[Senate Hearing 114-365]
[From the U.S. Government Publishing Office]





                                                        S. Hrg. 114-365


                 BANK CAPITAL AND LIQUIDITY REGULATION

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             SECOND SESSION

                                   ON

DISCUSSING THE STATE OF THE CURRENT CAPITAL AND LIQUIDITY REGIME IN THE 
  UNITED STATES AND THE EFFECTS OF CAPITAL AND LIQUIDITY RULES ON THE 
                             BANKING SYSTEM

                               __________

                              JUNE 7, 2016

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

MIKE CRAPO, Idaho                    SHERROD BROWN, Ohio
BOB CORKER, Tennessee                JACK REED, Rhode Island
DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois                  JON TESTER, Montana
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina            JEFF MERKLEY, Oregon
BEN SASSE, Nebraska                  ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas                 HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota            JOE DONNELLY, Indiana
JERRY MORAN, Kansas

           William D. Duhnke III, Staff Director and Counsel
                 Mark Powden, Democratic Staff Director
                    Dana Wade, Deputy Staff Director
                    Jelena McWilliams, Chief Counsel
                     Thomas Hogan, Chief Economist
                Shelby Begany, Professional Staff Member
            Laura Swanson, Democratic Deputy Staff Director
                Graham Steele, Democratic Chief Counsel
                       Dawn Ratliff, Chief Clerk
                      Troy Cornell, Hearing Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor

                                  (ii)






















                            C O N T E N T S

                              ----------                              

                         TUESDAY, JUNE 7, 2016

                                                                   Page

Opening statement of Chairman Shelby.............................     1

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

                               WITNESSES

Hal S. Scott, Nomura Professor and Director of the Program on 
  International Financial Systems, Harvard Law School, and 
  Director, Committee on Capital Markets Regulation..............     2
    Prepared statement...........................................    28
    Responses to written questions of:
        Senator Sasse............................................    71
        Senator Rounds...........................................    74
Marvin Goodfriend, The Friends of Allan Meltzer Professor of 
  Economics, Tepper School of Business, Carnegie Mellon 
  University.....................................................     4
    Prepared statement...........................................    33
    Responses to written questions of:
        Senator Sasse............................................    74
        Senator Rounds...........................................    77
Heidi Mandanis Schooner, Professor of Law, Columbus School of 
  Law, The Catholic University of America........................     5
    Prepared statement...........................................    36
    Responses to written questions of:
        Senator Sasse............................................    78
Paul H. Kupiec, Resident Scholar, American Enterprise Institute..     7
    Prepared statement...........................................    41

                                 (iii)

 
                 BANK CAPITAL AND LIQUIDITY REGULATION

                              ----------                              


                         TUESDAY, JUNE 7, 2016

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:02 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Richard Shelby, Chairman of the 
Committee, presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The Committee will come to order.
    Today we will hear testimony regarding one of the most 
critical areas of this Committee's jurisdiction: the regulation 
of the U.S. banking system. In particular, the panel of experts 
before us will discuss the appropriateness and effects of 
recent capital and liquidity rules.
    For years, I have urged regulators to implement strong 
capital requirements. I believe they are essential for a safe 
and sound banking system and also to avoid taxpayer bailouts.
    In 2006, when this Committee held a hearing on the Basel II 
Capital Accord, right here I remarked:

        We only need to look at U.S. economic history to see how thinly 
        capitalized banks have . . . made our financial system 
        vulnerable to unanticipated economic shocks and how a crisis in 
        the banking system quickly infects the rest of our economy.

    Shortly thereafter, our economy experienced the worst 
financial crisis in a generation, and it became clear, even to 
the Federal Reserve and other banking regulators, that the 
amount of high-quality capital held by many banks was 
insufficient.
    The question I think we must now ask ourselves is: Are 
banks in a position today to withstand another major financial 
crisis?
    Both Dodd-Frank and Basel III as implemented by U.S. 
regulators increased significantly the number of capital and 
liquidity requirements for financial institutions. But they 
also significantly increased their complexity. History has 
demonstrated that excessive complexity can actually lead to a 
weakening of capital standards--the exact opposite effect of 
what is intended.
    Recent studies have shown that simple capital ratios are 
better than complex risk-weighted ratios at predicting banks' 
asset risk and their probabilities of failure. These 
conclusions have been stated by experts from academic and 
governmental institutions such as New York University, the Bank 
of England, and the International Monetary Fund.
    Unfortunately, when pressed to do further analysis on the 
effectiveness of our capital and liquidity rules, our banking 
regulators have balked. In 2012, right here, I urged the 
regulators to conduct a transparent process in implementing 
Basel III and asked for more quantitative data on its 
effectiveness and economic impact.
    Regrettably, instead of performing their own rigorous 
analysis, they chose to outsource it to the Basel Committee. 
For example, the Federal Reserve relied on Basel analysis that 
included data from only 13 U.S. banks out of the 249 banks that 
were studied.
    Now, as banks respond to Basel and Dodd-Frank capital and 
liquidity requirements, I worry that regulators are again 
employing a process that is not thorough and does not consider 
the cumulative impact. Instead, they appear to think that more 
is better--more regulation, more regulators, and more spending. 
None of these, however, will necessarily ensure that banks 
actually hold more capital. In fact, the reverse may be true.
    If regulations are too complex to determine their 
cumulative impact or if they are even effective in the first 
place, then we must simplify them. Because unnecessary layers 
of complexity can create undue burdens for banks big and small, 
a more complex regulatory system could actually lead to an 
increase in systemic risk.
    How can we be assured that regulators are focused on the 
right measures when there are so many overlapping, and even 
counterintuitive, rules for capital and liquidity? I worry that 
they will be so focused on the details that they will, once 
again, be unable to see the forest for the trees.
    With that in mind, I look forward to hearing from the 
experts before us today on the state of our current capital and 
liquidity regime, as well as any recommendations that they may 
have. At this time I will introduce our witnesses.
    We will receive testimony from Professor Hal Scott, who is 
the Nomura Professor and Director of the Program on 
International Financial Systems at Harvard Law School, and he 
is no stranger to this Committee.
    Next we will hear from Dr. Marvin Goodfriend, The Friends 
of Allan Meltzer Professor of Economics at the Tepper School of 
Business at Carnegie Mellon University.
    Then we will hear from Professor Heidi Schooner, professor 
of law for the Columbus School of Law at The Catholic 
University of America.
    And, finally, we will receive testimony from Dr. Paul 
Kupiec, resident scholar at the American Enterprise Institute.
    We welcome all of you to the Committee. Your written 
testimony will be made part of the hearing record. We will 
start with Professor Scott.

        STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR AND
  DIRECTOR OF THE PROGRAM ON INTERNATIONAL FINANCIAL SYSTEMS, 
 HARVARD LAW SCHOOL AND DIRECTOR, COMMITTEE ON CAPITAL MARKETS 
                           REGULATION

    Mr. Scott. Thank you, Chairman Shelby, Ranking Member 
Brown, and Members of the Committee, for inviting me to testify 
before you today. I am testifying in my own capacity and do not 
purport to represent the views of any organizations with which 
I am affiliated.
    We have substantially increased capital requirements 
following the crisis. The largest U.S. banking organizations 
now face a total capital requirement of 15 percent of common 
equity on a risk-weighted basis and an overall leverage ratio 
of 5 percent for the holding companies and 6 percent for their 
insured depository institutions, and these increases are good.
    Although capital requirements can reduce the possibility of 
bank failures and moral hazard--a big plus--we should be aware 
that at any realistic level they cannot prevent the financial 
contagion that we experienced in 2008. In a financial panic, 
short-term debt holders run, regardless of any reasonable 
capital buffer, and these runs force banks to sell assets at 
fire-sale prices. The only way to stop financial contagion, in 
my view, is through central bank use of lender of last resort 
liquidity authority and expanded guarantees of short-term 
debt--powers, unfortunately, pared back by Dodd-Frank.
    Devising the content of capital requirements is a daunting 
task. The main problem with the leverage ratio is that it 
requires precisely the same amount of capital for all asset 
classes, irrespective of their various risks. As a result, the 
regulatory cost of capital is the same for both high- and low-
risk assets, giving bank management an incentive to increase 
return on equity by investing in high-risk assets with higher 
returns. Such incentives are inconsistent with prudent risk 
management.
    I would observe that, before 1986, when we joined the Basel 
process, the United States relied exclusively on a leverage 
ratio, and it was the weakness of this approach which spawned 
the risk weighting through the Basel Accords.
    However, risk-weighted measures themselves are also flawed, 
primarily due to the difficulty of assigning appropriate risk 
weights, whether that is done through standardized procedures 
or through bank models.
    In thinking about Basel capital and liquidity requirements, 
one very fundamental point must be kept in mind: They only 
apply to banks. This is significant in a financial system where 
nonbank financial institutions are of ever increasing 
importance. The costs to banks of meeting capital and liquidity 
requirements will undoubtedly spur even more growth of the 
nonbank financial sector.
    Finally, a few thoughts about the Fed's stress tests. I am 
concerned that the rationale for the assumptions underlying the 
stress tests as well as the Fed's model to predict losses are 
not open to public evaluation. While I share the Fed's concern 
that disclosure of the models could allow banks to game the 
system, more transparency is still needed.
    The Fed does subject its models to review by a Fed-
established Model Validation Council. However, the Fed chooses 
the experts, and no disclosure is provided about the actual 
evaluations of these experts. This could be done without 
disclosing the models themselves. Submitting the other 
components of the stress test, apart from the models, to public 
notice and comment, full rulemaking, would result in better 
decisionmaking and may in any event be
legally required.
    Thank you, and I look forward to your questions.
    Chairman Shelby. Dr. Goodfriend.

 STATEMENT OF MARVIN GOODFRIEND, THE FRIENDS OF ALLAN MELTZER 
  PROFESSOR OF ECONOMICS, TEPPER SCHOOL OF BUSINESS, CARNEGIE 
                       MELLON UNIVERSITY

    Mr. Goodfriend. Thank you, Mr. Chairman. I would like to 
speak today about the recently adopted liquidity coverage ratio 
requirement. It is an example of the complexity that you were 
talking about. I believe this is a particularly ill-conceived 
means to facilitate liquidity in the banking system, especially 
relative to the alternatives, which I will describe.
    The liquidity coverage ratio requirement mandates that a 
bank hold a stock of so-called high-quality liquid assets on 
its balance sheet sufficient to meet projected net cash-flows 
over a 30-day period. Sounds simple enough, but the rules for 
calculating the qualifying liquid asset numerator and the net 
cash outflow denominator are extraordinarily complex. The 
complexity may be appreciated by the length of the notice on 
the final LCR rule published in the Federal Register, which 
takes over 100 pages to respond to around 300 comments on the 
initial proposal.
    A presentation produced by Davis Polk to help its clients 
comply with the LCR takes remarkably 100 slides of such detail 
that it was hard for me to figure out what they were doing. I 
refer you to my testimony and the references therein for a 
convoluted discussion of what this means.
    There are two serious operational problems in employing the 
LCR, as it is called. The first problem is how high to set the 
overall required liquidity coverage ratio itself. Set too high, 
the requirement may bind too often, creating destabilizing 
scarcities of liquidity. Set too low, the requirement may bind 
too loosely, in which case the burdensome enforcement and 
compliance costs count for little.
    A second and equally important problem is that the LCR 
requirements encumber--they actually encumber the liquid assets 
that banks would otherwise have available to use in times of 
stress. Regulators acknowledge this encumbrance problem and 
intend to employ appropriate supervisory flexibility to grant 
allowances for LCR requirement shortfalls--that is their 
language--in periods of financial distress. Such discretion is 
likely to sow confusion. Will regulators be lenient or 
reluctant to grant such allowances? Banks will find it 
difficult to predict regulatory inclinations. Regulators, 
therefore, will find it more difficult to understand what banks 
are doing in terms of their liquidity. And if inadvertently 
made public, allowing these regulatory shortfalls could signal 
a bank's weakness.
    Now, one of the alternatives I want to talk about is 
monetary policy. Monetary policy remains the undisputed and 
most efficient provider of ultimate liquidity to the banking 
system in the form of reserve balances at the central bank. 
Monetary policy has long stabilized interest rates by 
accommodating the demand for required and excess reserves in 
periods of banking stress. Now for the first time in the United 
States, the Federal Reserve has the power to pay interest on 
reserves as acquired in 2008. That power enables the Fed to 
pre-position fully unencumbered excess reserves on bank balance 
sheets in large quantity at market interest without reserve 
requirements or regulations of any kind, even as the Fed 
targets interest rates for other monetary policy purposes.
    The Fed will no doubt shrink its balance sheet from the 
current $3 trillion outstanding to something more normal. My 
point is that, going forward, monetary policy utilizing 
interest on reserves would be a far less--a far, far less 
burdensome means of efficient pre-positioning liquidity on bank 
balance sheets than the liquidity coverage ratio.
    My last point is that the liquidity coverage ratio is also 
designed in part to deter liquidity funding risks that banks 
incur due to the use of uninsured, potentially unstable, short-
term wholesale liabilities. In aggregate, short-term wholesale 
funding comes from money markets which are funded in part by 
attracting retail deposits away from banking in the first 
place, so retail deposits can be repackaged for higher-
interest, wholesale funding at banks. In effect, the recycling 
of funds from retail to wholesale funding via money markets is 
a regulatory arbitrage. Banks readily pass intermediation and 
regulatory costs to retail depositors and lower retail deposit 
rates, but must pay higher interest when competing for 
institutional wholesale funding from money markets.
    Since institutional deposits are uninsured for the most 
part and managed professionally, they are more prone to being 
withdrawn at any sign of trouble. As a consequence, the banking 
system incurs ever greater liquidity funding risk.
    The question is: What is the best way to handle the growing 
funding liquidity risk in the banking system? One option is the 
liquidity coverage ratio, which is to cover and deter this kind 
of high-run prone, institutional, wholesale funding. But as I 
just said, the liquidity coverage requirements have tremendous 
enforcement and compliance costs and regulatory discretion 
complications.
    What is the second option? The second option is to 
internalize bank balance sheet risks with simple, sufficiently 
elevated bank capital leverage requirements. With enough of a 
bank's owners' capital at stake, a bank has the incentive to 
manage prudently not only its credit and market risks but its 
liquidity risks so as not to jeopardize its solvency due to a 
temporary shortfall of funding.
    Sufficiently elevated leverage would obviate the need for 
more burdensome LCR regulations and requirements. Regulation 
costs would be contained, as would the regulatory arbitrage 
that helps perpetuate the growth of wholesale funding in the 
first place.
    Thank you.
    Chairman Shelby. Professor Schooner.

    STATEMENT OF HEIDI MANDANIS SCHOONER, PROFESSOR OF LAW, 
   COLUMBUS SCHOOL OF LAW, THE CATHOLIC UNIVERSITY OF AMERICA

    Ms. Schooner. Chairman Shelby, Ranking Member Brown, and 
Members of the Committee, thank you for inviting me to today's 
hearing. I will raise two related concerns regarding bank 
capital.
    First, sufficient equity capital is vital to safety and 
soundness of financial institutions, and yet current capital 
regulations are insufficient to provide such safeguards.
    Second, current supervision by the regulators and the 
Federal Reserve in particular do not make up for such 
deficiencies. Equity capital remains extremely low.
    Financial institutions rely much more on borrowed money 
than other firms, yet banks that borrow less money to fund 
their operations are more resilient and less likely in a crisis 
to become distressed, to stop lending, or require Government 
assistance. For this reason, capital regulation, the set of 
rules that restricts the banks' borrowing, has emerged as the 
cornerstone of modern bank
regulation.
    Despite the significant benefits of capital regulation, it 
has its limitations. While current regulations require banks to 
fund their operations with less debt than in the years prior to 
the financial crisis, these new capital ratios remain much 
lower than many experts believe are adequate for safe 
operations.
    Also, challenges persist regarding the inputs to those 
ratios, which make a big difference with respect to their 
effectiveness. For example, as Professor Scott noted, there 
continues to be debate
regarding the use of risk-weighted ratios versus unweighted 
capital ratios. If I could use a teacher's analogy, I think of 
this as a little bit like comparing a grading curve that is 
weighted so that pretty much everybody gets a B to an 
unweighted grading curve which does not make such adjustments. 
We can all guess which system my students prefer, and I think I 
know which system banks prefer as well.
    While few would deny the significant benefits of equity 
capital, the industry complains that equity is costly. Yet the 
cost to financial institutions must be balanced against the 
social benefits of a more resilient financial system. 
Unfortunately, current capital regulations were not derived 
from an analysis of the social costs and benefits.
    The rules that govern bank capital are often referred to as 
``minimum capital ratios.'' This is because institutions that 
comply with current capital ratios are not necessarily safe or 
unlikely to fail in a crisis. In fact, we know that minimum 
capital ratios are a lagging indicator of banks' financial 
stability. During the financial crisis, banks that failed or 
required Government support appeared adequately capitalized 
under the then current rules.
    Because current minimum rules are insufficient, bank 
regulators examine banks individually to determine, among other 
things, the sufficiency of their capital. This firm-specific 
supervisory process effectively imposes higher capital 
requirements on banks through administrative enforcement 
actions brought against smaller banks and through the Federal 
Reserve's Comprehensive Capital Analysis and Review, or the 
CCAR, process. CCAR assesses a bank's ability to maintain 
minimum capital ratios under hypothetical stressed scenarios. 
Banks failing these capital stress tests are prohibited from 
paying dividends to their shareholders. CCAR, in effect, 
results in higher minimum capital requirements for large bank-
holding companies.
    While higher capital requirements through CCAR sound like a 
great idea, sound promising, this system is actually at odds 
with what we call ``prudential regulation'' in that the 
supervisory process builds only on weak minimum capital rules. 
Also, consider the fact that CCAR relies heavily on modeling of 
future events, and one thing we learned in the financial crisis 
is the folly of relying on such predictions.
    Our combined rulemaking and supervisory process would be 
more effective if capital ratios applied to all banks were set 
high--high enough so that the risk of serious 
undercapitalization, distress, or insolvency was small. This 
would mean that capital ratios would be consistent with a 
precautionary approach, erring on the side of more capital. In 
addition, the supervisory approach would continue to be engaged 
dynamically for assessment of firm-specific risks and, when 
appropriate, to trigger prompt corrective action well in 
advance of insolvency to build equity back to precautionary 
levels through retained earnings or other actions.
    Prudent capital regulation would shift the downside risk 
from the public to equity investors. These are the people who 
enjoy the upside of bank profits and, thus, are the most 
natural candidates to bear the downside risk. Strong equity 
capital would correct the current distortion and establish 
safer banks and a more resilient financial system.
    Thank you.
    Chairman Shelby. Dr. Kupiec.

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

    Mr. Kupiec. Thank you. Chairman Shelby, Ranking Member 
Brown, and distinguished Members of the Committee, thank you 
for convening today's hearing. I have submitted detailed 
written testimony which I will summarize in my oral remarks.
    Complex regulations are justified when complexity is 
necessary to do the job. Crafting simple and effective 
regulation is difficult. Today's subject reminds me of a 
favorite idiom: ``I did not have time to write a short memo, so 
I wrote a long one.'' The bank regulators have been writing a 
lot of long memos lately, and it is time to require them to 
make them shorter.
    U.S. regulators, in cooperation with the Basel Committee 
and more recently the Financial Stability Board, are busy 
writing complex new rules, but there are serious concerns that 
those rules will not satisfy the goals set by Congress. In some 
cases, the complex rules are not achieving the goals 
articulated in legislation. In other cases, hastily drafted 
legislation directs regulators to pursue a single-minded goal 
without regard to the costs involved for banks, consumers, or 
the vitality of the economy. This needs to change.
    Back in the early 1990s, Congress passed FDICIA and Prompt 
Corrective Action, or PCA. PCA requires regulators to impose 
remedial measures on weak banks and to close failing banks 
quickly before they can generate losses for the Deposit 
Insurance Fund.
    Basel capital ratios are used in the prompt corrective 
action rules, but they have a terrible record of performance. 
In the past financial crisis, on average regulators closed 
banks when their Basel capital ratios were positive, but the 
closed banks still generated large insurance fund losses. In 
fact, the loss rates in the recent crisis were larger than loss 
rates in the crisis periods before PCA and Basel capital ratios 
were in place.
    Basel capital ratios overstate the true liquidation value 
of an institution. Analysis by myself and others showed that 
simple
transparent measures of a bank's solvency condition--for 
example, the so-called nonperforming asset coverage ratio--
identify weak and failing institutions far more efficiently 
than the Basel capital ratios.
    Researchers have estimated that the Deposit Insurance Fund 
losses would have been reduced substantially had the 
nonperforming asset coverage ratio been used in place of the 
Basel capital ratios in prompt corrective action rules. So on 
the most basic level, the complex Basel capital rules are not 
doing their job.
    When you hear from bank regulators, I am sure they will 
tell you that this is no longer a problem as Basel III fixed 
the holes in the rules. But this is not true. Basel III 
improvements do not fix the underlying problem that made Basel 
capital ratios perform so poorly. It is the lack of timely 
reserves for nonperforming assets.
    Another example of unnecessary complexity is the total 
loss-
absorbing capacity, or TLAC, rules formulated by the Basel and 
the Financial Stability Board. In the United States, the final 
Federal Reserve Board TLAC regulations have yet to be issued. 
As you may know, TLAC requires the largest bank-holding 
companies to have not only a higher minimum level of regulatory 
capital, but also to maintain minimum amounts of long-term 
subordinated debt. The sole purpose for TLAC holding company 
debt is to give regulators a slush fund so that they can 
recapitalize large banks owned by the large bank-holding 
companies. My analysis has convinced me that the TLAC 
regulations will not solve the too-big-to-fail problem. The 
TLAC regulations will work when the Secretary of the Treasury 
can invoke a Title II resolution. If the Secretary cannot 
invoke Title II, parent-holding company TLAC resources are not 
available to regulators. And there are many plausible scenarios 
in which a bank subsidiary might fail without Title II as an 
option.
    Indeed, the clean holding company requirements in the 
proposed TLAC rule will make it less likely that the Secretary 
can use Title II. But if the situation does allow regulators to 
use TLAC, the outcome is even more disturbing. The proposed 
TLAC strategy will extend new Government guarantees to more 
than $4.3 trillion in
liabilities issued by the subsidiary banks of TLAC holding 
companies. Without TLAC, these liabilities would suffer a loss 
in a bank failure.
    With more Government guarantees, TLAC will make the too-
big-to-fail problem worse not better, and because TLAC imposes 
no constraints on how the holding company can use TLAC funds, 
there is no guarantee that TLAC will reduce the too-big-to-fail 
interest rate subsidiary.
    TLAC is a clear case where regulators should be asked to go 
back and write a much shorter memo because there is a much 
simpler fix. All TLAC goals can be achieved by raising the 
capital requirements on too-big-to-fail bank subsidiaries.
    My written testimony also includes a discussion of the 
liquidity regulations, but as my time is short, I cannot cover 
these in my oral remarks. Thank you, and I look forward to your 
questions.
    Chairman Shelby. At this time, before we ask questions, I 
want to recognize Senator Brown for his opening statement.

               STATEMENT OF SENATOR SHERROD BROWN

    Senator Brown. Thank you. Thank you, Mr. Chairman, and 
thanks for the unorthodox way that you are doing that. I 
appreciate it. And I also appreciate that this Committee almost 
always starts exactly on time. I appreciate your punctuality. 
It did not serve me today, and I apologize for being late.
    And I also ask, Mr. Chairman, that at the conclusion of my 
remarks, when the questions begin, that on the Democratic side 
Senator Warren be called on and then Senator Merkley and then 
me, in that order.
    Chairman Shelby. So ordered.
    Senator Brown. Thank you.
    In the lead-up to the recent crisis, it appeared that large 
financial institutions were meeting or exceeding their capital 
requirements, but in reality, they were allowed to use leverage 
that
exceeded 30 times their capital due to hidden off-balance-sheet 
exposures and a weak definition of what counted as core 
capital. To make matters worse, these institutions had invested 
in too many risky and opaque assets that lost value quickly, 
funded by short-term liabilities that could be called at a 
moment's notice.
    American taxpayers paid the price for this reckless 
behavior. The American people paid the price in lost homes and 
jobs and billions of bailout dollars. Whenever we talk about 
the millions of jobs lost and the billions in household wealth 
erased, we sometimes grow numb to these statistics. We have to 
remember that there are people behind these numbers. That is 
why we passed Wall Street reform. We have seen the millions of 
homes foreclosed on. We have seen the wealth that retirees 
lost. We have seen the jobs lost, and these are hundreds of 
thousands and millions of Americans whose lives got worse as a 
result of regulators' and this body's failure on financial 
reform issues.
    To have a healthy economy and safe financial system, we 
need to have a strong regulatory framework. In its 5-year 
anniversary report on Wall Street reform, the ratings agency 
S&P credited capital and liquidity rules, as well as stress 
tests and living wills, with enhancing the safety of the U.S. 
banking system. To their credit, the Fed, the FDIC, and OCC 
have gone above and beyond the international Basel capital 
agreement through rules like a higher leverage ratio and a 
capital surcharge.
    Last week, Fed Governor Jay Powell suggested the capital 
requirement should increase for institutions as they become 
larger and more complex, forcing them to rethink their 
activities and their business models.
    Last week's announcement that the Fed will raise the 
capital levels for the largest banks to pass its stress test 
indicates that the Fed as a whole thinks there is more work to 
be done. Experts on the left and on the right agree that 
capital is a vital element of financial stability. Capital 
lessens the likelihood that an institution will fail. It lowers 
the cost of the financial system and, most importantly, to the 
economy if it does. Requiring the largest banks to fund 
themselves with more equity will provide them with a simple 
choice: they can either fully internalize the risk that they 
pose to the economy--Governor Powell's words. They can either 
``fully internalize the risk,'' or they can become smaller and 
simpler.
    Banks have argued and banks will continue to argue that 
making them have more equity will reduce lending and will cause 
the economy to contract. But banks have a range of options to 
meet the new standards in ways that do not limit lending, 
including seeking out equity investments, retaining earnings, 
limiting dividends and stock repurchases, and curtailing 
bonuses.
    We have heard arguments that stronger capital requirements 
put our institutions at a competitive disadvantage, but there 
is evidence that U.S. banks' higher capital has been a 
competitive advantage.
    For example, the president of one of the largest U.S. banks 
said in February that our banks benefited from moving quickly 
to raise more capital.
    Still, the recent living wills results show that several of 
our Nation's banks still have deficiencies and shortcomings in 
their capital and in their liquidity, and most of them could 
not fail without threatening our financial system.
    That is why we have these regulations; it is why we should 
not merely fight to preserve the status quo. We also need to 
move forward. We need stronger, simpler rules that cannot be 
gamed by Wall Street economists or watered down by Wall Street 
lobbying.
    Unfortunately, too many of the efforts we see in Congress 
right now are intended to undermine and roll back regulation--
ultimately putting Americans back at risk, as if we forgot what 
happened in 2007 and 2008.
    The financial crisis has had a real and deep impact on 
working families. We are still trying to undo the damage, 
putting strong safeguards in place to make sure it never 
happens again.
    I look forward to my colleagues' questions.
    Chairman Shelby. Thank you, Senator Brown.
    I will start with you, Professor Scott. In your testimony 
you stated that, ``A major problem with the stress tests . . . 
is that their design is largely secret and not open to public 
evaluation.'' In what ways could the Federal Reserve make the 
stress test process more transparent?
    Mr. Scott. Thank you for the question, Senator Shelby. I 
think there are two parts to this.
    One is that the stress test contains a lot of different 
assumptions about extreme scenarios--what the rate of GDP 
growth will be or decline will be, unemployment rates and so 
forth. These assumptions, which are critical to the outcome of 
the test, are never put out for notice and comment through a 
normal rulemaking procedure because I believe that the Fed 
regards these as supervisory measures. The whole stress test 
legally, therefore, is an adjudication aimed at specific banks 
rather than a general regulation. So my first advice would be 
for those components, the assumptions underlying the test, they 
be put out for notice and comment.
    Second, the model. The Fed has a model by which they take 
the data that is supplied to them by the financial institutions 
based on their assumptions and predict loss rates, and those 
loss rates figure into whether the banks have adequate capital.
    The Fed believes the disclosure of the model would allow 
banks to game the model. Now, maybe that is a legitimate 
concern. I am sympathetic to that. However, that does not 
excuse any
transparency around the model. They created a council of 
experts which is supposed to evaluate the model. The problem is 
we do not know anything about what the experts evaluate or what 
they say, so I think there should be more transparency around 
the models evaluation by the experts, which does not require 
the actual disclosure of the model itself.
    Those would be my recommendations.
    Chairman Shelby. Dr. Kupiec, I will direct my next question 
to you. The chief economist of the Bank of England has argued 
that the complexity of the Basel system, and I will quote, 
``makes it close to impossible to account for differences 
across banks. It also provides near limitless scope for 
arbitrage.''
    Do you agree? If so----
    Mr. Kupiec. Absolutely. The system----
    Chairman Shelby. Explain to the Committee.
    Mr. Kupiec. Well, just since 2011 and the Dodd-Frank Act, 
we had revisions, thousands of pages of revisions and new 
rules. We have trading book rules that are hundreds of pages 
thick and very complex, rule upon rule. We have now the basic 
capital rules to Basel III. We have G-SIB capital add-ons 
rules. We have liquidity rules, not just a short-term liquidity 
rule that Dr. Goodfriend talked about, but now we have a net 
stable funding ratio, which is a 1-year liquidity type rule in 
place.
    How these rules interact and how they work on a bank and 
bank management I do not think anybody has worked out. Even the 
Federal Reserve, or the Chairman of the Federal Reserve herself 
said that, you know, they do not have a good handle on how all 
the rules interact.
    When it comes to things like risk weights and modeling, 
markets are very creative about ways to turn an asset with a 
very high risk weight through some financial engineering 
process into something that has a lower risk weight. So how did 
they do that? Well, they turned mortgages that used to be held 
on bank balance sheets, even if they were private label and not 
guaranteed, they turned them into securities that were rated 
AAA, so they got a much lower risk capital weighting. And then 
they brought them into the trading book, which gave them an 
even lower risk capital weighting. All this was done in plain 
daylight under the regulatory--you know, regulators knew this 
was going on. We went into the banks. I was a regulator once. 
But all of this transpires over time. The more complexity, the 
more ways there are to change the way things look, to get them 
in through the bank, and the harder it is for anybody to 
assess, especially before there is a financial crisis, before 
something goes wrong, the harder it is to assess or win an 
argument that there really are problems here. Mortgages and 
mortgage-backed securities were considered incredibly safe, you 
know, all the way up to when they were not, and that is kind of 
the problem with these kind of very complex rules.
    Chairman Shelby. Thank you.
    Dr. Goodfriend, since the financial crisis, U.S. regulators 
have put greater emphasis on what they call the 
``macroprudential regulations'' that are aimed at reducing 
total risk in the banking system. Do you believe that 
macroprudential regulations can
effectively reduce systemic risk in the banking system? Why or 
why not?
    Mr. Goodfriend. I think macroprudential regulations are a 
way of misdirecting attention from permanently higher capital 
in the form of leverage ratio requirements. Macroprudential 
regulations, when people talk about them, they are usually 
described as ``countercyclical,'' which means we will leave the 
capital ratios relatively low when we do not need them, and 
when the economy looks like it needs them, we will crank them 
up.
    The dynamics, the dynamic management of macroprudential 
regulations is in my view a fool's errand, and I come from 
central banking where we worry about managing the interest rate 
over the business cycle. It is very difficult to do that. I 
cannot imagine having macroprudential regulations dynamically 
managed over the business cycle in the way that interest rates 
are managed over the business cycle. You would have a whole 
slew of problems managing macroprudential regulations 
themselves, and you would also have this entanglement with the 
interest rate being managed over the cycle. I am very much 
against macroprudential regulations as a dynamic tool to keep 
the aggregate more persistent capital regulations lower on 
average. I think that is a misdirection and would be very 
dangerous.
    Chairman Shelby. Professor Scott, one more question for 
you. The Federal Reserve's annual review of large and regional 
banks' capital plans, known as CCAR, determines banks' ability 
to withstand stress scenarios. Last week, Fed Governors Powell 
and Tarullo both made comments suggesting that the G-SIB 
surcharge will be incorporated into this review. Governor 
Tarullo said, ``Effectively, this will be a significant 
increase in capital.''
    To what extent has CCAR become the new standard for 
regulatory capital requirements? And what are some of the pros 
and cons of using annual stress tests as a mechanism to 
regulate capital? I know that is a lot of territory.
    Mr. Scott. I will try to do my best.
    Chairman Shelby. Oh, you will do better than that.
    [Laughter.]
    Mr. Scott. I think the virtues of CCAR are important. They 
look to the future. It is a dynamic process. The question is: 
Given the banks' plans, given what their business is, given how 
the economy evolves, will the bank have enough capital?
    Basel is more of a static measure, a balance sheet static 
measure. So there are different ways of going about it.
    Now, some people think we need both because they kind of 
look at different things, sort of static and future. I would 
say that most banks would manage to the future, and I think 
most of us would be concerned not what is going on today but 
what is going to go on in the future.
    So I think the stress tests are a good thing and have a 
very big role to play. I think they are becoming the binding 
constraint; that is, many banks believe that when we come to 
the end and the question is how much capital do I really have 
to hold, and I look at what Basel says I have to hold, and then 
I look at what the stress test says I have to hold, the stress 
test says more.
    So the effective level of capital that we look at when we 
talk 15 percent or 20 percent--really the stress tests are 
driving all this--those numbers are a little bit misleading 
because we really want to know what the stress tests dictate 
are the levels of capital.
    In terms of raising the levels through the stress test, I 
think the Governors did indicate--and I would say this was a 
good thing--that they are going to put out for comment, notice 
and comment, this increase for G-SIB capital requirements part 
of the stress test. I commend that.
    At the same time I think they should be taking all the 
assumptions that they are using in the stress test and also put 
those out for notice and comment.
    Chairman Shelby. Professor, would that actually be an 
increase or would it just be the way they would deem it to be 
an increase in----
    Mr. Scott. As I understand it, it would basically further 
increase the capital requirement. That is my understanding--of 
the stress test. In other words, you would have to now have 
more capital as a G-SIB to pass a stress test than you would 
without this increase.
    Chairman Shelby. I will pose this to all of you, and then I 
will recognize Senator Warren. Do any of you know of any 
financial institution that has failed or been bailed out, you 
know, all of it, that has been well capitalized, well managed, 
and well regulated? I do not know of any, but you might, an 
institution that is well capitalized, well managed, and well 
regulated. Professor Scott, do you know of one?
    Mr. Scott. I cannot think of one off the top of my head, 
Senator.

        I would also like to elaborate further on my response to 
        Chairman Shelby's question regarding the failure or bail out of 
        any well-capitalized, well-managed and well-regulated financial 
        institution. While there were no such
        institutions that failed or required a bailout during the 
        financial crisis, JPMorgan and Wells Fargo were such 
        institutions that received bail out funds through the Capital 
        Purchase Program (``CCP''). As part of the CCP, the Government 
        required healthy financial institutions that did not need 
        support, along with the less healthy institutions that did need 
        support, to take Government assistance. The reason to require 
        healthy institutions, including JPMorgan and Wells Fargo, to 
        receive assistance was to avoid publicly identifying any 
        particular banks as troubled. However, since most analysts can 
        typically distinguish the relative health of banks, I do not 
        believe this practice should continue in the future.

    Chairman Shelby. What about you, Dr. Goodfriend?
    Mr. Goodfriend. No, I do not.
    Ms. Schooner. No, I do not.
    Chairman Shelby. We all want to avoid bailouts, and we want 
a strong banking system, and I think you start with capital and 
how you count it.
    Senator Warren.
    Senator Warren. Thank you, Mr. Chairman. Thank you, Senator 
Brown. And thank you all for being here today.
    According to news reports, Congressman Hensarling, the 
Republican Chairman of the House Financial Services Committee, 
will soon be introducing a bill that repeals many of the 
financial reforms Congress put in place after the 2008 crisis. 
Now, we have only seen a summary of the bill so far, but even 
from that, it is clear that Congressman Hensarling and his 
fellow Republicans think that the poor Wall Street banks have 
suffered too much under the new rules and it is time for them 
to return to the good old days before the 2008 crisis when 
these banks could run wild.
    Now, I only have 5 minutes today, but let us take a look at 
some of the many problems with Congressman Hensarling's ``wet 
kiss'' for the Wall Street banks.
    The first is the Congressman's claim that he can end too-
big-to-fail by repealing the Financial Stability Oversight 
Council's ability to designate huge financial firms as too-big-
to-fail and put some extra restrictions on them. Apparently, 
Congressman Hensarling thinks that you can end too-big-to-fail 
simply by stopping regulators from calling firms ``too big to 
fail.'' I do not actually think that is how it works.
    So, Professor Schooner, do you think that limiting the 
FSOC's ability to identify too-big-to-fail banks and subjecting 
them to additional controls will end too-big-to-fail?
    Ms. Schooner. No, I do not. I think the one thing we 
learned from the financial crisis is that prior to 2008 we 
focused our prudential regulation basically on the solvency of 
commercial banks. And what we saw in the crisis was that our 
focus was too narrow, that there are other financial 
institutions that present risks, and there are risks outside of 
insolvency. And so the creation of the FSOC and the SIFI 
designation process was a major response to those views, to the 
lessons learned from the crisis. So eliminating the SIFI 
designation will not make those risks disappear, and it will 
only leave them unchecked and will now make our financial 
system safer.
    Senator Warren. Thank you. So let us look at some of the 
other changes that the Congressman proposes. Financial 
regulators have been independently funded since they were 
created, in some cases dating as far back as the Civil War. The 
idea was to keep politicians from interfering by threatening to 
cutoff a regulator's budget when the regulator tried to clamp 
down on a politically powerful bank.
    Congressman Hensarling wants to get rid of that protection 
so that the bank regulatory process will be subject to more 
political meddling. He also wants to subject any new major 
financial rule to a second vote in Congress, effectively giving 
congressional Republicans the ability to block any rule that 
they or their friends on Wall Street do not like.
    Now, Professor Schooner, do you believe that these changes 
will make our financial system more secure or less secure?
    Ms. Schooner. As this Committee is well aware, bank 
regulators are often not the most popular people in the world. 
They are the ones that tell banks to stiffen their lending 
requirements, et cetera, and that is often not popular, which 
is why independence of banking agencies is a key design feature 
around the world.
    Another key design feature for bank agencies is their 
responsiveness. They need to be able to act quickly to threats 
and emerging changes in the markets. It sounds like this 
proposal would undermine both independence and responsiveness, 
and I do not think it would make our banks safer.
    Senator Warren. Well, thank you very much. You know, 
Congressman Hensarling is in New York today meeting with Donald 
Trump to discuss what we could call his ``Wet Kiss for Wall 
Street Act.'' Now, while most Republicans in Congress are 
debating not whether to run away from Trump but how far and how 
fast, Congressman Hensarling is sprinting toward Trump Tower.
    You know, I get that the Republicans want unity right now. 
They want to do well in the elections, and they think unity is 
how to get there. But if unity means a marriage between Donald 
Trump's toxic racism and Jeb Hensarling's Wall Street 
giveaways, then I think they would be better off with division. 
That is not what the American people are looking for, and it is 
a path to ruin both for our economic system and for our 
country.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Scott.
    Senator Cotton. Thank you, Mr. Chairman.
    Dr. Kupiec, last year, in the Wall Street Journal, you made 
a statement that the Basel Committee apparently never 
considered the possibility that interest rates would remain at 
or near zero for many years, and that in a zero rate 
environment, the new liquidity rule would make it uneconomic 
for banks to hold large institutional deposits unless they 
charged these customers negative interest rates.
    The Basel liquidity rule was supposed to ensure that banks 
have adequate liquidity, but instead it is encouraging banks to 
reject liquid deposits.
    If liquidity is still being forced out of the banking 
system--and it appears that it is--how will banks be affected 
if they are required to hold additional capital above current 
mandated levels?
    Mr. Kupiec. The issue with liquidity, the Basel Committee 
never considered that interest rates would go negative across 
the term structure. It is not such a--it is not as big of a 
problem in the United States. It is a huge problem in Europe. 
And the fact of banks charging people to hold their money in 
Europe is a much bigger problem than in the United States. But 
even in the United States, many of the large banks have sort of 
encouraged their clients that had a lot of deposits on board to 
maybe find somewhere else to put it.
    So, I mean, if a banking system is not there to hold 
deposits, I do not know what a banking system is for. So this a 
fundamental problem with the rule.
    When you come to liquidity rules and you go back in 
history--and some of my colleagues on the panel today know a 
lot about this stuff--the first thing historically that made a 
banker a banker was that he had to have liquidity. If in the 
olden days before there was regulation and insurance and a bank 
was not liquid, well, then, it was shut down. So having 
liquidity is the first-order thing that a banker has to do to 
be a banker. And now what we have done is we have introduced 
all these very complicated rules that tell bankers how to, in 
essence, be a banker. You cannot be a large bank unless you 
hold 30 days' worth of assets that, if you have a depositor 
run, you could fire-sale your assets for 30 days and still fund 
yourself if you were totally locked out of the markets. That is 
the liquidity coverage rule. It pushes banks into Treasuries. 
It pushes you into things that in Europe have negative interest 
rates and in the United States have very low interest rates.
    So you are going to have your balance sheets loaded up with 
a bunch of Government securities. You are going to try to buy 
the long-dated securities because they count the same in the 
liquidity coverage ratio as short-dated securities. But long-
dated securities give the bank at least a little bit of yield 
where short-dated securities give the bank nothing. As soon as 
interest rates hike, when interest rates spike at the long end 
of the yield curve, I am going to be bankrupt. I am going to be 
looking at huge interest rate losses because I have to hold--
when I have to mark my portfolio to market, I have got to hold 
all these long-dated Treasurys to meet the liquidity 
requirement. So the liquidity requirement itself introduces 
interest rate risk into the banking system.
    Then the next rule you put on top of that is the net stable 
funding ratio, which says for a year I have got to construct my 
balance sheet so that I have enough equity and just the right 
people that take my debt so that I could run the bank down for 
an entire year without ever having to sell my high-quality 
liquid assets. So I have to structure my balance sheet in this 
way, and in some magical way, the regulators say this is a 
costless activity for banks, that it is not going to cost them 
a dime to do this kind of thing.
    So these kind of liquidity rules in conjunction with things 
like negative interest rates are really, really problematic. 
They muck with the heart of what it is to be a banker.
    Senator Cotton. Thank you.
    Dr. Goodfriend, would you have anything to add to that 
statement?
    Mr. Goodfriend. I agree completely that, as I said in my 
opening remarks, the liquidity coverage ratio is ill-conceived. 
Even if you think there is some reason to get the banks to hold 
more liquidity, the liquidity coverage ratio is about as 
destructive a regulation as you can imagine, especially given 
in the United States the Federal Reserve's power to pay 
interest on reserves. This is a game changer. It amazes me that 
we have a regulation that I understand comes from Europe, and 
we have institutional circumstances in the United States that 
obviate the need for it.
    What I mean is with interest on reserves, the Federal 
Reserve will be able to pre-position on bank balance sheets 
essentially enough liquidity in terms of balances at the Fed 
that would satisfy the financial stability concerns that the 
liquidity coverage ratio was designed to deal with. But it will 
do so without any regulations at all. The Fed can pre-position 
reserves in the way that it had not been able to do before 
2008, before the Fed had the power to pay interest on reserves.
    Let me just continue. Before the Fed had the power to pay 
interest on reserves, the Fed had to maintain a scarcity of 
reserves in the banking system in order to raise interest 
rates. It is a little arcane but it is a critical point. And 
since that time, the Fed no longer has to maintain a scarcity. 
By far, the most effective way to liquefy the banking system is 
to have the reserves created by the central bank, and we can do 
that.
    So for the life of me, I do not understand how the 
liquidity coverage ratio could come about with such onerous, 
complicated, arcane regulatory means at a time when we do not 
need it in the United States. We should have left that idea, I 
think, abroad.
    Senator Cotton. Thank you.
    Chairman Shelby. Senator Merkley.
    Senator Merkley. Well, thank you, Mr. Chairman.
    There is a lot of conversation here about a liquidity 
crisis, so we might as well ask the question whether or not 
there is a liquidity crisis at all. Corporate bond issuance is 
strong. Borrowing costs are near historic lows. In 2015, the 
dollar volume of corporate bond issuances was a record $1.5 
trillion compared to half of that 10 years earlier, in 2005, 
before the crisis. Securitization markets are performing well. 
Securitized product issuance was hovering around $200 billion 
in 2014 and 2015 in line with the early 2000s. Secondary 
markets, bid-ask spreads, and corporate bond markets were down 
to around 30 basis points in 2015, which is certainly a lot 
lower than 90 basis points at the height of the crisis. But it 
is even lower than the 40 basis points in 2006.
    Professor Schooner, is there a liquidity crisis in the U.S. 
banking system?
    Ms. Schooner. I do not believe that there is a liquidity 
crisis, but I also want to say that I think that if we were to 
expect improving our regulation of financial institutions, that 
doing so would have absolutely no effect on our markets. I 
think that would be not a reasonable expectation, and that we 
should expect movements in response to creating safer financial 
institutions, and we have to keep our eye on them. But I do not 
think we should be alarmed when we see movements of this kind.
    Senator Merkley. Well, I do think it is worth noting that 
the New York Federal Reserve Bank President, William Dudley, 
gave a speech in New York City. He was rebutting this contrived 
argument that there is some liquidity crisis. He said, and I 
quote, ``There is limited evidence pointing to a reduction in 
the average levels of liquidity.'' And he went on to say it was 
a ``noteworthy assertion and would have significant 
implications for regulatory policy if it were correct.'' But, 
of course, he rebutted that it was not correct.
    It is also interesting that liquidity is put up as some 
kind of nirvana, some kind of essential--the more buyers you 
have, the better. But if liquidity is fueled by high leverage 
ratios that destabilize the system, is that a good idea, 
Professor Schooner?
    Ms. Schooner. No, I do not think we want to sacrifice a 
goal of liquidity by creating very unstable, highly indebted 
financial institutions. That does not seem to be a tradeoff 
that is worth making.
    Senator Merkley. So here we have a lot of bubble talk about 
liquidity, but it is really an argument that they are trying to 
put forward to say let us deregulate the banks once again, let 
us forget the fact that the last time we did this it destroyed 
the savings of Americans, it destroyed their retirement 
savings, it often destroyed their mortgages, it destroyed often 
their very jobs. And so I think it is important to understand 
what this is aimed at and the false premise that is being put 
forward right from the beginning.
    Chairman Volcker said traders' and investors' sense of an 
ability to sell anything instantaneously contributed to the 
excessive leverage and risk taking that led up to the crisis. 
Just one more point to bear in mind about this kind of false 
idol that is being put forward here today.
    I wanted to turn to the orderly liquidation authority and 
the effort to eliminate that. That was a bipartisan effort to 
say if a bank is in trouble, the shareholders should be at 
risk, the bond holders should be at risk, not the taxpayers. 
Why do we see this effort through Chairman Hensarling and his 
Wall Street crew to repeal the orderly liquidation authority 
and put taxpayers back on the hook and try to restore too-big-
to-fail? Professor?
    Ms. Schooner. I think banks want to avoid any kind of 
regulation, and they have, you know, good reasons for doing 
that. But I think we need to keep in mind that even when we ask 
for higher capital regulations, the capital, for example, is 
only one element of the way in which we have traditionally 
regulated financial institutions. There are a whole host of 
factors that go into making for safer organizations. And 
certainly eliminating the too-big-to-fail massive problem 
requires an ability to resolve institutions in an orderly 
fashion, and if we do not have that mechanism for resolution in 
an orderly fashion, we will be back to the same sort of 
bailouts that we saw in the financial crisis.
    Senator Merkley. So here we have Hensarling leading the 
charge to privatize the gains and socialize the losses, stick 
the taxpayer once again, and let me point out that that is not 
the basic theory of capitalist enterprise. The basic theory is 
you take your risks, and you make mistakes, you suffer the 
losses. You do not stick the losses on other people. You 
certainly do not stick it on middle-class Americans, destroying 
their jobs, their savings, and their mortgages.
    And so I hope that everyone in America will pay attention 
to this gambit to restore the false premises that undermined 
the economy and destroyed the success of so many millions of 
American families in its effort to once again enable Wall 
Street to stick their losses on the American people. It was 
wrong then. It did a lot of damage. It would be wrong now.
    Thank you.
    Chairman Shelby. Senator Rounds.
    Senator Rounds. Thank you, Mr. Chairman.
    You know, I do not think there is anybody up here that 
wants to see banks without regulations, and I have never talked 
to a single banker anyplace that does not think that 
regulations are not important. I think they want a fair playing 
field. I also think that if you take a look at this Committee, 
I think we all want to see a very stable financial institution 
or series of financial institutions of all different sizes. 
None of us want to see a taxpayer bailout again, and at the 
same time, though, as we look at stable financial institutions, 
we want to see competition, because we all want to be able to 
borrow money at a rate which is as inexpensive as possible. And 
if we have got assets, we want to be able to get a fair rate of 
return when we put our money into a savings account. I think 
that is what most Americans want.
    I think the job of this Committee is to look at financial 
institutions and the regulations that are there, and we tweak 
them when we think that they need to be tweaked, and at the 
same time we offer stability long term.
    Yet when we look at Dodd-Frank, we have got a huge series 
of rules, and over a period of now 6 years, we have not made 
changes to them. We have simply expected that the regulators 
would make the changes based upon a framework. It looks to me 
like maybe we have not done our job to come back in and take a 
look at a regulatory framework which should be tweaked.
    I would like to ask each one of you just very quickly--and 
then I want to touch a little bit about the availability of 
money in the marketplace, and credit--if there was one thing 
under Dodd-Frank that really Republicans and Democrats should 
look at and say there are fixes that should occur, can you give 
me just one or two real quick things that you think we really 
ought to be taking a look at to make the system work better? 
Professor.
    Mr. Scott. Thank you, Senator. I believe that we have 
strengthened the financial system in many ways by Dodd-Frank--
capital requirements and liquidity. There are problems with how 
we are doing it, but I think we have strengthened the system.
    I think, on the other hand, we have very much weakened the 
system by the provisions of Dodd-Frank which limit the ability 
of the Federal Reserve to be the lender of last resort in a 
crisis. We all hope there will not be another banking crisis, 
but I can assure you there will be one. The question is when. 
Despite all these efforts, there will be another banking 
crisis. They are endemic in our history and in the history of 
global finance.
    So the Fed's powers to lend to nonbanks is, as I indicated 
earlier, a growing sector of the economy largely fueled by a 
lot of the regulation that we are putting on the banks. The 
amount of short-term liabilities in the nonbanking system is 
growing, and the Fed's ability to lend in a crisis under 13(3) 
amendments to Dodd-Frank has decreased.
    We also took away the ability of the Federal Deposit 
Insurance Corporation, the FDIC, to raise insurance limits 
during the crisis, which they did on transaction accounts, 
which are key to the payment system. They raised them to 
infinity. OK? That power has been removed by Dodd-Frank, and as 
you recall also, the Treasury guaranteed the money market funds 
that power.
    Now, we do not all----
    Senator Rounds. Let me just move along just because I am 
going to run out of time, but I would like to give the other 
folks----
    Mr. Scott. Yes, OK. That would be one thing I would fix.
    Senator Rounds. OK.
    Mr. Scott. But, you know, just one word, Senator. We have 
done all that because we think bailouts are bad. But I think we 
need to rethink what we mean by a bailout.
    Senator Rounds. OK. Dr. Goodfriend?
    Mr. Goodfriend. Yes, I think in general the regulations 
that Dodd-Frank has imposed on depository institutions have 
increased the regulatory arbitrage that I talked about in my 
opening remarks. In other words, the regulations are offset by 
lowering deposit rates that are available to retail deposits. 
The small guy is the guy that is getting hurt. And what happens 
is the small guy says, well, I am going to put my money in 
money market funds, repackage it, and re-lend it back to the 
banks as institutional wholesale funding. And those rates the 
banks cannot push down. They have to compete aggressively for 
wholesale deposits.
    So what is happening is these regulations that are being 
imposed by Dodd-Frank on the banks, in my view, are increasing 
this kind of round-tripping of money and making our banking 
system much more unstable in the sense that the retail funding 
is falling as a share and the wholesale funding is rising as a 
share. In other words, those regulations are going exactly 
against the problem that they are trying to solve, and it does 
not seem to me that Dodd-Frank has taken that into account at 
all.
    Senator Rounds. Dr. Schooner?
    Ms. Schooner. Very quickly, more equity capital. I think 
that this Committee should consider proposals like what were in 
Brown-Vitter, which would require a 15-percent leverage ratio. 
So I think when we talk about capital, if we are talking about 
actual equity and not equity disguised as debt, or debt 
disguised as equity, that considering heavier capital 
requirements would be a big
improvement.
    Senator Rounds. Thank you.
    Dr. Kupiec?
    Mr. Kupiec. I think simplification is key. Higher equity 
and things like debt that are disguised as equity, which is 
exactly what the TLAC rule is that I railed against in my 
comment, these things obfuscate what is really going on. The 
complexity is beyond imagination even for folks like me and Hal 
Scott and all these people at the table even to get a grip on. 
And if people like us cannot get a handle on this stuff, you 
better hire a few law firms or something. I do not know. It is 
beyond the pale, the complexity in the rules. It really has to 
change. And it is up to Congress to tell the regulators to make 
it simpler, more transparent.
    Senator Rounds. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Brown.
    Senator Brown. Thank you, Mr. Chairman.
    Professor Scott, let me start with you. In 2009, in the 
aftermath of the financial crisis, the Committee on Capital 
Markets Regulation, which you lead, released a proposal for 
regulatory reform that included a couple things I could 
mention: more intense prudential supervision--I am quoting--

         more intense prudential supervision, a better process than 
        bankruptcy for resolving the insolvency of financial 
        institutions, and a comprehensive approach to regulating risk 
        in the financial sector.

    Title I of Wall Street reform, as you remember--you were 
successful--adopted these recommendations by imposing 
heightened prudential regulations on the largest banks and 
provided a framework for addressing risks in the nonbank 
financial sector while Title II created an orderly liquidation 
process for large financial institutions. Senator Warren 
mentioned Chairman Hensarling's proposal today. He has proposed 
repealing both of these titles. Do you continue to support the 
proposals that you made in 2009? Or do you agree with Chairman 
Hensarling?
    Mr. Scott. Well, I certainly continue to support the 
proposals----
    Senator Brown. Could you turn your microphone on?
    Mr. Scott. I am sorry. I certainly continue to support the 
proposals we made in 2009. With respect to Chairman Hensarling, 
I have not looked in detail at this. You know, there are many 
amendments that are being made here to Dodd-Frank. I would be 
concerned with eliminating Title II in its entirety. I think 
that has enhanced our ability to resolve large systemically 
important institutions.
    Other parts, though, of exactly what he wants to do with 
FSOC, what the remaining authority would be to, for instance, 
regulate products and services, which I think might be a better 
approach to dealing with things than designating a few SIFIs--
we only have a couple--I think were removed is to thinking we 
should look at products and services which are a concern in the 
industry rather than trying to solve this problem through 
designation of specific institutions that we think are 
systemically important.
    But I think a lot of the devil is in the details, as 
anything, so----
    Senator Brown. Yes, of course it is, but he also does 
propose repealing those two titles, which are important, so 
thank you.
    Professor Schooner, let me ask you a handful of questions. 
There is a lot of talk about rolling back regulations for banks 
of various sizes that meet higher capital standards. While I do 
not agree with all of his proposal, Tom Hoenig has proposed 
targeted relief for truly simple institutions. However, others 
have suggested we do not need things like living wills in Title 
II of Dodd-Frank if banks just had more capital.
    Should we be concerned by proposals that use capital 
requirements as a Trojan horse for a broad-based deregulation 
of the industry?
    Ms. Schooner. I think we should. I think that we would make 
the system much safer with higher equity capital, but I do not 
think, unfortunately, that equity can solve all problems unless 
we had 100 percent equity, and I do not think we are going 
there.
    There might be some regulations. As we have mentioned, the 
proposals with respect to TLAC and requiring more debt of 
institutions, if we had higher equity, those proposals do not 
make a lot of sense. But I think ignoring some of the problems 
with resolving highly complex institutions and making an 
attempt to do so proactively, figure out the process for doing 
that proactively through living wills, would be a big mistake 
even if we had higher equity levels, and it certainly would not 
make our financial system safer.
    Senator Brown. Thank you. Thank you for your comments about 
Brown-Vitter in response to a question from, I believe, Senator 
Rounds. As you know, that proposal helped--contributed to the 
public debate that later did lead to OCC and the Fed and the 
FDIC imposing capital requirements, so while that bill 
obviously was--never really got serious hearings or moved 
forward in the legislative process.
    Three years ago, Fed Chair Bernanke testified that unsafe 
practices by large financial institutions pose a risk not just 
to themselves but to the rest of society. Setting policy, we 
should look at the social costs and not just the cost to the 
firms. These are Chairman Bernanke's words. And given the 
enormous cost of the crisis, that strong measures to prevent a 
repeat are obviously well justified on a cost-benefit analysis, 
the cost to society, the benefit to the banks.
    Many in Washington are pushing for more cost-benefit 
analysis and analyses. What are the appropriate costs and 
benefits to consider when thinking about increased capital?
    Ms. Schooner. So I think that oftentimes when we talk about 
cost-benefit analysis, it sounds scientific. But, of course, 
many value judgments go into any kind of cost-benefit analysis. 
And I would certainly urge anyone conducting that kind of 
analysis to seriously consider the social costs over the 
private ones.
    I believe private costs to financial institutions can often 
be dealt with through appropriate implementation periods, and 
sometimes those costs are appropriate to be borne by the 
individuals dealing with such institutions. The financial 
crisis, as you have said and others on the Committee have said, 
is beginning to fade in memory, but I just have to say that the 
impact on the economy was so severe, and I think we also forget 
sometimes that the impact, some studies have shown, go to the 
health of citizens. So the impact is very broad, and 
considering the social benefits of avoiding financial crises, 
should also be very important in any kind of cost-benefit 
analysis.
    Senator Brown. Thank you. I appreciate your reminding this 
Committee again--this Committee seems to suffer from some 
collective amnesia about what happened to a whole lot of 
families. I have said in this Committee before, my wife and I 
live in Zip Code 44105 in Cleveland. That Zip Code 9 years ago 
for the first half of the year had more foreclosures than any 
Zip Code in the United States of America, and I still see the 
blight in that community, my community, and still know some 
families who lost their homes and their lives were turned 
upside down, and that is something we absolutely never should 
forget.
    I appreciate, too, your saying that cost-benefit sounds 
scientific, in this all-knowing world, with Washington pundits 
nodding their heads in their all-knowing way that saying cost-
benefit sounds so serious, and, you know, maybe you can do it 
occasionally in a food safety or a public health way, although 
it is awfully hard to quantify then, but clearly the damage 
that bad financial regulation or inadequate regulation brings 
to a society as a whole is awfully difficult to quantify.
    Let me ask one last question. Professor Schooner, we heard 
a number of complaints that capital rules are too onerous. 
Governor Powell's comments in my opening statement speak to 
that. The Federal Reserve has tied a number of its rules to 
factors like international footprint, to size, to 
interconnectedness, to short-term funding, to complexity. The 
rules for the largest banks are more stringent for them because 
they are more systemic and they are more complex themselves.
    Give me your thoughts, if you would, Professor Schooner, on 
this approach for the largest banks, if they want to reduce the 
requirements, the tradeoff is either reducing their own size or 
complexity or risk to the system.
    Ms. Schooner. So, obviously, the regulations on larger 
complex banks are more onerous, are more complex, but I believe 
that is clearly in reaction to the growing complexity, size, 
interconnectedness of financial institutions, not the other way 
around. We did not create complex regulations and then ask for 
the banks to become more complex.
    And I also think that this criticism is a little unusual 
since it is exactly what banks do with their customers. When a 
bank lends to a larger, more complicated borrower, they require 
more complicated covenants, place more onerous restrictions on 
that borrower than they would with a smaller, safer borrower. 
So I think that the complexity and the onerousness is often 
quite appropriate given the institutions that we are trying to 
regulate, and they could avoid some of that if they were to 
become smaller, safer, less leveraged, as we have been 
discussing.
    Senator Brown. Thank you so much.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Toomey.
    Senator Toomey. Thank you, Mr. Chairman. I must say I think 
this hearing took an Orwellian turn a little while ago, and I 
feel the need to revisit some of the unbelievable things that I 
have been hearing.
    First of all, the notion that repealing Title II puts 
taxpayers on the hook for a bailout is just amazing to me. 
Title II is the part of Dodd-Frank that explicitly authorizes 
and creates the mechanism by which taxpayers can be forced to 
bail out financial institutions. That is what Title II does in 
black and white language. Is that not true, Dr. Kupiec?
    Mr. Kupiec. That is correct.
    Senator Toomey. Right. So now we are told that if we repeal 
the authorization to force taxpayers to bail out banks and have 
a different mechanism for resolving, which I will get to, which 
is basically bankruptcy, that that somehow puts taxpayers on 
the hook. The fact is taxpayers are on the hook today because 
of Dodd-Frank.
    What we learned or should have learned during the financial 
crisis, among other things, it seems to me, is that we did not 
have an adequate resolution mechanism for the failure of a very 
large, complex financial institution. And the way to solve 
that, it seemed to me, was to fix the Bankruptcy Code so that 
we would have an adequate resolution mechanism without having 
to put taxpayers on the hook.
    But we did not do that in Dodd-Frank. Instead, what we did 
was we said we will explicitly authorize the taxpayer bailout 
in Title II, but since that would be very, very embarrassing, 
we will empower regulators to do anything they want and 
encourage them to do everything to take complete control of 
financial institutions, regulate every minute activity, forbid 
whole categories of activities so that we hope we will not 
actually have to go there.
    So when Members of Congress, House Members and myself, are 
advocating repeal of Title II, it is to do it together with 
reform in the Bankruptcy Code so that the only people who take 
a loss if a big financial institution fails will be 
shareholders and unsecured creditors. And if we actually had 
that mechanism in place and we had the political will to force 
that mechanism rather than a bailout, which is what my friends 
on the other side want to preserve in Title II, while they 
nevertheless rail against bailouts, if we had that mechanism in 
place, then unsecured creditors would be the ones who would 
impose the discipline on the financial institution because they 
would be acting out of self-interest to avoid losses.
    I also want to address another bill that I am amazed to 
hear the discussion about. Some of us think that Congress has 
spent a lot of years shirking its responsibility by kicking all 
kinds of authority to regulators to write rules and regulations 
and then deny the
accountability that ought to go with that. Effectively, it is a 
legislative function. Oh, and by the way, it is also an 
enforcement
function, and it is also a judiciary function. The regulators 
are omnipotent in some respects.
    I think we ought to be accountable for the authority we 
grant, that we delegate to a regulator, and that is what the 
Hensarling proposal is. It says when a new regulation is 
proposed, let us subject it to an up-or-down vote so that 
Members of Congress can no longer deny accountability. I know 
Members of Congress like to be able to avoid that 
accountability. There are some here who would like to be able 
to look the other way and say, ``Oh, those bad regulations, 
that is someone else's fault.'' But that is shirking our own 
responsibility.
    Let me go to a specific example of the excessive and 
counterproductive regulations that result from this approach 
that we have taken instead of a better ability to resolve 
failed institutions, and that is the LCR rule. And, Mr. 
Goodfriend, you have suggested you are not too fond of this 
rule, I gather. I do not want to put words in your mouth, but I 
think there is a redundancy to it compared to enhanced capital 
requirements. The complexity is unbelievable, which I think 
several of you have acknowledged.
    Could we be clear about one thing? When we impose this type 
of--this specific regulation, the LCR rule, does that not add a 
cost to making loans? Does that not result, all else being 
equal, in a higher cost of borrowing for a small business, a 
medium-sized business, whoever would like to borrow the money 
that is subject to this rule? Isn't the cost ultimately borne 
by the consumer, Dr. Goodfriend?
    Mr. Goodfriend. Absolutely, and I think the costs are borne 
by the most vulnerable, the smaller borrowers, the smaller 
depositors, the people who do not have the time every day to 
worry about what they are doing with their money and which bank 
they should be in. And so it is not only that the costs get 
passed on. They get passed on to the most vulnerable people on 
both sides, the borrowing and the depositing side.
    Senator Toomey. Dr. Kupiec, do you agree that those costs 
end up being borne by consumers?
    Mr. Kupiec. Yes. Somebody has to pay the costs. If you are 
required to hold a large volume of highly liquid assets that, 
by definition, have smaller returns because they are so liquid, 
then you are not earning on them, and you have to pass the 
costs of managing the bank on to somebody. So you are going to 
pay your depositors less and charge more on your loans.
    Senator Toomey. And this rule that apparently we must not 
let Congress have any authority over, it goes into effect on 
banks with a balance sheet of $50 billion, I think initially, 
right? A SIFI designated bank is subject to LCR rules. Is that 
correct? Right.
    Dr. Kupiec, do you think a $50 billion bank in America is 
systemically important to our $17 trillion economy?
    Mr. Kupiec. Absolutely not, and I think most $50 billion 
banks know how to manage their own liquidity without the 
regulators writing a rule to tell them how to manage it.
    Senator Toomey. Do you think it has occurred to them that 
they might have to honor depositors who would like to withdraw 
money, do you think really?
    Mr. Kupiec. I think they know that, yeah.
    Senator Toomey. OK. Thank you very much.
    Chairman Shelby. Senator Tester.
    Senator Tester. Thank you, Mr. Chairman.
    Just for the record, because I think it has to be said, the 
bailout was done during the Bush administration, and the guy on 
this side of the aisle did not vote for it.
    So that aside, I have a couple questions--I will be quick; 
they deal with stress tests--for Scott and Schooner. Look, the 
stress tests have--there is some good news attached to them. I 
think we only had one U.S. bank that had to go back to the 
drawing board last year once it was done. It does give us some 
information not only for the regulators but for Congress, for 
the public, as it relates to our largest financial 
institutions.
    That being said, I am curious to know--and it kind of goes 
to some of the questions Senator Toomey was saying--where the 
line should be drawn. We drew the line at $10 billion, 
Professor Scott. Is that the right spot to have it? Or should 
we be looking to modify that? Should we be going off a business 
model? What exactly--how should we be dealing with this? 
Because I get a lot of input from my community banks, and they 
are critical to a rural State like Montana. In fact, they are 
critical to the whole damn country, quite frankly. So could you 
give me some enlightenment on that issue?
    Mr. Scott. Well, I think the stress tests, Senator, are 
being applied today to the largest banks.
    Senator Tester. Right.
    Mr. Scott. And what the cutoff for that should be, you 
know, I think they should be extremely large. They should be G-
SIBs. They should be banks that we have concern about the 
systemic impact of their failure. As I testified, my concern 
about the stress test today is the lack of transparency around 
the design of the test and the evaluation of the test itself.
    Senator Tester. Yes. How about you, Professor?
    Ms. Schooner. So I think that I agree with what Professor 
Scott said, that stress tests should be focused on the largest 
financial institutions. I think that the CCAR tests apply to 
about the top 30 institutions.
    Could there be a better designation? Could we decide that 
it was based on complexity?
    Senator Tester. Right.
    Ms. Schooner. But I think that the problem with that from a 
regulatory resource standpoint is we could spend a lot of time 
trying to figure out which financial institutions should be 
subject to stress tests and make a lot of argument about that 
rather than just doing the stress test. So I do think that an 
asset-size threshold is sort of efficient and can give us a 
rough estimate of which institutions it makes sense to----
    Senator Tester. And that from my perspective is--it is a 
lot cleaner. It is a lot easier. Let us put it that way. I do 
not know if it is cleaner, but it is easier. The question is 
where--I mean, you have both said it should be for the largest 
banks. The question is: Where is that line drawn? Because that 
is the debate we have all the time here, quite frankly.
    Ms. Schooner. I have difficulty with answering that because 
I do--if I take a long view of banking in the United States, I 
do think that regional banks can often cause big problems. I 
mean, we saw that in the S&L crisis. They do not have the kind 
of economic impact that we saw in the 2008 financial crisis, 
but they can create a lot of damage to local economies. So I 
have trouble drawing the lines as well.
    Senator Tester. In what level do you draw regional banks 
at, between where and where? In your mind. I am not going to 
hold you to it.
    Ms. Schooner. Yeah, in my mind, $50 billion and above.
    Senator Tester. OK. Professor? Turn your mic on, please.
    Mr. Scott. I think we should concentrate on the very 
largest banks with these tests. What is the test designed to 
do? It is to make sure that a systemically important 
institution does not fail because we are concerned that it 
would be so connective that it would send such a bad message 
that we can, you know, stimulate runs on the financial system, 
that other institutions tied to it would be failing. So I do 
not think that is 37 banks. OK?
    So I think exactly where to draw the line, it needs to be 
higher. But exactly where it should be I am not sure.
    Senator Tester. OK. Just very quickly because I have only 
got about half a minute left. We have talked about community 
banks, how important they are. They are critically important to 
my State. And I think, as has already been said here, they were 
not involved with the meltdown. They did not deal with the 
exotics or the risky financial products.
    Mr. Scott, in your testimony you talked a little bit about 
your concerns with how risk weights are calculated for assets, 
so I just want to focus on the community banks' perspective on 
that. Would you elaborate on your concerns about how risk 
weights are calculated? And would you share any concerns that 
you have about the effect these risk weights have, particularly 
on community banks?
    Mr. Scott. Well, risk weights can be calculated in very 
different ways. The two most prominent ways of thinking about 
this are standardized and models. So under a standardized 
approach, the Government comes along and says this is the risk 
weight you should have on this asset. I have great difficulty 
in believing that our Government can assess the risk weight of 
complex financial instruments. I just think that is a job that 
is tremendously difficult, at best.
    So the other alternative is model, and as we moved from 
Basel I to Basel II, we allowed much more reliance on banks 
using their own models to calculate, and the supervisors would 
supervise the use of the models. That has also led to 
difficulty because the banks have, I would say, a knowledge 
advantage about how they devise their own models.
    Senator Tester. Sure.
    Mr. Scott. There is concern they are gaming the models to 
get lower results. So there has been some dissatisfaction with 
the use of the models. So where do we go from there? You know, 
both of these--then there is the leverage ratio. OK. So we have 
got this risk-weight problem. We do not know how to do it. Let 
us go to leverage. Well, leverage is nothing but the same risk 
weight for every asset. OK? And it was that approach that led 
us to go to Basel in 1986. We said this is crazy. A loan to IBM 
is going to be risk-weighted? The loan to a startup company? 
That does not make any sense.
    So the fact of the matter is methodologically we are at sea 
in terms of having valid ways to assess the risk of assets.
    Senator Tester. Thank you. I am not sure it was entirely 
helpful, but thank you. I want to thank all of you for your 
testimony. Thank you very much.
    Chairman Shelby. I want to take a few seconds just to thank 
all of you for your participation here today. This has been a 
very interesting, very complex hearing, and we appreciate your 
input, your preparation, and everything. And what we really 
want--and I believe whether we are Republicans or Democrats--
for the most part, we want a strong banking system. We want a 
system that works for the market economy and opportunities for 
everybody. We do not want bailouts, whatever it is.
    Thank you very much.
    [Whereupon, at 11:26 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                   PREPARED STATEMENT OF HAL S. SCOTT
Nomura Professor and Director of the Program on International Financial 
                    Systems, Harvard Law School and
           Director, Committee on Capital Markets Regulation
                         Tuesday, June 7, 2016
    Thank you, Chairman Shelby, Ranking Member Brown, and Members of 
the Committee for inviting me to testify before you today on bank 
capital and liquidity regulation. I am testifying in my own capacity 
and do not purport to represent the views of any organizations with 
which I am affiliated, although some of my testimony is based on the 
work of the Committee on Capital Markets Regulation (CCMR). My 
testimony will focus on two key aspects of capital and liquidity 
regulation. The first is a general overview of the effectiveness of 
capital and liquidity regulations in reducing systemic risk. Second, I 
will discuss the process by which regulators impose capital and 
liquidity requirements, with a particular focus on Federal Reserve 
stress testing of financial institutions.
    A capital requirement is a mandated minimum level of equity and 
subordinated debt (i.e., ``capital'') as a percentage of a bank's 
assets. In general, capital requirements have one primary goal--to 
ensure a minimum level of capital capable of
absorbing a bank's potential losses.
    The capital requirements in the United States today are largely 
based on the international standards set under Basel III, but are 
stricter in some respects. Similar to Basel III, we require banks to 
hold total minimum Tier I and Tier II capital of 8 percent of risk-
weighted assets and total minimum common equity of 4.5 percent of risk-
weighted assets. By 2019, these requirements will rise to 10.5 percent 
and 7 percent, respectively. Also similar to Basel III, we apply an 
additional capital surcharge for the largest banks. However, while 
Basel III has a top surcharge of 2.5 percent, the U.S. surcharge can 
reach as high 4.5 percent.\1\ In total, a U.S. banking institution with 
a 4.5 percent surcharge would face a total capital requirement of 15 
percent of common equity on a risk-weighted basis when the phase-in is 
complete in 2019. Basel III has also established a leverage ratio of 
capital to total assets of 3 percent. U.S. regulators have added on top 
of this an enhanced requirement for the largest U.S. bank-holding 
companies, increasing the leverage ratio to 5 percent for the eight 
largest bank-holding companies and 6 percent for their insured 
depository institutions.
---------------------------------------------------------------------------
    \1\ See Federal Reserve Press Release, July 20, 2015, available at 
https://www.federalreserve.gov/newsevents/press/bcreg/20150720a.htm.
---------------------------------------------------------------------------
    Capital requirements are aimed at reducing systemic risk in several 
ways. First, capital can reduce the probability of a bank failing. This 
is important because the failure of several important banks at the same 
time, from an external shock like the housing price collapse in 2007, 
could endanger the stability of the financial system and, in turn, the 
economy. Capital erects a bulwark against such failures.
    Second, capital can help to minimize the possibility that 
connections between banks can lead to a chain reaction of failures. If 
bank A has a credit exposure to bank B, then bank A's failure would 
cause losses for bank B that could cause bank B's failure. This could, 
in turn, trigger the failure of other connected financial institutions.
    Third, adequate levels of capital can reduce moral hazard by making 
it less likely that banks will take risks that could endanger their 
solvency. This is because the private suppliers of capital would lose 
their investment if the bank failed and so they will seek to prevent 
their bank from taking undue risks. Insured depositors do not have 
similar monitoring incentives.
    One should bear in mind that if we could resolve failing banks 
through effective and swift reorganizations, without the use of public 
capital, then a bank's failure would be less likely to put the entire 
system at risk. Minimum capital requirements would therefore be less 
necessary to protect against bank failures, because the systemic 
consequences of such a failure would be reduced. Unfortunately, as of 
now, such a resolution procedure is still a work in progress.
    Although capital requirements can serve these important purposes, 
at any realistic level they cannot prevent the financial contagion that 
we experienced in 2008, where widespread fears over the stability of 
the financial system led to a run on short-term funding in both the 
bank and nonbank sector. Indeed, contagion was the key systemic risk 
concern in the prior financial crisis and will be the key concern in 
any future crises.
    But capital is not the solution to contagion, because in the midst 
of a crisis, no reasonable amount of capital will hold up against the 
panic of short-term debt
holders. Even higher capital proposals, such as Admati and Hellwig's 
suggestion of 20 to 30 percent of total assets, would not prevent 
failures in the face of contagion.\2\ The only sure-fire level of 
capital that can prevent failure would be 100 percent. However, this 
would preclude banks from holding any debt, including deposits of any 
kind. The resulting massive contraction of credit would be completely
unacceptable.
---------------------------------------------------------------------------
    \2\ A. Admati et al., ``Fallacies, Irrelevant Facts, and Myths in 
the Discussion of Capital Regulation: Why Bank Equity is Not Socially 
Expensive'' 55 (Oct. 22, 2013), http://www.gsb.stanford.edu/sites/
default/files/research/documents/Fallacies%20Nov%201.pdf.
---------------------------------------------------------------------------
    The most effective means of combating contagion is through central 
bank use of ``lender-of-last-resort'' liquidity authority and expanded 
deposit guarantees. During the recent financial crisis, these very 
means were used to combat contagion. The Fed employed its authority as 
lender of last resort and the FDIC enhanced deposit guarantees. Much of 
the Fed lending was conducted through its section 13(3) emergency 
powers to provide liquidity to nonbank financial institutions.
    Unfortunately, Dodd-Frank has pared back many of the very powers 
that were so successfully deployed during the crisis. The Fed's 13(3) 
authority and the FDIC's authority to expand deposit insurance have 
been weakened. We are currently in a world exposed to contagion, but 
the Fed and FDIC have less effective weapons at their disposal to fight 
it. Ironically, this lack of contagion-fighting tools could put more 
pressure on Congress to bail out large financial institutions in the 
future.
    In addition to the limitations on the ability of minimum capital 
requirements to prevent contagion, devising the content of capital 
requirements is a daunting task. As mentioned earlier, capital 
requirements can take the form of a simple leverage ratio, which 
compares the bank's capital to its total assets, or more complicated 
risk-based measures that include risk-weightings of assets.\3\ Both 
simple leverage ratios and risk-based capital ratios have a role in the 
regulatory framework, but each are flawed in different respects.
---------------------------------------------------------------------------
    \3\ This is part of the Basel approach.
---------------------------------------------------------------------------
    The main problem with a leverage ratio is that it requires 
precisely the same amount of capital for all asset classes, 
irrespective of their various risk profiles.
Effectively, a leverage ratio is a risk-weighted assets approach under 
which all asset classes are assigned a risk weight of 100 percent. As a 
result, the regulatory cost of capital is the same for both high- and 
low-risk assets, giving bank management an incentive to increase return 
on equity by investing in high-risk assets with higher returns. Such 
incentives are inconsistent with prudent risk management and sound 
banking practice. Indeed, before 1986 the United States relied 
exclusively on a leverage ratio and the weakness of this approach 
spawned risk-weighting through the Basel Accords.
    However, risk-weighted measures are also flawed, primarily due to 
the difficulty of assigning appropriate risk weights. Under the first 
Basel Accord, which applied to U.S. banks during the 2008 financial 
crisis, banks were required to hold 8 percent capital against all 
corporate loans--whether to IBM or a fly by-night startup. On the 
opposite side of the spectrum, banks were not required to hold any 
capital against Government debt--whether to Uncle Sam or Greece--
reflecting the desire of governments to drum up demand for their debt 
securities. Finally, banks were only required to hold 4 percent capital 
against residential mortgages, whether prime or subprime, as part of 
the U.S. Government's housing promotion policies--and we all know how 
that turned out. Under the second Basel Accord, large banks were 
permitted to base their capital calculations on internal models, which 
could be opaque and lacked consistency across banks. Smaller banks had 
to use a more standardized approach based on external credit ratings, 
and we also know the widespread problems with credit ratings.
    The Basel approach to accounting for a financial institution's 
operational risk has also been flawed. Operational risk is 
fundamentally different from all other risks taken by banks, such as 
market and credit risk, but is much harder to measure and model. It 
accounts for roughly 9 to 13 percent of the total risk of a bank, with 
legal liability being a major component of it.\4\ Despite its 
importance, however, the approach to measuring operational risk to date 
has been overly complex and has lacked comparability across 
institutions.
---------------------------------------------------------------------------
    \4\ See Mark Ames, Til Schuermann & Hal Scott, Bank Capital for 
Operational Risk: A Tale of Fragility and Instability, 2014, available 
at http://fic.wharton.upenn.edu/fic/papers/14/14-02.pdf.
---------------------------------------------------------------------------
    The Basel III regime has recognized many of these flaws and has 
made some progress toward addressing the deficiencies in the risk-based 
system by narrowing the definition of bank capital to rely more heavily 
on equity, the strongest forms of capital, and improving the 
calibration of risk-weights, including the treatment of securitized 
assets and off-balance sheet exposures. It is also currently exploring 
more reliance on standardized measures as compared with banks' internal 
models for both credit risk and operational risk. However, getting the 
standardized measures correct is no easy task and poses as many 
problems, if not more, than the use of internal models.
    In the end, even with the Basel III revisions, both the leverage 
and risk-weight approaches remain problematic. There is still much 
disagreement regarding appropriate risk-weighting, whether it should be 
done by Government dictate or bank models, as well as lack of consensus 
around the use of simple leverage ratios versus risk-based capital 
requirements. If one tries to compensate for these flaws by even higher 
levels of capital than we are now imposing, one is faced with a 
possible significant contraction of credit, which would have 
consequences across the entire economy. We must be careful not to let 
our fear of bad times stifle the possibility of good times.
    Before turning to liquidity, I want to briefly mention a new 
objective that has become a driver of increased capital requirements--
to pressure large banks to shrink in order to have a lower capital 
burden.\5\ The underlying idea is that shrinking large financial 
institutions would make our financial system safer. However, I have 
seen no evidence supporting this. Indeed, history has demonstrated that 
financial systems of all shapes and sizes are vulnerable to panic and 
crashes. In fact, the fragmented system of small banks in the United 
States was a constant source of instability in the 19th and early 20th 
centuries.\6\ If we think large banks may be bad for financial 
stability, this should be further analyzed, and I commend Neel Kashkari 
at the Minneapolis Fed for facilitating such a debate. And if we 
conclude that the existence of large banks increases the likelihood of 
a financial crisis, then we should require their shrinkage directly, 
not through the back door of capital requirements (or for that matter 
for flunking living wills tests).
---------------------------------------------------------------------------
    \5\ See Federal Register Vol. 80, No. 157, available at https://
www.gpo.gov/fdsys/pkg/FR-2015-08-14/pdf/2015-18702.pdf.
    \6\ See, e.g., Michael D. Bordo et al., Why Didn't Canada Have a 
Banking Crisis in 2008 (or in 1930, or 1907) (Nat'l Bureau of Econ. 
Research, Working Paper No. 17312, 2011), http://www.nber.org/papers/
w17312.
---------------------------------------------------------------------------
    Although we have always known that liquidity was important, 
particularly as a means to deal with contagious runs, liquidity 
requirements are a much more recent form of prudential regulation and 
one that did not exist before the 2008 crisis. Before and during the 
crisis we relied on the Fed to be the liquidity provider, but the heavy 
criticism of the Fed's role as lender of last resort in 2008 has 
resulted in a new policy, requiring banks to have their own liquidity 
as a first line of defense against bank runs. This is despite the fact 
that it may be more efficient to provide liquidity on a collective 
basis through the central bank. More specifically, Basel III introduced 
the liquidity coverage ratio (``LCR'') and the net stable funding ratio 
(``NSFR''). The LCR has a 30-day horizon, requiring a minimum amount of 
high quality liquid assets (``HQLA'') to cover expected funding run-
offs. The NSFR has a 1-year horizon.
    However, the effectiveness of these new liquidity requirements is 
unproven. The amount of needed liquidity depends on assumptions about 
the runoff rates of various types of funding. For example, liquidity 
regulation assumes that retail funding is much more stable than 
wholesale funding--while this was true in 2008, Fed lending and the 
expansion of guarantees may have contributed to this. In the future, 
Fed lending and an expansion of guarantees may not be available. 
Further, in the Fed's proposal issued last week to implement the NSFR, 
the Fed stated that the NSFR builds on the same goals as the LCR, but 
over a longer horizon.\7\ However, contagion and financial crises are 
issues of short-term panic. It is difficult to imagine a year-long 
liquidity crisis for a bank, so the justification for the NSFR seems 
considerably weaker than for the LCR.
---------------------------------------------------------------------------
    \7\ See Federal Register Vol. 81, No. 105, available at https://
www.gpo.gov/fdsys/pkg/FR-2016-06-01/pdf/2016-11505.pdf.
---------------------------------------------------------------------------
    There is also a concern that high liquidity requirements for banks 
could actually decrease liquidity in a crisis. This is because banks 
that formerly lent to other banks in need of funding during a crisis 
may now hoard their liquid assets to comply with the new liquidity 
requirements. While the Fed has said that they would suspend or relax 
the LCR in a crisis,\8\ how this would happen and to what banks it 
would apply is very unclear. And during normal times, liquidity may 
also be negatively affected by the combination of the Volcker rule, 
which limits proprietary trading, and the leverage ratio, which makes 
it uneconomical for a bank to hold any liquid assets in excess of those 
required. For example, one measure of bond market liquidity is trading 
depth, or the trading volume as a share of the outstanding stock of an 
asset class. Since 2007, U.S. treasuries have lost 70 percent and U.S. 
corporate bonds have lost 50 percent of their trading depth. U.S. high-
yield debt is down 30 percent. So, there is some evidence that bond 
market liquidity has declined in recent years. Of more concern, 
however, is how these markets would function under stress--on this 
subject we need to know much more.
---------------------------------------------------------------------------
    \8\ See speech given by Daniel K. Tarullo, Federal Reserve Board 
Governor, on Liquidity Regulation at the Clearing House 2014 Annual 
Conference, Nov. 20, 2014.
---------------------------------------------------------------------------
    In thinking about capital and liquidity requirements one very 
fundamental point must be kept in mind--they only apply to banks 
(albeit money market funds now also have SEC imposed liquidity 
requirements). This is significant in a financial system where nonbank 
financial institutions are of increasing importance.\9\ The Financial 
Stability Board (``FSB'') reports that the overall size of the nonbank 
financial sector stands at $80 trillion as of its November 2015 
report.\10\ In addition, nonbank financial assets have consistently 
increased by over $1 trillion annually from 2011 through 2015 and, on a 
percentage basis, the FSB finds that assets of nonbank financial 
intermediaries has reached 59 percent of aggregate GDP.\11\ The costs 
of meeting capital and liquidity requirements will undoubtedly spur 
even more growth of the nonbank financial sector. However, given the 
different business models of other financial firms, such as money 
market funds, insurance companies and broker-dealers, it would not make 
sense to impose bank capital and liquidity
requirements on them. Indeed, in an Advanced Notice of Proposed 
Rulemaking released on June 3rd, the Fed indicated its intent to adopt 
capital requirements that are specific to the insurance industry and 
not to simply apply bank capital standards.\12\
---------------------------------------------------------------------------
    \9\ Financial Stability Board, Global Shadow Banking Monitoring 
Report 2015 1 (Nov. 2015), available at http://www.fsb.org/wp-content/
uploads/global-shadow-banking-monitoring-report-2015.pdf.
    \10\ Id. at 2.
    \11\ Id. at 10.
    \12\ Board of Governors of the Federal Reserve System, Capital 
Requirements for Supervised Institutions Significantly Engaged in 
Insurance Activities, Advanced Notice of Proposed Rulemaking, June 3, 
2016, p. 26, http://www.federalreserve.gov/newsevents/press/bcreg/
bcreg20160603a1.pdf.
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    I turn now to the second part of my testimony, about the process 
for establishing capital and liquidity requirements. Generally, the 
U.S. regulatory agencies ``gold plate'' (enhance the stringency of) the 
Basel requirements and then implement them through rulemakings that 
must comply with the requirements of the Administrative Procedure Act, 
which provides for notice and comment, as well as judicial review. 
Although this process could be improved by a cost-benefit requirement--
that is a broad subject for another day that goes well beyond just 
capital and liquidity regulation.
    Of possible concern is the Basel process itself. Once Basel adopts 
a requirement, the 28 countries that comprise the Basel Committee on 
Banking Supervision (BCBS), which include the United States, are 
expected to comply by implementing the international requirements into 
domestic law. Thus, while the U.S. banking agencies engage in a notice 
and comment procedure in implementing the Basel Accords domestically, 
there is very little room for these agencies to depart from what has 
already been agreed. To the BCBS's credit, this problem has been 
greatly alleviated by the BCBS itself providing notice and comment 
procedures as part of their own standards setting process.
    But today, the Basel standards are only a piece of the total 
capital requirements picture. For U.S. banks, stress testing by the 
Federal Reserve is often the binding capital constraint, meaning that 
banks are required to hold more capital to pass stress tests than to 
comply with Basel requirements as implemented in the United States. And 
based on recent comments from the Fed, the capital requirements imposed 
through stress tests will soon be increased even further for the 
largest U.S. banks.\13\
---------------------------------------------------------------------------
    \13\ See Ryan Tracy and David Reilly, Fed Governors Signal Bigger 
Bank Capital Requirements Looming, Wall Street Journal, June 2, 2016.
---------------------------------------------------------------------------
    The Fed adopted rules creating a stress testing process for large 
financial institutions under its supervision after the financial 
crisis.\14\ The Fed currently conducts an annual stress test as part of 
the Fed's annual assessment of the capital planning processes used by 
certain large financial institutions, known as the Comprehensive 
Capital Analysis and Review (the ``CCAR'').\15\
---------------------------------------------------------------------------
    \14\ See 12 CFR  252.41 et seq.
    \15\ Ben S. Bernanke, Chairman of the Board of Governors of the 
Federal Reserve System, Stress Testing Banks--What Have We Learned? 
(Apr. 8, 2013). The Fed also conducts an annual stress test under 
Section 165(i) of the Dodd-Frank Act.
---------------------------------------------------------------------------
    The Fed uses the results of the stress tests to assess the ability 
of those institutions to absorb losses and maintain minimum regulatory 
capital ratios in stress
situations, and ultimately, under the CCAR, to determine whether to 
object to the capital distribution plans of those institutions. If an 
institution fails the Fed's stress tests, the Fed can prevent an 
institution from returning cash to shareholders through dividends or 
stock buybacks.
    In many ways, I think that stress tests, which are dynamic and look 
to the future, are an effective way to set capital requirements--they 
are certainly more in line with how firms themselves think about the 
need for capital. A major problem with the stress tests, however, is 
that their design is largely secret and not open to public evaluation. 
To conduct annual stress tests, the Board adopts a number of components 
that directly affect the outcome of the tests. In particular, the Fed 
establishes the hypothetical macroeconomic and financial scenarios that 
underlie the stress tests, e.g., GDP growth and unemployment rates, 
assumptions regarding institutions' future capital actions and uses 
economic models to project each institution's capital levels and ratios 
under hypothetical scenarios. The Fed adopts the framework's components 
without subjecting them to public notice and comment. In fact, the Fed 
does not even disclose the models that it uses to make critical 
projections as to estimated post-stress capital levels.
    A possible justification of this approach could be that the Fed 
views the stress tests as part of the supervisory process, or more 
technically as ``adjudications'' rather than ``rulemaking'' under the 
Administrative Procedure Act (APA). Adjudication is concerned with the 
operations of individual institutions based on institution-specific 
facts compared to rules that apply generally to a large number if not 
all institutions. Adjudication unlike regulation does not require an 
agency to follow notice and comment procedures. The argument that the 
components of the stress tests are adopted as part of adjudication is 
open to debate because, in fact, the stress test components, like the 
economic scenarios and undisclosed Fed model, are predetermined and are 
applied uniformly across institutions.
    By not proceeding through notice-and-comment rulemaking, the Fed 
has exposed the legality of those components of the stress tests to 
potential legal challenge and uncertainty. It is difficult to see why 
the public should not have the opportunity to comment, for example, on 
what would be a reasonable GDP assumption in an
extreme scenario in the coming year. In the 2014 CCAR (conducted in 
2013), the severely adverse scenario assumed a real GDP decline of 4.75 
percent in 2014. In reality, real GDP rose 2.4 percent in 2014. Of 
course, the purpose of the stress test is to use an adverse scenario, 
but what are the limits of adversity? Could the Fed assume a meteor 
would hit the earth?
    When it comes to the stress test model the Fed uses to predict 
losses, special considerations may be at play. Former Fed Chair 
Bernanke suggested that disclosure of the models, which would have to 
accompany notice and comment, could cause banks to rely solely on the 
Fed's stress test models and not maintain an independent risk-
management system.\16\ Governor Tarullo has added that the Fed does not 
want to ``teach to the test'' by disclosing the models, thus allowing 
companies to construct portfolios to game the system.\17\ I think these 
are valid concerns but there still needs to be more model transparency.
---------------------------------------------------------------------------
    \16\ Ben S. Bernanke, Chairman of the Board of Governors of the 
Federal Reserve System, Stress Testing Banks--What Have We Learned? 
(Apr. 8, 2013).
    \17\ Governor Daniel K. Tarullo, Member of the Board of Governors 
of the Federal Reserve System, Stress Testing After Five Years (June 
25, 2014).
---------------------------------------------------------------------------
    The Fed does subject its models to review by a Fed-established 
Model Validation Council that consists of five outside experts from the 
academic community.\18\ However, the Fed chooses these experts and no 
transparency is provided regarding the review process or the actual 
evaluations of the experts. I recommend increased disclosure of the 
expert opinions. This can be done without disclosing the actual models 
themselves. Submitting the other components of the stress test 
framework to public notice and comment would seem legally required, and 
in any event would result in better decisionmaking, increase public 
confidence in the process and increase the
legitimacy of Fed actions.
---------------------------------------------------------------------------
    \18\ See https://www.federalreserve.gov/aboutthefed/mvc.htm.
---------------------------------------------------------------------------
    Thank you and I look forward to your questions.
                                 ______
                                 
               PREPARED STATEMENT OF MARVIN GOODFRIEND\1\
---------------------------------------------------------------------------
    \1\ Served as Senior Vice President and Policy Advisor at the 
Federal Reserve Bank of Richmond from 1993 to 2005.
---------------------------------------------------------------------------
          The Friends of Allan Meltzer Professor of Economics
         Tepper School of Business, Carnegie Mellon University
                         Tuesday, June 7, 2016
INTRODUCTION
    I am pleased to be invited to testify today before the Senate 
Committee on Banking, Housing, and Urban Affairs on ``Bank Capital and 
Liquidity Regulation.'' In response to the 2007-09 credit turmoil, 
regulators in the United States and abroad strengthened bank capital 
requirements and introduced two new regulations
intended to manage liquidity risk: the liquidity coverage ratio (LCR) 
and the net stable funding ratio (NSFR). My remarks today will focus on 
the LCR because it is the first of the new liquidity regulations to be 
put into effect and is supposed to be fully phased in by 2017.
    In the aftermath of the credit turmoil, the Basel Committee on 
Banking Supervision and the Dodd Frank Act recommended that bank 
regulators adopt a new short-term requirement to promote liquidity 
resilience. U.S. bank regulators
announced the new liquidity coverage ratio requirement in September 
2014.
    The LCR requirement may be said to update reserve requirements as a 
liquidity management regulation in three ways. First, the LCR 
requirement can be satisfied with securities earning a market rate of 
interest, instead of bank reserves that historically have paid below 
market interest. Second, the LCR requirement can be satisfied with a 
wide range of securities appropriately rated and capped according to 
their perceived liquidity. Third, the LCR requirement mandates that 
banks hold a stock of so-called high-quality liquid assets (HQLA) 
sufficient to meet projected net cash outflows over a 30-day period. 
The ratio of HQLA over projected net cash outflows must exceed unity; 
hence, the regulation is known as the liquidity coverage ratio 
requirement.
    The LCR requirement is being introduced to facilitate banking 
liquidity in two senses--on the asset side, to better pre-position 
liquid assets on bank balance sheets, and on the liability side, to 
better guard against liquidity risks due to the use of uninsured 
wholesale short-term funding of bank assets.
    I make two broad points in this regard. First, modern monetary 
policy utilizing interest on reserves is far less burdensome and a more 
efficient alternative to LCR requirements as a means of pre-positioning 
liquid assets on bank balance sheets. Second, simple sufficiently 
elevated bank capital leverage ratio requirements are far less 
burdensome and a more efficient alternative to LCR requirements as a 
means of guarding against wholesale liquidity funding risks.
    Section 1 provides some perspective on the complexity of the rules 
involved in calculating LCR requirements that introduce significant new 
burdens of enforcement for regulators and compliance costs for banks.
    Section 2 points out operational complications involved in 
employing the LCR over time to pre-position liquid assets on bank 
balance sheets in the manner of its
reserve-requirement antecedent. It explains that, as a means of pre-
positioning liquidity on bank balance sheets, monetary policy utilizing 
interest on reserves is
preferable to the LCR because monetary policy can do so in the 
requisite quantity, without new rules and regulations, and without 
encumbering the reserve liquidity itself.
    Section 3 addresses liquidity funding risks due to banks' reliance 
on uninsured short-term wholesale funding in money markets. It explains 
the recycling of funds from low interest retail deposits through money 
markets to wholesale funding, in part, as an arbitrage around costly 
bank regulations. Thus, simple sufficiently elevated capital leverage 
ratio requirements that incentivize banks to manage their liquidity 
funding risks prudently, with minimally intrusive rules and 
regulations, are to be preferred to the more burdensome LCR requirement 
alternative.

  1)  LIQUIDITY COVERAGE RATIO REQUIREMENT RULES

    The LCR is an extraordinarily complex regulation to implement. The 
complexity may be appreciated by the notice of the final LCR rule 
published in the Federal Register, which explains the final LCR rules 
in over 100 pages of responses to around 300 comments on the initial 
proposal.\2\ A presentation produced by Davis Polk and Wardwell LLP to 
help its clients comply with the LCR requirement incredibly takes 100 
detailed slides to explain the final LCR rules.\3\ There are 31 
separate sections in the Davis Polk table of contents with headings 
such as: Which Organizations are Affected, When is the LCR Calculated, 
General Eligibility Criteria for HQLAs, Operational Requirements for 
Eligible HQLAs, HQLAs: Level 1 Assets, HQLAs: Level 2A Assets, HQLAs: 
Level 2B Assets, Denominator of LCR: Total Net Cash Outflow Amount, 
Prescribed Outflow and Inflow Rates, Falling Below 100 percent LCR 
During Periods of Stress, Basel Committee's Public Disclosure Standards 
for the LCR, etc.
---------------------------------------------------------------------------
    \2\ ``Liquidity Coverage Ratio: Liquidity Risk Measurement 
Standards; Final Rule,'' Federal Register, Volume 79, Number, 197, 
Friday October 10, 2014, Rules and Regulations, pp. 61440-541.
    \3\ ``U.S. Basel III Liquidity Coverage Ratio Final Rule, Visual 
Memorandum,'' Davis Polk and Wardwell LLP, September 23, 2014.
---------------------------------------------------------------------------
    Large, internationally active, or otherwise systemically important 
banking organizations are required to calculate their LCR each business 
day, with lower degrees of compliance required of less systemically 
important banks. To appreciate the level of detail involved in the 
computation of the LCR, consider in turn the numerator and the 
denominator of the calculation.
    With regard to the numerator, bank assets are sorted into numerous 
buckets with varying discounts and caps for qualifying as HQLA based on 
the perceived robustness of their liquidity. For instance, level 1 
assets include bank reserves and U.S. Treasury securities; level 2A 
assets including certain securities issued by U.S. Government-Sponsored 
Enterprises get a 15 percent discount when counted as HQLA and are 
capped at 40 percent of total HQLA; level 2B assets including some 
liquid and marketable corporate securities and some publicly traded 
common stocks get a 50 percent discount and are capped at 15 percent, 
and so on.
    The denominator is calculated by adding up a bank's obligations and 
means of funding, multiplying each by an applicable outflow or inflow 
rate set by regulators on the basis of a combination of experience 
during the 2007-09 credit turmoil, banks' internal stress scenarios, 
and pre-existing supervisory standards. There are numerous obligation 
and funding categories and multiplier rates. For example, stable and 
fully insured retail deposits are multiplied by a 3 percent outflow 
rate; wholesale funding secured by overnight Treasury repurchase 
agreements is multiplied by a 0 percent outflow rate; undrawn committed 
lines extended by a bank to a wholesale nonfinancial entity are 
multiplied by a 30 percent outflow rate; payments contractually payable 
to a bank from nonbank wholesale counterparties are multiplied by a 50 
percent inflow rate, provided that with respect to revolving credit 
facilities, the amount of the existing loan is not included in the 
unsecured wholesale cash inflow amount and the remaining undrawn 
balance is included in the outflow amount. The fraction of outflows 
that can be offset with potential inflows is capped at 75 percent. Such 
is the complexity of the LCR calculation.

  2)  PRE-POSITIONING LIQUIDITY ON BANK BALANCE SHEETS: LCR 
        REQUIREMENTS VS MONETARY POLICY

    The pre-positioning of liquid assets on bank balance sheets via LCR 
requirements shares well-known deficiencies of reserve requirements as 
a means of liquidity provision. The most fundamental problem in 
employing the LCR is how high to set the required liquidity coverage 
itself. Set too high, the requirement may bind too tightly in 
aggregate, routinely elevating the implicit yield on liquidity too 
much, or causing the value of liquidity to spike inordinately during 
periods of financial stress. The result being depressed prices of 
illiquid assets and depressed yields on liquid assets. On the other 
hand, set too low the requirement may bind too loosely, in which case 
the burdensome complexity, enforcement, compliance costs of the LCR 
would count for little.
    A second problem is that LCR requirements will encumber liquid 
assets on bank balance sheets available otherwise for banks to utilize 
in distress. And banks will build up excess, usable liquidity above and 
beyond LCR requirements. Banks' willingness to hold excess or usable 
liquidity under LCR requirements might even fall somewhat from what it 
was without the LCR.
    Acknowledging the ``encumbrance problem,'' regulators ``affirm the 
principle that a covered company's HQLA amount is expected to be 
available for use to address liquidity needs in a time of stress. The 
agencies believe that the proposed LCR shortfall framework would 
provide them with the appropriate amount of supervisory flexibility to 
respond to LCR shortfalls.''\4\
---------------------------------------------------------------------------
    \4\ ``Liquidity Coverage Ratio: Liquidity Risk Measurement 
Standards; Final Rule,'' Federal Register, Volume 79, Number, 197, 
Friday October 10, 2014, Rules and Regulations, pp. 61517-8.
---------------------------------------------------------------------------
    It is easy to see, however, that discretionary regulatory shortfall 
allowances could create problems of their own. Will regulators be 
lenient or reluctant to grant such allowances? Banks will find it 
difficult to predict regulatory inclinations; regulators, therefore, 
will find it more difficult to understand bank liquidity decisions. And 
if inadvertently made public, allowing the LCR to fall below 100 
percent could signal a bank's weakness.
    Regulators will also adjust on a discretionary basis discounts and 
caps on assets in the computation of HQLA, as well as outflow/inflow 
rates on obligation and funding categories in computing net cash 
outflows. Such adjustments would tighten or loosen the LCR requirement 
for the banking system as a whole. These discretionary adjustments 
could create problems reminiscent of those described above, especially 
if used to tighten or loosen the LCR in response to aggregate liquidity 
conditions. Moreover, adjusting the detailed asset, obligation, and 
funding computations underlying HQLA or outflow/inflow rates, or even 
the possibility of doing so, could complicate pricing of assets and in 
financial markets. Finally, new assets, obligations, and funding 
categories will evolve over time, partly for reasons of regulatory 
arbitrage in response to LCR regulation, complicating matters further.
    For all the complexity and seeming comprehensiveness of the LCR, 
monetary policy remains the indispensable and most efficient provider 
of ultimate liquidity to the banking system in the form of reserve 
balances at the central bank. Monetary policy has long stabilized 
interest rates by accommodating the demand for required and excess 
reserves in periods of banking stress. Now for the first time in the 
United States, Federal Reserve monetary policy utilizing the power to 
pay interest on reserves acquired in 2008 has the power to pre-position 
unencumbered excess reserves on banking balance sheets in large 
quantity at market interest without reserve requirements, even as the 
Fed targets interest rates for other monetary policy purposes.\5\ Thus, 
in December 2015 the Fed began to raise interest rates (by raising 
interest on reserves from \1/4\ percent to \1/2\ percent) with around 
$3 trillion of excess reserves still on its balance sheet as a result 
of the expansion during and following the 2008 credit turmoil. The Fed 
will no doubt shrink aggregate bank reserves substantially as it 
normalizes its balance sheet. Going forward, however, monetary policy 
utilizing interest on reserves would be far less burdensome and a more 
efficient alternative to LCR requirements as a means of pre-positioning 
liquid assets on bank balance sheets to promote financial resilience.
---------------------------------------------------------------------------
    \5\ Before 2008 without the authority to pay interest on reserves, 
the Fed had to maintain a scarcity of reserves in the banking system 
sufficient to force banks to bid interest rates up to the Fed's target 
by competing to borrow the scarce reserves. The abundant reserves 
created today do not depress interest rates below interest on reserves 
because banks will not lend below the rate they get on reserves at the 
Fed. See Marvin Goodfriend, ``Interest on Reserves and Monetary 
Policy,'' Federal Reserve Bank of New York Economic Policy Review, May 
2002, Volume 8, Number 1, pp. 77-84.

  3)  ENSURING BANK FUNDING LIQUIDITY: LCR REQUIREMENTS VS. BANK 
---------------------------------------------------------------------------
        CAPITAL LEVERAGE RATIO REQUIREMENTS

    The LCR is designed in part to cover liquidity funding risks due to 
the use of uninsured and potentially unstable short-term wholesale 
liabilities. In the aggregate, short-term wholesale funding comes from 
money markets, which are funded, in part, by attracting retail deposits 
away from the banking system in the first place, so retail deposits can 
be repackaged for higher-interest wholesale funding at banks. In 
effect, the recycling of funds from retail to wholesale funding via the 
money market is a regulatory arbitrage. Banks readily pass 
intermediation and regulatory costs to retail depositors in lower 
retail deposit rates, but must pay higher interest when competing for 
institutional wholesale funding. Hence, the regulatory arbitrage is 
naturally perpetuated. Since institutional deposits are uninsured for 
the most part and managed professionally, they are more prone to being 
withdrawn at any sign of trouble. As a consequence, the banking system 
incurs ever greater liquidity funding risk.
    As the economy and the financial system grow over time, retail 
funds are increasingly placed directly in money markets where they fund 
longer-term less liquid
assets via ``shadow banks.'' Nevertheless, the money market continues 
to be a net supplier of funds to the banking system via wholesale 
funding, which continues to grow steadily as a share of overall bank 
funding.
    The question is: What is the best way to handle the growing funding 
liquidity risk in the banking system? One option is to utilize LCR 
requirements with all their enforcement and compliance costs, 
regulatory discretion complications, and market distortions outlined 
above.
    A second option is to internalize bank balance sheet risks using 
simple, sufficiently elevated bank capital leverage ratio requirements. 
With enough of a bank's owners' capital at stake, a bank would have the 
incentive to manage prudently not only its credit and market risks but 
its liquidity risks too, so as not to jeopardize its solvency due to a 
temporary loss of short-term funding. A high-enough simple, leverage 
ratio requirement would obviate the need for more burdensome LCR
requirements. Regulatory costs would be contained, as would the 
regulatory arbitrage that helps perpetuate the growth of wholesale 
funding of banks and its attendant liquidity risks.
    Moreover, a tightly binding bank capital leverage ratio requirement 
would deter intermediation through the more lightly regulated money 
markets. This it would do by attaching an elevated equity capital cost 
to the expansion of bank balance sheets when banks take up wholesale 
funding. Wholesale funding of banks would then leave money market rates 
commensurately lower than otherwise to cover the added balance sheet 
cost. Relatively lower money market rates, in turn, would deter 
intermediation through the more lightly regulated money markets.
    In conclusion, rules and regulations should be simple enough so 
that bankers can manage banks without being expert in complex financial 
regulations. Simple, sufficiently elevated leverage ratio requirements 
offer the potential for regulatory relief. A high leverage ratio 
requirement wouldn't disadvantage banks that chose relatively riskless 
assets. Institutions with safe balance sheets should not be expected to 
earn much higher return on equity than safe assets themselves, excess 
returns would come from the value added of their financial services. On 
the other hand, if the required leverage ratio can be pushed high 
enough, then banks could be allowed to choose their risk assets with 
minimal regulations in return for a commensurably higher return on 
equity. The real question is: how high should the minimum leverage 
ratio be set, with adequate regulatory powers for monitoring and 
intervention, to justify the freedom for banks to fund and deploy 
assets efficiently?
                                 ______
                                 
             PREPARED STATEMENT OF HEIDI MANDANIS SCHOONER
               Professor of Law, Columbus School of Law,
                   The Catholic University of America
                         Tuesday, June 7, 2016
    Chairman Shelby, Ranking Member Brown, and Members of the 
Committee, thank you for this opportunity to participate in today's 
hearing on bank capital and liquidity regulation. In my testimony, I 
will make two central observations regarding the regulation of bank 
capital.
    First, I will emphasize the importance of equity capital and the 
failure of current capital regulations to restrict heavy borrowing by 
financial institutions whose distress or default would cause collateral 
harm. While adequate capitalization is central to the safe operations 
of financial institutions, little justifies the current low levels of 
capital required under banking rules. More equity capital and less debt 
makes banks more resilient and better able to withstand inevitable 
economic crises. Current capital regulations were not derived from a 
valid analysis of the costs and benefits of different requirements. In 
fact, a growing body of research finds that current levels are unsafe 
and without justification from the public's perspective. The system can 
be made safer while at the same time correcting many distortions by 
significantly increasing equity capital.
    Second, I will observe that the significant public resources 
allocated to the firm-specific supervisory process (through examination 
and stress testing) are not utilized efficiently given the dangerously 
low capital requirements. Supervision is difficult particularly given 
the conflict between the narrow interests of the banks in operating 
with so much debt and the public interest in making them safer by 
insisting, as normal creditors would have insisted, on much more equity 
to protect
creditors and the public.
    The risks associated with inadequate capitalization are borne by 
the public. These risks appear invisible and are thus tempting to 
ignore. I urge the Committee to consider a burden-shifting, 
precautionary approach to capital regulation that could more 
effectively protect the public from the negative effects of chronic 
under-capitalization that remains tolerated in banking.
Capital Ratios: Important but Insufficient
    Financial institutions rely much more on borrowed money than other 
firms. One reason for this is that they have readily willing lenders in 
the form of depositors who need banks to smooth their uncertain need 
for cash. While tax advantages make debt an attractive source of funds 
for all firms (including nonbank firms), banks have added incentives. 
Banks borrow more than other firms because their creditors (e.g., 
depositors) are not as demanding as the creditors of nonbank firms. The 
risks to banks' creditors are minimized by governments' explicit (e.g., 
deposit insurance) and implicit guarantees that prevent their default. 
Banks' creditors thus are considerably more complacent than normal 
creditors,\1\ and it falls on regulators to protect the creditors from 
banks' excessive risk-taking. Perhaps most troubling is the fact that 
the heavy borrowing and Government subsidies feed on themselves. As a 
financial institution uses its borrowed money to expand, the expected 
Government subsidy increases allowing the bank to borrow more and grow 
even larger.
---------------------------------------------------------------------------
    \1\ Viral Achara, Hamid Merhan, Til Schuermann, and Anjan Thakor, 
Robust Capital Regulation, Federal Reserve Bank of New York Staff 
Reports, no. 490 (June 2011).
---------------------------------------------------------------------------
    Banks that borrow less money to fund their operations are more 
resilient and therefore less likely to require Government assistance or 
to become distressed and stop lending or cause financial instability 
through their connections in the system. For this reason, rules that 
restrict a bank's borrowing (known as ``capital regulation'') have 
emerged as the cornerstone of modern bank regulation. Numerous studies 
demonstrate that better capitalized banks perform better during 
crises.\2\ Capital regulation is appealing because, if done properly, 
it diminishes the need for other, potentially more intrusive, forms of 
prudential regulation.
---------------------------------------------------------------------------
    \2\ Sebastien Gay & Balthazar D. Bergkamp, Does Basel Save Our 
Banks? The Effect of Basel I Capital Requirements on Bank Failures 
(2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2629268 
[https://perma.cc/5PMZ-BAKQ]; Andrea Beltratti & Rene M. Stulz, The 
Credit Crisis Around the Globe: Why Did Some Banks Perform Better?, 105 
J. Fin. Econ. 1, 8-10 (2012); Allen Berger & Christa H.S. Bouwman, How 
Does Capital Affect Bank Performance During Financial Crises?, 109 J. 
Fin. Econ. 146 (2013). An International Monetary Fund (``IMF'') study 
found that banks with higher and better-quality capital were able to 
continue lending during the Financial Crisis. Tumer Kapan & Camelia 
Minoiu, Balance Sheet Strength and Bank Lending During the Global 
Financial Crisis, (Int'l Monetary Fund IMF Working Paper No. 13/102 May 
2012).
---------------------------------------------------------------------------
    Despite the manifold positive and normative claims supporting 
capital regulation, it suffers from limitations. First and foremost is 
the reality that the international regulation of capital, which began 
in the 1980s, did not prevent the devastating
Financial Crisis in 2008. Using this measure, capital regulation has 
been a failure. The reason for this is that the requirements were much 
too low and allowed regulated institutions to take enormous risk and 
use much more borrowed money even while appearing to satisfy the rules. 
Simply put, capital regulation failed because it allowed banks to 
operate with far too little equity and much too much debt. Perhaps this 
should come as no surprise given the lack of any principled basis for 
current minimum capital rules. The Basel Committee on Bank Supervision 
never demonstrated support for setting the original risk-based capital 
ratio at 8 percent and yet that number continues to serve as a key 
point of reference. Moreover, U.S. bank regulators have never provided 
more than vague reasons for setting minimum capital ratios other than 
the observation that most banks were already in compliance with any 
newer, higher standards.\3\
---------------------------------------------------------------------------
    \3\ Eric A. Posner, How Do Bank Regulators Determine Capital 
Adequacy Requirements, 82 U. CHI. L. Rev. 1853 (2015).
---------------------------------------------------------------------------
    In addition to the reality that current levels of capital (e.g., 
the 8 percent risk-based capital ratio referenced above or the 4 
percent leverage ratio discussed below) lack foundation, the components 
of capital are subject to seemingly endless debate. Valuing assets, 
assessing the riskiness of assets, identifying off-balance sheet 
exposures--to name but a few--are all essential elements in the 
calculation of capital ratios and all are debatable and subject to 
error. Limitations in the various ratios are also apparent. The 
standard criticism of the leverage ratio, for example, is that it does 
not distinguish between types of assets. The typical criticism of the 
risk-weighted capital ratio is that it attempts to measure the 
riskiness of assets but does so poorly. Basel II was an attempt to 
improve risk weighting but was never fully implemented in the United 
States because of the FDIC's concerns that the newer, more complex risk 
assessment (which relied on banks' internal risk models for key inputs) 
would actually result in higher risk concentration. Importantly, all of 
these complications and limitations are reduced when the minimum 
required is not so minimal.
    Given the obvious benefits of equity capital, policymakers raised 
regulatory capital requirements so that banks are now required to fund 
their operations with less debt than in the years prior to the 
Financial Crisis. With regard to the leverage ratio which compares 
capital to unweighted assets, U.S. banks have long been
required under Federal Deposit Insurance Corporation regulations to 
maintain a leverage ratio of 4 percent.\4\ More recently, bank-holding 
companies have also been required to comply with a leverage ratio of 4 
percent.\5\ Consistent with the Basel III reforms, the United States 
has incorporated a more demanding supplementary leverage ratio. Bank-
holding companies with assets equal to or greater than $250 billion or 
on-balance sheet foreign exposures equal to $10 billion must comply 
with a supplementary leverage ratio of 3 percent.\6\ The supplementary 
leverage ratio includes on-balance sheet and many off-balance sheet 
exposures in the calculation of assets.\7\ In addition, going beyond 
the standards set under Basel III, beginning on January 1, 2018, bank-
holding companies with assets greater than $700 billion must maintain 
an enhanced supplementary leverage ratio of 5 percent to avoid 
restrictions on dividends and discretionary bonus payments.\8\ These 
newer capital ratios remain, however, much lower that many experts 
believe are adequate for safe operations and challenges persist 
regarding the inputs to those ratios which significantly impact their 
effectiveness.\9\
---------------------------------------------------------------------------
    \4\ 12 C.F.R.  325.3(b)(2). Certain highly rated institutions are 
held to a 3 percent leverage ratio. Id.  325.3(b)(1). But that rule 
must be balanced against prompt corrective action rules (triggering 
certain agency action as bank capital deteriorates), which require an 
adequately capitalized bank to have a 4 percent or greater leverage 
ratio. Id.  325.103(b)(2)(iii).
    \5\ 12 C.F.R.  217.10(a)(4).
    \6\ 12 C.F.R.  217.10(a)(5) (supplementary leverage ratio of 3 
percent applies to ``advanced approaches Board-regulated 
institutions,'' which is defined in 12 C.F.R.  217.100(b) through 12 
C.F.R.  217.2). More capital is required to meet the supplementary 
leverage ratio than the simple (generally applicable) leverage ratio.
    \7\ 12 C.F.R.  217.10(c)(4).
    \8\ 12 C.F.R.  217.11(c). In addition, the FDIC-insured bank 
subsidiaries of such large institutions must maintain a supplementary 
leverage ratio of 6 percent to be considered well capitalized under 
prompt corrective action rules. 12 C.F.R.  324.403.
    \9\ See, for example, FDIC Vice Chairman Hoenig's discussion of the 
leverage ratio treatment of cleared derivatives. Thomas M. Hoenig, The 
Leverage Ratio and Derivatives, Presented to the Exchequer Club of 
Washington, DC (Sept. 16, 2015).
---------------------------------------------------------------------------
    A growing number of authoritative commentators are urging 
significantly higher capital requirements. It is important to note that 
differences in percentages discussed by various experts may or may not 
signal a lack of consensus. The ratios involved rely heavily on key 
definitions (what constitutes equity, for example) and measurements 
(e.g., what is the value of an asset). Even so, a consensus that more 
is better has formed. Economists Admati and Hellwig argue for levels in 
the 20 to 30 percent range relative to total assets and they note the 
measurement issues.\10\ An eminent group of 20 scholars urged that if 
``at least 15 percent, of banks' total, nonrisk-weighted, assets were 
funded by equity, the social benefits would be substantial.''\11\ The 
Systemic Risk Council, a group of former policymakers and legal and 
financial experts, has written in support of a 10 percent nonrisk-
weighted capital requirement.\12\ Researchers at the Bank of England 
and Bank of International Settlements estimate that ``optimal bank 
capital . . . should be around 20 percent of risk weighted 
assets.''\13\ Brown-Vitter \14\ would require the largest banks to 
comply with a 15 percent leverage ratio.
---------------------------------------------------------------------------
    \10\ Anat Admati & Martin Hellwig, The Bankers' New Clothes: What's 
Wrong With Banking and What To do About It 182 (Princeton Univ. Press, 
2013).
    \11\ Anat Admati et al., Healthy Banking System is the Goal, Not 
Profitable Banks, Financial Times (Nov. 8, 2010).
    \12\ Letter from Sheila Bair, Founding Chair of the Systemic Risk 
Council, to Senator David Vitter (May 20, 2015).
    \13\ David Miles, Jing Yang, and Gilberto Marcheggiano, Optimal 
Bank Capital, Bank of England Discussion Paper No. 31. (2011). http://
www.bankofengland.co.uk/monetarypolicy/Documents/externalmpc/
extmpcpaper0031.pdf.
    \14\ Terminating Bailouts for Taxpayer Fairness Act of 2013, 113th 
Cong. (2013).
---------------------------------------------------------------------------
    While few would deny the significant benefits of equity capital, 
the industry claims that equity is costly. Assertions regarding the 
costs of equity, however, identify potential private costs not social 
ones.\15\ For example, if banks' funding costs increase due to a higher 
equity requirement, then, it is said, banks will charge their loan 
customers higher interest rates. Yet these private benefits of 
excessive borrowing are funded through taxpayer-paid subsidies and also 
make the financial system fragile, thus being highly costly for 
society. If policymakers desire low-cost loans, then such subsidies can 
be provided directly to borrowers in ways other than through subsidies 
that reward fragile banks.
---------------------------------------------------------------------------
    \15\ For a full exploration of this issue, see Anat Admati, The 
Compelling Case for Stronger and More Effective Leverage Regulation in 
Banking, 43 Journal of Legal Studies 535 (2014).
---------------------------------------------------------------------------
Capital Supervision: Unrealized Promise of Safety and Soundness
    The rules that govern bank capital, as discussed above, are often 
referred to as ``minimum'' capital ratios. Institutions that comply 
with the current ratios are not necessarily safe or unlikely to fail in 
a crisis, given that the requirements still allow extremely high levels 
of debt. Experience suggests that minimum capital ratios are a lagging 
indicator of a bank's financial stability. Banks that failed or 
required Government support appeared adequately capitalized, under the 
then current rules, during the Financial Crisis.\16\ Thus, the firm-
specific supervisory process is meant to correct the deficiencies of 
the one-size-fits-all rule-based regulation.
---------------------------------------------------------------------------
    \16\ Thomas M. Hoenig, FDIC Vice Chairman, Basel III Capital: A 
Well-Intended Illusion (Ap. 9, 2013).
---------------------------------------------------------------------------
    The supervisory process plays a significant role in the regulation 
of banks' capital. Capital adequacy is a key measure in the supervisory 
process; it is listed as the first factor under the supervisory rating 
system, CAMELS.\17\ Through the process of bank examination, regulators 
can (and do) determine that a particular bank must exceed the minimum 
capital ratios set in applicable rules. A study of capital enforcement 
actions brought against banks (virtually all smaller banks) from the 
period of 1993 to 2010 found that bank regulators had imposed a 
leverage ratio of between 4.5 percent and 28 percent through formal 
enforcement actions during the period studied.\18\
---------------------------------------------------------------------------
    \17\ CAMELS is an acronym for the examiners assessment of six key 
areas: Capital adequacy, Asset quality, Management, Earnings, 
Liquidity, and Sensitivity to market risk.
    \18\ Julie Andersen Hill, Bank Capital Regulation by Enforcement: 
An Empirical Study, 87 Ind. L.J. 645, at 681 (2012). Hill's study 
includes data for enforcement actions that relied on other ratios as 
well, including risk-based capital ratios. The bank that was subjected 
to a 28 percent leverage ratio was identified as an outlier in Hill's 
study. Most banks subject to higher leverage ratios fell within a range 
of 12 percent and 17 percent.
---------------------------------------------------------------------------
    In response to the Financial Crisis, the Federal Reserve reformed 
many aspects of its supervision of large banks. With regard to capital 
supervision, large bank-holding companies with assets of 50 billion 
dollars or more are required by the Federal Reserve to submit an annual 
capital plan and are subject to the Federal
Reserve's annual Comprehensive Capital Analysis and Review (``CCAR'') 
process.\19\ The Federal Reserve may object to a bank-holding company's 
capital plan and thereby prohibit the bank-holding company from making 
capital distributions (i.e., paying dividends to shareholders, among 
other things). CCAR is an annual assessment that complements 
supervisory stress testing mandated under Dodd-Frank.\20\
---------------------------------------------------------------------------
    \19\ For a full discussion of the development and early experience 
with the CCAR program, see Robert F. Weber, The Comprehensive Capital 
Analysis and Review and the New Contingency Bank Dividends, 46 Seton 
Hall L. Rev. 43 (2015).
    \20\ 12 U.S.C.  5365(i)(1) (2012).
---------------------------------------------------------------------------
    CCAR includes both a qualitative assessment of a bank-holding 
company's capital planning process and a quantitative assessment of the 
bank-holding company's ability to maintain post-stress capital ratios 
above the applicable minimum ratios in
effect.\21\ By testing banks' regulatory capital under both expected 
and stressed
(hypothetical) conditions,\22\ CCAR, in effect, results in higher 
minimum capital requirements for large bank-holding companies. For 
example, with regard to the leverage ratio, while the minimum 
requirement under the Federal Reserve's rules is 4 percent, CCAR 
requires, in effect, higher leverage ratios for all 31 individual bank-
holding companies reviewed. The 2015 CCAR projects a minimum leverage 
ratio of
between 4.1 percent to 7.6 percent under severely adverse scenarios and 
between 4.5 percent to 9.1 percent for adverse scenarios for bank-
holding companies with assets equal to or greater than $250 billion or 
on-balance sheet foreign exposures equal to $10 billion.\23\ Note that 
the 2015 CCAR uses the general leverage ratio and not the stricter 
supplementary leverage ratio discussed above. The supplementary 
leverage ratio will also not be used in the 2016 CCAR.\24\
---------------------------------------------------------------------------
    \21\ Bd. of Governors of the Fed. Reserve Sys., Comprehensive 
Capital Analysis And
Review 2015: Assessment Framework and Results 9 (Mar. 2015).
    \22\ Stressed conditions are provided both by the Federal Reserve 
and developed by the bank-holding company itself. 12 C.F.R.  
225.8(d)(2)(i)(A).
    \23\ Bd. of Governors of the Fed. Reserve Sys., Comprehensive 
Capital Analysis and Review 2015: Assessment Framework and Results 15-
18 (March 2015). The Federal Reserve has completed Comprehensive 
Capital Analysis and Review (``CCARs'') every year since 2011.
Results from year to year during that time are somewhat difficult to 
compare. This is because the CCAR quantitative assessment focuses on a 
bank-holding company's ability to maintain required minimum ratios 
during stress periods and the required minimum ratios have changed 
during this time period. Bd. of Governors of the Fed. Reserve Sys., 
Comprehensive Capital Analysis and Review 2014: Assessment Framework 
And Results 10, Box 2 (Mar., 2014).
    \24\ Bd. of Governors of the Fed. Reserve Sys., Comprehensive 
Capital Analysis and
Review 2016 Summary Instructions 6 (January 2016).
---------------------------------------------------------------------------
    While the effective imposition of higher capital requirements 
through CCAR (or, for smaller banks, via administrative enforcement) 
sounds promising, this system is actually at odds with the concept of 
``prudential'' regulation in that the supervisory process builds only 
incrementally upon weak minimum rules.\25\ Consider the fact that the 
CCAR process is one that tests--hypothetically--a bank's ability to 
maintain compliance with capital ratios under various stressed 
scenarios and recall the lack of any principled basis on which the 
minimum ratios were derived. Even assuming the value of testing against 
low equity levels, stress testing presents significant challenges. For 
example, the Office of Financial Research released a study raising 
serious concerns regarding stress tests' evaluation of counterparty 
risk.\26\ Broadly, stress tests rely heavily on modeling of future 
events and the Financial Crisis highlighted the folly of over reliance 
on such predictions.
---------------------------------------------------------------------------
    \25\ ``The premise of the stress tests is the flawed notion that 
equity is scarce and expensive and that banks should have `just 
enough.' '' Anat R. Admati, The Missed Opportunity and Challenge of 
Capital Regulation, 235 National Institute Economic Review R4, R10 
(Feb. 2016).
    \26\ Jill Cetina, Mark Paddrik, Sriram Rajan, Stressed to the Core: 
Counterparty Concentrations and Systemic Losses In CDS Markets, OFR 
Working Paper 16-01 (Mar. 8, 2016).
---------------------------------------------------------------------------
    Our combined rulemaking and supervisory system would be more 
effective if capital ratios applicable to all banks were set high--high 
enough so that the risk of serious undercapitalization, distress or 
insolvency is very small. This would mean that capital ratios would be 
consistent with a precautionary approach, erring on the side of more 
capital. Conceptually, capital regulation would be set and defined as 
``prudent'' capital as opposed to ``minimum'' capital. While 
discussions of capital regulation tend to focus on systemically 
important firms, prudent capital requirements should not be limited to 
such firms. As discussed above, bank regulators routinely determine 
that small banks are undercapitalized even when they meet current 
minimum standards. Large regional banks may not be too big to fail, but 
they can contribute significantly to the depth of a financial crisis 
(Washington Mutual and Countrywide are obvious examples). It may be 
appropriate to have different thresholds based on bank size (as is the 
current practice with regard to minimum capital rules) but capital 
regulations for all banks should require much more significant equity 
than what is required under current rules. In addition, the supervisory 
process should continue to be engaged, dynamically, for assurance of 
compliance with rules and assessment of firm-specific risks. The 
supervisory process would, for example, trigger prompt corrective 
action well in advance of insolvency to build equity back to 
precautionary levels through retained earnings and other actions so the 
fear of insolvency does not rattle markets.
    Prudent capital regulation would shift downside risk from the 
public to managers and equity investors who enjoy the upside and are 
thus the most natural candidates to bear, and thus care more about, the 
downside. In well-functioning markets, those who benefit most from 
banks' profitability should bear the downside burden. Strong equity 
capital would correct the current distortion and establish safer banks 
and a more resilient financial system.
                                 ______



[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]




  RESPONSES TO WRITTEN QUESTIONS OF SENATOR SASSE FROM HAL S. 
                             SCOTT

Q.1.a. I'd like to discuss contingent convertible capital 
instruments, commonly known as CoCo bonds.
    What lessons can be drawn from Europe's experience with 
CoCo bonds?

A.1.a. CoCo bonds have been far from a success in Europe, which 
should give U.S. regulators pause as to their potential 
effectiveness in increasing financial stability. While the 
theoretical concepts underlying the use of CoCos are appealing, 
the empirical evidence in European banks shows these products 
are unpopular for both issuer and investor. As we saw in 
February of this year, during volatile times the market for 
CoCos can dry up entirely.

Q.1.b. Do you believe CoCo bonds can uniquely help a firm 
withstand significant financial distress? If so, how?

A.1.b. No, in fact the complexity of the instruments and the 
uncertainty around triggers in the midst of a financial crisis, 
precisely at times when certainty is paramount, can ultimately 
undermine the stability of the issuer, rather than strengthen 
it.

Q.1.c. How should Federal regulators treat CoCo bonds?

A.1.c. Federal regulators should proceed with caution in 
employing CoCo bonds as part of the regulatory framework. They 
are far from a regulatory ``silver bullet'' in promoting 
financial stability. Developments in the European market should 
be continuously
monitored.

Q.2.a. I'd like to ask about Federal Reserve Governor Powell 
testimony at the April 14, 2016, Senate Banking Committee that 
``some reduction in market liquidity is a cost worth paying in 
helping to make the overall financial system significantly 
safer.''
    Is there also a risk that reducing liquidity in the 
marketplace also makes the marketplace unsafe?

A.2.a. Yes, reducing liquidity in the marketplace will make the 
financial system unsafe for a variety of reasons. A contraction 
of
liquidity, particularly during times of stress, can cause 
otherwise healthy financial institutions to fail as liquidity 
issues can lead to solvency issues. In addition, a reduction of 
liquidity can also exacerbate fire sale risks, which themselves 
can have severe systemic consequences.

Q.2.b. If so, how should regulators discern the difference 
between an unsafe reduction in liquidity and a safe reduction 
in liquidity?

A.2.b. This is a difficult task since the line between safe and 
unsafe liquidity reduction can fluctuate under a number of 
circumstances. Therefore, it is crucial that regulators have a 
strong tool box to respond to liquidity crises. It is of 
critical importance that the United States maintain a strong 
lender of last resort in the Federal Reserve as a key component 
of the tool box.

Q.3.a. I'd like to ask about the various capital requirements 
that have been imposed after the 2008 financial crisis. Have 
Federal regulators sufficiently studied the cumulative impact--
including on liquidity in the marketplace--of these various 
changes?

A.3.a. No, there has not been sufficient comprehensive analysis 
of the cumulative impact of the post-2008 financial reforms.

Q.3.b. If not, how should Federal regulators resolve this 
issue? For example, some have called to delay the imposition of 
new financial rules and regulations, to facilitate a broader 
study of these issues.

A.3.b. As the post-2008 reforms continue to take effect, 
regulators should conduct an ex-post review of all such 
reforms. For example, the amount of capital held by the largest 
banks has more than doubled since the financial crisis and the 
liquidity position has nearly tripled. Large banks have also 
simplified their structures since the financial crisis, easing 
the ability of regulators to unwind them in case of failure. 
All these measures should be considered in conjunction with 
each other to determine the cumulative impact. This should be 
done before additional rules and regulations are imposed.

Q.4.a. I'd like to discuss stress tests. How should 
policymakers balance the tension between providing more 
transparency and guidance to regulated entities about how to 
pass a stress test, and
concerns that to do so would allow regulated entities to 
allegedly ``game'' these processes?

A.4.a. The concern that full disclosure of the stress tests 
models will result in the Fed ``teaching to the test'' is a 
valid concern. I therefore do not recommend that the Fed fully 
disclose the models. However, I think there is room for more 
transparency in the process. I recommend increased disclosure 
of the expert opinions that come out of the Model Evaluation 
Council. And rather than full disclosure of the models 
themselves, I recommend submitting the other components of the 
stress test framework to public notice and comment. The 
increased transparency should give regulated entities better 
guidance for passing the stress test without compromising their 
effectiveness.

Q.4.b. Do stress tests accurately depict how a firm would 
perform during a financial crisis, when taking into account 
``systemic'' considerations? If not, what should be done, if 
anything, to improve their accuracy?

A.4.b. As I mentioned previously, I believe the accuracy of the 
stress tests is greatly improved with input by outside experts. 
While the Model Evaluation Council does include five outside 
experts from the academic community, the Fed chooses the 
experts and no transparency is provided regarding the review 
process of the actual evaluations of the experts. I recommend 
increased disclosure of the expert opinions, which I believe 
will ultimately lead to improved accuracy of the stress tests.

Q.5.a. I'd like to ask about House Financial Services Chairman 
Hensarling's legislation, the Financial CHOICE Act, which--in 
part--would allow banks to opt-out of various regulatory
requirements, in exchange for meeting a 10 percent leverage 
ratio that is essentially the formulation required by the 
current Supplemental Leverage Ratio.
    What are the most persuasive arguments for and against 
relying upon a leverage ratio as a significant means of 
reducing systemic risk in the financial system?

A.5.a. The simplicity of a leverage ratio is its most 
beneficial feature, but also has its drawbacks. On the one 
hand, a leverage ratio does not require calibration of risk 
weights, which can be poorly constructed by regulators and 
gamed by financial institutions. On the other hand, since a 
leverage ratio requires the same amount of capital regardless 
of the riskiness of assets, it encourages financial 
institutions to maximize risk. For these reasons, leverage 
ratios should be part of the regulatory framework, but should 
not replace risk-weighted measures.

Q.5.b. Under this legislation, is the 10 percent leverage ratio 
the right level? If not, where should policymakers set the 
level at?

A.5.b. I do not believe leverage ratios should replace other 
regulatory requirements, so no reasonable level of a leverage 
ratio would be sufficient. Extreme leverage ratios approaching 
100 percent would ensure financial stability, but would come at 
such
severe costs to the broader economy that such levels are not 
worth the trade-off. Leverage ratios should be used as a 
backstop to prevent excessive build-up of leverage, not as the 
binding capital requirement. Therefore, the appropriate level 
will serve as such a backstop, with risk-weighted measures 
serving as the binding
requirements.

Q.5.c. What evidence do you find or would you find to be the 
most persuasive in discerning the proper capital levels under 
this proposal?

A.5.c. Capital levels should be set to strike the appropriate 
balance between stability of financial institutions and optimal 
efficiency of the overall financial system, which necessarily 
involves some amount of leverage. Since no reasonable level of 
capital will completely eliminate the risk of failure, 
particularly in the face of contagion, I believe emphasis on a 
strong lender of last resort is an important pillar of 
financial stability. Regulatory capital requirements in 
conjunction with a strong lender of last resort is the
optimal way to protect our system.

Q.5.d. If the leverage ratio was set at the right level, do you 
find merit in eliminating a significant portion of other 
regulatory requirements, as with the Financial CHOICE Act? Are 
there any regulations that you would omit beyond those covered 
by the Financial CHOICE Act?

A.5.d. No, I do not believe it possible to set a leverage ratio 
at a reasonable level that will merit elimination of a 
significant portion of other regulatory requirements. Leverage 
ratios should serve as a back-stop that prevents excessive 
leverage that may result from the risk-based framework. They 
should not be the binding capital requirements.

Q.5.e. What impact would this proposal have on liquidity in the 
marketplace?

A.5.e. If financial institutions were to face a leverage ratio 
exclusively, then firms will avoid lower-risk, lower-margin 
assets in favor of higher-risk assets. As a result, liquidity 
in safer assets, such as Treasuries and foreign sovereign debt, 
could be reduced dramatically. Liquidity in investment-grade 
corporate debt may also decline.
                                ------                                


  RESPONSE TO WRITTEN QUESTION OF SENATOR ROUNDS FROM HAL S. 
                             SCOTT

Q.1. Are there any suggestions to balance the independence of 
appraisals with assuring the appraiser has sufficient 
knowledge,
especially in rural areas or very dense cities?

A.1. I do not have any specific suggestions on this front, but 
generally believe that increased transparency of the appraisal 
process will serve to improve the process.
                                ------                                


  RESPONSES TO WRITTEN QUESTIONS OF SENATOR SASSE FROM MARVIN 
                           GOODFRIEND

Q.1. I'd like to discuss contingent convertible capital 
instruments, commonly known as CoCo bonds.

   LWhat lessons can be drawn from Europe's experience 
        with CoCo bonds?

   LDo you believe CoCo bonds can uniquely help a firm 
        withstand significant financial distress? If so, how?

   LHow should Federal regulators treat CoCo bonds?

A.1. I am not familiar with Europe's experience with CoCo 
bonds. The attractiveness of CoCo bonds is that they appear to 
be a middle ground acceptable to banks, on one hand, and 
regulators on the other. They are a kind of compromise. Banks 
like the fact that CoCo's are normally debt, which allows more 
leverage, with potential tax benefits and higher standard ROE 
numbers. Regulators like the triggers that potentially convert 
CoCo's to loss-absorbing equity in times of stress. I don't 
think regulators should encourage the use of CoCo's as a 
substitute for simple equity capital for two reasons. First, 
debt in general already enjoys subsidies that encourage 
excessive leverage. Second, triggers are problematic in 
practice. Triggers linked to observable market prices can be 
inappropriately tripped, exacerbating financial distress; and 
linked to accounting measures, triggers can be activated too 
late to save a troubled bank. Moreover, in practice 
discretionary regulatory actions, whether explicitly allowed or 
not, will complicate the activation of triggers, creating 
confusion or possibly overriding completely the conversion of 
CoCos into equity in times of stress out of concern for wider 
destabilization of financial markets.

Q.2. I'd like to ask about Federal Reserve Governor Powell's 
testimony at the April 14, 2016, Senate Banking Committee that 
``some reduction in market liquidity is a cost worth paying in 
helping to make the overall financial system significantly 
safer.''

   LIs there also a risk that reducing liquidity in the 
        marketplace also makes the marketplace unsafe?

   LIf so, how should regulators discern the difference 
        between an unsafe reduction in liquidity and a safe 
        reduction in liquidity?

A.2. The collapse of funding liquidity, so destructive during 
the 2007-09 crisis, was a symptom of fundamental insolvency 
brought about by the excessive leverage that funded longer-term 
illiquid
assets, e.g., mortgages, with short-term money market 
instruments. The lesson is that above all, the solvency of the 
banking system must be protected by higher capital ratio 
minimums, supported by adequate supervisory monitoring, and 
appropriate enforcement powers. Only then will the banking 
system utilize a safe level of funding liquidity, e.g., 
wholesale funding. Bank balance sheet scarcity due to tightened 
capital requirements may be causing banks to withdraw from 
market making, i.e., providing market liquidity. That may be 
creating opportunities for nonbank entities to enter the 
business of providing market liquidity. This development need 
not make market liquidity provision riskier as long as 
regulators make sure that such provision, which may involve 
insurance companies or hedge funds, cannot exploit any 
underpriced explicit or implicit Government credit 
enhancements.

Q.3. I'd like to ask about the various capital requirements 
that have been imposed after the 2008 financial crisis.

   LHave Federal regulators sufficiently studied the 
        cumulative impact--including on liquidity in the 
        marketplace--of these various changes?

   LIf not, how should Federal regulators resolve this 
        issue? For example, some have called to delay the 
        imposition of new financial rules and regulations, to 
        facilitate a broader study of these issues.

A.3. It was clear in the aftermath of the 2007-09 crisis that 
regulators needed to enforce much higher minimum equity capital
ratios on the larger banks, as I said above, with requisite 
monitoring, and enforcement powers. Leverage ratios prior to 
and during the crisis for the larger banks in the United States 
were 3 percent or less. In the early 20th century, before banks 
could count on deposit insurance, Fed credit policy, or 
Government credit enhancements, voluntary leverage ratios 
ranged from 15 percent to 20 percent and higher. So in my view 
it is right to go ahead and move required leverage ratio 
requirements much higher without delay.

Q.4. I'd like to discuss stress tests.

   LHow should policymakers balance the tension between 
        providing more transparency and guidance to regulated 
        entities about how to pass a stress test, and concerns 
        that to do so would allow regulated entities to 
        allegedly ``game'' these processes?

   LDo stress tests accurately depict how a firm would 
        perform during a financial crisis, when taking into 
        account ``systemic'' considerations? If not, what 
        should be done, if anything, to improve their accuracy?

A.4. If the Fed believes that it knows the ``risk space'' very 
well, then it makes sense for it to provide more explicit 
guidance to banks to prepare for the stress test. But to the 
extent that the banks might know the ``risk space'' better than 
the Fed, the Fed would want to be vague about its view of the 
``risk space'' and let banks prepare for the stress test based 
on their own perception of the ``risk space.'' In the latter 
situation, banks would find it more difficult to prepare for 
the stress test. In order to answer this question, the Fed and 
the banks should discuss which of the two are better at 
forecasting the ``risk space.'' In any case, the stress tests 
should not be seen as a means of gauging how well particular 
institutions would perform in future stressful situations. 
There are too many uncertainties for the tests to be precise 
predictors of future performance. At most, the stress tests 
should be seen as a regulatory monitoring tool to facilitate 
the enforcement of equity capital minimums on banks.

Q.5. I'd like to ask about House Financial Services Chairman 
Hensarling's legislation, the Financial CHOICE Act, which--in 
part--would allow banks to opt-out of various regulatory 
requirements, in exchange for meeting a 10 percent leverage 
ratio that is essentially the formulation required by the 
current Supplemental Leverage Ratio.

   LWhat are the most persuasive arguments for and 
        against relying upon a leverage ratio as a significant 
        means of reducing systemic risk in the financial 
        system?

   LUnder this legislation, is the 10 percent leverage 
        ratio the right level? If not, where should 
        policymakers set the level at?

   LWhat evidence do you find or would you find to be 
        the most persuasive in discerning the proper capital 
        levels under this proposal?

   LIf the leverage ratio was set at the right level, 
        do you find merit in eliminating a significant portion 
        of other regulatory requirements, as with the Financial 
        CHOICE Act? Are there any regulations that you would 
        omit beyond those covered by the Financial CHOICE Act?

   LWhat impact would this proposal have on liquidity 
        in the
        marketplace?

A.5. The key ideas behind the higher leverage ratio requirement 
are these. First, with enough owners' capital at stake, a bank 
would have the incentive to manage prudently not only the 
credit and market price risks of its assets, but its liquidity 
funding risks too, so as not to jeopardize its solvency due to 
a temporary loss of short-term funding. Second, enforcing 
higher capital minimums is essential to offset the incentive 
otherwise for competitive banks to position themselves (by 
taking on excessive leverage and risks) to take advantage of 
anticipated discretionary underpriced ex post credit 
enhancements delivered by the central bank or Government in 
times of financial stress. Third, the simple minimum
leverage ratio requirement is preferable to risk-based capital 
requirements. There is no reason to weight assets according to 
their supposed risks. If leverage ratios are set high enough, 
then banks could be allowed to choose their risk assets within 
relatively wide limits to earn a higher return on equity 
commensurate with the risk of their assets and their leverage 
ratio. Not only are risk weights largely superfluous if the 
leverage ratio requirement is made high enough, but risk-
weights themselves can be gamed by the banks potentially to 
greatly weaken the effective regulatory constraint on leverage.
    If anything, the minimum 10 percent leverage ratio 
requirement in the Choice Act may be too low in relation to the 
15 percent to 20 percent and higher leverage ratios chosen by 
banks early in the 20th century. See my answer to question 3.
    Generally speaking, I enthusiastically support the notion 
at the heart of the Choice Act that banks should be afforded 
substantial regulatory relief in exchange for agreeing to a 
higher minimum
leverage ratio requirement. However, I am inclined to think 
that substantial regulatory relief should be granted at minimum 
leverage ratio requirements closer to 20 percent, at least for 
systemically important banks.
    In effect, my answer to question 2 above addresses the 
impact on market liquidity of the proposal in the Choice Act.
                                ------                                


 RESPONSES TO WRITTEN QUESTIONS OF SENATOR ROUNDS FROM MARVIN 
                           GOODFRIEND

Q.1. Has liquidity in these markets diminished in recent years? 
Are such markets less resilient than they used to be? If yes, 
would you attribute the change to market structure issues or to 
recent regulations, including bank capital and liquidity rules?

A.1. Based on the evidence summarized in Governor Powell's 
testimony cited above and other work I've seen, it does appear 
that market liquidity may have deteriorated in Treasury and 
corporate bond markets in recent years. It appears likely that 
the deterioration is due to both capital and liquidity rules 
and evolving market structure. Although I would add following 
my answer to question 2 above that market structure is likely 
to evolve still further in ways that might recover lost market 
liquidity.

Q.2. Given that future liquidity is fundamentally 
unpredictable, what steps can Congress or regulators take ex 
ante to try to head off market panics, short of insuring market 
losses? Given that, in some panics, no amount of liquid assets 
could prove sufficient, do liquidity requirements make sense?

A.2. I don't think liquidity requirements make sense. As I said 
in my oral statement at the June 7th hearing, and explained in 
detail in my written testimony, the liquidity coverage ratio 
(LCR) is a particularly ill-conceived means of facilitating 
liquidity in the banking system, especially relative to the 
alternatives. First, monetary policy utilizing interest on 
reserves is a far less burdensome and a more efficient 
alternative to LCR requirements as a means of pre-positioning 
liquid assets on bank balance sheets. Second, simple 
sufficiently elevated bank capital leverage ratio requirements 
are far less burdensome and a more efficient alternative to LCR 
requirements as a means of guarding against wholesale funding 
risks. Congress and regulators should support the Fed's use of
interest on reserves and monetary policy to pre-position 
reserve
liquidity on bank balance sheets albeit with a much smaller Fed 
balance sheet; and Congress and regulators should work to relax 
the LCR requirements with all their enforcement and compliance 
costs, regulatory discretion complications, and market 
distortions in exchange for higher minimum leverage ratio 
requirements as proposed in the Choice Act. See my written 
testimony for details.
                                ------                                


  RESPONSES TO WRITTEN QUESTIONS OF SENATOR SASSE FROM HEIDI 
                       MANDANIS SCHOONER

Q.1. I'd like to discuss contingent convertible capital 
instruments, commonly known as CoCo bonds.

   LWhat lessons can be drawn from Europe's experience 
        with CoCo bonds?

   LDo you believe CoCo bonds can uniquely help a firm 
        withstand significant financial distress? If so, how?

   LHow should Federal regulators treat CoCo bonds?

A.1. I have not studied the experience of CoCo bonds in Europe. 
I do, however, have several concerns regarding financial 
stability proposals relying on these and other, similar, debt 
instruments. First, requiring banks to hold more debt as 
opposed to equity is not the best way to make banks safer. 
While CoCos are convertible to equity under some circumstances, 
they are debt instruments. Requiring banks to fund their 
operations with less debt rather than more is a better way to 
protect banks during a financial crisis. Second, because CoCo 
bonds are relatively new, significant uncertainty remains with 
regard to how institutions and markets would react to the 
conversion of such instruments from debt instruments to common 
equity. This uncertainty could prove highly problematic under 
crisis conditions. Finally, I believe that a wiser course for 
regulators is to focus on increasing banks' equity. In this 
regard, I am disappointed that in the most recent stress tests 
the Federal Reserve missed the opportunity to restrict dividend 
payments by the largest banks.

Q.2. I'd like to ask about Federal Reserve Governor Powell 
testimony at the April 14, 2016, Senate Banking Committee that 
``some reduction in market liquidity is a cost worth paying in 
helping to make the overall financial system significantly 
safer.''

   LIs there also a risk that reducing liquidity in the 
        marketplace also makes the marketplace unsafe?

   LIf so, how should regulators discern the difference 
        between an unsafe reduction in liquidity and a safe 
        reduction in liquidity?

A.2. Market liquidity is a key concern because highly illiquid
markets can trigger and exacerbate a financial crisis. While 
determining the factors influencing, and the optimal level of, 
market
liquidity may prove elusive, we know that highly leveraged 
institutions are less able to withstand fluctuations in market 
liquidity than firms with less debt. Thus, preparing firms for 
those inevitable fluctuations by reducing their debt is an 
effective means of addressing the question of market liquidity.

Q.3. I'd like to ask about the various capital requirements 
that have been imposed after the 2008 financial crisis.

   LHave Federal regulators sufficiently studied the 
        cumulative impact--including on liquidity in the 
        marketplace--of these various changes?

   LIf not, how should Federal regulators resolve this 
        issue? For example, some have called to delay the 
        imposition of new
        financial rules and regulations, to facilitate a 
        broader study of these issues.

A.3. I do not know whether Federal regulators have conducted 
such studies. However, as elaborated in my written testimony, 
significant research supports increases in required capital. 
Better capitalized banks perform better during financial 
crises. Banks with less debt are able to continue to lend 
during economic downturns and may avoid reliance on Government 
support. As indicated in my testimony, a significant consensus 
among economists and former policymakers supports significantly 
higher capital than the levels
required under current rules.

Q.4. I'd like to discuss stress tests.

   LHow should policymakers balance the tension between 
        providing more transparency and guidance to regulated 
        entities about how to pass a stress test, and concerns 
        that to do so would allow regulated entities to 
        allegedly ``game'' these processes?

   LDo stress tests accurately depict how a firm would 
        perform during a financial crisis, when taking into 
        account ``systemic'' considerations? If not, what 
        should be done, if anything, to improve their accuracy?

A.4. Stress testing is an important part of modern bank 
supervision, a process that seeks to prevent firms' financial 
distress in order to protect the entire financial system and 
economy. Stress testing can provide both regulators and banks 
with valuable information regarding a bank's performance during 
a crisis. While I have conducted no study of the effectiveness 
of stress testing, I disagree that the evaluation of stress 
testing should focus on whether that process accurately 
predicts how a firm would perform during a crisis. This 
standard seems impossible to achieve. Instead, stress testing 
should be evaluated on whether it provides regulators and 
regulated firms with information that is important to their 
performance during a crisis.

Q.5. I'd like to ask about House Financial Services Chairman 
Hensarling's legislation, the Financial CHOICE Act, which--in 
part--would allow banks to opt-out of various regulatory 
requirements, in exchange for meeting a 10 percent leverage 
ratio that is essentially the formulation required by the 
current Supplemental Leverage Ratio.

   LWhat are the most persuasive arguments for and 
        against relying upon a leverage ratio as a significant 
        means of reducing systemic risk in the financial 
        system?

   LUnder this legislation, is the 10 percent leverage 
        ratio the right level? If not, where should 
        policymakers set the level at?

   LWhat evidence do you find or would you find to be 
        the most persuasive in discerning the proper capital 
        levels under this proposal?

   LIf the leverage ratio was set at the right level, 
        do you find merit in eliminating a significant portion 
        of other regulatory requirements, as with the Financial 
        CHOICE Act? Are there any regulations that you would 
        omit beyond those covered by the Financial CHOICE Act?

   LWhat impact would this proposal have on liquidity 
        in the marketplace?

A.5. While a 10 percent Supplemental Leverage Ratio would be an 
improvement over the current requirements, it is still lower 
than the levels many economists recommend as a safe. Picking 
ratios and deciding on the right levels is difficult and 
important differences are buried in the details. Valuing 
assets, assessing the riskiness of assets, identifying off-
balance sheet exposures--to name but a few--are all essential 
elements in the calculation of capital ratios and all are 
debatable and subject to error. Limitations in the various 
ratios are also apparent. The standard
criticism of the leverage ratio, for example, is that it does 
not distinguish between types of assets. The typical criticism 
of the
risk-weighted capital ratio is that it attempts to measure the 
riskiness of assets but does so poorly. If the leverage ratio 
were increased significantly, proposals requiring banks to hold 
convertible debt, for example, would be unnecessary. While 
increasing capital levels could be a means for reducing 
regulatory burden, another key benefit of making banks safer by 
increasing their equity is eliminating the need for Government 
support during a crisis.