ON LARGE BANK HOLDING COMPANIES'',
BY ALLAN H. MELTZER