[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]
ENDING ``TOO BIG TO FAIL:''
WHAT IS THE PROPER ROLE OF
CAPITAL AND LIQUIDITY?
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTEENTH CONGRESS
FIRST SESSION
__________
JULY 23, 2015
__________
Printed for the use of the Committee on Financial Services
Serial No. 114-45
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HOUSE COMMITTEE ON FINANCIAL SERVICES
JEB HENSARLING, Texas, Chairman
PATRICK T. McHENRY, North Carolina, MAXINE WATERS, California, Ranking
Vice Chairman Member
PETER T. KING, New York CAROLYN B. MALONEY, New York
EDWARD R. ROYCE, California NYDIA M. VELAZQUEZ, New York
FRANK D. LUCAS, Oklahoma BRAD SHERMAN, California
SCOTT GARRETT, New Jersey GREGORY W. MEEKS, New York
RANDY NEUGEBAUER, Texas MICHAEL E. CAPUANO, Massachusetts
STEVAN PEARCE, New Mexico RUBEN HINOJOSA, Texas
BILL POSEY, Florida WM. LACY CLAY, Missouri
MICHAEL G. FITZPATRICK, STEPHEN F. LYNCH, Massachusetts
Pennsylvania DAVID SCOTT, Georgia
LYNN A. WESTMORELAND, Georgia AL GREEN, Texas
BLAINE LUETKEMEYER, Missouri EMANUEL CLEAVER, Missouri
BILL HUIZENGA, Michigan GWEN MOORE, Wisconsin
SEAN P. DUFFY, Wisconsin KEITH ELLISON, Minnesota
ROBERT HURT, Virginia ED PERLMUTTER, Colorado
STEVE STIVERS, Ohio JAMES A. HIMES, Connecticut
STEPHEN LEE FINCHER, Tennessee JOHN C. CARNEY, Jr., Delaware
MARLIN A. STUTZMAN, Indiana TERRI A. SEWELL, Alabama
MICK MULVANEY, South Carolina BILL FOSTER, Illinois
RANDY HULTGREN, Illinois DANIEL T. KILDEE, Michigan
DENNIS A. ROSS, Florida PATRICK MURPHY, Florida
ROBERT PITTENGER, North Carolina JOHN K. DELANEY, Maryland
ANN WAGNER, Missouri KYRSTEN SINEMA, Arizona
ANDY BARR, Kentucky JOYCE BEATTY, Ohio
KEITH J. ROTHFUS, Pennsylvania DENNY HECK, Washington
LUKE MESSER, Indiana JUAN VARGAS, California
DAVID SCHWEIKERT, Arizona
FRANK GUINTA, New Hampshire
SCOTT TIPTON, Colorado
ROGER WILLIAMS, Texas
BRUCE POLIQUIN, Maine
MIA LOVE, Utah
FRENCH HILL, Arkansas
TOM EMMER, Minnesota
Shannon McGahn, Staff Director
James H. Clinger, Chief Counsel
C O N T E N T S
----------
Page
Hearing held on:
July 23, 2015................................................ 1
Appendix:
July 23, 2015................................................ 49
WITNESSES
Thursday, July 23, 2015
Calomiris, Charles W., Henry Kaufman Professor of Financial
Institutions, Columbia University Graduate School of Business.. 5
Chakravorti, Sujit ``Bob,'' Managing Director and Chief
Economist, The Clearing House Association L.L.C................ 7
Michel, Norbert J., Research Fellow in Financial Regulations, The
Heritage Foundation............................................ 10
Parsons, John E., Senior Lecturer, Sloan School of Management,
Massachusetts Institute of Technology.......................... 8
APPENDIX
Prepared statements:
Calomiris, Charles W......................................... 50
Chakravorti, Sujit ``Bob''................................... 64
Michel, Norbert J............................................ 74
Parsons, John E.............................................. 85
ENDING ``TOO BIG TO FAIL:''
WHAT IS THE PROPER ROLE OF
CAPITAL AND LIQUIDITY?
----------
Thursday, July 23, 2015
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 10:04 a.m., in
room 2128, Rayburn House Office Building, Hon. Jeb Hensarling
[chairman of the committee] presiding.
Members present: Representatives Hensarling, Royce, Lucas,
Garrett, Neugebauer, Pearce, Posey, Luetkemeyer, Huizenga,
Duffy, Hurt, Stivers, Fincher, Stutzman, Mulvaney, Hultgren,
Ross, Pittenger, Barr, Rothfus, Messer, Schweikert, Guinta,
Tipton, Williams, Poliquin, Love, Hill, Emmer; Waters, Sherman,
Hinojosa, Lynch, Scott, Himes, Foster, Kildee, Delaney, Sinema,
Beatty, Heck, and Vargas.
Chairman Hensarling. The Financial Services Committee will
come to order.
Without objection, the Chair is authorized to declare a
recess of the committee at any time.
Today's hearing is entitled, ``Ending `Too Big to Fail':
What is the Proper Role of Capital and Liquidity?''
I now recognize myself for 5 minutes to give an opening
statement.
I woke up, I guess it was the day before yesterday, to an
article in one of the Hill publications, I think it was
Politico. The article dealt with the Dodd-Frank Act, since we
have either celebrated or bemoaned the fifth anniversary of
Dodd-Frank. The subtitle to the article was, ``Suddenly,
Democrats are resisting any changes to the 5-year-old financial
regulation law.'' The article goes on to say that a number of
moderate Democrats are quite frustrated that their leadership
is preventing them from engaging in meaningful bipartisan work
on the issue.
I do not know the article to be accurate. It certainly
feels like it, from this position, from this Chair. I just want
to again say publicly what I have said privately to my friends
on the other side of the aisle: The Majority stands ready to
work with you to clarify, to improve, and to deal with any
unintended consequences of the law.
Both Mr. Dodd and Mr. Frank have previously indicated areas
of the law that they would work on to improve. I trust that
they continue to be Democrats in good standing. I would hope
you could be a Democrat in good standing and work with the
Majority. I hope there is not a knee-jerk ideological reaction
to anything that deals with Dodd-Frank. Again, but it certainly
feels that way.
I guess, to some extent, though, there is good news,
because today's topic, capital and liquidity, is barely
mentioned in Dodd-Frank. There is a differentiation where Dodd-
Frank empowers the regulators, who already had, pre-Dodd-Frank,
the authority to set prudent capital and liquidity standards.
They provide for a differential for SIFIs. But outside of that,
they are largely silent on the issue.
And regardless of what you believe to be the genesis of the
financial crisis, I think we can all agree, looking through the
rearview mirror, that clearly, capital and liquidity standards
were insufficient, to put it mildly.
Prior to the crisis, there were very complex, risk-based
capital standards in place. And in implementing these various
complex, risk-based capital standards--as we know, they were
principally designed by the Basel Committee out of Switzerland.
And regulators in both the United States and in Europe were
essentially encouraged to crowd in to both mortgage-backed
securities and sovereign debt. Think Fannie Mae, Freddie Mac,
and Greek bonds.
Thus, rather than mitigating financial instability, as the
capital standards were intended to do, it appears that Basel
helped fuel the financial instability, rather than continue
with Basel help concentrated.
Now since the crisis, U.S. banks have raised more than $400
billion in new capital, and regulators have required
institutions to maintain higher capital buffers--again, an
authority they possessed pre-Dodd-Frank. I, for one, believe
that generally, this is a good thing. But the capital standards
that were already complex have become even more complex with
Basel III. I do not necessarily believe this to be a good
thing.
Again, relying on regulators to calibrate risk and predict
future economic conditions according to highly complex models,
models that neither market participants nor regulators
themselves fully understand, clearly appears to be a recipe for
financial crisis. We have seen the danger of one global view of
risk.
So there are a number of questions that this committee must
explore. Although capital and liquidity standards have
increased post-crisis, do we really know by how much? How
opaque do balance sheets still appear? How many items that were
once off-balance-sheet will find their way back onto balance
sheet? What amount of capital is the proper amount? Too much,
economic growth can stall; too little, and too many failures
could yet ensue.
So at today's hearing, we will explore, is there a better
way? For example, are we better off measuring capital adequacy
according to a more straightforward leverage ratio, which takes
discretion away from regulators and seeks to give greater
weight to market forces in allocating resources and achieving
financial stability?
Are there specific forms of capital, such as those that
convert debt to equity? In the event of predetermined market
triggers, could they promote greater market discipline and
better risk management at large, complex financial
institutions?
And to help us with these questions, we have assembled a
panel of noted experts, and I certainly look forward to hearing
their testimony.
The Chair now recognizes the gentleman from California, Mr.
Sherman, for 2 minutes.
Mr. Sherman. Thank you.
I notice here in the audience is Marc Shultz, who up until
recently was sitting behind me. Marc is now with the Office of
Financial Research, which is housed in Treasury and advises the
FSOC.
And, Marc, I just want to say for the record, you didn't
stop working for me; I just stopped paying you.
You know, Mr. Chairman, the title of this hearing begins
with the words ``Ending Too Big to Fail.'' The best approach to
end ``too-big-to-fail'' is to end ``too-big-to-fail.'' The
title should not be, ``Strengthening Too-Big-to-Fail,''
``Improving Too-Big-to-Fail,'' ``Better Governing Too-Big-to-
Fail, ``Watching Too-Big-to-Fail,'' or ``Scrutinizing Too-Big-
to-Fail.'' We have to end ``too-big-to-fail.''
That is why you ought to join me and Senator Bernie Sanders
in sponsoring legislation to say ``too-big-to-fail'' is too big
to exist; break them up.
And, Mr. Chairman, this is not a bill supported only by
Socialists. It is a bill supported by the ICBA, which
represents 90 percent of the bankers in this country, or 90
percent of the banks in this country, most of whom are not
Socialists.
Until we end ``too-big-to-fail,'' we will be having
ineffective hearings on how to watch the ``too-big-to-fail.''
They enjoy a basis-point advantage when they seek capital, so
they are going to keep getting bigger and bigger. They are
going to put regional banks at a disadvantage. That is why the
ICBA endorses this bill, and I hope very much that the chairman
will, as well, but I am not holding my breath.
The fact is that when we classify entities as SIFIs or
``too-big-to-fail,'' we should be focusing on their
liabilities. Lehman Brothers did not fail because it had too
many assets. And that is why, when they start classifying as
SIFIs organizations that have no liabilities, whose failure
would not leave a single creditor without being paid, then I
think it is just a desire by the regulators to regulate anybody
that is big and juicy.
Instead, we ought to be breaking up those entities whose
actual and contingent liabilities are of such a magnitude that
if they fail to pay those liabilities, they take the economy
down with them.
I yield back.
Chairman Hensarling. The gentleman yields back.
The Chair now recognizes the ranking member for 3 minutes
for an opening statement.
Ms. Waters. Thank you, Mr. Chairman.
Over the years, as this committee has debated, passed, and
overseen the implementation of the Dodd-Frank Wall Street
Reform Act, we have heard a number of doomsday scenarios about
the consequences of new liquidity and capital requirements for
financial institutions. Well, as we celebrate the 5-year
anniversary of Dodd-Frank and as these requirements have gone
into effect, I am pleased to report that the world hasn't
ended.
Today, our financial markets are stable and secure. Banks
are making record profits. Lending is up. And we have a
financial system that is stronger, safer, and more resilient
than ever before.
Prior to the financial crisis, regulators were asleep at
the switch. As banks leveraged up and concentrated their
activities in risky mortgages while being allowed to rely on
their own risk models, bank executives made huge bonuses on
these short-term gains, but when the music stopped, it was
taxpayers who took the losses.
Dodd-Frank mandates that regulators work together to
closely monitor the Nation's large banks, setting a floor for
capital and liquidity standards to ensure financial companies
are risking their own capital rather than taxpayer money. Just
this week, regulators finalized a rule that would require even
higher capital standards at the largest globally systemic banks
that actively seek out the riskiest lines of business.
While the implementation of Dodd-Frank is incomplete, it is
already working. A staff report by committee Democrats,
released this week, found that Dodd-Frank has made our
financial system more transparent, more stable, and more
accountable by arming our regulators with vital tools to
monitor the financial system for risk, increase transparency,
and institute new investor protections.
And to make certain this approach is not overly onerous,
Dodd-Frank has created a flexible and tiered regulatory
framework to ensure these heightened standards are tailored to
banks of different sizes.
Since the passage of Wall Street reform, the American
economy has stabilized, adding around 12.8 million private-
sector jobs over 64 consecutive months of job growth, dropping
the unemployment rate from its peak of 10 percent in 2009 to
5.3 percent currently.
Mr. Chairman, when discussing the proper role of capital
and liquidity, it is important to keep in mind that today our
financial system is safer and stronger than it has been in a
generation, regardless of the claims we hear from the most
fervent opponents.
I thank you, and I yield back the balance of my time.
Chairman Hensarling. The gentlelady yields back.
We are all familiar with the celebrated question, ``Is
there a doctor in the house?'' Today, we appear to have four of
them at the witness table.
So, going left to right, today we will welcome the
testimony of Dr. Charles Calomiris, who is the Henry Kaufman
Professor of Financial Institutions at the Columbia University
Graduate School of Business. His research spans several areas
including banking, corporate finance, financial history, and
monetary economics. He received a B.A. from Yale University,
and a doctorate in economics from Stanford.
Our next witness, Dr. Bob Chakravorti, is the managing
director and chief economist of The Clearing House Association.
He was previously a senior economist at the Federal Reserve
Banks of Chicago and Dallas. He is the author of more than 40
articles for industry, academic, and Fed publications. He
received his Ph.D. and M.A. in economics from Brown University,
and his B.A. from UC Berkeley.
Next, Dr. John Parsons is a senior lecturer at the Sloan
School of Management at MIT. He previously worked at the
economics consulting firm of CRA International, where he was a
vice president and principal. He earned his B.A. from
Princeton, and a Ph.D. in economics from Northwestern
University.
Finally, Dr. Norbert Michel is a research fellow in
financial regulations at The Heritage Foundation. He previously
taught finance, economics, and statistics at Nicholls State
University's College of Business. He holds a B.A. from Loyola
University, and a doctorate in financial economics from the
University of New Orleans.
I do not recall if all of you all have testified before. If
not, we have this lighting system: green means go; when the
yellow light comes on, it means you have a minute left; and red
means stop. Each of you will be recognized for 5 minutes to
give an oral presentation of your testimony, and without
objection, each of your written statements will be made a part
of the record.
Professor Calomiris, you are now recognized for your
testimony.
STATEMENT OF CHARLES W. CALOMIRIS, HENRY KAUFMAN PROFESSOR OF
FINANCIAL INSTITUTIONS, COLUMBIA UNIVERSITY GRADUATE SCHOOL OF
BUSINESS
Mr. Calomiris. Chairman Hensarling, Ranking Member Waters,
and members of the committee, it is a pleasure and an honor to
share my thoughts on the ``too-big-to-fail'' problem and, more
generally, the problems of bank instability, credit collapses,
and financial burdens on taxpayers that result from private
risk-taking at public expense.
Title II of Dodd-Frank is supposed to ensure orderly
liquidation of ``too-big-to-fail'' banks, now called SIFIs, but
is more likely to institutionalize bailouts by establishing
specific procedures through which they will occur. Rather than
pretending that we will have the legal mechanisms and political
will to liquidate SIFIs, we should focus on preventing them
from becoming insolvent. That means focusing on the adequacy of
bank capital and cash.
Book equity is a poor measure of the true value of equity.
When banks suffer losses on tangible assets, such as loans,
they typically delay loss recognition. Overstating equity
capital allows them to avoid curtailing risky activities.
Furthermore, the book value of equity does not capture losses
of intangible assets. Lost servicing income, other fee income,
and reduced values of relationships with depositors and
borrowers have been the primary drivers of loss in bank values
since 2006.
We should raise equity capital ratio requirements further,
but we cannot rely only on book equity ratios to measure bank
health. We need to measure the economic value of equity and put
in place reliable regulatory requirements which ensure that
banks will maintain adequate and meaningfully measured equity
capital.
I propose requiring alongside a book equity requirement
that large banks maintain a substantial proportion of funding
in contingent convertible debt, CoCos, that converts into
equity on a dilutive basis when the market value of equity
persistently falls below 10 percent of assets. Dilution ensures
that bank managers face strong incentives to replace lost
equity in a timely manner to avoid the dilutive conversion of
CoCos.
Bank CEOs would have a strong incentive to maintain a
significant buffer of equity value above the 10-percent
trigger. They would increase that buffer voluntarily if the
riskiness of banks' assets rose, resulting in a self-enforcing,
risk-based equity requirement based on credible self-
measurement of risk, in contrast to the current system of risk-
measurement gaming by banks.
This CoCos requirement would virtually preclude SIFI
bailouts. Bailouts cannot occur if banks remain very distant
from the insolvency point.
Additionally, stress tests could be a promising means of
encouraging bankers to think ahead, but, as they are
structured, stress tests are a Kafkaesque Kabuki drama in which
SIFIs are punished for failing to meet unstated standards. That
not only violates the rule of law, the protection of property
rights, and adherence to due process; it makes stress tests a
source of uncertainty rather than a helpful guide to
identifying unanticipated risks.
And the penalties for failing a stress test are wrong.
Limiting dividends makes sense for a capital-impaired bank but
not for a healthy bank in compliance with all its regulatory
requirements. In that case, it is inappropriate to try to
decide the dividend decision for the board of directors.
Finally, the stress-testing standards currently being
applied are not very meaningful.
We can do much better. The Fed should be required to
provide clear guidance. Stress tests should be an input into
capital requirements, not used to control dividend decisions.
Finally, stress tests should focus on the loss of economic
value, by analyzing consequences for bank cash flows, divided
by line of business, using data from bank managerial accounts.
That is not happening now.
Liquidity requirements are another good idea being
implemented poorly. A better, simpler approach would require
SIFIs to maintain reserves at the Fed of 25 percent of their
debt. To avoid turning that into a tax, reserves should bear
market interest. This would require banks to hold a significant
proportion of their assets in riskless debt.
This would not bind on SIFIs today, given their huge excess
reserve holdings, nor would this have been binding in the early
1990s. But it would have been very helpfully binding on SIFIs
leading up to the recent crisis. Large banks held 25.8 percent
of their assets in cash form in January 1994. That fell to 17.2
percent by January 2001 and to 13.5 percent by January of 2008.
Applying to SIFIs the right combination of regulations
governing book equity, CoCos, stress tests, and reserves would
virtually eliminate the risk of ``too-big-to-fail'' bailouts.
But that is not the only bank bailout risk we face. The
most important source of systemic risk for small banks, the
ones that cost us so much in both the 1980s and the 2000s with
their cost of failure, one that was visible both in the 1980s
and the 2000s, was their excessive exposure to real estate
lending. Real estate risk is highly correlated, and it is hard
to shed in a downturn.
As of January 2008, roughly three-quarters of small-bank
lending was in real estate loans. Large banks had lower
exposures but still very large ones. The obvious answer is to
limit bank real estate lending, forcing real estate financing
to emigrate to REITS, insurance companies, and other more
natural providers of real estate finance.
These reforms not only would virtually eliminate the ``too-
big-to-fail'' problem; they would stabilize the entire banking
system, protect taxpayers, reduce regulatory uncertainty, and
improve the performance of banks.
Thank you for your attention.
[The prepared statement of Dr. Calomiris can be found on
page 50 of the appendix.]
Chairman Hensarling. Thank you.
Dr. Chakravorti, you are now recognized for 5 minutes for
your testimony.
STATEMENT OF SUJIT ``BOB'' CHAKRAVORTI, MANAGING DIRECTOR AND
CHIEF ECONOMIST, THE CLEARING HOUSE ASSOCIATION L.L.C.
Mr. Chakravorti. Chairman Hensarling, Ranking Member
Waters, and members of the committee, thank you for inviting me
to testify today on the critical topic of capital in the
banking system.
My name is Bob Chakravorti, and I am the chief economist at
The Clearing House, where I oversee empirical studies on
financial regulations. The Clearing House is a nonpartisan
organization that represents the interests of our owner banks
by developing and promoting policies to support a safe, sound,
and competitive banking system. I appreciate the opportunity to
share my observations on regulation of bank capital.
The strength and resilience of the American banking system
are essential. Banks serve as unique financial intermediaries
between those who save and those who borrow and those who are
unwilling to take risk and those who are willing to bear risk
for a price. Our modern economy relies on banks to provide
these critical financial intermediation functions.
Next, I will offer five key observations.
First, robust capital requirements are clearly an essential
tool for promoting the safety and soundness of individual
institutions and enhancing the stability of the financial
system as a whole. Simply put, capital acts as a cushion that
can absorb potential losses from all activities in which banks
engage. That, in turn, supports their strength and resilience.
Second, very significant improvements to the regulation of
bank capital have occurred since 2008, including measures
proactively adopted by banks themselves. Between early 2008 and
late 2014, the largest bank holding companies more than doubled
the amount of their common equity Tier 1 capital relative to
risk-weighted assets and substantially increased their leverage
ratio.
U.S. regulators have similarly responded to the crisis by
rapidly overhauling the bank regulatory capital framework,
including: increasing requirements for the quantity and quality
of capital; making various asset risk weights more
conservative; introducing capital stress-testing and
supplemental leverage ratio for larger banks; finalizing the
U.S. G-SIB surcharge earlier this week; and introducing a total
loss-absorbing capacity requirement, which is forthcoming.
In addition to these very significant improvements in bank
capital regulation, other parts of the regulatory landscape are
very different from what existed in 2007. Many of these
improvements are specifically designed to reduce systemic
risk--for example, a new comprehensive liquidity regime which
includes the liquidity coverage ratio, the upcoming net stable
funding ratio, and liquidity stress-testing. Taken together,
these measures reduce the probability of default and the
systemic impact of that default.
Third, along with these clear benefits, capital has costs.
As economists, we like to say there is no such thing as a free
lunch. My written statement details that, at some point,
increasing bank capital levels may result in a reduction in key
banking activities that support our overall economy, including
mortgage and small-business lending, commercial lending,
market-making, and other financial intermediation services.
Fourth, I wish there was a clear consensus around how much
capital is the right amount, but unfortunately, academics and
policymakers continue to disagree on this difficult question.
What is clear, however, is that there are tradeoffs. For
example, there is a tradeoff of the benefits of increased
financial stability at the expense of potential reduction in
economic growth. And there are competitive impacts for U.S.
banks in the global economy that are subject to capital
standards higher than internationally agreed upon.
Finally, as we wrestle with the question of how much
capital is enough and where we go from here, I urge you to take
into account the full consequences of the new regulatory
regime, particularly in terms of the downstream impact to the
real economy that have not been fully realized.
Additional empirical analysis is essential to inform these
decisions. This is a good time for policymakers to pause and
evaluate where we have landed in the tradeoff between financial
stability and the banking system's contribution to the U.S.
economy.
Thank you again for the opportunity to testify today. I
look forward to answering your questions.
[The prepared statement of Dr. Chakravorti can be found on
page 64 of the appendix.]
Chairman Hensarling. Dr. Parsons, you are now recognized
for 5 minutes for your testimony.
STATEMENT OF JOHN E. PARSONS, SENIOR LECTURER, SLOAN SCHOOL OF
MANAGEMENT, MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Mr. Parsons. Thank you, Chairman Hensarling, Ranking Member
Waters, and members of the committee. It is a pleasure to meet
here with you today and discuss this subject.
I think it is very interesting that there is significant
unanimity here that, in the last number of years, as the
chairman pointed out and others have, supervisors have
substantially improved bank capital requirements, and, in many
diverse ways, the analysis of capital in banking institutions
has been improved, which has made the system substantially
safer.
So maybe I should just pause for one moment about that
substantial agreement. I guess, as an economist, I have to
agree that there is no such thing as a free lunch. But there
are places you can get cheap eats, and when you do, you should
definitely go for them. So, in my opinion, we are nowhere near
worrying about major costs from these capital requirements to
the financial system.
Let me address very specifically one that has been floated
in the press for a number of years, and try to flesh out one or
two issues about that cost. There has been a lot of discussion
about perhaps liquidity in the corporate bond market has
declined and perhaps that decline has to do with the
regulations on banks and their inability to act as dealers.
So, first of all, what we really have heard in the press is
vague worries and discussions about this, identifications of
one or two statistics that have changed in the last number of
years, vague phrases that ``something'' has changed. So I have
a couple of points to say about those changes.
Certainly, some of those changes are a feature and not a
bug. When the banks have been asked to move their propriety
trading operations outside the bank and stop doing proprietary
trading, that is a good thing for the safety of the system, and
that trading can still go on. Hedge funds can still operate
outside of the banking system. But that trading is no longer
financed by a taxpayer backstop. How much trading is right to
be done is something that is determined by the costs and
benefits of that trading and the decisions of the individual
traders, but it is no longer subsidized by taxpayers. That is a
benefit to society and not a cost.
But it is also true that an awful lot of other things are
going on in the bond market right now. We have watched over the
last few decades how the equity markets have changed because
computing power and communication have transformed trading. We
have also noticed that that has happened in the U.S. Treasury
market dramatically over the last few years and seen the report
about last October's problem, because there are difficulties
when that happens. The trading is cheaper in this newer way,
but it has new problems.
The same thing is beginning to happen in the corporate bond
market. It is far from what has happened in Treasuries, but it
nevertheless is happening. That is technology changing. We need
to respond to that, we need to welcome it, and we need to watch
for the problems that it has. But it has nothing to do with
capital standards, and capital standards can't solve the
glitches that arise in doing it and make it more effective for
society.
So, that is one thing on the costs.
The other thing I wanted to raise out of my testimony is,
as we hear so many different capital standards thrown around,
one particular item that has been discussed that I think bears
fleshing out a little bit is stress tests and how important
stress tests are. Several of us agree about that, as well.
I just want to highlight two ways in which stress tests are
very important. First of all, they are very forward-looking,
which is something we need and we all agree is needed. Second
of all, they allow you to question, sort of, convenient
assumptions that are relatively weak in important ways.
Some people criticize stress tests the way the Fed has
applied them because they have been ``vague.'' But really what
the Fed is doing is inviting bank officers to come to the table
and provide leadership about what kinds of things we should be
worrying about, provide leadership in identifying the major
risks and showing that the bank is going to be ready for those
major risks.
We should welcome that kind of demand for the major banks
in the United States to identify and play an active role in
ensuring that the system is safe. It shouldn't be a system
where the regulators are the only ones involved in determining
what counts as a safe and healthy system. We should be doing
that in partnership, and the stress tests are a very good
opportunity to do that in partnership.
Thank you very much, and I look forward to talking more on
the subject.
[The prepared statement of Dr. Parsons can be found on page
85 of the appendix.]
Chairman Hensarling. And Dr. Michel, you are now recognized
for your testimony.
STATEMENT OF NORBERT J. MICHEL, RESEARCH FELLOW IN FINANCIAL
REGULATIONS, THE HERITAGE FOUNDATION
Mr. Michel. Thank you.
Chairman Hensarling, Ranking Member Waters, and members of
the committee, I am Norbert Michel, a research fellow in
financial regulations at The Heritage Foundation. The views
that I express in this testimony today are my own, and they
should not construed as representing any official position of
The Heritage Foundation.
The aim of my testimony this morning is to argue that a key
step toward ending ``too-big-to-fail'' is to promote market
discipline by eliminating risk-based capital requirements.
There are three main issues that I would like to address.
First, recent efforts to restrict the Federal Reserve's
direct lending to firms so that it will closely conform to the
classic prescription for a last-resort lender are
counterproductive because they do not increase this market
discipline.
This classic prescription says that the central bank should
readily provide short-term loans to solvent firms on good
collateral at high rates of interest. But we have to ask
ourselves, why would a large group of private lenders not make
loans on these terms? And one of the reasons is because strict
regulatory requirements can prevent firms from making these
loans.
In this case, the absence of private lending is a
regulatory failure, not a market failure. And the removal of
these restrictions would allow private lenders to make prudent
loans rather than hold idle funds.
Unfortunately, Title I of Dodd-Frank has only magnified
this problem by ensuring that new versions of the Basel
requirements will be forced on financial firms. These rules,
along with other regulatory policies, literally create the need
for government-sponsored lending under the guise of providing
liquidity that the market failed to provide. But we should make
no mistake that this is a regulatory failure, and major
regulatory failures contributed to the 2008 crisis.
And that brings me to my second main issue, which is that
the Basel requirements contributed to the meltdown not because
they required too little capital per se but because regulators
failed to properly measure risk.
The Basel rules were forced on commercial banks in the late
1980s, and the regulators assured the public at that time that
these new requirements would, in fact, force banks to hold a
cushion against unexpected losses. To build that cushion,
regulators literally specified risk levels for bank assets by
assigning different risk weights. Lower weights required lower
capital; higher weights required higher capital.
The system specifically required less capital to be held
against GSE-issued mortgage-backed securities than against
either home mortgages or commercial loans. Unsurprisingly, most
commercial banks followed the same practice. They sold their
customers' mortgages to the GSEs, and they held, instead, the
GSE securities.
So, when the GSEs became insolvent, virtually all banks
were stuck with nearly the same asset structure and exposed to
the same losses, even though the typical bank at that time had
exceeded its minimum capital requirements by 2 to 3 percentage
points for the 6 years leading up to the crisis.
There is no doubt that these statutory capital requirements
failed and the whole concept is flawed. The only reason that
Dodd-Frank gave us Basel III, indirectly, is because the crisis
exposed Basel II as deeply flawed before it was even fully
implemented.
And that brings me to my third and final point, which is
that there is no reason to think that Basel III will perform
any better, because it maintains the main regulatory flaw that
we have basically always had in the United States, which is
that regulators, rather than markets, determine bank capital
standards.
If we want to improve bank safety, we should scrap this
overly complicated, top-down system and replace it with a
simple set of rules that allows markets to adequately price
risk and to discipline firms that take on too much.
True reforms would include the repeal of, at the very
least, Titles I and II of Dodd-Frank as well as the elimination
of the Fed's authority to make loans directly to firms. These
changes would provide a credible basis for believing that it is
unlikely financial firms will be bailed out in a future crisis.
Then, and only then, will major improvements that expose
firms to more market discipline be possible. For instance, in
return for reducing regulations, a simple, flat capital ratio
could easily replace the enormously complex Basel rules.
Another good option is a contingent convertible debt
requirement.
But those ideas still fall short of purely market-
determined capital ratios, and that is what our long-term goal
should be.
One way to get there would be to offer financial firms an
optional escape clause. Allow them to opt out of the Federal
regulatory framework, as well as the Federal safety net, in
exchange for converting to a partnership entity. Thus, in
return for real deregulation, financial firms' owners would be
fully liable directly for their companies' losses, as it should
be in any business.
Thank you for your consideration, and I am happy to answer
any questions you may have.
[The prepared statement of Dr. Michel can be found on page
74 of the appendix.]
Chairman Hensarling. Thank you.
The Chair now yields himself 5 minutes for questioning.
So, Dr. Michel, it is pretty clear that you don't think
BASEL I and Basel II historically got it right. It doesn't
appear that you are a fan of Basel III either.
Mr. Michel. Not exactly.
Chairman Hensarling. Do you have any hope that a Basel IV
or a Basel V could ever get it right? Or could you simply
expound upon your views of what is the systemic risk of having
one world view of risk imposed upon the global financial
system?
Mr. Michel. The general problem is that, just sort of like
what we saw happen last time, you have basically everybody
forced into the same sort of structure and the same sort of
investments or the same sort of capital allocations, and if one
thing goes wrong, it hits everybody equally.
We have a very long history in the United States of this
sort of--what I would just sort of call a populist tendency to
direct all of the bank capital requirements and standards, so
to speak, and the entire structure of that industry. And it has
driven it into the ground more than once. I don't know how many
times we have to go through this to figure out what we are
doing wrong, but--
Chairman Hensarling. Dr. Calomiris, you have obviously
contributed a very unique idea to the public debate here.
I read your full testimony, your extended version. So I
think you have maintained that CoCos would encourage banks to
recognize losses earlier than they otherwise would because of
the aspect of market discipline. They would have an incentive
to build their capital buffer earlier.
Can you expound on that view and how this is important to
taxpayer protection?
Mr. Calomiris. Yes. Thank you, Mr. Chairman.
The basic idea is simple. If banks had to maintain their
true economic value of their equity ratio at above 10 percent--
that means that the market believes that the banks actually
have equity in excess of 10 percent of their assets--banks
would never be anywhere near the insolvency point, and we
wouldn't ever worry about bailouts.
If you create a penalty for banks in persistently getting
below that which is credible, then bankers won't get below it.
And CoCos are really just a way to create that penalty through
a very diluted conversion of debt instruments into equity. And
if a CEO just stood by and let that dilution happen, he or she
would be fired.
And so we are working off the incentives of people to self-
identify their losses and to self-identify their risks and to
hold more capital when their risks are high and to replace lost
capital very quickly because, number one, that CEO doesn't want
to get fired.
When I was having breakfast with a vice chairman of one of
the large banks in the summer of 2008, I said to him, ``Why
aren't you raising more capital?'' He said, ``We don't like the
price. And did you notice what happened with Bear Stearns? So
why should we?''
And what didn't he like? He didn't like having to get
dilutively offering new equity at a price that was too low. But
if he had had those CoCos hanging over his head, he would have
jumped to raise new capital to avoid the even greater dilution
of that conversion.
So, that is the basic argument.
Chairman Hensarling. Speaking of interest, also in your
writings you have spoken about a convergence of interest
between large banks and their regulators that might diverge
from the interest of taxpayers in times of stress. You spoke
about the Bear Stearns scenario. Can you expand upon your views
there, please?
Mr. Calomiris. There is a large literature, academic
literature that has identified persistent, across many
countries, the tendency for supervisors to allow banks not to
identify losses during recessions. The reason is, if you
identify losses, banks might have to curtail credit. That is
not popular with politicians or regulators, especially in
democracies that hold elections.
For example, it wasn't until the 1988 election in the
United States was over that we recognized major losses in the
S&Ls. There are some recent articles showing that the same
thing happened during our crisis in 2008.
So we know that we can rely upon supervisors to go along
with bankers in understating losses, not just in the United
States but around the world.
Chairman Hensarling. The opponents of your idea will say
that this simply becomes a juicy target for those who will
choose to short a bank's equity, that this is a very rich
target for short-sellers who wish to game the system. How do
you address that concern?
Mr. Calomiris. A couple of ways.
First of all, I would only allow qualified institutional
investors to be holders of this, who are prohibited from short-
selling. So they would have very little incentive to short-
sell.
Secondly, I said persistent declines in market value,
meaning 120 days. You can't maintain a profitable short
position in a deep market, like a market for JPMorgan or
something like that, to try to push shares down for that long a
period.
So I don't really think this is a realistic concern for
both of those reasons.
Chairman Hensarling. My time has expired. I now recognize
the ranking member for 5 minutes.
Ms. Waters. Thank you very much.
I am looking at a definition of ``capital,'' and I am
listening to ways that ``capital'' is defined by different
people.
I want to read something to you. This is for Dr. Parsons.
Under a definition of what exactly is capital, ``A bank's
capital, similar to shareholders' equity, is the amount left
over when a bank's liabilities are subtracted from its assets,
which also means that a bank's assets are equal to its
liabilities plus its capital.
``In other words, a bank's capital ratio describes the mix
of debt--that is, liabilities and equity--capital--the bank
uses to fund its assets. Capital is not an amount set aside
that cannot be lent. It is a source of funds for lending. To
remain solvent, the value of a firm's assets must not exceed
its liability.''
Now, for you: Banks subject to heightened capital standards
often point out that these standards prevent them from lending
into their communities. What would you say to critics of the
Dodd-Frank Act who claim that capital standards hurt borrowers
and small businesses that want access to credit?
Mr. Parsons. Thank you.
So, yes, you highlight the fact that a lot of people, in
discussing bank capital, use this terminology, like banks
``hold'' capital--
Ms. Waters. Yes.
Mr. Parsons. --as if they immobilize it and don't use it.
And that is wrong. The bank is funded by equity, by debt, by a
variety of sources. All of that money can be put to work in
purchasing assets and making loans and so on. So all of that,
all sources of capital, debt capital and equity capital, can go
to work. It is not a cost for the company doing it.
Some of what people think are costs are because we are
subsidizing debt through the tax system, since interest is tax-
free, and if we force the company to hold more equity instead
of debt, in a sense the company loses some of its subsidy. But
that is not a cost to society; that is a cost to that
particular--where withdrawing a subsidy is not the same thing
as a real cost paid out in real resources.
Ms. Waters. In addition to capital and liquidity standards,
regulators have the authority under the Dodd-Frank Act to use
the living-wills process to make the largest banks less risky.
How well do you think regulators have implemented this
provision so far?
I am really looking at living wills, I am looking at stress
tests, and I am looking at capital as a way of preventing us
from ever having to bail out again. Could you give me some
discussion on that?
Mr. Parsons. So, yes, in the financial crisis, of course,
we suddenly found ourselves with institutions which were
extremely large doing a lot of complex activities--activities
which were crossing many international boundaries, the same
units having components of their business crossing
international boundaries. We found ourselves with regulators
unable to really see what the bank was doing and to be able to
take action because they had some understanding of the bank.
We have addressed that complexity in a lot of ways--the
Dodd-Frank Act that deals with derivatives in one title and so
on and so forth. Living wills is one step where you can work
with the bank to figure out a structure for the bank that is
more rational and something that the regulators can understand
and look to the need for resolution so that the bank can
participate in structuring itself in a way that it can do its
business but be prepared so that in the case of a crisis it can
be resolved in a way which does not disrupt the activity, its
business, its lines of business, that allows those lines of
business to go forward.
I would say that, so far, it has been useful, so we have
improved things a lot. But we, obviously--as you can hear from
the regulators in responding to the living wills, there is
obviously a lot of complexity and uncertainty that remains and
has yet to be worked out of the system.
Ms. Waters. Thank you so very much.
Let me just wrap this up by saying, is it correct to say to
those who claim that capital requirements are preventing banks
from making loans, that that is just absolutely not true?
Mr. Parsons. Yes.
Chairman Hensarling. The time of the gentlelady has
expired.
The Chair now recognizes the gentleman from New Jersey, Mr.
Garrett, chairman of our Capital Markets Subcommittee.
Mr. Garrett. I thank the chairman. And I thank the chairman
for this hearing.
I would like to jump right into that last question, but
before I do, one of the books that I really found fun reading
that I recommend to everybody is, ``The History of Money from
1776 up until the Great Depression.''
And if you go through that and all the stats and everything
else in between the lines, basically what the point of the book
is--or, one of the side points of the book is that up until the
creation of the Fed and the FDIC and what have you, the
overriding principle in the financial markets was market
discipline.
Because all the local banks had to have their own market
discipline because they knew there was not going to be any
bailout for either the depositors through the FDIC nor bailout
for the banks through the Federal Reserve or elsewhere. So that
was a real incentive to be prudent in your investments and in
your lending by your Main Street bank, and for the large banks
as well, because the investors looked at it and said, if you
are not prudent, we are not going to invest in it because you
are a risky market.
That changed at the turn of the last century, and that, of
course, changed dramatically again with Dodd-Frank, which
basically codifies the idea of ``too-big-to-fail'' and that the
American public is now on the hook for bailing out these
institutions.
And this is not just my thought; this is a bipartisan
thought. And I often give credit where credit is due, and that
is my predecessor on this committee, the Democrat gentleman
from Pennsylvania, who often said that we should, when he was
working through Dodd-Frank, try to place in it some elements
that would re-instill market forces. Unfortunately, I can't
speak for him, but most of us understand that Dodd-Frank did
not do that, did not instill market forces, but went in the
opposite direction.
So I am going to just--I will try to go left to right.
Dr. Calomiris, you did a paper I saw back a couple of years
ago, in 2011, and you were looking at the build-up to the
crisis, and you gave all the stats and numbers of 2007 and
2008. And you said the capital markets were wide open, and
commercial banks' investments were able to raise up to $450
billion in those 2 years. In other words, things were going
well, as far as the build-up of assets and capital. But they
were raising preferred shares, which goes along your last line
of testimony.
So part of the effective regime going forward is, what,
making sure that they are holding the right type of capital,
right? So if you would just comment on that in 30 seconds,
because I have a follow-up on that.
Mr. Calomiris. My CoCos proposal gets right at your
question--
Mr. Garrett. Okay.
Mr. Calomiris. --and has to do with how you bring market
forces and market discipline into the capital adequacy
discussion. So the point is, if you require bank CEOs to have
to pay attention to whether the market equity ratio is falling
and have to worry about those consequences, they will make sure
to maintain capital adequacy.
So that is--I have been working on exactly the topic you
are talking about for about 20 years, and I think that would
be--
Mr. Garrett. So is there a perfect or a best number? A 5,
10, 15, 20, higher percentage?
Mr. Calomiris. My view is--and it is not based on anything
too precise or scientific, to be quite frank--is that alongside
a 10-percent equity-to-assets minimum requirement, I would have
an additional 10 percent of CoCos that would convert into
equity if you ever got below that 10-percent market equity
ratio.
Mr. Garrett. So we saw there was a complete failure of
Basel II, and now we have Basel III. Is Basel III going in the
right direction or is it going in the wrong direction with
regard to all of this?
Mr. Calomiris. Basel III depends, as Mr. Michel said, on
those risk weights being properly calculated by the banks. And
I don't really believe in that.
But I do believe that if we had my proposal on the table--
Mr. Garrett. Okay.
Mr. Calomiris. --if the banks had to comply with that, that
would incorporate market perceptions of risk and value, and we
would have an automatic, real risk-weighted capital system.
Mr. Garrett. Let's bring it down to the other end.
Dr. Michel, you can comment on that, but can you also
comment on the last question of the ranking member? Is it
regulation in the market that is affecting lending in the
marketplace today, or is it just the marketplace?
Mr. Michel. So, first, since it is in my brain, I agree
with Charlie's proposal. It is a great idea. And if it were a
question of Basel III or the convertible requirements, I am all
for the convertible capital.
Mr. Garrett. There you go. We have agreement.
Mr. Michel. Yes.
And then as far as the liquidity and regulation issue, I
think it depends on how we are defining the terms. In my
testimony, I did not specifically address, in my mind anyway,
higher regulation impacting liquidity in the market as we now
stand. I think--
Mr. Garrett. I should say, not regulation, but the fallout
of the regulation, which is the capital requirements.
Mr. Michel. I personally believe that it is more of a
supply issue than a liquidity issue. I think we are forcing
banks to hold more liquid assets and hold more assets in
general, and--
Mr. Garrett. Okay. And that affects their lending ability.
Mr. Michel. And it affects, ultimately, liquidity and
lending ability--
Mr. Garrett. Thank you.
Mr. Michel. --in the long run, yes.
Mr. Garrett. Thank you.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Texas, Mr.
Hinojosa.
Mr. Hinojosa. Thank you, Mr. Chairman, and thank you,
Ranking Member Waters, for holding this important hearing
today.
My first question is going to be for Dr. Norbert Michel.
In your testimony, you chide the Federal Reserve's actions
during the 2008 financial crisis. According to the GAO report
cited in your testimony, from December 1, 2007, through July
21, 2010, the Federal Reserve loaned financial firms more than
$16 trillion through its broad-based emergency programs. If I
understand your testimony correctly, you suggest that the Fed
should not have loaned firms any money during that crisis, but
rather conducted its traditional open market operation in order
to provide market liquidity.
Given that enormous amount of direct liquidity provided by
the Fed, do you think the Federal Reserve could have similarly
prevented the collapse of the financial system through the
traditional open market operations alone?
Mr. Michel. Okay, so, technically, I didn't say that they
shouldn't have done that in the crisis. And I don't think that
they had any choice at that point, given the system that we
have.
Now, ideally, what I--so what I said is that, ideally, we
would have a system that would not let them do that. That is
what I said. And, yes, I do think that would be better.
I do think that if we reformed the primary dealer system so
that it is not just a small group of banks involved in Treasury
auctions, that it is all banks, say, with top two CAMELS
ratings, then, yes, that would greatly improve liquidity and
greatly reduce the chance that we would ever need any sort of
emergency lending at all.
Mr. Hinojosa. Dr. Parsons, I really enjoyed your
presentation.
Do you agree with Dr. Michel that we should get rid of the
risk-based capital standards? Why yes, or why not?
Mr. Parsons. I don't really see any alternative to the
government playing some role in establishing capital standards.
Banks are going to be a major part of our financial system, and
the dangers of things like runs in different parts of the
banks, different activities, are ever-present. And in order to
ensure that the system will live through turbulent times, the
public has to take a role in establishing some standards and in
guaranteeing that the bankers have equity at risk.
I think we all agree it is equity at risk that we want as a
way to help guarantee that the banks are prudent in their
borrowing. And the only way to guarantee that that equity is at
risk is a public authority has to mandate it when you allow the
bank to have a charter and do its banking rules.
I think, as I wrote in my testimony, banks are very complex
institutions; they do a lot of different things. So you
absolutely have to sometimes be differentiated when you are
examining them and look for specific risks and look for
different amounts of risk. There are lots of ways to do that.
Risk-weighting was one way to do that, but also in the stress
tests, that is another way to do it.
So I think you have to have a public authority who gets in
and pays attention to the risks. If you try to stand back, you
will be sideswiped sooner or later. How the public authority,
the supervisors, get engaged on the different kinds of risks
can be done in many different ways. It is very complicated, and
I am very open-minded about all of those different ways.
Mr. Hinojosa. Thank you for your response.
My next question is for Charles Calomiris. In your
testimony, you suggest raising the minimum equity asset ratio
to 10 percent and raising the minimum equity-to-risk weighted
asset ratio to 15 percent.
What is your advice to commentators trying to protect the
``too-big-to-fail'' banks if they were to follow your
recommendations?
Mr. Calomiris. My idea in proposing the 10- and 15-percent
increases--which aren't very big increases, but they are
increases from where we are now--my idea is those aren't going
to be very effective if we don't combine them with other things
that make the measurement of risk realistic.
And that is why I really emphasize that my point to them
would be that this isn't going to work either unless you do
something to credibly measure risk. Right now, we allow banks
to measure risk for us. That is something anyone who has had
children knows is not a very good strategy. So CoCos are an
obvious way to get around this problem.
I should also point out that there are some other good
ideas which I didn't have time to get into. We can use markets
to measure risk, to some extent, too. Senator Barbara Boxer's
staff and I, when Dodd-Frank was being debated, came up with
some ideas for that, and I am happy to go into it--
Chairman Hensarling. Dr. Calomiris, regrettably, the time
of the gentleman from Texas--
Mr. Calomiris. And so, there are other ideas I would be
happy to go into about how to improve it.
Chairman Hensarling. The time of the gentleman from Texas--
Mr. Hinojosa. Thank you.
Chairman Hensarling. --has expired.
The Chair now recognizes the gentleman from Missouri, Mr.
Luetkemeyer, chairman of our Housing and Insurance
Subcommittee.
Mr. Luetkemeyer. Thank you, Mr. Chairman.
And welcome to our guests this morning.
Dr. Chakravorti, last week the European Commission
published a consultation paper on the potential impacts of
capital requirements on European financial institutions in the
EU economy. The paper makes clear the importance of examining
the impact of higher capital requirements on lending and the
economy.
European regulators are going to specifically look at the
appropriateness of capital requirements, the impact of capital
requirements on long-term investments and growth, and the
impact of capital requirements on lending to small and medium-
sized enterprises and consumers. They have also committed to
hold public hearings on the issue.
My question to you is, has the Federal Reserve or any U.S.
financial regulator expressed the need to examine the
implications of capital requirements? It looks like the
Europeans are sitting down and studying it. Are we doing that?
Mr. Chakravorti. Thank you for the question.
Let me first say that I don't follow the European context,
but I applaud their decision to study the impacts. I think that
is a very important factor in deciding regulation, and
regulation is a continuous process. And it is very important
that research is done in that direction, so I applaud their
decision to do that.
Mr. Luetkemeyer. Don't misunderstand me. I am not
supporting them and their models and what they do. My concern
is they are willing to do the studying before they implement
the rules and regulations. It looks to me like we failed to do
that in this situation.
My question is, do you see us, in any respect, studying
this beforehand, before we make the rules and implement--
Mr. Chakravorti. I hope in the future that we do study it
before we go further in the rules, absolutely.
Mr. Luetkemeyer. Okay.
Dr. Calomiris, we had a great discussion here with regards
to capital Tier 1, risk-based assets. Tom Hoenig, who is the
Vice Chairman of the FDIC--whom I know pretty well and have
listened to on numerous occasions--has written extensively, and
spoken extensively on capital and risk-based assets and things
like that. He believes that we need to have about 10 percent
Tier 1. And then, after that, he does not take into
consideration a lot of the other risk-based assets that are
there, believing that we need to have a Tier 1 solid capital
structure to be able to be the initial backstop. The rest of it
is fine, but he believes we need to have at least 10 percent
Tier 1.
It appears you are in agreement with that. Would you like
to elaborate on that a little bit?
Mr. Calomiris. I agree that there should be a focus that we
have a 10-percent Tier-1-to-asset ratio, but I don't think that
is enough. All that does is basically say that all assets have
a risk weight of 1. But if you do that, there is a danger that
banks might decide to start making assets have higher risk
weights than 1 without that simple leverage ratio really
solving that problem. That is why the CoCos requirement kind of
fixes that.
So I think that is a necessary part of the solution, but it
is not sufficient.
Mr. Luetkemeyer. One of the things that I heard Dr. Michel
talk about was the CAMEL ratings. And CAMEL ratings basically
rate the entire bank. It rates your management; it rates your
earnings and your capital and also the risk that you take. And,
to me, it is important that you have a bigger picture.
We have been focusing just on the risk of the assets, but I
think if you have somebody who is a CAMEL-1-rated bank, you
have excellent loans, you have excellent management, they know
what they are doing. And so I think it is harder to put a
square peg in a round hole, and I think that is what we are
trying to do here sometimes. But I think the CAMEL ratings are
a good indication of the management of the bank and all of
the--a bigger picture. Let me put it that way.
What are your thoughts?
Mr. Calomiris. I have been doing research on exactly this,
and it makes the same point I was just making.
The leverage ratio is sort of all about capital, but it is
not about earnings. And, in fact, it is what I call balance
sheet fetishism. Banks lose value because their cash flows
shrink. Banks aren't just assets, they are not just tangible
assets, and we are acting in our capital regulation as if that
is true. And banks are in trouble, when they get into trouble,
because their earnings fall.
So the point of that camel story that you were you just
saying is, we need more than just a leverage ratio. And that is
why I am focusing on those additional items. So the two
actually fit together well.
And I know that I am using your time, but I do want to
point out that I would like to also, if someone is interested,
talk about the cost of capital requirements on lending. Ms.
Waters raised that. And I would like to have a chance to talk
about that. Because I don't agree with some of the panelists--I
think those costs are there, but I think we should do it
anyway.
Mr. Luetkemeyer. Okay. You managed to use up my time. But I
have one quick question--you made a comment a while ago with
regards to banks need to get out of real estate lending, and I
would like to have somebody elaborate on that after a while.
Because that is kind of a scary thought, to get completely out
of real estate lending, unless I misunderstood you.
Chairman Hensarling. A very brief answer.
Mr. Calomiris. I am not suggesting they get completely out
of it, although I would point out that 100 years ago national
banks were prohibited from any real estate lending based on the
correct perception that real estate lending is very--
Mr. Luetkemeyer. You realize you are making a really good
case for GSEs this way.
Mr. Calomiris. There is more than one way to redirect real
estate lending.
Chairman Hensarling. The time of gentleman has expired.
The Chair now recognizes the gentleman from Massachusetts,
Mr. Lynch.
Mr. Lynch. Thank you, Mr. Chairman.
And, Dr. Calomiris, I might give you a minute or so to
expand on what you have been talking about at the end of this.
We are dealing with a situation now where, look, we have
higher quality, and greater quantity of capital in banks than
we did before Dodd-Frank, and what we are struggling with is
how much capital to require banks to hold without leaking out
into an area of growth where we may inhibit the banks from
doing some of the other things we want them to do. And we are
trying to rightsize this in a way that optimizes the use of
capital in a way that creates that stable environment, yet,
again, doesn't limit growth and other activities.
Dr. Parsons, we have a situation now where we have foreign
affiliates of U.S. banks that are dealing in swaps, and in many
cases they are not cleared swaps, and they are transferring the
risk back to their deposit-backed banks here in the United
States. And the risk that is being created there is not
something that I think is being addressed in our discussion
here today.
If a foreign affiliate implodes because of uncleared and
risky swaps transactions, that liability, that risk immediately
comes right back to the FDIC and on that bank that should be
carrying sufficient capital but it hasn't because it is
acquired, the risk has been acquired by a foreign affiliate.
Is there anything that you see in either the risk-weighting
analysis or the stress testing that could get at that risk that
is offshore that we don't require--the financial institutions
are arguing that they shouldn't be required to post collateral
for their foreign swaps affiliate, yet it does create risk, and
there seems to be a disconnect here.
Mr. Parsons. So certainly the supervisors--the Fed
certainly has authority to examine the company's full trading
in swaps, including the impact on its foreign affiliates into
the American bank. It is a problem, as you indicated, that some
of that trading would somehow be covered by the FDIC. That
doesn't necessarily make sense. But there are a number of
actions going on that can address that.
So capital requirements at the bank holding company level
can take into account the riskiness of that swap dealer
activity. The living wills effort is an effort that can help
shape how that risk can travel across boundaries and units,
allowing it to be brought back. As well as, in the process of
trying to set up the orderly liquidation authority in the right
way, there is this effort to prevent the swaps from being
settled immediately so that there is time to move things.
All of these are in process, but none of them have been
completely implemented, except the authority for capital
requirements is definitely an authority that the Fed has.
Mr. Lynch. Okay. Thank you.
Dr. Calomiris, you wanted to talk earlier about some of the
costs that you think this activity might require, but you also
said that it is stuff we should do anyway. Could you go ahead
and elaborate on that?
Mr. Calomiris. Thanks very much for giving me the chance.
Mr. Lynch. No problem.
Mr. Calomiris. I will just mention this because you may
want to have a staff person look at this. So if you look at
page 12, which is a reference list for my testimony, you will
see there are 4 articles there by Shekhar Aiyar and several
other people, including myself, all published in refereed
journals. What these articles do is they look at the U.K.'s
experience with what effect capital requirement changes have on
lending supply, because that is the environment where we can
observe it, because they are varying them a lot on a bank-
specific basis. There is also research in Spain.
And they all corroborate the same conclusion, and this is a
scary conclusion: If you increased capital requirements for a
bank in the U.K. from 11 percent, which was the mean, to 12
percent of assets, you would cause them to reduce the supply of
lending to nonfinancial firms by about 7 percent. It is a huge
effect. It is about 10 times what the Basel Committee thought
the effects were when they were contemplating capital
requirement increases.
So I want to emphasize, it is not correct to say that this
doesn't have a social cost. It does. But it is worth it. It is
worth it because, if the banking system implodes, that is going
to be an even worse contraction of credit. So you have to run a
safe banking system even if it means in the short run you are
having some negative effects on loan growth.
That is my answer to your question and also Ms. Waters'
question. It is not a free lunch. It is not even close to a
free lunch.
Mr. Lynch. I yield back.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Michigan, Mr.
Huizenga, chairman of our Monetary Policy and Trade
Subcommittee.
Mr. Huizenga. Thank you, Mr. Chairman.
Over here, gentleman. This new configuration makes it feel
like you are in the park across the street from Rayburn.
Dr. Calomiris, I would like to bite on your debate that you
threw out there a question or so ago. I am a former licensed
REALTOR. I would love for you to hit on the cost of capital on
lending ability, which you said you wanted to address, and then
as you started to address, real estate lending and how that may
be affected.
And then I would like to move on, Dr. Michel, to Basel and
transparency there.
Mr. Calomiris. So let's think about where we are. Let's
just take January 2008 for the banking system. Seventy-five
percent of loans are in real estate, which means either real
estate development loans or mortgages.
Real estate is highly correlated and in tune with the
business cycle, and it is very hard to shed, as a bank, those
real estate risks during a downturn, which is why,
historically, banks have not been real estate lenders.
If you go back to the 1920s, real estate lending was done
in the United States by insurance companies and building and
loans, neither of which financed real estate lending with
short-term debt because it is crazy to finance real estate
lending with short-term debt.
We do it because we decided politically to do it. We
decided with deposit insurance to make that happen. It wasn't a
good idea. And as banks have lost market share, deposit
insurance has kept them from shrinking, which they should have
done, and instead they have pushed them into doing more real
estate lending.
Real estate lending should be done by maturity-matched
intermediaries, real estate investment trusts, insurance
companies, capital markets of various kinds. It should not be
done by short-term debt. That is a mistake that we did in the
1930s and since and it has cost us. It is politically almost
impossible for people sitting in this room on both sides of the
aisle.
I am not talking about eliminating it. I am talking about
reducing it. Seventy-five percent is a ridiculous number. We
should be phasing it down.
Mr. Huizenga. Thank you for getting both the REALTORS and
the bankers to call my office here very shortly. Very few
people can unite them that way.
So I do want to then, really quickly, if you could touch on
the liquidity standards, capital and liquidity standards. You
seemed to be indicating that there is a cost of that on lending
ability for banks. If you could really quickly hit that, and
then I want to hear from Dr. Michel.
Mr. Calomiris. There is no avoiding the fact that if you
tell bankers they have to keep some of their portfolio in cash,
that tells them that they can't keep all of it in loans.
My point is, if you look prior to the runups in the late
1990s and 2000s, banks in the United States always had riskless
securities, that is Treasuries plus cash, in excess of 25
percent. In fact, it was more like 40 percent during most of
the post-World War II era.
What we have done is, look at where we got by January 2008
where it was 13.5 percent for the largest banks. They were
doing that because they could, because they had the safety net.
The point is, sure, of course, if you require banks to hold
more cash, it means they will do less lending, but that is not
bad. You should require them to operate safely. They shouldn't
be able to have 100 percent of their assets in loans.
Mr. Huizenga. Okay.
Dr. Michel, Basel, is there enough transparency there on
the banking supervision, and your thoughts on that?
Mr. Michel. Okay. And I know I am screwing things up, but I
would love to add something to what Charlie just said.
Mr. Huizenga. Yes, but you have a minute and 15 seconds.
Go.
Mr. Michel. All right. On the transparency stuff, I don't
know how we are--I hate to say this--but it depends on exactly
what we are talking about. Again, if you go back and look at a
1993 Boston Fed paper, a 1996 OCC press release, a 2006 OCC
press release, they basically all say the same thing, that
roughly 80 percent of the swaps market is in the large banks,
we know it is in the banks, and don't worry about anything, the
right people are taking care of this. We are looking at it. We
are dealing with it.
So that is transparent. The whole thing was transparent.
Everybody knew what they were doing. So I don't know what we
added. It was already transparent, as far as I am concerned.
And then I still have 30 seconds. So I agree with Charlie
that it is a stupid idea to do short-term lending to fund long-
term projects like real estate. We had a crazy system before
the 1930s, it got crazier after the 1930s, and we haven't
stopped doing that.
But we have based all of this on the wrong premise. If we
were talking about a company like Walmart, Walmart has hundreds
of millions of customers, and millions of suppliers. Many of
those businesses depend on Walmart for their living. You can
make exactly the same arguments about Walmart that you can
about banks. And if we were talking about putting a Federal
regulator in charge of saying who Walmart can sell to, and who
they can buy from, we would all say that is insane, but that is
exactly what we are doing now with the banks.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from California, Mr.
Sherman.
Mr. Sherman. Dr. Michel, the one difference with Walmart is
they don't have hundreds of billions of dollars of liabilities.
And I--
Mr. Michel. Technically, they do.
Mr. Sherman. And reclaiming my time. I certainly don't see
hundreds of billions of liabilities on their balance sheet. Of
course, there are contingent liabilities.
I want to shift over to credit rating agencies. We have to
have risk-based capital, so bank examiners have to determine
risk. Banks all too often just decide to put all their money in
marketable securities. So you might have a portfolio of 1,000
marketable securities.
Now, the credit rating agencies say: Don't regulate us.
Don't sue us. Let us do what we do. And if we ever screw up, it
is your fault for relying on us.
Now, let's say you are a bank examiner. You go in to
examine a bank and they have 1,000 different portfolio
securities, every one of which has a rating. The easiest thing
to do is to just say, ``Okay, well, here is your risk base. You
have some B-plus, you have some A-minus. Those are your
risks.'' What the credit rating agencies say is, ``Ignore our
ratings.''
How could a bank regulator independently evaluate the
creditworthiness of every marketable bond and CBO in that
portfolio given the fact that the bond rating agencies charge
about a million dollars per issue, so in theory, at their
rates, that is a billion dollars' worth of work?
Dr. Calomiris, can you tell me, could a bank regulator do
anything other than rely upon the ratings if they are examining
a bank with 1,000 different marketable bonds?
Mr. Calomiris. I came to the conclusion that they can't.
And that was the basis for the work that Senator Boxer's staff
and I did during the Dodd-Frank discussion, and we drafted an
amendment that would require the reform of the ratings so that
they would be useful credibly. I won't go into that--
Mr. Sherman. I will also point out that we had the Frank
and Sherman amendment which ends the idea that the issuer
selects the underwriter, just as--selects the evaluator. I
assure you that if I could have picked the person to grade my
tests in law school, I would have done better, especially if I
also paid them, and especially if they made a million dollars
per test. So the idea that we can just let the credit rating
agencies sell their ratings to be selected and then say the
solution is that nobody should rely upon them is manifestly
false.
In evaluating risk, you have not only the default risk, but
the interest rate risk. In the materials that were prepared for
us for this hearing, they describe risk-based capital and said,
in effect, sovereign debt of the United States would be given a
zero risk because there is no default risk.
There is a huge interest rate risk. If you take in a bunch
of 30A deposits to buy a bunch of 30-year Treasuries, is it
true that under Basel III you assign a zero risk to a bank that
borrows for 30 days and lends to the U.S. Government for 30
years, Doctor?
Mr. Calomiris. Yes.
Mr. Sherman. Is there anybody in the business world who
thinks it is risk-free to lend for 30 years and borrow for 30
days?
Mr. Calomiris. No.
Mr. Sherman. I would also point out the effect this has on
our districts and the small businesses. A few people have been
bored in this room listening to me.
So if you take a huge risk by buying a 30-year bond when
you are borrowing your money for 30 days, the regulators come
in and kiss you on both cheeks. If instead you make a 1-year
loan to Jack's Pizzeria in my district, they come in, and what
kind of reserve do they require?
Mr. Calomiris. The capital weight would be 100 percent,
probably, for that loan, risk-weighted assests.
Mr. Sherman. A hundred.
Mr. Calomiris. Yes, instead of zero.
Mr. Sherman. So if you play on Wall Street and you invest
your money on Wall Street, you can have enormous upside and
downside risk, and if the upside comes through, you can get a
big bonus, and the regulators come in and say, ``You are not
risky.'' Even though the riskiest thing you could do, that I
can think of, is to borrow money short, and lend it long, but
if you lend to small businesses in our district, pow.
I yield back.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Wisconsin, Mr.
Duffy, chairman of our Oversight and Investigations
Subcommittee.
Mr. Duffy. Thank you, Mr. Chairman.
It is fascinating listening to my friends across the aisle
as they have grown over the last 4\1/2\ years. They started off
telling us how Dodd-Frank was going to end ``too-big-to-fail.''
It was a sure fix to end ``too-big-to-fail,'' if you listened
to the debates with former Chairman Frank. That is the reason
why we have a 2,000-plus-page bill while we have 400 new rules.
But the tone has changed. They are now admitting that Dodd-
Frank, in all of its sweeping reform, does not end ``too-big-
to-fail.'' Does the panel agree with my Democrat friends that
Dodd-Frank doesn't end ``too-big-to-fail?'' There is no
disagreement on that? Okay. I didn't think so.
Mr. Parsons. I disagree.
Mr. Duffy. You disagree with Republicans and Democrats that
it ends ``too-big-to-fail?''
Mr. Parsons. I think it makes very important efforts that
are having an impact on preventing that from happening.
Mr. Duffy. But it doesn't end it. And I think maybe we
could start, instead of having a movement and a push now to say
2,000-plus pages, 400 new rules, we didn't get it right, so
let's add more legislation, more rules, and more regulations
onto the ones that already exist, I would actually buy into,
let's repeal Dodd-Frank because it doesn't work, and it was a
failure, and let's work together with a blank sheet and see how
we can learn from the lessons of 2008 and work together to get
reform that is actually effective.
But I want to move on to risk-weighted assets. Risk-
weighted assets, does that concentrate risk?
Mr. Michel. Do the risk-weighted assets themselves
concentrate risk? Because they don't necessary address risk
concentration, if I am correct there. I believe they left that
out. I don't believe they have addressed that. So--
Mr. Duffy. But would it encourage banks to uniformly buy
similar assets?
Mr. Michel. Oh, I see. Well, yes, in that sense, yes. You
have particular assets that have lower weights, so those are
going to tend to be favored. So in that sense, yes.
Mr. Duffy. And if we have more banks holding similar
assets, does that create more systemic risk?
Mr. Michel. I would argue yes.
Mr. Duffy. Yes. So risk-weighted assets actually can create
more risk, more systemic risk, than actually alleviating that
risk in the marketplace. Am I wrong on that?
Mr. Michel. No, I think you are correct on that.
Mr. Duffy. And how well have our--
Mr. Michel. And the weights have to be right, and we have
already messed that up. So--
Mr. Duffy. I want to ask you about that. How well have the
regulators actually done in getting this right?
Mr. Michel. Personally, I don't want to--I would say the
regulators are not clairvoyant, just like anybody else. So I
don't mean this in a bad way necessarily; I just don't think
that you could expect anybody to get it right.
Mr. Duffy. Say that again.
Mr. Michel. I just don't think that we could expect anybody
to get that right. The stress tests are a great example. I have
a lot of experience with economic projections, and I think if
you gave me 10 minutes, I could teach pretty much anybody with
an Excel spreadsheet to do what I can do. It is really not as
sophisticated as we pretend in economics. If we look at
inflation, something like inflation, over the last 10 or 15
years you can't beat a one-period forecast of using last
period's inflation.
Mr. Duffy. And so, we are trying to find this right
balance. We all agree that we need sound, smart regulation in
our financial sector. No one disputes that. But we need to have
some balance between regulation and market discipline. Is that
a fair statement?
Do you think we now have, to the panel, the right balance
with sound regulation and market discipline?
Mr. Michel. No.
Mr. Duffy. Yes?
Mr. Parsons. I think we shouldn't think necessarily of
market discipline and regulation as if they are opposed to one
another. You have heard from the panel ideas for ways to
structure incentives by regulation, the CoCos that are being
proposed, that is regulation to create market incentives. When
we talk about capital standards, we are talking about demanding
that the equity owners have skin in the game to create market
incentives to manage the bank right.
So what we are trying to do in crafting good regulation is
to create a healthy market. That is that we are trying to do.
Mr. Duffy. Right. And do you think we have been successful
in the United States in doing that?
Mr. Parsons. I think you heard from lots of people that we
have made great strides since the crisis to right the ship.
There are still problems, obviously, and there are going to be
debates going on for a long time. But I think it is important
to say we have made some really great strides.
Mr. Duffy. It seems like my friends across the aisle will
oftentimes blame markets for the crisis, and because, they will
allege, markets fail, we need to look to regulators and give
them more power and authority. But isn't it fair to say that
the regulators failed in the lead-up to the 2008 crisis?
Dr. Calomiris?
Mr. Calomiris. Absolutely. And I don't know if we have time
for me to answer your first question, we probably don't, but
yes.
Mr. Duffy. I haven't heard the gavel yet. So maybe you can
start.
Okay.
Chairman Hensarling. Now, the gentleman has heard the
gavel. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Georgia, Mr.
Scott.
Mr. Scott. Thank you, Mr. Chairman.
I would like to talk about, get the panel's thoughts on
Basel III's leverage ratio and its impact on banks. The crux of
the matter is this: These new capital requirements for our
prudentially regulated financial institutions are indeed vast
in scope, and indeed, they are a necessary means to ensuring
that banks are properly capitalized, as warranted under Dodd-
Frank.
But there is one narrow aspect that seems to be working at
odds with the principles of the Dodd-Frank Act, as well as
long-established market regulations, and that fact is this:
End-user customer margins, which have long been posted to bank-
affiliated clearing members for the clearing of derivatives,
are treated punitively.
Recently finalized capital rules consider client margins
something the bank can leverage, even though Congress has for
decades required that customer margins posted by clients for
cleared derivatives must remain segregated from the bank-
affiliated clearing members' own accounts and that it should be
treated as belonging to the customer.
Now, here is the first question. How is it now assumed that
the margin can be used by the bank as leverage? More
specifically, the Basel III leverage ratio now extends to off-
balance-sheet exposures that are not driven by accounting
rules.
And in this off-balance-sheet context, my second question
is, why is customer margin collected by a bank-affiliated
member of a clearinghouse being treated as something the bank
can leverage when Congress has long required such margin to be
segregated away from the bank's own resources?
Could I get a comment on that from Dr. Parsons or Dr.
Michel, and--I don't want to murder those last two names there,
so I will say the two gentlemen on the end whose names begin
with the letter ``C.''
Mr. Parsons. I think the basic issue you are bringing up
about customer margin, the reason why it has become an issue as
you highlighted, the problem is you are dealing with a business
to be a futures commission merchant or a swap dealer collecting
margin, that is a business, and that business has some risks.
They are trying to measure the size of that business as a proxy
for measuring the risk of that business.
And the customer margin is part of what defines the size of
the business. If you have one company offering more swaps to
its customers and having larger margin, you have a larger
business. And so you need to think about the riskiness of that
business and charge capital for it.
Now, if it is true that you can successfully segregate it
and guarantee that there is never any real risk of those funds
getting back to the customers, there might be some way around
that. And it is also true that there should be a way of
improving the measurement of risk. So with derivatives
themselves, with the market value of the derivatives
themselves, they calculate these potential exposures instead of
using book value of the assets. And that is one, I think it is
clunky, but it is an effort to do what you want done.
Mr. Scott. But don't you feel, though, that the Basel III
leverage ratio misinterprets the exposure-reducing effect of
segregated margin?
Mr. Parsons. I think the problem is people want to either
treat things one way or another, and we need to arrive somehow
at a better destination. Treating it, that dollar, as being 100
percent exposed maybe is the wrong thing, but saying because it
is segregated, legally there is no risk in that business, that
is clearly also wrong. So we are sort of--we are finding that
we need to get a more sophisticated appreciation of the
problem. So something needs to get done to improve it.
Mr. Scott. Okay. My time is up. I'm sorry.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from South Carolina,
Mr. Mulvaney.
Mr. Mulvaney. I thank the chairman.
Gentlemen, I want to talk about something a little bit
different here today. We had the opportunity to talk to Mr.
Hoenig about ways to relieve regulatory burdens on various
entities.
Some interesting work, by the way, that other members of
the committee and I have been discussing--myself, Mr.
Schweikert, and Mr. Hill have tried to figure out a way to
carve out certain banks from the larger regulatory scheme, to
say, look, there are some banks that don't need the extra level
of oversight that we get with Dodd-Frank. They aren't
sophisticated. They aren't interconnected. They don't present a
systematic risk. And many times that is not based on their
size, but by their business models.
I am just curious if anybody has given any thought to that,
if they are familiar with what Mr. Hoenig had talked about, and
if they had any thoughts on this concept of creating, not a
second banking system, but a different type of system where you
could opt out of certain regulatory requirements if you were a
very simple, well-capitalized, well-run bank. And I would be
curious to know opinions in favor of that and opinions against
that as we simply try and gather information and do our
research.
Dr. Parsons, do you want to start?
Mr. Parsons. As I indicated in my testimony, it is true
that there are lots of different types of banking activities,
and this effort to have many, many different ratios is an
effort to cope with the many different activities sometimes
bundled into one bank. If you can find a way to carve some out
and define them and say, ``I am only doing this, and therefore
I only have certain risks,'' and if that is real, then that
should be a sensible way to adjust the capital ratio.
Mr. Mulvaney. Yes, sir.
Mr. Michel. I would be in favor of it as well. In a more
expansive way, I would be in favor of it for everybody. Instead
of letting the regulators decide what is really risky and what
is really complicated and what is really simple, let the
markets decide. Have the carve-out. Let them do that. Let the
investors decide on their own and let them take the loss.
Mr. Mulvaney. Yes, sir.
Mr. Chakravorti. I think if you tailor according to the
underlying risks and what you outline, that is definitely an
advantage for the system as a whole.
Mr. Mulvaney. Dr. Calomiris?
Mr. Calomiris. I agree. I think if we can get to the point
where we know bankers are playing with their own money and not
ours, and we also know that they are not doing things that are
very hazardous in terms of highly correlated risks, so that
they are not creating credit crunch risk for the whole economy
when we have a downturn, then we don't have to micromanage with
this excessive interference in how they run their business. And
I think, again as Dr. Michel said, this applies to all banks.
I would point out that the regulatory costs are very
different from different regulations for different kinds of
banks. If you ask small banks, they will tell you QM
compliance, qualified mortgage compliance is very costly for
them. If you ask large banks, they might come up with a
different answer.
So I think the point is, this micromanagement is a lose-
lose. It makes our banks not perform well, and it makes them
not perform well for us, not just for their stockholders. So,
yes, that is why we want to have good capital rules, and I
think the CoCos for the large banks would get us there.
Mr. Mulvaney. The one criticism I have of what Mr. Hoenig
has suggested is that he seems to want to limit it to
community-based financial institutions and he doesn't want to
take it to the larger scale.
By the way, for purposes of the discussion, his brief
summary is that banks that hold effectively zero trading assets
or liabilities, banks that hold no derivative positions other
than interest rate swaps and foreign exchange derivatives, and
banks whose total notional value of all the derivatives'
exposures would be less than $3 billion, that is the basic
concept that he is trying to lay out there. But he limits it to
community banks, to smaller banks.
Is there any reason to do that, in your mind, Dr.
Calomiris?
Mr. Calomiris. I would say no. I know Tom pretty well. He
comes from Kansas. And the banks that are sort of in his
experience, in his frame of reference, are pretty small banks,
and I think he has a lot of sympathy for them, especially since
a lot of them have to also compete with the subsidized farm
credit system, which doesn't have to retain branches but gets
to raise its money through a GSE.
So small banks in places like Kansas are really taking it
on the chin. But that doesn't mean we should only focus on
them. I think it needs to be a broader focus.
Mr. Mulvaney. I thank the gentleman.
I yield back the balance of my time.
Chairman Hensarling. The gentleman yields back.
The Chair now recognizes the gentleman from Illinois, Mr.
Foster.
Mr. Foster. Thank you, Mr. Chairman.
And I would like to say that as the author of the Dodd-
Frank amendment that authorized contingent capital but did not
mandate contingent capital, I am thrilled with the fact that
there appears to be the possibility of some bipartisan, maybe
even consensus, that this could be part of the solution to
strengthening capital requirements beyond what is already in
Dodd-Frank.
It is interesting to go through the history of this. To my
knowledge, it is Mark Flannery of the University of Florida who
first significantly--for the record, Dr. Calomiris gave me a
strong nod on that--whom I think deserves credit for raising
this in a significant way. Then the Squam Lake Working Group
later picked it up and identified it as one of the major
elements of strengthening bank capital requirements.
I was particularly influenced by an analysis by Steve
Strongin's group at Goldman Sachs where they did a
retrospective analysis of the failure and concluded that had
banks been required to hold contingent capital, they would have
raised capital early in the crisis when they still could have,
and that at least the banking part of the crisis would have
largely been avoided.
And this has to do with a point that Dr. Calomiris has
made, which is that they would be worrying not about being
insolvent, but being in violation of capital requirements or
the trigger mechanism.
The Squam Lake Group worked through a variety of trigger
mechanisms. You appear to be an advocate of a market-based one.
There are regulatory. There are a variety of these.
At the time of the Dodd-Frank hearings and the amendment
that I got adopted into both the House-passed and eventually
the final bill, it was difficult to mandate, to adopt a
mandate, because there was no experience with these. Since that
time, the Europeans have a lot of experience, successful
experience, I believe, with CoCo bonds with a variety of
trigger mechanisms. So I think there is a lot to be learned,
but I think they are generally viewed as a successful
experiment.
Now, that is particularly the case with the Swiss banking
system. Switzerland is in a tough place because they have giant
banks, which they want to have, but their economy isn't big
enough to realistically backstop. So they have had to have a
very deep capital stack to handle their ``too-big-to-fail''
problem, which is handled significantly with CoCo bonds.
And so I think that there is a lot more experience today
than there was at the time we passed Dodd-Frank, and I think
that proceeding in this direction is something that, on a
bipartisan basis, we really should proceed on.
Okay. So the first question I have here is, what has been
learned by the European experience in this, particularly in
terms of the pricing of these instruments?
Dr. Calomiris?
Mr. Calomiris. We have learned a few things. One is that
these issues were oversubscribed by the market. A lot of people
said the market wouldn't want to buy them. They were
oversubscribed. So obviously the market does want to buy CoCos.
Institutional investors were very attracted to them.
But we haven't really tested them because the test of them
comes on the downside. And my own view is that the market
trigger is a much better idea than what the Swiss have used,
which is a regulatory trigger, precisely because regulators and
supervisors are not dependable during downturns to really
identify the losses and to trigger the mechanism, because it is
going to be very politically difficult to do it.
And, by the way, all the things you cited, from Flannery
through Goldman Sachs, are cited in my study, which is a review
of that whole literature. And I would associate myself strongly
with everything you said.
Mr. Foster. Let's see. So I will give you also the pricing.
There is the question of whether they oversubscribed. The thing
that I found particularly encouraging about it, if you looked
at the presentations to potential debt investors by
organizations like Credit Suisse, is they have exactly the kind
of transparency that you would love to see. In order to get a
good price, they have to reveal their books to the market. And
so you really get this market-based feedback that I think is a
fundamentally good addition to regulatory oversight.
My next question is, what areas of U.S. law would need to
be changed in order to actually implement contingent capital?
These are changes in tax law, for example. You mentioned that
there would be requirements or prohibitions from different
groups on investing in these, because obviously you don't want
the ``too-big-to-fail'' firms investing in each other's
contingent capital.
So what are the specific other legal changes that would be
necessary to actually get this implemented in the United
States?
Mr. Calomiris. I think the most desirable obvious one is to
make it clear that, at least for my version of CoCos, they
should be treated as deductible debt.
Now, the key issue here, and it also affects pricing, is
are we talking about bail-in CoCos, which I am not talking
about, or are we talking about these sort of preventative CoCos
that make banks raise capital? In my version, I would say that
these CoCos are almost never going to convert because the whole
point is to make banks avoid conversion. Whereas the bail-in
CoCos that some people have devised, including, unfortunately,
I think the Swiss model, they convert at very low regulatory
trigger ratios. And so those are going to have to be priced
with higher yields because there is more risk associated with
those.
So my answer is, I think the tax law has to recognize that
if the CoCos is as CoCos does, if they are my kinds of CoCos,
they should be treated as debt. If they are bail-in CoCos,
maybe they should be treated as a mix of debt and equity for
tax purposes. So there is a little bit in the weeds here. I am
sorry to give such a technical answer.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from North Carolina,
Mr. Pittenger.
Mr. Pittenger. Thank you, Mr. Chairman.
And I thank each of you for being with us today.
Senators Vitter and Brown have recommended that the banks
maintain a leverage ratio of 15 percent. Do you believe that
this is an appropriate means by which we should address this,
and would you be supportive of it?
Dr. Michel?
Mr. Michel. It gets to one of the problems, which is that
this is an arbitrary--these are all arbitrary numbers. So, that
is one issue. But if we are talking about simply raising the
number and leaving all the other regulations and requirements
in place, then, no, I am not.
Mr. Pittenger. No, I am not saying they need to be. It was
an offset to that. It would require a less intrusive regulatory
environment to do that.
Mr. Michel. I am sympathetic to the idea that you want them
to hold more capital, but I would still think that the
contingent convertible debt is a much better way to go than
something like that. And it has to have the offset.
Mr. Pittenger. Sure.
And, Dr. Calomaris, you have already spoken to that, but I
would be glad to have you--
Mr. Calomiris. Just to say briefly, my version has 20
percent absorption capacity, but it mixes it in equity and
CoCos 10 and 10, rather than just 15 in equity. And the point
is that during a downturn, this is more robust, and it relies
on the incentives of banks to make sure that we are measuring
real capital. That is, I think, what is missing in the Brown-
Vitter proposal.
But I have supported the idea of the Brown-Vitter proposal,
which is we need to increase the absorptive capacity. I want to
make it 20 percent, but make it 10 and 10 rather than 15 all
equity.
Mr. Pittenger. Dr. Chakravorti, do you have a perspective
on this? Is there a sweet spot as it relates to capitalization
and credit access?
Mr. Chakravorti. What I think needs to be done in the
capital space is you need to have a belts-and-suspenders
approach. So we have multiple ways to regulate capital. One is
risk-based, one is leverage, one is stress testing, and the
other that hasn't been talked about right now is something
called the TLAC requirement, that you have to hold debt that
would convert once you are a going certain.
So I think once you combine all of these different
regulations, and you need them because they do different
things, as we have discussed, just a straight-out leverage
ratio doesn't weight risk appropriately, but at the same time,
risk-based regulation may not get it right. We discussed that
stress testing actually has the benefit of having scenarios to
look at it. So to try to calibrate that number, one has to look
at the totality of those regulations.
Mr. Pittenger. Thank you.
Dr. Michel, please just expand on your perspective of how
Dodd-Frank has exacerbated ``too-big-to-fail.''
Mr. Michel. How has it exacerbated ``too-big-to-fail?''
Mr. Pittenger. Yes.
Mr. Michel. In the first place, if you want to end ``too-
big-to-fail,'' you don't have regulators identify the banks
that we say we can't live without. So if you are identifying
systemically important financial institutions, systemically
important financial market utilities, and saying that, look,
the regulators believe these guys go down and they kill the
economy, you have a really tough case to make for having ended
``too-big-to-fail.''
If you go beyond that and you look at Title II, Title II
takes the parent holding company and basically wipes it out in
order to keep the subsidiaries going. So everybody knows that
going in.
And the bridge company is exempt from taxes, and the bridge
company can only get funding really and truly from the Federal
Reserve or the FDIC. If you look at it and say, well, they are
prohibited from getting these funds, that is not quite right, I
don't believe. The fact is that they can only go into the Title
II proceeding after the Fed and the FDIC certify that there is
no private funding available for the bridge company.
So I think Title I and Title II, easy. Title VIII is a sort
of newfangled entity, the financial market utility, that comes
under this umbrella as well. So those three titles alone pretty
much seal the deal in terms of perpetuating ``too-big-to-
fail.''
Mr. Pittenger. Yes, sir. Thank you.
I yield back.
Mr. Neugebauer [presiding]. I thank the gentleman.
And now. the Chair recognizes himself for 5 minutes.
On Monday, as many of you know, the Federal Reserve
finalized its G-SIB capital surcharge rule, which would be
applied to eight of the United States G-SIB bank holding
companies. And the final rule imposed a surcharge that almost
doubled the surcharge proposed by the Basel Committee in some
cases. Thus, U.S. financial institutions will be required to
hold significantly more capital than their foreign competitors.
Vice Chairman Stanley Fischer raised that question, the
global financial competitiveness, at the Board's opening
meeting. His concerns were kind of summarily dismissed by the
Federal Reserve staff.
This is not the first time, and likely not the last time,
that we are seeing the United States go beyond the Basel
standards. We have seen the Federal Reserve do this with the
supplementary leverage ratio. We are likely to see it do the
same with the net stable funding ratio and TLAC proposal.
Dr. Chakravorti, do you worry about the U.S.
competitiveness if we keep making the U.S. banks play by a
different set of rules than the international banking
community?
Mr. Chakravorti. Thank you for the question, Mr. Chairman.
The way I view it is we have done a lot of work on the G-
SIB when the G-SIB proposal was announced, and what we found is
that there have been various improvements in the systemic risk
of these banks because of various regulations, and that really
wasn't incorporated.
So the idea that the Federal Reserve would increase over
and above the Basel requirement and come up with its own
metric, which is called Method 2, certainly leaves the banks at
a disadvantage to foreign competition. And it is something that
it wasn't really well justified in doing so, especially when
they agreed upon the standard coming out of Basel.
Mr. Neugebauer. Dr. Michel, do you have anything to add to
that?
Mr. Michel. No. I don't have anything to add to that. I
think that is accurate. I don't have anything additional to say
there.
Mr. Neugebauer. One of the issues that I have heard this
week from one of the larger financial institutions is that
there is a disincentive now for them to hold certain kinds of
assets because the more assets that they hold, the more capital
they have, maybe the more liquidity, and that certain kinds of
assets just don't generate that same kind of return to justify
having to go out and bring in additional capital or to bring in
additional liquidity, which in many cases may not earn a return
to justify holding those kind of assets.
How do we address this displacement and this understanding
that some of these assets are actually going to global banks
outside the United States because they are able to deal with
those assets in a different way regulatorily than these
domestic banks?
Mr. Chakravorti. Sir, you are absolutely correct in saying
that when you regulate you are going to have some market
impacts on certain products. And those products, sometimes they
are an intended effect, and sometimes they are an unintended
effect. But what is clear is that if the regulated banking
sector does not provide it, there is a risk that that product
will be provided outside the banking system, whether it be in
the United States or outside the United States.
When that occurs, it is not clear that where it is going to
is as strongly regulated as the banking sector. So in fact you
might actually increase systemic risk, something that you don't
really want to do, by proposing the regulation if your intent
is to reduce it overall in the financial system.
Mr. Neugebauer. Dr. Parsons, I wasn't here, but I think Mr.
Duffy asked all of the panel if they thought that Dodd-Frank
had ended ``too-big-to-fail.'' And I believe you said that you
thought it had ended ``too-big-to-fail.'' Is that correct?
Mr. Parsons. I think it has reduced ``too-big-to-fail''
significantly. I think having a healthier financial market with
better capital requirements that reduce the taxpayer backstop
is a good thing. And if another society wants to lower their
capital requirements and have their taxpayers subsidize their
banking business, I don't think it is good for the United
States to get into competition in putting the taxpayers' money
behind the banks.
I also think having a healthy financial system here is
competitively good for the United States. And so I don't think
getting into a competition to keep our capital requirements low
is going to help business here. We have always had extremely
good financial markets that have been attracted capital to the
United States.
Mr. Neugebauer. The reason I ask that question is because I
believe in April of 2013 you wrote an article with your
colleague Simon Johnson in which you basically dismissed the
arguments that Dodd-Frank had ended ``too-big-to-fail.'' So
have you changed your position now? I am a little confused by
that.
Mr. Parsons. No. First of all, I was very careful to say we
have reduced it because there are a lot of problems that
remain. The fact that we haven't taken care of the living
wills, the fact that we still don't understand the orderly
liquidation authority, we haven't fully implemented it, those
are very critical problems that we need to resolve.
Also, we just on Monday had these surcharges placed on the
G-SIBs. So those surcharges will make those banks reevaluate
activities which are activities potentially that the taxpayer
has to backstop.
And so we are watching a process, and that process is still
not complete. But we have made great progress.
Mr. Neugebauer. Okay. My time has expired.
I now recognize the gentleman from Kentucky, Mr. Barr, for
5 minutes.
Mr. Barr. Thank you, Mr. Chairman.
And thanks to our witnesses here today.
Dr. Michel, a quick question for you. We have heard a lot
about the causes of the financial crisis. And one of those
narratives is that deregulation and unrestrained free markets
were the cause of the financial crisis.
Can you elaborate a little bit more on your testimony about
the fact that there was plenty of regulation, in fact quite a
bit more regulation was added to the Federal Register in the
run-up to the financial crisis, but that it was dumb
regulation? And in particular, can you amplify your testimony
about the risk-weighting approach of the Basel capital
standards and how that may have contributed to the financial
crisis?
Mr. Michel. The Basel portion--and so, yes, I agree. And I
have written quite a bit about this and listed a lot of other
regulations that were supposedly deregulations that were just
different kinds of regulations.
The Basel portion, though, we have developed a system that
literally weights certain things heavier than others. So there
is a built-in incentive in that system to buy more assets that
have lower risk weights--or, I'm sorry, to hold more assets
that have lower risk weights.
And if you go back to the history of that, in the 1950s the
Federal Reserve started the risk-bucket approach. It was picked
up and used in the 1970s by the Basel Committee. The whole idea
was to better match risk and capital to lower capital. That is
the whole idea.
Mr. Barr. Specifically, can you speak to the risk weighting
of GSE mortgage-backed securities?
Mr. Michel. Sure. My numbers might be off. I know they are
in my written testimony. I think you could lower your capital
by 60 percent if you held the GSE mortgage-backed security
instead of the actual mortgage.
Mr. Barr. So Fannie Mae and Freddie Mac led to the largest
taxpayer bailout in American history primarily because of bad
government policies that induced the origination of subprime
mortgages, and yet the regulators got it wrong in terms of the
risk weighting of those assets. Is that correct?
Mr. Michel. Yes, that is correct. They also got the private
label mortgage security weight wrong.
Mr. Barr. And Dodd-Frank, although it doesn't specifically
require adoption of Basel III, it does, as you said, in
Sections 165 and 171 direct Federal banking agencies to
implement Basel III proposals. Do the Basel III proposals in
any way make adjustments that signal that they have learned
from their mistakes in the run-up to the financial crisis?
Mr. Michel. The GSE mortgage-backed security risk weight is
the same. The private label has been restructured completely.
There is not really one number. That is kind of a mess.
Mr. Barr. Let me just move on really quickly. You have
talked about how Dodd-Frank, obviously through the designation
process designating systematically important financial
institutions, enshrines ``too-big-to-fail,'' but what about
exacerbating ``too-big-to-fail?'' And what I mean there in
particular is all of the additional capital requirements, the
regulatory compliance costs imposed on small community banks--
we know that since 2010, we have lost 1,200 banks. There have
been only four de novo charters. There has been a dramatic
consolidation of banking.
Dr. Parsons thinks that Dodd-Frank has reduced the problem
of ``too-big-to-fail,'' but how have we done that if we have
fewer banks and there is concentration of risk in larger, more
systemic institutions now, much more so than before 2008?
Mr. Michel. We have a long-term trend that has been
exacerbated by regulation in general. Dodd-Frank has certainly
made that worse. And we have literally concentrated the banks
more. So it is, again, pretty hard to argue that we have
reduced that problem in that respect. Yes, I would agree there.
Mr. Barr. Let me just go to any one of you on the opaque
nature of stress tests, and specifically for regional banks
over $50 billion. I am thinking of small regional banks whose
management has expressed to me and others that the CCAR
requirements are very opaque, that there is not really any
predictability in terms of knowing whether or not they are
going to pass or fail these stress tests, and specifically this
Comprehensive Capital Analysis and Review.
What they have told me is that it has dramatically
increased their compliance costs and that the increase in
compliance cost means less capital deployed in their community.
Dr. Calomiris, could you speak to that? And, in fact, I
would want to reference back to your testimony where you
described the stress testing process as ``Kafkaesque Kabuki''
drama. Can you elaborate on that a little bit?
Mr. Calomiris. Thanks for asking. So Kafkaesque because
what Kafka, of course, made fun of was governments that would
sort of make up the rules after they saw what you did. And that
is exactly what we do with the stress tests. You don't have to
reveal what the rules are. You are going to be held
accountable.
And even if the Fed's own secret quantitative measure of
your risk shows that you don't have a problem, they still
reserve the right based on qualitative, whatever that means,
beliefs to make you fail. That is Kafka incarnate.
Kabuki, because it is a particular sort of drama that is
very staged. So it is both a staged drama and a Kafkaesque
drama, so hence ``Kafkaesque Kabuki.''
For small banks, of course, they are just not set up. As
you pointed out, they can't deal with the overhead of actually
doing this on a credible basis. This is a fairly complicated
thing to do.
But my view is that stress tests, if the Fed is held
accountable for a framework, can be extremely useful for large
banks. But we have to make it based on real data, not based on
what the Fed is doing. But looking at cash flows and making
banks think about themselves, line of business by line of
business, modeling their cash flows, I can tell you, could be
done a lot better.
Mr. Barr. Thank you for your testimony.
Mr. Neugebauer. The time of the gentleman has expired.
The gentleman from Pennsylvania, Mr. Rothfus, is recognized
for 5 minutes.
Mr. Rothfus. Thank you, Mr. Chairman.
Dr. Calomiris, I want to follow up on a couple of those
points. The capital and liquidity standards developed by the
Basel Committee are intended for large internationally active
banking organizations. U.S. regulators have defined that
concept as any banking organization with: (A) $250 billion or
more in total assets; or (B) more than $10 billion in on-
balance-sheet foreign exposure.
Do you believe the threshold set by regulators based on
assets or foreign exposure is appropriate for capturing those
large and internationally active banking organizations the
Basel standards were intended and designed for?
Mr. Calomiris. Quick answer, no. And more generally, I
don't think there is any intellectual basis, either in logic or
fact, that stands behind these liquidity standards as they are
constructed. They were simply arbitrarily constructed. There is
no theory and there is no fact supporting them, much less the
cutoff, which I think runs against the whole history of how we
think about cash regulations.
Remember back in U.S. history, we required money center
banks in New York to maintain 25 percent in cash, but then we
required country banks to not have to maintain quite so much in
cash because banks that are at the center of the system have a
more important systemic liquidity risk. So I don't think that
this--I think it is almost for sure.
Mr. Rothfus. Well, yes, because there is an issue that
these regulations bleed over into areas that they maybe weren't
intended to. For example, how could regulators adapt these
thresholds to ensure that regional banking organizations
focused on predominantly domestic banking activities and that
are not internationally active are not subject to capital
liquidity requirements designed for more complex global banking
organizations?
Mr. Calomiris. Yes, I agree with you that it is a misfit.
But I do want to caution that small banks also have systemic
risk. It is called real estate. So it is a different kind of
systemic risk.
But remember, we had banking crises in the 1980s. What were
they? Ag banks, commercial real estate problems, primarily in
the east, and mortgage crisis, and also oil and gas and also
some other things.
But the point is, all of these things were done by small
banks. Small banks can be a source of systemic risk too. You
don't have to be big. If you all fail at the same time, that is
also a risk.
Mr. Rothfus. Well, if you all fail. But, for example, one
small bank is not going to bring down the entire U.S. system.
Mr. Calomiris. But if the small banks as a whole, and this
isn't--
Mr. Rothfus. As a whole. But, again, I think we have had a
conversation with this committee before about whether it is
going to be one bank or an entire group of them.
But I want to go to Dr. Michel. In explaining the problems
with a system in which regulators determine capital adequacy by
risk weighting the assets in banks' portfolios, noted banking
analyst Richard Bove wrote this:
``Outwardly, risk weighting would appear to make sense. In
practice, it causes funds to be directed to whatever sectors of
the economy the government favors and away from sectors that
the government does not like. It results in differing interest
rates based upon the amount of capital required. The power to
make these crucial decisions is given to the banking regulators
who do so in private. Thus, one of the most important factors
in moving funds through the economy is done behind closed doors
by a small number of nonelected officials.''
Dr. Michel, do you share Mr. Bove's concern that Basel's
risk-based capital system is especially a license for
regulators to engage in credit allocation, some might call it
picking winners and losers, and to manage the economy? Is this
really a role that we want regulators playing?
Mr. Michel. I think that is a concern, and I don't think
that it is a role that a regulator should be playing. And if
you go a little bit deeper into the details, the Basel rules
have risk weights for individual bank loans. And the largest
banks, they actually get to--they are literally allowed to work
with the regulators to come up with that, which just is a
license for regulatory capture. The entire system is a mess.
Mr. Rothfus. Dr. Michel, what have been the consequences
for economic growth and the vitality of our financial system of
the decision by the authors of Dodd-Frank to really essentially
double down on regulatory complexity, as we see was in place
before and after Dodd-Frank?
Mr. Michel. Just having to divert so many resources to
compliance is a major problem. If you talk to smaller bankers
in particular, even smaller regional banks, they have been
getting hit with these things for years.
The Basel requirements were never intended for anybody
other than internationally active banks. That was the original
intention. And U.S. regulators decided, no, we are going to put
them on everybody.
It doesn't make any sense to have smaller community banks
going with these standards. And I would argue that it doesn't
make any sense to have them anyway. But if you are going to
have them on, you shouldn't have them on the smallest banks and
probably not on a lot of the regional banks.
Mr. Rothfus. Mr. Chairman, I yield back.
Mr. Neugebauer. I thank the gentleman.
Now the gentleman from Indiana, Mr. Messer, is recognized
for 5 minutes.
Mr. Messer. I thank the panel. I appreciate the lengthy
conversation today about the Byzantine nature of the capital
and liquidity standards under Basel. I would like to start by
focusing my testimony towards Mr. Chakravorti and Mr.
Calomiris.
As I think you are probably aware, Federal banking
regulators excluded all American municipal bonds from being
treated as high-quality liquid assets under the LCR rule. This
creates a remarkable situation where certain German
subsovereign debt qualifies as high-quality liquid assets when
American investment grade municipal bonds do not.
This makes no sense to me. These investments are some of
the safest investments in the world. And, of course, by not
qualifying these assets in that way, it could raise borrowing
costs for American local municipalities as they borrow.
I have, looking at that, coauthored bipartisan legislation
with Congresswoman Maloney that would essentially direct the
FDIC, the Federal Reserve, and the OCC to classify investment
grade municipal securities as level 2A high-quality liquid
assets.
And I would just like your feedback on that. As several of
you have testified, the situation is far too complex as it is,
but it certainly makes no sense to me to be penalizing
investment grade American municipal bonds.
Mr. Chakravorti. I support the view that high-quality
liquid assets, given its risk profile and liquidity profile,
should be as broad as possible. And if these munis do satisfy
that requirement, I am fully supportive of them being in the 2A
category.
Mr. Messer. Mr. Calomiris?
Mr. Calomiris. We have a little difference of opinion here.
So I don't think we want to play the game of the in and out.
And the way we do that is we focus on cash at the Fed bearing
interest, basically banks holding Treasury bills, and that is
what cash is, and we should just focus on a cash requirement.
But what your point really illustrates is that the Basel
Committee is the political equilibrium of people sitting at a
table. They push for including covered bonds as a cash asset.
Covered bonds are, from a systemic standpoint, a terrible thing
to include. They cause what we call asset stripping.
So Basel is a political G7 dining room table where deals
are made and tradeoffs are made, and we shouldn't have to deal
with and have to accept those definitions of what our liquidity
requirement should be.
Mr. Messer. Would anyone else like to chime in?
Mr. Michel. I would agree with Charlie. I wish I had come
up with the dining room table analogy. I like that.
It makes no sense. It is purely political. It is almost
wholly arbitrary, except for the fact that it is political, and
it is a terrible system.
Mr. Messer. Yes. And there are a host of other things that
ought to be included as well.
I yield back the balance of my time. Thank you.
Mr. Neugebauer. Thank you.
I now recognize the gentleman from California, Mr. Royce,
for 5 minutes.
Mr. Royce. Thank you, Mr. Chairman.
I think the need for cross-border resolution of compromised
financial institutions was made pretty painfully apparent
during the 2008 global financial crisis. Rightfully, cross-
border resolution is today at the forefront of the
international regulatory reform agenda.
I thank these witnesses for being with us.
During a recent update on the FDIC's efforts to create a
framework for the resolution of SIFIs and G-SIBs, Chairman
Martin Gruenberg said that there has been no greater or more
important regulatory challenge in the aftermath of the
financial crisis than developing the capability for the orderly
failure of a systemically important financial institution.
Now, I agree with him that this is an issue of paramount
importance. However, I question the comment in describing the
work to date in solving this cross-border resolution conundrum
as: The progress has been impressive.
I wanted to ask Dr. Chakravorti, do you share Chairman
Gruenberg's assessment on the progress made on ending ``too-
big-to-fail'' around the world and eliminating taxpayer
liability in the case of a financial downturn or do you side
with the IMF, which believes that there remains considerable
additional work, in their words, to be done to establish an
effective regime for cross-border resolution?
Mr. Chakravorti. That is a tough tradeoff, Mr. Congressman,
to choose between the IMF and the FDIC. What I would like to
say is that it is a very difficult issue. I have visited the
FSB and Basel. It is a complex issue.
I know that much of the cross-border that we should worry
about is in a few countries. So I think there is great movement
in the direction to get a cross-border agreement with some of
these countries, but it is very difficult. And I think we have
to start somewhere, and we are certainly going in the right
direction.
Mr. Royce. Then, let me ask Dr. Michel, what steps do
policymakers around the globe need to take to actually ensure a
method of cross-border resolution exists, one that does not
place American companies at a competitive disadvantage while
still preventing future taxpayer bailouts?
Mr. Michel. On the specific details of the cross-border
issue, I would have to defer. I am not comfortable with the
specific details there. But in general, I think what we need to
do is worry about making the American system as competitive as
possible. And bankruptcy law change would be much better than
the Title II that we got in Dodd-Frank.
Mr. Royce. Let's open it up to the rest of the panel then
very quickly. But we have had some time to think about this.
Ever since 2008, it should have been on our mind.
Mr. Calomiris. Let me just talk about that. I agree with
you. In fact, if you look at what the problem was in terms of
cross-border with the failure of Lehman, it was which regulator
is in charge of which assets? That was the major problem. That
was the major disruption and confusion. And I think that is
something that we are really moving to solve, and I think it
can be solved. That is different from orderly liquidation,
which I think is a pipe dream.
So my own view is, in terms of Realpolitik, the only way we
are going to solve this problem is with some kind of
ringfencing where there is clear allocation of authority over
which assets and which liabilities will be adjudicated and
controlled by which regulatory entities. And we can't have a
completely fluid international balance sheet. It is simply not
pragmatic.
So my view is international financial institutions can have
operations that are international, but they have to have legal
entities that are well-defined within national borders.
Mr. Royce. Thank you.
I am going to yield back, Mr. Chairman, because I see Mr.
Schweikert is pensively waiting, and I know time is short.
Mr. Neugebauer. I thank the gentleman.
And now the gentleman from Arizona, Mr. Schweikert, is
recognized for 5 minutes.
Mr. Schweikert. Thank you, Mr. Chairman.
To my friend from California, was that ``pensive'' or just
too much caffeine?
This actually has been an interesting conversation, and you
always run into the situation when you are last, that a number
of your questions have already been answered. So could we do a
quick lightning round, because there are a handful of things I
would love to get my head around?
Dr. Michel, in your opening statement you talked about if
you would also charter certain institutions as partnerships and
then the loss piece moves to the partners. Can you give me like
20, 30 seconds on that?
Mr. Michel. Sure. Before the Depression, what we had was
basically sort of a double liability system, and it wasn't a
corporate limited liability. It was you are responsible for
your losses as well as an amount up to the amount that you had
put in. During the 1930s and RTC and a lot of details, we
basically killed that. And I think for the last--I think the
last investment banking firm to get rid of that entity was
Bear. I could be wrong, but it was one of them.
Mr. Schweikert. Would that be another way of also saying,
okay, here is equity capital, but also the liability within
that equity capital?
Mr. Michel. Yes.
Mr. Schweikert. Okay. Simple enough?
Mr. Michel. I believe so, yes. And I know that a lot of
those companies will not want to do that right off, but if you
look at the amount of regulation that we force on them and you
take some of it away, some may be willing to go for the
tradeoff.
Mr. Schweikert. We are going to come back to that
opportunity and how do you incentivize either greater capital
or either greater risk participation.
And I always mispronounce, is it Dr.--
Mr. Calomiris. ``Calomiris.''
Mr. Schweikert. --``Calomiris.''
Okay. Real estate concentration, particularly for those of
us from the Southwest, we have seen our boom-and-bust cycles
and our real estate often taking down our S&Ls back in the late
1980s, what it has done to our banks.
The ability for banking institutions to syndicate risk on
their real estate book, saying we have this many real estate
loans, is there a way to hedge it, sell it off to private
equity, or even in today's world where I am watching the new
crowdsourcing, the lending clubs of the world in the real
estate market, but also taking that same model and allowing
those same banking institutions that act as aggregators where
that real estate debt ultimately is not sitting on their books,
they are just acting as the collection, management,
bookkeeping, and the risk is actually, shall we say, cascaded
with the series of individual institution, private equity
investors. Is that a model of breaking up that risk
concentration?
Mr. Calomiris. Any model that creates better
diversification and better maturity matching of the financing
of real estate is going to be a big improvement. And this isn't
farfetched. This is what we are already seeing.
Insurance companies do a lot of small local commercial real
estate financing. The farm credit system now has very high
capital requirements, and its mutual structure shares some of
that risk. I am not a big fan of the farm credit system, but my
point is that insurance companies, real estate investment
trusts, and the farm credit system are all very different kinds
of financing structures from traditional banks.
And I can't resist just adding one more thing: You all know
the story of, ``It's a Wonderful Life.'' That was a building
and loan. That movie is inaccurate. Building and loans couldn't
have runs, because they weren't funded by short-term debt. That
movie is just wrong.
Mr. Schweikert. Are you telling me Hollywood has lied to me
again?
Dr. Parsons, if I were sort of rebuilding the whole concept
around Dodd-Frank, and saying, look, in a modern world, with
modern technology, and modern information, how do I actually,
at least from my view of the world--I want a broad financial
system. We keep referring to it as the banking system, and then
those who want to sound more sinister, the shadow banking
system.
But ultimately, how do I create a world here where my
community bank may be where I go for that loan, but I also may
go on the Internet, I may go to a fraternal organization.
Wouldn't that breaking up of risk concentration ultimately make
us much more robust when the markets are--when we go through a
rough cycle?
Mr. Parsons. I think that is a great idea. I think we got
ourselves into a situation leading into the crisis where we had
these gigantic universal banks where we were pushing into the
portfolio every kind of activity that really wasn't even
related, but we were also then finding ourselves with certain
utilities, like the payment system and the like, hostage to
losses on various portfolios. What you proposed is exactly a
better financial system.
Mr. Schweikert. So to that same concept, how do I turn to
those same financial institutions and say: You should be able
to participate in financial markets, but in many different
ways. My particular fixation on the crowdsourcing of lending,
because it minimizes the cascade effect if the loan goes back,
because it is not either the bank or therefore the guarantors
and the taxpayers in the chain of liability. There has to be a
solution here that is much more dynamic for our markets.
Mr. Parsons. I think the regulators are trying to do that
kind of thing. When you look at the--
Mr. Schweikert. There, I disagree with you.
Mr. Parsons. --and you look at the G-SIB charge, they are
attempting to identify the risk of the specific activity.
Mr. Schweikert. Last comment: The regulators aren't doing
that. As a matter of fact, the regulators in many ways are
crushing the innovation right now.
With that, I yield back.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Maine, Mr.
Poliquin.
Mr. Poliquin. Thank you, Mr. Chairman.
And thank you, gentlemen, for being here today. I
appreciate it.
I am sure everyone agrees that our financial services
industry is the envy of the world. The reason why we have such
a strong economy, although we do have problems now, but over a
long period of time is because our financial services industry
provides the cash, the capital, the money, so businesses can
borrow and expand and hire more workers and our families can
borrow more money to buy a home or a new car.
Now, I am very concerned, like a lot of folks in this room,
that the Dodd-Frank set of regulations, parts of them, are
really smothering our financial system and therefore impacting
our economy and that is why we have had such anemic growth over
the last 6 years of this recovery. And one of the parts of
Dodd-Frank that I am concerned about, Mr. Messer spoke about a
short time ago, dealing with our high-quality liquid assets
issue.
Now, when I was the State treasurer up in Maine for a
period of time, we did lots of work with the municipal bond
market, and we accessed the market to repave Route 1, for
example, that brings all of our tourists up to Maine so they
can have nice lobsters and good vacations. This is very
important to our State. Our department also helped a lot of our
small towns, like Greenville or Jackman or Machias, if they
needed to build a new sewage treatment plant. And so having the
access to cheap credit for our States, our counties, our
cities, and our towns is critically important going forward.
If you look at our municipal bond market today, it is very
safe, it is very liquid, it is transparent, it has been around
for about 80 years, and there is about $4 trillion today
outstanding in our municipal bond market. A couple of years
ago, 2013, there was about $325 billion one year that was
issued. There are 1,600 broker-dealers that affect transactions
on both sides of the trade, and every 15 minutes the results of
transactions are posted on the electronic platform.
So in addition to that, moms and dads and grandparents who
are buying securities, who are saving for their retirement,
hundreds of thousands of them across our country participate in
this market, along with mutual funds, insurance companies, and
they all provide, again, the cash, the cheap credit to our
towns so they can grow, so we can build a new playground for
the kids down the street, or you can make sure you have a new
library if you need one.
So this is really important. And I am very concerned that
now the Fed and the FDIC are looking at this whole asset class
and saying, for some reason, that these very safe liquid
securities should not be included in the liquidity coverage
ratio.
So I would like to ask you, Dr. Chakravorti, if you don't
mind commenting on this, tell me what your thoughts are. Am I
missing anything here? Because it doesn't seem to be fair or
right to me that we exclude this whole type of asset class from
the liquidity coverage ratio for banks, because if we do, it is
going to have a big impact on moms and dads who are struggling
through this recession, because they are going to have to pay
higher taxes to pay for higher interest rates if we restrict
this type of whole asset class from this issue we have here.
Mr. Chakravorti. As I mentioned before, I think it is very
important when deciding characteristics of things that fall
into the A1, A2, level 2 category of the LCR that these
instruments truly be liquid and truly possess the underlying
risk characteristics that you want.
Mr. Poliquin. And do you feel that municipal bonds, in
fact, do meet those requirements?
Mr. Chakravorti. Let me just say, I haven't studied every
municipal bond in the country to tell you those
characteristics. I can tell you that I am sure there are some
that qualify. I can't say whether they all do. I am not an
expert in that area.
Mr. Poliquin. How about general obligation bonds? In other
words, if you look at the State of Maine, for example, is that
individuals and businesses who pay income tax and folks who go
visit our great State and pay sales tax when they buy a lobster
or can of Coke, these are all of the assets, the revenues that
backstop the interest payments on our GO bonds every 6 months
and the principal backed every 10 years.
Mr. Chakravorti. I understand how they are financed and
things like that, but things that come to mind, and please
don't take this the wrong way, are Greece, Orange County, and
other sovereigns that--I am not saying Maine is in this
category; I am not trying to say that.
Mr. Poliquin. Thank you.
Mr. Chakravorti. But what I am saying is that if there are
municipal bonds that meet the characteristics of asset similar,
then they should be--
Mr. Poliquin. I would make a case to you, Dr. Chakravorti,
in my final moments if I may, Mr. Chairman, that our sovereign
States here, which are required to balance their books every
year, are a much safer bet than some of the debt--
Mr. Chakravorti. Absolutely. I don't--
Mr. Poliquin. --accrued around here in Washington. Let me
tell you that.
But I thank you very much. I appreciate your comments, Dr.
Chakravorti.
Chairman Hensarling. The time of the gentleman has expired.
The Chair now recognizes the gentleman from Arkansas, Mr. Hill.
Mr. Hill. Thank you, Mr. Chairman.
And I thank our panel for being with us today.
I really want to get into a long, extended debate about
these real estate comments I have listened to today, because I
don't buy it. I have been in this business for almost 40 years
now. And I think customers and banks fully share interest rate
risk in traditional commercial real estate lending, portfolio
lending. And so I really want to take issue with that, but I
will not dwell upon it.
Mr. Sherman talked about rating dependencies, and in my
view, that is one of the more paper-oriented burdens actually
coming out of Dodd-Frank, is requiring banks to do a lot of
independent credit analysis and not be relying on the rating
agencies. In fact, it was completely counter to the discussion
I felt that you had, is that bank exams now do not allow you to
simply state for the rating sheet in a bank looking at your
portfolio. I think in some instances that is a good idea, and
in some it is not. But it is a huge source of paper burden on
small banks.
An example: In Arkansas, school bonds, which is fully,
gosh, 100 percent, I would say, of the municipal exposure of
commercial banks in Arkansas, are AA rated and guaranteed by
the State of Arkansas, so it is the equivalent of a GO in
Arkansas, and yet every one of those has to have stapled to it
the Bloomberg evaluation analysis and an independent credit
review, some of which is virtually impossible to do. So I
really think that is an area we could reform the regulatory
practice as a result of Dodd-Frank.
Also, you all talked about in the capital ratings, which
are so geared to credit risk, and you didn't really mention
interest rate sensitivity risk, which is also the ``S'' in the
CAMELS rating. And it is not a one-stop shop. When we make a
loan or buy a bond, we are taking credit risk, but we are also
accounting for and graded on interest rate sensitivity risk.
And I didn't hear any discussion of that today. Some of you
acted as if it didn't go into the calculus of that. I want to
give you a chance to talk about the balance between those two.
Dr. Michel, would you like to start?
Mr. Michel. As far as I know, Basel III does not include
any sort of weight for interest rate risk.
Mr. Hill. No, but your examine practice does. Every bank
has an interest rate sensitivity component.
Mr. Michel. I misunderstood.
Mr. Hill. Yes, that is my point. You are all beating up on
Basel III, but we are not taking into account that we have
another binder on the shelf in the boardroom that is all about
interest rate sensitivity, and the two work together. So really
comment on that if you would, please. Meaning, you have Basel
weight, sure, but it is not the only thing a bank takes into
consideration.
Mr. Michel. Well, no. There are certainly going to be
things that they have missed. Aside from the fact that they are
arbitrary, and aside from the fact that they are going to get
certain things wrong in what they have accounted for, there
would be some things that they would not account for. The
CAMELS ratings is actually much better in terms of just
accounting for sort of a comprehensive look at the bank.
Mr. Hill. Yes.
Mr. Calomiris. I think that after Basel II and going on to
Basel III, large banks do have to, as part of their internal
risk-based modeling, take account of their interest rate
exposure--
Mr. Hill. All banks, not large banks.
Mr. Calomiris. But I am saying under Basel, this was
reformed.
Whether that is done accurately is a separate question. And
I think that there is a lot of reason to believe that our
models of doing that which are being used might not be
accurate.
Mr. Hill. Right. We can't eliminate risk in the banking
business. That is the business that we are in. So I don't think
we can regulate our way out of that. And I think that is one of
the big flaws in the Dodd-Frank Act.
How would you take into a CAMELS rating, even though they
are confidential, in this idea of a market-based capital
standard and market-based risk, to Mr. Mulvaney's point? Any
suggestions or ideas there?
Mr. Calomiris. My view is that there are several different
pieces that you could use. I know that time is short. My CoCos
suggestion goes right to the point.
I would also point out that there are other simple things.
Suppose that you said that the risk of a loan is going to be
captured by its relative interest rate spread? There is a lot
of evidence that is true, that nonperforming loans are closely
linked to interest rate spreads. You could use that market
information to measure loan risk.
Now, that is not perfect, but if you had used the highest
interest rate in a mortgage as a measure of its risk, you would
have budgeted a lot more capital for subprime mortgages than we
did.
Mr. Hill. I would like to talk about that another day as
well.
Thank you, Mr. Chairman.
Chairman Hensarling. The time of the gentleman has expired.
The Chair asks unanimous consent that the gentleman of
Georgia be granted an additional minute. Without objection, the
gentleman from Georgia is recognized.
Mr. Scott. Thank you very much, Mr. Chairman.
Very quickly, I think we are overlooking, as I said, an
unintended consequence of this leverage capital rule. And I
hope you will have time to respond to me.
And here is my concern. When you require capital be held
against collateral for which banks are prohibited from
leveraging their own benefit, this will increase the cost
significantly of end users. And nobody has talked about that.
I am very much concerned about this. This will affect all
of our end users, people who had no issue with this meltdown. I
am talking about our farmers, our agriculture businesses, our
manufacturers, our energy producers.
And my fear is that banks will be less likely to take on
new clients for a derivative clearing, and as a result market
participants will have fewer choices and will be less likely to
use derivatives from hedging their own risk for management
purposes.
And as a result of mandatory clearing obligations for some
derivatives, some market participants, like what I mentioned
are innocent end users and agribusinesses, will not have any
option available to them to hedge their underlying risk and
will find this unwarranted capital treatment grounds against
our banks a reason for discontinuing their customer-facing
clearing businesses. This is an underlying but becoming more
obvious unintended consequence.
Mr. Calomiris, would you respond? I think you mentioned it
a little bit.
Mr. Calomiris. I think you are right, that we have to
strike a balance, and we have to recognize that there are costs
associated from imposing capital requirements, absolutely no
question about it.
At the same time, I just want to reiterate that if you
aren't gearing your capital requirements to making your banking
system safe, a collapsed banking system has much worse
consequences for those end users.
And let me point out, the United States has had since our
origins, 17 major banking crises. We are one of the least
stable banking systems in the world. And part of that reflects
the fact that we have sometimes bent too far in the direction
of short term, wanting to help borrowers politically, and at
the expense of our stability.
When we look at Canada to the north, they have never had a
banking crisis. That is a very interesting thing to note. And
they feel pretty well served by their banks, and I think they
like their stability.
Mr. Scott. Yes.
Just, Mr. Chairman, I want to end with this, that hopefully
we can pay a little closer attention to this, because we don't
want to inadvertently affect very dramatically our end users,
our manufacturers, and our agribusinesses and small businesses
because of Basel III.
Thank you, Mr. Chairman.
Chairman Hensarling. The time of the gentleman has expired.
There are no other Members in the queue, thus, I would like
to thank all of our witnesses for their patience and their
testimony today.
The Chair notes that some Members may have additional
questions for this panel, which they may wish to submit in
writing. Without objection, the hearing record will remain open
for 5 legislative days for Members to submit written questions
to these witnesses and to place their responses in the record.
Also, without objection, Members will have 5 legislative days
to submit extraneous materials to the Chair for inclusion in
the record.
This hearing stands adjourned.
[Whereupon, at 12:32 p.m., the hearing was adjourned.]
A P P E N D I X
July 23, 2015
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