[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
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Available at: http: //www.fdsys.gov /
______
U.S. GOVERNMENT PUBLISHING OFFICE
21-603 PDF WASHINGTON : 2017
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Publishing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC,
Washington, DC 20402-0001
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.
---------------------------------------------------------------------------
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.