    [Senate Hearing 114-115]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 114-115

        MEASURING THE SYSTEMIC IMPORTANCE OF U.S. BANK HOLDING COMPANIES

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

                                    HEARING

                                   BEFORE THE

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

                        ONE HUNDRED FOURTEENTH CONGRESS

                                 FIRST SESSION

                                       ON

     EXAMINING THE APPROPRIATE CRITERIA THAT THE FEDERAL RESERVE AND OTHER
       REGULATORS COULD USE TO DETERMINE WHETHER AN INSTITUTION POSES A
                     SYSTEMIC RISK TO THE FINANCIAL SYSTEM

                                   __________

                                 JULY 23, 2015

                                   __________

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

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman

    MICHAEL 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 and Senior Counsel

                        Jelena McWilliams, Chief Counsel

                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

                                  ----------

                            THURSDAY, JULY 23, 2015

                                                                       Page

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

    Opening statements, comments, or prepared statements of:
        Senator Brown................................................     2

                                   WITNESSES

    Robert DeYoung, Capital Federal Professor in Financial Markets
      and Institutions, University of Kansas School of Business......     3
        Prepared statement...........................................    25
        Responses to written questions of:
            Chairman Shelby..........................................    37
    Deborah Lucas, Sloan Distinguished Professor of Finance, and
      Director, MIT Center of Finance and Policy, Sloan School of
      Management.....................................................     5
        Prepared statement...........................................    26
    Jonathan R. Macey, Sam Harris Professor of Corporate Law,
      Corporate Finance, and Securities Law, Yale Law School.........     7
        Prepared statement...........................................    29
    Michael S. Barr, Roy F. and Jean Humphrey Proffitt Professor of
      Law, University of Michigan Law School.........................     8
        Prepared statement...........................................    31

                                     (iii)

        MEASURING THE SYSTEMIC IMPORTANCE OF U.S. BANK HOLDING COMPANIES

                                  ----------

                            THURSDAY, JULY 23, 2015

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Committee met at 9:32 a.m., in room SD-538, Dirksen
    Senate Office Building, Hon. Richard C. Shelby, Chairman of the
    Committee, presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The hearing will come to order.
        Today, we will hear from experts on the best criteria and
    methods to determine the systemic importance of U.S. banks.
        For nonbanks, Dodd-Frank set up a process governed by a
    council of Federal regulators to determine if an institution is
    systemically important. As imperfect as this process is, there
    is no such process for banks. Instead, Dodd-Frank deems a bank
    systemically risky if it has $50 billion or more in total
    assets. Moreover, once a bank reaches this arbitrary threshold,
    it is automatically designated as systemically important. Under
    this automatic framework, where there is no clear exit from the
    designation, a bank has little incentive to reduce its level of
    systemic risk.
        Many experts have expressed concerns about the arbitrary
    $50 billion threshold as an automatic cutoff for systemic risk.
    Many of us share their concerns. In March, financial regulators
    testified right here that there are currently banks above $50
    billion that were regulated as if they were systemically risky,
    even though they were not considered to be so. This regulatory
    framework should not capture institutions whose failure would
    not lead to systemic contagion. Doing so has a true cost to the
    financial system.
        First, it imposes a layer of regulation on financial
    institutions that lend primarily to small businesses and local
    or regional communities.
        Second, it unnecessarily spreads too thin the important
    resources of our financial regulators. This does not make the
    financial system safer.
        As I have said before, systemic risk is difficult to
    measure, but 5 years after Dodd-Frank, the law that mandates
    systemic risk regulation, we have better tools to assess it and
    we should use them.
        Last week at a hearing here in this Committee, Chairperson
    Yellen of the Federal Reserve testified that she would support
    giving some flexibility to the Federal Reserve to determine
    which banks should be subject to enhanced standards based on
    their set of multiple criteria. In fact, the Federal Reserve
    uses a similar approach to determine the systemic importance of
    banks in its regulation of bank capital.
        Earlier this week, the Federal Reserve finalized a capital
    surcharge rule for the Nation's largest and most systemically
    risky banks. This rule incorporates a framework based on many
    factors, including not only size, but also interconnectedness,
    cross-jurisdictional activity, substitutability, and
    complexity. According to the Fed, these five broad categories,
    quote, ``are viewed as good proxies for and are correlated with
    systemic importance.''
        Today, I look forward to hearing the views of our panel of
    witnesses on measures that can be used by regulators to
    determine if a bank poses a systemic risk. Improving such
    measures will allow our regulators to focus their resources on
    the systemically important banks in order to protect American
    taxpayers and the U.S. economy from the next financial crisis.
        Senator Brown.

                   STATEMENT OF SENATOR SHERROD BROWN

        Senator Brown. Thank you, Mr. Chairman, for holding this
    hearing. It was almost a year ago I held a similar Subcommittee
    hearing in which Professor DeYoung testified. Thank you again.
    I thank him and all of our witnesses for being here today.
        Tuesday, as we know, is the fifth anniversary of the day
    that President Obama signed the Wall Street Reform Act into
    law. Our country was emerging from a devastating economic
    crisis, one caused in large part by financial institutions that
    ran wild and regulators that did little or nothing about it.
    Some Americans have recovered, but it is a slow process and
    every household's story is different. Wall Street Reform
    stabilized and strengthened our economy despite dire Republican
    predictions.
        The financial crisis was caused by poor mortgage
    underwriting, lax capital standards, lax liquidity standards,
    inadequate risk management, regulators that failed to challenge
    the banks that they supervised. Congress through Dodd-Frank
    crafted a reasonable response, directing agencies to institute
    standards for capital and liquidity and risk management and
    stress testing to lower the likelihood and the costs of large
    bank holding company failures, called for heightened rules for
    banks over $50 billion in total assets, 31 of the largest bank
    holding companies. It urged regulators not to take a one-size-
    fits-all approach, allowing for tailoring based upon a variety
    of factors, so the $50 billion bank would not be treated the
    same way as a $2 trillion bank.
        On Tuesday, for example, as the Chairman said, the Fed
    finalized a rule to increase capital standards. That rule
    applied to the eight largest United States banks. Many of the
    powers in Title I of Dodd-Frank were not new, but after
    regulators failed to use their authority leading up to the
    crisis, Congress wanted to ensure that regulators used their
    authorities in ways that have teeth. The new rules were not
    meant to cover only systemically important or too-big-to-fail
    banks. In fact, these words are not even used in the law.
    Enhanced prudential standards are intended to respond to the
    last crisis, more importantly, though, to prevent the next one.
        We all agree that a regional bank is not systemic in the
    same way that a large money center bank is. The failure of one
    regional bank, assuming it is following a traditional model,
    will not threaten the entire system.
        But, as we have heard in past hearings, the failure of a
    single large institution can create systemic risk, but so can
    multiple failures of similar small or midsize institutions, as
    we saw in 2008. Systemic importance is also about the
    importance of an institution to homeowners and small businesses
    in the economic footprint where that bank operates. Congress
    should only open up Dodd-Frank if it can identify real problems
    affecting actual institutions, and it should be careful to do
    so without undermining safety and soundness or consumer
    protection.
        That is why I am concerned by Title II of the bill that was
    passed by this Congress along party lines in May and the
    language that was included in an appropriations markup
    yesterday. Secretary Lew said this proposal was, quote,
    ``designed to gut the heart of Dodd-Frank,'' unquote. So, if
    the goal is to have something signed into law, we need to take
    a more modest approach.
        I would appreciate hearing today which specific prudential
    standards are inappropriate for regional banks and why, and
    whether the concerns being raised stem from implementing
    regulations or from the law itself. We need to strike the right
    balance. If the Fed should use its authority to tailor its
    regulations to the institutions and activities that it thinks
    present the most risk, but it should not become complacent and
    take its eyes off of all possible sources of risk.
        I thank the witnesses for joining us today.
        Chairman Shelby. Thank you, Senator Brown.
        Our witnesses today include, and we will start with
    Professor DeYoung. He is the Capital Federal Distinguished
    Professor of Finance at the University of Kansas.
        Professor Deborah Lucas, the Sloan Distinguished Professor
    of Finance and Director at the MIT Center for Finance and
    Policy.
        Professor Jonathan Macey, the Sam Harris Professor of
    Corporate Law, Corporate Finance, and Securities Law at the
    Yale Law School.
        And the Honorable Michael Barr, who is no stranger to this
    Committee, the Roy F. and Jean Humphrey Proffitt Professor of
    Law at the University of Michigan Law School.
        All of your written testimony will be made part of the
    hearing record.
        We will start with you on the left, Professor DeYoung. You
    are recognized.

       STATEMENT OF ROBERT DEYOUNG, CAPITAL FEDERAL PROFESSOR IN
    FINANCIAL MARKETS AND INSTITUTIONS, UNIVERSITY OF KANSAS SCHOOL
                              OF BUSINESS

        Mr. DeYoung. Thank you, Chair. You asked us to share our
    perspective on which factors are important for determining the
    systemic risk of bank holding companies and to provide explicit
    examples of which rules and regulations or factors might be
    inappropriate, and I will get to the latter during the
    discussion. I will get to the former during my remarks here.
        Bank size is, of course, the most immediate consideration.
    Larger bank holding companies tend to have more volatile
    earnings, tend to be less liquid, tend to be more
    interconnected, and tend to be more difficult to value in a
    resolution. But, by itself, as we all have discussed, the bank
    size is neither a necessary nor a sufficient indicator of its
    systemic risk. Drawing a bright line at $50 billion, or at $200
    billion, or at any other place, will capture some nonsystemic
    banks.
        A good example is Washington Mutual, which held over $300
    billion in assets at the time of its failure in 2008. The FDIC
    was able to resolve WAMU without systemic consequences, without
    Government financial support. So, resolvability, in addition to
    assets, is another important factor in addition to bank size
    for determining whether or not a banking company poses a
    systemic threat.
        The bill in question here would redraw the bright line at
    $500 billion of assets, but it is not as bright a line as that
    seems. It would also rely on the Federal Reserve and the
    Financial Stability Oversight Council to evaluate the systemic
    importance of banking companies below this asset size
    threshold. This approach would automatically define the six
    largest bank holding companies in the U.S. as systemically
    important and, of course, not so coincidentally at all, on
    Monday, the Federal Reserve announced systemic risk capital
    surcharges on these same six firms.
        For smaller firms, the Fed and the FSOC will be free to
    consider multiple indicators of systemic risk other than asset
    size--off-balance sheet positions, earnings volatility,
    interconnectedness, cross-country exposures, and many others.
        A good example, I think, of this type of multifactor
    approach could be found in a recent policy brief from the
    Office of Financial Research. Now, I am not in a position to
    endorse the exact formulations within the OFR methodology, but
    I do strongly endorse the general approach that it takes. It
    uses predefined weights to translate each bank's size, business
    activities, financial complexity, and interconnectedness into a
    quantitative score that represents each bank's relative
    systemic importance. This approach applies the same filters to
    every banking company, so in a way, human discretion does not
    play a role in determining the relative outcomes.
        Now, the natural concern is that one or more banks that
    pose systemic threats would be mistakenly left off this list,
    and in order to err on the side of caution, we should maintain
    a low asset size threshold. I understand this concern, but
    given what we have learned, I believe it is somewhat
    unwarranted. In any case, mistakenly putting nonsystemic banks
    on the list imposes costs, as well, and we have to recognize
    those costs. The size of a banking company is just one
    potential indicator of systemic risk.
        For example, consider four U.S. bank holding companies that
    are each similar sized, between $300 and $400 billion: U.S.
    Bank Corp., PNC, Bank of New York Mellon, and State Street. In
    the Office of Financial Research's scoring exercise, two of
    these banks, U.S. Bank Corp. and PNC, get relatively low
    systemic risk scores because they practice traditional banking.
    They hold a diversified portfolio of loans. Those loans are
    fully funded by stable core deposits. They have very little
    off-balance sheet exposures, and their clientele is almost
    completely domestic.
        The other two banks, in contrast, the Bank of New York
    Mellon and State Street, get relatively high systemic risk
    scores in this method because they hold very few loans, rely on
    relatively unstable deposit funding, have large cross-country
    exposures, and provide infrastructure and logistics that are
    essential for the smooth operations of securities markets.
        Of course, under such an approach, the Fed and the FSOC
    would still have to determine where to draw the line. That is
    where discretion happens. I strongly suspect that these
    agencies will err on the side of caution when drawing this
    line, and I think we can look at the example of MetLife, which
    was designated as a SIFI, as a case study of this.
        In closing, I want to reemphasize one of the factors I
    talked about before, and that is the importance of
    resolvability in determining a bank's systemic importance. If a
    bank holding company can be resolved without causing
    disruptions in financial markets or contagion to other banks,
    either through regular bankruptcy or through orderly
    liquidation authority, then that bank should not be considered
    to be systemically important.
        It is not the job of bank regulators to prevent
    insolvencies at poorly run banking companies. I think we could
    all agree that poorly run banking companies should exit the
    market and stop wasting society's scarce resources. Our goal
    should be a safe resolution for these banks, not additional
    regulatory and supervisory safeguards that, by keeping poorly
    run banks out of trouble, keeps them operating and keeps them
    in business.
        So, I will end there. Thanks for your time this morning. I
    hope my remarks are useful. I look forward to answering your
    questions.
        Chairman Shelby. Thank you.
        Professor Lucas.

     STATEMENT OF DEBORAH LUCAS, SLOAN DISTINGUISHED PROFESSOR OF
    FINANCE, AND DIRECTOR, MIT CENTER OF FINANCE AND POLICY, SLOAN
                          SCHOOL OF MANAGEMENT

        Ms. Lucas. Thank you. Chairman Shelby, Ranking Member
    Brown, distinguished Members of the Committee, thank you for
    inviting me to speak with you today. I have been asked, too, to
    comment on the appropriate criteria for determining whether a
    bank holding company poses the systemic risk to the financial
    system.
        Banks deemed to be strategically important financial
    institutions, or SIFIs, are subject to a higher level of
    oversight and, often, higher capital requirements. Those
    measures reduce the likelihood of distress and spill-overs to
    the financial system, but also entail additional costs for the
    banks. Ideally, banks would only be designated as SIFIs when
    the financial stability benefits outweigh those costs.
        Unfortunately, those cost-benefit tradeoffs are difficult
    to quantify. Major systemic risk events are rare, but extremely
    costly. History may be a poor guide to the future.
        The good news is that, despite the challenges, the results
    of recent analyses using new data suggest that the current
    criteria used for SIFI designation could be improved upon in
    several ways. I have two main conclusions.
        The first is that the threshold for automatic SIFI
    designation for bank holding companies could be raised
    substantially from its current level of $50 billion of assets
    without significantly increasing systemic risk. That conclusion
    rests on the findings of several regulatory and academic
    studies that use a variety of approaches to identify SIFIs. It
    also reflects the common sense observation that the very
    largest bank holding companies are enormously more complex and
    interconnected than their midsized or even large peers.
        What is striking about those analyses is that quite
    different measurement approaches come to very similar
    conclusions, with just eight of the largest U.S. bank holding
    companies standing out for their likely systemic importance.
    The smallest of those, State Street, has assets now of about
    $280 billion, which is more than five times the current $50
    billion threshold for SIFI designation.
        Consistent with that emerging evidence, and as Senator
    Shelby and Senator Brown noted, the Federal Reserve issued a
    white paper last week that contemplates replacing the $50
    billion asset size threshold with one of three alternatives
    that effectively would increase the cutoff to at least $250
    billion. The Fed's analysis also suggests the possibility of
    setting a threshold based on the relative systemic risk score
    rather than setting a dollar-size cutoff. Such an approach
    would have the advantage of automatically adjusting over time
    and certainly deserves further consideration.
        My second conclusion is that it would be advisable for
    regulators to use several criteria in addition to asset size to
    more accurately identify SIFIs. There seems to be general
    agreement that size alone is not the best proxy for an
    institution's contribution to systemic risk, and financial
    regulators in the U.S. and abroad have identified five broad
    categories of factors to consider, including size,
    interconnectedness, substitutability, complexity, and cross-
    jurisdictional activity. Several of the analyses I referred to
    earlier incorporate those criteria into the risk scores used to
    identify the most systemically risky bank holding companies.
        Nevertheless, incorporating multiple criteria involves
    several significant challenges. The first is creating well-
    defined metrics for each criterion. The second is designing a
    weighting scheme that determines the relative importance of
    each in an overall risk score. And making those choices,
    considerations, include data availability, stability of
    outcomes, avoiding excessive complexity, and preserving
    transparency.
        Choosing a weighting scheme is particularly difficult.
    There is not a precise definition nor even complete agreement
    about what makes a financial institution systemically risky,
    and there is little evidence about the relative importance of
    the different criteria or their predictive accuracy. It is,
    nevertheless, promising that the various approaches now under
    consideration point to a consistent set of bank holding
    companies as SIFIs and that asset size is highly correlated
    with all of the leading measures.
        However, the metrics that regulators are beginning to adopt
    are still new and evolving. Hence, I think it is advisable to
    allow some latitude for revising the methodology as new data
    becomes available and as market practices and perceived risks
    change over time.
        I only have a few seconds left, so I would like to use this
    opportunity to just briefly discuss what I see as the most
    serious deficiency in systemic risk oversight as it is
    currently conducted, and that is the exemption of major
    Government-run financial institutions from SIFI designation
    and, hence, from any formal oversight by systemic risk
    regulators.
        Government financial institutions, particularly Fannie Mae,
    Freddie Mac, FHA, and so forth, are collectively much larger
    than the bank holding companies currently classified as SIFIs.
    They satisfy most of the other criteria for SIFI designation,
    such as high degrees of interconnectedness. So, these sorts of
    considerations support the idea that Government financial
    institutions are an important source of systemic risk and,
    hence, also should fall under FSOC's mandate.
        Thank you very much.
        Chairman Shelby. Thank you.
        Professor Macey.

        STATEMENT OF JONATHAN R. MACEY, SAM HARRIS PROFESSOR OF
    CORPORATE LAW, CORPORATE FINANCE, AND SECURITIES LAW, YALE LAW
                                 SCHOOL

        Mr. Macey. Thank you, Senator Shelby and Ranking Member
    Brown and Members of the Committee, former law professor
    colleagues. It is a professor to be here to talk about whether
    it is appropriate to continue to assume that all banking
    companies with more than $50 billion in assets are systemically
    important and, therefore, subject to a heightened level of
    prudential regulation.
        Currently under consideration is a proposal that would move
    the automatic threshold to $500 billion and then authorize the
    Fed and the Financial Stability Oversight Council to evaluate
    the systemic importance of banking companies below that $500
    billion asset size threshold. This bill would reduce from 36 to
    6 the number of financial institutions subject to the automatic
    designation as systemically important, and I support this
    approach for the following five reasons.
        First, the bill would reduce some of the distortive effect
    of the current regulatory regime, which provides incentives for
    midsize banks to stop growing in order to avoid the SIFI
    designation and provides incentives for institutions above the
    threshold to grow until they approach the size of the so-called
    big six in order to be able to amortize the additional cost of
    regulation placed on such institutions designated as
    systemically important.
        Second, the bill would inject a greater degree of
    intellectual rigor into the SIFI designation process. In
    particular, regulators would not be able to focus solely on an
    arbitrary measure and would have to look at the kinds of
    objective factors that Professor Lucas was describing, and I
    think it is useful to remember that when Dodd-Frank was
    initially proposed, it was marketed as eliminating the
    longstanding practice of treating some institutions as too big
    to fail. But, if we look at what I regard as the flawed process
    by which MetLife was designated as a SIFI, we do have a need to
    impose better analytics and more intellectual rigor on the
    designation process.
        Third, I think that the bill would promote fairness by
    reducing reliance on an arbitrary line of demarcation that
    nobody has been able to support or defend, either analytically
    or empirically.
        Fourth, I think the bill would reduce some of the
    pathologies in bank regulation that Dodd-Frank created. The
    financial system is more concentrated, more interconnected, and
    more opaque than it was before the financial crisis. Much of
    this, I acknowledge, happened during the financial crisis, but
    things are not getting any better. Massive concentration caused
    by Bank of America acquiring Countrywide and Merrill Lynch,
    JPMorgan acquiring Washington Mutual--although that was a good
    deal, I agree with that--and also acquiring Bear Stearns, and
    Wells Fargo's acquisition of Wachovia. Now, the six largest
    financial institutions hold over 60 percent of all of the
    assets in the financial system and hold a virtual 100 percent
    market share of shadow banking activities.
        For people like me who think that the administrative State
    should be subject to the rule of law, Dodd-Frank poses
    significant challenges. Never has so much rulemaking authority
    and discretion been granted so broadly. As I have observed
    before, Dodd-Frank, for all of its merits, it is not really
    directed at people. It is an outline, a very long outline,
    directed at bureaucrats and it instructs them to make still
    more regulation and to create still more bureaucracies. And,
    the efforts to designate mutual funds and other businesses that
    really do not provide any systemic risk are really illustrative
    of that.
        And, fifth, the--for people like me who think the best way
    to avoid having financial institutions that are too big to fail
    is to reduce to zero the number of institutions that are too
    big to fail, the proposed legislation provides positive
    incentives for banks to be smaller and negative incentives on
    banks to become larger. Like the Fed's new capital requirements
    for the eight largest financial institutions, the proposed
    statute imposes some cost on the very largest financial
    institutions, which I support.
        Regulators, left to their own devices, have incentives to
    increase the list of systemically important financial
    institutions. These incentives are unfortunate. Regulators
    should be given incentives to reduce, not to expand, the list
    of SIFIs, and if the concept of systemic risk is to have any
    meaning, it must be the case that reducing systemic risk by
    reducing the number of firms that pose such risk is an
    important goal for any regulator.
        Thank you.
        Chairman Shelby. Thank you.
        Professor Barr.

    STATEMENT OF MICHAEL S. BARR, ROY F. AND JEAN HUMPHREY PROFFITT
          PROFESSOR OF LAW, UNIVERSITY OF MICHIGAN LAW SCHOOL

        Mr. Barr. Chairman Shelby, Ranking Member Brown,
    distinguished Members of the Committee, it is my pleasure to
    appear before you today, 5 years after enactment of the Dodd-
    Frank Wall Street Reform and Consumer Protection Act.
        That Act was passed in response to the worst financial
    crisis since the Great Depression. In 2008, the United States
    plunged into a severe financial crisis that shuttered American
    businesses, that cost millions of households their jobs, their
    homes, and their livelihoods. The crisis was rooted in years of
    unconstrained excess and prolonged complacency in major
    financial capitals around the world. The crisis demanded a
    strong regulatory response.
        I want to focus today on aspects of prudential oversight
    established in the Dodd-Frank Act. Under the Act, the Fed is
    directed to provide for a graduated system of regulation with
    increased stringency depending on the risk that the firm poses
    to financial stability. The Fed may tailor these prudential
    standards for individual firms or categories of firms.
        The enhanced prudential measures include risk-based capital
    requirements and leverage limits, liquidity requirements, risk
    management, resolution planning, credit exposure reporting,
    concentration limits, and annual stress tests.
        The Fed under the Act is not required to apply these more
    stringent standards to bank holding companies with assets under
    $50 billion. Annual firm-led stress tests, however, are
    required for firms between $10 and $50 billion in size, and
    publicly traded bank holding companies $10 billion and above
    must establish risk committees.
        None of these enhanced measures apply to about 95 percent
    of banks, the category commonly described as community banks,
    those under $10 billion in assets, more than 6,000 banks in
    communities all across the country.
        Graduated standards are already at work. Fed stress testing
    applies to the largest firms in the country, the 31 firms with
    assets of $50 billion and above. The largest and most complex
    banks face more stringent standards. The Fed, for example,
    imposes a supplementary leverage ratio, a countercyclical
    capital buffer, and detailed liquidity coverage rules on only
    14 firms with over $250 billion in assets. The eight largest
    banks are subject to even tougher standards, including capital
    surcharges, more stringent leverage ratios, and long-term debt
    requirements. This graduated approach makes sense.
        Some have argued that the size threshold for heightened
    prudential standards should be substantially increased, while
    others have argued that banks should not be subject to any
    heightened standards unless they are specially designated as
    systemic. Both approaches, in my judgment, are mistaken.
        First, some have mistakenly said that the Act describes
    firms with $50 billion in assets as systemic, but that is
    simply not the case. There is no automatic designation under
    the Act. Congress set the $50 billion threshold as a floor, to
    establish a floor under which smaller firms would know that
    they are not subject to the new rules. But, the rules were not
    meant to apply only to the very few largest firms in the
    country. They are not intended to apply only to systemically
    important firms. They are designed, as I said, to work in a
    graduated and tailored way.
        Second, others have argued that bank holding companies
    should have to be designated for heightened supervision by the
    same process FSOC uses for nonbank firms. But, that runs
    counter to the purposes of nonbank designation. Bank holding
    companies should not be required to be designated in order to
    be supervised. Bank holding companies are already supervised by
    the Fed, and the Fed already has the authority to impose
    heightened prudential standards on such firms on a graduated
    basis as they increase in size and complexity.
        The reason for the designation process for nonbank
    financial institutions is that such institutions were not
    subject to meaningful consolidated supervision by the Fed at
    all. Firms such as Lehman Brothers and AIG could operate with
    less oversight, more leverage, and riskier practices.
    Recognizing that policing the boundaries of financial
    regulation is critical to making the financial system safer,
    the Dodd-Frank Act established a process for bringing such
    nonbank financial institutions into the system of regulatory
    oversight. It makes little sense to require designation of
    firms that are already supervised by the Fed, and it will
    dramatically slow down and disrupt the Fed's existing
    oversight.
        None of these changes would help community banks. There is
    undoubtedly much that could be done to reduce the regulatory
    burden on the smallest banks. For example, small community
    banks would benefit from clear safe harbors and short plain
    language version of rules that apply to them, longer exam
    cycles, and streamlined reporting.
        Today, the U.S. financial system is more resilient, but
    there is still much more work to do together. Thank you.
        Chairman Shelby. The Federal Reserve currently employs a
    multifactor test to determine if a bank is globally
    systemically important for the purposes of determining capital
    requirements. I will direct this to you, Professor Lucas and
    Professor Macey. In your opinions, what are the greatest
    benefits of using criteria like this rather than solely the $50
    billion asset threshold to regulate systemic risk?
        Ms. Lucas. Well, the reason is, as some of the examples
    cited, demonstrated that there are financial institutions that
    are larger than $50 billion who, nevertheless, operate as very
    traditional banks. There is nothing particular about their
    activities that would suggest singling them out as being
    systemically important. As people have noted, you can get
    systemic importance when a lot of banks act in the same way,
    but it does not make sense to apply special regulations to
    banks that in most respects act like much smaller institutions.
        Chairman Shelby. Professor Macey.
        Mr. Macey. Yes. I mean, it seems kind of straightforward to
    me, simple, really. If I am running a bank, because being
    designated as systemically important is costly, if there were a
    multifactor approach and not a bright line $50 billion
    approach, then I could take steps to avoid being systemically
    important without shrinking dramatically, and I think that is
    the kind of incentives we, as a regulatory--as people thinking
    about regulation--want to give to people running banks, that we
    want them to engage in activities that do not impose systemic
    risk, to, all else equal, decline or refrain from excessive
    engagement in activities that are systemically risky, and this
    sort of multifactor test is the only way to get there. Or, to
    put it differently, having a bright line cutoff at $50 billion
    eliminates that incentive.
        Chairman Shelby. Thank you.
        Professor DeYoung, how does resolvability relate to
    systemic risk, and is it possible for a bank to be large in
    terms of total assets but still be easy to resolve if they had
    some challenges?
        Mr. DeYoung. Yes. We often equate the two terms,
    systemically important and too big to fail, correct. But, now,
    I would not necessarily divide things up that way. I would say
    that if a bank can be resolved, then I think what I stated was
    that I do not think we should--we should not consider that bank
    to be systemically important.
        Now, what does it take for a bank to be resolved? A bank
    needs to have assets that are easily valued, right. We need to
    have buyers who can take a look at that bank, or FDIC
    evaluation staff and take a look at that bank----
        Chairman Shelby. Sure.
        Mr. DeYoung. ----and figure out what the assets are worth,
    play that off against the liabilities, do this to some high
    degree of accuracy, not perfectly, but a high degree of
    accuracy, and at that point, we have a value for the bank.
        Once we have a value for the bank, two things could happen.
    Another bank could purchase that failed bank, or we could have
    a resolution process in which the bank's assets are sold off in
    pieces, because, as I said, they are easy to value.
        Now, if we have an organization that has much off-balance
    sheet activity, a lot of counterparties, derivatives that are
    traded over the counter which are not always easily valued, any
    kind of assets or liabilities that are traded in thin markets,
    these are the kind of banks that----
        Chairman Shelby. That situation makes everything more
    complex, does it not?
        Mr. DeYoung. Yes, that is exactly right. And a key--I want
    to come back just to the key--is that at that point, we cannot
    value the bank, in which case makes resolution very difficult,
    because we cannot find a buyer for the bank or we cannot find--
    we do not know how big the hole is, right. We do not know what
    the cost would be to resolving that bank.
        Chairman Shelby. Thank you.
        Mr. DeYoung. So, banks like that need to operate under
    different rules.
        Chairman Shelby. Professor Lucas, what are the risks of
    grouping banks whose failure would not be contagious to the
    system with banks who are systemically risky institutions?
        Ms. Lucas. I do not think it is a risk to the system to
    include those smaller banks, but I think the integrity of the
    regulatory process should not draw into its net institutions
    that do not need to be there. So, that is basically the
    argument. And, actually, to take what Dr. Barr said and turn it
    a little bit, those smaller banks are already heavily regulated
    by the Federal Reserve, and so if I did not believe that there
    was already a substantial amount of oversight, I might not be
    arguing for lifting the limit, but because there is, it is not
    clear that you need this additional layer of regulation.
        Chairman Shelby. Professor DeYoung--my last question--you
    said in your testimony that even large banks with total assets
    of over $300 billion might have little systemic risk. Other
    witnesses give some examples. Could you explain to the
    Committee how a bank might be so large and yet exhibit little
    systemic risk. It is because of what kind of banking they are
    doing and the risk they take?
        Mr. DeYoung. Yes. We speak about traditional banking, and
    this is an excellent question. If you look at a bank that is
    very large and then you take a look at its balance sheet and it
    has got the loans, maybe the mortgage loans, maybe the business
    loans, maybe the credit card loans, whatever, and they are
    performing, the other side of the balance sheet shows how those
    loans are funded. If these loans are funded with stable deposit
    liabilities, which we tend to call core deposits, these are
    deposits that will not run if there is some kind of financial
    crisis, so we will not have a liquidity problem, OK, so that we
    will not have a liquidity problem there.
        On the other side of the balance sheet, these loans are
    easy to value in whole or in part, depending on what kind of
    loans they are. So, once again, I get back to my point that if
    a bank can be valued, then it becomes resolvable and
    nonsystemic.
        Chairman Shelby. Thank you.
        Senator Brown.
        Senator Brown. Thank you, Mr. Chairman.
        Professor Barr, thank you for pointing out, in spite of
    what we hear from many in this town and at many different
    hearings, that Dodd-Frank does not actually designate banks
    systemically important, that it is just not part of Dodd-Frank
    and to suggest that is not showing sufficient intellectual
    rigor and insight and understanding or something worse than
    that.
        I want to ask Professor Barr a series of yes or no
    questions, if I could, pretty simple questions.
        Is it a good thing that large banks have more capital and
    less leverage?
        Mr. Barr. Yes.
        Senator Brown. Is it a good thing for large banks to have
    more liquidity than they did before the crisis?
        Mr. Barr. Yes.
        Senator Brown. Comptroller of the Currency Tom Curry has
    made it his mission, in part, to install a more enhanced
    prestige and stature with higher compensation for a risk
    officer at medium-sized and large banking institutions. Is that
    a good idea?
        Mr. Barr. Yes.
        Senator Brown. And, I assume that means large banks should
    have a whole strong risk management structure to them?
        Mr. Barr. Yes.
        Senator Brown. Professor DeYoung mentioned resolvability.
    This question, again, is for you, Professor Barr. Should large
    banks be able to detail how they can fail safely?
        Mr. Barr. Yes.
        Senator Brown. Is it appropriate for large banks to conduct
    regular stress tests?
        Mr. Barr. Yes.
        Senator Brown. Dodd-Frank contains all these provisions, so
    it sounds like Dodd-Frank, in your mind, has made the financial
    system stronger?
        Mr. Barr. Yes.
        Senator Brown. Thank you.
        One more yes or no question, and I want to ask you a little
    bit more detail to test your reasoning ability, which you have
    not yet--you have showed in your testimony, but not yet in the
    questions and answers.
        Factors like capital structure and riskiness and complexity
    and financial activity size, other risk-related factors, are
    they appropriate criteria for use as a basis for crafting
    prudential standards?
        Mr. Barr. I think they are. I think the important thing is
    we do not need them in the particular provision that has been
    subject to controversy in this hearing thus far because, as I
    said, bank holding companies are already subject to
    supervision. You do not need them to bring them into the system
    of supervision. They are useful tools to then decide, once
    firms are supervised, what is the appropriate level of capital,
    how stringent should the regulation be, what is the supervisory
    expectation with respect to risk management of the firm, how do
    you deal with resolvability. All those are really important
    factors.
        I agree that they are and should be graduated and that the
    very largest firms that are the most complex firms, that are
    firms that are the most interconnected, should have the highest
    capital requirements, for sure. That is what is already in the
    Dodd-Frank Act. It is what is already in Fed regulation. And, I
    think, you know, one of the problems sometimes is that Dodd-
    Frank is too big to read.
        Senator Brown. You were looking forward to using that line
    today.
        Mr. Barr. I was.
        Senator Brown. That was very well done.
        [Laughter.]
        Senator Brown. Let me explore what you just said about the
    way that Dodd-Frank authorizes the Fed to tailor its standards.
    A Fed official said in 2012, quote, ``Dodd-Frank was spot on in
    requiring the Fed to make sure that we do not apply a one-size-
    fits-all approach to every bank holding company above $50
    billion.'' Discuss, if you would in the last couple minutes,
    how well you think has the Fed tailored its rule sufficiently
    and fairly and precisely enough for bank holding companies over
    $50 billion in assets, or could they do more. Give me thoughts
    and suggestions.
        Mr. Barr. Well, I think, overall, I have been impressed
    with the Fed's ability to tailor and provide a graduated
    approach under the rule. As I said, for the eight largest bank
    holding companies, quite stringent regulation, capital
    requirements, liquidity rules, and stress testing. Slightly
    less stringent but still quite tough rules over 250. And a more
    graduated approach between 250 and 50. I think that is
    appropriate. There may be some additional measures, simplifying
    stress tests for firms between 50 and the 250 range that could
    be done within the existing framework.
        And then, I think, really, the area where I would like to
    see the most work done is for small banks. I think that small
    banks face regulatory burden that could be addressed both by
    the Fed and the other regulators in a productive way under
    current law, and it is the small banks that, I think, are
    facing, really, the kind of burden we ought to be worried about
    and they need clearer rules, more safe harbors, and a lighter
    touch.
        Senator Brown. Yesterday, the U.S. Senate in a vote has
    declared that community banks are now one billion instead of
    the 10 billion that I thought we mostly agreed on here. When
    you say small banks, are you saying a billion or are you saying
    ten billion? The ten billion is legislation that we have worked
    on here, but the Senate yesterday spoke fairly resoundingly
    that it is now one billion. Your thoughts?
        Mr. Barr. Well, I think, generally speaking, there is some
    variation, but people think of ten billion as the marking point
    below which firms are thought of as community banks. And then
    there is some gradation within that. I mean, a firm--a bank
    that is a $900 million bank needs a lot lighter touch than a
    firm that is close to a $10 billion bank. So, I think there
    needs to be graduation, even within the community bank
    standard, but ten billion and below is generally thought of as
    in the category of community bank.
        Senator Brown. Thank you.
        Chairman Shelby. Senator Toomey.
        Senator Toomey. Thank you, Mr. Chairman.
        My friend from Ohio, the Ranking Member, began with a
    celebration of the anniversary of Dodd-Frank, so I thought I
    would just share my observations on this occasion, as well,
    which is that after a crisis which was caused by the Federal
    Government, monetary policy and lending regulations and
    mandates that created a housing bubble, we discovered that, in
    the crisis, that we did not have an adequate resolution
    mechanism for the failure of a large complex institution. I
    mean, that was pretty clear.
        Rather than addressing that problem, which I think should
    have been done through reforms of the bankruptcy code, we
    created Dodd-Frank, and what we have to show for that now is
    big banks are now essentially public utilities, completely
    controlled by regulators who operate with enormous
    subjectivity, stifling innovation, reducing liquidity in all
    kinds of important markets.
        Medium banks, medium-sized banks have been saddled with all
    kinds of costs, which means they are--and regulations--which
    means they are necessarily lending less than they otherwise
    would be lending.
        And, we have managed to completely eliminate--we have
    completely destroyed the entire de novo banking industry of
    America. While we used to routinely launch 100, 200 new
    community banks every year all across America, the last 5 years
    since Dodd-Frank, through this morning, we have had one de novo
    community bank in America, which I think can only be attributed
    to some combination of the outrageous monetary policy and the
    unbelievable level of regulation. That is, I think, a pretty
    disturbing outcome.
        But, I want to get to the questions addressed at this
    hearing specifically. I wonder if anybody on the panel could
    name a single $50 billion bank in America--just name one--the
    failure of which would result in a measurable impact on
    American GDP. Is there one bank that comes to mind, a $50
    billion bank?
        Mr. Barr. I think, Senator, if I might say, if you get a
    series of smaller banks that fail at the same time----
        Senator Toomey. OK. OK.
        Mr. Barr. ----they can have an impact in the economy----
        Senator Toomey. So----
        Mr. Barr. ----and that is true for the largest
    institutions, too.
        Senator Toomey. Got you. OK. So, nobody has named a single
    bank. I think you are implicitly suggesting that probably the
    answer to my question is there is not a single bank, but if
    many banks all failed simultaneously.
        So, now, let us ask a different question. What is the
    chance--Professor Macey, maybe you could address this--do you
    think there is any chance at all that the regulation of these
    banks that do not individually pose any systemic risk creates a
    risk correlation that might actually enhance the risk of a wave
    of failures? What I am getting at is, certainly, the regulators
    can identify some risks and they will surely force these banks
    to go at great lengths to avoid those risks. Is there any risk
    that regulators, being human, might not see a risk that is out
    there, but will have driven all these individually unrisky
    banks to a very similar profile and have actually increased the
    risk that multiple failures could occur for some reason that
    they are not anticipating? Is there any risk of that at all?
        Mr. Macey. I think there is a huge risk. I think it is even
    larger than the problem associated with the inevitable fact
    that regulators are not perfect, that once a regulation is
    promulgated, rational financial institutions will respond by
    looking for the most profitable unregulated niches. This
    reaction, in turn, creates a kind of lemmings problem which is
    really the quintessential kind of essence of systemic risk,
    because what is dangerous is if you have a whole bunch of banks
    entering into the same line of business at the same time, if
    that line of business, like the residential mortgage-backed
    securities or CDOs, turns sour, then you have a--by definition,
    then you have a systemic risk problem of major proportions.
        Senator Toomey. So, I just want to underscore this point
    that you are making, which is that when we add this additional
    layer of regulation on institutions that are not individually
    systemicly risky, we actually increase the risk that we will
    have a widespread problem.
        Mr. Macey. Unless we can invent a world in which regulated
    entities do not respond to regulation in ways that are----
        Senator Toomey. Which is, of course, inconceivable. All
    right. Let me ask a specific----
        Mr. Macey. Did not even have it in the Soviet Union.
        Senator Toomey. Right. Let me ask a question of Professor
    DeYoung. I am going to run out of time here. You mentioned PNC.
    PNC is roughly $350 billion. If you look at their activity,
    they look at lot like a community bank. They have almost no
    international activity. They have a very small derivatives
    portfolio. What they do is they take deposits and they make
    loans to consumers and small- and medium-sized businesses, and
    yet they are currently going to be subject to the liquidity
    coverage rules that was meant by Basel to apply to much larger,
    multinational, international, and complex institutions. Is it
    not the case that the liquidity coverage ratio, when applied to
    someone who does not pose this risk, necessarily means less
    lending will occur?
        Mr. DeYoung. Well, I share your observation that PNC is a
    very large but very traditional bank, right, we say a very
    traditional community--or maybe a very large community bank,
    and they are not systemically important in the ways we think of
    other banks of similar size. You mentioned liquidity. The
    liquidity risk at banks like this is low because they do not
    fund themselves--they are not funded with market--market
    instruments that will fail to refinance when there is financial
    market distress. They are funded with deposit customers who
    have multiple reasons for staying with the bank.
        So, on the issue of liquidity, this is one of those
    potentially inappropriate regulatory answers. I share your
    concern that liquidity coverage ratios and net stable funding
    ratios, when applied to banks whose main business is lending,
    will reduce their lending capacity. I think this is, obviously,
    a true thing, either by reducing the amount of loans they can
    hold or by increasing their cost of funding, one way or the
    other.
        I will also point out that there is no academic study yet--
    I know there are some studies underway, one of which I have
    just begun--that takes a look at the effect of liquidity
    minimums on banks that are also constrained with capital
    minimums. We have not imposed binding liquidity minimums on
    banks in the past. We have always--supervisors have always and
    bankers have always known this is important and they have
    informally made sure liquidity was good. But, once you have
    binding liquidity requirements, along with binding capital
    requirements, now you have two constraints on a bank's balance
    sheet, and, frankly, we do not know how that is going to play
    out because we have not observed it before.
        Senator Toomey. Thank you. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Warren.
        Senator Warren. Thank you, Mr. Chairman, and thank you all
    for being here today.
        You know, there is a lot of talk about Section 165 of Dodd-
    Frank, which requires the Fed to impose some tougher rules on
    banks with more than $50 billion in assets. The main question
    seems to be whether a bank with more than $50 billion in assets
    poses more risk than a smaller bank. It is an interesting
    theoretical question, but we are not engaged in a theoretical
    exercise here. We are dealing with the very practical issue of
    trying to keep the financial system from melting down, because
    when it did in 2008, it cost this economy an estimated $14
    trillion. That is a lot on the cost side.
        In theory, the Fed could tailor its rules to fit each one
    of the 7,000 banks in the country, but we do not live in
    theory. We live in the world. We know that is impossible and
    that Congress is going to have to give the Fed some basic
    guidance on where they should direct their attention. We have
    to draw some lines. The question is, how do we draw lines to
    ensure the safety of the system?
        So, I want to follow up on Senator Toomey's question. In
    recent weeks, I have asked both Professor Simon Johnson of MIT
    and Chair Yellen of the Fed whether or not the failure of two
    or three banks of $50 billion in assets could pose a systemic
    risk and both said yes. So, Professor Barr, you have been doing
    yes/no questions. Do you agree----
        [Laughter.]
        Senator Warren. ----with Chair Yellen and with Simon
    Johnson on this?
        Mr. Barr. Yes, I do. I think that if there are multiple
    institutions of that size that are failing at the same time, it
    is usually an indication that there is broader weakness in the
    financial system, and that is why it is important for the
    Federal Reserve to be regulating for resiliency across the
    financial system and not just at the very largest firms.
        Senator Warren. OK. So, you talk about--it sounds to me
    like we have consensus that two or three $50 billion banks
    could pose a systemic risk. Let us as the auto-correlation
    question that Senator Toomey asked. First, I want to ask it the
    other way around. Did we see correlated risk before Dodd-Frank,
    Professor Barr?
        Mr. Barr. I think there was undoubtedly correlated risk in
    the financial system leading up to the financial crisis of
    2008. We had widespread use of mortgage assets, for example,
    throughout the financial system as collateral for repo
    transactions, securities financing transactions, and other
    items, and underlining special purpose vehicles used in
    derivatives transactions. So, there was a significant degree of
    auto-correlation in the lead-up to the crisis. And, of course,
    during the crisis, most asset classes became correlated and
    that crushed the system.
        Senator Warren. That is right. Indeed, if we had not had
    correlation, we would not have had the collapse, would we. Is
    the Fed aware of the problem of correlation?
        Mr. Barr. I think they are quite aware of it.
        Senator Warren. You think they are quite aware of the
    problem and try to cope with it. This is part of what they look
    for in their regulations, right?
        Mr. Barr. Correct.
        Senator Warren. OK. So, thank you. On the other hand, I
    want to look at the other half of this. The $50 billion banks
    generally pose less risk than a $1 trillion bank or a $2
    trillion bank. It would make no sense for the Fed to require
    the same rules and impose the same rules on a $50 billion bank
    as it does on a $2 trillion bank.
        So, Professor Barr, you helped write Dodd-Frank, so let me
    ask. Does the Fed currently have all the legal authority it
    needs to tailor the rules so that a $2 trillion bank is subject
    to much tougher regulation than a $50 billion bank?
        Mr. Barr. Yes, they have all the authority they need, and,
    in fact, they have exercised that authority to impose massively
    tougher rules on the largest institutions than on smaller ones.
        Senator Warren. OK. And, then, one more practical question
    on this. Let us say Congress raises the threshold to $250
    billion or $500 billion, as has been suggested, but gives the
    Fed discretion to impose tougher standards on banks below the
    threshold. That is, you move the threshold and then say you can
    impose tougher standards.
        Professor Barr, do you think it is likely that the Fed
    would actually use that discretion to apply tougher standards
    to banks below the threshold?
        Mr. Barr. I worry about whether they would, in fact, do
    that. I mean, I think Congress decided in the Dodd-Frank Act in
    a number of instances that the Federal Reserve had too much
    discretion in the past, and in this instance and in a number of
    other instances reined in Fed discretion, and I think that was
    a wise choice.
        Senator Warren. All right. Well, you worry about it, and I
    have to remember what hangs in the balance is the entire
    economy, not just of the United States, but the world. You
    know, Congress chose a very practical approach in Section 165.
    Any bank that hits $50 billion in assets, a bank that is one of
    the 40 or so largest banks in this country, will generally be
    subject to some tougher rules. But that bank can go to the Fed
    and make the case for tailoring the rules to fit its specific
    risks.
        If the Fed is not doing a good job of using its existing
    authority to tailor the rules appropriately, then Congress
    should demand that the Fed do a better job. I am willing to
    hold the Fed's feet to the fire to do what the statute says.
    But simply raising the $50 billion threshold and cutting a
    whole bunch of big banks loose is a dangerous overreaction, and
    if it goes badly, it is the American people who will end up
    paying.
        Thank you, Mr. Chairman.
        Senator Crapo. [Presiding.] Senator Cotton.
        Senator Cotton. Thank you.
        Professor Macey, I want to touch on a couple points in your
    testimony in which you say that the Shelby bill would reduce
    from 36 to 6 the number of financial institutions subject to
    the automatic cutoff and that you support it for a few
    different reasons. One of those reasons, and I quote from your
    testimony, is for people like you who believe the
    administrative State should be subject to the rule of law,
    Dodd-Frank poses significant challenges. Never has so much
    rulemaking authority and regulatory discretion been granted so
    broadly. As I--you--previously argued, laws classically provide
    people with rules. Dodd-Frank is not directed at people. It is
    an outline directed at bureaucrats and it instructs them to
    make still more regulations and to create more bureaucracies.
    Could you please elaborate on this analysis.
        Mr. Macey. Yes. Thank you for giving me the opportunity.
    This hearing has been something of an epiphany for me because
    people universally have been talking about what I call the
    spoke regulation, which is regulation directed at a particular
    firm, as being a good thing. The idea of having a one-size-
    fits-all approach is bad. What was called tailored regulation
    is good.
        I understand that Dodd-Frank makes it very difficult to
    have any other kind of regulatory approach, but generally
    speaking, it is not really consistent with the rule of law or
    what I think is kind of the American way, that you have
    regulation that is directed at particular firms. The idea is,
    you know, firms in the economy should be treated the same way.
        You know, you look at the designation of General Electric
    Capital Corporation as a SIFI. Putting aside the merits of
    that, what then ensued was a bunch of corporate governance
    rules for General Electric Capital that defined things like,
    you know, independent director for that entity different than
    the way an independent director would be defined at JPMorgan
    Chase or some other firm.
        You know, I think it is a healthy thing, I think it is
    important to say to the extent that Dodd-Frank compels us to do
    this, it is an unfortunate cost or consequence of the
    regulation. So, I think that the ultimate goal that we need to
    think about is to think about ways in which we can reduce the
    number of institutions that are systemically important and
    thereby subject to this kind of particular bespoke regulation
    rather than embrace this idea of bespoke regulation as the new
    normal. Thank you.
        Senator Cotton. Professor Macey, when you describe bespoke
    regulation, I have to say, I do not hear the term regulation,
    or I do not hear anything like the rule of law, which is to
    prescribe standards of conduct that will apply prospectively
    with general application to all actors. When I hear you say
    bespoke regulation, I hear arbitrary discretion in the hands of
    regulators and bureaucrats.
        Mr. Macey. Right. Well, I think that that is a tremendous
    danger, that, you know, I am kind of with the Federalist 10
    idea that enlightened statesmen will not always be at the
    helm----
        Senator Cotton. Shocking, I know.
        Mr. Macey. ----and that seems to be true of bank regulatory
    agencies as well as other places. So, I share your view
    entirely.
        Senator Cotton. Do you think our political and financial
    elites over the last, say, eight or 10 years, have demonstrated
    the ability to conduct such a bespoke regulation in an
    effective manner in forums like the FSB and the FSOC, the IMF,
    the Federal Reserve, and so forth?
        Mr. Macey. You know, you kind of--I think one should hope
    for the best, expect the worst. The reality is that the people
    who are promulgating these regulatory reactions are moving back
    and forth to the banking sector and they are not moving back
    and forth randomly to financial institutions. They are moving
    back and forth to the largest ones. And, I think that as the
    CEO of JPMorgan Chase recently said to his shareholders, this
    being all things to all people and the biggest possible firm is
    good for us, and he is right.
        Senator Cotton. Mm-hmm. Well, I do not mean to question
    anyone's integrity or motives, just to say that in the
    incredibly complex international financial markets, it is hard
    for me to imagine any one person or any small group of people
    have all of the wisdom and especially all of the knowledge
    necessary to engage in such kind of one-off case-by-case
    decisions in a prudent manner as opposed to laying out clear
    criteria well in advance that is well known to all market
    players.
        Mr. Macey. I agree, and I do think that markets have a
    certain element of wisdom that bureaucracies and individual
    people cannot manage to reflect, and I think it would be nice
    if regulation reflected that notion a little bit more, in my
    opinion.
        Senator Cotton. Thank you.
        Senator Crapo. Senator Heitkamp.
        Senator Heitkamp. Thank you, Mr. Chairman.
        It has been interesting, because there has been a lot of
    rewriting of history, I think, today, and a lot of concern for
    the sense that this, almost for some of the panel members, that
    what happened in 2008 did not happen, and it did not happen
    because people made bad decisions, people who were acting in a
    regulatory environment, but also had an obligation, in many
    cases a fiduciary obligation, to actually be honest about what
    their products were. And, so, I am a little perplexed by this,
    although I tend to share an attitude that we have an obligation
    to constantly look back on a regulatory scheme and say, is this
    working? Is this right?
        But, to not go down the rabbit hole too much, Professor
    Macey, is it possible for Congress to legislate broadly, the
    end result of which would be only one entity would fall within
    a constitutional classification?
        Mr. Macey. Sure. I think----
        Senator Heitkamp. That is----
        Mr. Macey. Oh, sure.
        Senator Heitkamp. ----the only point I wanted to make, that
    we best not get so embroiled in the consequences and look
    instead at the regulation.
        And, so, this hearing is about 165 and, obviously, a
    critical component, and I am curious--and I am going to open
    this up to anyone--when we look at the tailored application of
    165, and I think the intent probably was that we cannot simply
    just always put a monetary value and assume that we are going
    to achieve the intended result. Congress does this very often,
    maybe perhaps too often, turfing a lot of responsibility to the
    regulators, and then sits in panels like this and complains
    because the regulators have done what we gave them the
    authority to do.
        And, so, if--you know, we will let you play Fed for the day
    and talk about the current exercise of 165 policy, I guess,
    Professor Lucas, and say, where do you think the Fed is getting
    it right and where are they getting it wrong, and if we were
    going to not look at a broad sweeping change of 165 and the
    categories of 165, where should we be looking that makes the
    most amount of sense?
        Ms. Lucas. OK. So, I am sympathetic to much of what you
    said and I think that the reason that I came down where I did,
    which was that it would be reasonable to raise the threshold,
    is that there are some things that the Fed is doing where,
    although if I did believe that it would significantly reduce
    systemic risk, it would not bother me, but I believe that when
    you do something like ask a very simple but fairly large bank
    to undergo stress tests, that is a fairly significant
    regulatory burden that will not result in any reduction at all
    of systemic risk.
        And, I think that just for general respect for the
    regulatory system, you want to set up the rules so that you do
    not annoy or impose costs on institutions----
        Senator Heitkamp. With no benefits.
        Ms. Lucas. ----where it is certainly not necessary. So, I
    think it is the stress testing and just the heightened
    examination.
        So, again, I think that it comes down to the transparency
    that is already there for those banks, or as Dr. DeYoung put
    it, the resolvability. It is not clear to me that the Fed does
    not already know everything it needs to know about those banks
    to deal with the systemic risk, whether they fail individually
    or collectively, because the--you know, if you think about what
    these regulations are doing, it is actually extremely small.
        So, we are talking about it like it makes a big difference,
    but, in fact, it is a very small difference, because even the
    ones that are subject to higher capital requirements, it is a
    very small increment to their capital requirements. So, it is
    not going to make much difference to the total amount of
    failures and----
        Senator Heitkamp. Mr. Barr, do you have input there, too?
        Mr. Barr. I think that, overall, the graduated tailored
    approach the Fed has taken makes a lot of sense, and it has
    particularly been effective at the very largest institutions--
    --
        Senator Heitkamp. Could you give your response to Professor
    Lucas's point about, you know, a lot of this is ``make work''
    and it does not add to the quality of the regulation in terms
    of preventing systemic risk.
        Mr. Barr. You know, my experience with stress testing is
    that it makes a big difference inside the firm in terms of
    improvements in risk management, attention to appropriate
    capital planning, organizational structure, and data integrity.
    So, I think it actually makes quite a big difference to risk
    management at the firm and I think it would be a mistake to not
    apply that stress testing approach more broadly in the economy.
        Senator Heitkamp. I am out of time, but I think what you
    can see here is obviously a difference of opinion. There is not
    anyone on this panel--I hope there is not anyone on this panel
    who wants to impose burdens that do not have a public good,
    instead are just ``make work,'' and that is the balance we are
    at. We have litmus tests that set a target to provide
    certainty. I am sympathetic to the argument that we are not
    really--that is not always necessarily the right indicator of
    what we need to do, but it does provide a bright line.
        With that said, the response to that when we are looking at
    systemic risk may be to give the regulators more authority,
    which I have a sense here some of the folks would not be
    particularly supportive of. It is objective versus the
    subjective and it is a tough balance. But, I was not here when
    Dodd-Frank was written, but I am certainly interested in
    hearing how we can make it better and how we can streamline it,
    especially for the small community banks.
        So, thank you. It has been a really engaging panel.
        Senator Crapo. Thank you.
        I will take my turn at the questions now, and I want to
    follow up on this same line of questioning, and to do so go
    back to last week when we had Chair Yellen, Janet Yellen, here
    in front of us. I reminded her that I asked this same question
    to Governor Tarullo, I believe it was last year now. It has
    been a while back. And, the question basically was, is there
    some flexibility that we can have that would actually help to
    reduce burdens on the regulatory system that we are imposing in
    this context but still maintain the necessary prudential
    standards and protection.
        Governor Tarullo and Chair Yellen, in my opinion, gave the
    same answer. I am going to quote what Chair Yellen said in the
    hearing last week, where I asked her the question of whether
    some kind of an adjustment of the $50 billion threshold would
    be livable or appropriate, even. Her answer was yes, that she
    would be open to a, what she called a modest increase in the
    threshold, and she wanted to make it very clear that in her
    concept, the banks that were below the threshold would still be
    subject to a significant amount of regulatory authority.
        I am going to use her own words here. She said, ``I guess
    the reason I would be open to it is that, as he indicated,
    Governor Tarullo, and as you just stated, we do have some
    smaller institutions that under Section 165 are required to do,
    for example, supervisory stress testing and resolution
    planning, and for some of those institutions, it does look from
    our experience like the costs exceed the benefits.''
        As I hear that, when I hear that the costs of a rule or a
    system exceed the benefits, I can extrapolate that into a lot
    of things, but one of the things that it extrapolates into in
    this context is that the consumers are going to be paying a
    higher price for their services in this industry if we require
    this.
        She went on to talk--I am skipping down a little bit. She
    said, ``At present, every firm over $50 billion has to do
    things like supervisory stress testing, and I think that what
    we have found is, in some cases, the burden associated with
    that for many of those firms really exceeds the benefit to
    systemic stability.''
        Now, she--to be careful here, I want to make it clear that
    she said that she thought the Fed ought to have the authority
    to look carefully at the risk profiles of all the banks that
    they are regulating, and for some of those banks that may fall
    below whatever threshold Congress might set, there may be a
    risk profile for that particular bank or a set of banks that
    should have heightened scrutiny and perhaps even be required to
    do stress testing, or whatever it may be, but that not every
    single solitary bank under any standard, just an arbitrary
    dollar number, should be subject to the same, what I will call,
    rigid rule.
        I would just like to have each of you comment on that. We
    will start on the left with you, Mr. DeYoung. I have already
    used up three of my 5 minutes, so if you guys could each be
    relatively brief, I would appreciate it.
        Mr. DeYoung. OK. I will attempt to be brief. I think banks
    should do stress tests without being asked to do them. I think
    a poorly run bank will not do a stress test and it will not be
    forewarned or guarded and will not be able to prepare against
    stress. So, I do not think stress tests are a bad thing or make
    work or a waste of time. For many firms that are not
    systemically important, though, there should be--I have stated
    before, there should be no--the Federal Reserve, I think, would
    have no interest in applying that to firms for which there is a
    zero, a zero marginal benefit in terms of its systemic
    importance.
        In terms--I just want to mention an offer that was made in
    the American Banker by Tom Hoenig a couple of weeks ago in an
    op-ed, that for small banks that have traditional balance
    sheets and do not have a lot of off-balance sheet activities
    and do not have over-the-counter derivatives, Vice Chairman
    Hoenig said we should roll back even the Basel III increments
    on higher capital. So, I think there is an example there of
    graduated supervision and applying these things appropriately.
    Of course, Mr. Hoenig is not in a position to deliver on this
    promise, of course, but I think----
        Senator Crapo. Understood.
        Mr. DeYoung. ----up and down the size of banks, there is
    room for a graduated authority and regulation.
        Senator Crapo. Thank you.
        Professor Lucas.
        Ms. Lucas. OK. I will be very brief. I basically agree with
    you, but I do think it is important to really leave open the
    possibility for the Fed to use discretion. Particularly, they
    have to be able to do that quickly when events are unfolding
    that might create systemic risk at a very short time scale.
    But, with that proviso, I think it is quite safe to raise the
    limits for the reasons you said.
        Senator Crapo. Thank you.
        Professor Macey.
        Mr. Macey. Yes. I think one can divide all these
    regulations up into basically two categories. One are
    regulations that presume--that in order to be effective require
    the regulator to be smarter than the bankers and to figure out
    when the bankers are engaging in risky behavior that they are
    kind of trying to hide.
        And then the second category of regulation, which is the
    category that I like, are regulations which incentivize the
    regulated entities to do the right thing, that is to say, to
    the extent that shareholders of financial institutions have to
    internalize or bear the cost of a bank failure, then I would
    believe those firms are going to do what Professor DeYoung was
    talking about and have incentives to do these stress tests
    themselves or take other steps to be meaningfully prudential.
    And, we have seen--so that good regulations have that
    characteristic.
        And, we have seen--if we take, for example, risk-based
    capital requirements or that this is a private sector invention
    that was a terrific idea, but once it got internalized in a
    regulation it became kind of ossified, I am not opposed to
    them. I think they are better than nothing, but they never
    really got up to the, I think, to the promise that the
    technology initially promised. I think the same is exactly true
    for so-called value at risk, VAR, models.
        So, I think we just need to regulate with incentives rather
    than regulate from a central planning point of view.
        Senator Crapo. Thank you.
        Mr. Barr.
        Mr. Barr. Senator Crapo, I think we need to focus the
    attention on the regulatory relief that the smallest banks
    need. I think the banks under a billion, banks under ten
    billion, often face regulatory burdens that are quite difficult
    for them to handle with very small compliance staff. So, I
    think if we can focus attention on the need to get longer exam
    cycles for strong compliant institutions at that level, clear
    safe harbors from rules where appropriate, much shorter plain
    language versions or regulations so they do not have to hire an
    army of consultants to comply with them, I think that is really
    the area that ought to be the focus, and I think we are doing
    OK on the larger institutions, I really do.
        Senator Crapo. All right. My time has more than expired.
        Did you have any more questions?
        Senator Brown. [Shakes head side to side.]
        Senator Crapo. All right. That concludes the questions. I
    want to thank this panel. Chairman Shelby had to leave for
    another committee which he chairs, and so he wants to also give
    you his thanks for being an excellent panel. He told me when I
    came in to relieve him that we had an outstanding panel of
    experts here that we could well learn from. We appreciate you
    bringing your expertise to us today. Thank you.
        This hearing is adjourned.
        [Whereupon, at 10:48 a.m., the hearing was adjourned.]
        [Prepared statements and responses to written questions
    supplied for the record follow:]
                      PREPARED STATEMENT OF ROBERT DEYOUNG
       Capital Federal Professor in Financial Markets and Institutions,
                    University of Kansas School of Business
                                 July 23, 2015
        Thank you for the opportunity to address the Committee. The
    Chairman has asked me to share my perspective on which factors are
    important for determining the systemic risk of bank holding companies.
    I am pleased to do so.
        Bank size is the most immediate consideration. Larger banking
    companies tend to have more volatile earnings, tend to be less liquid,
    tend to be more interconnected, and tend to be more difficult to value.
    The raw data shows that bank failure during and after the financial
    crisis was clearly correlated with bank asset size.
        But by itself, a bank's size is neither a necessary nor a
    sufficient indicator of its systemic risk. Regulators currently treat
    all banking companies with more than $50 billion of assets as
    systemically important. But this single-factor, bright line approach
    will is far too simple. A good example is Washington Mutual, which held
    over $300 billion in assets at the time of its failure in 2008. The
    FDIC was able to resolve WAMU without systemic consequences and without
    Government financial support. So resolvability is another important
    factor, in addition to bank size, for determining whether or not a
    banking company poses a systemic threat.
        The Shelby bill would redraw the bright line at $500 billion in
    assets, and rely on the Federal Reserve and the Financial Stability
    Oversight Council to evaluate the systemic importance of banking
    companies below this asset size threshold. This approach would
    automatically define the six largest bank holding companies in the U.S.
    as systemically important--not coincidentally, on Monday of this week
    the Federal Reserve announced systemic risk capital surcharges for
    these same six firms. For smaller firms, the Fed and FSOC would be free
    to consider multiple indicators of systemic risk other than asset size,
    such as off-balance sheet positions, earnings volatility,
    interconnectedness, and cross-country exposures. Both sets of banks
    would be subject to enhanced regulatory and supervisory treatment.
        A good example of this type of multifactor approach can be found in
    a recent policy brief from the Office of Financial Research (OFR 15-01,
    February 12, 2015). While I am not in a position to endorse the exact
    formulations within the OFR method, I strongly endorse its general
    approach. It uses predefined weights to translate each bank's size,
    business activities, financial complexity, and interconnectedness into
    a quantitative score that represents each bank's relative systemic
    importance. This approach applies the same risk filters to every
    banking company, so human ``discretion'' plays no role in determining
    the relative outcomes. And while the calculations may appear
    complicated, both the results and the reasoning are transparent.
        The natural concern is that one or more banks that pose systemic
    threats could be mistakenly left off the list, and to avoid this we
    should err on the side of caution and maintain the $50 billion
    threshold. I think this concern is unwarranted; and in any case,
    mistakenly putting nonsystemic banks on the list imposes costs as well.
    The size of a banking company is just one potential indicator of
    systemic risk, it is an incomplete and sometimes misleading indicator.
        For example, consider four U.S. bank holding companies, each with
    assets in the neighborhood of $300 to $400 billion: U.S. Bancorp, PNC,
    Bank of New York Mellon, and State Street. In the OFR's scoring
    exercise, U.S. Bancorp and PNC get relatively low systemic risk scores
    because they practice traditional banking: they hold diversified
    portfolios of loans, fully funded by stable deposits, have very little
    off-balance sheet exposures, and their clientele is almost completely
    domestic. In contrast, Bank of New York Mellon and State Street get
    relatively high systemic risk scores, because they hold very few loans,
    rely on relatively unstable deposit funding, have large cross-border
    exposures, and provide infrastructure and logistics that are essential
    for the smooth operations of securities markets.
        Of course, the Fed and FSOC would still need to determine where to
    draw the line between SIFI and non-SIFI. I strongly suspect that these
    agencies will err on the side of caution when drawing this line. The
    designation of MetLife as a SIFI provides a case study.
        In closing, I want to reemphasize the importance of resolvability
    in determining a bank's systemic importance. If a bank holding company
    can be resolved without causing disruptions in financial markets or
    contagion to other banks--either through regular bankruptcy or via
    orderly liquidation authority--then such a bank should not be
    considered systemically important. It is not the job of bank regulators
    to prevent insolvencies at poorly run banking companies. I think we can
    all agree that poorly run banks should exit the market and stop wasting
    society's scarce resources. Our goal should be safe resolutions for
    these banks--not additional regulatory and supervisory safeguards that,
    by keeping poorly run banks out of trouble, keeps them operating and in
    business.
        Thank you for your time this morning. I hope that my remarks have
    been useful. I look forward to your questions.
                                     ______

                      PREPARED STATEMENT OF DEBORAH LUCAS
     Sloan Distinguished Professor of Finance, and Director, MIT Center of
                 Finance and Policy, Sloan School of Management
                                 July 23, 2015
        Chairman Shelby, Ranking Member Brown, distinguished Members of the
    Committee, thank you for inviting me speak with you about the
    appropriate criteria for determining whether a financial institution
    poses a systemic risk to the financial system. \1\
    ---------------------------------------------------------------------------
         \1\ The views expressed are my own and do not represent those of
    the MIT Center for Finance and Policy.
    ---------------------------------------------------------------------------
        My main focus today is on that issue as it applies to bank holding
    companies (BHCs). My basic conclusions are that: (1) the threshold for
    automatic SIFI designation for BHCs could be raised substantially from
    its current level of $50 billion in assets without measurably
    increasing systemic risk; and (2) it would be advisable for regulators
    to use several criteria in addition to asset size to more accurately
    identify SIFIs. In fact, regulators have been exploring multifactor
    approaches for SIFI designation, and those methods appear to be able to
    more accurately identify the institutions most likely to cause
    contagion than a crude size cutoff. However, best practices in this
    area are still evolving. Any formulaic approach that regulators adopt
    may need to be revised as new data become available and as market
    practices change.
        I also would like to use this opportunity to briefly discuss what I
    see as the most serious deficiency in systemic risk oversight as it is
    currently conducted. That is the exemption of major Government-run
    financial institutions from SIFI designation, and hence from any formal
    oversight by systemic risk regulators. Those Government institutions--
    such as Fannie Mae, Freddie Mac, FHA, the Federal student loan
    programs, and perhaps State and local pension funds--are collectively
    much larger than the BHCs currently classified as SIFIs. They also
    satisfy most of the other criteria suggested for SIFI designation such
    as a high degree of interconnectedness. \2\ Federal mortgage guarantors
    were at ground zero of the financial crisis. Those considerations
    support the idea that such institutions represent an important source
    of systemic risk and hence should fall under FSOC's mandate.
    ---------------------------------------------------------------------------
         \2\ Other examples of governmental activities that could pose
    systemic risk include the student loan programs of the U.S. Department
    of Education and the many pension-related activities of State and local
    governments.
    ---------------------------------------------------------------------------
        The Dodd-Frank Wall Street Reform and Consumer Protection Act was
    passed in the wake of the most severe financial crisis and subsequent
    economic downturn since the Great Depression. Those events revealed the
    vulnerability of the global financial system and the real economy to
    cascading failures of complex, highly interconnected financial
    institutions, and were the impetus for the enhanced regulatory
    framework established. At this 5-year anniversary of the Act, and with
    the benefit of experience and new data, it makes sense to consider ways
    to improve its implementation so as to more effectively reduce systemic
    risk while minimizing the associated regulatory burden.
    SIFI Designation for Bank Holding Companies
        BHCs deemed to be SIFIs are subject to a higher level of oversight
    and additional restrictions, such as increased capital requirements and
    stress testing. Those provisions reduce the likelihood of spillovers of
    financial distress to the broader market, but entail costs for the
    affected institutions. The cost-benefit tradeoffs are difficult to
    quantify. Major systemic risk events are rare but the potential private
    and social costs are enormous. There is little data to assess
    probabilities or likely costs, and history may be a poor guide to the
    future. There also is considerable disagreement about magnitude of the
    costs imposed by SIFI status.
        Despite the measurement challenges, recent analyses of newly
    collected data suggest that the current criteria used for SIFI
    designation could be improved upon in several ways.
    Asset Size Threshold
        A growing body of evidence suggests that the asset size threshold
    of $50 billion for BHCs to be automatically deemed as SIFIs is much
    lower than is necessary to protect financial stability. That conclusion
    rests on the findings of several studies that employ a variety of
    approaches to identifying SIFIs. It is also supported by the
    commonsense observation that however one measures it, the very largest
    BHCs are enormously more complex and interconnected than their midsized
    peers.
        The OFR recently released a policy brief showing that a
    multidimensional measure of systemic risk only identifies the very
    largest U.S. banks as SIFI candidates. \3\ That analysis identifies the
    eight BHCs listed in Table 1 as standing out for their systemic
    importance. The smallest of those, State Street, had assets of $279
    billion as of March 2015.
    ---------------------------------------------------------------------------
         \3\ ``Systemic Importance Indicators for 33 U.S. Bank Holding
    Companies: An Overview of Recent Data'', by Meraj Allahrakha, Paul
    Glasserman, and H. Peyton Young, Office of Financial Research Brief,
    February 12, 2015.

        A very different approach to identifying systemically important
    banks has been proposed and implemented by Professor Robert Engle of
    NYU and his colleagues. \4\ Their method relies on statistical analysis
    of stock price dynamics and bank leverage. It currently identifies five
    of the eight institutions listed in Table 1 as being in the top 10 of
    systemically risky U.S. financial institutions. I mention this study
    primarily because it demonstrates that very different methodologies
    seem to come to similar conclusions on which BHCs are most systemically
    important.
    ---------------------------------------------------------------------------
         \4\ Those statistics and a description of the methodology are
    available at: http://vlab.stern.nyu.edu/.
    ---------------------------------------------------------------------------
        Just last week, the Federal Reserve issued a White Paper that
    discusses replacing the $50 billion asset size threshold with one of
    three alternatives that effectively would increase the cutoff to at
    least $250 billion. \5\ They consider two related formulas, one
    developed by the Bank for International Settlements (based on size,
    interconnectedness, complexity, cross-jurisdictional activity, and
    substitutability). The second replaces substitutability with reliance
    on short-term wholesale funding. Both formulas identify the group of
    banks shown in Table 1 as having the highest systemic risk. The White
    Paper also suggests the possibility of setting a threshold for the
    determining globally systemically important BHCs based on relative
    systemic risk scores rather than setting a dollar size cutoff. Such an
    approach has the advantage of automatically adjusting over time, and
    certainly deserves further consideration.
    ---------------------------------------------------------------------------
         \5\ ``Calibrating the GSIB Surcharge'', Board of Governors of the
    Federal Reserve System, July 20, 2015.
    ---------------------------------------------------------------------------
    Criteria for SIFI Designation
        There is general agreement that size alone is not the best proxy
    for an institution's contribution to systemic risk. Financial
    regulators in the U.S. and abroad have identified five broad categories
    of factors to consider. Those include size, interconnectedness,
    substitutability, complexity, and cross-jurisdictional activity. The
    OFR and Federal Reserve analyses described above incorporate those
    criteria into the risk scores used to identify the most systemically
    risky BHCs.
        Incorporating those multiple criteria involve two sets of
    challenges: (1) creating well-defined metrics for each criterion; and
    (2) laying out a weighting scheme that determines the relative
    importance of each in an overall risk score. Broad considerations in
    making those choices include data availability, stability of outcomes,
    avoiding excessive complexity, and preserving transparency.
        To illustrate the complexity of constructing a risk score based on
    multiple characteristics, it is telling that even the definition of
    size is not straightforward to determine. For example, the OFR and
    other regulators measure size in the risk scores they report by
    including total assets plus the net value of certain securities
    financing transactions plus credit derivatives and commitments as well
    as counterparty risk exposures.
        Choosing a weighting scheme is especially difficult. There isn't a
    precise definition or complete agreement about what makes a financial
    institution systemically risky, and there is little evidence about the
    relative importance of the different criteria or their predictive
    accuracy.
        It is promising that the various approaches now under consideration
    point to a consistent set of BHCs as SIFIs, and that size is highly
    correlated with all of the leading measures. However, the metrics that
    regulators are beginning to adopt are still new and evolving. Hence it
    seems prudent to allow some latitude for revising the methodology used
    as new data become available and as market practices and perceived
    risks change over time.
    SIFI Designation for Nonbank Financial Institutions
        It is beyond the scope of this testimony to discuss in detail the
    criteria for SIFI designation of nonbank financial institutions.
    However, similar issues regarding size cutoffs and what other criteria
    to include will certainly arise. In making those rules, a caution is
    that the relevance and relative importance of various criteria will
    differ considerably across different types of institutions. For
    example, major exchanges such as the CBOT are likely to be deemed
    systemic because of their centrality in certain derivatives markets,
    but the overall size of their balance sheets is largely irrelevant to
    their contribution to systemic risk. Therefore it will be important to
    think carefully about the specific mechanisms that generate systemic
    risk in each instance, and to avoid using a one-size-fits-all approach.
    Government Financial Institutions as SIFIs
        Several factors support the contention that the Government is a
    significant source of systemic risk. The most obvious is its sheer size
    in its role as a financial institution (or more accurately, a
    collection of loosely affiliated financial institutions). My
    calculations show that just through its traditional credit programs,
    the Government comprised a $3 trillion financial institution in 2013,
    and that figure increases to over $18 trillion when Fannie Mae, Freddie
    Mac, the Federal Home Loan Banks, deposit insurance, and the Pension
    Benefit Guarantee Corporation are included. \6\ Figure 1 illustrates
    the size of those Government institutions relative to the largest BHCs.
    ---------------------------------------------------------------------------
         \6\ ``Evaluating the Government as a Source of Systemic Risk'',
    Deborah Lucas, Journal of Financial Perspectives, November, 2014.
    ---------------------------------------------------------------------------
        Many of the other criteria identified as important for BHCs,
    including interconnectedness, substitutability, and complexity, also
    apply to these Government financial institutions. Lack of transparency
    and light supervision also contribute to the likelihood that they are a
    source of systemic risk.
        However, probably more important for systemic risk than the
    Government's direct effect on the allocation and riskiness of credit is
    its influence on the incentives facing private individuals and
    institutions through its regulatory, tax and other policies. The
    Government's policies reflect a variety of sometimes competing
    political objectives, and there is no ``invisible hand'' guiding the
    Government toward adopting policies that foster efficiency and avoid
    the buildup of systemic risks. In fact, systemic risks arising from
    Government actions may be relatively hard for policymakers and the
    public to identify because of the lack of transparency surrounding
    Government activities.

        For those reasons, bringing large Government financial institutions
    under the oversight of FSOC would have important benefits for the
    stability of the financial system. Actions that FSOC could consider
    include initiating a regulatory audit, whereby the OFR would be
    directed to undertake a systematic evaluation of Federal financial
    regulations across agencies to identify unintended consequences that
    could give rise to systemic risk. It could also require the improvement
    and standardization of certain financial disclosures by those
    institutions.
        Thank you for the opportunity to share these ideas. I look forward
    to your questions.
                                     ______

                    PREPARED STATEMENT OF JONATHAN R. MACEY
         Sam Harris Professor of Corporate Law, Corporate Finance, and
                        Securities Law, Yale Law School
                                 July 23, 2015
        Chairman Shelby, Ranking Member Brown, Members of the Committee,
    and panel colleagues, I am grateful for the opportunity to talk to you
    today. My name is Jon Macey, and I am a professor of law at Yale Law
    School. I am here only in that capacity. I represent no firm, industry,
    organization, or party. It is a pleasure to be here. Thank you giving
    me the opportunity to address your Committee on the important topic of
    measuring systemic risk in U.S. Bank Holding Companies.
        The central question for today is whether it makes sense to
    continue to assume that all banking companies with more than $50
    billion of assets are systemically important and therefore subject to a
    heightened level of prudential regulation. Currently under
    consideration is Senator Shelby's proposal to reduce the central
    reliance on a bright line test by moving the automatic threshold to
    $500 billion in assets, and authorize the Federal Reserve and the
    Financial Stability Oversight Council to evaluate the systemic
    importance of banking companies below this asset size threshold.
        The Shelby bill would reduce from 36 to 6 the number of financial
    institutions subject to the automatic cutoff. I support this new
    approach for five reasons.
        First, the bill will reduce the distortive effect of the current
    regulatory regime, which provides incentives for midsize banks to stop
    growing to avoid the SIFI designation, provides incentives for
    institutions above the threshold to grow at least until they approach
    the size of the so called ``big six'' financial institutions in order
    to be able to amortize the additional costs of regulation placed on
    institutions designated as systemically important.
        Second, the proposal in the bill under consideration would inject a
    degree of intellectual rigor into the SIFI designation process that is
    currently lacking. Regulators would have to pay more attention to
    factors besides asset size. The role played by other factors, such as
    operational complexity, balance between the liquidity characteristics
    and maturity dates of assets and liabilities, off-balance sheet
    positions, earnings volatility, interconnectedness, and cross-country
    exposures would receive attention. While supporters of Dodd-Frank
    initially marketed the legislation as eliminating the long-standing
    practice of treating certain financial institutions as ``too big to
    fail,'' nobody seriously asserts that financial institutions designated
    as SIFIS would be allowed to disappear. In my view the flawed process
    by which MetLife was designated as a SIFI illustrates the need to
    impose more intellectual rigor on the SIFI designation process. The
    MetLife designation process ignored basic principles of risk
    regulation, failed to distinguish plausible risks from implausible
    risks, and failed to appreciate the differences between MetLife's
    business and balance sheet and the business and balance sheets of bank
    holding companies. Requiring regulators to rely less on the $50 billion
    Maginot Line would incentivize regulators to be more analytically
    rigorous in the designation process.
        A third reason to support this bill is that the new approach to
    SIFI designation reflected in the statute would make the regulatory
    system more fair by reducing reliance on an arbitrary line of
    demarcation that nobody has been able to support or defend either
    empirically or theoretically.
        Fourth the change would reduce some of the current pathologies in
    bank regulation that Dodd-Frank created. The financial system is more
    concentrated, more interconnected and more opaque than it was before
    the financial crisis. Almost all of this increase occurred during the
    crisis as regulators encouraged big distressed financial firms to
    acquire other even more distressed financial firms. Bank of America
    acquired Countrywide and Merrill Lynch, JPMorgan acquired Washington
    Mutual and Bear Stearns, and Wells Fargo acquired Wachovia. Now the six
    largest financial institutions hold over 60 percent of all of the
    assets in the financial system and hold a near-100 percent market share
    of shadow banking sector activities.
        For people who, like me, believe that the administrative State
    should be subject to the rule of law, Dodd-Frank poses significant
    challenges. Never has so much rulemaking authority and regulatory
    discretion been granted so broadly. As I previously observed in the
    Economist Magazine, ``Laws classically provide people with rules. Dodd-
    Frank is not directed at people. It is an outline directed at
    bureaucrats and it instructs them to make still more regulations and to
    create more bureaucracies.''
        The key term ``systemically important financial institution'' is
    not defined, other than with reference to the fact that financial firms
    that are designated as systemically important are systemically
    important. Since systemic failure is, by definition, catastrophic,
    regulators feel justified in acting aggressively to reduce the
    likelihood that such failure will occur.
        The efforts of regulators to have money market funds and mutual
    funds designated as SIFIs is a prime example of the regulatory over-
    reaching that is not merely enabled but encouraged by Dodd-Frank.
    Simply by recognizing the primordial fact that the assets in these
    funds belongs to the investors and not to the funds themselves, so that
    losses in the value of the assets held by these funds is not a loss for
    the entity, but rather for the investors who hold shares in the entity.
        Recently we have seen bespoke regulations imposed on General
    Electrical Capital Corporation (GECC), as well as with the recent
    imposition of customized capital requirements on JPMorgan Chase,
    Citigroup, Bank of America, and the five other largest U.S. banks that
    are tailored to the perceived riskiness of each of these financial
    institutions. My point is not that such firm-by-firm regulation is bad.
    My point is that such regulation is inevitable, and that it inevitably
    creates an uneven competitive playing field among institutions. It is
    only modestly comforting that these financial institutions are so
    complex that it is not possible to tell, a priori which institutions
    advantaged and which are disadvantaged by the Federal Reserve's new
    rules. We are clearly not living in a first or even second best
    regulatory environment as we pass the fifth anniversary of Dodd-Frank.
    From a policy perspective, as regulations increasingly are tailored to
    reflect regulators' views of banks' riskiness as measured by the
    formulas they themselves develop, exposure to the risk of favoritism,
    capture and other symptoms of a runaway regulatory State multiply
    exponentially.
        Fifth, for those who, like me, believe that the best way to avoid
    having financial institutions that are too big to fail is to reduce to
    zero the number of institutions that are too big to fail, the proposed
    legislation provides positive incentives for banks to be smaller and
    negative incentives on banks to become larger. Like the Fed's new
    capital requirements for the eight largest financial institutions, the
    proposed statute imposes some costs on the very biggest financial
    institutions.
        On the bright side, it is worth noting that the proposed statute
    would require the FSOC to provide any BHC under review for possible
    designation as a SIFI with (1) a ``detailed explanation'' for any
    proposed or final designation as a SIFI, (2) opportunities to meet with
    FSOC members and staff, and (3) the opportunity to submit a ``remedial
    plan'' prior to final designation to avoid a SIFI designation. Further,
    the FSOC must reevaluate existing BHC SIFIs with assets of less than
    $500 billion at the request of the Federal Reserve and at least every 5
    years. These aspects of the legislation seem modest and
    uncontroversial, but in my view they are an important first step in
    restoring a measure of the regulatory accountability that was lost with
    the passage of Dodd-Frank.
        Regulators have incentives to increase the list of systemically
    important financial institutions and to regulate those institutions
    expansively. These incentives are unfortunate. Regulators should be
    given incentives to reduce, not to expand the list of SIFIs. Unless our
    regulators have truly lost their way, it must be the case that reducing
    and indeed eliminating the number of financial institutions designated
    as SIFIs is a key goal of our public servants. The probability of
    failure of every firm in the private sector except for those that are
    too big to fail is above zero. For financial institutions the
    probability of failure can change dramatically in a very short period
    of time. The more systemically risky firms there are in the economy,
    the more risky the economy will be. If the concept of systemic risk has
    any meaning whatsoever it must be the true that reducing systemic risk
    by reducing the number of firms that pose such risk is an important
    goal of any regulator worth her salt.
                                     ______

                     PREPARED STATEMENT OF MICHAEL S. BARR
       Roy F. and Jean Humphrey Proffitt Professor of Law, University of
                              Michigan Law School
                                 July 23, 2015
        Chairman Shelby, Ranking Member Brown, distinguished Members of the
    Committee, it is my pleasure to appear before you today, 5 years after
    enactment of the Dodd-Frank Wall Street Reform and Consumer Protection
    Act.
        That Act was passed in response to the worst financial crisis since
    the Great Depression. In 2008, the United States plunged into a severe
    financial crisis that shuttered American businesses, and cost millions
    of households their jobs, their homes and their livelihoods. The crisis
    was rooted in years of unconstrained excesses and prolonged complacency
    in major financial capitals around the globe. The crisis demanded a
    strong regulatory response in the U.S. and globally as well as
    fundamental changes in financial institution management and oversight
    worldwide. The U.S. has led these reforms, both domestically and
    internationally.
        In the U.S., the Dodd-Frank Act created the authority to regulate
    Wall Street firms that pose a threat to financial stability, without
    regard to their corporate form, and to bring shadow banking into the
    daylight; to wind down major firms in the event of a crisis, without
    feeding a panic or putting taxpayers on the hook; to attack regulatory
    arbitrage, restrict risky activities through the Volcker Rule and other
    measures, regulate repo and other short-term funding markets, and beef
    up banking supervision and increase capital; to require central
    clearing and exchange trading of standardized derivatives, and capital,
    margin and transparency throughout the derivatives market; to regulate
    payments, settlement, clearance, and other systemic activities; to
    improve investor protections; and to establish a new Consumer Financial
    Protection Bureau to look out for the interests of American households.
        I want to focus today on aspects of the system of prudential
    oversight established in the Act.
    Supervision of Bank Holding Companies
        The Federal Reserve has supervisory authority, as it has long had,
    over bank holding companies. The Fed is directed under section 165 of
    the Act to provide for a graduated system of regulation, with
    increasing stringency, depending on the risk that the firm poses to
    financial stability, based on its nature, scope, size, scale,
    concentration, interconnectedness, or other factors. The Fed may tailor
    these more stringent prudential standards for individual firms or
    categories of firms, based on a similar set of factors regarding risk.
        These enhanced prudential measures include risk-based capital
    requirements and leverage limits, liquidity requirements, risk
    management, resolution planning, credit exposure reporting,
    concentration limits, and annual stress tests.
        The Fed is not required under this provision to apply these more
    stringent standards to bank holding companies with assets under $50
    billion. Annual firm-led stress tests, however, are required for firms
    between $10 and $50 billion in size, and the Fed must itself stress
    tests firms over $50 billion in size, in addition to such firms semi-
    annual firm-led stress tests. Publicly traded bank holding companies
    $10 billion in asset size and above must establish risk committees. (I
    should also note that under the Act, the Federal Reserve may, upon
    recommendation of the Financial Stability Oversight Council, raise the
    threshold above $50 billion for certain prudential standards, those
    involving contingent capital, resolution planning, concentration
    limits, enhanced public disclosures and short-term debt limits.)
        None of these enhanced measures apply to about 95 percent of banks,
    the category commonly described as community banks, those under $10
    billion in assets--more than 6,000 banks in communities all across the
    country.
        Graduated standards are already at work. Fed stress testing applies
    to the largest firms in the country, the 31 firms with assets of $50
    billion and above. Such firms represent a wide variety of risk
    profiles, business strategies, sizes, specializations, and include both
    foreign and domestic firms. The largest, most complex financial
    institutions face the most stringent standards, as provided for under
    the Act. The Fed, for example, imposes a supplementary leverage ratio,
    a countercyclical capital buffer, and detailed liquidity coverage rules
    only on 14 firms with over $250 billion in assets. The very largest
    U.S. banks on a global basis, currently eight bank holding companies,
    are subject to even tougher standards, including capital surcharges,
    more stringent leverage ratios, and long-term debt requirements.
        In my view, this graduated approach to supervision and regulation
    makes sense. Some have argued that the size threshold for heightened
    prudential standards should be substantially increased, while others
    have argued that banks should not be subject to any heightened
    standards unless they are specially designated as systemic. Both
    approaches, in my judgment, are mistaken.
        First, as to size, some have mistakenly said that the Act describes
    firms with only $50 billion in assets as systemic. But that is simply
    not the case. Congress set the $50 billion threshold, and another
    threshold for other measures at $10 billion, to provide a floor under
    which smaller firms would know that they are not subject to the new
    sets of rules. But the rules were not meant to only apply to the very
    few largest firms in the country. They are not intended to apply only
    to systemically important firms.
        They are designed to work in a graduated, tailored way to increase
    the resiliency of the financial system as a whole. Risks aggregate
    across the financial system, including from institutions of a variety
    of sizes and types. It is the very antithesis of macroprudential
    supervision to focus only on the very largest handful of financial
    firms and to ignore risks elsewhere in the system. Moreover, smaller
    financial institutions themselves face risk from larger institutions
    and from activities across the system as a whole. Understanding those
    risks is essential if we are to have a safer financial system than the
    one we had before the financial crisis. We must not intentionally blind
    regulators to these risks in advance.
        Second, as to the idea of designation, others have argued that bank
    holding companies should have to be designated for heightened
    supervision by the same process the FSOC uses for nonbank firms. But
    that runs counter to the purpose of nonbank designation. Bank holding
    companies should not be required to be designated for heightened
    supervision. Bank holding companies are already supervised by the Fed,
    and the Fed already has authority to impose heightened prudential
    supervision on such firms, on a graduated basis, as they increase in
    size and complexity.
        The reason for the designation process, under section 113 of the
    Act, for nonbank financial institutions is that such institutions were
    not subject to meaningful, consolidated supervision by the Fed at all.
    Firms such as Lehman Brothers and AIG could operate with less
    oversight, more leverage and riskier practices. Recognizing that
    policing the boundaries of financial regulation is critical to making
    the financial system safer, fighting regulatory arbitrage, and
    providing oversight of shadow banking, the Dodd-Frank Act established a
    process for bringing such nonbank financial institutions into the
    system of regulatory oversight.
        It makes little sense to require designation of firms that are
    already supervised by the Fed, and it will dramatically slow down and
    disrupt the Fed's existing oversight system. It will make the financial
    system weaker, not stronger.
        None of these changes will help truly small, hometown banks. There
    is undoubtedly much that could be done to reduce regulatory burden on
    the smallest banks. Small banks could benefit from clear safe harbor
    rules and short, plain-language versions of regulations that do apply
    to them. The Fed can continue to improve its tailored and graduated
    approach to supervision. Strong, compliant small banks should have
    longer examination cycles and streamlined reporting requirements.
    Regulators and the industry should come together in a task force to
    come up with better ways to implement the goals of the Bank Secrecy Act
    and related rules to make it more likely that we catch terrorists and
    criminals, with lower regulatory burden. And we need a level playing
    field for small business lending, so community banks can compete with
    nonbank providers to provide safe, transparency, consumer-friendly
    loans to small businesses and entrepreneurs.
    Nonbank Designations and the Financial Stability Oversight Council
        Critics have also attacked the work of the Financial Stability
    Oversight Council, or FSOC. FSOC has authority to designate
    systemically important firms and financial market utilities for
    heightened prudential oversight by the Federal Reserve; to recommend
    that member agencies put in place higher prudential standards when
    warranted; and to look out for and respond to risks across the
    financial system.
        One of the major problems in the lead up to the financial crisis
    was that there was not a single, uniform system of supervision and
    capital rules for major financial institutions. The Federal financial
    regulatory system that existed prior to the Dodd-Frank Act developed in
    the context of the banking system of the 1930s. Major financial firms
    were regulated according to their formal labels--as banks, thrifts,
    investment banks, insurance companies, and the like--rather than
    according to what they actually did. An entity that called itself a
    ``bank,'' for example, faced tougher regulation, more stringent capital
    requirements, and more robust supervision than one that called itself
    an ``investment bank.'' Risk migrated to the less well-regulated parts
    of the system, and leverage grew to dangerous levels.
        The designation of systemically important nonbank financial
    institutions is a cornerstone of the Dodd-Frank Act. A key goal of
    reform was to create a system of supervision that ensured that if an
    institution posed a risk to the financial system, it would be
    regulated, supervised, and have capital requirements that reflected its
    risk, regardless of its corporate form. To do this, the Dodd-Frank Act
    established a process through which the largest, riskiest, and most
    interconnected financial firms could be designated as systemically
    important financial institutions and then supervised regulated by the
    Federal Reserve. The Council has developed detailed interpretive
    guidance and a hearing process that goes beyond the procedural
    requirements of the Act, including extensive engagement with the
    affected firms, to implement the designation process outlined in Dodd-
    Frank. The approach provides for a sound deliberative process;
    protection of confidential and proprietary information; and meaningful
    and timely participation by affected firms. The Council has already
    designated a number of firms under this authority.
        Critics of designation contend that it fosters ``too big to fail,''
    but the opposite is true. Regulating systemically important firms
    reduces the risk that failure of such a firm could destabilize the
    financial system and harm the real economy. It provides for robust
    supervision and capital requirements, to reduce the risks of failure,
    and it provides for a mechanism to wind down such a firm in the event
    of crisis, without exposing taxpayers or the real economy to the risks
    of their failure. The FDIC is developing a ``single point of entry''
    model for resolution that would allow it to wind down a complex
    financial conglomerate through its holding company with ``resolution-
    ready'' debt and equity, while permitting solvent subsidiaries to
    continue to operate. Similar approaches are being developed globally.
        Other critics argue that the FSOC should be more beholden to the
    regulatory agencies that are its members, but again, the opposite is
    true: Congress wisely provided for its voting members, all of whom are
    confirmed by the Senate, to participate based on their individual
    expertise and their own assessments of risks in the financial system,
    not based on the position of their individual agencies, however
    comprised. Members must individually attest to their assessments in the
    FSOC's annual reports. The FSOC has the duty to call on member agencies
    to raise their prudential standards when appropriate, and member
    agencies must respond publicly and report to Congress if they fail to
    act. This system of checks and balances requires that FSOC members
    leave their agency's ``turf'' at the door, and focus on systemwide
    risks and responses. If anything, the FSOC's powers should be
    strengthened, so that fragmentation in the financial regulatory system
    does not expose the United States to enormous risk, as it did in the
    past.
        Some critics contend that certain types of firms in certain
    industries or over certain sizes should be categorically walled off
    from heightened prudential supervision, but such steps will expose the
    United States to the very risks we faced in the lead up to the last
    devastating crisis. The failure of firms of diverse types and diverse
    sizes at many points in even very recent memory--from Lehman and AIG to
    Long Term Capital Management--suggest that blindspots in the system
    should at the very least not be intentionally chosen in advance by the
    Congress. The way to deal with the diversity of sizes and types of
    institutions that might be subject to supervision by the Federal
    Reserve is to develop regulation, oversight and capital requirements
    that are graduated and tailored to the types of risks that such firms
    might pose to the financial system, as the agencies have been doing.
    FSOC and member agencies also have other regulatory tools available
    with respect to risks in the system for firms not designated for Fed
    supervision, including increased data collection and transparency,
    collateral and margin rules for transactions, operational and client
    safeguards, risk management standards, capital requirements, or other
    measures.
        Some critics complain that the FSOC's work is too tied to global
    reforms by bodies such as the Financial Stability Board (FSB). But
    global coordination is essential to making the financial system safe
    for the United States, as well as the global economy. The United States
    has led the way on global reforms, including robust capital rules,
    regulation of derivatives, and effective resolution authorities. These
    global efforts, including designations by the FSB, are not binding on
    the United States. Rather, the FSOC, and U.S. regulators, make
    independent regulatory judgments about domestic implementation based on
    U.S. law. And U.S. regulators follow the normal notice and comment
    process when developing financial regulations. The FSB itself has
    become more transparent over time, adopting notice and comment
    procedures, for example, but it could do more to put in the place the
    kind of protections that the FSOC has established domestically. \1\
    ---------------------------------------------------------------------------
         \1\ See Michael S. Barr, ``Who's in Charge of Global Finance?'',
    Georgetown Journal of International Law 45, no. 4 (2014): 971-1027.
    ---------------------------------------------------------------------------
        As with designation, global coordination--and independent
    regulatory judgment--is essential to capital rules. Strong capital
    rules are one key to a safer system. Before the crisis, the financial
    system was woefully undercapitalized, and that the system was saved
    only with a massive infusion of taxpayer-funded capital, and a wide
    variety of unprecedented guarantees, liquidity provision and other
    backstops by the FDIC, the Federal Reserve, and Treasury. There's
    already double the amount of capital in the major U.S. firms than there
    was in the lead up to the financial crisis. Globally, regulators are
    developing more stringent risk-based standards and leverage caps for
    all financial institutions, and tougher rules for the biggest players.
    In the U.S., regulators have proposed even stronger leverage and
    capital requirements for the largest U.S. firms, and other countries
    are putting in place stricter approaches when warranted by their local
    circumstances.
        In my judgment, the local variation based on a strong minimum
    standard is healthy for the system, taking into account the different
    relative size of financial sectors and differing local economic
    circumstances. There's been progress on the quality of capital--
    focusing on common equity--and on better and more comparable measures
    of the riskiness of assets, but more could be done to improve
    transparency of capital requirements across different countries and to
    make them stronger buffers against both asset implosions and liquidity
    runs. We need to continue to insist that European capital standards and
    derivatives regulations are strong--and enforced even-handedly across
    the board.
        The United States has taken a strong lead in pursuing global
    reforms, galvanizing the G20, pushing for the creation of the global
    Financial Stability Board, and pursuing strong global reforms on
    capital, derivatives, resolution, and other matters.
        The G20 has been driving financial reforms at a global level; the
    Financial Stability Board pursues agreement among regulators; and
    technical teams at the Basel Committee on Banking Supervision, the
    International Organization of Securities Commission, and the
    International Association of Insurance Supervisors hash out industry-
    relevant reforms. While the process of reaching global agreement has at
    times been quite messy, divisive, and incomplete, the last thing we
    need is to hamstring global cooperation or U.S. regulation. These
    mechanisms should be strengthened and improved, not ignored or
    weakened.
        Strong U.S. financial rules are good for the U.S. economy, American
    households and businesses, and we also need a stronger, harder push to
    reach global agreement on core reforms. In fact, such an approach is
    essential in order to reduce the chances of another devastating global
    financial crisis that crushes the U.S. economy.
    Measuring Risk
        The 2007-2009 financial crisis revealed the pressing need to
    develop better methods to understand and manage risk in the financial
    system. Since the crisis, financial regulators, scholars, and the
    financial industry have turned their attention to these issues, and
    made progress, but our ability to identify, monitor, and mitigate risk
    in the financial system remains far behind where we need to be. This is
    particularly challenging because many of the risks that are of central
    concern are low probability events with unacceptably high costs for the
    real economy.
        Stress testing is a central and innovative risk management tool
    used since the financial crisis by both regulators and practitioners.
    Stress testing attempts to capture the effects of macro-shocks on the
    balance sheets and activities of firms. Unlike fixed capital ratios, of
    either the risk-based or leverage ratio type, stress testing seeks to
    understand how macro-shocks would deplete capital. Moreover, the stress
    tests are not as easy as fixed capital rules for firms to game. Despite
    these advantages, stress testing remains crude and static with respect
    to systemic effects, and is focused on the risks facing each individual
    firm. Although the goal of stress testing is to analyze and measure
    systemic risk, it is in many ways still stuck measuring the static
    effects of macro-shocks on units of capital at individual firms.
        While there have been significant recent advancements, our current
    stress tests fail to account for the increased interconnectedness and
    complexity of the financial system. The models do not yet capture the
    complex network of financial transactions that connect firms and that
    can spread and magnify risk in the event of a crisis. The models are
    not dynamic--meaning, they do not account for market participants'
    responses to stressful events. Such responses themselves may change the
    nature of the events in question. Moreover, even if these more robust
    models existed today, regulators do not, at least as of yet, have full
    access to the financial data needed to use the models to measure
    systemic risk.
        We need to continue to develop new ways of thinking about how to
    identify, measure, and mitigate systemic risks by drawing on methods
    from other disciplines and experience from other sectors that face
    systemic risks. We should explore how methods from other disciplines--
    such as system analysis, agent-based modeling, machine-based learning,
    behavioral finance, and data visualization and security--can be used to
    improve stress testing and financial risk management practices and
    regulation. We should also examine how risk is measured, monitored, and
    mitigated in other sectors and contexts, such as in supply chains and
    electrical grids, and in the context of climate change; how
    stakeholders in these contexts make tradeoffs between stability,
    efficiency, and innovation; and how lessons from these contexts should
    be applied or adapted to understand risks in the financial system.
        At the end of the day, no one model will be adequate to
    understanding and measuring risk in the financial system. We will need
    to improve stress testing, early warning, macro asset, equity, and
    credit price models, and other ex ante measures of risk. We will need
    to do better at crisis monitoring and response, including resolution of
    failing firms during a crisis. We will also need to develop better ex
    post analytics to understand the crisis that have occurred.
    The Path of Reform
        The Dodd-Frank Act laid a firm foundation for a more resilient
    financial sector, one that works for American families, instead of
    exposing us all to needless risk and harm. Since enactment, a new
    Consumer Financial Protection Bureau has been built from scratch. New
    rules governing derivatives have been implemented to bring trading out
    of the shadows and reduce risk through central clearing, capital and
    margin requirements. A resolution authority has been put in place to
    deal with failing firms so we are no longer faced with the devastating
    consequences of the failure of a firm like Lehman Brothers or the
    untenable bailouts of firms like AIG. Regulators have the ability to
    designate large firms for supervision by the Fed, so the financial
    sector can no longer avoid stringent regulation just by altering their
    corporate form. The largest firms have to hold a lot more equity
    capital as a buffer against losses, and the Volcker Rule, heightened
    prudential supervision, stress tests, and other measures are reining in
    risk.
        The U.S. financial system is more resilient than it was in 2008.
    But there's still much work to do.
        We need to keep pushing for stronger reforms of the largest, most
    complex banks and other financial institutions. Stress testing and new
    capital rules have dramatically increased the levels of capital at the
    largest firms, but we do not yet know whether these levels are
    sufficiently robust to withstand a severe financial crisis. A bank
    liability tax could help further reduce incentives to take on risky
    short-term debt. And shadow banking activities, repo and securities
    financing transactions, and other activities need to be made safer with
    strong margin and collateral rules. We need to better align manager's
    incentives with financial stability, by putting banker bonuses at risk
    when a firm's capital level drops below specified levels or when the
    firm is hit with fines or sanctions.
        More broadly, Fannie Mae and Freddie Mac remain in conservatorship
    without a decision about long-term housing finance; money market mutual
    funds remain susceptible to runs; certain high-frequency trading
    strategies and market structure problems threaten financial stability
    and undermine the fairness of our markets; and critical investor
    protection authorities have gone unused.
        To be clear: the financial system is safer, consumers and investors
    better protected, and taxpayers more insulated, than they were in
    2008--by a lot. But that is not enough. We need to stay on the path of
    reform to make the financial system safer, fairer, and better harnessed
    to the needs of the real economy. We need to keep pushing for a
    financial system that works for us.
           RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN SHELBY
                          FROM ROBERT DEYOUNG

        Thank you for inviting me to appear before the Committee on
    July 23, 2015, at the hearing on ``Measuring the Systemic
    Importance of U.S. Bank Holding Companies''. It is my pleasure
    to provide written answers to these additional questions.
        Please note that I have added one additional question to
    this list. Question (11) below is a question that was asked at
    the hearing by Senator Warren, but was not directed to me.

    Q.1. Enhanced prudential standards pursuant to Section 165 of
    Dodd-Frank impose additional costs and burdens on financial
    institutions and on the broader economy. Please identify what
    you believe to be the costs attributable to the current
    regulatory regime for bank holding companies above $50 billion
    because of the Section 165 requirements. In your opinion, has
    the Federal Reserve done an adequate analysis to determine how
    these burdens affect both the banks subject to Section 165 and
    the economy as a whole?

    A.1. All banks with more than $50 billion in assets should
    regularly perform some type of macroeconomic stress testing,
    regardless of whether it is mandated by Government regulators.
    Prudent risk management requires these banks to understand
    their vulnerabilities to potential changes in macroeconomic
    conditions.
        Stress testing requires increased spending on internal
    labor and/or external consultants. When these expenses result
    from a bank's internal risk management practices, they cannot
    be characterized as ``burden.'' However, any additional
    expenses beyond these--that is, expenses incurred by the bank
    to perform additional layers of testing mandated by Government
    regulators--by definition constitute regulatory burden. The
    expenses associated with preparing and submitting the Federal
    Reserve's annual CCAR fall largely into this category.
        Banks do not report these expenses publicly. However, in a
    May 18, 2015, American Banker article (``Banks Keep Mum About
    Stress-Test Costs, Clouding Reg Debate''), Chris Cumming
    reports that Wells Fargo allocated 128,000 labor hours to the
    CCAR task in the fourth quarter of 2014. Assuming a relatively
    low figure for salaries and benefits of $30 per hour, this
    amounts to $3.84 million in expenses for one quarter, or just
    over $15 million on an annual basis. This is a very rough
    estimate of the CCAR burden. It might be too high (e.g., the
    fourth quarter may have been peak time for the CCAR exercise)
    or too low (e.g., it does not include expenditures on external
    consulting, nor the lost output from diverting these workers
    from other tasks). In any case, this rough estimate
    demonstrates that the regulatory burden imposed on banks by the
    CCAR is nontrivial.
        It is important to note that the costs of complying with
    CCAR cannot simply be scaled up or down based on a bank's size,
    because much of the CCAR exercise entails fixed costs. For
    example, if a bank is only one-tenth the size of Wells Fargo
    ($160 billion in assets, versus $1.6 billion for Wells), the
    burden associated with CCAR will be substantially more than 10
    percent of the burden on Wells Fargo.

    Q.2. Is it possible that a very large bank could fail without
    causing widespread damage to the financial system? Please
    explain.

    A.2. This is surely possible. If the FDIC is allowed to
    exercise its Orderly Liquidation Authority (OLA), a large
    insolvent bank will be able to continue its operations. That
    is, the bank will be able to provide payments services for its
    depositors, make its insured depositors fully liquid, fulfill
    all of the credit commitments it has made to its borrowers,
    honor all of its short-term credit market contracts (e.g.,
    commercial paper, Treasury repos, purchased Fed funds), and
    honor all of its derivatives counterparty obligations.
        Under this scenario, there may be short-run spikes in
    financial markets, but these will be temporary and will
    dissipate as market participants observe that the bank is
    honoring all of its contracts and obligations. There should not
    be any widespread damage to financial markets. Indeed, as the
    FDIC establishes its reputation by exercising its OLA authority
    on multiple occasions, even these temporary disruptions should
    lessen.
        This is not to say that losses will not be taken. The
    bank's equity holders will take a 100 percent loss. Some or
    perhaps all of the bank's bondholders will take partial or full
    losses. And some of the bank's uninsured depositors may take
    partial losses. It is likely that the FDIC will also take
    losses in the short run, as it injects the funds necessary to
    recapitalize the bridge bank, as well as to offset any ongoing
    operational losses of the bridge bank and its subsidiaries.
    However, in the long run, the FDIC should be able to recover
    these losses with increased charges to the banking industry.

    Q.3. Is it possible that regulating all banks with $50 billion
    in assets as systemically important might actually encourage
    systemic risk rather than reduce it? Please explain.

    A.3. This is a novel theory. It is based on the presumption
    that any bank declared to be systemically important (a SIFI)
    will change its risk-taking behavior and begin to act like it
    is too big to fail (TBTF). But this is a false presumption. If
    a bank will not be bailed out, it cannot be a TBTF bank, and
    hence it will not take the additional risks typically
    associated with TBTF banks. Indeed, the FDIC has already
    established its ability to resolve banks in the general size
    range of $50 billion (e.g., IndyMac) and beyond (e.g.,
    Washington Mutual). For banking companies that are larger or
    more complex than these examples, the FDIC can now use its OLA
    powers of seizure and resolution. So if the FDIC is allowed to
    exercise its new resolution authority, then SIFI designation by
    itself will not encourage banks to take or create systemic
    risks.

    Q.4. At the hearing, you did not get an opportunity to respond
    to certain questions. I would be interested in your response to
    the following questions:
        Is it a good thing that large banks have more capital and
    less leverage?

    A.4. The increased equity capital requirements in Basel III for
    the most part represent an improvement. The inclusion of a
    plain vanilla minimum leverage ratio for all banks (which the
    U.S. has required for many years) was an important step. Even
    more important is the adoption of procyclical capital
    minimums--a macroprudential tool that will help reduce the
    buildup of excess bank credit during economic expansions, and
    will help prevent harmful reductions in bank credit during
    economic recessions.

    Q.5. Is it a good thing for large banks to have more liquidity
    than they did before the crisis?

    A.5. We have very little understanding of how mandatory
    liquidity minimums, such as Basel III's LCR and the NSFR, will
    influence bank risk taking in general or bank insolvency in
    specific.
        By itself, establishing higher capital minimums should
    prevent banks experiencing liquidity problems from failing. A
    clearly solvent bank can always access short run liquidity from
    the interbank market or from its central bank. This allows the
    bank to honor its short-term financial obligations, thus
    eliminating fire sales that drive down asset prices and
    investor flight from short-term credit markets.
        My fear is that the main effect of regulatory liquidity
    mandates, when placed on top of higher regulatory capital
    mandates, will be to reduce the creation of bank credit.

    Q.6. Comptroller of the Currency Tom Curry has made it his
    mission, in part, to install more enhanced prestige and stature
    with higher compensation for Chief Risk Officers at medium-
    sized and large banking institutions. Is that a good idea?

    A.6. It is a great idea, but it is unlikely to be effective. To
    the extent that Chief Risk Officers at large banking companies
    have too little prestige and stature, this is because of faulty
    corporate cultures. Regulators have a poor track record of
    affecting changes to corporate cultures.

    Q.7. Should large banks have strong risk management structures
    in place?

    A.7. Of course they should. For example, see my answer to
    question (1) above, regarding internal stress testing. But the
    most effective way to encourage strong risk management at banks
    is to credibly ensure that failed banks are never bailed out.

    Q.8. Should large banks be able to detail how they could fail
    safely?

    A.8. Again, we have very little understanding of how a
    resolution plan or ``living will'' will make it easier for
    either the FDIC or a bankruptcy court to efficiently resolve a
    failed complex banking company. These efforts may end up being
    helpful . . . or they may end up being 100 percent burden,
    imposed partially on bank shareholders and partially on
    taxpayers (who are paying for this new regulatory effort). All
    we really have at this point is a hope for the former.

    Q.9. Is it appropriate for large banks to conduct regular
    stress tests?

    A.9. Yes. See my answer to question (1) above.

    Q.10. Are capital structure, riskiness, complexity, financial
    activities, size, and other risk-related factors appropriate
    criteria to use as a basis for crafting prudential standards?

    A.10. Prudential standards start with capital structure. Banks
    should hold enough capital to (i) absorb 100 percent of the
    losses that a bank expects to incur under a historical worst
    case scenario and (ii) allow Government supervisors to observe
    large losses occurring in real time, well before the bank
    actually becomes insolvent.
        Banks' riskiness and banks' financial activities stem from
    banks' business models. They are of secondary importance for
    prudential regulation; regulators should set bank-specific
    capital minimums high enough to reflect these risks. Moreover,
    regulatory interference with banks' business models has the
    potential to cause more harm than good.
        Complexity for complexity's sake is not desirable and
    should be discouraged. Complexity that arises naturally from a
    bank's business model should be allowed. Complexity that arises
    due to compliance with Government regulation (e.g., the
    multibank holding company structures necessary to legally
    operate an interstate bank prior to 1996) calls for a
    reexamination of that regulation.
        Bank size should influence prudential regulation only for
    banks that are too large to fail. This would also hold for
    banks that are too complex to fail. In both of these cases,
    systemic risk is the underlying worry. But given the FDIC's new
    OLA powers, I believe that neither of these cases will be
    operative going forward, so long as the FDIC is permitted to
    seize and resolve large and complex insolvent banking
    companies.

    Q.11. At the hearing, I did not have the opportunity to answer
    the following question, which Senator Warren directed to just
    one of the other panel members. I paraphrase: ``Could the
    simultaneous failure of multiple banks, each of which holds
    assets of $100 billion, cause systemic risk?''

    A.11. Again, I point out that the FDIC has already established
    its ability to resolve banks in this general size range
    (IndyMac, Washington Mutual) during quite difficult
    macroeconomic conditions. The FDIC's ability to perform large
    bank resolutions has only been strengthened by its new OLA
    powers.
        There is nothing about ``simultaneous'' large bank failures
    that changes this assessment. If an OLA-based seizure and
    resolution works as designed, the failed bank will not default
    on any contracts or obligations with its insured depositors,
    with its line of credit customers, with its counterparties in
    credit markets, or with its counterparties in derivatives
    markets. As it becomes clear that all of these contracts are
    being honored, any disruptions in credit markets (e.g.,
    commercial paper) and asset markets (e.g., loan-backed
    securities) will be minimal.
        One potentially limiting factor is the length of time that
    the FDIC needs operate these banks prior to selling their
    assets (in whole or in parts) back into private hands. If these
    multiple bank failures occur during a recession, the FDIC will
    likely need to operate these banks for several years before
    they are stabilized. In this case, many commentators will argue
    that ``we have nationalized these banks.'' This is obviously an
    incorrect statement, as the goal is stabilization, not
    ownership. But such an argument could create political pressure
    for the FDIC to sell the insolvent banks too quickly--or
    perhaps even create pressure to bail out these banks rather
    than invoke OLA powers.
        Thank you again for soliciting my opinion on these issues
    of importance to the U.S. banking industry. Please do not
    hesitate to contact me regarding clarification or additional
    questions.