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S. HRG. 113–481 

WHAT MAKES A BANK SYSTEMICALLY 

IMPORTANT? 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS AND CONSUMER 

PROTECTION 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED THIRTEENTH CONGRESS 

SECOND SESSION 

ON 

EXAMINING THE CHARACTERISTICS OF BANKS THAT MAKE SOME OF 

THEM SYSTEMICALLY IMPORTANT 

JULY 16, 2014 

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

( 

Available at: http://www.fdsys.gov/ 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JOE MANCHIN III, West Virginia 

ELIZABETH WARREN, Massachusetts 

HEIDI HEITKAMP, North Dakota 

MIKE CRAPO, Idaho 

RICHARD C. SHELBY, Alabama 

BOB CORKER, Tennessee 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

TOM COBURN, Oklahoma 

DEAN HELLER, Nevada 

CHARLES YI, Staff Director 

GREGG RICHARD, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

TAYLOR REED, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

SHERROD BROWN, Ohio, Chairman 

PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

JON TESTER, Montana 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

ELIZABETH WARREN, Massachusetts 

RICHARD C. SHELBY, Alabama 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

JERRY MORAN, Kansas 

DEAN HELLER, Nevada 

BOB CORKER, Tennessee 

GRAHAM STEELE, Subcommittee Staff Director 

TONNIE WYBENSINGER, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

WEDNESDAY, JULY 16, 2014 

Page 

Opening statement of Chairman Brown ................................................................ 1 

Opening statements, comments, or prepared statements of: 

Senator Toomey ................................................................................................ 9 

WITNESSES 

Richard J. Herring, Jacob Safra Professor of International Banking, The 

Wharton School, University of Pennsylvania .................................................... 3 

Prepared statement .......................................................................................... 30 

James B. Thomson, Professor and Finance Chair, University of Akron ............. 5 

Prepared statement .......................................................................................... 110 

Robert DeYoung, Capitol Federal Distinguished Professor in Financial Markets and Institutions, University of Kansas School of Business ...................... 6 

Prepared statement .......................................................................................... 115 

Paul H. Kupiec, Resident Scholar, American Enterprise Institute ..................... 8 

Prepared statement .......................................................................................... 116 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter from Paul Saltzman, President, The Clearing House Association L.L.C., 

Executive Vice President and General Counsel of The Clearing House Payments Company L.L.C., submitted by Chairman Brown .................................. 135 

Statement submitted by Christy L. Romero, Special Inspector General for 

the Troubled Asset Relief Program .................................................................... 138 

(III)

(1) 

WHAT MAKES A BANK SYSTEMICALLY 

IMPORTANT? 

WEDNESDAY, JULY 16, 2014 

U.S. SENATE, SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER

PROTECTION, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Subcommittee met at 10:24 a.m., in room SD–538, Dirksen 

Senate Office Building, Hon. Sherrod Brown, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN SHERROD BROWN 

Chairman BROWN. Welcome. The Subcommittee will come to 

order. First, apologies to the witnesses and those in attendance for 

the sort of truncated way we are doing this today. There was a vote 

called late yesterday to be held at 10:15 today. So we have at least 

two Members of the Subcommittee who I think will join us. Senator 

Toomey, the Ranking Member, will have—normally he would do an 

opening statement after I would, and because he was not able to 

vote and come back as quickly, at the conclusion of the testimony 

of the four of you, Senator Toomey will certainly be given the right 

to do an opening statement, as any other Senators who join us will. 

Three regional banks are headquartered in my home State of 

Ohio, one in each of the three biggest cities—Cleveland, Cincinnati, 

and Columbus. They serve customers throughout the State with 

other regionals located/headquartered in other States obviously 

serving Ohio, too. 

These banks operate under a very traditional banking model. 

The CEO of one of them talked about her bank as a ‘‘core funded 

bank,’’ the term she used. They take deposits, they lend lending to 

families and small businesses. Each has assets of over $50 billion, 

making them subject to enhanced supervision by the Federal Reserve. 

While nonbanks are judged based upon a specific set of criteria, 

the Dodd-Frank Act requires all banks, as we know, with more 

than $50 billion in assets to automatically be viewed as systemically important. 

Each of these three Ohio banks serves an important role in the 

communities they serve, but from what I can tell, none of these regional institutions would threaten the United States or global financial system or economy if they were to fail. 

Many in Washington attack the Financial Stability Oversight 

Council, or FSOC, for designating institutions as systemic. Let us 

2 

be clear: the $50 billion line was created by Congress, not by 

FSOC. 

Some Washington politicians say that this systemically important designation means that all of these banks are, in parlance we 

used, ‘‘too big to fail.’’ But financial regulators say that the failure of a $50 or a $60 or a $100 billion bank would not, in fact, threaten the financial system. 

This group of 33 banks contains banks with diverse business 

models—universal banks, regional banks, trust banks, and foreign 

banks—and diverse geographic footprints—Columbus, Ohio; Pittsburgh, Pennsylvania; Montreal; Salt Lake City, Utah; Santander, 

Spain. They range in size from $2.4 trillion, the largest, in assets, those that have been designated, to $56 billion; from operating in 100 

countries to operating in just one. Clearly, these banks are not the 

same. 

That is why other rules use different thresholds. For example, banks with $250 billion are subject to a liquidity coverage ratio; 

banks with more than $700 billion in assets must meet a supplementary leverage ratio. 

It is clear that regulators believe that these institutions present 

different levels of risk. In May, Governor Tarullo said that banks 

between $50 and $250 billion—which all three of these Ohio banks 

are, incidentally—are ‘‘overwhelmingly recognizable as traditional 

commercial banks (though a few do have significant capital market 

or other activities).’’ 

So today we are exploring what makes a bank systemically important by looking at issues like size and leverage and business 

model and funding sources. We will consider what the failure of a $100 billion bank, a $300 

billion bank, or a $1 trillion bank might mean for the financial system and the economy. 

We will look at tools that regulators have—or should have, or 

your suggestions need to have—to prevent the failure of a systemically important bank, or to protect taxpayers and the economy if 

one does, in fact, fail. 

It is important that we strike the right balance between identifying the institutions and activities that present the most risk 

while not becoming complacent and not taking our eyes off of potential sources of risk. 

I thank the witnesses, and let me introduce each of you, and we 

will begin the testimony. As I said, at the conclusion of your remarks, if other Senators want to make opening statements, they 

certainly can. 

Dr. Richard Herring is the Jacob Safra Professor of International 

Banking at the University of Pennsylvania’s Wharton School, codirector of the Wharton Financial Institutions Center. Professor 

Herring is a member of the Systemic Risk Council at the FDIC’s 

Systemic Resolution Advisory Committee. Welcome, Dr. Herring. 

Dr. James Thomson is the finance chair at the University of Akron’s College of Business Administration. Prior to joining the University of Akron, Professor Thomson held multiple roles at the Federal Reserve Bank of Cleveland, including vice president and finanVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
3 

cial economist. He worked as a financial economist at the independent General Accounting Office. He calls Mentor, Ohio, his 

home. Welcome, Dr. Thomson. 

Dr. Robert DeYoung is the Capitol Federal Professor in Financial 

Markets and Institutions at the University of Kansas School of 

Business. In addition to his work with the university, Professor 

DeYoung is a visiting scholar at the Federal Reserve Bank of Kansas City and a senior research fellow at the FDIC’s Center for Financial Research. Prior to joining the faculty, Professor DeYoung 

was an Associate Director of Research at the FDIC, Economic Adviser at the Federal Reserve Bank of Chicago, and a Senior Financial Economist at the Office of the Comptroller of the Currency. 

Dr. Paul Kupiec is a resident scholar at the American Enterprise 

Institute. He joined AEI from the FDIC where he held multiple 

roles, including Director of the Center for Financial Research. His 

past experience includes positions at the IMF, Freddie Mac, the 

Board of Governors of the Fed, the Bank for International Settlements, and JPMorgan’s Risk Metrics Group. From 2010 to 2013, 

Dr. Kupiec served as Chair of the Basel Committee on Bank Supervision Research Task. 

Welcome to the four of you. Dr. Herring, if you would begin, keep 

your comments as close to 5 minutes as you can, and after your 

conclusion, we will move on. Dr. Herring. 

STATEMENT OF RICHARD J. HERRING, JACOB SAFRA PROFESSOR OF INTERNATIONAL BANKING, THE WHARTON 

SCHOOL, UNIVERSITY OF PENNSYLVANIA 

Mr. HERRING. Thank you very much, Chairman Brown. I am 

grateful for the opportunity to testify this morning on what I think 

is a very important issue. 

Interestingly, the very question of whether and whether it is possible to identify systemically important banks still divides experts. 

Some people feel that it is both impossible and dangerous to categorize such institutions. I think this is actually unrealistic because we know they exist. We have seen how they benefit from 

Government intervention. And instead the question should be how 

we, in fact, limit the category, perhaps reduce it, and try to devise 

procedures to make these institutions safe to fail. 

There has been considerable effort to actually try to devise indicators that would help us understand what this category looks like. 

The most refined set have been produced by the Financial Stability 

Board and, of course, amended and revised by FSOC. They include 

size, and I quite agree with you that size is by no means the only 

distinguishing feature, and the $50 billion threshold is way too low. 

They would included interconnectedness, which involves certainly 

capital market interconnections; cross-border activity; complexity; 

and the lack of substitutes for the services they provide in the global economy. 

These all give you different dimensions. I think they are all important, but I think they are not sufficient in and of themselves. 

In addition, there have been considerable efforts in both the official world and the academic world to model sources of interaction 

and to try to understand the drivers of systemic risk. I think both 

of these activities are worthwhile. I certainly think they will give 

4 

us better insights into what actually drives this problem. But I 

think in some sense they miss the point. 

As a practical matter, what makes an institution systemic is the 

decision of regulators to intervene and support. And I think it is 

pretty easy to understand the process. 

When you are standing on the brink of what you fear may be a 

crisis because you do not know the reactions, I think the key determinant for regulators is whether they have resolution tools that 

they think are reliable. And during the crisis, they did not. So time 

after time we saw sleepless weekends in which regulators devised 

really desperate bailout measures that, in the end, probably undermined safety and soundness of the system, but bought it at a very 

high price in the short term. 

The one time they failed to do so with regard to Lehman Brothers indicated why they have taken such pains. Although some people would regard that as a useful application of bankruptcy policy 

in the United States, I think there is no doubt in the rest of the 

world it was hugely damaging. And, in fact, we are still trying to 

deal with the pieces in something like 60 to 70 different bankruptcy proceedings around the world. 

While Dodd-Frank, I think, deserves a lot of credit for trying to 

deal with this problem, part of it simply tries to reduce the probability of failure by increasing the quality and quantity of capital, 

which I think is very worthwhile. There are other measures which 

also may be important, but I think we should recognize that it 

never will and never should make these institutions fail-safe, because, in fact, banks add value to the economy by taking prudent 

risks—by intermediating between borrowers and savers, by buying 

and selling risk, and providing reliable payment systems. 

But I think the most important part of Dodd-Frank and, in fact, 

the most remarkable change in the regulatory landscape is the attempt to provide better resolution tools. It begins with living wills, 

which are supposed to describe the plans that a bank has for rapid 

solution and the unwinding of the bank, without creating crisis situations for others. These are massive plans. I think there is a danger that some of them are too big to understand, which is a whole 

new category, at 10,000 pages. But also I think there is a huge lost 

opportunity in public disclosure. If we want them really to work, 

we need to inform the public about what the priorities will be and 

exactly how the authorities will intervene. 

In addition, we need better resolution tools. There is a huge effort underway at Stanford Hoover to provide better bankruptcy 

proceedings. It has just been put on the Web site. There is a Chapter 14 proposal that has been the result of an enormous amount 

of work by a group of academics. And, of course, there is the Title 

II resolution procedure by the FDIC. This involves putting the 

FDIC in a whole new role trying to cope with the unwinding, actually the surgical intervention in a large, sick institution, literally 

over a weekend. They need to pull the trigger. They need to intervene over the weekend, stabilize, provide capital and liquidity, and 

open up the systemically important operations. 

There are several obstacles that all three of these—both of these 

resolution procedures face. One of them is how to override ipso 

facto clauses that could undermine it all. Two is how to provide 

5 

sufficient liquidity to maintain confidence. Three is how to sustain 

international cooperation. And four is something actively considered by the Fed just now: how much debt to require at the holding 

company level. 

I would argue, finally—and this is the end—that not only the 

level of debt is important but also the kind of debt. I think that 

if we do not take the opportunity to think about this carefully, we 

will have missed an important opportunity to improve incentives 

for banks to manage their risk more effectively and to recapitalize 

more promptly. But this would require, I think, looking very carefully at the Tax Code because the main hurdle to adopting something like a CoCo appears to be the IRS’ reluctance to permit interest payments on CoCos to count as deductions in looking at taxable 

income. 

Thank you very much. 

Chairman BROWN. Thank you very much, Dr. Herring. 

Dr. Thomson. 

STATEMENT OF JAMES B. THOMSON, PROFESSOR AND 

FINANCE CHAIR, UNIVERSITY OF AKRON 

Mr. THOMSON. Thank you, Senator Brown and Members of the 

Committee, for the opportunity to speak here today. The focus of 

this hearing, identifying the factors that make a financial institution systemically important, is the first step in designing an institutional and legal framework to rein in the risk of these systemic 

firms post to the financial markets and ultimately the macroeconomy. 

Viewing systemic spillovers as market failure, we need to identify the source, severity, and whether the failure merits Government intervention, and if so, the most economically effective way 

to structure that intervention. 

During a 30-year career as a financial economist, I have studied 

financial markets, banking, payment systems, failed bank resolution, and the Federal financial safety net from a public policy perspective. The ideas I express today are informed by reading and research I have done in these areas, especially papers on systemically 

important financial institutions, the need for an asset salvage 

agency, and systemic banking crises. 

One of the things I want to sound today is that ‘‘too big to fail’’ 

is a misleading term. Size is not the only distinguishing characteristic that makes financial firms systemic. Through my research in this area, I have identified four characteristics, what I 

call the four C’s of systemic importance: contagion, correlation, concentration, and context or conditions. 

The factors that lead to institutions being treated as systemically 

important tend to be prevalent in the larger firms, and that is why 

size shows up on the list. 

In my written statement, I stress how each of these four C’s has 

been part of the rationale for generous Government treatment of 

the creditors, managers, and stockholders of troubled financial 

firms. It is important to emphasize that the decisions on how we 

handle economically failed institutions are themselves an important source of systemic risk. We need to understand whether an inVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
6 

stitution authorities label as systemic in the handling of its economic insolvency are truly systemic or merely politically expedient. 

The Dodd-Frank Wall Street Reform and Consumer Protection 

Act, enacted in 2010 in response to the recent financial crisis, contains numerous reforms to the financial system and supervisory infrastructure. In my written statement, I provide my thoughts on 

Dodd-Frank’s provisions dealing with systemically important institutions. In the interest of time, I will skip over that section of my 

written statement and spend my remaining time on the need for 

supervisory contingency or disaster plans—a missing element of reform. 

Systemic importance reflects constraints faced by financial market supervisors in enforcing timely closure rules. It does not matter 

what powers Congress gives financial supervisors to conduct orderly resolutions of financial companies if the regulators remain reluctant to use them. A major step forward to limiting systemic importance is requiring financial system supervisory agencies to develop and to commit to contingency plans for handling the failure 

of one or more systemically important financial firms. 

These contingency plans should contain a series of options, actions taken to contain systemic spillovers, with blanket guarantees 

of all creditor/counterparty claims to be, without exception, the last 

option on the list. Scenario analysis should be used to test and refine these disaster plans. Much as Dodd-Frank Section 165 resolution planning by systemically important firms is intended to promote the orderly resolution of these firms—whether it be through 

bankruptcy or through FDIC receivership—supervisory disaster 

plans should allow for resolution of systemic firms with the least 

impact on long-term incentives facing these firms. 

Dodd-Frank was hailed by its drafters as the antidote to too big 

to fail. While provisions in this important reform legislation move 

us toward the goal of reining in the effects of systemic importance 

in the financial system, much remains to be done. 

Thank you. 

Chairman BROWN. Thank you, Dr. Thomson. 

Dr. DeYoung. 

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

Mr. DEYOUNG. Thank you, Senator Brown, for inviting me to address the Committee today. 

When you invite four economists to address the Committee and 

the first three of them tell you virtually the same thing, I think 

you will be happy. My remarks are quite consistent with what Professor Thomson and Professor Herring had to say. 

The Dodd-Frank Act contains new measures aimed at reducing 

systemic risk at U.S. financial institutions. From my perspective, 

these measures can be divided relatively neatly into two different 

categories. 

On the one side, we have ex ante measures that try to make 

banks’ balance sheets resilient to systemic macroeconomic events. 

Some key examples of this, of course, are higher minimum capital 

ratios, liquidity ratios, and regulatory stress tests. 

7 

On the other side, we have ex post measures that try to limit the 

amplification of systemic events—contagion—caused when banks 

default on their financial obligations. This approach centers on the 

FDIC’s orderly liquidation authority and the information made 

available to the FDIC in living wills. 

It has been my observation that we pay most of our attention to 

the ex ante systemic risk prevention measures—they are important 

measures—setting rules and limits for banks; and we tend to have 

less confidence in ex post measures designed to contain systemic 

risk once it rears its head. 

In 2006, just a year before the financial crisis began, the average 

U.S. banking company had nearly double the risk-weighted capital 

ratios necessary to be deemed ‘‘well capitalized’’ by bank regulators; 95 percent of all banking companies at that time cleared the 

adequately capitalized threshold by at least 300 basis points. As we 

know, these large stores of equity capital were not by themselves 

large enough to prevent hundreds of bank insolvencies in the years 

that followed. Accordingly, Dodd-Frank and Basel III require higher levels of capital for banks. As I said, this is clearly important 

and a step that we must take. But we cannot forget that restrictions like these impose costs on banks that ultimately result in 

fewer financial services being provided. 

Now, in the shadow of the financial crisis, this may seem like a 

very wise tradeoff. We accept less lending and slower economic 

growth in exchange for a reduction in the severity of the next systemic financial event. But the orderly liquidation powers in DoddFrank provide us with a historic opportunity to avoid having to accept this tradeoff. OLA should allow us to not only limit the contagious aftereffects of a systemic crisis, but also to establish a 

newly credible regulatory regime that is devoid of the too-big-to-fail 

incentives that have so long fostered risk in our financial system. 

The economic logic is a straightforward story. When investors become convinced that large complex banks will, in fact, be seized 

upon insolvency—with shareholders losing everything and bondholders suffering losses—then credit markets and equity markets 

will more fully price bank risk taking; profit-seeking banks will 

then face clear incentives to reject high-risk investments ex ante. 

That is the economic story, but the political story is far from 

straightforward. OLA requires bank regulators to credibly establish 

that they can and will seize, unwind, and eventually liquidate large 

complex insolvent banks. The FDIC’s ‘‘single point of entry’’ plan 

I think is a workable plan. Nevertheless, in my discussions with 

scores of banking and regulatory economists across the country, I 

meet with a near uniform skepticism that the FDIC will be permitted to fully exercise its new resolution authorities during a financial crisis when multiple large banking companies are nearing 

insolvency. Essentially, their belief is that the deeper the financial 

crisis, the greater the probability that OLA will be suspended. 

So, in my opinion, the most important actions that Congress and 

the administration could take to limit systemic risk in the financial 

system is to strongly and repeatedly enunciate their support of orderly liquidation authority and to pledge that they will not stand 

in the way of its implementation during a deep financial crisis. Our 

banking system is most effective when scarce economic resources 

8 

are moved from poorly managed banks to well-managed banks. 

Hence, we do not want a banking system that is devoid of bank 

failure; rather, we want a banking system that is resilient to bank 

failure. And I think orderly liquidation authority is essential to establishing this resiliency. 

Thanks again for inviting me, and I look forward to any questions you might have. 

Chairman BROWN. Thank you, Dr. DeYoung. 

Dr. Kupiec. 

STATEMENT OF PAUL H. KUPIEC, RESIDENT SCHOLAR, 

AMERICAN ENTERPRISE INSTITUTE 

Mr. KUPIEC. Thanks, Chairman Brown, Ranking Member 

Toomey, and distinguished Members of the Subcommittee. My written testimony addresses the specific questions posed in the Subcommittee’s letter of invitation. In my oral testimony, I am going 

to skip over the details for the most part and provide an overall 

perspective on the issues that are raised in this hearing. 

The Dodd-Frank Act made sweeping changes in the way U.S. 

banks and financial markets are regulated. Four years on, required 

rulemaking continues, and the implications of the legislation are 

only still being discovered. 

The overarching Dodd-Frank goal is to prevent another financial 

crisis, and I doubt anyone would speak against this goal. But in attempting to achieve the goal, Dodd-Frank includes a large body of 

poorly balanced legislation. It grants regulatory agencies vast new 

powers to regulate and allows these powers to be exercised with almost no checks and balances. 

The power and discretion granted by the act are problematic because the duties and responsibilities assigned by the act are vague 

and ambiguous. The agencies and the FSOC are directed to exercise new powers to ensure financial stability and mitigate systemic 

risk. But financial stability and systemic risk are never defined in 

the legislation. 

The mix of new unchecked powers and vague, ambiguous goals 

is a toxic for economic growth. For example, what does ‘‘ensure financial stability’’ mean? Does it mean regulators need only focus 

on preventing another financial crisis? Is that the only job? 

The duties and responsibilities assigned by the act never recognize a link between economic growth and financial intermediation. 

Financial intermediation is necessary for economic growth, and if 

intermediation is restricted, economic growth will suffer. Financial 

crises devastated economic growth because the crises interrupt financial intermediation. Similar forces operate in noncrisis times. If 

regulations impede financial intermediation, they will also reduce 

economic growth. 

The Dodd-Frank Act does not recognize this tradeoff. Instead, it 

builds in a bias for overregulation. There is no regulatory reward 

for preventing a financial crisis, but regulators will certainly be 

disgraced, if not punished, should there be another financial crisis. 

So what are their incentives? 

The issue is analogous to monetary policy where decades ago it 

was recognized that price stability cannot be the only goal of the 

Federal Reserve. It must balance price stability against goals of enVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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couraging employment and economic growth. The Dodd-Frank Act 

lacks this balance and instead directs agencies to use their new 

powers to stop bad intermediation. But do regulators, councils, or 

even us economists have the judgment and ability to identify and 

stop only bad financial intermediation? And is this ability so trusted that we should be able to carry out this vague assignment without supervision and review? 

History suggests not, but this is what the Dodd-Frank Act does. 

Section 113 of the Dodd-Frank Act provides a concrete example. It 

grants the FSOC the power to designate nonfinancial intermediaries for enhanced prudential supervision and regulation by 

the Board of Governors. The standard for designation is vague. It 

puts very few constraints on the FSOC’s designation ability. For 

example, the FSOC is not required to identify specific issues or features that mandate designation or demonstrate how an FSOC designation will mitigate risk. And so the FSOC has not provided 

these details. 

There is no link to Title I orderly resolution plans in that statute 

even though a key standard for designating a firm involves the risk 

that failure of the firm generates systemic risk. Why isn’t a firm 

required to submit a resolution plan as part of the designation 

process? Would a good review preclude designation? Perhaps. But 

then the adequacy of the orderly resolution plan is determined solely by the regulators’ subjective judgments, so maybe the added 

work would not amount to much. 

In my written testimony, I discuss many specific examples where 

underlying imbalances of the Dodd-Frank Act lead to overregulation. Other specific examples of overregulation include designating 

all bank holding companies larger than $50 billion for heightened 

supervision and prudential standards. 

Another example is the Board of Governors’ stress test and the 

power for regulators to restrict the use of short-term debt. 

I have also discussed instances where the new Dodd-Frank Act 

powers will not achieve intended goals. In particular, I identify 

missed opportunities regarding duties assigned under the Title I 

orderly resolution plan process, and I also point out serious shortcomings in Title II orderly resolution authority. 

Under the FDIC’s single point of entry resolution strategy, Title 

II creates new uncertainties for the resolution of large financial institutions, and it potentially extends the Government’s safety net 

beyond the guarantees provided under the deposit insurance resolution system. 

Thank you, and I look forward to your questions. 

Chairman BROWN. Thank you, Dr. Kupiec. 

Senator Toomey is recognized for an opening statement. Thank 

you. 

STATEMENT OF SENATOR PATRICK J. TOOMEY 

Senator TOOMEY. Thank you, Chairman Brown. I want to thank 

our witnesses for joining us today. This is an important topic. 

Dodd-Frank obviously deals with the whole too-big-to-fail issue in 

a number of ways. One of the major ways is through the SIFI designations, which I would argue then precipitate the micromanagement of these financial institutions by a host of regulators in what 

10 

will, in my view, ultimately be a futile attempt to make failure impossible. 

I see a lot of problems with this approach. One is that institutions end up being designated as SIFIs, despite the fact that they 

are not systemically dangerous to our economy. 

The second problem is that the layers of regulations impose real 

costs. There are direct costs of compliance, and then there are all 

the indirect costs of a reduction in innovation and dynamism that 

comes when regulators have the power to run these financial institutions like public utilities, which is really where we pretty much 

are. 

And, finally, of course, the regulators themselves, as we know, 

are not omniscient. They are not going to be perfect. They are not 

going to always get it right, and in the end, eventually institutions 

will fail anyway. 

Dodd-Frank deals with the failure itself, of course, through the 

orderly liquidation authority, the failure of a SIFI, and I have 

major, major reservations about this. Some of the problems that 

worry me is, number one, the highly subjective nature of this process; the extensive discretion that is given to the regulators in implementing it; the fact that there is no real option for restructuring 

when; in fact; that might be the best solution for an institution; the 

fact that creditors have no certainty because we grant discretion to 

the regulator to decide which of the various equally standing creditors are more equal than others; and, finally, there is an explicit 

bailout mechanism that is written into the statute in the orderly 

liquidation authority, and I thought we wanted to move in a direction where we would not permit taxpayers to have to be bailing out 

these institutions. 

So I will now blatantly and shamelessly plug my bill, Mr. Chairman, which repeals the orderly liquidation authority and instead 

makes the necessary reforms to our Bankruptcy Code so that in the 

event of the failure of a large complex financial institution, we 

would have a rules-based, transparent, credible way to resolve that 

institution without all of these problems that I think are inherent 

in the orderly liquidation authority. But I digress, and I appreciate 

your indulgence. 

The issue more at hand I think for this hearing is some of the 

problems that Dodd-Frank imposes, particularly on regional banks. 

This goes right to the issue of designations. In my view, there is 

nothing magic about a $50 billion threshold above which we ought 

to automatically assume every institution is systemically important 

and significant and dangerous. That threshold, of course, gives no 

consideration to the activity of the bank, the nature of the bank’s 

activities and whether or not it gives rise to these risks. And then 

the overregulation that comes with the enhanced prudential standards are enormously problematic. 

A couple of issues that I would like to hear about today that concern me as they affect regional banks is the liquidity coverage 

ratio. Again, it seems to me that this rule will treat regional banks 

as though they were very large, complex, internationally active, 

money center Wall Street-type banks, when, in fact, the nature and 

activity of these regional banks is nothing like that of the large, 

complex, money center banks. 

11 

The comprehensive capital analysis and review and the supervisory stress tests, another very, very onerous regulation that we 

could debate whether or not it makes sense for the biggest of 

banks. I do not see how we can defend the proposition that small 

regional banks with a simple business model should be subject to 

the same kinds of tests. 

So these would be some of the things I hope we can discuss, Mr. 

Chairman. I do oppose the overall framework of Dodd-Frank, but 

it seems to me a couple of the most egregious laws are subjecting 

financial institutions that are not, in fact, systemically risky to 

these very onerous regulations imposes a real cost. At the end of 

the day, it means credit is less available and less affordable for 

American consumers and businesses, and that is what is happening 

today that I believe is a direct result of Dodd-Frank. And so I am 

looking for ways to relieve that problem that we have created. 

I thank you for your indulgence. 

Chairman BROWN. Thank you, Senator Toomey. Let us begin the 

questions. 

Observers note the financial system was generally able to absorb 

in 2007 and 2008 the failures of regional banks and thrifts. Perhaps one of the most notable was in Dr. Thomson’s home State, 

Cleveland, with National City absorbed by PNC out of Pittsburgh, 

causing certain hardship in that city, in our State, and job loss. But 

the system absorbed it without great damage, obviously, to the stability of the system. FDIC sold a $307 billion Washington Mutual 

at no apparent loss to U.S. taxpayers. 

So my question to all four of you, and I will start, Dr. Herring, 

with you: What would happen today if a $250 billion or a $150 billion or a $50 billion systemically important bank, SIFI-designated 

bank, were to fail? Would we need a megabank like JPMorgan to 

absorb it, to rescue it? As you answer that, each of the four of you, 

talk to us about industry concentration, if that would be the logical 

outcome of more concentration as we saw between 2007 and 2010. 

Dr. Herring. 

Mr. HERRING. I certainly agree that the legislation sets the threshold way too low. There is nothing magical about $50 billion. 

I would argue that—well, if you take a look at the Financial Stability Board’s list of global systemically important institutions, it 

contains 8 American banks out of 29 international. And that range 

of eight banks ranges in size from JPMorgan Chase, which is about 

$2.4 trillion, down to State Street Bank, which is about $220 billion. So the current criteria do have a nuanced effect. They do rely 

on much more than just size. And I think it is highly unlikely that 

any bank that has a strictly regional footprint should really be regarded in the same rubric at all. And I quite agree that overregulation is a tremendous threat, that, in fact, the biggest growth in the 

banking industry over the last 3 years has been in the employment 

of compliance officers. Having some is good, but certainly that 

should not be the main thrust of bank growth these days. 

On the other hand, I think it is dangerous to rely on forced mergers that are arranged over a weekend as a way out. I think one 

of the huge mistakes that was made during the crisis was relying 

on really Government-assisted concentration in the system. I think 

we have ended up with the result where we started with banks 

12 

that were too big to fail and ended with banks that are emphatically too big to fail, which is a terrible mistake. 

I think the resolution process should make sure that the bank 

that emerges from the resolution process is no longer too big to fail 

in any dimension. If that means breaking it up into smaller banks, 

I think that is a good thing to do. We do not want these institutions rattling around that can cause the regulators to take destructive actions in the belief that they are saving the system in the 

short run but actually undermining long-term discipline. 

So I have enormous sympathy with the thought that you should 

treat these smaller banks and the larger regionals quite differently, 

but I am not sympathetic to the thought we should merge them 

with the giants. 

Chairman BROWN. So, Dr. Thomson, what would happen if one 

of them failed? 

Mr. THOMSON. I do not think the implications of one of them failing other than the impact on the region itself is going to be that 

great. It is not going to send the shock through the financial system that taking down a very large institution would, because quite 

simply they are not as interconnected, they are not carrying as 

much of the off-balance-sheet types of risks that are more difficult 

to trace. And I think from the standpoint of employment in the region, the failure of a large regional bank is an issue, but it is not 

a threat to the national financial system. You will get some local 

impacts on credit availability, and I think the big trick here is the 

way we have always dealt with large company failures is to find 

a larger company to put them into, creating larger and larger companies. So we go from a financial system where the top 10 or 15 

banks had about half the assets to one where the top 4 have something on order of like 70 percent of the assets? 

So I agree with Dr. Herring that we need to find a way to do this 

that does not just assemble these megabanks and that takes into 

consideration that the end product will not be a bigger bank that 

is a bigger problem than what we had to begin with. 

Chairman BROWN. Dr. DeYoung. 

Mr. DEYOUNG. Well, I also agree with Professor Herring that a blanket $50 billion threshold for SIFIs is too low. FSOC has the authority to declare a bank a SIFI regardless whether it is a larger 

or smaller than that. So the blanket at $50 billion is too low. 

You asked about concentration. I want to make clear that the 

concentration of power and influence among a smaller number of 

financial institutions is far more dangerous than any pricing or 

market power concentration that would happen. The banking system in the U.S. is far from concentrated in a pricing standpoint. 

We have high levels of competition. Concentration of large banks 

together is more of a question of whether they gain influence. And to your question about what would happen if a $200 or $300 

billion bank failed, a systemically important bank failed, well, I am 

going to line up with Dodd-Frank and say that the FDIC would 

then exercise its orderly liquidation authority, if allowed to do so. 

The question is—there are two questions here. One is whether they 

are allowed to do so, and I have no horse in this race. I know Senator Toomey favors a rewriting of the bankruptcy laws to allow us 

to handle bank insolvencies that way. The issue is that we actually 

13 

do it and we actually are able to resolve these systemically important institutions without disrupting financial markets. And I believe we can do it within the OLA authority within the Government. We can do it through a rewriting of the banking laws. Either 

way, the crucial thing is we actually do it and establish credibility 

that it will be done. And I have had occasion to speak with the 

folks at the FDIC a couple of times about how they would do it, 

and specifically how quickly this process would run. And I myself 

would prefer a slow process in which contracts are allowed to run 

off, the bank is allowed to stabilize. Yes, we have losses, but we 

do not race in order to find a buyer for that bank, that we use the 

word ‘‘liquidation’’ and that we take that word seriously, that we 

stabilize the bank, we liquidate it if possible into pieces, and not 

resolve that at the end through some kind of a large purchase and 

assumption merger. 

Chairman BROWN. Thank you. 

Dr. Kupiec. 

Mr. KUPIEC. Thank you very much, Chairman Brown. This is a 

very important question, and it is actually a question that is at the 

heart of the whole SIFI designation Dodd-Frank process. 

When you say would a bank of this size be systemically important and should it be designated, well, if it fails in isolation, certainly not. What happens if it fails in a real crisis when many 

banks are failing? That is the problem. And the problem in DoddFrank, Dodd-Frank is ambiguous. It does not say when a failure 

is supposed to cause systemic risk. And this is a real ambiguity, 

so you do not know how the FSOC or anybody else is actually evaluating the circumstances surrounding the failure, and that is an 

ambiguity that really should be taken care of. We need to specify 

under what conditions it will be a problem. 

I have suggested in my written testimony—I have a pretty 

lengthy part on it, on this issue, about regional banks, and I agree 

with my colleagues that a regional bank should be broken up, and 

that—if it could be broken up in a resolution, that means it is not 

systemic. 

What I think this needs to mean—and this is my reference to the 

lost opportunity under the Title I authority—is that when you do 

an orderly resolution plan and submit it to the FDIC and the Federal Reserve Board, the FDIC should be required to figure out that 

if that bank were to be taken into a regular FDIC resolution, not 

a Title II resolution but through the normal FDIC resolution process, how would the FDIC break that bank apart? 

Now, there are a lot of problems with breaking a bank apart. 

Historically, when the FDIC gets a big bank, it sells the bank in 

a whole-bank transaction. And there is a legal reason for that. 

Under FDICIA, the FDIC is required to resolve a bank in a way 

that is least costly to the Deposit Insurance Fund. And a wholebank resolution is almost always the least costly way to resolve a 

bank. So, legally, if there is a whole-bank bid for a very large bid, 

under current law if it is an FDIC resolution, an FDI Act resolution, the FDIC does not have a choice. They cannot take the bank 

into a bridge bank and take all the time to break it apart if it will 

cost more. And it almost certainly will cost more. But the time 

taken to bridge a bank in the resolution process and break it apart 

14 

is the price we have to pay to reduce systemic risk. But to do that, 

you do not need Title II. You just need to use Title I, the plan, the 

planning part, and change the law so that the FDIC is required to 

break large banks up when it resolves them. 

In that case, there would be no reason to treat—in my opinion, 

at least most of the things that we would call regional banks now, 

$250 billion or less that mostly do commercial banking in a region, 

most of those do not have any business being designated at all. 

Now, again, if all of them are in trouble at the same time, we 

have a problem. You cannot—unless you are willing to let the 

FDIC bridge all these banks and run them until they can sell 

them. And even under Title II we have a problem because you have 

still got the FDIC bridging banks and breaking them apart. 

So the problem is not really solved in the context of a true financial crisis when there is a problem and lots of banks get in trouble 

at once. 

So I think there is still a lot to work on here. I think that is 

when contingent capital—although it is not a resolution, it is a reorganization, but contingent capital has a lot more promise in a 

systemic crisis when many large institutions would be in danger of 

a Title I or a Title II or direct Government guarantee. 

So I could speak more about the Title II and why the bank—why 

the FDIC needs to take over the holding company. There is the 

whole case of NexBank in 2002 that was a horrible resolution experience for them. I am happy to talk about that at length, but I 

think I should stop now. 

Chairman BROWN. Thank you, Dr. Kupiec. 

Senator Toomey. 

Senator TOOMEY. Thanks, Mr. Chairman. 

A quick follow-up on some of the points that Dr. DeYoung made, 

which I thought were some thoughtful and interesting points on 

managing a resolution through Title II. But it strikes me that parts 

of Title II are problematic in the way they are written, problematic 

in doing a slow process. It seems that Title II is effectively mostly 

an execution order. The bank gets executed. I mean, that is the 

purpose as a practical matter. Management has to be all fired regardless of which managers are actually at fault. That does not distinguish—and, frankly, I would really seriously question the competence of the FDIC to run JPMorgan Chase or to run Lehman 

Brothers. The FDIC is competent at rolling up small banks over a 

weekend. There is no question about that. But running a $2 trillion 

multinational that is enormously complex, I really rather doubt it. 

But this is probably a better topic for a different time, if we could. 

I want to go back to observing a very interesting agreement that 

I discerned, I think, which is I think every single panelist here said 

that it does not make sense to have an automatic SIFI designation 

at $50 billion by virtue of that criteria alone. That is an important 

agreement because, of course, the law does exactly that. 

So I share that view, but rather than trying to guess what the right number is, because, frankly, I do not think $75 billion is the 

right number either, I wonder if each of you would comment briefly 

on whether we should have qualitative criteria instead of an arbitrary dollar value of assets, things like funding sources, capitalization, liquidity, the composition of assets, other criteria that we 

15 

might use rather than pick some other arbitrary number above 

which we would designate everybody for this very expensive, in my 

view, overregulation. Dr. Herring, if you would begin. 

Mr. HERRING. Yes, I think that the international agreement on 

identifying global systemically important institutions actually does 

speak to your point. They do have five quantitative indicators, but 

there is a clear role for a judgmental override that must be clearly 

stated. And that is how, in fact, we get some smaller banks, and 

some of the bigger banks that actually do not have systemic implications are not included. 

Senator TOOMEY. Could I just suggest, adding a subjective element would be one way to get away from a numerical hard and 

fast—— 

Mr. HERRING. A judgmental, a qualitative—— 

Senator TOOMEY. Right. But we could also have other quantitative measures. 

Mr. HERRING. You could. 

Senator TOOMEY. Like liquidity and capitalization and off-balance-sheet—— 

Mr. HERRING. Those are included. 

Senator TOOMEY. ——activity here they may or not be subjective. 

They could be fairly—— 

Mr. HERRING. No, those are all included in the quantitative indicators. Each of those—— 

Senator TOOMEY. Not under Dodd-Frank, right? 

Mr. HERRING. Not under Dodd-Frank, but under the FSB, which 

I think had the benefit of coming after Dodd-Frank. 

Senator TOOMEY. Right. 

Mr. HERRING. And, frankly, did a more sophisticated job of looking at this question. Congress did this in an immense rush, and I 

do not think it was a very thoughtful solution. 

I would also add that I share your interest in having sort of better procedural clarity, and I think better bankruptcy laws could be 

helpful. I would commend the work of the Hoover Stanford group. 

I must confess that I played a minor role in it, but it has just been 

published, a Chapter 14 proposal, that would, in fact, amend the 

Bankruptcy Act to deal with financial—— 

Senator TOOMEY. I would just point—their work very significantly informed my judgment as we developed our legislation. 

Dr. Thomson. 

Mr. THOMSON. I do not think that having a hard and fast number, a bright-line rule in legislation like the $50 billion or $250 billion, is useful for making the designation. Now, it may be useful 

to have a rule where you automatically review a company for that 

designation, but not designate them until you look at the number 

of factors, liquidity, their interconnectedness, their importance in a 

particular financial market, and if somebody clears 40 percent of 

the derivative contracts of a certain type, that should probably go 

into your consideration as to whether or not they are systemically 

important or not. 

So I think having some benchmark but being just a guideline we 

will automatically review for this would be the way to go, but then 

to dig deeper and understand what are the very things that are 

going to prevent us from either in isolation as a single institution 

16 

or as a group of institutions take them down, which is part of the 

reason why I mentioned in my remarks, we should be developing 

these contingency plans by the regulatory agencies on how would 

we actually take these institutions down. 

Now, the living wills that are in Dodd-Frank is a piece of the information of how do we go about that. When we develop these 

plans, that would tell us where the pressure points in the system 

are, ones we need to address in identifying which institutions are 

the problem. 

Senator TOOMEY. But what I understood you to say is that you 

agree with the premise that the actual activities of the bank ought 

to be given more weight than an arbitrary dollar value of assets? 

Mr. THOMSON. Yes, any threshold set using the dollar value of 

assets is inherently arbitrary, my work shows size is not the determining factor. It is the activities themselves. And it just turns out 

that really large banks tend to be in all the activities that leads 

us to consider them systemically important. 

Senator TOOMEY. All right. Thank you. 

Dr. DeYoung. 

Mr. DEYOUNG. Yes, you have put your finger on one of the potential weaknesses of orderly liquidation authority, and that is, who 

will run these institutions after we excuse the board and the top 

management? 

A couple of things. One is, of course, at that point the bank will 

be run in a very different way with a very different objective function. The objective will be not to grow the bank, not to look for risk 

opportunities, not to look for growth opportunities, but to service 

the customers, to allow financial contracts to run their course, and 

to stabilize the finances of the bank. So the challenges are a little 

bit different. We would need to know where all the bodies are buried, of course, and hopefully the orderly—the living will would do 

that. But it may not be as big a challenge as one would think. This 

does speak to the concept, to the question of credibility. This is all 

part of what we will find out when we allow the FDIC or a bankruptcy court under a different set of rules to resolve one of these 

large banks in a slow and thoughtful way. Credibility has to be established, and as we do that, of course, we will make mistakes. 

But, you know, the first time we go through this, it is not going 

to be perfect. Losses do have to be taken somewhere. 

Senator TOOMEY. Dr. Kupiec. 

Mr. KUPIEC. Yes, thanks. I think this whole thing is a fundamental problem because systemic risk is not really a very well developed science. It really became popular, a popular thing to talk 

about, to write papers about, after the crisis. The economics and 

the science really are not sound and there yet. Of course, we all 

know we think systemic risk exists because we saw the crisis. 

Now, in terms of size alone as a cutoff, I agree with you that any 

arbitrary size is—there is no science that supports a $50 billion— 

I have that in my testimony, I agree. It doesn’t support any number. But if the pure economics of it is, especially in the case of a 

bank, size is related to the damage it would cause to the economy 

if you were to lock it up and shut it down and freeze everybody 

that uses that bank for financial intermediation. 

17 

Now, the reason we do not see size mattering in modern times 

is because we already had in place mechanisms to prevent the 

bank intermediation function from getting locked up. The FDIC 

stepped in, and it sold the bank to another bank. And so there was 

a small disruption and some problems there. But more or less the 

economics smoothed out because the FDIC had already stepped in. 

Back in the 1930s, when you did not have that process, it was 

a really bad time. You lost access to credit, financial intermediation, deposits got locked up. It was really bad for the economy. 

So the reason we do not see large bank failures per se having an 

effect on the economy is largely because we had things in place for 

a long time that helped fix that. So size clearly does matter for systemic risk, pure and simple, but we have things that can handle 

the systemic risk associated with many of these things. It is only 

when you get to the very large banks that either the things we 

have in place now make bigger banks—that is the way we fix it, 

we put a failing big bank into another big bank, and we create another bigger bank. You can only play that game for so long, and 

we are kind of at the end of that route. Or we do something else. 

And this breaking apart of the bank—and I am on board with 

Bob in that, but I do not think you run the bank’s business down. 

I think you have to run it as a bank, but you have to split it up 

and sell it, because if the bank really does have important functions and you really take over that bank and you say, OK, now we 

are in lockdown mode, all these things have to stop, you have to 

stop lending, it is just run off contracts, but then you are going to 

impose financial losses. 

So I think you have to run the bank, but you have to plan to 

break it up in the resolution process if you get there. And I think 

that should be through Title I and deposit insurance. The holding 

company issues I think should be solved through the Title I process, and I think about it that way. But I think there is a tradeoff 

here, and we do know from history that, you know, just holding 

onto the bank and running it down, you know, is not going to be 

as smooth as a whole-bank resolution has been in the past. 

Thanks. 

Chairman BROWN. Senator Warren. 

Senator WARREN. Thank you, Mr. Chairman. Thank you all for 

being here. 

I want to focus on another part about SIFIs. Last week, the new 

Vice Chair of the Fed, Stanley Fischer, spoke about the Fed’s role 

in financial reform, and he made some claims about the too-big-tofail problem that I would like to be able to get your comments on, 

and I am just going to kind of break it apart into the different 

claims he made. 

His first claim was that the evidence was basically mixed on 

whether bigger banks take on more risk than their smaller counterparts. And I find that hard to believe, particularly for banks in 

the United States. 

Professor DeYoung, you have noted that four out of ten of the 

biggest U.S. banks in 2008 either failed or had to be bailed out. 

That is a 40-percent failure rate. By contrast, only 6 percent of 

smaller banks failed during the crisis. 

18 

So, Dr. DeYoung, given those data, is it fair to conclude that big- ger banks, say those over $500 billion in assets, tend to take on 

more risk than their community bank and regional bank counterparts? 

Mr. DEYOUNG. Well, thank you for reading my research, or 

thank you to your staff for reading my research. I appreciate that. 

I think it is unquestionably true that, on average, larger banks 

are involved in riskier activities. And in the end, at least over the 

most recent distress we have gone through, they are failing in larger proportions, and I think you have to be blind to conclude otherwise. 

Senator WARREN. OK. Good. We have got a point one. 

Mr. DEYOUNG. That is point one. 

Point two, though—point two, though, is have we done things 

to—is it size alone that is causing these banks to take more risk? 

Senator WARREN. Well, we are going to come there. 

Mr. DEYOUNG. Yes. 

Senator WARREN. We are going to come there; I promise. 

Mr. DEYOUNG. Very good. OK. 

Senator WARREN. OK? Because we are just going to do these, 

though, by pieces because I want to make sure I am getting them. 

Mr. DEYOUNG. Very good. I am going to hold you on that. 

Senator WARREN. All right. 

Mr. DEYOUNG. OK. 

Senator WARREN. The second one is about the question about 

economies of scale for big financial institutions. 

Vice Chair Fischer addressed the economies of scale, saying 

whether or not banks become more efficient and reduce their marginal costs as they grow bigger, and he pointed to recent studies 

that say that such economies of scale exist even for the largest 

banks. 

So I am a little skeptical on the point, but I want to open it up 

to the panel. Does JPMorgan, for example, really become more efficient when it grows from $2.4 trillion to $2.5 trillion, or we will do 

an even bigger leap, when it grows from $1.5 trillion to $2.5 trillion? 

And I will just go down the list here. Dr. Herring. 

Mr. HERRING. I think that is—oh, excuse me, I think that is a 

very difficult issue. 

All the evidence until very, very recently has indicated that economies of scale peter out at a level well below the $250 billion 

mark. And, in fact, if you look at banks of any given scale, the difference in efficiency between the most efficient bank and the least 

efficient bank is much, much greater than anything you could get 

out of scale and scope. 

There has been some very recent research actually done by the 

new President of the Cleveland Fed that suggests otherwise. 

What concerns me about this is that I do not feel comfortable 

that it has taken into account the too-big-to-fail advantages, nor do 

I think that it has taken into account the obvious diseconomies of 

management. It is very, very difficult to manage one of these institutions. It is humanly impossible to understand everything that is 

going on. And I think there is a limit to our ability to actually exercise effective control over such huge, complicated institutions. 

19 

That really needs to be taken serious. 

Senator WARREN. OK. Good. 

Dr. Thomson, did you want to add anything to that? 

Mr. THOMSON. Yes. Along with the funding advantages that 

these institutions enjoy because, obviously, you do not have to pay 

as much for liabilities if people credibly believe that you will never 

be closed and have losses imposed on them. 

There are all sorts of activities where massive size gives these 

banks an advantage over smaller ones. And I think that these advantages show up as cost efficiencies in studies of scale and scope 

economies in banks, where in fact, it is an artificial efficiency. 

If you look at some of the things like lines of credit, standby letters of credit and all these sorts of things, customers take those 

from banks they think who can perform on them. 

If you are a bank that is considered too big to fail, you are considered somebody who is a good credit, who will be able to perform 

on that contract going forward. 

And, I think this aspect of systemic advantage is why studies 

pick up cost efficiencies in the largest institutions. 

I do not believe in the credibility of economies of scale literature that find cost efficiencies above the $250 billion mark. 

Senator WARREN. OK. Anything you want to add to that, Dr. 

DeYoung, on the efficiency point. 

Mr. DEYOUNG. Yeah, on the efficiency part. 

Senator WARREN. I promise we are coming to the third one. 

Mr. DEYOUNG. On the efficiency, yeah, scale economies. We do 

not have any idea whether there are scale economies of large 

banks. 

I published—I am editor of the Journal of Money, Credit and 

Banking. Two of the most recent three important scale economy 

studies have been published in my journal. The most recent—and 

all three of those—all three of these important studies find different results. All right. 

So we do not know. No disparagements toward the researchers; 

these are incredibly different things to be trying to estimate. 

I will point out that the most recent of the three papers does adjust, or attempts to adjust for, the financial advantages that toobig-to-fail banks have, as James has mentioned. 

Senator WARREN. Yes. 

Mr. DEYOUNG. Puts those into the cost functions that they are 

estimating. And when they control for the too-big-to-fail advantage, 

the scale economies go away. 

So this is one out of three studies. We cannot draw any firm conclusions on this, but it does suggest that—and this is to the point 

earlier—large banks are more risky; however, they have lower 

costs of financing due to too-big-to-fail, and this gives them a different set of profitable opportunities to chase. 

Senator WARREN. So I will tell you what; instead of asking the 

same question a fourth time, what I will do is I will now cut to the 

one that intersects the pieces. 

And that is so we have the problem of the increased riskiness of 

the largest financial institutions, no evidence that they are more efficient, some evidence that what they are doing is taking advantage 

of the benefits of too-big-to-fail. 

20 

I want to hit the very last part of this, and that is the intersection of size with risk with cost. 

And, that is if two banks have an equal chance of failure—let’s 

set it up that way—is there anyone who thinks that the failure of 

a $2.5 trillion bank poses a smaller risk to the economy than the 

failure of a bank that is half that size or a quarter that size? 

I want to see the intersection here. 

Why don’t I start with you, Dr. Kupiec, and we will come back 

down the other direction. 

Mr. KUPIEC. No, I clearly think that size does create bigger spillover effects, and at the very largest institutions it would be a bad 

thing if one of those institutions fails. There is no—I think there 

is no doubt about that. Even under the best Title II Dodd-Frank 

thing we could come up with, it still would not be pretty. 

But where this kicks in, in the size range, is, I think, a pretty difficult question to know. So, if a $250 billion bank is 10 times 

smaller and not doing the same activities as JPMorgan Chase, a 

$100 billion bank is not doing anything like that probably. 

So, I mean, there is a big range here, and I think, for sure, the 

systemic risk is related to size. I have published papers that show 

that, using historical data from 1900s, before we had any safety 

nets. It is pretty clear that if you have a lot of little banks fail, you 

have got a problem. You have one big bank failing; you have got 

a problem if the little banks fail at the same time. 

But where this line crosses, I cannot pick a number. 

Senator WARREN. OK, cannot pick a number, but we are sure 

that the end is somehow different here—the furthest point out on 

it. 

Mr. KUPIEC. I would agree with that. 

Senator WARREN. Dr. DeYoung. 

Mr. DEYOUNG. Yes, I agree with Paul; there is no way we can 

draw a brightline. 

I will point out that some of these large banks were using the 

same business models as the large banks that became insolvent 

and came through the crisis with flying colors. In fact, some of 

them came through so well that we asked them to buy some of the 

large failed banks. 

I would not draw any lessons and apply them to all banks. The 

best of all cases is we remove the too-big-to-fail subsidies and then 

let the market determine which bankers are good, smart bankers 

and which bankers are not. 

Senator WARREN. Dr. Thomson. 

Mr. THOMSON. Yes. I am in agreement with my two colleagues. 

An element of this is not only would a large institution have a 

much bigger impact because it is just going to affect so many more 

markets and so many more activities, but there is also the aspect 

of anticipation. 

We can imagine a $250 billion bank being taken down and failed. 

We cannot imagine this happening to a $2.4 trillion institution. 

And the expectations of what is going to happen and how that will 

be handled is important. If the failure is handled differently than 

the market expects it to be handled, as we saw with Lehman 

Brothers, that is going to create the dislocation. 

Senator WARREN. Good point. 

21 

Dr. Herring. 

Mr. HERRING. I agree with all three of the panelists. 

Let me make one additional point about economics of scale, and 

that is that there are elements that clearly do have economies of 

scale. If technology is involved, we know that running larger 

batches of things is going to give you lower cost. 

And what we need to figure out is a way for the whole industry 

to participate in those economies of scale rather than concentrating 

them in a single institution and tying up a systemically important 

function with the fate of one institution. 

The other issue that is giving rise to economies of scale that is 

very worrisome about the current regulatory system is that the 

fixed costs of running a bank—having the systems in place, having 

compliance officers in place—is becoming a very large barrier to 

entry, and it is something that actually will make it more efficient 

to be larger. 

Senator WARREN. Oh, yes, and again, talking about where we are 

on that continuum. 

Mr. HERRING. Yeah. 

Senator WARREN. But it is a very good point, Dr. Herring. 

So, thank you. I appreciate it. 

I think we have agreement that size matters, that it would not 

be smart just to limit the size of banks and sit back and say we 

have solved every problem, but that the combination of adding risk, 

of banks that are more complex, that there is a greater impact if 

they do fail—and I would add that they have more political power 

and that permits them to pull in additional subsidies—all matter, 

and that happens because they get big. 

So we cannot win the battle against too-big-to-fail just by attempting to make banks safer. I think the battle for a safer banking system is also a battle over size. 

Thank you. 

Thank you, Mr. Chairman. 

Chairman BROWN. Thank you, Senator Warren. 

Dr. DeYoung, I think before you were able to get here Senator 

Warren spoke about the advantage of size, that competition is not 

so much price and the failure of the market there or the advantages they have, but the advantages in political power that you 

spoke of. And I think that was good insight. 

I found your answers to the economies of scale issue pretty interesting, that Senator Warren brought up, even in contrast with the 

study, as one of you pointed out, by the new Cleveland Fed President. And I think your comments were pretty compelling. 

I want to ask Dr. Thomson one question about that and then 

shift to something else. 

You mentioned you are all familiar with IMF and Bloomberg and 

the estimates of 60–80 basis point advantage on the capital markets—$80 billion. You all, of course, are familiar with those studies 

and those contentions. 

But, Dr. Thomson, you said it is much more, though, the advantages they have because of size are greater than just the capital 

market cost of capital. Could you expand on those for a couple of 

minutes? 

Mr. THOMSON. Yes. I mean—— 

22 

Chairman BROWN. Delineate as much as you can on that. 

Mr. THOMSON. Yeah. So Dr. Herring mentioned one thing; compliance is much easier for large firms. If you have to add 1 person 

to a staff of 50, that is a much smaller cost than adding 1 person 

to a staff of 2. 

There are a lot of contracts where the perception of being too big 

to fail gives a bank a competitive advantage. 

There was some research that was done in the late 80s early 90s 

looking at whether loans made through lines of credit or loans extended through standby letters of credit or other types of guarantees, whether they were riskier or not. And what they were finding 

is they were not. 

And what some of the research was finding was, in fact, that 

safer banks were the ones who were writing these types of contracts, they were the ones doing the business, and that this was a 

form of market discipline on them because customers do not buy 

contracts that require performance by somebody if they do not 

think you can perform. 

Well, if you are too big to fail, if you are thought of as somebody 

who will never be closed, then I will feel safer entering into a contract with you than somebody else who I think there is a chance 

that next year when I need that credit that they will not be there 

to perform. 

And so it is these types of aspects that are within the businesses 

of these institutions that give them an advantage that you will not 

pick up by just looking at a funding cost, but it gives them a fundamental advantage in the business because they have—they are 

competing with—a guarantee that other people do not have. 

Chairman BROWN. And you think customers—is there evidence 

in studies that customers sense that, know that and act upon that? 

Mr. HERRING. Yes. There are, in fact, services that advise corporations on banks they should establish a relationship with because those banks are more likely to be able to perform on the contracts. It is a very good point. 

Chairman BROWN. Good. Well said. Thank you. 

A housekeeping issue, I ask unanimous consent the following two 

documents be included in the record—a letter from the Clearing 

House Association, a statement from the Special Inspector General 

for the Troubled Asset Relief Program, SIGTARP. 

Without objection, we will enter that in the record. 

In a statement just submitted to the record—and this is a question I want to ask all of you—the Special Inspector General for 

TARP says that nine institutions that were given capital injections. 

The four largest banks, three large investment banks and two custodial banks ‘‘were chosen for their ’perceived’ importance to the 

markets in the greater financial system.’’ 

The Government conducted stress tests after TARP but also announced that FDIC would guarantee the debt of all banks with at 

least $100 billion in assets. 

And, according to the GAO, the Government offered banks with 

$50 billion or more financial support of around 10 to 11 percent of 

their assets; for banks with between $10 and $50 billion, the support percentage was about half of that amount. 

23 

So, two questions for each of you, and I will start with you, Mr. 

Kupiec: 

Why were these decisions made in 2007 and ’08; what do you 

think? 

And how important are market perceptions, and what does the 

market expect today? 

Mr. KUPIEC. Well, the TARP decisions were clearly made in a crisis mode, and they wanted to ensure or inject confident in the public on the largest institutions. 

When it came to picking and choosing among the smaller institutions who got money in TARP, there was an application process. It 

went through review. 

I am not particularly—I was not privileged to be involved in 

those discussions. So I do not know exactly, you know, why they 

got less money, but certainly the headline institutions were the 

first to take; they were taken care of. 

Chairman BROWN. So, Dr. DeYoung, how important are market 

perceptions, and what does the market expect today? 

Mr. DEYOUNG. Well, for the smaller banks, market perceptions 

are pretty much moot. There were many, many small banks who 

are not publicly traded that received TARP. 

And the market perceptions—I mean, you are talking about financial markets, correct? This is your question? 

Chairman BROWN. Yes. 

Mr. DEYOUNG. Yes, financial markets are not important there. 

I would say as long as the subsidies here were done in a transparent fashion there would be no uncertainty to investors, and 

therefore, I think that the pricing of the risk of these firms would 

be very efficient. 

The minute these subsidies start to go—start to happen with 

some lack of transparency, then I think market perception becomes 

very important because then if there is any risk, any uncertainty, 

about whether a bank is being supported or not supported or the 

degree of their support I think the markets will discount the price 

or increase the risk of those institutions. 

So I think your question depends on how transparent the process 

was, and with TARP it seems to have been relatively transparent. 

Chairman BROWN. Dr. Thomson. 

Mr. THOMSON. All right, so one comment on the TARP at the 

large side. Institutions at the top end, of course, were not given a 

choice. They were going to take the TARP money although we 

know two of them decided that they needed extra TARP money in 

the process. Again, that application process for the smaller institutions was a bit different. 

I think whenever you, during a crisis period, signal that you are 

going to stand behind institutions without setting any type of thing 

in place that says this is it, this is the only time, you condition 

market expectations for those types of bailouts to become forthcoming the next time. 

And this is a self-reinforcing process. The more markets believe, 

the greater the potential dislocation and the more you are going to 

tie the hands of the bank regulators and Congress to provide the 

subsidies to these institutions until you can put in place something 

credible that says, going forward, this is what is going to happen. 

24 

And then you have to be able to follow up and do it when that happens. 

Otherwise, you are just going to perpetuate the very same sorts 

of risk-taking through the subsidies that is going to drive the next 

crisis. 

Chairman BROWN. Dr. Herring. 

Mr. HERRING. I very much agree with those points. 

I think that the TARP episode is exactly what Dodd-Frank is trying to prevent and it is a very important point of market expectations. 

I think probably the best example of that was the bailout of Bear 

Stearns which, unquestionably, made the Lehman Brothers crisis 

much greater. The markets expected that if Bear Stearns received 

a subsidy and it was half as complex, half as large as Lehman 

Brothers, Lehman Brothers surely would. 

And when markets are disappointed in something that they have 

come to believe because of the behavior of officials over time, they 

react very badly. When people think the rules of the game have 

changed, they rush for quality. We saw that in markets with pressure bills from one point even going negative. And they tend to sit 

on the sidelines until they think they know the rules of the game 

again. 

That means that if we want a new regime to work, we have got 

to be very consistent in applying it. Sadly, that probably means 

that we need a crisis of just the right size, something that will 

show these tools work, whether they be bankruptcy or the Title II 

authority, and work effectively so that people will have confidence 

that we have a new regime in place. 

But I think, until then, there are going to be very troublesome 

questions about whether we, in fact, have the ability to do what we 

say we are going to do. 

And the willingness, I think, has been a good point made before, 

too. 

Chairman BROWN. Thank you. 

Talk about FSOC and ask for your thoughts and recommendations about what they might consider. 

Dodd-Frank authorized FSOC to make recommendations to the 

Fed regarding enhanced prudential standards and adjusting the 

applicability of those standards to different kinds and different 

sizes of institutions. 

FSOC, for example, may set an asset threshold that is higher 

than $50 billion for the applicability of certain enhanced prudential 

standards under Section 165, such as resolution plans or concentration limits. 

Should FSOC do that? 

What would you recommend that FSOC do in making those judgments, Dr. Herring? 

Mr. HERRING. I think this question is very much parallel to the 

question of identifying SIFIs. Just as we have said that size is not 

a magic number for a SIFI designation, I think it surely should 

have enhanced supervision as well. 

That, of course, takes you into some uncomfortable judgmental 

grounds because you need multiple kinds of indicators and you 

25 

probably need some sort of judgment overlay. It should be transparent, but I think it would be a mistake to base it on size alone. 

Chairman BROWN. Dr. Thomson. 

Mr. THOMSON. Yes, I concur. I think we—— 

Chairman BROWN. We have kind of established that for all four 

of you on size. 

So, speak elsewhere, what else that they should have. What else 

they should consider as they make suggestions, make statements, 

make rules? 

Mr. THOMSON. Well, I think one of the things that we need is 

more information transparency, more granularity of information. 

One of the big things we see is concerns about transmission over 

payment systems or through common asset holdings or through derivatives markets. 

We are starting to get more information collected on this. Some 

of it is an outgrowth or direct result of Dodd-Frank. 

We do not collect all of the information we need, particularly for 

the institutions we think are systemically important. We do not collect the types of information at the level of detail—collecting such 

information from large institutions would not pose an undue burden on them, while it would for a small one—that would allow us 

to really see what these connections are. 

Now, in Europe, we do see this information being collected, and 

we see this information being used to understand what the connections are, what the pressure points are and what the danger points 

are. 

And I think until we start putting more information in place the 

process for labeling financial firms as systemic is going to be more 

judgmental than what I would be comfortable with. 

Chairman BROWN. Dr. DeYoung, thoughts? 

Mr. DEYOUNG. I will pass on this question. I will let Paul go. 

Chairman BROWN. OK, Dr. Kupiec. 

Mr. KUPIEC. The FSOC—it sounds like a good idea, and the section gives the FSOC the power to sort of designate a different set 

of criteria. But in the end the FSOC is not very transparent, and 

it is all judgment-based. 

And the FSOC is dominated by bank regulators, by far and 

away, and it is not clear to me that the bank regulators would 

want to give up some of the smaller banks. 

I think they very much like, according to Governor Tarullo’s 

speeches, their stress-testing approach. They want to replace the 

capital requirements, in fact. Governor Tarullo is on record of saying he would like to replace Basel with stress test as the primary, 

and it is the primary tool right now in which the Fed determines 

capital. 

But the whole system of designation by the FSOC—because there 

is really no hard and fast science about systemic risk, when does 

the failure of a firm cause financial instability? 

Is it if it fails by itself in isolation during good times or if it fails 

by itself in isolation during not so good times, or is it when it fails 

with other firms at the same time and times are not good? 

These are all different circumstances, and the law in no way 

speaks to what the situation needs to be for the FSOC to consider. 

26 

It is very vague and ambiguous, and it is entirely then left up to 

the judgment of the FSOC. So I do agree that a $50 billion automatic designation for bank 

holding companies is way too low. 

I also agree that I do not know the right number that that 

should be raised to, but I do not think turning it all over to the 

judgment of the FSOC, the way it operates today and without any 

real constraints and transparency, is something that I would recommend. 

Once the FSOC determines that a company is systemically important, how does it get out of that? 

It does not tell you when it designates it. The insurance companies that have been designated do not have a list of things they 

have to do to become undesignated. 

There are property rights involved. When you are designated, all 

of a sudden you have to satisfy a whole bunch of rules. This slams 

profitability and shareholders, and pretty soon you have got Fed 

regulators crawling over you, you know, once a year. And you are 

an insurance company. You never had this before. 

There are real issues associated with this decision, and yet, the 

firm that is getting evaluated does not have a whole lot of say. 

They do not, for example, have to file an orderly Title I resolution plan to the FSOC before they get designated, where one of the 

criteria for designation is the fact that if they were to fail in bankruptcy it would cause a problem. Well, you do not even give them 

the right to file that report. 

There is none of that that has been done in any of the designations. 

So, right now, until we really tune up the FSOC designation 

process, and put some structure on it and some controls on it, I feel 

very uncomfortable in recommending that they get any additional 

powers, frankly. 

Chairman BROWN. OK, understanding. Thank you. 

Dr. Kupiec, understanding your reluctance, your concern about 

empowering FSOC further, I want you—I want all of you—to be 

more specific about sort of where we go. 

And this panel has all said making this determination based on size alone, especially the size being $50 billion, does not make 

sense. It is costly. It is onerous. It is a burden on these banks that 

should not be there just by that criterion alone. I understand that. 

We know a number of things. 

We know banks above $50 billion have a whole different—as I 

mentioned in my opening statement, and Senator Toomey, and a 

number of us have, that banks above $50 billion have a whole different range of business models, some way less risky than others. We know that banks with less than $100 billion, on average, hold 

just 6 percent of the assets of all the banks over that are SIFI-designated. We know that the large—that the banks above $100 billion average less than 1 percent of the largest banks’ over-the-counter derivatives. 

They engage in just 1 percent of repo and security lending. 

So we can see where the risk mostly is concentrated. It is, obviously, not in the smaller banks. 

27 

So my question—a series of questions on this: 

Should regulators focus on particular business models or activities? 

Should regulators think about physical commodities? 

We did a couple of hearings in this Subcommittee on banks’ ownership of everything from oil tankers to aluminum and electricity 

generation. Should contending—I think the conclusions in these 

hearings were, one, big banks have an advantage that in the real 

economy is perhaps unfair and that it brings more risk to the financial system, their involvement that way in the real economy, all 

those issues. 

So, be as specific as you can, and I will start with you, Dr. 

Kupiec. And I think this probably will be the last question. 

Mr. KUPIEC. OK. 

Chairman BROWN. And one more thing, how specific you can be 

on what kinds of determinants we should make, we should use, 

whether it is FSOC or somebody else, as regulators. 

Mr. KUPIEC. Looking at the practical side of things, that probably 

nobody is willing to open up Dodd-Frank very broadly at least and 

you want to make a few adjustments around the edges to make it 

better, if I had to propose something, I suppose I would still use 

a dollar cutoff as the simplest thing. 

I would look—looking at the list of holding companies and recognizing what I think they do—and I have not analyzed every one of 

them in detail—the cutoff would be somewhere between today, to 

allow for growth, maybe $250 billion. 

And I would add some requirements that they not be involved in 

any critical specialized activity, perhaps like, you know, asset custody—be a big asset custody manager or have too big a capital 

markets operation. 

I do not think that is perfect, and I do not—and it is certainly 

not right in any scientific way. But if I had to come up with a specific solution, based on what I know today, I would not turn it over 

to a subjective assessment to the FSOC, bank by bank. I think 

there is no control there. 

I would think, second best, I would be forced to stick with a dollar number and a few caveat criteria, and it would look something 

like that, I think. 

Chairman BROWN. Dr. DeYoung. 

Mr. DEYOUNG. Yeah, none of us are willing to commit to a number. I guess Paul came pretty close there. 

Chairman BROWN. I would say he did. 

Mr. DEYOUNG. He got pretty close. He actually said an integer. 

Business models are important. You do not want to name a business model, but I will point to two places we should be looking. 

Traditional banks originate and hold—originate loans and hold 

them. They do the financing of the loan. They underwrite the credit 

risk of the loan, and they bear the risk from the loan. 

Other banks have a business model in which they originate the 

sell, they make some fees, and they get rid of the risk. They do not 

do any financing. And although they have underwritten the loan, 

you are not sure about how they have basically handed over the 

bond raters to tell investors how risky these credits are. 

28 

Most banks do a mixture of these two types of underwriting and 

financing. So that is one dimension. 

Unfortunately, you would have to draw a line someplace—what 

percentage of your activities originate in hold; what percentage 

originate in sell? But the more originate and sell the bank does, the 

more systemic risk this is generating within the economy. 

The other place to look is whether the bank is funding itself with 

deposits or funding itself with market finance. 

And you know market finance. If you go down the list of firms 

that we look at as being particularly systemically crucial to what 

happened in the crisis, they all were funding their long-term assets 

with short-term market finance. So that would be the other place 

to look. 

Now these are functions. These are not necessarily business models, but this is where I would look. 

Chairman BROWN. Fair enough. 

Dr. Thomson, before you answer this, you had said in, I believe, 

your opening testimony, maybe it was in response to a question, 

that we should—you acknowledge that $50 billion is probably too 

low a number, but you said perhaps if it is $50 billion and up you 

automatically review their other activities. 

But if I heard you right, $50 billion would sort of be the trigger. 

Let’s review the activities of every bank over $50 billion, not designate them SIFI—I am reading a bit into what you said—perhaps 

not designate them as SIFI unless they have other high-risk activities or high-risk activities. 

Is that—do you want to—— 

Mr. THOMSON. Yes however, I do not think $50 billion is the 

right number. I would go higher, somewhere on the order of $250 

billion for an automatic review, with the proviso that there are institutions that are under $250 billion we may also want to look at 

because of the nature of their activities. 

But I think that setting a threshold for where you look and then 

apply some judgment is the answer—maybe that is where FSOC 

gets involved. 

Chairman BROWN. So set a lower threshold, 50 or 100 for automatic review, but then look for the other, but at 250 it is automatic 

designation. 

Mr. THOMSON. No, I would set a higher threshold, and I would 

set the higher threshold and have automatic review for designation 

above that dollar amount with, on a case-by-case basis, review of 

institutions below that dollar amount and maybe have a second 

threshold below which you just do not really look because I think 

there is little risk those institutions below a certain size are engaged in the activities that get larger institutions reviewed. 

In your opening remarks, you talked about the traditional regional banks that are in Ohio, Pennsylvania, Illinois, and Indiana 

that do a very sort of classic, what you might call a Glass-Steagall 

type banking business. They lend. They provide trust services for 

customers. They raise most of their funding through their retail 

branch networks. 

And that is a very, very different type of business than someone 

who is doing proprietary trading or a lot of trade on behalf of customers. 

29 

I think if you want to point to activities associated with systemic 

importance, I would look at activities that go beyond what we think 

of this traditional retail-focused banking model. 

Chairman BROWN. Thank you. 

Dr. Herring. 

Mr. HERRING. I do think that this analysis should be very congruent with the analysis for designation of SIFIs. 

And I think the Financial Stability Board has actually developed 

a reasonable analytical approach that weights size. It weights 

interconnectedness, which would include involvement in capital 

markets activities and commodities. It evaluates cross-border activity, complexity, the lack of substitutes for the services the firm 

funds and liquidity profile. 

And all of these things are weighted. One can argue about the 

subjectivity of the weights, but it gives you something to start 

from. 

Then I think if you are going to apply judgment, it should be 

very transparent. If you pick somebody up that is lower on this list 

and put it in, you should be very explicit about why you are doing 

it. If somebody on that list at a higher order is taken out, you 

should be very explicit about what you are doing. 

I think that is the best we can do with our current state of 

knowledge. 

Chairman BROWN. Thank you. Thank you all. 

Some Members of the Subcommittee may send you written questions in the next few days. Please answer them as quickly as you 

can if that happens. 

And thanks very much for your candor today and your good answers. The Subcommittee is adjourned. 

[Whereupon, at 11:51 a.m., the hearing was adjourned.] 

[Prepared statements and additional material supplied for the 

record follow:] 

30 

1The Financial Stability Oversight Council (FSOC) has refined these criteria and applied 

them to a broader range of financial institutions in the United States. 2This is, of course, a prime example of a time inconsistency problem: what the authorities 

say ex ante is quite different from what they can expect to do ex post. 

PREPARED STATEMENT OF RICHARD J. HERRING 

JACOB SAFRA PROFESSOR OF INTERNATIONAL BANKING, THE WHARTON SCHOOL, 

UNIVERSITY OF PENNSYLVANIA

JULY 16, 2014 

Chairman Brown, Ranking Member Toomey, and distinguished Members of this 

Subcommittee, I am grateful for the opportunity to address you today at this hearing entitled, ‘‘What Makes a Bank Systemically Important?’’ 

I am Jacob Safra Professor of International Banking at the Wharton School, Codirector of the Wharton Financial Institutions Center, Cochair of the U.S. Financial 

Regulatory Subcommittee, Executive Director of the Financial Economists Roundtable, a member of the Systemic Risk Council and the FDIC Systemic Resolution 

Advisory Committee as well as the Hoover Institution Stanford Resolution Project. 

Although my views have certainly been influenced by discussions with my colleagues in these groups, the views I express today are my own. 

The question of what makes a bank systemically important continues to divide experts. Some believe that recognition that some banks are systemically important 

will exacerbate moral hazard, leading to competitive inequities and the 

misallocation of resources. The concern is that institutions designated as systemically important benefit from implicit Government guarantees that will give them 

an unwarranted competitive advantage. This is a legitimate concern, but, of course, 

much of the Dodd-Frank Act aims to eliminate the category of too-big-to-fail institutions and extinguish the implicit guarantee. I think this is the correct approach, although disagreement continues about whether the goal has been accomplished. 

Experience during the recent crisis indicates that the authorities are unlikely to 

refrain from bailouts if an institution which they regard as systemic encounters extreme financial stress. Thus I think it is pointless to deny that some institutions 

will be considered systemic. Rather we should aim to find ways to resolve them 

without creating intolerable spillovers for other institutions, financial markets and, 

most importantly, the real economy. If we succeed, it will end the implicit benefits 

banks derive from being regarded as systemic. 

Since the crisis, officials have undertaken major efforts to identify the factors that 

make some institutions ‘‘systemic.’’ The Financial Stability Board has developed criteria for making the designation based on several different indicators. 1 These indicators include the size of banks, their interconnectedness, their cross-jurisdictional 

activity, their complexity and the lack of readily available substitutes for the services they provide. Each November the FSB publishes a list of G–SIBs. Currently 29 

institutions are designated as G–SIBs. These 29 banks accounts for the bulk of activity in equity and bond underwriting, loan syndication, derivatives, foreign exchange and custody. Eight of the G–SIBs are headquartered in the United States 

and they range in size from nearly $2.5 trillion to $222 million indicating that factors in addition to size matter. 

Substantial efforts are underway to refine the indicators and to model the interactions among institutions that create systemic concerns. Although these efforts 

may help us better understand the interconnectedness of financial institutions and 

markets, I think that they focus on the wrong question. In practice, the authorities 

treat an institution as systemic if they fear that a loss to uninsured depositors and 

creditors would damage the financial system and the real economy. When faced with 

the prospect of a disorderly resolution, officials have too often improvised bailouts 

over frantic, sleepless weekends. If the authorities cannot make a credible commitment to abstain from bailouts, Systemically Important Banks (SIBs) will grow larger, more complex and more dangerous. 

I believe that the authorities have granted bailouts so frequently because they 

lacked reliable resolution tools. They relied instead on a policy of constructive ambiguity, believing they could limit moral hazard by asserting that access to the safety 

net was uncertain. This policy seems naive and ineffectual. It can work only if market participants believe that bailouts will be random. But market participants do 

not believe that bailout policy is determined by a spin of a roulette wheel. They expect that the authorities will behave rationally and provide bailouts to institutions 

that are regarded as systemic. 2

The Dodd-Frank Act can be viewed as a multipronged attempt to eliminate bailouts and neutralize the threat posed by SIBs. Many of these measures are designed 

31 

to reduce the likelihood that institutions will fail. The most important of these is 

the imposition of higher, better quality capital requirements with differentially 

higher capital requirements for SIBs. This is a welcome reversal of the policy before 

the crisis of giving SIBs differentially lighter capital requirements. While strengthened capital requirements will ensure that SIBs have better shock absorbers, they 

cannot prevent failures—nor should they. Banks are in the business of taking risks 

and so long as they do so prudently they provide substantial benefits to the economy 

by intermediating between savers and investors, buying and selling risk and operating the payments system. 

If banks cannot be made fail-safe, they must be made safe to fail. This requires 

resolution policies and procedures that will ensure that investors and creditors bear 

the cost of bank failures, not taxpayers. The Dodd-Frank Act addresses this problem 

in Titles I and II. This is a major enhancement of the regulatory framework. Before 

the Dodd-Frank Act, most institutions paid no attention to how they might be resolved in the event of severe financial distress or what measures they might take 

to minimize the damage to the financial system. Lehman Brothers illustrated the 

problem starkly. It entered bankruptcy with no preparation. Indeed, the managers 

were uncertain about how many legal entities the holding company controlled and 

employees were unclear about which legal entity they worked for. 

Title I requires rapid resolution plans for all SIBs. These so-called living wills 

show how the SIB could be resolved under bankruptcy without causing damaging 

spillover effects on other institutions and financial markets. Living wills must include: (1) an executive summary with a strategic analysis describing the firm’s plan 

for a rapid and orderly resolution (without, however, defining what period of time 

qualifies as ‘‘rapid’’); (2) a description of how resolution planning is incorporated in 

the firm’s corporate governance structure; (3) a description of the group’s overall organizational structure that includes a hierarchical list of all material entities, as 

well as jurisdictional and ownership information and mapping of core business lines 

and critical operations into corporate entities; (4) a description of management information systems that support the covered company and its material entities, including a detailed inventory and description of key applications along with identification 

of the legal owner or licensor and related service level agreements; (5) a description 

of interconnections and interdependencies among a covered company and its material entities and the covered company’s critical operations and core business lines 

along with a description of how service levels would be sustained during a material 

financial distress or insolvency; and (6) identification of supervisory authorities and 

regulators that oversee the covered company. 

For the largest and most complicated banking groups that have thousands of subsidiaries, the third requirement has been onerous. It demands not only a mapping 

of lines of business into corporate entities, but also details regarding material entities, critical operations and core business that, at a minimum, describe types and 

amounts of liabilities. It also requires details about the booking of trading and derivatives activities, as well as an identification of major counterparties including descriptions of any interconnections or interdependencies among them. Finally, it requires that covered companies list all material trading, payment, clearing, and settlement systems in which they participate. 

Most of these requirements can be seen as attempts to minimize the prospect of 

a Lehman Brothers-like disorderly bankruptcy by ensuring that both covered companies and regulators have thought through the end game in advance. Although this 

will not ensure an orderly resolution, it increases the likelihood that SIBs can be 

made safe to fail. Not only will the authorities have a more accurate view of the 

SIB and its interactions with the rest of the financial system, but also the process 

and costs of drawing up rapid resolution plans and responding to regulatory evaluations, may give institutions an incentive to reduce their complexity. Moreover, the 

authorities have the authority to compel a SIB to simplify its structure if it is not 

sufficiently responsive to regulatory reviews of its resolution plan over an extended 

period. 

While the D–F Act generally supports greater market discipline, it does not address the issue of public disclosure of resolution plans. The FRB and FDIC, however, have required disclosure of a public section of the plan containing an executive 

summary that describes the business of the covered company including: ‘‘(i) the 

names of material entities; (ii) a description of core business lines; (iii) consolidated 

or segment financial information regarding assets, liabilities, capital, and major 

funding sources.’’ This could have been an effective way of harnessing market discipline to support the simplification of SIBs, but unfortunately, the FRB and FDIC 

chose to permit institutions to limit their disclosures to publicly available information. 

32 

3For additional details, see Carmassi and Herring (2013) in Appendix 1 and The Systemic 

Risk Council Jetter (2013) re: ‘‘Improving the Public Disclosure of Large Complex Financial Institutions’’ in Appendix 2. 4The current bankruptcy process is thought to be too slow and cumbersome to deal with an 

institution that trades 24 hours a day, 7 days a week and must rely on the confidence of its 

counterparties and creditors to maintain its operations. Moreover, a series of amendments to 

the Bankruptcy Code has increasingly immunized counterparties in qualified financial contracts 

from major aspects of the bankruptcy process, especially the imposition of automatic stays. 

If the information is already publicly disclosed, it’s not clear what value this disclosure requirement adds. This timid approach represents a significant lost opportunity. If the authorities had been serious about enhancing market discipline, they 

should have required disclosure of information that would enable potential creditors 

of the covered company to understand the statutory hierarchy of claims on the various entities in resolution, and precisely how the authorities propose to conduct a 

resolution. In the absence of such information, creditors cannot be expected to price 

claims efficiently. Moreover, some of the information in the first rounds of disclosures falls short of the more modest goal of helping the public understand the business of the covered company because it is difficult to reconcile with other publicly 

available information. 3

Living wills must assume that resolution takes place under bankruptcy. But current bankruptcy procedures are not sufficiently swift and flexible to ensure an orderly resolution. 4 The Hoover Resolution Project has devoted considerable effort to 

developing a new proposal for a Chapter 14 to the Bankruptcy Code that would be 

able to deal with the special demands of complex financial institutions. See http:// 

www.hoover.org/sites/default/files/rp-14-july-9-tom-jackson.pdf for a description of 

the proposal and an analysis of how it would improve current bankruptcy procedures. This is a particularly important initiative because bankruptcy is the default 

option under Title I of the Dodd-Frank Act. 

At the same time, the FDIC has refined plans for implementing its stand-by authority to act as receiver under Title II of the Dodd-Frank Act. Although the FDIC 

has performed this role for banks of moderate size, it has never had to face the challenge of acting as receiver for a SIB. Indeed, before passage of the Dodd-Frank Act 

its authority was limited to the insured depository institution within the SIB holding company. 

The FDIC has proposed to resolve SIBs by (1) placing the parent holding company 

under the control of FDIC as receiver and (2) transferring to a new ‘‘bridge’’ financial company most of the assets and secured liabilities, leaving behind much of the 

unsecured debt. Regardless of where the losses occurred in the SIB, only the holding 

company would be taken into bankruptcy. This approach has been termed a ‘‘single 

point of entry’’ (SPOE). 

In principle, the new financial company would be strongly capitalized (after shedding a large amount of its prior debt), would have the capacity to recapitalize operating subsidiaries when necessary, and would have the confidence of other market 

participants. This would enable it to continue its critical operations in the financial 

system. Since the bankruptcy would be confined to the holding company, spillover 

effects should be avoided. 

The success of both the Chapter 14 proposal and the SPOE strategy depend on 

three issues that remain unresolved. First is that the bridge company have all of 

the assets, rights and liabilities of the holding company that has entered bankruptcy. This is crucial for maintaining business as usual in the operating entities 

and would require overriding ‘‘ipso facto’’ clauses that permit contracts to be terminated based on a change of control, bankruptcy proceedings or a change in agency 

credit ratings. This is particularly a problem with regard to qualified financial contracts. Currently counterparties may liquidate, terminate, or accelerate qualified financial contracts of the debtor and offset or net them out. This can result in a sudden loss of liquidity and, potentially, the forced sale of illiquid assets in illiquid markets that might drive down prices and transmit the shock to other institutions holding the same asset. Qualified financial contracts should be transferred in their original form to the bridge company so long as the debtor and its subsidiaries continue 

to perform payment and delivery obligations. 

Second, both approaches depend on cooperation from the relevant authorities in 

countries where the SIB has operations. Virtually all SIBs have substantial crossborder operations and so an orderly resolution depends on cooperation in the transfer of assets and contracts to the bridge. The FDIC has taken a leading role in trying to forge an international agreement regarding harmonization of resolution policies. It participates in crisis resolution groups that review resolution plans for 

GSIBs and it has published a paper with the Bank of England supporting the 

33 

5 In principle, if losses at a subsidiary exceed the long-term unsecured debt at the holding 

company, the additional loss could be imposed on creditors of the subsidiary. But, once the prospect of creditors bearing loss in subsidiary is introduced, subsidiaries may be subject to a run 

by creditors and counterparties. 6For additional details, see Appendix 3. 

SPOE. Nonetheless, agreements and understandings tend to unravel in a crisis and 

countries may try to ring-fence the assets they control. The recent crisis did not provide much evidence of cross-border cooperation in resolution. 

Third, both approaches require that ‘‘sufficient’’ long-term unsecured debt be left 

behind in the bankrupt holding company to recapitalize the bridge company. 5 Although it is relatively easy to compute an amount of loss absorption capacity that 

would be sufficient under conventional stressful conditions, tail risks are crucial and 

inherently very difficult to measure. 

I would like to conclude with a somewhat different point, however. I believe that 

how the long-term debt is structured can also be important. Long-term debt matters 

not only because of its ability to absorb loss, but also because it has the potential 

to incentivize banks to manage their risks more prudently and to issue new equity 

before they reach the brink of insolvency. 

Charles Calomiris and I have argued that a properly designed contingent convertible debt (CoCo) requirement can provide strong incentives for the prompt recapitalization of banks after significant losses of equity or for the proactive raising of equity capital when risk increases. 6 Correspondingly, it can provide strong incentives 

for effective risk governance and help limit regulatory ‘‘forbearance,’’ the tendency 

of supervisors to delay recognition of losses. We show that, to be effective, a large 

amount of CoCos (relative to common equity) should be required. CoCo conversion 

should be based on a market-value trigger that is defined by a moving average of 

a quasi-market-value-of-equity ratio. All CoCos should convert if conversion is triggered and the conversion ratio should be dilutive of preexisting shareholders. Unfortunately, this proposal has not received serious consideration in the U.S. because 

the Internal Revenue Service appears unlikely to permit interest paid on CoCos to 

be deducted in the computation of taxable income and so banks would prefer to 

issue conventional, long-term debt. In view of the enormous costs of a financial crisis and the potential for a properly structured CoCo to create incentives that would 

reduce the probability of a crisis, this tax policy should be reviewed. 

Thank you for the opportunity to testify on this important topic. 

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1 James B. Thomson, ‘‘On Systemically Important Financial Institutions and Progressive Systemic Mitigation’’, DePaul Business & Commercial Law Journal 8 no. 2 (Winter 2010), 135–150; 

James B. Thomson, ‘‘Cleaning up the Refuse From a Financial Crisis: The Case for a Resolution 

Management Corporation’’, The Florida State University Business Review 10 no. 1 (Spring 2011), 

1–23; Ozgur E. Ergrungor and James B. Thomson, ‘‘Systemic Banking Crises’’, Research in Finance 23 (2006), Elsevier Ltd., Amsterdam, 279–310. 

PREPARED STATEMENT OF JAMES B. THOMSON 

PROFESSOR AND FINANCE CHAIR, UNIVERSITY OF AKRON

JULY 16, 2014 

I would like to thank Senator Brown and the Members of the Senate Committee 

on Banking, Housing, and Urban Affairs and Consumer Protection Subcommittee on 

for the opportunity to speak here today. The issue of systemically important financial institutions is of critical importance to the stability of financial markets and the 

ultimately the macro economy. Understanding what makes a financial firm systemic 

is the first step in designing an institutional and legal framework to rein in systemic firms. Viewing systemic spillovers as market failure we need to identify the 

source of that market failure, the severity of the market failure, whether the market 

failure merits Government intervention and if so, the most economically effective 

way to structure that intervention. 

United States financial history over the past 40 years is littered with examples 

of Government interventions into financial markets in response to lobbying by particular sectors (esp. housing) to the pending failure of large financial institutions. 

Early on we referred to these intuitions as too big to fail and the public policy issue 

as the too big to let fail problem. One of the themes I want to sound today is that 

too big to fail is a misleading term. Size is not the distinguishing characteristic that 

makes financial firms systemic. Section 113 of the Dodd-Frank Wall Street Reform 

and Consumer Protection Act of 2010 (hereafter called ‘‘Dodd-Frank’’) lists 11 such 

characteristics. However, the factors that lead to institutions ‘‘being treated’’ as systemically important also tend to be prevalent in larger firms. It is important to emphasize that decisions on how we handle economically failed financial institutions 

are themselves an important source of systemic risk. We need to understand whether an institution authorities label as systemic in the handling of its economic insolvency are truly systemic, or merely politically expedient. 

During a 30-year career as a financial economist I have studied financial markets, 

banking, payments systems, failed bank resolution, and the Federal financial safety 

net from a public policy perspective. The ideas I express today observations below 

are informed by reading and research I have done in these areas, especially papers 

on systemically important financial institutions, the need for an asset salvage agency, and systemic banking crises. 1

As I mentioned above, the past 40 years of U.S. financial history is replete with 

examples of economically failed financial firms whose solvency resolution involved 

systemic considerations or were handled through regulatory forbearance (that is, 

were allowed to continue operations with the hope that they would recover). Examining a number of these cases and the stated rationale for how they were handled 

allowed me to identify four sources of systemic importance. It is important to note 

systemic importance in these cases was based on a judgment call in the face of a 

potentially disruptive event in financial markets and not hard evidence the firms 

were indeed systemically important. 

Sources of Systemic Importance 

Obviously size, an imperfect measure of systemic importance, is correlated with 

systemic importance because large financial firms are more likely to have characteristics of systemic importance. The $50 billion threshold set by Title I Sec 121 of 

Dodd-Frank is probably sufficiently low that it captures the lion’s share of banking 

companies that would be flagged under one or more of the systemic criteria discussed below. However, just relying on size does not give us an understanding of 

how to design laws and regulatory infrastructure to deal effectively with systemically important institutions. Along with size I would stress what I call the ‘‘4 C’s’’ 

of systemic importance: Contagion, Correlation, Concentration, and Context/Conditions, and discuss how each of the 4 C’s has been part of the rationale for generous 

treatment of the creditors, managers and stockholders of troubled financial firms. 

In the systemic context, Contagion is a metaphoric way to describe the transmission of losses across the financial system or the locking up of financial markets 

from the insolvency of one or more major financial firms. Contagion as a source of 

systemic importance appears on the scene in 1974 with the failure of Bankhaus I.G. 

Herstatt AG, which failed coincidentally as the United States authorities were dealVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00114 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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2Walker F. Todd and James B. Thomson, ‘‘An Insider’s View of the Political Economy of the 

Too Big to Fail Doctrine’’, Congressional Record, vol. 138 (no. 102), S9978–9987 (July 20, 1992), 

102nd Congress, 2nd session. Reprinted from ‘‘Public Budgeting and Financial Management: An 

International Journal’’, vol. 3 (no. 3), pp. 547–617 (1991). Also published as Working Paper 9017, 

Federal Reseve Bank of Cleveland (December 1990). 3See Janet Mitchell, 1988, ‘‘Strategic Creditor Passivity, Regulation, and Bank Bailouts’’, 

CEPR discussion paper no. 1780. 4See Edward J. Kane, 1989, The S&L Insurance Mess, How Did It Happen? Washington DC: 

The Urban Institute Press. 5See Alessandro Penati and Aris Protopapadakis, 1988, ‘‘The Effect of Implicit Deposit Insurance on Banks’ Portfolio Choices With an Application to International Overexposure’’, Journal 

of Monetary Economics, 21: 107–126. 

ing with the largest protracted U.S. bank failure resolution to date, Franklin National Bank, 1974, and the 1984 FDIC rescue of the Continental Illinois Bank and 

Trust Company. 2 Contagion would also seem to be a factor in the 2008 Federal Reserve Bank of New York’s assisted acquisition of Bear Stearns by JPMorgan Chase. 

The ‘breaking of the buck’ by Reserve Primary Money Fund in September 2008 following the Lehman Brothers bankruptcy filing in is another example of contagion. 

Contagion is a fundamental consequence of the degree of a megafirm’s interconnectedness, be it through the payments system, a clearing, and settlement system, asset 

holdings, or off-balance sheet contracts (such as derivatives). 

Currently we do not collect information with sufficient granularity for us to understand the potential for contagion in the market place or how to aggregate what 

information exists in ways that would let us measure, monitor and police this risk. 

Information and clearing requirements in the over the counter (OTC) market under 

Title VII Sections 725, 728, 729, 742, 763, and 764 of Dodd-Frank could produce 

some of the information needed. However, much more needs to be done to identify 

the dealer’s counterparties. Congress should direct the Office of Financial Research 

(OFR) to collect International Swap Dealers Association (ISDA) master agreements 

for the purpose of constructing measures of exposure in the OTC derivative markets. 

Moreover, financial institutions with assets in excess of the $50 billion threshold for 

systemic banking companies should be required to report to Federal financial market supervisors and to their Boards of Directors any exposures to another financial 

firm in excess of 10 percent of their tier-I capital. Such exposure should be broken 

down by type—funding market, clearing and settling, interfirm balances (including 

correspondent balances), lending and security holdings, and off-balance sheet exposure. Collecting this information would allow the Federal Reserve to determine if 

the limits to be set on exposure should below the 25 percent of capital under Section 

165 of Dodd-Frank. It would also promote the orderly resolution of a failed financial 

firm as regulators could work to limit the spillover effects of the firm’s failure without automatically resorting to blanket guarantees of the financial firm’s creditors. 

Correlation can create a too-many-to-fail problem. It occurs when many institutions hold similar balance-sheet positions. 3 Correlating one’s risk taking enhances 

political clout to resist closure should the firm become insolvent. Financial supervisors will face pressures to forbear as the cost of dealing with an insolvent industry 

will be high from a fiscal and political standpoint. 4 When risky bets go bad the odds 

of survival are increased if a firm is one of many facing ruin. Examples of this phenomenon in U.S. financial history include the 1980s savings and loan debacle (correlated interest rate risk), the 1980s international debt crisis (correlated sovereign 

risk), and more recently the subprime mortgage crisis. 5

Today, measurement of correlation across Dodd-Frank classified systemic financial firms is being addressed through the Comprehensive Capital Analysis and Review (CCAR) stress tests conducted by the Federal Reserve. These tests are mandated under Title I Section 121 of Dodd-Frank. While the results of the stress tests 

are scrutinized at the institution level as part of the capital planning review, information on the extent of loss exposure across firms subject to the stress tests under 

the various shock scenarios would give a clear picture of the extent to which these 

firms are taking on correlated risks. The stress tests should include specific industry 

shocks such as a decline in commercial real estate prices for financial market sectors that represent a growing share of the risk exposure of the financial services 

industry. Again, aggregation of risks across firms is the problem. This may require 

the reporting of asset exposure by 3 digit Standard Industrial Classification (SIC) 

codes for all CCAR firms and nonbank financial firms that meet the conditions to 

be considered systemically important by the Financial Services Oversight Council 

(FSOC). 

The third source of systemic importance is Concentration. Here we are referring 

to market concentration, the presence of a few big players in a key market or activity and the degree of contestability (the ease with which new firms can enter). ConVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00115 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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6For the over the counter derivatives markets the reforms to that market under Title VII 

of Dodd-Frank may lessen the systemic importance large banking companies may derive from 

the SWAPS market. 7http://libertystreeteconomics.newyorkfed.org/2011/04/everything-you-wanted-to-know-aboutthe-tri-party-repo-market-but-didnt-know-to-ask.html#.U8FZVLFwV2M 8http://www.clevelandfed.org/research/policydis/pdp19.pdf 

centration becomes a source of systemic importance when the failure of a firm 

causes a major disruption or the locking up of a key financial market or activity. 

Two prime examples of this are in the set of financial contracts that are not subject 

to the trust-avoidance provisions of United States bankruptcy law. Currently, the 

seven largest U.S. banks account for 98 percent of OTC derivative contracts written 

by U.S. banks. Reportedly JPMorgan Chase has had as much as 40 percent share 

of the plain vanilla interest-rate swap market. It is hard to imagine that the impact 

of a JPMorgan Chase failure on the SWAPS market would not influence how its insolvency would be handled. 6 The other example is the triparty repo market, a $1.6 

trillion market where hundreds of billions of dollars of intraday credit is extended 

by the two large depository institutions (Bank of New York Mellon and JPMorgan 

Chase) that serve as the intermediaries (clearing banks) in that market. 7

The fourth source of systemic importance for a financial firm is context/conditions, 

that is, the economic or financial market conditions at the time the firm becomes 

insolvent. Firms that come under financial distress during a period of market fragility are more likely to be treated as systemic than firms that run aground during 

more normal market conditions. Context/conditions explains why Drexel Burnham 

Lambert filed for bankruptcy in 1990 but Bear Stearns was put through a Federal 

Reserve Bank of New York assisted merger in early 2008. It also partially explains 

why the Federal Reserve Bank of New York intervened to broker a deal for Long 

Term Capital Management. 8 Context/conditions includes the exercise of political 

clout, something Members of your Committee are very familiar with. 

Dodd-Frank Reforms 

Dodd-Frank was enacted in 2010 in response to the financial crisis. It is a massive piece of legislation—848 pages and 16 Titles. The Act contains a number of provisions dealing with systemically important institutions. Below are my thoughts on 

Sections 113, 115, 121, and 165 and Title II of Dodd-Frank. I will also discuss the 

need for supervisory contingency/disaster plans so as to facilitate orderly resolution 

of systemically important financial institutions in a time-consistent manner. 

Factors for Systemic Determination Under Section 113 of Dodd-Frank 

The period leading up the financial crisis saw the emergence of ‘‘Shadow Banks’’— 

nonbank financial intermediaries engaged in activities that mirror banking. These 

shadow entities resemble banks in that they tend to employ a high degree of leverage and financed opaque assets with short-term liabilities. Shadow banks and shadow banking activities are a form of regulatory arbitrage as activities move from the 

more heavily regulated banking sector into a less regulated sector. Hence, it is important to identify nonbank financial firms that are systemically important. 

The general criteria outlined in Section 113 of the Dodd-Frank for determining 

the systemic importance of a nonbank financial firm are consistent with what would 

be suggested by my the 4 C’s above. In fact, the 11 factors the FSOC is to use go 

beyond what I identified in my research. Setting so many characteristics that FSOC 

must use in determining whether nonbank firms are deemed systemically important 

financial institutions creates unnecessary discretion that invites political manipulation. Measuring systemic risk by the value of a firm’s taxpayer put provides a more 

concrete and accountable way for FSOC to determine who is and is not systemically 

important. 

FSOC’s Authority Under Section 115 of Dodd-Frank 

Section 115 of the Dodd-Frank provides FSOC a consultative role in the supervision of systemic financial firms. That is the FSOC can make recommendations on 

the Federal Reserve Board concerning regulations, supervisory standards and disclosure requirements applicable to systemic firms supervised by the Federal Reserve. 

It is unclear whether the FSOC’s role under Section 115 will have much of an impact. The Board of Governors and other agencies are not required to follow FSOC 

recommendations and other avenues exist for financial supervisors to provide input 

into new regulations and supervisory policies and procedures. 

It may be the case however, that public and political pressure that would come 

with the issuance of guidance by the FSOC to the Board would influence the Board’s 

decisions with respect to supervision of systemically important financial firms. Congress could increase the influence of the FSOC by holding hearings where the FedVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00116 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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eral Reserve Chairman must explain how the Board implemented FSOC recommendations and if it did not, why not. 

Section 121 of Dodd-Frank 

Section 121 largely clarifies powers the Federal Reserve likely had under existing 

banking law and extends this authority to nonbank firms subject to supervision by 

the Federal Reserve. To the extent that financial system supervisors failed to act 

because they were uncertain as to their authority under U.S. law, Section 121 of 

the Dodd-Frank could improve the effectiveness of the Federal Reserve in its oversight of systemically important financial institutions. I question, however, whether 

clarity of authority to act is constraint on financial supervisors. The Bear Stearns 

and AIG rescues, along with the extension of the financial safety net through aggressive use of 13(3) lending authority by the Federal Reserve and the FDIC’s Temporary Liquidity Guarantee Program, suggest a willingness of financial supervisors 

to act when statutory authority is unclear. 

Under a liberal reading one can argue that Section 121 directs the Federal Reserve Board to take into account systemic risk when reviewing mergers and acquisitions by systemically important financial companies under Federal Reserve supervision. I believe that systemic risk should be a consideration by the Federal Reserve 

when reviewing any proposed merger or acquisition, and in any proposed restructuring of a financial company under its regulatory purview. Furthermore, I believe 

that systemic risk should be part of the Justice Department’s antitrust guidelines. 

Section 165 of the Dodd-Frank Act (2010) 

Section 165 of the Dodd-Frank has five provisions of particular note. First is the 

limit on the leverage ratio, setting the minimum amount of equity a systemically 

important company must hold. Second are the resolution plan provisions (living 

wills) that systemically important companies must file detailing how they would dismantle the company under Chapter 11 of the Bankruptcy Code. Third are the limits 

on exposure to a single counterparty which we discussed above. Fourth is the authority for the Federal Reserve to set limits on short-term debt. Finally, there is the 

requirement of annual stress tests. 

Section 165 more than doubles the minimum leveraging standard from 33 to 1 

to 15 to 1 for systemically important financial institutions. While on paper this 

seems like a material increase in capital standards, the 6.5 equity to assets under 

Section 165 of the Act is below the tier-I capital ratio for U.S. banking firms over 

the past two decades. Even during the financial crisis tier-I capital for the industry 

never fell below 10 percent of assets. Bank of America which required a second capital infusion under the Troubled Asset Relief Program (TARP), would have exceeded 

the minimum 6.5 capital standard at the end of 2008 without the TARP infusions. 

Leveraging standards are likely to fail because they are based on book value of capital and not market values. The average loss on assets for banks closed from 2007 

through 2009—despite the presence of prompt corrective action provisions which 

also relied on book capital valuations under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)—was around 36 percent of assets. 

Resolution plans should improve the management of the systemic firms and reduce their complexity. This may indeed be happening. For instance, the number of 

CitiGroup’s nonbank subsidiaries fell from 1378 at the end of 2012 to 993 currently. 

Part of this decline was due to a decline in foreign nonbank subsidiaries from 375 

to 322 over the same time period. Properly implemented, these ‘‘funeral plans’’ 

should improve the management of systemic firms by having management explicitly 

consider worst-case scenarios. These plans should provide financial market supervisors a blueprint on how to dismantle a systemic company, including which financial markets might be affected by the demise of the firm thus allowing for a more 

orderly resolution of the firms. Taking a more macro view of these plans, financial 

market supervisors can compare plans across the major systemic firms. The macro 

view of the funeral plans could provide information on potential stress points in the 

financial system during periods of market fragility. That is how the living wills 

should work in principle. In practice it is too early to see if the resolution plans will 

have the desired impact. Beyond the review of submitted plans for their compliance 

with the final rule adopted by the Federal Reserve and FDIC, these two supervisory 

agencies need to conduct audits of these plans, analogous to the stress tests for capital planning, to determine their feasibility. 

Limits on short term debt authorized under Section 165 are being implemented 

as part of the liquidity requirements under the Basel III international capital requirements. Specifically they would be embodied by the Net Stable Funding Ratio, 

one of the two Basel III liquidity ratios (the other being the liquid asset ratio). Minimum requirements for liquidity should help improve financial system stability and 

114 

9 A sentiment expressed in a recent speech by Federal Reserve Board Governor Tarullo. See 

p. 15 of the Governor Tarullo’s speech, which can be found at http://www.federalreserve.gov/ 

newsevents/speech/tarullo20140508a.pdf. 

the resiliency of individual financial companies. Whether the Basel III approach to 

liquidity is the economically most desirable way to regulate liquidity is something 

that needs careful study. 

The annual Comprehensive Capital Analysis and Review (CCAR) involves stress 

tests of systemic financial companies and possibly is the most important of the Section 165 reforms. It is the closest thing to assessing systemic institution solvency 

on a market value basis. Care must be taken that stress scenarios are calibrated 

over a sufficiently long period of financial history to ensure the results remain 

meaningful as the 2007–2009 financial crisis gets farther back in our rearview mirror. With the implementation of the CCAR it is unclear that the CCAR coupled with 

a straight leveraging ratio would not be sufficient and, hence, that model-based capital requirements as in Basel II and III are no longer necessary. 9

Dodd-Frank’s Title II Orderly Liquidation Authority 

Orderly liquidation authority (OLA) under Title II of Dodd-Frank is a misnomer. 

The character of this new resolution authority is not new. It is modeled after and 

extends the bridge bank authority created by the Competitive Equality Banking Act 

(1987). Experience suggests that the expectation is restructuring and reorganization, with liquidation being the last resort. The resolution powers under Title II of 

Dodd-Frank also incorporate features of the Bankruptcy Code. Two general observations about OLA: First, the main use of OLA is likely to be to handle the failure 

of a large bank holding company. The prospect of a disorderly resolution of the parent holding company and its nonbank subsidiaries under bankruptcy was a source 

of systemic uncertainty prior to Dodd-Frank. Second, there are efficiencies in having 

a single entity, the FDIC, handle both the bank and nonbank parts of the estate 

of a bank holding company. 

In Title II of Dodd-Frank Congress grants the FDIC the ability to impose a oneday automatic stay on qualified financial contracts (QFC), allowing it time to decide 

which contracts to bring into the bridge institution and which ones to place into part 

of the estate to be liquidated. This 1-day stay can effectively be a 3-day stay if the 

resolution is triggered on a Friday. Cherry picking of contracts is reduced by requiring all the contracts of a single counterparty be treated the same way. Congress 

should revisit the safe-harbor provisions for QFCs passed as part of the 2005 bankruptcy reforms. I believe the collateral runs by QFC counterparties on Bear Stearns 

and Lehman Brothers are an unintended consequence of the special treatment of 

QFC counterparties in bankruptcy. A limited stay and the anti-cherry picking provisions of Title II should be incorporated into the Bankruptcy Code. 

It is curious that the firms exempt from bankruptcy are not subject to OLA, in 

particular insurance companies. AIG and Prudential have been designated as systemically important nonbank financial firms and MetLife is a bank holding company. Hence, major parts of three large systemically important financial institutions 

cannot be resolved under OLA, an important gap in the coverage of this authority. 

Another gap in OLA is it does not extend to the foreign activities of systemically 

important financial firms. So international subsidiaries of systemic banks and 

nonbank subsidiaries of foreign banks in the U.S. complicate the resolution of these 

companies and remain a source of systemic importance. One might observe the 

movement of activities off-shore in response to OLA. A possible example of such regulatory arbitrage is the growth of CitiGroup’s foreign nonbank assets. CitiGroup as 

a whole grew 1.60 percent from the end of 2012 through the first quarter of 2014. 

Its nonbank assets grew at a rate of 8.60 percent over the same period while its 

nonbank foreign assets grew at a rate of 29.25 percent. The reason for CitiGroup’s 

shifting of assets offshore is unclear. However, it is consistent with regulatory arbitrage in response to OLA. 

Additional Steps Needed To Address Systemic Risk 

Systemic importance reflects constraints faced by financial market supervisors in 

enforcing timely closure rules. It doesn’t matter what powers Congress gives financial supervisors to conduct orderly resolutions of financial companies if regulators 

remain reluctant to use them. A major step forward to limiting systemic importance 

(ending too big to fail) is requiring financial system supervisory agencies to develop 

and commit to contingency plans akin to the firm’s living wills for handling the failure of one or more systemically important financial institutions. These plans should 

contain a series of options, actions taken to contain systemic spillovers, with blanket 

guarantees of all creditor/counterparty claims to be, without exception, the last opVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00118 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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10For a discussion of contingency or disaster planning see, Joseph G. Haubrich, James B. 

Thomson, and O. Emre Ergrungor, ‘‘Central Banks and Crisis Management’’, Federal Reserve 

Bank of Cleveland 2007 Annual Report and Edward J. Kane, 2001. ‘‘Using disaster Planning 

To Optimize Expenditures on Financial Safety Nets’’, Atlantic Economic Journal 29(3): 243–253. 

tion on the list. 10 Scenario analysis should be used to test and refine these disaster 

plans. Much as the intent of Section 165 resolution planning by systemically important firms is intended to promote the orderly resolution of these firms (whether 

through bankruptcy or FDIC receivership), supervisory disaster plans should allow 

for resolution of systemic firms with the least impact on long-term incentives facing 

these firms. 

Dodd-Frank was hailed by its drafters as the antidote to Too Big to Fail. While 

provisions in this important reform legislation move us towards the goal of reining 

in the effects of systemic importance in the financial system, much remains to be 

done. 

PREPARED STATEMENT OF ROBERT DEYOUNG 

CAPITOL FEDERAL DISTINGUISHED PROFESSOR IN FINANCIAL MARKETS AND

INSTITUTIONS, UNIVERSITY OF KANSAS SCHOOL OF BUSINESS

JULY 16, 2014 

Thank you for the opportunity to address the Committee this morning. The DoddFrank Act contains many well-considered prudential standards aimed at reducing 

the systemic risk of U.S. financial institutions and by extension the systemic risk 

of the U.S. financial system. Some of these safeguards tighten up existing prudential standards, while others impose brand new prudential standards. These measures touch on nearly every risk function at modern banking companies, and the list 

is a long one. 

From my perspective, these measures can be dividing relatively neatly into two 

separate categories. 

On one side we have ex ante measures that try to limit banks’ exposures to and/ 

or contributions to systemic macroeconomic events. Some salient examples include 

higher capital and liquidity ratios aimed at making bank balance sheets more resilient to systemic events, and regulatory stress tests designed to monitor the resiliency of bank balance sheets. On the other side we have ex post measures that try 

to limit the amplification of systemic events (contagion) caused when banks default 

on their financial obligations to creditors, borrowers, other banks or financial 

counterparties. This approach centers on the FDIC’s orderly liquidation authority, 

which is complemented by new stores information made available to the FDIC via 

resolution plans (living wills) and price discovery via exchange traded derivatives 

positions. 

It is my observation that we pay most of our attention to the ex ante systemic 

risk prevention measures—i.e., setting rules and limits for banks—and we tend to 

have relatively less confidence in ex post measures to contain systemic risk. The explanation for this, I think, is two-fold. First, we understand intuitively that for 

every dollar of risk that we can prevent beforehand, we will have one less dollar 

of risk to contain afterwards. And second, we are skeptical that regulators will take 

strong actions to seize and liquidate large insolvent banks during a deep recession 

or financial crisis. Given our intuition and our skepticism, we tend to stress ex ante 

risk prevention. 

Minimum equity capital standards are the backbone of our ex ante risk prevention framework. The idea is that by increasing a bank’s capital buffer, it will have 

enough resources to continue operating during an economy wide financial event and 

to emerge from the crisis financially solvent. But such a world requires extremely 

high levels of bank capital. My research (with Allen Berger, Mark Flannery, David 

Lee, and Ozde Oztekin) shows that in 2006, the average U.S. commercial banking 

company had nearly double the risk-weighted capital ratios necessary to be deemed 

well-capitalized by bank regulators, and that 95 percent of all banking companies 

cleared the adequately capitalized threshold by at least 300 basis points. As we 

know, these outsized stores of equity capital were not large enough to prevent hundreds of bank insolvencies in the years that immediately followed. The lesson here 

is that relying on ex ante regulations to reduce bank failure risk—whether this 

means more capital, more liquidity, more lending restrictions, etc.—will impose nontrivial costs on banks, and these costs will in turn result in nontrivial reductions 

in financial services. 

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In the shadow of the financial crisis, this may seem like a wise tradeoff—less 

lending and slower economic growth in exchange for a reduction in the severity of 

the next systemic financial event. But the orderly liquidation powers in Dodd-Frank 

provide us with an historic opportunity to avoid having to accept this tradeoff. OLA 

should allow us to not only limit the contagious after-effects of a systemic crisis, but 

also to establish a newly credible regulatory regime devoid of the too-big-to-fail that 

have for so long fostered systemic risk in our financial system. 

Indeed, this is a big claim. But the economic story is straightforward: when investors become convinced that large complex banks will be seized upon insolvency— 

with shareholders losing everything and bondholders suffering losses—then credit 

markets and equity markets will more fully price bank risk-taking; profit-seeking 

banks will then face clear incentives to reject high-risk investments ex ante. 

The political story, however, is far from straightforward. OLA requires bank regulators to credibly establish that they can and will seize, unwind and eventually liquidate large complex insolvent banks. The FDIC’s ‘‘single point of entry’’ plan for 

implementing OLA is a workable plan. Nevertheless, in my discussions with scores 

of banking and regulatory economists across the U.S., I meet with a near uniform 

skepticism that the FDIC will be permitted to exercise its resolution authority during a financial crisis in which multiple large banking companies are nearing insolvency. Essentially, their belief is that the deeper is the financial crisis, the greater 

is the probability that OLA will be suspended. 

In my opinion, the most important actions that Congress and the Administration 

can take to limit systemic risk in the U.S. financial system is to strongly and repeatedly enunciate their support of OLA and to pledge that they will not stand in the 

way of its implementation during a deep financial crisis. Our banking system is 

most effective when scarce economic resources are moved from poorly managed 

banks to well-managed banks. Hence, we don’t want a banking system that is devoid of bank failure. Rather, we want a banking system that is resilient to bank 

failure. OLA is the key to this resiliency. 

Thank you for your time this morning. I hope that my remarks have been useful. 

I look forward to your questions. 

PREPARED STATEMENT OF PAUL H. KUPIEC 

RESIDENT SCHOLAR, AMERICAN ENTERPRISE INSTITUTE

JULY 16, 2014 

Chairman Brown, Ranking Member Toomey, and distinguished Members of the 

Subcommittee, thank you for convening today’s hearing, ‘‘What Makes a Bank Systemically Important?’’ and thank you for inviting me to testify. I am a resident 

scholar at the American Enterprise Institute, but this testimony represents my personal views. My research is focused on banking, regulation, and financial stability. 

I have years of experience working on banking and financial policy as a senior economist at the Federal Reserve Board, as a Deputy Director at the IMF and most recently for almost 10 years as Director of the FDIC Center of Financial Research 

where I served a 3-year term as chairman of the Research Task Force of the Basel 

Committee on Bank Supervision. It is an honor for me to be able to testify before 

the Subcommittee today. 

I will begin with a high-level summary of my testimony: 

• There is a trade-off between financial intermediation and economic growth. 

When prudential regulations reduce financial intermediation, they will restrict 

economic growth. The Dodd-Frank Act (DFA) does not recognize this trade-off. 

• The DFA does not define systemic risk, and this ambiguity allows regulators 

wide discretion to interpret DFA new DFA powers. 

• When designated nonbank financial firms, DFA criteria is unclear. Should the 

firm be designated if its isolated failure causes financial instability, or is the 

criterion that the firm’s failure in the midst of crisis and many other financial 

failures will cause financial instability? These two cases represent very different 

standards for designation. 

• Because DFA assigns regulators with the (impossible) task of ensuring financial 

stability without recognizing and limiting regulators’ ability to slow economic 

growth by overregulating the financial system, DFA builds in a bias toward 

overregulation of the financial system. 

• DFA gives regulators many powers to meet vague objectives. There are few controls over the exercise of regulators’ powers and extremely limited ability to appeal regulatory decisions to judicial review. In many cases these regulatory 

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powers can be exercised arbitrarily resulting in limiting or even canceling investor property rights without compensation or due process. 

• Designating bank holding companies larger than $50 billion for enhanced prudential supervision and regulation is arbitrary and a clear case of over regulation. 

• The imposition of explicit enhanced prudential regulations for the largest institutions creates a two-tiered system of regulation that will have long run negative implications for the structure of the financial industry. 

• The provision of enhanced prudential power to limit the use of short-term debt 

does not recognize that a substantial finance literature finds that the use of 

short-term (uninsured) debt is a method investors use to control risk-taking by 

borrowers. Short-term debt is cheaper, in part, because of this risk control 

mechanism and the imposition of binding short-term debt restrictions will lead 

to higher borrowing costs. 

• Mandatory Board of Governor stress tests have many negative side effects. 

They involve highly intrusive and detailed modeling of individual bank operations. Stress loss estimates are not the output of pure modeling exercises, but 

loss estimates depend to a substantial degree on judgments made by the Board 

of Governors. Along with enhanced prudential regulations for the largest institutions, the stress test process creates investor perceptions that the largest institutions are too-big-to-fail. Since the historical track record of stress-test based 

regulation is checkered at best, it is likely that there may be a time when the 

Board of Governors has the largest financial firms fully prepared for the wrong 

crisis. 

• A Title II resolution using the FDIC’s single point of entry (SPOE) strategy does 

not fix the too-big-to-fail problem. In order to keep subsidiaries open and operating to avoid creating financial instability, in many cases, SPOE will require 

the extension of Government guarantees that are far larger than those that 

would be provided under a bankruptcy proceeding and Federal Deposit Insurance Act (FDIA) resolution. 

• The Title II and SPOE create new uncertainty regarding which investors will 

be forced to bear losses when a bank holding company fails. 

• When Title II is used on a bank holding company because a subsidiary bank 

failed, it creates a conflict of interest between contributors to the deposit insurance fund and contributors to the orderly liquidation fund. 

• Title II and SPOE alter investor property rights without prior notice, compensation, or due process and with little scope for judicial protection. 

• Contingent capital is a more attractive means for address the consequences of 

the distress of a large and important financial intermediary. Its benefits are 

even more apparent in a crisis, when multiple financial institutions may be in 

distress. 

• The FDIA resolution process should be improved to avoid creating too-big-to-fail 

banks. Title I orderly resolution plan powers can be used to require the FDIC 

to plan to break up large institutions in an FDIA resolution rather than use 

a whole bank purchase. This may require legislation to amend the FDIC’s least 

cost mandate if favor of requiring large institutions to be broken up in the resolution process even if it imposes a larger loss on the insurance fund. 

• Improvements in the FDIA resolution process can be a substitute for mandatory 

enhanced supervision and prudential standards that apply to many institutions 

that exceed the Section 165 size threshold. 

I. Financial Intermediation, Economic Growth, and Systemic Risk 

It is has long been recognized that banks play a special role in capitalist economies. Today, the idea that ‘‘banks are special’’ is such a cliche that many may have 

forgotten what underlies this belief. Since Government regulations are designed 

around the idea that banks are special, it is useful to briefly review the economic 

functions of banks and highlight the link between bank regulation and economic 

growth. 

In many capitalist economies, banks are the only intermediaries that collect consumer savings and channel them into private sector investments. In bank-centric 

economies, if banks make sound investment decisions, the economy grows, banks 

profit, and consumers earn interest and their deposits are safe. If banks make poor 

investment choices, their investments fail, consumers lose their savings and economic growth plummets. 

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1Other securities can also be used as collateral but high quality information insensitive longterm debt securities like U.S. Government securities and highly rated corporate debt are preferred collateral. 

Some economies, including the U.S. economy, also benefit from nonbank financial 

intermediation, sometimes called ‘‘shadow banking.’’ Nonbank financial intermediation occurs when consumers channel their savings into private sector investments 

without the intermediation of a bank. 

In the most common form of nonbank intermediation, firms issue publicly traded 

securities that consumers can purchase and own directly, but savers may also purchase and own securities indirectly through collective investment vehicles like mutual funds, insurance companies, private equity, hedge funds, or other nonbank financial institutions. These intermediaries along with broker-dealers are part of the 

financial infrastructure that makes it possible for consumers to purchase and sell 

securities and thereby channel their savings into investments without using the 

banking system as the investing intermediary. 

The ability to invest saving using nonbank forms of intermediation generally gives 

savers more control over their investment decisions as well as the ability retain a 

larger share of the profit (or the loss) generated by their investment decisions. 

Nonbank intermediation is typically a cheaper source of funding for firms that have 

achieved a good reputation among investors by repeatedly honoring the financial 

claims they have issued in the past and through public disclosures that help to 

make their operations and financial condition as transparent as possible to investors. 

Banks also play a key role in creating the supply of money that consumers use 

as a store of value and medium of exchange. Transferable bank deposits are an important part of the money supply. Money is an extremely important economic invention. It allows consumers to specialize in their most productive labor activity in exchange for receiving compensation in the form of a widely accepted medium of exchange (money) they can use to purchase the goods and services they choose to consume or to save using bank or nonbank intermediation. 

Without money, consumers would have to barter. Without money, consumers 

must find someone offering the goods or services they want, and at the same time, 

the counterparty must want the output their own labor services. Making an investment is even more difficult because a saver must also trust that the counterparty 

will be willing and able to provide the promised service in a future period. When 

an economy lacks money, it must satisfy ‘‘a double coincidence of wants,’’ and economic output and growth are severely limited. 

Money facilities trade, but it is costly for firms and consumers to hold money. 

Cash pays no interest. Bank deposits offer minimal yield, and banks may impose 

costs to transfer deposit balances. If firms and consumers can find ways to minimize 

their holding of cash and bank deposits, they are better off because they have more 

control over where their savings are invested, they have the potential to earn higher 

returns, and they save on bank transactions costs. However, because transactions 

in real goods and services require the transfer of cash or bank deposits, firms and 

consumers either need to own money balances before transacting or be able to borrow them from somewhere. But most firms and consumers do not have established 

reputations that allow them to borrow based only on their pledge to repay in the 

future. 

The market solution to the borrower reputation problem is to use liquid long-term 

debt securities issued by reputable firms as collateral for borrowing. 1 Liquid longterm debt securities that are perceived to have stable values that are largely insensitive to new information are ideal collateral for borrowing. These securities can be 

traded among savers without the need to spend a large amount of effort to collect 

information and evaluate the likelihood that they will maintain their value in the 

near term. Firms and consumers may purchase these securities not for their ultimate cash payoffs, but to use them to secure borrowing when they are unable to 

borrow based on their promise of repayment alone. 

Securities that are widely perceived as having a stable predictable value function 

as so-called inside-money. They are held by firms and consumers as a temporary 

store of value in lieu of bank deposits because they offer higher yields and can be 

quickly converted into cash and deposit money at minimal cost. When firms or consumers need to transact, they exchange the securities for cash. A real world example of inside money is the market for repurchase agreements for Government, agency and high-quality structured and corporate credits. The stock of inside money is 

an important component of the economy’s effective money supply. 

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Defining Systemic Risk 

Against this background, it is useful to consider a definition for systemic risk. My 

preferred definition of systemic risk is that it is the possibility that a disruption in 

the financial intermediation process could cause a significant reduction in real economic growth. 

In the simple stylized economy have I described in the prior section, financial 

intermediation can be disrupted in two ways. The first is that the failure of a financial intermediary or many financial intermediaries will disrupts financial intermediation. To take an extreme example, if the economy has only a single bank and it 

fails, consumers can no longer use it to channel their savings into investments, its 

bank deposits are no longer acceptable as money, and economic growth will clearly 

decline. 

The nonbank intermediation process can also be disrupted and cause systemic 

risk. The failure of a key intermediary could make it very difficult for savers to purchase or sell securities. An important failure or series of intermediary failures could 

cause important disruptions in this form of intermediation. 

Nonbank intermediation can also be interrupted without an intermediary failure. 

Events or new information can make savers reluctant to purchase existing securities 

making it difficult or impossible for investors to sell the securities they own. When 

the value of existing securities is materially diminished, the agents holding securities for use as collateral have a diminished ability to borrow or may be unable to 

borrow at all and this will restrict their ability to transact in goods and services. 

The Dodd-Frank Act and Systemic Risk 

The Dodd-Frank Act uses the phrase ‘‘systemic risk’’ 39 times in directing the financial regulatory agencies to identify, mitigate, and minimize ‘‘systemic risk.’’ But 

the Dodd-Frank Act never defines systemic risk. Because the term is ambiguous, the 

law allows the regulatory agencies wide discretion to interpret the powers it conveys. The DFA directs agencies to draft and implement rules to control and minimize ‘‘systemic risk’’ without requiring the agencies to identify specifically what they 

are attempting to control or minimize. 

Another troubling aspect of the Dodd-Frank Act is that the law does not recognize 

that rules and regulations that reduce systemic risk will have an impact on economic growth. The necessity of such a relationship is easiest to see in a bank-centric 

economy. If systemic risk reduction is accomplished by imposing regulations that 

limit the risk of bank investments, regulation will also limit economic growth. A 

fundamental principle of finance is that risk and return are positively related. Regulations that limit the risk of bank investments, if they are effective, will necessarily 

constrain banks to low-risk, low-return investments. Very stringent bank regulation 

may ensure that bank deposits remain safe, but they will also force banks to channel consumer saving into low-risk, low-return investments, and the economy will 

grow more slowly than it otherwise would. 

The Dodd-Frank Act takes a very naive approach toward controlling systemic risk. 

Instead of clearly identifying what it is trying to accomplish and legislating appropriate measures, it defines financial stability as the absence of systemic risk and 

grants regulators an extensive set of new powers while assigning them the responsibility of ensuring U.S. financial stability. 

One way to ensure financial stability and remove systemic risk is to restrict financial intermediation. If there is little or no financial intermediation, then it cannot 

be a source of systemic risk. Unfortunately this solution has very serious consequences for economic growth. 

An alternative solution is to restrict the kinds of financial intermediation that 

cause systemic risk. This is the Dodd-Frank approach. It requires regulators to separate ‘‘good’’ financial intermediation from ‘‘bad’’ financial intermediation and to impose rules to stop bad intermediation. The problem is that is unclear that any person or agency has the capacity to distinguish good intermediation from bad intermediation, and stopping intermediation has negative consequences for economic 

growth. While this problem is inherent to some degree in any form of financial regulation, Dodd-Frank grants regulators extensive new powers to identify and stop 

‘‘bad’’ financial intermediation as the means to achieve an ultimate (and impossible 

goal) of ensuring financial stability without any requirement that regulators recognize the implicit cost on economic growth. 

Post Dodd-Frank, if we do not achieve financial stability, then easiest conclusion 

is that the regulators failed because they did not stop enough ‘‘bad’’ intermediation 

since regulators had been given sweeping powers to stop bad intermediation. 

Whether the conclusion is true or not does not matter. The fact that the conclusion 

will be made by some builds in a clear bias encouraging regulators to overregulate 

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in their pursuit of financial stability. Clear constraints on regulatory power are necessary, or regulators will overregulate and economic growth will suffer. 

I will now discuss in detail some of the specific issues that were raised in the invitation to testify at today’s hearing. 

Section 113 Designation 

Section 113 of the DFA provides the FSOC guidelines that should be followed 

when designating nonbank financial firms to be supervised by the Board of Governors and subjected to heightened prudential standards. The standard for designation is ‘‘if the Council determines that material financial distress at the U.S. 

nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could 

pose a threat to the financial stability of the United States.’’ 

Issues Associated With Section 113 

Section 113 includes a laundry list of factors that the Council can consider in 

making the designation, but the language merely identifies factors the Council can 

consider; it does not include any quantitative standards to guide the designation 

process. The characteristics that may be considered for designation are very broad, 

but without quantitative guidance, the guidelines are arbitrary and impose little 

rigor on the designation process. For example, the guidelines never mention whether 

the firms’ distress should be considered in isolation in an otherwise well-functioning 

financial market, or whether the threat to financial stability engendered by firm distress should be assessed in the context of a dysfunctional financial market under 

the assumption that many other banks and nonbank financial institutions are also 

failing. Clearly, the financial stability consequence of a firm failure in an otherwise 

quiescent financial market is far less severe than a failure under stressed financial 

market conditions. 

In practice, Section 113 guidelines merely restrict the FSOC’s designation discussion and the case (if any) it makes to support its decision, but the designation outcome is completely governed by the Council vote. Moreover, since the directive lacks 

objective standards for designation, the criterion used to designate firms will almost 

certainly across administrations as different politically appointed officials are represented on the Council. Without objective minimum quantitative standards for designation, there is little scope for continuity over time or for a designated firm to use 

data, analysis, or case precedent to overturn an opinion rendered by the Council. 

One especially telling feature of Section 113 is that the designation guidelines do 

not require the Council to simultaneously recommend specific heightened prudential 

standards for the designated firm to mitigate systemic risk or consider whether the 

heightened prudential standards that otherwise apply (set by the Board of Governors) will reduce the probability that the firm’s financial distress would pose a 

material threat to the financial stability of the United States. Indeed all of the 

Council’s designations to date have been made without any Council recommendations for specific heightened prudential standards and before the Federal Reserve 

has revealed how it will supervise the nonbank financial institutions or what 

heightened prudential standards the designated firms must satisfy. 

There is no requirement in Section 113 that the Council specify what specific 

characteristics or activities of the nonbank financial firm lead the Council make a 

designation. The justifications for all of the Council’s designations made thus far are 

vague and lack any specific information that would inform the designated firm or 

other potential designees of the actions they might take to avoid designation. Should 

the council take an interest in designating an institution, there is little or no objective information the institution might use to proactively modify its operations, capital, or organizational structure to reduce its ‘‘systemic risk’’ to acceptable levels. 

In summary, the legislation that guides the designation process for nonbank financial institutions gives financial firms little or no ability to protect themselves 

against an arbitrary designation by the Financial Stability Oversight Council. Moreover, the criterion used to designated financial firms will likely vary as administrations and their politically appointed FSOC representatives change. Since designation has the potential to materially change an institution’s regulatory framework as 

well as the potential to restrict its investments options and business processes, the 

designation process should be amended to include minimum quantitative standards 

for designation and a requirement that the Council credibly establish that Federal 

Reserve supervision and the enhanced prudential standards that will apply reduce 

the potential for the firm’s distress to create financial instability. 

Sections 115: FSOC Recommendations for Enhanced Regulation 

Section 115 empowers the FSOC to recommend specific enhanced prudential 

standards for designated financial institutions. The FSOC has authority to recVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00124 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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ommend that the Board of Governors impose heightened prudential standards on 

designated firms. These recommendations can require firm-specific standards and 

may include enhanced leverage ratio and risk-based capital requirements, liquidity 

requirements, short-term debt and concentration limits, contingent capital requirements, enhanced risk management requirements, resolution planning and credit exposure reports, and enhanced public disclosure. 

Issues Relate to Section 115 Powers 

Section 115 includes no guidelines or requirements to constrain the heightened 

prudential standards that the FSOC may recommend. Indeed Section 115 does not 

even discuss a process that must be followed to issue a recommendation. For example it is unclear whether the issuance of an FSOC recommendation requires an 

FSOC vote or the voting majority need for approval. Section 115 lacks any requirement that the FSOC support its recommendation for heightened prudential standards with objective evidence that shows that the recommended standards will successfully limit the firm’s ability to destabilize the U.S. financial system should the 

firm become distressed. 

Sections 121: FSOC Discretion To Grant Board of Governors Additional 

Corrective Powers 

Section 121 gives the Board of Governors the authority to request FSOC approval 

for additional powers that enable it to restrict the activities of a specific designated 

firm including preventing the institution from entering into mergers, barring it from 

specific investment activities or offering specific financial products, requiring 

changes to its business practices, and even requiring divestures if the Council determines that the institution poses a grave threat to U.S. financial stability that cannot be mitigated by other means. 

The primary issue raised by Section 121 powers is that Section 121 does not require that FSOC produce specific evidence to demonstrate that its restriction recommendation will curtail systemic risk or improve the stability of U.S. financial 

markets. Section 121 requires no objective criteria to limit or constrain the FSOC’s 

powers and protect the property rights of the designated financial firm’s shareholders and creditors. 

Section 165: Enhanced Supervision and Prudential Standards 

Section 165 directs the Board of Governors to establish heightened prudential 

standards that apply to bank holding companies in excess of $50 billion and 

nonbanks financial firms designated by the Council. The Board of Governors is required to set heightened prudential standards for risk-based capital requirements, 

liquidity requirements, concentration limits, risk management requirements and 

resolution plans and credit exposure reports. The Board of Governors is also empowered to set standards for short-term debt limits, contingent capital requirements, enhanced public disclosure, or other standards the Board of Governors deems appropriate to mitigate or prevent risks to financial stability that may arise from the distress of a designated company. 

Section 165 also requires the Board of Governors to administer annual stress test 

to bank holding companies with consolidated assets in excess of $50 billion and designated nonbank financial institutions and to publicly report on the results. The 

Board of Governors may use the results of the stress test to require designated institutions to modify their orderly resolution plans. In addition, Section 165 requires 

that all financial institutions or holding companies larger than $10 billion with a 

primary Federal regulator must conduct annual stress tests similar to the Board of 

Governors stress test and report the results to their primary Federal regulator. 

Section 165 also provides the Board of Governors and EDIC with the powers to 

impose heightened prudential standards on designated firms that do not submit resolution plans that provide for a rapid and orderly resolution under Chapter 11 

Bankruptcy in the event the designated firm suffers material financial distress or 

failure. 

Issues Raised by Section 165 Requirements 

When does a bank become systemic and require heightened prudential standards? 

There is no science evidence that supports a threshold of $50 billion for subjecting 

bank holding companies to heightened prudential standards. While the factors that 

are mentioned in Section 165 as potential indications that an institution may be a 

source of systemic risk—size, leverage riskiness, complexity, interconnectedness, 

and the nature of the institutions financial activities—are reasonable features to 

consider, there is no economic research that supports the use of a specific thresholds 

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for any of these individual factors to indicate a need for heightened prudential regulation. 

As of March 2014, the U.S. has 39 bank holding companies with consolidated assets in excess of $50 billion. Of these, 4 had consolidated assets greater than $1 trillion, 4 had assets between $500 billion and $1 trillion (and none of the 4 are primarily commercial banks), 8 had assets between $200 and $500 billion (5 of these 

are specialty banks), and 23 had assets less than $200 billion. Of the 23 banks with 

under $200 billion in consolidated assets, most are almost exclusively involved in 

commercial banking and many might be characterized as ‘‘regional’’ banks. 

There are huge differences in the characteristics of the 39 bank holding companies 

that are subjected to enhanced prudential supervision by the $50 billion limit imposed under Section 165. Very few of these institutions can truly be considered systemically important. Moreover, for the vast majority of these institutions, their failure could be handled using an FDI Act resolution if the appropriate planning were 

undertaken using Title I orderly resolution planning authority. There should be no 

need to invoke Title II. Thus, in my opinion, the $50 billion threshold set for enhanced prudential standards in Section 165 has erred on the side of excessive caution. 

Enhanced capital and leverage requirements for designated bank holding companies 

The enhanced bank capital and leverage standards required by Section 165 have 

been enthusiastically supported by many economists and policy makers, and I agree 

that higher bank capital requirements are appropriate for institutions that are truly 

systemic. But the class of institutions that is truly systemic is far more restricted 

than the class prescribed in Section 165. 

The enhanced capital and leverage requirements that have been implemented by 

the Board of Governors are associated with the U.S. implementation of Basel III. 

These requirements have been designed for use by banks and bank holding companies. They are not appropriate for nonbank designated firms who are also subject 

to the heightened prudential requirements under Section 165. 

Enhanced capital and leverage requirements for designated nonbanks 

Section 165 seems to give the Board of Governors the discretion to modify these 

enhanced prudential requirements and tailor them to more closely fit the businesses 

of nonbank designated firms. Thus far, the Board of Governors has not modified any 

of these enhanced prudential standards and argued that the Collins amendment imposes Basel I capital requirements as a minimum standard on all designated companies. Legislation clarifying that the DFA Collins amendment does not apply to insurance companies has passed the Senate and been introduced in the House of Representatives. 

Still, the issue of the applicability of Section 165 enhanced prudential standards 

highlights fundamental weakness in the drafting and implementation of the DoddFrank Act. The Financial Stability Oversight Council has designated a number of 

nonbank financial institutions without either knowing what enhanced prudential 

standards will apply or assuming that nonbanks will have to meet the same standards as bank holding companies. In either case, it is doubtful that the Council’s deliberations considered how designation would improve U.S. financial sector stability. 

A two-tiered system of bank regulations will stimulate the growth of large institutions 

A second issue raised by the imposition of enhance prudential standards on the 

largest institutions in the banking system is that a two-tiered system of regulations 

officially recognizes two distinct types of banks: (1) those that are small and can be 

allowed to fail without social cost; (2) those that are very large and create large failure costs that must be avoided by stricter regulation. Under this system, the smaller banks may benefit from less burdensome regulation. But investors understand 

that these institutions will be allowed to fail and softer regulations seemingly makes 

their failure more likely. In contrast, large banks have added regulatory burden, but 

they also have been explicitly identified by the Government as so important that 

they need additional regulation to ensure their continued existence. 

The differences in capital and leverage regulations between small and large banks 

mandated by Section 165 and implemented as Basel III are mechanical and may 

not be the decisive factor that differentiates the largest banks. However, the Board 

of Governors stress test and the resolution plans (joint with the FDIC) mandated 

by Section 165 include very intrusive correctional powers where the Fed or the 

FDIC can require extensive operational changes or additional capital at the largest 

institutions. For the largest institutions, post Dodd-Frank, it is not hyperbole to say 

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the Board of Governors (and to a far lesser extent the FDIC) now have a direct and 

important role managing the largest bank holding companies. 

When the Government is intimately involved in planning and approving large 

bank operations, why wouldn’t investors believe that their investments were safer 

in the largest banks? The enhanced prudential standards imposed by Section 165 

contribute to investor perceptions that the largest banks are too big to fail. 

Over time, the two-tiered approach to banking regulation will erode the ability of 

small banks to compete for uninsured deposits and reduce their ability to issue unsecured liabilities. Since Dodd-Frank also prohibits the use of trust preferred securities, small bank options to fund growth beyond their retail deposit bases will be severely limited. As a consequence, Section 165 requirements are likely to encourage 

additional consolidation in the U.S. banking system as large deposits and assets further migrate into the institutions that are required to meet enhanced prudential 

standards. 

Limits on the use of short-term debt 

Section 165 short-term debt limits give the Board of Governors the power to require designated financial firms to extend the maturity of their funding debt (except 

for deposits, which are exempted from the rule) and restrict the use of short-term 

collateralized funding including the use of repurchase agreements. Curiously, the 

deposit exemption is not restricted to fully insured deposits. Banks may issue uninsured deposit without restrictions even though this source of funding is among the 

most volatile and the first to run. 

Short-term debt restrictions limit one of the most visible symptoms of a financial 

crisis—the inability of financial firms to roll-over their maturating debt. They try 

to alleviate this problem by requiring that firms have, on average, a longer time 

buffer before they face the inevitable maturing debt roll-over. But all going-concern 

debt eventually becomes short-term and must be refinanced. 

The idea for short-term debt restrictions is also popular in many postcrisis academic papers that argue that there is an underlying market failure that can be fixed 

by short-term debt limits. Banks gain private benefit from funding short term because they have a monopoly on issuing demandable deposits and an implicit guarantee advantage in issuing other short-term deposit-like liabilities. The bank benefit 

is that short-term funding is usually the cheapest source of finance. 

The market failure arises when there is a liquidity shock and investors for some 

reason become unwilling to roll-over banks’ short-term liabilities and banks are 

forced to sell assets to meet redemption requirements. Because many banks are 

using ‘‘excess’’ short-term funding because of the apparent interest cost savings, 

they must all shed assets, and this depresses the market price of assets, causing 

a so-called ‘‘fire-sale’’ decline is asset prices. The decline is asset prices must be recognized by all institutions, even ones that may not be funding with excess short 

term-debt. And so the lesson from these models is that ‘‘asset fire sales’’ are an externality attached to the overuse of short-term debt, and if regulators restrict bank’s 

ability is fund short term, then the externality can be controlled. Well maybe, but 

there will be real economic costs that are not recognized in these models. 

First, all debt eventually become short term, so limiting the amount of banks and 

other financial firms short term debt does not remove the issue that all debt must 

eventually be rolled over regardless of maturity. The economic models that demonstrate ‘‘fire sale’’ externalities are highly stylized and static. In these models, if 

banks fund long term (in the third and final model period) they do not have to refinance in the second period when the fire sale occurs. By forcing banks to issue 

claims in the ‘‘last’’ period of the model, the claims magically never have to be refunded in the horizon of interest. While this solves the fire sale problem in these 

economic models, it does not fix the real life problem that seemingly far-off future 

periods have a habit if turning into tomorrow, and debt that was once long-term, 

becomes short term and must be rolled over. 

The ‘‘fire sale’’ models of short-term debt also ignore a large literature in corporate 

finance that argues that short-term debt is cheaper because it is a mechanism for 

controlling the risk that the managers of a financial institution (or any corporation 

for that matter) take. If the manager of a corporation is forced with the discipline 

of continuously rolling over a significant share of the corporation’s funding, then the 

manager must ensure that the corporations finances are always sound and its debt 

holders are never surprised by the firm’s is investments. 

Short-term debt is a bonding device. The need to roll over debt helps to keep the 

manager from investing in longer-term risky investments with uncertain payoffs unless debt holders are fully aware and approve (i.e., are already compensated) for 

such investments. If the manager conveys that the firm investments in short term 

and relatively safe activities, should debt holders learn otherwise, the manager’s 

124 

debt holders may refuse to roll over the debt at existing rates and the manager will 

be forced to abandon longer term investments before they can (possibly) produce the 

desired high payoff. 

When short-term debt controls the risks the manager takes, investors can charge 

lower rates. Thus, short-term debt provides cheaper funding in part because it limits borrower risk-taking. Indeed academic many papers argue that, before deposit 

insurance, banks funded themselves with demandable deposits because depositors 

required the demandable feature to discipline the bank, since the soundness of the 

bank’s assets could not otherwise be verified by depositors. Deposit insurance largely destroys the risk control benefits of demandable deposits. I say largely because 

there is evidence that some insured deposits still run. 

Thus, there are sound economic reasons for arguing that short-term debt restrictions on designated financial firms may be less advantages than they might seem. 

Short-term (noninsured deposit) debt controls risk taking, and the current wave of 

theoretical economic models that produce ‘‘asset fire sales’’ do not consider the risk 

control benefits of short-term debt. If financial firms are forced to fund themselves 

longer-term debt, their cost of debt will increase, and either the institutions will absorb these costs and be less profitable or pass these cost on to customers in the form 

of higher loan rates and lower returns on deposits. Section 165, and indeed the current wave of macroprudential economic models, do not recognize that short-term 

debt restrictions are likely to have real economic costs on borrowers. 

Mandatory Board of Governors annual stress tests 

Section 165 Board of Governor stress tests are perhaps the most problematic form 

of enhanced prudential supervision required by the Dodd-Frank Act. The value of 

these exercises for identifying and mitigating financial sector excesses is highly 

questionable, and yet the Federal Reserve System spends an enormous amount of 

resources on this activity. Indeed senior Federal Reserve officials have argued that 

Basel regulatory capital rules should be suspended, and the Board of Governors annual stress test should be formally recognized as the means for determining minimum capital requirements for large bank holding companies. 

Aside from the confidence of senior Federal Reserve officials, there is no evidence 

that coordinated macroeconomic stress tests will be effective in preventing future financial crisis. Already, these stress tests have missed the ‘‘London Whale’’ at JPM 

Chase and a multibillion dollar hole in Bank of America’s balance sheet. Fannie 

Mae and Freddie Mac both passed severe Government-designed macroeconomic 

stress test right before they failed in September 2008. Even before the financial crisis, many countries produced financial stability reports that included bank stress 

tests and none anticipated or prevented the crisis. Prior pan-European EBA stress 

tests failed to identify a number institutions that become problematic in short order. 

Based on the track record to date, stress tests have a pretty poor record for detecting ‘‘problem’’ institutions. 

A stress-test based approach for setting bank capital has two gigantic measurement problems. First, the macroeconomic scenario must actually anticipate the next 

financial crisis. And secondly, regulators must be able to translate the macroeconomic crisis scenario into accurate predictions about actual bank profits and 

losses. 

Few regulators possess the prescience necessary to accomplish this first step. Rewind your clock to 2006 and ask yourself if the Board of Governors would have used 

a scenario that predicted the housing crisis. It was less than 2 years away, but the 

Fed did not see it coming. The New York Fed’s staff was publishing papers that dismissed the idea of a housing bubble and the Federal Reserve Chairman’s speeches 

argued—worst case—there may be some ‘‘froth’’ in local housing markets. Even as 

the subprime bubble burst, the new Fed Chairman publicly opined that the economy 

would suffer only minor fallout. 

Even if the Board of Governors stress scenario correctly anticipates a coming crisis, the crisis must be translated into individual bank profits and losses. The problem here is that bank profits and losses are not very highly correlated with changes 

in macroeconomic indicators. Quarter-to-quarter bank profits do not closely follow 

quarterly changes in GDP, inflation, unemployment, or any other macroeconomic indication. The best macroeconomic stress test models explain only about 25 percent 

of the quarterly variation in individual bank profits and losses, meaning that more 

than 75 percent of the variation in bank profit and losses cannot be predicted using 

GDP, unemployment, or other business cycle indicators. 

Because of these measurement issues, bank loss predictions from macroeconomic 

stress tests have very little objective accuracy. Even using the best models, there 

remains a great deal of uncertainty surrounding how each bank may actually perform in the next crisis, presuming the stress scenario anticipates the crisis. 

125 

2 If the SIFI is primarily a broker-dealer, The FDIC plays a consultative role and is replaced 

in its primary role by two-thirds of the sitting members of the Securities and Exchange Commission. If the SIFI is primarily an insurer, the FDIC has a consultative role and the case is made 

by the FRB and the Director of the Federal insurance Office. 

These issues are real and serious and they make macroeconomic stress testing 

more of an art than a science. There is no formula or procedure that will lead to 

a single set of stress test bank loss estimates that can be independently calculated 

by different stress test modelers. Thus, it is not surprising that the Board of Governors and the U.S. banks rarely agree on stress test results. The Fed uses its artistic judgment to produce large losses while the banks’ aesthetics favor smaller loss 

estimates. Both the bank and the Fed are probably wrong, but the Fed’s judgment 

always prevails when it comes to the stress test capital assessment. 

The stress test process requires the Board of Governors to be intimately involved 

in modeling the operations and exposures of each large banking institution. It also 

requires the Federal Reserve Board to use its own judgment to set each large bank 

holding company’s ‘‘stress tested’’ capital plan. What if the Board of Governors is 

wrong? How can they let an institution that they are essentially managing fail? 

When regulations get so intrusive that the regulator virtually ‘‘runs the bank,’’ it 

becomes difficult for the Government to impose losses on the institution’s shareholders and bondholders if the institution fails. This precarious situation could easily encourage the Board of Governors to over regulate the largest institutions to ensure that there is never a failure on its watch. This outcome is a recipe for permanently slower economic growth and stagnant financial institutions. 

It may not be widely appreciated, but the coordinated macroeconomic stress test 

approach to regulation encourages a ‘‘group think’’ approach to risk management 

that may actually increase the probability of a financial crisis. Stress test crisis scenarios have to be specific so that banks and regulators can model the same event. 

Moreover, the Board of Governors imposes some uniformity in loss rates across all 

designated banks by using its own stress test estimates. The Board of Governors 

is very much like a coach or a central planner that tries to ensure some coherence 

in each designated firms estimates and capital plans. Unintentionally perhaps, by 

requiring all firms to approach the stress test problem the Board of Governors approve way, the process is encouraging all large institutions to think and operate the 

same way. What happens when all the largest banks are steeled against the wrong 

crisis scenario? Could the financial losses generated by a different an unexpected 

crisis actually be made worse by the coordinated stress test exercise? 

The finial Section 165 issue I will discuss is related to the requirement that designated firms file an annual orderly resolution plan. Section 165 directs the Board 

of Governors and the FDIC to determine whether designated firms’ orderly resolution plans are credible or whether they would fail to facilitate an orderly resolution 

of the company under title 11 of United States Code. However, Section 165 does not 

provide any specific guidance that constrains the agencies’ judgment. There are no 

specific criteria specified that can be used to identify a credible plan; there are no 

objective standards that must be met. The credibility of a plan is entirely based on 

subjective judgments by the Board of Governors and the FDIC. 

Title II: Orderly Liquidation Authority 

Title II creates a special administrative process similar to the Federal Deposit Insurance Act (FDIA) administrative process for resolving failed banks. Title II also 

creates a special funding mechanism that can be used to ‘‘liquidate failing financial 

companies that pose a significant risk to the financial stability of the United States 

in a manner that mitigates such risk and minimizes moral hazard. (Sec. 204 (a))’’ 

Title II is invoked when two-thirds of the serving members of the Federal Reserve 

Board and FDIC 2 board of directors make a written recommendation for the use 

of Title II to the Secretary of the Treasury. The recommendation must include: 

• A determination that that the financial firm is endanger of default 

• A determination that default under the Bankruptcy Code would have a serious 

destabilizing impact on the financial system 

• A summary of the effect of default on financial conditions 

• An assessment of the likelihood of a private sector solution 

• An evaluation of why a normal Bankruptcy process would be problematic 

• A recommendation for Title II actions to be taken 

• An evaluation of likely impacts on counterparties, creditors, shareholders, and 

other market participants. 

126 

3The FDIC can move any assets and liabilities of its choosing from the receivership into the 

bridge financial companies. The bridge financial company is exempt from regulatory capital requirements and all taxes: U.S., State, county, territory, municipality, or other local taxing authority. The bridge company charter is for 2 years but can be extended to up to 5 years. 4The DFA says the interest rate must be at least as large as the prevailing rate on U.S. Government obligations of a similar maturity plus and interest rate premium at least as large as 

the different between the prevailing rate in a corporate bond index of similar maturity and the 

prevailing rate on U.S. Government securities of a similar maturity. The DFA does not specify 

the credit quality of the corporate bonds that should be used to set a lower bound on the credit 

spread. 5The criteria are given in Section 210(o)(4). Among the criteria for setting assessment rates 

is a particularly striking catchall criterion: ‘‘any risks presented by the financial company in the 

10-year period immediately prior to the appointment of the Corporation as receiver for the covered financial company that contributed to the failure of the covered financial company (p. 

1511). 

Based on this recommendation, the Secretary of the Treasury in consultation with 

the President of the United States makes the final determination to use Title II 

powers. 

When Title II is invoked, the Secretary of the Treasury notifies the distressed financial firm’s board of directors that the FDIC will be appointed receiver under 

Title II of the DFA. Should the board of directors not consent to the appointment, 

the Secretary of the Treasury can petition the United States District Court for the 

District of Columbia for an order that appoints the FDIC as receiver. The Court has 

24 hours to object to the petition as arbitrary and capricious and provide a reason 

supporting this determination. Faced with an objection, the Treasury Secretary can 

amend and refile the petition and continue this process until the Court appoints the 

FDIC as receiver. 

Once a petition is filed, the Court must decide within 24 hours or the FDIC is 

appointed receiver. Once the FDIC is appointed as receiver, the special resolution 

process cannot be stayed by the courts. The FDIC has three years to complete its 

receivership duties, but the time limit can be extended to 5 years with Congressional approval. 

Title II assigns the FDIC specific responsibilities that must be satisfied in the resolution process. These responsibilities are summarized in Table 1. Title II allows the 

FDIC to treat similarly situated creditors differently if it improves recovery values 

or limits disruptions to the financial system. However, any disadvantaged claimants 

must receive a recovery at least as large as they would receive in a Chapter 7 bankruptcy. The FDIC also has the power to charter a bridge financial institution to affect the resolution and it can make use of an Orderly Liquidation Fund (OLF) to 

fund the resolution. 3

The OLF is an FDIC line of credit with the U.S. Treasury that can be used to 

fund Title II resolutions. The FDIC can pledge receivership assets to secure funding. 

Within the first 30 days of the appointment of the FDIC as receiver, Title II limits 

the amount of OLF funding to 10 percent of the consolidated assets of the distressed 

holding company as reported on its last available financial statement. After 30 days, 

the FDIC can borrow up to 90 percent of the fair value of the total consolidated assets of each covered financial company that are available for repayment. 

To access OLF funds, the FDIC must secure the Secretary of the Treasury’s approval of an orderly liquidation plan, a specific plan for the liquidation of the receivership that demonstrates an ability to amortize OLF loan balances and pay interest 

consistent with the repayment schedule agreement. The interest rate on the OLF 

loan will be set by the Secretary of the Treasury, but it must be at least as large 

as the prevailing interest rate on similar maturity corporate loans. 4

Should the projected repayment schedule from the receivership be unable to discharge the OLF loan terms within 60 months of the loan origination, the FDIC must 

follow a prescribed assessment protocol to collect the additional funds needed to discharge the debt. In the protocol, the FDIC first recovers any additional benefits that 

it paid out to similarly situated creditors in order to maximize the recovery value 

of the receivership or attenuate systemic risk (Section 210(o)(D)). If this recovery is 

insufficient, the FDIC then must impose a risk-based assessment on all financial 

firms with consolidated assets in excess of $50 billion. Title II includes an extensive 

list of criteria the FDIC must consider in setting the assessment rate 5 and it requires the Council to produce a ‘‘risk matrix’’ for criteria that the FDIC must take 

into consideration when setting OLF repayment assessment rates. 

127 

6http://www.fdic.gov/news/board/2013/2013-12-10lnoticeldis-blfr.pdf 

Title II clearly states that distressed financial firms should be resolved through 

the normal judicial bankruptcy process unless the bankruptcy destabilizes the financial system. To increase the probability that a financial firm can be resolved through 

a normal bankruptcy process, DFA Title I Sec. 165 requires designated financial 

firms to submit annual plans that outline a strategy to affect their orderly reorganization under a chapter 11 bankruptcy. The plan must be approved by the Board 

of Governors and the FDIC, and should objections be raised, designated firms are 

required to remedy objections and the Board of Governors and FDIC have the power 

to require any needed changes. 

The FDIC Single Point of Entry Title II Resolution Proposal 

Title II creates a new Orderly Resolution Authority, assigns the task to the FDIC, 

and imposes some broad guidelines the FDIC must follow but it does not dictate exactly how the FDIC must resolve a company put into Title II receivership. Title II 

leaves the FDIC with significant discretion to manage a receivership. To provide 

clarity to the Title II process, the FDIC has released a proposed strategy for executing a Title II resolution. The strategy envisions taking the top holding company 

of the distressed financial firm into receivership. This objectives of this ‘‘Single Point 

of Entry’’ strategy (SPOE) 6 are summarized in the FDIC Federal Register release, 

The SPOE strategy is intended to minimize market disruption by isolating 

the failure and associated losses in a SIFI to the top-tier holding company 

while maintaining operations at the subsidiary level. In this manner, the 

resolution would be confined to one legal entity, the holding company, and 

would not trigger the need for resolution or bankruptcy across the operating 

subsidiaries, multiple business lines, or various sovereign jurisdictions. p. 

76623. 

Under a SPOE Title II resolution, the FDIC will be appointed receiver of the failing institution’s top holding company. The FDIC will then charter a bridge financial 

institution, fire the existing management, hire new management, transfer all holding company assets into the bridge bank (p. 76617), and the bridge institution would 

function as the new top holding company. The holding company shareholders and 

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most of its liabilities will remain in the receivership to absorb the failed institutions 

losses. 

The FDIC has the power to treat similarly situated creditors of the receivership 

differently if disparate treatment is necessary to maximize the return to creditors 

left in the receivership or to maintain essential operations of the bridge financial 

holding company. Using this power, vendors and liabilities related to retained employees would be transferred to the bridge holding company so they could maintain 

continuity in essential vendor and employee services. Also, secured holding company 

claims would be transferred to the bridge bank along with the collateral assets. 

Most of the liabilities of the distressed financial firm’s top holding company would 

be converted into receivership certificates. Since most holding company liabilities 

would not be transferred into the bridge holding company, the new bridge company 

would be predominately equity funded. With the help of Government guarantees 

using the OLF if necessary, the bridge bank will issue new debt instruments and 

downstream the proceeds to recapitalize any subsidiaries that suffered losses or replace lost funding so that subsidiaries do not have to shed assets in a ‘‘fire sale’’ 

to meet redemption demands. 

The SPOE is designed to have the equity and debt holders of the parent company 

absorb all of the losses of holding company subsidiaries, but the FDIC anticipates 

circumstances when this may not be possible: 

if there are circumstances under which the losses cannot be fully absorbed 

by the holding company’s shareholders and creditors, then the subsidiaries 

with the greatest losses would have to be placed into receivership, exposing 

those subsidiary’s creditors, potentially including uninsured depositors, to 

loss. An operating subsidiary that is insolvent and cannot be recapitalized 

might be closed as a separate receivership. Creditors, including uninsured 

depositors, of operating subsidiaries therefore, should not expect with certainty that they would be protected from loss in the event of financial difficulties (p. 76623). 

Issues Raised by a Title II SPOE Resolution 

Most large financial firms that might be subject to Title II are primarily banks 

Most of the large financial institutions that might be candidates for a Title II resolution are bank holding companies. For the majority of these institutions, their primary asset is a bank or a subsidiary bank holding company. Figure 1 shows the 

share of each parent holding company’s equity that is invested in a subsidiary, affiliated bank, or a subsidiary bank holding company for all bank holding companies 

larger than $10 billion in consolidated assets. For most of these institutions, their 

primary asset is a bank, and even in cases where these institutions have multiple 

banks or subsidiary bank holding companies, they usually have one large depository 

institution that holds most of the holding company’s consolidated assets and issues 

most of the holding company’s consolidated liabilities. This feature is important because if the bank holding company’s largest asset is a big bank, the holding company will only be in financial distress when the largest bank is in distress. 

For most Title II candidate firms, parent equity = consolidated holding company equity 

To understand how well the SPOE might work in practice, it is instructive to take 

a closer look at the equity and liability characteristics of bank holding companies 

larger than $100 billion, banks that might require a Title II resolution. Table 2 reports March 2014 data on all holding companies larger than $100 billion. Two of 

these holding companies are savings and loan holding companies which have less 

detailed disclosures reported in the Federal Reserve public data base. The first important point to recognize in Table 2 is that when the equity in the parent holding 

company is exhausted by losses in its subsidiaries, then there is, at best, only a tiny 

amount of equity remaining in the consolidated institution. 

Table 2 shows that, for most of these institutions, once the parent is facing insolvency because losses exhaust its equity, any equity in its remaining solvent subsidiaries would be consumed by the losses in the holding company’s insolvent subsidiaries. So if the parent’s equity is exhausted or nearly exhausted when it is taken 

into a Title II receivership, then parent liability holders must be relied on to bear 

the receivership losses. 

129 

In many cases Title II and SPOE will provide larger Government guarantees 

than bankruptcy 

To keep a financial firm’s subsidiaries open and operating, the FDIC will have to 

guarantee all the subsidiary liabilities so that counterparties do not undertake additional insolvency proceedings that would suspend subsidiary operations and tie up 

their assets in additional (potentially foreign) legal proceedings. If the FDIC guarantees subsidiary liabilities, then only the parent holding company’s liabilities remain 

to absorb losses and recapitalize and fund subsidiaries. 

The final column of Table 2 shows that, in most cases, the parent’s liabilities comprise only a small fraction of the consolidated liabilities of these financial firms. 

This pattern is most pronounced when the holding company’s largest assets are held 

in subsidiary banks. The implication is that a Title II SPOE resolution will extend 

Government guarantees to the largest majority of the financial firm’s liabilities and 

impose the losses on only a small share of liabilities issued by the consolidated financial firm. This feature creates a Government guarantee that is, in many cases, 

much larger than the Government guarantee that would arise when a bank fails 

and the holding company goes into a commercial bankruptcy proceeding. 

130 

Holding company minimum debt regulations will be as complicated as Basel 

capital regulations 

If the FDIC plans to keep subsidiary entities open and operating to maintain financial stability, and the SPOE is the resolution strategy, then Title II is likely to 

expand the Government safety net beyond what would happen in a bankruptcy proceeding. The FDIC and Board of Governors position on this critique is that the 

agencies will in time craft new debt requirements for the parent holding company 

to ensure that it has an adequate stock of senior and subordinated debt to absorb 

substantial losses. But crafting holding company minimum debt requirements is a 

process that is analogous to the process of calculating regulatory capital requirements. The development of regulatory capital requirements has taken tremendous 

regulatory and bank resources, not to mention more than 15 years of development 

time. Moreover, holding company minimum debt requirements will also have international competitive implications if large foreign banks do not face similar requirements. This sets up the case for another yet another Basel process to set international requirements for holding company debt issuance. 

The OLF is a new guarantee fund that conflicts with the deposit insurance 

fund 

If the parent holding company liabilities are insufficient to support receivership 

losses and distressed subsidiary recapitalization needs, the FDIC will have to use 

the OLF to fund the receivership. This will require an FDIC assessment of all financial firms with consolidated assets larger than $50 billion to fund the receivership. 

While it has not been widely discussed since the passage of the DFA, the OLF 

Title II mechanism sets up a new Government guarantee fund. Under the SPOE, 

it will guarantee all but the parent holding company liabilities of the failing financial firm unless the FDIC decides to put some subsidiaries into default. Unless there 

are some operational details yet to be released, resources from the OLF will be 

available to guarantee deposits at a bank subsidiary. Consequently, Title II creates 

a conflict of interest between banks that support the deposit insurance fund and 

larger institutions that will be assessed to fund the OLF. This conflict becomes 

transparent when considering a SPOE resolution for a bank holding company whose 

primary asset is a single large bank. 

Among bank holding companies with consolidated assets greater than $50 billion, 

there are 13 institutions that own a single bank subsidiary. Selected characteristics 

131 

7For example, the senior and subordinated debt holders in WAMU bank suffered large losses 

while the senior and subordinated debt in the holding company had a 100 percent recovery on 

their securities. 

of these institutions are reported in Table 3. Of these institutions, only Goldman 

Sachs and Ally Financial have significant investments in nonbank subsidiaries. Investments in the operating subsidiaries in the remaining 11 holding companies are 

concentrated in the holding company’s single bank. If any of these holding companies is in distress, their bank must also be failing. If any of these designated institutions becomes distressed and imperils the financial stability of the U.S. financial 

system, then the Secretary of the Treasury and the President must make a decision 

whether to put the distressed firm through an FDIA resolution, or invoke Title II 

and use a SPOE resolution. This decision has important consequences. 

An FDIA bank resolution resolves the bank using the FDIC’s long standing administrative resolution process. Under this process, the failed bank’s shareholders 

and senior and subordinated debt holders bear the institution’s losses. Deposit protection, if needed, is provided by the deposit insurance fund, a fund that is built 

from assessments on all insured banks. Under an FDIC bank resolution, the holding 

company equity holders will suffer very large losses, and the holding company is 

often forced to reorganize in bankruptcy. Holding company senior and subordinated 

debt holders may have a better experience, and indeed they may even suffer no loss 

in bankruptcy. 7

Under a Title II resolution, the investors that own senior and subordinated debt 

in the bank will be fully protected under the SPOE strategy. Bank deposits, insured 

and uninsured, will also be fully protected under a Title II resolution. The SPOE 

will impose losses on investors in senior and subordinated holding company debt 

holders if the receivership losses cannot be fully absorbed by the holding company’s 

equity. Any additional losses and recapitalization needs that cannot be covered by 

the holding company debt will be borrowed from the OLF. Repayment of these OLF 

funds will be assessed against any financial firm with assets greater than $50 billion. 

With Presidential approval, Title II empowers the Secretary of the Treasury to 

change property rights without prior notice, public debate, or Congressional action 

The decision to use an FDIC Act resolution versus a Title II SPOE resolution has 

important consequences for investors. While holding company bankruptcy and FDIA 

resolutions are the presumed status quo where bank debt holders bear losses and 

bank holding company debt holders have a better chance of recovery, the Secretary 

of the Treasury and the President can, quickly and without public debate or Congressional approval, change the rules. 

If Title II is invoked, losses are shifted onto holding company debt holders, and 

bank deposits, investors in bank debt, and the deposit insurance fund are fully protected against any losses. Title II allows the President and his appointed Secretary 

of Treasury to completely change property rights and shift losses among distinctly 

different investors without prior notice, public debate, or any vote from Congress. 

132 

Unless the holding company has specific characteristics that are uncommon 

among the largest holding companies, invoking Title II has the potential to provide 

Government guarantees far in excess of those that might be in force under an FDI 

Act resolution. The last column of Table 3 reports the liabilities of the parent holding company as a percentage of the subsidiary bank liabilities. Except for Goldman 

Sachs and Ally Financial, a Title II SPOE resolution would impose losses on only 

a very small fraction of liabilities issued by the consolidated holding company. If the 

bank subsidiary liabilities were protected by the SPOE, it is probable that a large 

share of the holding company’s losses would be borne by the firms that must contribute to the OLF. 

Title II provides inadequate funding to prevent asset ‘‘fire sales’’ 

The SPOE raises a few additional issues. Under Title II, access to OLF funds are 

limited to 10 percent of the value consolidated assets of the failed financial firm as 

reported on its last financial statement. After 30 days, or when the FDIC completes 

an assessment of the market value of the receiverships’ assets, OLF funding can increase to up to 90 percent of the market value of assets available to fund the receivership. The 10 percent cap on SPOE funding raises some important issues. 

It is highly unlikely that a large financial institution fails because it prepares its 

financial statements and discovers that it is undercapitalized. Instead, long before 

financial statements reflect true distressed values, market investors lose confidence 

and withdraw funding from the firm. The firm ultimately suffers a liquidity crisis 

that forces it to find a buyer or to reorganize. In the case of Wachovia and WAMU, 

somewhere close to 10 percent of their depositors ‘‘ran’’ in the weeks before they 

failed. Thus, history suggests that a large financial institution that is in danger of 

failing will have losses that require capital injections, but they will also face funding 

withdrawals that must be replaced if they are to avoid asset ‘‘fire sales.’’ 

When the FDIC is required to quickly replace funding withdrawals and inject capital using the OLF, the 10 percent funding cap could become an important impediment. To avoid the cap, the FDIC may have to revalue the receivership assets quickly and then request funds in excess of 10 percent of holding company’s initial consolidated assets. In reality, the FDIC does not have the capacity to value receivership assets that quickly, especially if the failure is a surprise. While I believe that 

the 10 percent funding cap is an example of good Congressional governance on 

paper, in practice, the FDIC will likely be forced into a speedy and less than rigVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00136 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING 71614080.eps
133 

orous revaluation because it will have access additional OLF funding in the early 

days of a Title II receivership. 

How will Title II work when and a bank subsidiary is simultaneously being 

resolved under the FDI Act? 

Some of my criticisms of the SPOE have been anticipated in the FDIC Federal 

Register proposal where the FDIC reserves the right to take the subsidiary bank 

or nonbank subsidiaries into separate receiverships: 

if there are circumstances under which the losses cannot be fully absorbed 

by the holding company’s shareholders and creditors, then the subsidiaries 

with the greatest losses would have to be placed into receivership, exposing 

those subsidiary’s creditors, potentially including uninsured depositors, to 

loss. An operating subsidiary that is insolvent and cannot be recapitalized 

might be closed as a separate receivership. Creditors, including uninsured 

depositors, of operating subsidiaries therefore, should not expect with certainty that they would be protected from loss in the event of financial difficulties (p. 76623). 

It is unclear how this policy would work when a large financial holding company 

is predominately comprised of a large bank, especially of the bank is internationally 

active. The overarching goal of the SPOE’s is too keep critical subsidiaries of the 

holding company open and operating to facilitate global cooperation, prevent ‘‘ringfencing,’’ multiple competing insolvencies, and counterparty reactions that create 

operational difficulties and systemic risk. The resolving the large bank subsidiary 

would certainly create the problems SPOE tries to avoid. 

The FDIC’s SPOE proposal does not explain how a Title II resolution would work 

when it is paired with a FDIA resolution of a bank subsidiary. It is unclear how 

losses will be allocated between bank and holding company creditors and between 

contributors to the deposit insurance fund and the OLF. It is also difficult to envision how the FDIC might be able to close a very large internationally active bank 

subsidiary, and impose losses on its creditors, while keeping it open and operating 

and out of extranational bankruptcy proceedings. 

Does Title II work in a true financial crisis? 

The last and biggest issue is how Title II and the SPOE would work when multiple large financial firms are simultaneously in distress. Would SPOE be used to 

simultaneously to resolve multiple large financial institutions through bridge banks? 

How different is this from nationalizing these banks which could comprise a large 

part of the banking system? 

Title II and SPOE do not fix the too-big-to-fail resolution problem in a true financial crisis when the distress of large financial institutions is mostly likely to arise. 

In my judgment, Title II complicates and compounds the too-big-to-fail issue at 

times when a single large institution fails in isolation without providing a practical 

solution in a financial crisis when many large financial firms are likely to be distressed simultaneously. 

If Not Title II and SPOE, Then What? 

I have argued that Title II implemented using SPOE does not fix the too-big-tofail problem and instead introduces many new complications into the resolution 

process. There may be better policies available to deal with the distress of a large 

systemically important financial institutions and I briefly discuss some of these options. 

Mandatory contingent capital 

I would argue that a requirement for large institutions to fund themselves with 

an adequate buffer of contingent capital is probably a better solution than SPOE. 

First, it is useful to realize that SPOE operates similarly to a contingent capital 

buffer, only the Secretary of the Treasury decides when to trigger the conversion 

of debt into equity, and to date, no requirements have been issued that force designated holding companies to issue a minimum amount of senior or subordinated 

debt that might be converted. 

Under Title II and the SPOE, neither investors in holding company debt nor investors in the senior and subordinated debt of the subsidiary bank know whether 

they will be called on to convert their debt claims into an equity claim against the 

receivership. As a consequence, both groups of investors will demand a risk premium for the additional uncertainty. 

Contingent capital, or a requirement to issue so-called ‘‘co-cos’’ would solve many 

of the problems associated with SPOE. Its issuance would be required by all designated firms ex ante and not just required ex post in a Title II resolution. PresumVerDate Nov 24 2008 15:40 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00137 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-16 WHAT MAKES A BANK SYSTEMICALLY IMPORTANT\HEARING
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ably co-cos would be required at the holding company level so that all designated 

firms are treated through the same recapitalization mechanism. Conversion triggers 

should be explicit and written into the contingent capital contract terms before 

bonds are sold, so that investors have the best available information to price the 

securities correctly. Provided issuance requirements are sufficient, co-cos would 

avoid the need to use of the OLF. 

To the best of my knowledge, European approaches for requiring contingent capital do not require immediate management removal. Managers may continue to 

serve (or not) according to the preferences of the shareholders after conversion. DFA 

requires managers and directors to be fired and replaced in a Title II resolution. 

To satisfy this requirement, the FDIC claims it will have a collection of vetted managers waiting to run a SPOE bridge institution. This claim seems a bit of a stretch. 

There are probably few people with such a capability, and my guess is that they 

are already fully employed and well compensated. 

Unlike the SPOE, it is easy to envision how contingent capital might work in a 

financial crisis when many designated firms simultaneously approach distress. Multiple conversions would recapitalize designated institutions without the need to resort to simultaneous Title II resolutions. 

There are still many unresolved issues related to the use of contingent capital to 

solve the too-big-to-fail problem. Foremost among these is the design of appropriate 

conversion triggers. Triggers should be based on objective criteria and not left to the 

discretion of regulators. A second issue is what happens if you need a resolution 

mechanism after conversion is triggered? Even allowing that open issues remain, 

still I think that contingent capital is a more practical solution relative to Title II 

and a SPOE resolution. 

Using Title I to fine-tune FDIC large bank resolutions 

Historically, when large banks fail, the FDIC arranges a whole bank transaction 

in which a larger, typically healthier bank, assumes all the deposits and most if not 

all of the institutions assets. Sometimes the FDIC uses a loss share agreement to 

partially cover losses on the failed bank assets that are of questionable quality. A 

whole bank transaction was used to resolve WAMU, the largest bank failure in U.S. 

history, without cost to the deposit insurance fund. 

The problem with whole bank resolutions is that there needs to be a bigger 

healthier bank to purchase the failing institution, and even when one exists, if a 

sale is successful, it creates a new larger institution. One step toward fixing the toobig-to-fail problem, is to require the FDIC to break up failing banks when they sell 

them in a normal FDI Act resolution. 

There are costs associated with changing the public policy priorities in an FDIC 

resolution. Whole bank purchases often impose the least cost on the deposit insurance fund because bidders value acquiring the entire franchise intact. It may be 

costly and require significant time and resources to separate and market large failing banks piecemeal. For example, it may be difficult to identify all bank operations 

associated with a single customer relationship, and more difficult yet to package 

these customer relationships into subfranchises that are readily marketable. But the 

added resolution costs are costs that must be born to avoid creating too-big-to-fail 

banks through the resolution process. Indeed the FDIC SPOE envisions a similar 

process in a Title II resolution. 

There may be practical ways to reduce the cost of requiring the FDIC to break 

up large banks in an FDIA resolution. For example, the FDIC could be required to 

use Title I orderly resolution planning powers to require organizational changes 

within the depository institution that would allow the institution to be more easily 

broken apart in a resolution. This may involve organizational changes to information systems, employee reporting lines or other process to ensure that the bank has 

the capacity to conduct key operations in house and is not relying on venders or 

consultants in a manner that would inhibit the break-up of the institution in a resolution process. 

There are many complicated, complex, and potentially costly issues that must be 

solved before a large bank could be successfully dismantled and sold in pieces in 

an FDIC resolution. However, these issues are a subset of the issues the FDIC must 

solve if it is to undertake a Title II resolution of the largest, most complex and internationally active institutions and downsize them in the resolution process. 

Once large regional banks can be managed and downsized in the course of a normal bank resolution, there would no longer be a case to require these banks to meet 

heightened prudential capital, leverage, stress test, or other regulatory standards 

prescribed by Section 165 (excepting the requirement to submit a satisfactory orderly resolution plan). Improvements in the resolution process can substitute for 

overly rigorous prudential regulations that limit economic growth. 

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

LETTER FROM PAUL SALTZMAN, PRESIDENT, THE CLEARING HOUSE 

ASSOCIATION L.L.C., EXECUTIVE VICE PRESIDENT AND GENERAL 

COUNSEL OF THE CLEARING HOUSE PAYMENTS COMPANY L.L.C., 

SUBMITTED BY CHAIRMAN BROWN 

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STATEMENT SUBMITTED BY CHRISTY L. ROMERO, SPECIAL 

INSPECTOR GENERAL FOR THE TROUBLED ASSET RELIEF PROGRAM 

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