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93–180 PDF 2015

S. HRG. 113–551 

EXAMINING THE GAO REPORT ON 

EXPECTATIONS OF GOVERNMENT SUPPORT 

FOR BANK HOLDING COMPANIES 

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 WHETHER THE ERA OF TOO BIG TO FAIL IS FINALLY OVER 

JULY 31, 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 

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 

GEOFFREY OKAMOTO, Republican Subcommittee Staff Director 

MEGAN CHENEY, Legislative Assistant 

(II)

C O N T E N T S 

THURSDAY, JULY 31, 2014 

Page 

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

Opening statements, comments, or prepared statements of: 

Senator Toomey ................................................................................................ 3 

Senator Vitter ................................................................................................... 4 

WITNESSES 

Lawrance Evans, Director, Financial Markets and Community Investment, 

Government Accountability Office ...................................................................... 6 

Prepared statement .......................................................................................... 34 

Responses to written questions of: 

Chairman Brown ....................................................................................... 198 

Deniz Anginer, Assistant Professor of Finance, Pamplin School of Business, 

Virginia Tech ........................................................................................................ 8 

Prepared statement .......................................................................................... 50 

Edward Kane, Professor of Finance, Boston College ............................................ 10 

Prepared statement .......................................................................................... 124 

Anat Admati, George G.C. Parker Professor of Finance and Economics, Graduate School of Business, Stanford University .................................................... 13 

Prepared statement .......................................................................................... 130 

Douglas Holtz-Eakin, President, American Action Forum ................................... 15 

Prepared statement .......................................................................................... 195 

Responses to written questions of: 

Chairman Brown ....................................................................................... 199 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Charts submitted by Chairman Sherrod Brown ................................................... 201 

Report submitted by the Government Accountability Office ............................... 202 

Statement submitted by the American Bankers Association ............................... 296 

Comments regarding the ‘‘GAO Report on Large Bank Holding Companies’’, 

by Allan H. Meltzer .............................................................................................. 303 

(III)

(1) 

EXAMINING THE GAO REPORT ON EXPECTATIONS OF GOVERNMENT SUPPORT FOR 

BANK HOLDING COMPANIES 

THURSDAY, JULY 31, 2014 

U.S. SENATE, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER

PROTECTION

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

Washington, DC. 

The Subcommittee met at 2:02 p.m., in room 538, Dirksen Senate 

Office Building, Senator Sherrod Brown, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN SHERROD BROWN 

Chairman BROWN. The Subcommittee will come to order. 

Thank you, Senator Toomey, for working with us on so many 

issues, including your cooperation in this hearing. Thank you. 

Thank you, Senator Vitter, for joining us. 

There will be other Members here, too. 

And thanks to the witnesses whom I will introduce in a moment. 

Too big to fail is the Government policy that ensures that certain 

financial institutions cannot be allowed to fail because their failures would cause too much damage to our Nation’s financial system and our Nation’s economy. 

This is the Subcommittee’s sixth hearing since 2011 on the issue 

of too-big-to-fail banks. We are here to ask again whether too big 

to fail is finally over. 

Some Wall Street institutions and their paid consultants and lobbyists argue that no bank is too big to fail. 

Upton Sinclair, the American writer, once said, ‘‘It is difficult to 

get a man to understand something, when his salary depends on 

his not understanding it.’’ 

But most objective observers agree with Federal Reserve Chair 

Janet Yellen who said that ‘‘Our work is not finished.’’ When the 

four largest U.S. banks are 25 percent larger today than they were 

in 2007, before the implosion of the economy, it is hard to disagree 

with her statement. 

Yesterday, Christy Romero, the Special Inspector General for 

TARP, released a report in which she concluded the six largest U.S. 

bank holding companies ‘‘remain interconnected to each other in 

2013 as they were in 2008.’’ She agreed we have more to do. 

Too big to fail distorts incentives and encourages excessive 

growth and leverage and complexity. 

2 

Today we are here to examine one effect of too-big-to-fail policies—the financial benefits enjoyed by the largest banks. The GAO 

report shows that megabanks’ funding advantage varies based 

upon how one measures it. Unfortunately, this estimate contains 

many limitations and is clouded by both extraordinary interest rate 

policies and a number of subsidies that are difficult to quantify. 

But this report has some valuable lessons about too big to fail 

and shows that right now the subsidy may have been reduced but 

could be about 50 basis points. GAO also says the subsidy may 

have been reduced not because we ended too big to fail but because 

of, their words, ‘‘improvements in banks’ holding companies’ financial conditions.’’ 

Unfortunately, market perceptions of financial conditions change 

quickly. For example, banks’ credit default swap spreads increased 

suddenly and not until well into 2008. 

Secretary Lew told this Committee last month that the only real 

moment when you know for sure is when there is a crisis. 

We rarely have the foresight to know when a financial crisis is 

about to happen. GAO’s report, though, gives us a glimpse of the 

next crisis. It estimates that the funding advantage would return 

to levels similar to those in 2008 as investors and depositors 

flock—and that word, flock, is exactly right—as depositors and investors flock to the megabanks because they believe the U.S. Government will rescue them. 

In another crisis, the biggest banks’ advantages potentially rise 

to as much as 500 basis points. Taking an estimate from one of the 

most conservative models of this scenario, the 6 largest banks 

would get an annual subsidy of about $13 billion in all of their liabilities. Using some of the higher estimates, it could be 10 times 

that. 

This suggests that under Secretary Lew’s test, the largest banks 

are still too big to fail; taxpayers are still supplying them with an 

implicit guarantee. 

Whether you view the Government support as a form of catastrophic insurance or a stock option or a nontransparent contingent 

liability for the Federal budget, we know that taxpayers really, in 

the end, never receive full value for it. 

The first GAO report issued in November, when Dr. Evans joined 

us before, showed that Government programs underprice support 

during a crisis. 

As a second report shows, we have not taken the necessary steps 

to ensure that we will not have to prop up the largest banks again. 

Unless you think that we can eliminate financial crises forever, 

the GAO report is another reminder we have more work to do to 

eliminate too-big-to-fail policies and the advantages and the distortions which they create. 

When we think about the costs and benefits of too-big-to-fail policies, industry wants us to think only about their costs. 

Steel companies dump waste into a river. They then argue it will 

be costly to clean it up, but it has a higher human cost to the miners and the children who get sick from the pollution. It passes more 

health care costs onto our society. The same with damage done by 

policies on too big to fail. 

3 

Those who believe in a society with rules understand that auto 

safety might cost car companies to install seatbelts and airbags, 

but those protections save lives. 

And financial rules might cost bank executives a little smaller 

bonuses, somewhat smaller dividends perhaps, but they will help 

prevent a repeat of what we had 5 years ago with millions of foreclosures and millions of lost jobs. 

Senator Toomey, thank you. 

STATEMENT OF SENATOR PATRICK J. TOOMEY 

Senator TOOMEY. Thank you very much, Chairman Brown, and 

thanks for having this hearing. 

I want to also thank Senator Vitter for requesting the GAO report and thank the GAO for their contribution to this discussion. 

It seems to me the GAO report on whether or not big banks get 

a subsidy is inconclusive, but in any case the real work that we 

ought to be focused on, the real issue here, is the extent to which 

Dodd-Frank has codified too big to fail. 

The way I see it, what Dodd-Frank does is it looks at banks, designates them as SIFIs and then attempts to micromanage them so 

massively and so completely that failure is, theoretically, not possible. I think that is the basic mentality of Dodd-Frank. 

Well, there are some problems with this approach. 

One is we have institutions designated as SIFIs who absolutely 

are not systemically important, and we have had hearings where 

we have had that discussion. There is no question in my mind 

about that. 

We also have the massive direct and indirect costs of complying 

with the overregulation and the micromanagement, which I would 

suggest goes well beyond a slightly diminished dividend to shareholders. It means there is less credit available, and the credit that 

is available is available at higher prices. So that is a problem for 

our entire economy. 

I would also suggest that the premise that regulators, as long as 

they have enough power, will make it impossible for an institution 

to fail; that is based on the mistaken notion that these regulators 

are omniscient, or have greater wisdom or intuition than they did 

before 2008, because there was no absence of regulators at the time 

that the financial crisis hit. 

Finally, I would simply argue that failure has to be an option. 

In a market-based economy, in a capitalist system, in a free society, you have to be free to fail. And that is without a taxpayer bailout. 

And so that is what we ought to be looking to achieve—a system 

where we can have a failure that is not catastrophic and that does 

not involve taxpayers being forced to make a bailout. 

So my suggestion is that what we ought to do—and I am open 

and looking forward to having your support on my legislation, Mr. 

Chairman—is let’s repeal Title II. To the extent that anybody 

thinks there is a subsidy or there is a codification of too big to fail, 

it must reside in Title II, which is where the orderly liquidation authority is. 

And rather than have this subjective process, which is what Title 

II is, where there is no option for restructuring, there is no cerVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
4 

tainty about creditor rights and there is an explicit mechanism for 

taxpayers to come in and be forced to make a bailout, rather than 

all of that, why not do this in bankruptcy, which is what bankruptcy is supposed to be all about? 

If you have a properly designed bankruptcy code, which I think 

does require some modifications, creditors would be on the hook for 

losses, not taxpayers; you could allow for either a liquidation or a 

reorganization, whichever makes sense; creditors of equal standing 

would be treated equally rather than the subjective treatment that 

Title II of Dodd-Frank contemplates; and you have a bridge bank 

mechanism that would allow for a resolution to occur without systemic problems. 

So I think that too big to fail is a real concern. I think the real 

solution is to go to the heart of where the problem is. The problem 

is in Dodd-Frank, and so I hope we will be able at some point to 

address that. 

Again, I thank you for having this hearing, Mr. Chairman. 

Chairman BROWN. Thanks, Senator Toomey. 

Senator Warren? No opening statement. 

Senator Vitter. 

STATEMENT OF SENATOR DAVID VITTER 

Senator VITTER. Thank you, Chairman Brown, for holding this 

hearing today and for partnering with me in requesting the study 

from the GAO that was released today on the expectation of Government support for megabanks-large bank holding companies. 

Chairman Brown and I started our work together based on a 

shared belief that Dodd-Frank had not ended too big to fail. We 

began by writing the regulators in 2012, urging them to use their 

statutory authority to deal with the too-big-to-fail problem and end 

bailouts once and for all. Unfortunately, they were not as aggressive as they needed to be. 

We then introduced our legislation requiring prior capital standards, and in January 2013, we asked the GAO to study and report 

to Congress on the perks of a megabank being considered too big 

to fail. 

I guess I disagree somewhat with my colleague, Senator Toomey, 

that this report is completely inconclusive. I think it is very helpful, and I think it moves the debate significantly. 

Not long ago, a lot of folks led by the megabanks were denying 

any funding advantage, any too-big-to-fail subsidy. Now I think 

that debate is over. Everyone agrees it exists, and we are debating 

how big it is and for what reasons it is here or here or wherever. 

I think that is a significant shift in the debate and we are approaching a consensus on this. From this report, I think it supports 

that consensus. 

Let me just point to a couple of quotes. 

‘‘Remaining market assumptions about Government support can 

give rise to advantages for the largest bank holding companies in 

three broad categories to the extent these assumptions affect decisions by investors, counterparties and customers of these firms. 

Those categories are funding costs, financial contracts that reference ratings and an ability to attract customers.’’ 

5 

And then in addition, out of this GAO report, it says that if today’s megabanks had the same environment and credit risk as in 

2008 the market would expect bailouts and their funding advantage would increase to between 102 and 495 basis points. So that 

is significant. 

Finally, let me point to one other key metric that I am very concerned about. It is outside of this report, but it is a key metric that 

is unassailable, and that is the accelerating pace since the crisis of 

consolidation. 

The megabanks have gotten much bigger. Smaller community 

banks have gotten far fewer in number. That was a preexisting 

trend, but that trend has been put on steroids through the crisis 

and Dodd-Frank. That trend is unassailable, beyond debate. 

And I think that is very worrisome for our banking system and 

sadly ironic, given that on the private side—Government was certainly responsible for the crisis in terms of many policies, but on 

the private side it was very large institutions, not smaller community banks. They have essentially benefited in terms of where they 

are in the market, benefited through the crisis and, in light, benefited by our response in terms of Dodd-Frank. 

Those smaller institutions that had nothing to do with the crisis 

have receded and in a much more vulnerable position than they 

were before the crisis and the legislative response. 

I look forward to our witnesses today and to an informed discussion based on what they have to say. 

Thank you. 

Chairman BROWN. Thank you, Senator Vitter. Thank you for 

your work on requesting this report and as Senator Toomey said, 

too. 

Dr. Lawrance Evans is a Director in the Financial Markets team 

at the GAO, where he has also served as an economist and led engagements in the GAO’s International Affairs and Trade Team. 

Prior to his service there, Dr. Evans was a research fellow at Amherst College and a research assistant at the Center for Economic 

Policy and Analysis. 

Welcome back, Dr. Evans. 

Mr. EVANS. Thank you. 

Chairman BROWN. Dr. Deniz Anginer is an assistant professor of 

finance at Virginia Tech’s Pamplin School of Business and is currently on leave from the position as a financial economist with the 

Development Research Group at the World Bank. Prior to joining 

the World Bank, Dr. Anginer worked as a risk and finance consultant at Oliver Wyman. 

Dr. Edward Kane is a research professor of finance at Boston 

College. In addition to his more than 50-year career in banking and 

economic teaching and research, Professor Kane served as a consultant to private companies and Government agencies including 

the Office of the Comptroller of the Currency, the General Accounting Office and the Federal Reserve Banks of Boston and Chicago. 

He currently serves as a research associate at the National Bureau 

of Economic Research and is a member of the Shadow Financial 

Regulatory Committee. 

Welcome. 

6 

Dr. Anat Admati is the George Parker Professor of Finance and 

Economics at Stanford University’s Graduate School of Business. 

Professor Admati spent more than 30 years studying and teaching 

finance and economics and has written extensively about the function and regulation of financial markets. 

Thank you, Dr. Admati, for being here. 

Douglas Holtz-Eakin is President of the American Action Forum. 

Dr. Eakin was a member of the Financial Crisis Inquiry Commission and served as Director of the Congressional Budget Office and 

Chief Economist of the President’s Council of Economic Advisors. 

In addition to his appointments across multiple Administrations, 

Dr. Holtz-Eakin was a senior fellow at the Peterson Institute for 

International Economics, Director of the Maurice Greenberg Center 

for Geoeconomic Studies and the Volcker Chair of International Economics at the Council on Foreign Relations. 

Welcome back to one of your many times to testify, Dr. HoltzEakin. 

Dr. Evans, if you would begin. 

STATEMENT OF LAWRANCE EVANS, DIRECTOR, FINANCIAL 

MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT 

ACCOUNTABILITY OFFICE 

Mr. EVANS. Thank you. Chairman Brown, Ranking Member 

Toomey, and Members of the Subcommittee, it is my pleasure to 

appear before you today to discuss the existence of any funding advantages the largest banks may have received due to perceived 

Government support. 

The report we released today reflects GAO’s extensive work on 

this issue. When I appeared before the Subcommittee in January, 

I noted that the question of whether or not banks receive benefits 

because of investor expectations of loss protection was largely an 

empirical one. As a result, my remarks today will focus on our 

original quantitative analysis. 

It is important to note up front that this was a difficult task, particularly because measuring investor perceptions is complicated. 

The very nature of our exercise necessitated a number of methodological choices and raised a number of issues over which reasonable 

people may disagree. 

Consumers of this research should know that precise and firm 

conclusions likely reflect key assumptions and confident decisions 

on difficult methodological issues that would benefit from professional skepticism and full disclosure. As a result, our report carries 

a heavy dose of caution and nuance and reflects the uncertainty 

underpinning our modeling effort. 

There are many funding sources one could analyze. We selected 

senior unsecured bonds. 

Bond yield spreads are a direct measure of what actual investors 

charge banks to borrow money in the market and are sensitive to 

credit risk and, thus, investor expectations. Senior unsecured debt 

is among the most important sources of nondeposit funding and intended to absorb losses under FDIC’s resolution authority. 

While there are many approaches to examining potential funding 

cost advantages, we chose an econometric methodology. This allows 

us to examine the relationship between size and bond funding costs 

7 

and take into account other factors that might drive funding cost 

differences, like credit risk and bond liquidity. 

Specifically, our model allows the funding cost-risk relationship 

to be influenced by bank holding company size and for that influence to change from year to year. 

Our time period covers 2006 to 2013, which captures many important changes in the regulatory environment and any impact this 

may have had on market expectations. 

Because uncertainty is inherent in modeling, it is best practice 

to analyze and report its effects. We directly incorporate sensitivity 

analysis into our findings by estimating 42 models for each year. 

The multiple model specifications reflect the various defensible 

ways to incorporate credit risk, bond liquidity and size into the 

analysis. 

For example, there is no agreement in the literature on which institutions may be considered too big to fail. Therefore, we capture 

systemic importance using different measures, including total assets and indicators for banks designated as G–SIBs and those designated as SIFIs by Dodd-Frank. 

Our analysis suggests a funding cost advantage for large banks 

during the financial crisis but provides mixed evidence of such advantages in recent years. For example, most models in 2013 suggest that funding cost advantages have declined or reversed, but 

there were a few models that found lower funding costs for large 

banks. 

Because we are agnostic about which models are the right ones, 

GAO remains cautious against strong conclusions. The weight of 

the evidence, though, suggests progress has been made, but it is 

still too soon to declare victory as funding cost advantages might 

resurface should crisis conditions reemerge. 

This is an important possibility to consider because changes over 

time in our estimates of the funding cost-size relationship may reflect changes in investors’ belief about, one, the likelihood that a 

bank will fail, two, the likelihood that it will be rescued by the 

Government if it fails, and three, the size of the losses the Government may impose on investors if it rescues the bank. However, we 

cannot precisely identify the influence of each of these factors. 

In a hypothetical scenario, when we assume credit risk returned 

to financial crisis levels in 2013, most of our models suggest, again, 

lower funding costs for larger banks. 

The hypothetical scenarios we examined did not provide the 

same overwhelming type of evidence of advantages we found in 

2008 and 2009, and Dodd-Frank and other financial reforms could 

make financial crisis risk scenarios less likely. 

But the outcome of these scenarios suggests that in addition to 

changes in expectations of Government support some of what we 

see is likely related to balance sheet repair and, therefore, a lower 

probability of failure. 

To be frank, it may take another crisis to truly test the effectiveness of financial reforms. 

We detail important limitations associated with our econometric 

analysis in the written statement and full report. Suffice to say 

here that our work is not perfect, and we have not exhausted the 

many ways one might investigate funding cost advantages. Users 

8 

of the report should give our cautionary notes serious attention before moving from our findings to public policy. 

Now we understand that stakeholders are invested on both sides 

of this issue. We encourage interested parties to base their examination of our work on an objective and thorough reading of the actual report. 

Shortly, you will hear from Professor Kane, who likely only had 

a limited time to review our report. Professor Kane’s written testimony contains a number of statements that are either inaccurate, 

mischaracterize our methodology or result from the application of 

inappropriate criteria to assess the validity of our study. 

GAO will welcome an opportunity to respond as we believe we 

have made an important contribution to the literature and the public policy debate. 

Chairman Brown, Ranking Member Toomey, and Members of the 

Subcommittee, this concludes my prepared statement. I look forward to any questions you might have. 

Chairman BROWN. Thank you, Dr. Evans. 

Dr. Anginer. 

STATEMENT OF DENIZ ANGINER, ASSISTANT PROFESSOR OF 

FINANCE, PAMPLIN SCHOOL OF BUSINESS, VIRGINIA TECH 

Mr. ANGINER. Mr. Chairman and the distinguished Members of 

the Subcommittee, thank you for convening today’s hearing and inviting me to testify. 

My name is Deniz Anginer. I am an assistant professor at 

Pamplin Business School and Virginia Tech. 

Along with my colleagues, Viral Acharya and Joe Warburton, I 

have examined market expectations of implicit Government guarantees to so-called too-big-to-fail institutions. Most of my testimony 

is based on this research. 

The too-big-to-fail doctrine holds that the Government will not 

allow large financial institutions to fail if their failure would cause 

significant disruption to the financial system and to economic activity. 

In our research, we find that large financial institutions and 

their investors expect the Government to back the debts of these 

institutions should they encounter financial difficulty. These expectations of Government support are embedded in the price of bonds 

issued by major financial firms, allowing them to borrow at lower 

rates. 

Expectation of Government support by the market also results in 

a distortion in how risk is reflected in the debt prices of large financial institutions. 

An explicit Government guarantee dulls market discipline by reducing investors’ incentives to monitor and to price the risk-taking 

of large financial firms. 

In our analysis, we show that while a positive relationship exists 

between risk and cost of debt for medium- and small-sized institutions, this relationship is 75 percent weaker for the largest institutions. Changes in leverage and capital ratios are likewise less sensitive to changes in risk for these large financial firms. 

Because they pay a lower price for risk than other financial institutions, the perceived guarantee provides too-big-to-fail firms with 

9 

a funding advantage. We estimate a funding cost advantage of approximately 30 basis points over the years 1990 to 2012, peaking 

at more than 100 basis points in 2009. 

The total value of the subsidy amounted to about $30 billion per 

year on average over the same time period, topping at $150 billion 

in 2009. 

We also examined nonfinancial firms. If bond investors believe 

that all of the largest firms, both financial and nonfinancial, are 

too big to fail, then large nonfinancial firms should enjoy subsidies 

similar to that of large financial firms. However, we find that this 

is not the case, suggesting that the difference is likely due to an 

expectation of an implicit Government guarantee. 

Compared to the GAO study, we find lower implicit subsidy values for the years 2007 to 2011 and slightly higher numbers in 

2012. We have not examined the year 2013, the year in which the 

GAO finds the greatest decline. 

Although most of the attention will be paid to the analyses that 

try to quantify the dollar values of the subsidy and its changes over 

time, it is important to note that it is very difficult to directly relate these changes to the introduction of Dodd-Frank and other regulations. 

It is very hard to separate out changes in the probability of large 

financial firms experiencing distress from the probability that they 

will be bailed out. As the GAO report points out, this is especially 

true as the risk premium in the market has declined in recent 

years and large financial firms have seen significant improvements 

in their balance sheets and capital ratios, reducing their probability 

of experiencing financial distress. 

Although it is very difficult to establish a direct link between 

regulations and changes in subsidy over time, examining these 

changes in subsidy using alternative methods over a short time 

window would be more helpful in analyzing the impact of DoddFrank and other regulations. 

In our study, we examined changes in risk sensitivities of cost of 

debt after the introduction of Dodd-Frank. We examined changes 

in subsidies accruing to large financial firms compared to nonfinancial firms. We also examined the cost of implicitly guaranteed 

debt to explicitly guaranteed debt issued by the same firm under 

the FDIC’s Temporary Liquidity Guarantee Program. 

Using these alternative approaches, we find that Dodd-Frank did 

not significantly alter investors’ expectations that the Government 

will bail out too-big-to-fail financial firms should they falter. 

Despite its no-bailout pledge, Dodd-Frank leaves open many avenues for future rescues. For instance, the Federal Reserve can offer 

a broad-based lending facility to a group of financial institutions in 

order to provide a disguised bailout to the industry or a single firm. 

In addition, Congress can sidestep Dodd-Frank by amending or 

repealing it or by allowing regulators to interpret their authority 

in ways that protect creditors and support large institutions. 

Finally, it is also important to note that the analysis conducted 

by us and the GAO only measured the direct subsidy that may accrue to too-big-to-fail firms. There may be other indirect effects 

such as misallocation of capital or excessive and correlated riskVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
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taking to exploit the implicit guarantees that are not captured by 

the analysis. 

To conclude, Governments are generally not required to make 

any apparent financial commitment or outlay or request funds from 

the legislatures or taxpayers when they implicitly guarantee toobig-to-fail institutions. Implicit guarantees lack the transparency 

and accountability that accompany explicit policy decisions. 

Taxpayers’ interests could be better served by estimating on an 

ongoing basis, both in good times and in bad times, the accumulated value of the subsidy. Public accounting of accumulated toobig-to-fail costs might restrain those Government actions and policies that encourage too-big-to-fail expectations. 

Thank you. 

Chairman BROWN. Thank you, Dr. Anginer. 

Dr. Kane, welcome. 

STATEMENT OF EDWARD KANE, PROFESSOR OF FINANCE, 

BOSTON COLLEGE 

Mr. KANE. Thank you, Mr. Chairman, for inviting me to testify 

today. I want to congratulate you and the rest of the Committee 

for continuing to battle against too big to fail in the face industry 

efforts to tell us it has gone away. Finally, I also want to thank 

Mr. Evans for making you more eager to hear what I have to say. 

[Laughter.] 

Mr. KANE. What I have to say is that GAO bungled the assignment you gave it. The GAO goes wrong at the outset in how it defines too big to fail. 

The definition of too big to fail offered in the report’s first sentence is incomplete. It describes too big to fail (TBTF) as an active 

policy of intervention when the most important part of TBTF is a 

passive policy of forbearance, which allows institutions that are insolvent to continue to roll over, and even expand, their debt. 

Deeply insolvent banks are what I term zombie institutions. 

They can only prevail because they are backed by the black magic 

of Government implicit guarantees. 

The GAO also misunderstands the character of the funding advantages that your Committee asked them to study. The GAO 

treats these guarantees as if they are merely a form of bond insurance on outstanding bonds. 

The character of too-big-to-fail guarantees is richer than insurance on outstanding bonds because, as long as regulators forbear 

from resolving its insolvency, a truly too-big-to-fail firm can extract 

further guarantees by issuing endless amounts of additional debt. 

So what is funding cost? Funding cost is the cost of the funding 

mix. Being too big to fail lowers both the cost of debt, which GAO 

studied, and the cost of equity, which it did not. 

too big to fail guarantees lower the risk that flows through to 

holders of both kinds of securities. It chops off their losses at a certain point and directs the flow of further losses to taxpayers. 

This means that, period by period, the incremental reduction in 

interest payments on outstanding bonds, deposits and repos is only 

part of the subsidy that the stockholders enjoy. The missing part 

is the increase in stock prices that comes from having investors disVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
11 

count the firm’s current and future cash-flows at an artificially low 

rate of return on equity. 

Limitless guarantees shift the risk of the deepest possible losses 

away from creditors and stockholders. It is as if the profit flow 

move through a pipeline with a Y in it. Once a TBTF becomes insolvent, further losses go to the taxpayers until the economy recovers. 

So the issue is not whether things are better today. The economy 

is better; so the banks will be better. 

The issue is whether we continue to encourage them to take on 

too much tail risk. 

The value of these incentives is the greatest part of what the 

GAO missed. We must recognize that guarantee contracts have two 

components. The first allows the guarantee party to put responsibility for covering losses that exceed the value of the assets of the 

bank holding company to the guarantor. No guarantor wants to expose itself to unlimited losses on this put. 

For this reason, all guarantee contracts incorporate a stop-loss 

provision that gives the guarantor a call on the assets of the firm. 

Ordinarily, the stop-loss kicks in just as insolvency is approached 

or breached. 

In the FDIC Improvement Act of 1991, efforts to exercise the 

Government’s call is termed prompt corrective action. We did not 

see prompt corrective action in 2008 for TBTF institutes. 

By definition, the Government’s right to take over a firm’s assets 

will never be exercised in a financial institution that is truly too 

big to fail. Nonexercise means that the Government has effectively 

ceded the value of its loss-stopping rights to the too-big-to-fail 

BHC’s stockholders. The value that forbearance gives away is what 

the GAO’s measure ignores. 

I offer a picture, Figure 2, in my testimony that graphs the behavior of AIG’s stock price before, during and after the 2008 crisis. 

The only time AIG’s stock price approached zero—and it did so 

twice—was when the notion of a Government takeover was seriously under discussion so that the probability of stockholders’ continued rescue was falling. As soon as this course of action was tabled, the stock price surged again because, TBTF policies were 

turning the stop-loss back to the stockholders. 

Also, the designation of systemically important financial institutions is really not a binary condition; that is, it is wrong to say that 

a BHC either is TBTF or it is not. TBTF does not start at a particular size; it lies on a continuum and is influenced by several 

variables. Any firm’s access to Senators and Congresspersons grows 

with its geographic footprint—this is part of the problem caused by 

the ongoing consolidation among the biggest BHCs—and with the 

number of employees that can be persuaded to contribute to reelection campaigns. 

To do a proper investigation, one cannot just look at bond markets. One should be looking also the stock market. 

I present in Figure 3 some work that Hovakimian, Luc Laeven, 

and I have done to estimate average dividend that taxpayers ought 

to have been paid by large banking firms from 1974 to 2010. We 

can see the cyclical pattern that we have been talking about. But 

12 

we can also see secular learning about and growing exploration of 

the value of these guarantees. 

Prior to each new recession, at the peak, more benefit has been 

extracted by too-big-to-fail institutions. I fear what is apt to happen 

in the next crisis. 

In deciding to ignore studies that use the contingent-claim approach to evaluate TBTF subsidies, the GAO fell into the trap of 

thinking of bailout expenditures as either loans or insurance. It is 

important that we understand the difference between guarantees, 

insurance, and loan contracts. 

An insurance company does not double and redouble the coverage of drivers it knows to be reckless. 

Similarly, lifelines provided to an underwater firm cannot be 

thought of as low-interest loans. Loans are just not available to 

firms that are in dire straits. 

The ability to extract implicit guarantees on new debt and the 

hugely below-market character of bailout programs means the repayment of funds that were actually advanced—i.e., just the funds 

that were actually advanced—does not show that a bailout program 

is a good deal for taxpayers. 

I believe that the politicians who have made that claim are 

embarassing everyone in Government. They are causing the public, 

who does understand this, to lose confidence in the policymaking. 

So what should we do to sanction reckless pursuit of TBTF subsidies? That is the second part of my statement: How can we sanction the exploitation of too-big-to-fail quantities? 

I have stressed that in principle the risks in backstopping these 

firms cannot be calculated and priced in the straightforward way 

that the risks of bonds or insurance contracts can. 

Now I want to convince you to characterize bailout support as equity funding, as loss-absorbing equity funding, provided to a zombie firm when no one else will give it a nickel. We have got to see 

that managers who adopt risk management strategies that willfully conceal and abuse taxpayers’ equity stake are sanctioned explicitly by corporate and criminal law rather than excused by insurance law as inevitable moral hazard. 

I believe the way we frame problems is critically important in 

making policy. 

If we think of bailout support as a loan, if recipients pay it back, 

it is a good loan. 

If we think of it as insurance, we would suppose that actuaries 

have been able to somehow figure out the risks and that the Government should be able to price and control its exposure to moral 

hazard. 

I am saying—— 

Chairman BROWN. Please wrap up. 

Mr. KANE. OK. Recklessly pursuing tail risk is an ethical violation. 

Regulatory capture has actually infiltrated the bureaucratic system that is supposed to limit risk-taking and sewn loopholes into 

the rules. Capital requirements in particular have gone very, very 

awry. 

I believe that genuine reform would compel the Department of 

Justice to prosecute megabank holding companies that engaged in 

13 

easy-to-document securities fraud. There is value in documenting 

the violations and prosecuting these crimes in open court. 

I know that Senator Warren has been pushing a bill that would 

make settlement deals much more transparent. We need to underscore how managers benefit when the fines fall only on the shareholders. 

But BHC managers that have committed theft by safety net from 

taxpayers are individuals. If we do not set up sanctions that punish 

individuals, we are going to get even more theft in the future. 

Chairman BROWN. OK. I am going to cut you off. Thank you, Dr. 

Kane. 

Dr. Admati, thank you. 

STATEMENT OF ANAT ADMATI, GEORGE G.C. PARKER PROFESSOR OF FINANCE AND ECONOMICS, GRADUATE SCHOOL 

OF BUSINESS, STANFORD UNIVERSITY 

Ms. ADMATI. Chairman Brown, Ranking Member Toomey, and 

Subcommittee Members, I am very grateful for the opportunity to 

speak to you today. 

too big to fail is primarily about the collateral damage from the 

failure of some very large and complex companies. 

The global financial system is highly interconnected, opaque and 

fragile, like a set of dominos near one another. The systemic 

dominos are particularly large and central. If one of them fails, or 

if people fear that it might be unable to fulfill some of its many 

promises, the system may collapse. And the same is true is multiple banks are in trouble at the same time even if they are not 

so big. 

The trends are not encouraging on this despite the Dodd-Frank 

Act, and I can elaborate on that later if you would like. 

In this scenario, the Government and the Fed must choose 

whether to let the natural process of failure play out or to intervene and, if so, how. 

When Lehman Brothers, a medium-sized investment bank that 

did not take deposits, filed for bankruptcy almost 6 years, the experience was traumatic. Massive interventions supported numerous 

other institutions. Some of the largest ones were among big-time 

recipients. 

Here are some questions: 

Is this fragile system the best system we can have? 

Must we live with it like we must live with the risk of an earthquake? 

Was the financial crisis the 100-year flood, and it is not cost-beneficial to build an expensive dam just for the rare event? 

Would making the system safer entail sacrificing its benefits? 

Is the problem just that they are too big and, therefore, breaking 

them up would solve the problems? 

Is finding a way to make them fail the solution? 

The answer to all these questions is no. 

We first must diagnose the problems and see which ones are 

most solvable and at reasonable cost. This does not happen, unfortunately. We are still living in a sick system, and we keep missing 

the most effective and straightforward medicines, and we can do 

something about this. 

14 

Let me say, briefly, the failed scenarios are all bad, and even 

changing the bankruptcy law will not help that. Bankruptcy certainly, as it is, is not going to work without collateral damage. So 

we can commit to something, but we have to bear the results of 

what we decide to do. 

I hope the Fed does not need too many iterations with its living 

wills to admit this obviously reality. I am glad Senator Warren 

pushed Chair Yellen about this recently. 

I have further questions to ask, and I did in my statement. 

Title I of Dodd-Frank gives the Fed perfect authority to act not 

only once it admits that bankruptcy is not a viable option without 

harm but, right now, while it is still iterating. Instead, the Fed is 

failing the public. 

Title II, orderly liquidation authority, is not really liquidation. It 

can maintain the firm’s infected intents, too. 

The FDIC is doing the best it can. This option is better than 

bankruptcy right now, certainly, but Title II is also not the solution 

of too big to fail, and it is especially not a solution to the inefficiencies and distortions in the system. 

Harm starts much before the fail is reached. In fact, the system 

is inefficient and distorted every single day, and much more can be 

done to improve it. 

This hearing is about implicit supports, and we heard something 

about it. I have a lot to say on that, and in fact, some of the documents that I submitted elaborate a little bit more on some of what 

Dr. Kane said over here and more about what these insidious subsidies really are. 

Implicit supports that the banks do not pay for do create a subsidy. Measuring the size of this subsidy is really complicated. A lot 

of assumptions are made, and often bad assumptions are made. 

But it is also besides the point is what I what to say. Even if 

you charge the companies every penny of the monetary cost of this 

subsidy, even if you did, and that would be difficult, this is a very 

bad system. 

I cite some papers in my statement that the GAO report and industry studies do not cite. 

And the bottom line is very clear; the subsidies are real, and they 

are very large. 

The main problem with the guarantees is that they reinforce an 

already distorted set of incentives and exacerbate the inefficiencies 

of the system. They create perverse incentives, and they enable excessive growth and other bad decisions. They intensify the conflict 

of interest between the banks and the rest of society. 

We are not getting what we want for these subsidies. We are 

maintaining a sick system. 

The key to the fragility of this system is the fragility of the institutions in it. This is not about the risk they take or about micromanaging them. This is about how they fund their investment. 

This is the most immediately fixable disease; banks simply use 

too little equity and too much debt. The tough regulations allow 

them to fund with 95 percent debt. This is unheard of anywhere 

without regulation, and there is nothing good about it. 

Citigroup would have satisfied these requirements in December 

2007. These requirements are outrageously inappropriate. 

15 

At the current levels, this level of indebtedness magnifies the 

risk in the system and creates fragility without doing anything useful for us at all. It works only for those in the system. The rest of 

us got talked into allowing it and living with the bad consequences. 

If you care about access to credit, we are not getting it. We are 

getting distorted credit. We get too little for some things that we 

want funded and too much elsewhere; that is wasteful. 

The key reason is that the lenders themselves have too much 

debt. They behave like distressed or zombie borrowers all the time. 

The people in the system are compensated to take risk, and the 

regulations are so bad; they distort the incentives further through 

a use of a risk weights that favor some investments over others 

and are manipulatable and distorted. 

We want risk to be taken with the right funding so that when 

things go wrong and do not work out there is no collateral damage. 

You may also believe that regulations are automatically bad and 

costly, but that is false. Some regulations are essential and good. 

Forcing banks to use more equity and less debt, if done effectively, 

brings only benefit. 

It acts to correct the distortions. It is a correction to what otherwise is crony capitalism. This is an area where the markets are not 

working, and only regulations or laws can correct this. 

We are doing a little bit of it, and they will tell you that we are 

doing a lot more. But we are doing it bad and insufficiently and 

ineffectively. 

The analogy I give is having speed limits that are entirely inappropriate. The fail is like ambulances and hospitals. We are not 

going to allow trucks to drive at 95 miles an hour through a residential neighborhood and take the chance that they implode and 

they burn the engine meanwhile. This is not a safe speed, and it 

is not hard to see that. 

Similarly, no corporation must live on 95 percent debt. Nobody 

does except in banking. Nobody can live like the banks except for 

the way they are allowed to and get away with. And that is without regulating it. 

I urge you to engage on these issues and to do what you can to 

improve this part of the regulation. The public should own this 

place, and the public is not served. Flawed claims that seem to 

have outside impact on this important debate are having that impact and should not. 

I look forward to a further discussion. 

Chairman BROWN. Thank you, Dr. Admati. 

Dr. Holtz-Eakin. 

STATEMENT OF DOUGLAS HOLTZ-EAKIN, PRESIDENT, 

AMERICAN ACTION FORUM 

Mr. HOLTZ-EAKIN. Thank you, Chairman Brown, Ranking Member Toomey, and Members of the Committee, for the privilege of 

being here today. 

I am going to make four brief points in my oral remarks, each 

of which is elaborated on in the written testimony that I submitted. 

Point number one is that any expectation of support for a bank 

holding company is, at its root, the result of discretionary policy actions taken, and the problem begins with policymakers and ends 

16 

with policymakers. It is not something that the banks did. It is not 

something that the creditors did. 

It is something that the policymakers, in a discretionary fashion, 

did. And creditors took it into account, charged too little in their 

loans to banks. Banks correctly responded to those incentives and 

expanded their portfolios inappropriately. 

It is a very simple identification of the problem. It is a policymaking problem. 

The second point is that the history of such interventions in a 

discretionary fashion is very erratic. It has consisted of interventions on behalf of large firms and on behalf of some very small 

firms. It has been interventions on behalf of financial firms and 

nonfinancial firms. Even in the most recent crisis, we saw both 

large and small banks receive some intervention, and we saw auto 

companies receive intervention. 

The nature of the intervention has changed. In some cases, it is 

to preserve the financial stake of bondholders. In other cases, they 

have been wiped out. 

And so it was unsurprising to me, having written my testimony 

before I read the GAO report, that when I read the GAO report 

they said there was a wide range of expectations among market 

participants and monitors about the nature of a potential Government intervention. Given the history, that range of expectations is 

utterly unsurprising to me and something the GAO should have 

found. 

The third point is that econometric attempts to pull out of differences in bond yields anything like quantifiable too-big-to-fail 

subsidy is a really elusive quest. It is well established that there 

are borrowing differentials between large and small entities in lots 

of industry, and indeed, financial services does not stand out as an 

especially large differential in the data. 

There are good reasons why markets might reward diversified 

firms, firms that have greater liquidity, and reward them even disproportionately in a crisis when liquidity and being able to move 

your financial assets is especially important. 

As a result, taking apart the differences in those bond yields is 

going to be highly sensitive to the nature of the specification, the 

nature of the estimation. 

And I think what you see in the GAO report is a stark tribute 

to exactly that—that we are going to get a different answer depending on how we do this analysis and you are unlikely to find 

a single sign or a single number on which to hang the analysis. 

And the last point is that given that this is an issue that comes 

from policymaker interventions it is hardly surprising that any toobig-to-fail expectation would change over time. We have seen radically important changes in the policymaking environment since the 

most recent financial crisis—Dodd-Frank, the Federal Reserve’s activities, you know, look across all the regulators, the existence of 

the FSOC, the activities of the FSOC. 

One would expect this to change. Indeed, the GAO had found 

that it had diminished somewhat. 

If you want to eliminate it, you have to eliminate the problem, 

which is discretion. 

17 

And in that regard I am quite sympathetic with the notion of 

Senator Toomey and his coauthors, that what you want to do is 

eliminate the discretion, put a fixed set of rules in the hands of a 

bankruptcy judge, design the rules so that you can deal with the 

admitted problem that illiquid financial institutions can become insolvent in a rapid fashion. So you have to build the system around 

that. 

But the solution to this is not to be found in changing the behavior of the creditors or the banks. It is changing the opportunity for 

behavior on the part of the policymakers. 

And I think the bankruptcy route and things like that are the 

most promising way for eliminating this problem in the future. 

Thank you, and I look forward to the chance to answer your 

questions. 

Chairman BROWN. Thank you, Dr. Holtz-Eakin. 

I want to start by observing that the GAO used three industryfunded studies to design this report, and the GAO arranged meetings with corporate treasurers of companies suggested exclusively—I believe exclusively—by the U.S. Chamber of Commerce, 

the same organization that sent a letter to the Subcommittee, sort 

of extolling the virtues of the largest banks in the country. So, just 

that observation. 

I want to start with Dr. Anginer and then work my way across 

the table, about the study. 

The GAO said the subsidy may have been reduced because of 

‘‘improvements in banks’ holding companies’ financial conditions.’’ 

One of the witnesses at our last hearing said that banks are in 

the business of taking prudent risks. 

Tom Hoenig estimates that the 8 U.S. globally, systemically important banks, the G–SIBs, have a 6.5 percent leverage ratio under 

U.S. accounting rules and a 4.62 percent ratio under international 

accounting rules. By comparison, the 10 largest banks in this country, under $1 billion, have a 9.25 percent leverage ratio under both 

measures. 

So my question is—and starting with you, Mr. Anginer, and 

working across—how do we encourage institutions to engage in 

prudent risks useful to our economy, prudent risks without 

incenting the kind of reckless behavior that leads to bailouts? 

If you would answer that, and then Dr. Kane and Dr. Admati 

and Dr. Holtz-Eakin. 

Mr. ANGINER. I think market discipline is very important. So the 

type of policies that encourage greater market discipline would be 

very useful in that regard. 

One of the things that we show in our analysis is that one of the 

effects of this too-big-to-fail doctrine is that it dulls market discipline. It reduces investors’ incentives to monitor the risk-taking 

of these financial institutions. 

So, to the extent that these policies reduce those incentives, you 

would expect greater risk-taking and not only greater risk-taking 

but a certain type of risk-taking as well. 

So, if you are a bank and you fail and none of the other banks 

are failing, you will most likely not get a bailout. If you fail when 

everybody else is failing, then you will get a bailout. 

18 

So this sort of incentivizes banks to take on a correlated risk, or 

similar risk, to all the other banks. This is also another important 

aspect that is often overlooked. 

And what we showed in our analysis is that this is usually penalized in other industries. So, if you are a company and you take on 

risk similar to other companies in the industry, the market will actually penalize you whereas in the financial sector we do not see 

this; they actually get a benefit. 

So market discipline is very important toward this type of perverse incentives. 

Chairman BROWN. Dr. Kane. 

Mr. KANE. What I see is a failure of the rule of law. Corporate 

and property law needs to recognize that the taxpayer is given an 

equity stake in these firms. And by thinking of the safety net as 

insurance, we excuse it as moral hazard and say it is regulators’ 

problem to stop it, even though they do not have the tools to stop 

it. 

Individual managers are paid to take potentially ruinous tail 

risks and rewarded and promoted on the basis of the value they extract by taking tail risks. 

Congress needs to enact offsetting personal and corporate penalties for willful efforts to pursue risks that recklessly abuse taxpayers’ equity stake and visit problems on nonfinancial and household sectors in the economy. Corporate penalties could include 

forced sales of some or all kinds of business. 

I think it is useful to think of the taxpayers’ stake in each toobig-to-fail firm as if it were a trust fund and conceive of Government officials as fiduciaries responsible for managing that fund. 

The reforms I propose seek to give regulators and managers and 

directors of too-big-to-fail firms an explicit and codified fiduciary 

duty to measure, disclose and service taxpayers’ stakeholding fairly 

and competently. 

We have to rework bureaucratic and private incentives to make 

this happen. That means regulatory agency and corporate mission 

statements must explicitly define, embrace and enforce fiduciary 

duties of loyalty, competence, and care to taxpayers—to taxpayers—who are implicit shareholders and are being treated unfairly relative to the explicit shareholders. 

Chairman BROWN. Dr. Admati. 

Ms. ADMATI. Well, corporate governance is broken in banks, 

mostly because most of the money they invest is creditors’ money, 

but the creditors are not really there in the governance. 

And what I am proposing and what is being proposed before is 

very complicated to do, but the first thing we have to do is bring 

the risk back to the investors. And the investors that should take 

the risk are the shareholders, and there should be more of their 

money. 

It is as if you increase their liability, but instead, you just have 

more of them with limited liability because that is what corporations are. 

So partnerships have more liability. Banks should have more responsibility and liability on their balance sheets. And the way to 

do that is not through triggers and through imposing it on creditors 

because of the collateral damage of doing that. 

19 

That is why the natural place is the way other companies do it, 

and the way they do it in other companies is because the creditors 

start telling them that they will not stand for it anymore unless 

they write incredibly punishing covenants and conditions and increase the costs. 

So if you have more shareholders, then you get more discipline 

from them. 

If banks were sent to the equity markets, they would be told by 

equity investors that they are too opaque. That is what they are 

saying. Listen to equity investors say that they cannot understand 

the disclosures, that they are uninvestable. 

And if they do not give them a high price for their equity, then 

we need to know that and we need to know why. And that is the 

price of their worth because maybe their balance sheets are too inflated. 

So the point is if they cannot raise equity then—at any price, 

then they fail a market stress test, and that is a stress test much 

better than the stress test that the Fed wants. 

Chairman BROWN. Dr. Holtz-Eakin. Mr. Holtz-Eakin. I will echo 

at the outset some of those remarks in that you want creditors 

doing their job, which is monitoring the risks that are embedded 

in the activities of a bank. 

And in addition to that you want the shareholders keenly aware 

that their money is at risk and that if, in fact, the bank is not wellrun they will lose it and that it will go away. 

If they do that, if the external forces convey appropriate appreciation of the risks, something very important will happen. 

One of the things I learned on the Financial Crisis Commission 

is that many of these institutions had remarkably bad internal risk 

assessment during the course of this period. I was stunned, but it 

was really very surprising. 

If the outside creditors and shareholders are telling you, do not 

worry about risk, you do not devote anything in your corporate 

management to controlling those risks. And it conveys all through 

these organizations. 

So we would get better risk management, not through the regulatory approach, but just from the outside incentives permeating 

the culture of the firm. 

Now, to do that, you have to take off the table the assistance, or 

expectation of assistance, by the Government in bad times. And 

that is the hardest thing because, honestly, when things go bad 

policymakers become very risk-averse, infinitely risk-averse. 

And, you know, they have asked many times, is there any chance 

this could happen? 

You say, well, there is a two-tenths of a billionth of a probability 

that something very bad is going to happen. 

And they say, OK, well, then let’s pull whatever leverage we 

have got. 

You have to take those levers away to get this to work, and that 

should be the focus of the Committee—finding ways to establish 

rules that will reorganize or liquidate these entities. Then the outside forces will do their job. 

Chairman BROWN. Thank you. 

Senator Toomey. 

20 

Senator TOOMEY. Thank you, Mr. Chairman. 

Senator MORAN. Would the Senator yield just for a second? 

Senator TOOMEY. I would be happy to yield to the Senator from 

Kansas. 

Senator MORAN. Mr. Chairman I am leaving to speak on the 

floor. I appreciate the Senator from Pennsylvania allowing me just 

a minute of his time, and I hope to return to ask substantive questions. 

But it is troublesome to me that in reading the testimony and 

hearing the testimony of the witnesses at least some of them appear to have known what was in the GAO report before the GAO 

report became public. 

And I tried recently, yesterday, to see if I could get a copy of the 

GAO report so I could be more intelligent in my asking questions, 

without success. I do not know whether something happened here 

that is inappropriate, but it does seem to me that there may be a 

double standard in who has information about their testimony and 

who did not. 

Senator TOOMEY. Thank you. 

Dr. Holtz-Eakin, I want to follow up. 

I think you make a very, very important point here about where 

the expectations for bailout come from, which one of the things you 

have stressed is previous policy decisions, right? 

Mr. HOLTZ-EAKIN. Yes. 

Senator TOOMEY. So if, in fact, the Government comes along and 

bails out institutions, then there is obviously some level of expectation that the Government will do this again in the future. 

But would you agree that in Title II of Dodd-Frank there is an 

explicit mechanism by which the regulators are empowered at their 

discretion to tap into taxpayer funding and execute a bailout of 

sorts. 

And so it would seem to me that the codification of that mechanism also contributes perhaps very significantly to the expectation 

that it might, in fact, get used. 

Could you comment on that? 

Mr. HOLTZ-EAKIN. Yes, I am quite sympathetic to that point of 

view. 

I mean, you can think of this in many ways as codifying what 

has been our experience with Fannie Mae and Freddie Mac, who 

we put on taxpayer funds, kept alive for a long time, have not fundamentally resolved in any way, and now you hear lots of agitation 

for them to be simply returned to the private sector. 

There is no discipline then, right? They get bailed out, and they 

survive. 

Senator TOOMEY. So is it your view that if we repeal Title II, 

which is the bailout mechanism of Dodd-Frank, and we made the 

reforms necessary for there to be a credible bankruptcy resolution 

that would actually be orderly and which would follow the ordinary 

rules of bankruptcy to the extent that we can—and I think you 

need to make some modifications to the current code to get there— 

would that at least diminish the likely expectations that there 

would be a taxpayer-funded bailout? 

Mr. HOLTZ-EAKIN. I think so, yes. My reading of the broad 

amount of research—and it is not specifically the GAO report—is 

21 

that we have already seen a diminishment. That expectation has 

dropped dramatically, postcrisis. 

This would further diminish it. So I do not think it would impose 

a great shock on financial markets. 

I do think it would be a step toward sounder policymaking. It is 

a sensible thing to do. 

Senator TOOMEY. Would there be—if that were to be the case, if 

we had that policy change and the expectations of a bailout correspondingly diminished, would you be able to comment on any 

benefits for taxpayers, for markets, for allocation of credit? Are 

there other benefits that come about? 

Mr. HOLTZ-EAKIN. Certainly, you would have less of a need for 

an elaborate supervisory regime, which is quite costly and raises 

the cost of credit and diminishes access to credit for consumers. I 

think that would be a tremendous benefit. 

You would have the benefit of a set of rules that all market participants understood rather than guesses at the discretionary actions of policymakers in a crisis. 

And all of those things produce better outcomes. 

Senator TOOMEY. Dr. Kane, if I understood your comment, I 

thought at one point you said that your recommendation is for the 

Government to impose penalties on the people who would take excessive risks because the taxpayers are the involuntary shareholders, effectively. 

Mr. KANE. Absolutely. 

Senator TOOMEY. Well, that, of course, supposes that the Government knows what is excessive, knows what the penalty ought to be 

for what somebody decides is excessive. 

And I wonder if a better approach is simply to make sure that 

the taxpayer is not an involuntary shareholder in the institution in 

the first place so that creditors can enforce behavior by virtue of 

their decisions on pricing and allocation of credit. 

Mr. KANE. Well, I think the best is often an enemy of the good; 

that is, we would like to make sure that authorities did not make 

bad policy, but the stresses of a crisis make bailouts so much easier 

than resolutions. 

We see bailout behavior all around the world. Along with some 

colleagues at the World Bank and the IMF, I have studied what 

happened to the safety net in 196 countries during this last crisis. 

In country after country, if they did not have deposit insurance, 

they created it. If they had deposit insurance, they extended the 

coverage and even guaranteed other kinds of debt of TBTF organizations. It is just so much easier to extend guarantees than running the risk of disorganizing the system in crisis circumstances. 

To get them to do hard things, we have to change the incentives 

of the bankers who play this risky game, and not just blame the 

authorities. 

What is the purpose of Section II? It responds to the excuse for 

inaction that authorities gave. This excuse was: ‘‘Oh, we did not 

have the powers to resolve TBTF firms.’’ 

So DFA gave regulators more powers, but power is not the true 

problem. 

The problem is incentives. Top officials are risking their careers 

and reputations, if they try to allocate losses. It resembles the 

22 

issues in exercising tough love. It is very hard for parents to show 

tough love when their child is caught, say, smoking marijuana or 

worse. Instead, they hire a lawyer to save them from the consequences of their bad behavior. 

On the other hand, the goal is not to send hordes of managers 

to prison. What we want to do is to build a system where the people who have been abusing the safety net have better incentives in 

the future. 

Senator TOOMEY. I think Dr. Admati has something she would 

like to add to this. 

Ms. ADMATI. All the benefits that were just mentioned here to 

having a bankruptcy code—which, by the way, in the modification 

of the bankruptcy code that you would need to have all the big institutions fail under bankruptcy, and good luck to all of us in that 

scenario—you would also need some kind of backstop. 

You yourself said you were going to need some liquidity support. 

It would look—and I heard the FDIC discuss this with bankruptcy experts. It would look very much like Title II. So where 

bankruptcy would change, it would change in the direction of 

where Title II is right now. I think the distinctions there are very 

minor. 

The point is that all the benefits to credit and less micromanaging are going to happen with more equity. Then there would be 

more money if banks retain their earnings, more money to make 

loans and better incentives. 

And so there is nothing about correcting that distortion that goes 

against anything that we want in this system. Nothing. 

Senator TOOMEY. Well, I see my time is expired, but Mr. Chairman—— 

Chairman BROWN. If you want to continue with Dr. Anginer, if 

you want to. 

Senator TOOMEY. Fine. 

Mr. ANGINER. Just on the point of whether Dodd-Frank might 

have codified too big to fail, actually, there is some empirical support for that. We looked at risk sensitivity of cost of debt for these 

large financial institutions that are deemed to be too big to fail by 

Dodd-Frank, and there is actually a decline in risk sensitivity. 

So the cost of debt has become less sensitive to risk after the introduction, again, suggesting that this too big to fail might have 

been codified. 

Senator TOOMEY. Thank you, Mr. Chairman. 

Chairman BROWN. Senator Reed. 

Senator REED. Well, thank you very much. 

This has been a very informative panel. Thank you all. 

Dr. Admati, I think you made the point, and you made several 

good points, that the size issue is sort of irrelevant in many respects, that there is no perfect size, right size, that it goes really 

more to capital that the company has, the equity and the leverage 

ratios. 

But a lot of times we have to take very simple approaches, and 

there has been a lot of discussion about not letting institutions 

grow beyond $250 billion. That seems, to me, to be treating a 

symptom and not effective. 

23 

Ms. ADMATI. I am glad you asked about that because about the 

size, the size is very large, and you have to wonder why. My answer to that is because the funding is too easy. 

And we saw conglomerates break up on their own weight, on 

their own inefficiency. 

If the funding gets straightened out, then we might begin to see 

it. For example, if it was beginning, if you were beginning to pass 

more and more of the down side to the shareholders, they might 

begin to see how inefficient these corporations are, and we might 

see a natural breakups that just make more nimble, better pieces 

of it. 

Yes, I think that some of the crude measures of size at some 

point by Government, et cetera, at some point, it really becomes 

just outsized by any measure at all. And so I can see that some 

of the crude rules that say, OK, enough is enough for size. 

These corporations are the largest in the economy by asset size. 

The amount that is controlled, sprawling across the globe, is 

unfathomable. Every study of governance shows a total breakdown, 

and all the repeated scandals are reinforcing that. This is a reckless industry. 

Senator REED. But we could sort of exclude the larger ones with 

the hope that that would solve the problem, but that would not 

necessarily help those that sort of get underneath the limit if they 

are insufficiently capitalized or overleveraged. 

Ms. ADMATI. Well, you can have a system with tiny, little pieces 

all failing at the same time, all interconnected, and it is not—that 

is why just size is not going to do it. 

Senator REED. I understand. 

And you raised some other issues. It is not just size. It is two 

others, which makes this a very challenging problem. 

It is management—the inability, because they are so large, to effectively manage even if the intention is to manage it well. 

And then, the interconnection to other institutions that might be 

poorly managed or led, or that take business approaches that compel the others to follow. 

And let me add a third dimension, which is we are in a global 

system, and what we do is affected by what other countries do. 

And, in fact, frankly, you have heard it before. One of the reasons these banks are so big is because they are global and their 

global competitors are just as big. 

And, oh, by the way and you might comment on this—they have 

a too-big-to-fail regime overseas, which is a competitive advantage 

that they have. 

Can you comment on that? 

Ms. ADMATI. Yes. And, again, I am very thankful for the question. 

That other countries might do worse than us is not a reason to 

follow them. 

So a huge problem in Europe, in fact, which is misdiagnosed because the Germans like to protect their banks, and so do the 

French, is that they have a sicker banking system than we do, and 

very bloated. 

And so, yes, we are not here to support a particular industry on 

our back. We are not allowing pollution when other countries allow 

24 

it, and we should not allow excessive risk even if other countries 

allow it. 

We should protect our citizens. The foreign banks that are here, 

we control what they can do here. 

We should worry about what we can worry about and lead the 

world as opposed to follow to the lowest common denominator. 

Senator REED. But let me ask Dr. Kane, too, to comment because 

Dr. Kane suggested—and I think your testimony together sort of 

is sympathetic—in that there are two paths. 

One is regulatory forbearance—of not being tough on capital, on 

equity, on management skills and things like that, and the other 

is the implicit subsidy for debt and for equity. And those are the 

two paths. 

For the first path there has to be very active regulation by the 

Federal Reserve particularly because I must say I do not think we 

are in a position to, on a daily basis, pass legislation to fix this. 

And then the second path is a much more structural path about 

just the public perception—equity perceptions. 

So I have just been very general. 

Dr. Kane, do you want to comment on this discussion we have 

had? 

Mr. KANE. Yes. 

First, when you ask why are U.S. firms so active globally, I 

would point out two disturbing phenomena. 

In the futures markets, we see parent firms ‘‘de-guaranteeing’’ 

their foreign susidiaries stripping formal guarantees from foreign 

affiliates. This lets the parent search out markets that can least 

well discipline their risk-taking. This is exposing the U.S. safety 

net because distressed subs are going to be supported by the parent 

in a pinch and by U.S. taxpayers in the next crisis. 

Second, we are observing what is called ‘‘inversion,’’ where, say, 

a company like Morgan Chase could merge with a small foreign 

firm, move the headquarters abroad and not pay corporate taxes 

here. In fact, the CEO claimed the right to do this. 

To me, this behavior is an ethical scandal. I am apalled by the 

ethical environment of an industry that would thumb its nose at 

the Government that rescued it a mere 5 years ago. 

I mean, again, in ordinary human relations we would sock somebody like that in the nose. 

You know, it just—— 

Senator REED. You must be from Boston. 

Mr. KANE. Well, I spent a lot of time there. 

No, I am from Northeast Washington, DC. We did a lot of that, 

here, too. 

[Laughter.] 

Senator REED. I just—may I have one? 

Chairman BROWN. Sure, go ahead. 

Senator REED. I think this has been terribly useful. And I will 

ask, at least, are we better off than we were in 2008 with some of 

the provisions we have adopted in Dodd-Frank like those on derivatives, and the fact that we have actually put emphasis on higher 

capital levels? 

25 

I think there is a sense like nothing has changed at all, and my 

sense is some things have changed, maybe not enough, but some 

things have changed. 

Mr. KANE. Again, yes, some things have changed, but cross-country swaps regulation is currently a complete disaster. 

In the U.S., we have the SEC and the CFTC trying to divide responsibility. Swaps and other derivatives are very protean types of 

instruments. There are futures now on swaps trading on exchanges. There is a problem with the capitalization of central clearing parties. They have taken on much more risk than before, but 

none of them has increased its reserve funds to support that, and 

no one is compelling them to do so. 

So one could say we are not in the same position in the sense 

that the details are different, but U.S. taxpayers are still very exposed. The next crisis threatens to be worse than the last one. 

Ms. ADMATI. I would say that some of the things that were done 

in Dodd-Frank are essential, and they gave authority that can be 

used well. 

The problem is the implementation. A few of the things that got 

written were written in such a way that makes implementation 

very difficult, like Volcker. And so in the end of all of that, you are 

not sure whether the thousand pages of rules are really going to 

do as much as was hoped. So that is one. 

And then Title VII is very important. So this is critical because 

the modernization act was an absolute disaster, and we know that. 

So the ability to regulate derivatives is there. However, CFTC is 

not getting budgets to do it. And Gensler did a mighty job of it except, you know, could not. 

So in the end the lesson that was learned was that the ones that 

did the bailouts extolled them, and the people learned that there 

will be more bailouts. 

So whether we can try to commit to not do them, it is very difficult. We should try to prevent it. 

Why are we having ambulances when we have speed limits so 

dangerous? That is the question we have to first ask. 

Senator REED. Thank you. 

Thank you, Mr. Chairman. You are very kind. Thank you. 

Chairman BROWN. Thanks, Senator Reed. 

Senator Vitter. 

Senator VITTER. Thank you, again, to all of our panelists. 

Let me start with sort of the biggest bottom-line question. Do 

any of you think that too big to fail as policy and market perception 

has ended, and if so, why? 

Anybody? 

Ms. ADMATI. The answer is no. 

Senator VITTER. OK. Do you—— 

Mr. KANE. No, for me, too. 

Senator VITTER. OK. 

Mr. HOLTZ-EAKIN. Greatly diminished, however. I mean, not 

gone but greatly diminished. 

Mr. EVANS. And, clearly, we show that there is a variation over 

time across models, and it may depend on credit risk conditions. So 

we would say, no. 

26 

Senator VITTER. OK. And do any of you think that firms perceived as too big to fail do not have a market advantage because 

of that? 

Mr. KANE. No. 

Ms. ADMATI. They do have a funding advantage. 

Mr. HOLTZ-EAKIN. That is not so obvious, I would say, at this 

point, honestly. 

There would be a funding advantage, but these are also the same 

entities that are subject to an enhanced supervisory regime. They 

have a much bigger regulatory cost. They have capital charges. 

And on balance it is not obvious they have a competitive advantage 

against smaller banks. 

Senator VITTER. OK. 

Mr. ANGINER. And just to clarify, I mean, losses to the taxpayer 

will depend on two things. One is the probability that these institutions will fail, as Dr. Evans pointed out, as well as the likelihood 

that they will be bailed out. 

Senator VITTER. Right. 

Mr. ANGINER. So some of the regulations actually increase some 

of the—made the banks in a much better position than they were 

five, 6 years ago. 

So the likelihood of failure has come down, but a likelihood of a 

bailout still remains. It is good to make that distinction. 

Senator VITTER. So my second question, does anyone else think— 

Dr. Holtz-Eakin says it is questionable. 

Does anyone else think that a too big to fail does not have a market advantage as a result? 

Mr. KANE. Could I add something? This increased regulatory 

burden is scalable, so that it has actually helped big banks. They 

can assign someone to fill out all the forms, while managers of very 

small banks find this burdening. Smaller banks are going to have 

to get bigger in order to spread the costs of filling out the paperwork. 

Senator VITTER. Right. Well, I would certainly agree with that, 

and that sort of goes to Dr. Holtz-Eakin’s point. 

I think the overall new regulatory environment is an advantage 

for big firms, not small firms, even though the burden is bigger for 

big firms. 

But, anyway, I want to use my time efficiently. 

Mr. Evans, do you have any response to the criticism that you 

all studied too-big-to-fail funding advantage in an overly narrow 

way by looking at bond debt? 

Dr. Kane talked about the entire equity side. In addition, a lot 

of people think that much of the advantage is in short-term funding of money market liabilities, which you did not look at. Do you 

have a response to that broad set of criticisms? 

Mr. EVANS. Right. Certainly, we did not exhaust the various 

ways institutions might benefit from perceptions of being too big to 

fail, but we used the dominant methodology in the literature, which 

is to study one particular slice of the liability stack. 

We think bonds are extremely important. You can learn a lot 

about bonds. It tells you a lot about what happens below it. 

So, if we are talking about trends—and, remember, we did not 

try to quantify a subsidy. We are talking about what happens over 

27 

time. And if it happens in bonds, it is quite likely that in places 

where there is a lower priority you are seeing it as well. 

Now Dr. Kane, when he says equity, he is really referring to 

some of these option pricing modeling approaches, which are highly 

theoretical. In fact, if I know leverage, if I know volatility, I can 

mechanically produce a result, and there is no room for investor expectation. 

So our model was strongly informed by Professor Anginer’s 

work—— 

Senator VITTER. OK. 

Mr. EVANS. ——and an independent review by some highly respected scholars. 

Senator VITTER. OK. And, finally, Dr. Admati, in your testimony 

you particularly focus on the significance and perhaps the potency 

of capital as a tool to dramatically lessen risk. Why is that, and can 

you expand on that a little bit? 

Ms. ADMATI. Well, equity is the most natural loss absorber. Equity gets the upside. Why should anybody but equity bear more of 

the downside? 

The fact of the matter is equity bears a downside for most corporations, first and foremost, and there is no corporation that has 

so much debt. 

And the banks do not have to have so much debt. They are not 

in the right range of equity levels that are reasonable for corporations. Without regulation, the markets tell them. 

And this is related to the point about what do supervisors need 

to do. The way to think about that, in my view, is not that the supervisors and the regulators are like equity holders. They take the 

place of the breakdown of credit markets for these precisely because the banks’ ability to borrow comes with not enough strings 

attached that usual creditors do. And that includes insolvency. 

Most companies could not live like the banks. 

If you erase the labels from the banks and you gave them—of 

course, you would have to erase a few zeroes so they are not recognizable as such, and gave their balance sheets to the banks, they 

would—with the disclosures that they have, they would not be able 

to borrow. 

My hypothetical funding costs for them? Very large, if they really 

lived on their own. 

In a hypothetical that they really are on their own, if we surely 

believe that with all the covenants and the prioritization that you 

have to think about, creditors will not come. 

What happens in the banks in reality—and it is easy to understand. Start with deposits. Start especially with deposits. Depositors are the most passive creditors. They do not even know they 

are creditors. They do not even think of themselves as creditors. 

That is where the problem starts. 

A bank CEO could say, I have a lot of deposits; therefore, I do 

not have a lot of debt. 

Right there is the problem. The fact that the bank CEO can momentarily forget that he owes the deposit shows you the problem 

right there. 

From that time on—and deposits are unsecured—they can go 

and borrow more with the assets they buy with deposits, and the 

28 

creditors will let them do it. And then the next creditor will let 

them do it. 

Companies cannot live like that in the real world, and the banks 

should not be allowed to. 

So what the regulators are doing is only coming in instead of the 

usual credit or covenants that would normally happen to a company that look like this. They should not live like this. 

That is what we have to do. The missing piece of it is that there 

is no credit discipline, and there will not be, and it is not the most 

effective way to get the discipline. 

First, push the rest of the balance sheet. Then there is obviously 

corporate governance that has to care about risk management. 

First, it has to be their own money. 

Senator VITTER. Thank you. 

Chairman BROWN. Thank you, Senator Vitter, and thank you for 

your assistance on this. 

Mr. KANE. May I just say one thing? 

Chairman BROWN. Dr. Kane, certainly. 

Mr. KANE. Mr. Evans said that the GAO used the ‘‘dominant 

methodology.’’ 

There are at least two broad methodologies. I believe the other 

one is actually dominant because we must be concerned about the 

taxpayer put—the ability to put losses to the taxpayer when they 

exceed stockholder equity. Equity is the natural loss-absorbing 

mechanism. To not look at taxpayer exposure as an option is conceptually inferior. 

The GAO methodology has a lot of people working on it who do 

not thoroughly understand option pricing. 

Chairman BROWN. Dr. Evans, if you would like to speak to that. 

Mr. EVANS. Just to quickly say, you would use that approach if 

you thought you were sure a subsidy exists and you just wanted 

to know how large it is. 

I mean, Merton, of Black-Scholes and Merton, used it in a deposit insurance context where it is most appropriate. 

Again, this is a highly theoretical model and makes some strong 

and extreme assumptions, and again, there is no room for investor 

expectations. 

Mr. KANE. Well, that is not true. It is changes in expectations 

that cause movements in the stock price that others use to pull estimates of the option out. 

So I am saying you do not quite understand the mechanism and 

are downplaying the role of assumptions in other economic research. 

Chairman BROWN. Dr. Anginer, conclude on that discussion, referee for a moment, and then let me move on. 

Mr. ANGINER. Sure, just a point on the methodology. It reminds 

me of the old joke about looking for a lost key under a lightpost 

because that is where the light is, not where the key is lost. 

And the reason we study bonds is that is where the data are 

available and makes the analysis much easier. 

But having said that, it is likely that we are underestimating 

risk for a number of reasons. 

One is that we are using equity prices. 

29 

Also, bonds, publicly traded bonds, are the first ones that are 

going to get hit on the balance sheet structure, on the debt structure, when there is a failure. 

So there is good reason to think that most likely we are underestimating; so these subsidy numbers would be larger. 

Chairman BROWN. OK. Thank you. 

Dr. Admati, you said that we should compare banks’ funding 

with and without Government support rather than compare bank 

by larger banks and smaller banks, if I recall. 

One way to do this is to incorporate ratings uplift that big banks 

get as a result of that implied support, actually, that regional community banks do not get. 

The GAO report does not do that. They say it is an indirect 

measure of the funding advantage. 

How important—and feel free, all of you, to comment on this, too, 

but it is directed first to you, Dr. Admati. 

How important is including or excluding this uplift in measuring 

financial benefits for the too-big-to-fail institutions? 

Ms. ADMATI. Well, I think the credibility of credit rating agencies, of course, is somewhat diminished after the crisis. So we 

should be always skeptical of what they say. 

However, they are capturing something real, which is that investors perceive—and the credit rating agencies know—that in the hypothetical if the banks are really on their own their funding costs 

would be a whole lot higher. 

And it has not just the interest rate. It has the whole conditions 

that come with it. 

Most of what scares companies from becoming highly indebted is 

that the creditors will write such restrictive conditions that will not 

allow them to move. 

And the banks get credit under incredibly comfortable, easy burdens that are different from other companies. 

Credit uplifts are trying to get at the way to do this, which is 

not to compare to other companies but to compare the company as 

it is to the hypothetical company without support. 

That is what we are after, conceptually. The problem is it is a 

hypothetical that is counterfactual, that we do not have. 

That is why I said in my hypothetical, with really no—with 

knowing that the depositor can come in the bank, that other shortterm creditors can come and dilute you as a junior creditor, the 

banks will have a very hard time borrowing. And some of the small 

banks have a hard time and, in fact, do not have bonds. So, already, you are biasing the whole discussion. 

The point is the banks are funding at an unreal world that they 

feel entitled to, that is completely outside the normal markets. 

So I think the credit rating—it is too bad that it was not included. Some of the studies that include it are informative, I would 

say. 

Chairman BROWN. Dr. Holtz-Eakin, do you have something on 

that? 

I would just note—and someone can correct me if I am wrong— 

recently, most, if not all, the major credit rating agencies have removed the credit uplifts. So you could not do that now. If you care 

30 

about too big to fail now, in 2013 and ’14, it is gone from that perspective. 

Chairman BROWN. Dr. Anginer and then Dr. Evans. 

Mr. ANGINER. So just on that, we actually examined the effect of 

these ratings on the pricing of debt. 

So some rating agencies issue two types of ratings. One is called 

a standalone rating, just incorporating the risk of an institution on 

its own, without any Government support, and another rating that 

incorporates the Government support. 

So, if you look at how these two types of ratings are priced, it 

is really the Government support that is being priced, not the 

standalone rest. 

So it is true that some of the rating agencies have recently downgraded some of the Government support, but we do not know what 

the pricing implications of those are. 

Chairman BROWN. Dr. Evans. 

Mr. EVANS. And I would say rating agencies are a less direct 

measure. In fact, they are indirect. If you can go straight to the 

market and study actual investors that participate in the market, 

you are going to get a much cleaner answer. 

Now we have interviewed a number of investment firms. Some 

of them do their own credit rating analysis. So it is not necessarily 

the case that you can go from credit ratings to actual bond spreads. 

Chairman BROWN. OK. Dr. Kane, and then I want to move on 

to a last question, and then we will wrap up. 

Mr. KANE. I do not see why you do not use all the data possible. 

Why would you look in just one place when you lost your keys in 

your house? 

Chairman BROWN. Fair enough question. 

Mr. EVANS. And that would apply to the option pricing approach, 

too, which is, again, highly theoretical. 

And if the option pricing model is a hammer and the world is a 

nail, you will always look there. 

But I will point out, in Dr. Kane’s written testimony, Figure 3— 

which, again, you would expect to see this trend because volatility 

is lower, leverage is lower—looks a lot like the graphics from 

GAO’s report. 

Chairman BROWN. OK. Dr. Anginer touched on an issue. I want 

to ask one question, and all of you feel free to weigh in here. 

A lot of the talk is about whether too big to fail overfocuses on 

what would happen if one institution got into trouble and needed 

to be resolved. 

When you look at the last terrible financial crisis and you look 

to the future, it seems more likely—I mean it does not seem so 

likely that one large institution will fail, and only one. Large, universal banks, by and large, conduct the same activities, have the 

same kind of portfolios, making it unlikely that there will only be 

one getting into trouble at a time. 

So two questions, and I guess I will start with you, Dr. Anginer, 

since you touched on it earlier, and I just want you to expand. 

How does the universal nature of the largest banks affect too big 

to fail, initially? 

And then what sort of risk-taking—because, ultimately, this 

hearing is about what too big to fail leads to, and that is incenting 

31 

risk-taking among these large banks and paying little price for it, 

except the price the public pays. 

What sort of risk-taking does that sort of universal nature of the 

largest banks incent, and does it make it more likely we have a 

systemic event rather than just isolated and just an isolated failure? 

So, Dr. Anginer and then anybody else that wants to weigh in. 

Mr. ANGINER. Sure. I think large financial institutions are 

incentivized to take these type of correlated risks. 

As I mentioned before, again, if you are a large financial institution and you fail when nobody else is failing, you are less likely to 

get bailed out. This incentivizes you to take on—do activities that 

others are doing. 

And just to—— 

Chairman BROWN. So you are saying that if you are a CEO of 

a large bank and you understand what you just said, that means 

that you are going to want to act like the others. You want to 

mimic the other banks; they want to mimic you. 

Mr. ANGINER. Exactly, exactly. 

Chairman BROWN. OK, for sort of safety in numbers. So you are 

all bailed out because one of you would not be—— 

Mr. ANGINER. Exactly. 

Chairman BROWN. ——if it were solely one. OK. 

Mr. ANGINER. Exactly. And we actually do see this in the data 

as well. 

So, if you are in another industry and you do what everybody 

else is doing, taking on similar risk, the investors in the market 

actually penalize you. 

Why? Because they want to be diversified. They do not want 

their company to fail when everybody else is failing because they 

are going to suffer greater losses. 

We see the opposite effect in the financial sector. They actually 

get a benefit when they take on similar risk. 

So, again, that is because we have these perverse incentives, that 

because of this too-many-to-fail effect, this universal banking model 

that you mentioned. And it leads to all sorts of perverse incentives, 

actually increasing systemic fragility. 

Chairman BROWN. Dr. Admati, next. 

Ms. ADMATI. Yes. I did not talk too much about the report and 

did not get into the details, but my commentary goes to a number 

of other issues that did not come up here. 

And I just want to say—and it is related to your question—this 

is something incredibly interconnected. That means the bailouts 

are interconnected. When AIG is bailed out, the banks are bailed 

out. When you bail out Greece, the German banks get bailed out. 

That is why you cannot even look exactly at one company and isolate these costs. 

It is much more complicated because it is not just that they do 

the same thing; it is that most of their activities are with each 

other. Actually, a small fraction of them come out to the rest of the 

economy. There is just so much intersystem activity in those balance sheets. 

And so the bailout issues are very, very complicated. In terms of 

measuring the subsidy, a lot of issues come. 

32 

I want to say as well that I mentioned at least one op-ed, and 

it was specifically about this study here, that says that that study 

is underestimated. 

And I mentioned studies that are not cited in the GAO report 

that go to the return on the equity, not options, but a study by 

Kelly, et al., that you did not use, and Lustig and all of those that 

were not there, some of which was not options. And it showed directly that the banks benefit from all kinds of—in all kinds of 

ways. 

So the subsidy is underrated. 

On volatility is low now, credit ratings took the uplift, all of 

those things—I want to remind everybody; 2006 was a great year. 

Volatility was very, very low. Everybody was making record profits. 

OK. 

So let’s just remember the good times can stop very quickly, and 

the euphoria of those good times and the low volatilities of these 

good times can change dramatically. Within less than a year or 

two, or starting mid-2007, volatilities have shifted from 10 percent 

on the VIX sort of index to 70 percent. 

And I was teaching through that time, so I could see it. 

Chairman BROWN. Thank you. 

Dr. Holtz-Eakin. 

Mr. HOLTZ-EAKIN. So there is an important difference between 

interconnectedness and suffering a common shock. And what we 

saw in the last crisis was a worldwide credit and housing bubble 

that, when it broke, was a common shock across all financial institutions. 

Institutions that rely on short-term funding and are heavily leveraged are the recipe for financial problems in those circumstances, and it is appropriate then to worry about an enhanced 

supervisory regime for those big institutions. And we have that 

now, and I think that is a sensible thing. 

And you should not somehow believe that they are all going to 

fall apart in the same instance. Indeed, I believe if you go back and 

just reread the history of the evolution of the 2007–2008 crisis, everyone’s remembrance of those awful days when Lehman went 

down, AIG, Fannie, Freddie, in close order. But the lead-up time 

was well over a year before that, a year and a half. 

I mean, we had early indicators of problems and stresses and 

policies that accommodated them, and the importance of the policy 

being better could have cut that off at the beginning. 

Now we are going to debate forever whether we should have let 

Bear Stearns go down along with Lehman or saved them both, but 

saving one and not the other was a disaster. That is inconsistent 

discretionary policymaking, and that is the problem. 

Ms. ADMATI. I would characterize the problem differently. The 

problem is one of forbearance and of not prompt corrective action. 

Fail is not a good option. That is the difficulty here. 

You can put all your eggs in the fail option, but we do not have 

to. That is why we have supervision that would interfere before. 

And I agree; the signs were there. But the fail allowed dividends 

out—dividends that would then have to be plugged in, or were 

plugged in, by top money that was actually debt and not equity, 

33 

that they did not lend, that they just wanted to return so they 

could pay bonuses again. 

Chairman BROWN. Dr. Kane. 

Mr. KANE. I would just like to emphasize the political side of 

being interconnected and being subject to common shocks. It is 

very hard in our system to say we are going to close, say, Bank of 

America and not Citi. That choice would just bring a tremendous 

amount of problems. 

Mr. HOLTZ-EAKIN. That is why you should not give them a 

choice. 

Mr. KANE. Well, the—— 

Ms. ADMATI. Well, some were not that big, by the way. 

Mr. KANE. Yeah, but my point is that if most BHCs are failing 

whatever test you run, or if they all are subject to a common shock, 

the situation requires choices to be made. The Government will not 

have the people in place to sort things out. 

Even with the slower processing of insolvency in 2008–2009, the 

FDIC brought people out of retirement to come back to work to 

help them. They did not have enough experienced personnel. 

Chairman BROWN. Thank you all. This was a very helpful discussion. Thank you. 

And you saw a lot of interest from my colleagues. Some, I assume, will have questions. Some Members of the Subcommittee 

perhaps or the full Committee, too, may have questions. If you 

would get answers to those within a week, it would be very helpful. 

Special thanks to Graham Steele and Megan Cheney in my office 

and Travis Johnson in Senator Vitter’s office for the work they 

have done for a year leading up to this. 

We have done a lot of Subcommittee hearings in this Subcommittee. This is one of the most important because it is the one 

that has such effect on our financial system. And the input from 

all of you was quite valuable. 

So the Subcommittee is adjourned and thank you. 

[Whereupon, at 3:38 p.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 

34 

PREPARED STATEMENT OF LAWRANCE EVANS 

DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT

ACCOUNTABILITY OFFICE

JULY 31, 2014 


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1 Viral V. Acharya, Deniz Anginer, and A. Joseph Warburton, ‘‘The End of Market Discipline? 

Investor Expectations of Implicit Government Guarantees’’ (available at: http://ssrn.com/ 

abstract=1961656). 2 Acharya, Anginer, and Warburton (2014). 

PREPARED STATEMENT OF DENIZ ANGINER 

ASSISTANT PROFESSOR OF FINANCE, PAMPLIN SCHOOL OF BUSINESS, VIRGINIA TECH

JULY 31, 2014 

Mr. Chairman and the distinguished Members of the Subcommittee, thank you 

for convening today’s hearing, and inviting me to testify. My name is Deniz Anginer. 

I am an assistant Professor at the Pamplin Business School at Virginia Tech. Along 

with my colleagues, Viral Acharya and Joe Warburton, I have examined market expectations of implicit Government guarantees to so called ‘‘too-big-to-fail’’ institutions. 1 Most of my testimony is based on this research. 

The too-big-to-fail (TBTF) doctrine holds that the Government will not allow large 

financial institutions to fail if their failure would cause significant disruption to the 

financial system and economic activity. In our research, we find that large financial 

institutions and their investors expect the Government to back the debts of these 

institutions should they encounter financial difficulty. These expectations of Government support are embedded in the prices of bonds issued by major financial institutions, allowing them to borrow at lower rates. 

Expectation of Government support by the market also results in a distortion in 

how risk is reflected in the debt prices of large financial institutions. An implicit 

Government guarantee dulls market discipline by reducing investors’ incentives to 

monitor and price the risk taking of large financial institutions. In our analyses, we 

show that while a positive relationship exists between risk and cost of debt for 

medium- and small-sized institutions, this relationship is 75 percent weaker for the 

largest institutions. Changes in leverage and capital ratios are, likewise, less sensitive to changes in risk for these large institutions. 2

Because they pay a lower price for risk than other financial institutions, the perceived guarantee provides TBTF institutions with a funding advantage. We find 

that the implicit subsidy has provided these institutions an average funding cost advantage of approximately 30 basis points per year over the 1990–2012 period, peaking at more than 100 basis points in 2009. The total value of the subsidy amounted 

to about $30 billion per year on average over the 1990–2012 period, topping $150 

billion in 2009. We have also examined nonfinancial firms. If bond investors believe 

that all of the largest firms (both financial and nonfinancial) are too big to fail, then 

large nonfinancial firms should enjoy a size subsidy similar to that of large financial 

institutions. However, we find this is not the case. 

Compared to the GAO study, we find lower implicit subsidy values for the years 

2007 to 2011 and slightly higher numbers in 2012. We have not examined 2013, the 

year in which the GAO finds the greatest decline. Although most of the attention 

will be paid to the analyses that try to quantify the dollar values of the subsidy 

and its changes over time, it is important to note that it is very difficult to directly 

relate these changes to the introduction of Dodd-Frank and other regulations. 

It is very hard to separate out changes in probabilities of large financial institutions experiencing distress from the probability that they will be bailed out. As the 

GAO report points out, this is especially true as the risk premium has declined in 

recent years and the large financial institutions have seen significant improvements 

in their balance sheets and capital ratios reducing their probability of experiencing 

financial distress. 

Although it is very difficult to establish a direct link between regulations and 

changes in subsidy over time, examining these changes using alternative methods 

over a short time window would be more helpful in analyzing the impact of DoddFrank and other regulations. For instance, in our study we examined changes in 

risk sensitivities of cost of debt after the introduction of Dodd-Frank. We examined 

changes in subsidies accruing to large financial firms compared to nonfinancial 

firms. We also examined the cost of implicitly guaranteed debt to explicitly guaranteed debt issued by the same firm under FDIC’s Temporary Liquidity Guarantee 

Program. 

Using these alternative approaches, we find that Dodd-Frank did not significantly 

alter investors’ expectations that the Government will bail out TBTF financial institutions should they falter. Despite its no-bailout pledge, Dodd-Frank leaves open 

many avenues for future TBTF rescues. For instance, the Federal Reserve can offer 

a broad-based lending facility to a group of financial institutions in order to provide 

a disguised bailout to the industry or a single firm. In addition, Congress can sideVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00054 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
51 

3See, e.g., David Skeel, ‘‘The New Financial Deal: Understanding the Dodd-Frank Act and 

Its (Unintended) Consequences’’ (2011); Arthur E. Wilmarth, ‘‘The Dodd-Frank Act: A Flawed 

and Inadequate Response to the Too-Big-To-Fail Problem’’, 89 Oregon Law Review 951 (2011); 

Standard & Poor’s, ‘‘The U.S. Government Says Support for Banks Will Be Different ‘Next 

Time’—But Will It?’’, (July 12, 2011). One aspect of the recent regulations, that our analyses 

suggest had a mild impact in reducing market expectations of support, is the release of the specifics of the FDIC’s Single Point-of-Entry approach to resolving financial institutions under OLA. 

This is consistent with the GAO interviews with large investors who point to the SPOE approach as affecting their expectations of future Government support. 

step Dodd-Frank by amending or repealing it or by allowing regulators to interpret 

their authority in ways that protect creditors and support large institutions. 3 As 

former Kansas City Fed President, Thomas Hoenig, noted: ‘‘The final decision on 

solvency is not market driven but rests with different regulatory agencies and finally with the Secretary of the Treasury, which will bring political considerations 

into what should be a financial determination.’’ 

Finally, it is also important to note that the analyses conducted by us and the 

GAO only measure the direct subsidy that may accrue to TBTF institutions. There 

may be other indirect effects such as misallocation of capital or excessive and correlated risk-taking (to exploit the implicit guarantee) that are not captured by the 

analyses. 

Governments are generally not required to make any apparent financial commitment or outlay, or request funds from legislatures or taxpayers, when they implicitly guarantee TBTF institutions. Implicit guarantees lack the transparency and accountability that accompany explicit policy decisions. Taxpayer interests could be 

better served, in both good times and bad, by estimating on an ongoing basis the 

accumulated value of this subsidy. Public accounting of accumulated TBTF costs 

might restrain those Government actions and policies that encourage TBTF expectations. 

Thank you for your time. 

References 

Acharya, V., D. Anginer, and A.J. Warburton (2014) ‘‘The End of Market Discipline? 

Investor Expectations of Implicit State Guarantees’’. NYU Working Paper. 

Skeel, David, (2011), The New Financial Deal: Understanding the Dodd-Frank Act 

and Its (Unintended) Consequences (Hoboken, NJ: John Wiley). 

Standard & Poor’s, (2011), ‘‘The U.S. Government Says Support for Banks Will Be 

Different ‘Next Time’—But Will It?’’ (July 12). 

Wilmarth, Arthur E., (2011), ‘‘The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-To-Fail Problem’’, Oregon Law Review 89, 951–1057. 

52 

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PREPARED STATEMENT OF EDWARD KANE 

PROFESSOR OF FINANCE, BOSTON COLLEGE

JULY 31, 2014 

I want to begin by thanking Chairman Brown for inviting me to testify today and 

to congratulate him and the Subcommittee for continuing to battle against the pernicious and unfair advantages that panic-driven crisis-management policies confer 

on mega-institutions, not only in this country but in financial-center countries 

around the world. The claim that the Dodd-Frank Act of 2010 or Basel III can end 

these advantages is a dangerous pipe dream. There will always be institutions that 

regulators will—especially in crisis circumstances—find macroeconomically, politically, and administratively too difficult to fail and unwind. The existence of a powerful propensity to rescue such too-big-to-fail (TBTF) firms is the central lesson taught 

both by the S&L mess and by the Great Financial Crisis. 

The GAO Has Bungled Its Assignment 

The GAO goes wrong at the outset. The definition of TBTF offered in the Report’s 

first sentence (lines 9–10) is incomplete. It describes TBTF as an active policy of 

‘‘intervention’’ without confronting the more dangerous additional role played by 

passive capital forbearance. 

The title of this hearing focuses on ‘‘funding advantages’’ that TBTF BHCs receive 

from expectations of unlimited Government support. The GAO’s estimated 42 statistical models each year seek to explain in a robust manner only how the interest 

spreads between bonds issued by large BHCs and comparable Treasuries relate to 

BHC size and credit risk. This conception of TBTF subsidies treats TBTF guarantees as if they were merely a form of bond insurance and builds in an additional 

downward bias by not using volume-based proxies for the extent to which after-issue 

trading in individual BHC bonds is less liquid than in Treasuries. 

But even if they were modeled perfectly, spreads on outstanding bonds capture 

only part of the impact of TBTF guarantees. TBTF guarantees are different from 

bond insurance because, as long as regulators forbear from resolving a BHC’s insolvency, a truly TBTF firm can extract further guarantees by issuing endless amounts 

of additional debt. 

Funding Cost Is More Than Debt Costs 

A BHC’s ‘‘funding cost’’ is the cost of its ‘‘funding mix.’’ Being TBTF lowers both 

the cost of debt and the cost of equity. This is because TBTF guarantees lower the 

risk that flows through to the holders of both kinds of contracts. The lower discount 

rate on TBTF equity means that, period by period, a TBTF institution’s incremental 

reduction in interest payments on outstanding bonds, deposits, and repos is only 

part of the subsidy its stockholders enjoy. The other part is the increase in its stock 

price that comes from having investors discount all of the firm’s current and future 

cash flows at an artificially low risk-adjusted cost of equity. This intangible benefit 

generates capital gains for stockholders and shows up in the ratio of TBTF firms’ 

stock price to book value. Other things equal (including the threat of closure), a 

TBTF firm’s price-to-book ratio increases with firm size. For four quarters in 2012– 

2013, Figure 1 compares the behavior of this ratio for banks in different size ranges. 

The comparisons show that on average this ratio increases with size in all four 

quarters. 

I hope that contemplating the following numerical example can drive home the 

need to account for the equity-funding component of annual and capitalized TBTF 

subsidies. Let us suppose a TBTF institution is projected to earn $12 billion a year 

forever and that $2 billion of its earnings comes from the reduction in its cost of 

debt. By hypothesis, market participants recognize that TBTF guarantees shift a 

range of the deepest possible losses away from creditors and stockholders to taxpayers. If authorities were expected to take over the firm and pay off guaranteed 

creditors just as it became insolvent, the debt component would be the whole story. 

But because authorities are expected to leave the stock in play come hell or high 

water, TBTF policies give comfort to shareholders, too. This comfort lowers the risk 

class of the stock, so that the warranted return on equity falls. 

Let us assume that the opportunity cost of equity would be 12 percent without 

the TBTF guarantee, but—in the presence of the contra-liability provided by the unlimited guarantee—this cost falls to 10 percent. Then, the capitalized subsidy built 

into the stock price would be not $16.7 billion ($2 billion/.12) or even $20 billion 

(=$2 billion/.10), but $36.3 billion. The capitalized subsidy is the difference between 

the $83.3 billion stock-market value of the unguaranteed firm (=$10 billion/.12) and 

the $120 billion ($12 billion/.10) in value that develops under TBTF guarantees. The 

annual subsidy that would deserve to be passed through the Federal budget would 

125 

be $4.4 billion: the $2 billion in interest saving plus another $2.4 billion (.02 x $120 

billion) subsidy on the firm’s equity funding. So, for this hypothetical BHC, the annual subsidy to equity would prove roughly the same size as the subsidy to debt. 

The warranted rate of return on the stock of deeply undercapitalized firms like 

Citi and B of A would have been sky high and their stock would have been declared 

worthless long ago if market participants were not convinced that authorities are 

afraid to force them to resolve their weaknesses. Had these BHCs’ assets and liabilities been transferred to bridge institutions or put into resolution, losses that contractually deserved to be incurred by uninsured creditors and postcrisis increases 

in the TBTF stock prices would have accrued to taxpayers. 

A simpler way to see what the GAO has missed is to think carefully about the 

structure of guarantee contracts. An external guarantee allows the guaranteed party 

to put responsibility for covering debts that exceed the value of BHC assets to the 

guarantor. No guarantor wants to expose itself to unlimited losses on this put. For 

this reason, all guarantee contracts incorporate a stop-loss provision that gives the 

guarantor a call on the guaranteed party’s assets. Ordinarily, this right kicks in just 

the insolvency threshold is breached. In the FDIC Improvement Act of 1991, efforts 

to exercise this call are termed ‘‘prompt corrective action’’ (PCA). 

By definition, the Government’s right to take over the firm’s assets will never be 

exercised in a financial organization is truly TBTF. This means that the Government has effectively ceded the value of its loss-stopping rights to TBTF stockholders. The value of this giveaway is what the GAO’s measure ignores. 

I can clarify this further by examining Figure 2. This figure graphs the behavior 

of AIG’s stock price before, during, and after the 2008 crisis. The only times AIG’s 

stock price approached zero was when a Government takeover of the firm was being 

actively discussed. Each time that this possibility was tabled, trading picked up and 

the stock price soared as new stockholders tried to share in the value of the 

unexercised call. 

GAO Neglect of Differences in Political Clout 

Postcrisis reforms seek to classify particular firms as either systemically important financial institutions (SIFIs) or not. But TBTF status is not a binary condition 

and does not start at a particular size. A firm’s access to Senators and 

Congresspersons grows steadily with its geographic footprint and with the number 

of employees that can be persuaded to contribute to reelection campaigns. TBTF 

BHCs give heavily to candidates in both political parties as Ferguson, Jorgenson, 

and Chen (2013) have documented. Holding size constant, the more organizationally 

complex and politically influential an institution becomes, the better the chance that 

Government examiners will find it difficult to observe its exposure to tail risk and 

to discipline such risk adequately. 

Need To Bring in the Behavior of Stock Market Prices 

To capture the full extent of TBTF subsidies, it is critical to make use of stockmarket data. Figure 3 of my presentation tracks annualized estimates that Armen 

Hovakimian, Luc Laeven, and I (2012) have made of the average dividend that taxpayers ought to have been paid on their stake in large BHCs. This Figure plots the 

mean value of the credit support in annualized basis points per dollar of assets supplied to large banking organizations, quarter by quarter between 1974 and 2010. 

The surge in the third quarter of 2008 is remarkable, as is its steady fallback afterwards. 

Regulators and policymakers persistently misframe bailout expenditures as either 

loans or insurance. This false characterization helps TBTF firms and their creditors 

to steal wealth from taxpayers. An insurance company does not double and redouble 

its coverage of drivers it knows to be reckless. Similarly, lifelines provided to an underwater firm should not be thought of as low-interest loans. Loans are simply not 

available to openly insolvent firms from conventional sources. The ability to extract 

implicit guarantees on new debt and the hugely below-market character of bailout 

programs means that the repayment of funds that were actually advanced does not 

show that a bailout program is a good deal for taxpayers. 

Bailout funding can more accurately be described as unbalanced equity investments whose substantial downside deserves to carry at least a 15 percent to 20 percent contractual return. The Government’s bailout deals compare very unfavorably 

with the deal Warren Buffet negotiated in rescuing Goldman-Sachs. Buffet’s deal 

carried a running yield of 10 percent and included warrants that gave him a substantial claim on Goldman’s future profits. Government credit support transferred 

or ‘‘put’’ to taxpayers the bill for past and interim losses at numerous insolvent or 

nearly insolvent TBTF firms. Authorities chose this path without weighing the full 

range of out-of-pocket and implicit costs of their rescue programs against the costs 

126 

and benefits of alternative programs such as prepackaged bankruptcy or temporary 

nationalization and without documenting differences in the way each deal would 

distribute benefits and costs across the populace (see Bair, 2012). 

In my opinion, it is shameful for Government officials to imply that TBTF bailouts 

were good deals for taxpayers. On balance, the bailouts transferred wealth and economic opportunity from ordinary taxpayers to much higher-income stakeholders in 

TBTF firms. Ordinary citizens understand that this is unfair and officials that deny 

the unfairness undermine confidence in the integrity of economic policymaking 

going forward. 

How To Sanction the Pursuit of TBTF Subsidies 

I hope my testimony convinces you that, in principle, the risks in backstopping 

TBTF firms cannot be calculated and priced in the straightforward ways that the 

risks of a bond or insurance contract can. Taxpayer guarantees to TBTF creditors 

provide unlimited loss-absorbing equity funding to zombie firms at a time when no 

sensible private party would even advance them a dime. 

I want to convince you further that interpreting bailout support as equity funding 

implies that managers who adopt risk-management strategies that willfully conceal 

and abuse taxpayers’ equity stake should be sanctioned explicitly by corporate and 

criminal law rather than excused by insurance law as inevitable moral hazard. 

I find it disgraceful that corporate law legitimizes managerial efforts to exploit 

taxpayers’ equity position. The norm of maximizing stockholder value is inappropriate for TBTF firms. In TBTF institutions, this norm leaves taxpayers’ unbooked 

equity stake inferior to that of ordinary shareholders in five ways: 

1. Taxpayers cannot trade their positions away. 

2. Downside liability is not contractually limited, but upside gain is. 

3. Taxpayer Positions carry no procedural or disclosure safeguards. 

4. Taxpayer positions are not recognized legally as an ‘‘equitable interest.’’ (This 

means TBTF firms may exploit them without fear of lawsuits.) 

5. TBTF Managers can and do abuse taxpayers by blocking or delaying recovery 

and resolution. 

The Problem of Regulatory Capture 

In and out of crisis, taxpayer interests are poorly represented by regulators because politicians and regulators have kept themselves less than fully accountable for 

the costs of bailouts and have simultaneously pursued conflicting political and bureaucratic goals. Over the years, the financial industry has infiltrated the bureaucratic system that ought to monitor and regulate aggressive risk-taking and woven 

huge loopholes into the fabric of capital requirements that—then and now—are supposed to keep financial instability in check. The industry’s capture of the regulatory 

system is politically very well-defended, because the subsidies are in part shifted 

forward to creditors and to customers in various industries (e.g., in realty and construction). 

Capture can be demonstrated in at least four complementary ways: (1) by enumerating the problems that the Dodd-Frank Act set aside (such as how to define systemic risk operationally or how to resolve the Fannie and Freddie mess); (2) by examining the many loose ends left in the Act’s efforts to handle regulation-induced 

innovation (especially in swaps) and to deal with institutions that have made or are 

making themselves too large, too complex, and too well-connected politically and bureaucratically to be closed and unwound; (3) by noting that crisis-management policies have helped the largest BHCs to become even larger; and (4) by recognizing 

that postcrisis reforms continue to feature loophole-ridden measures of accounting 

capital as the cornerstone of financial-stability policy. 

Why Capital Requirements Can’t Adequately Protect Taxpayers From BHC 

Shareholders 

Besides setting minimums that are far too low, gaping imperfections exist in 

weighing risks and measuring capital that open and solidify avoidance opportunities 

(see Admati and Hellwig, 2013). Actual and potential zombie institutions can use 

accounting tricks, organizational complexity, and innovative instruments to hide 

risk exposures and accumulate losses until their insolvency becomes so immense 

that they can panic regulators and command life support from them. 

The Basel control framework (see Basel Committee on Banking Supervision, 2013) 

is built on the fiction that all or most SIFIs can be persuaded to forgo individually 

profitable credit business for the greater good. This seems awfully naive (see Schelling, ‘‘Strategy of Conflict’’). The naivete lies in a set of unrealistic assumptions 

about the regulatory game: (1) that accounting ratios are difficult to misrepresent; 

127 

(2) that supervisors are hard to mislead; (3) that bankers dutifully accept statutory 

burdens rather than work aggressively to adjust their risk profile to neutralize the 

net effect of capital restrictions on SIFI profits and market capitalization; and (4) 

that meritorious commitments to protect unsophisticated depositors and to keep systemically important markets and institutions from breaking down in difficult circumstances do not provide convenient cover that tempts officials to obligate taxpayer funds over-generously and without revealing the full picture of fiscal and incentive effects. 

Capital requirements are merely restraints. Improved capital requirements increase the difficulty of extracting TBTF subsidies, but they do not reduce the legitimacy of adopting strategies that willfully pursue this goal. To do this, I propose 

that Congress declare that taxpayers have an equitable interest in any institution 

that can be shown to extract a subsidy from the safety net. In common law, an ‘‘equitable interest’’ is understood as a balance-sheet position that gives its owner a 

right to compensation from damages. I believe that we should conceive of this compensation as the dividend taxpayers would be paid on their implicit equity stake in 

any accounting period if information asymmetries did not exist. The net value of 

taxpayers’ stake in a TBTF firm increases with the extent to which creditors and 

stockholders are confident that they can hide tail risks and, if ruinous losses 

emerge, scare authorities into funding the losses without extracting due compensation. 

Genuine reform would compel the DOJ to prosecute megabank holding companies 

that engaged in easy-to-document securities fraud. Numerous representations and 

warranties can be shown to be deliberately deceptive and designed to benefit individual firms at the expense of the rest of us. As legal persons and convicted felons, 

guilty BHCs could be forced to break themselves up. Subsidiaries of felonious companies could lose the right to take insured deposits or act as broker-dealer firms and 

futures merchants. The beauty of such penalties is that managements and not Governments would have to design the breakup plan. 

Living wills, enhanced resolution authority, clawbacks of undeserved executive 

compensation, and an Office of Financial Research are potentially useful tools. But 

the failure to prosecute any TBTF firm or top manager in open court for criminal 

securities fraud tells us how easy it is to collect fines (because they are paid by 

stockholders) and how hard it can be for regulators to discipline individual managers of influential and interconnected BHCs. For top management, corporate-level 

fines are a nondeterrent slap on the wrist. Moreover, only a portion of most fines 

compensate the taxpayer by flowing through to the Treasury. Sad to say, most of 

these criticisms apply to the reform programs that are unfolding in the European 

Union as well. 

The Problem of Fairness 

Fairness is the heart of the Rule of Law. Whether or not enhanced resolution or 

contracts with bail-in provisions can be enforced in difficult circumstances, Corporate and/or Property Law needs: (1) to recognize that regulators’ demonstrated 

propensity to bail out creditors and shareholders in TBTF firms (e.g., in AIG, 

Fannie, and Freddie) assigns taxpayers’ a disadvantaged equity position in each 

TBTF firm, and (2) to enact personal and corporate penalties for willful efforts to 

pursue risks that abuse taxpayers’ equity stake and pervert the pattern of real investment. Corporate penalties could include forced sales of some or all lines of business. 

It is useful to think of taxpayers’ stake in each TBTF firm as if it were a trust 

fund and conceive of Government officials as fiduciaries responsible for managing 

that fund. The purpose of the reforms I propose is to give regulators, along with 

managers and directors of TBTF firms, an explicit and codified fiduciary duty to 

measure, disclose, and service taxpayers’ stake-holding fairly. To overcome shortterm benefits from ducking their implicit fiduciary responsibilities, regulators, managers, and board members need to face stricter legal liability for neglecting or incompetently performing these fiduciary duties. 

Governments must rework bureaucratic and private incentives to focus reporting 

responsibilities for regulators and institutions on uncovering the value of safety-net 

support. Regulatory-agency and corporate mission statements must explicitly define, 

embrace, and enforce fiduciary duties of loyalty, competence and care to taxpayers 

in operational and accountable ways. Otherwise, it is unreasonable to hope that 

managers will—or that regulatory staff can—contain systemic risk during future 

rounds of boom and bust. 

The report the GAO released today (General Accountability Office, 2014) is a 

small step in this direction. The downside of the report is that TBTF firms are going 

128 

to trumpet GAO’s low-ball and conceptually deficient measurement of the subsidy 

as if it were gospel. 

To support a culture of fiduciary duty, I have long maintained that we need to 

strengthen training and recruitment procedures for high-ranking regulators. If it 

were up to me, I would establish the equivalent of a military academy for financial 

regulators and train cadets from around the world. The curriculum would not just 

teach cadets how to calculate, aggregate, and monitor the costs of safety-net support 

in individual institutions and countries. The core of the curriculum would be to drill 

students in the duties they will owe the citizenry and to instruct them in how to 

confront and overcome the nasty political pressures that elite institutions exert 

when and as they become increasingly undercapitalized. 

Politically, a financial crisis is a struggle by financial firms whose assets have collapsed in value to offload the bulk of their losses onto creditors, customers, and taxpayers. In the early months of the 2008 crisis, Fed and Treasury officials assisted 

economically insolvent zombie institutions (such as Bear Stearns and AIG) to book 

new risks and to transfer their losses onto the Government’s balance sheet. Authorities did this by mischaracterizing the causes of these institutions’ distress as a 

shortage of market liquidity and helping insolvent firms to expand and roll over 

their otherwise unattractive debt. Far from assisting zombie institutions to address 

their insolvency, unwisely targeted and inadequately monitored Government credit 

support encouraged troubled firms not only to hold, but even to redouble the kinds 

of go-for-broke gambles that pushed them into insolvency in the first place. 

Indiscriminately bailing out giant firms was a mistake that has hampered, rather 

than promoted economic recovery. Similarly, prolonged uncertainty about the future 

of Fannie and Freddie continues to disrupt housing-finance activity. Blanket bailouts evoke gambles for resurrection among zombie and near-zombie beneficiary 

firms like AIG, while uncertainty about who will finally bear the extravagant costs 

of these programs dampens spending plans in every sector. These problems divert 

and restrain the flows of credit and real investment necessary to trigger and sustain 

a healthy economic recovery. 

References 

Admati, A., and Hellwig, M. (2013). ‘‘The Bankers’ New Clothes: What’s Wrong With 

Banking and What To Do About It?’’, Princeton University Press, Princeton. 

Bair, S. (2012). ‘‘Bull by the Horns: Fighting To Save Main Street From Wall Street 

and Wall Street From Itself’’, Free Press, New York. 

Basel Committee on Banking Supervision (2014). ‘‘Supervisory Guidelines for Identifying and Dealing With Weak Banks: Consultative Document’’, Banking for International Settlements, Basel. 

Ferguson, T., Jorgenson, P., and Chen, J., (2013). ‘‘Party Competition and Industrial 

Structure in the 2012 Elections: Who’s Really Driving the Taxi to the Dark Side?’’, 

International Journal of Political Economy, 42 (Summer), 3–41. 

Hovakimian, A., Kane, E.J., and Laeven, L.A. (2012). ‘‘Variation in Systemic Risk 

at U.S. Banks During 1974–2010’’, available at SSRN: http://ssrn.com/ 

abstract=2031798 or http://dx.doi.org/10.2139/ssrn.2031798 (May 29). 

United States Government Accountability Office, July 2014. ‘‘Bank Holding Companies: Expectations of Government Support’’, (GAO-14-621). 

129 


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1The banks and the Federal Reserve tried to keep information about the extent of Fed loans 

hidden. The information was released after Bloomberg fought in court. See Phil Kuntz and Bob 

Ivry, ‘‘Fed Once-Secret Loan Crisis Data Compiled by Bloomberg Released to Public’’, 

Bloomberg, December 22, 2011. Citigroup is discussed further below. 2 Cole (2012) shows that TARP did not help improve business lending, which is not surprising 

since the programs did not reduce the institutions’ indebtedness and the resulting debt overhangs (see Admati and Hellwig, 2013a, chapter 3, and Admati et al., 2014). Barofsky (2012) and 

Bair (2012) describe the bailouts programs. Additional references in the notes to chapter 9 of 

Admati and Hellwig (2013a), whose text is attached to this testimony. 

PREPARED STATEMENT OF ANAT ADMATI 

GEORGE G.C. PARKER PROFESSOR OF FINANCE AND ECONOMICS, GRADUATE SCHOOL

OF BUSINESS, STANFORD UNIVERSITY

JULY 31, 2014 

Chairman Brown, Ranking Member Toomey, and Members of this Subcommittee, 

I commend you for holding this hearing and am grateful for the opportunity to 

speak to you. I am a Professor of Finance and Economics at Stanford Graduate 

School of Business and my recent research and writings have focused on issues immediately relevant to today’s hearing. 

Recent experiences have helped foster the expectations of Government support 

mentioned in the title of this hearing. Since 2008, the Treasury, the Federal Reserve 

and the FDIC provided through various programs massive and unprecedented support to the financial system. The largest bank holding companies, to varying degrees, have had access to hundreds of billions, even trillions of dollars in relatively 

cheap loans and guarantees, and they benefited from bailouts of their counterparties 

such as AIG. For some, e.g., Citigroup, the support was critical. 1

Trillions of U.S. taxpayer funds were put at risk. The supports prevented the collapse of the system and helped many financial institutions avoid default, bankruptcy, or resolution in which their shareholders would be wiped out and at least 

some of their creditors would suffer losses. Yet, the programs did little to solve the 

housing crisis, failed to improve business lending meaningfully, and at times were 

excessively generous and inefficient. 2

Implicit guarantees for which banks do not pay create a subsidy, essentially free 

insurance for their debts, or at least a partial insurance that lowers the likelihood 

of losses in some scenarios. Because such subsidies are implicit and invisible, determining their value with any precision is difficult; there is no market in which the 

implicit guarantees are being valued (although some have tried to use credit insurance contracts to try to estimate their value). Any estimate depends on many variables that change over time, and estimation requires making many assumptions; 

such assumptions might or might not be true in reality. In fact, many of the variVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00134 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON

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3For example, in his letter to shareholders in April 2011, Jamie Dimon, CEO of JPMorgan 

Chase, denies his bank benefits from implicit subsidies and suggested that the industry pay any 

expenses associated with the failure of ‘‘dumb banks.’’ For a response to this letter, see Anat 

Admati, ‘‘An Open Letter to JPMorgan Chase Board of Directors’’, reprinted in Huffington Post, 

June 14, 2011). This letter, which was sent to at least one person within the bank, did not receive any acknowledgment and did not appear to affect the banks’ strategy. Misleading comments by bank executives and bank lobbyists as well as others are discussed in Admati and 

Hellwig (2013a) and in a number of short pieces, some of which are cited later in this document. 4 I am referring, for example, to the distortive corporate tax code that penalizes equity funding and encourages borrowing, which can become excessive, and to the sweeping exemptions of 

repos and derivatives from stay in bankruptcy, which has likely enabled and encourage excessive growth in these markets. These issues will come up briefly below and they are discussed 

in Admati and Hellwig (2013a, chapters 5, 9, and 10). 

ables that affect the size of the subsidy vary across different institution in complex 

ways. Moreover, actions by the institutions, by investors, and by regulators also 

have important impacts. Later in this document I will have additional comments on 

measuring the subsidies. 

When implicit-guarantee subsidies are provided to institutions that have significant discretion about their investments and the risks they take, the results can be 

perverse. Policymakers may hope that the subsidies are passed on to specific investments or people, but the institutions, as they benefit from the guarantees, may well 

have incentives to make different investments altogether. 

For example, guarantees may be provided in the hope that the banks will make 

certain loans, when in fact, given their compensation structures and the flawed regulations we have in place (e.g., the use of risk weights), the banks may only make 

the loan if it is very safe or if it is guaranteed by the Government. Instead, banks 

may prefer to invest in derivatives markets with more upside. 

The institutions benefiting most from the subsidies often deny the existence of 

any benefit and claim that they are happy to give up the implicit subsidies. 

‘‘Please,’’ they may say, ‘‘let banks fail when they should.’’ 3 The difficulty is that 

letting systemic institutions—or many institutions at the same time—fail may be 

disruptive and entail enormous collateral damage. Even if the direct costs of the 

failure are covered, the disruptions and inefficiencies that result are costly for the 

economy and the harm is borne by innocent citizens. As I will explain below, we 

do not have workable options for the failure of systemic institutions; moreover, the 

harm from their distress and even from the fear of their failure creates instabilities. 

Financial crises are sometimes portrayed as if they were unpreventable natural 

disasters, implying that bailouts are similar to emergency aid after an earthquake. 

This narrative is misleading. The crisis of 2007–2009 was an implosion of a system 

that had become too fragile, reckless, and distorted. Regulatory failures, including 

flawed and ineffectively enforced regulations, must take much of the blame for the 

excessive fragility and the buildup of risk. These failures can be corrected, and regulators have authority to do so under current laws, but, remarkably, obvious lessons 

have not been learned, and not enough has been done to make the system as safe 

as it can and should be. Some counterproductive laws have also remained in place. 4

The situation in banking is disturbingly similar to allowing heavy trucks with 

dangerous cargo to drive recklessly at 95 miles per hour in residential neighborhoods. If drivers get a bonus for reaching the destination quickly, and face little risk 

of injury or death even in an explosion (imagine that they have a special protective 

mechanism), they will drive recklessly and endanger innocent citizens. Authorities 

can send firefighters to put out fires and medics to treat the injured if an explosion 

occurs, but the public would wonder why truck companies reward reckless driving 

and, most importantly, why a safer speed limit was not set and enforced to prevent 

harm. 

Similar questions must be asked about the failure of financial regulation. We 

should have a financial system that supports the economy as efficiently and consistently as possible without major distortions. The system we have instead is too dangerous, exposing the public to unnecessary risk and distorting the economy. Much 

can be done—even within existing laws—to improve this situation. 

This Committee has an important role in helping bring about beneficial changes. 

In the rest of this document, I will elaborate on the above statements, diagnose the 

key problems, and outline some recommendations. Additional materials are attached 

and referenced; I will be happy to provide more at your request. 

Can/Will Large Bank Holding Companies Ever ‘‘Fail’’ and if so, How? 

The Dodd-Frank Act (DFA) intended, among other things, to eliminate bailouts. 

Yet virtually everyone involved in the financial system—even if some would not 

admit it—expects that the Government, possibly through the Federal Reserve and 

132 

5The dynamics of contagion are explained in Admati and Hellwig (2013a, chapter 5), White 

(2014), and testimony of James Thomson before this Subcommittee on July 16, 2014. 6These two paragraphs are adapted from Admati and Hellwig (2013a, p. 11), and the crisis 

is described in some detail in chapters 5 and 9 (the latter is attached to this testimony). Mr. 

Valukas made the statement here quoted in an interview on CBS 60 Minutes, aired April 22, 

2012. The last fact is included in the 2011 report of the Financial Crisis Inquiry Commission 

(p. 390). 

FDIC, will again provide supports to large bank holding companies and other institutions considered ‘‘systemic’’ if authorities fear that the failure of these institutions 

would cause significant harm to the economy. If many small institutions become distressed at the same time, they too may be supported. 

This assessment is based on the realities of today’s system and the state of its 

regulation. 5 Whereas regulators receive significant authority under DFA (some of 

which they had all along), the implementation of the law has been messy and uneven. Some of the most critical rules are insufficient and flawed; others appear 

wasteful, too costly relative to the benefit they provide. 

Policymakers who were involved in the bailouts extol the virtues of their actions 

while appearing willfully blind to their failure to reduce the fragility of the system 

before the crisis and to learn the lessons since. If anything, investors may reasonably expect that supports would be forthcoming for fear of another ‘‘Lehman moment’’ even with the alternative to bankruptcy offered through the new and still untested resolution authority by FDIC. 

The DFA titles most relevant for this discussion are Titles 1, 2, and 7. I’d like 

to focus my discussion mainly on Titles 1 and 2, although Title 7, which deals with 

derivatives markets, is also critical. The still-too-opaque markets in derivatives 

allow banks to hide enormous amount of risk from investors and regulators. Ineffective implementation of Title 7 and poor disclosures can undermine Titles 1 and 2 

and the objective of having a healthier financial system. 

Stating the obvious (but see more below for nuances), a business ‘‘fails’’ when it 

does not fulfill its debt commitments or is feared to be unable to pay the debts. For 

‘‘normal’’ companies in the U.S., failure involves filing for bankruptcy or liquidation 

under Chapter 11 or Chapter 7. 

Title 1 of DFA requires, among other things, that large bank holding companies 

submit ‘‘living wills’’ to regulators. These documents are meant to play out a scenario in which the holding company goes through bankruptcy process, presumably 

under Chapter 11. In her testimony before your Committee on July 15, 2014, Fed 

Chair Janet Yellen was asked some pointed questions about the living-wills process 

by Senator Elizabeth Warren. The exchange brings out some key issues. According 

to Chair Yellen, the largest bank holding companies have by now submitted three 

rounds of living-wills documents, and received feedback on the first set of submissions. The parts of these documents that are made public provide little information, 

often less than is included in standard financial statements. The full submission, 

according to Chair Yellen, goes into tens of thousands of pages. 

Senator Warren asked Chair Yellen a critical question: ‘‘Can you honestly say 

that JPMorgan could be resolved in a rapid and orderly fashion as described in its 

plans with no threats to the economy and no need for a taxpayer bailout?’’ The Senator pointed out that JPMorgan Chase has $2.5 trillion in assets and 3,391 subsidiaries, compared to Lehmann Brothers, which had $639 billion in assets and 209 

subsidiaries prior to its failure. 

The Lehman Brothers bankruptcy, filed on September 15, 2008, caused severe disruption and damage to the global financial system. In its immediate aftermath, 

stock prices imploded, investors withdrew from money market funds, money market 

funds refused to renew their loans to banks, and banks stopped lending to each 

other. Banks furiously tried to sell assets, which further depressed prices. Within 

2 weeks, many banks faced the prospect of default. 

To prevent a complete meltdown of the system, Governments and central banks 

all over the world provided massive supports to financial institutions. These interventions stopped the decline, but the downturn in economic activity was still the 

sharpest since the Great Depression. Anton Valukas, the lawyer appointed by the 

bankruptcy court to investigate Lehman Brothers, put it succinctly: ‘‘Everybody got 

hurt. The entire economy has suffered from the fall of Lehman Brothers . . . the 

whole world.’’ Within 21 months, American households lost $17 trillion; reported unemployment hit 10.1 percent at its peak in 2009. 6

Chair Yellen stated that Title 1 of DFA only requires the Fed to give feedback 

to the companies about their plans. She referred to an ‘‘iterative process’’ of submission and feedback. Title 1 apparently does not require that regulators give a pass/ 

fail grade to the living wills nor to determine definitively whether bankruptcy is a 

133 

7 Even the Nordic countries have not been able to agree on an SPOE procedure for Nordea. 

viable option. However, the title definitely authorizes regulators to take a number 

of strong actions if they find that bankruptcy would entail too much collateral damage. Such actions include increasing capital (equity) requirements, requiring that 

structures be simplified and assets sold (potentially ‘‘breaking up’’ the banks), etc. 

The U.S. bankruptcy code to which Lehman Brothers was subjected has not 

changed since 2008. Other countries have different processes, which Lehman Brothers’ foreign subsidiaries must follow. The tens of thousands of pages of living wills 

JPMorgan Chase has submitted to regulators might be of some use should it file 

for bankruptcy, at least under U.S. law (although they may well be dated by the 

relevant time, because banks’ counterparties and businesses can change in a matter 

of days or months). But the process will not be much faster and simpler than Lehman Brothers bankruptcy. Moreover, should the numerous counterparties of 

JPMorgan Chase become concerned that bankruptcy might be forthcoming, runs 

and disruptions similar to those observed in 2007–08 when Bear Stearns and Lehman Brothers became distressed will likely start significantly before any filing. 

It defies credibility to suggest that, at the current speed of the ‘‘iterative process’’ 

that Chair Yellen described regarding the living wills, and without major changes 

to their structure and funding mix, enormously large and complex institutions like 

JPMorgan Chase will be able to go through bankruptcy without major harmful effects. Yet, regulators may continue to ‘‘iterate’’ and fail to use their authority to act 

even knowing that bankruptcy is not viable, refusing to admit to and deal with this 

reality. I doubt this situation was the intent of Title 1. 

DFA authors, perhaps mindful after the Lehman Brothers experience that bankruptcy may not be a realistic option for large financial institutions, included an alternative mechanism in Title 2, which gives the FDIC authority to deal with the 

failure of any institution deemed ‘‘systemic’’ through a so-called Orderly Liquidation 

Authority (which actually doesn’t intend to liquidate the company). The FDIC has 

engaged in the last few years in a serious effort to make its plans for this process 

credible, focusing on an approach called Single Point of Entry (SPOE). 

SPOE represents an important and useful development, but, as bankruptcy expert 

David Skeel (2014, p. 3) assesses, ‘‘the technique also has important vulnerabilities, 

and some of the claims made on its behalf are quite exaggerated.’’ Among them, 

SPOE does not work for institutions that are active globally and that have systemically important operations in several countries, unless all the countries that are involved agree to such an approach. A recent coordination effort between U.S. and UK 

may allow for SPOE of U.S. authorities in U.S. holdings companies without intervention of UK authorities in UK subsidiaries, so the problem of UK authorities entering a Lehman Brothers subsidiary and finding that there is no cash to keep systemically important functions going might not arise. 

However, the U.S.–UK coordination is the only attempt of this sort, and it does 

not seem to be fully symmetric. If Barclays or Deutsche Bank were to run into trouble, U.S. authorities would probably not be willing to accept SPOE resolution by the 

domestic authorities of these banks, but instead would intervene directly in the 

holdings companies that organize these banks’ U.S. activities. Multiple-entry resolution, however, destroys operational procedures that have been managed in integrated fashion across jurisdictions, for cash management, as in the case of Lehman 

Brothers, or, even more importantly, the joint use of Information Technology systems. 

From the perspective of the different countries involved, single-entry resolution 

would involve significant conflicts of interest. If U.S. authorities had been in charge 

of Lehman Brothers, London, as well as the parent, would they have paid proper 

attention to London-specific concerns, including the systemically important marketmaking activities of Lehman Brothers in London? Alternatively, is it acceptable for 

U.S. authorities to follow the procedure suggested in the living will of Deutsche 

Bank, which argues that damage from resolution would be minimized if U.S. authorities were willing to trust the German authorities (Bafin, the supervisor, and 

FMSA, the resolution authority)? In a cross-border setting, SPOE resolution leaves 

too much room for the authority in charge to shift losses to other countries and it 

is therefore hardly workable. 7

Even if we had SPOE resolution for globally systemically important banks, some 

of these banks would most likely be ‘‘too big to fail.’’ Procedures would be lengthy 

and cumbersome and, meanwhile, there might be substantial systemic fallout. Regulators would then be reluctant to use the procedure if multiple financial institutions 

face default at the same time, or if resolution would expose problems at one or more 

subsidiaries. In sum, Title 2 is useful, but it is certainly not a silver bullet for addressing the ‘‘too-big-to-fail’’ problem and it does not eliminate expectations of supVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00137 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
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8See also White (2014) for a discussion of the issues regarding ‘‘fail’’ scenarios in ‘‘too big to 

fail.’’ 9Skeel and Jackson (2012), and Mark Roe, another bankruptcy expert, (see, e.g., ‘‘Reforming 

Repo Rules’’, Project Syndicate, December 21, 2011), call for reexamining these exemptions. 

Skeel (2014) also warns with regard to Title 2 resolution that ‘‘it reinforces problematic incentives for financial institutions to rely on short-term financing.’’ 

port for large bank holding companies. Moreover and importantly, even under the 

best scenario, using Title 2 resolution would be costly and entail collateral damage 

and, as in the case of bankruptcy, the distress of the corporation, and the fear or 

anticipation that Title 2 resolution might be invoked by its counterparties would 

likely already cause harm. 8

The living wills requirements and Title 2 of DFA try to make palatable the notion 

that, like other companies, financial institutions structured as limited liability corporations should fail if they take risk and become unable to pay their debts, thus 

wiping out their shareholders and imposing losses on their creditors through an orderly legal process. In a vibrant market economy, innovations involve risk, and failures should be tolerated. 

For normal companies, bankruptcy typically follows an actual or imminent default. Restructuring debts may allow the company to continue operating. Bankruptcy laws try to control the actions of managers and shareholders in insolvent 

companies, who have incentive to benefit themselves at the expense of creditors by 

taking out cash or gambling for survival. Since such problems and the legal and 

other costs of bankruptcy are anticipated by creditors, the terms of the debt claims, 

including both the interest rate and the conditions the contract puts on the borrower, are set by prudent lenders to compensate for the losses in the event of default and bankruptcy, and to control borrowers’ actions that go against the lenders’ 

interests. 

A source of great inefficiency in banking is that banking institutions can persist 

in a state of distress or even insolvency without their creditors becoming alarmed 

and without the institution experiencing the difficulty of most distressed borrowers 

to raise funds and continue operating. One reason for this anomaly is that banks’ 

creditors include depositors, who are insured and dispersed. Depositors are particularly passive in their role as lenders to the banks (a status most of them do not 

quite realize they have) and do not behave as normal creditors with standard debt 

contracts. Depositors rely on insurance and regulators to protect them. 

Banks can use depositors’ funds to invest in various loans and other assets that 

can sometimes be used as collateral and enable the bank to borrow even more under 

attractive terms. Creditors whose debts are secured by collateral care less than unsecured creditors about the borrower’s solvency. Lending to financial institutions 

through so-called repurchase agreements (repos) is even safer than secured lending, 

because, under safe harbor laws from 2005, repos, as well as derivatives, are exempted from the normal stay in bankruptcy. 9

For bank holding companies considered too big to fail, even unsecured bond holders feel reasonably sure they will be paid in full. In the financial crisis the creditors 

of numerous banking institutions, including those whose claims had counted as ‘‘regulatory capital’’ and were meant to absorb losses, were paid in full even as the institutions received large amounts of bailout funds and other supports. As discussed 

above, even today, and despite DFA, it is quite possible and even likely that the 

creditors of one of the largest bank holding companies will be paid in full even if 

the institution is insolvent. 

As long as creditors are paid and do not constrain the borrowing bank much, it 

can continue operating. In that case, only regulators are in a position to intervene 

even as highly distressed or insolvent borrowers, including banks, are extremely inefficient and their decisions are distorted by conflicts of interest with creditor. In 

fact, I will argue below that by most standards, the banks are permanently in a 

state of financial distress, yet they manage to get away with it. 

Essential, Yet Flawed and Insufficient Regulation 

In addition to the living-wills requirement, Title 1 of DFA authorizes the Federal 

Reserve, in collaboration with other regulators, to design prudential regulations 

meant to maintain the safety and soundness of the system. The Fed is charged with 

regulating bank holding companies as well as all institutions declared systemic by 

the Financial Stability Oversight Committee. 

As discussed above, the scenarios that involve default and failure of systemic institutions are complicated, disruptive, and harmful. There are no good options. It 

thus appears particularly important to try to prevent reaching these failure situations through prudent supervision and regulations. Most important among those 

135 

10On this insidious confusion, see Admati and Hellwig (2013a, chapters 1 and 6), Admati et 

al. (2013, section 3.1), Claims 1 and 2 Admati and Hellwig (2014), which is attached to this testimony, and my Tedx Stanford talk http://www.youtube.com/ 

watch?v=slI4vx7gHPQ&feature=youtu.be&a. 11See Wilmarth (2014). Bair (2012) and Barofsky (2012) include vivid descriptions of the bailouts. 12Onaran (2011) argues that both Citigroup and Bank of America were insolvent or ‘‘zombies’’ 

even in 2010. Admati and Hellwig (2013a, chapters 3, 4, and 11) emphasize the harm of allowing weak banks to persist. 13 Admati et al. (2014) discusses in detail how borrower-creditor conflicts affect funding decisions in highly indebted corporations, and the analysis is particularly applicable to banks. 

safety measures are capital requirements meant to control the funding mix of these 

companies, including to ensure that they fund their investments by appropriate 

amount equity—money from owners and shareholders—so that they can continue 

making loans and investments and still pay their debts even if they incur losses. 

(Note: the jargon that refers to capital as something banks ‘‘hold’’ or ‘‘set aside’’ is 

confusing, suggesting that capital represents idle funds like cash reserves that 

banks cannot use, which is false. 10) 

According to its financial statements, on December 31, 2007, the largest bank 

holding company at the time, Citigroup, reported that its shareholder equity or net 

worth (the difference between its reported assets and liabilities) was 5.2 percent of 

its total assets. Citigroup’s assets were valued at almost $2.2 trillion. As Lawrence 

White from New York University Stern School notes, however, this information does 

not capture some important facts. He writes (White, 2014, p. 7, footnotes omitted): 

‘‘Citigroup is best understood as a (roughly) $1.2 trillion depository institution, on 

top of which was a (roughly) $1 trillion holding company (including its nondepository subsidiaries). The holding company’s net worth was smaller than the 

depository’s net worth; in essence, if the net worth of the depository (i.e., the capital 

of the depository, which also counted as an asset for the holding company) was ignored, the holding company was insolvent.’’ 

Citigroup proceeded to collapse at the end of 2008 and needed a series of bailouts and massive other supports. Remarkably, the Government injected of $25 billion of 

TARP funds into Citigroup on October, 8, 2008, and, even with the market value 

Citigroup stock falling below $25 billion in November, the company was offered tens 

of billions in additional bailouts and hundreds of billions in cheap loans and guarantees from the Fed. (Citigroup, according to Arthur Wilmarth from George Washington University Law School is ‘‘a case study in managerial and regulatory failure.’’ 11) 

Indeed, regulators often show forbearance and allow insolvent banks to persist 

and even hide their losses. Insolvent institutions are highly dysfunctional and harm 

the economy. They do not make new loans and may become reckless, gambling for 

survival or looting the institutions. Recklessness was pervasive in the Savings and 

Loan Crisis of the 1980, and the dysfunctionality of weak banks is evident in Europe in recent years. Yet, when banks are supported, their indebtedness is often 

maintained because the supports are given in the form of more loans. 12 Solvent corporations can in fact raise equity at some price, although their managers and shareholders are unlikely to do so voluntarily. Creditors or regulators can bring about reduction of indebtedness through covenants or regulation. 13

A glaring failure of regulatory reform efforts across the globe (not just in the U.S., 

indeed, the situation is worse in Europe) is that, even as the largest global financial 

institutions have grown ever bigger, more complex, more connected and more dangerous, they continue to be allowed to operate with dangerously high levels of indebtedness and much too little equity, and to hide too much risk in opaque markets 

and off their balance sheets. 

The minimal requirements agreed upon in Basel III allow equity to be as low as 

3 percent of the total assets. Even with the harsher U.S. requirements, 95 percent 

of the total assets of the largest bank holding companies can be funded with debt. 

Note that this requirement would have been satisfied by Citigroup in December, 

2007. Capital regulations also rely on an enormously complex and manipulable system of risk weights that distorts banks’ decisions and exacerbates the fragility of 

the system, among other things making business lending relatively unattractive. 

Bankers and regulators claim that the new capital regulations are tough when in 

fact these reforms amount to a tweak and they have no valid justification. In the 

speeding analogy, the reforms are analogous to reducing the speed limit for loaded 

trucks from 90 miles per hour to 85 miles per hour in residential neighborhoods, 

with police unable to measure the actual speed. The claims made to justify the regulation or to fight higher equity requirements are fraught with flaws that range from 

false statements to misleading claims that divert the discussion. These statements 

136 

14See Admati (2014), Admati and Hellwig (2013a, 2014), and Admati et al. (2013, 2014). 

Admati et al. (2013) was first posted in August, 2010. These and additional references are available at http://bankersnewclothes.com/: and (for more academic writing) http:// 

www.gsb.stanford.edu/news/research/admati.etal.html. 15 As discussed in Admati and Hellwig (2013a, chapter 3), the effects of overhanging debt can 

be seen in the case of homeowners who would not invest in the house if its value is low relative 

to the mortgage, or who might take a second mortgage even as this may put the lender of their 

first mortgage at risk. 16This phenomenon is explores in details in Admati et al. (2014), which is highly relevant 

to understanding the rationale for leverage regulation. See also Admati et al. (2013) and Admati 

(2014). 17White (2014) provides some comparisons based on book value of equity. The comparisons 

of banks and nonbanks on the basis of market value are starker. The latter have on average 

60 percent or more equity relative to total assets. 18Some claim that debt disciplines managers. In banking, this idea is a myth, as discussed 

in Admati et al. (2013, section 5), Admati and Hellwig (2013b) and Admati and Hellwig (2014, 

Claim 22), attached. 19This is explained in detail in chapter 8 of Admati and Hellwig (2013a) and in many other 

writings. See Claim 8 in Admati and Hellwig (2014), attached. 

are discussed in details in many of my writings, with colleagues, over the last 4 

years; a small sample of which is attached to this testimony. 14

A key observation for understanding corporate funding decisions is that heavy 

borrowing creates strong conflicts of interest between borrowers and lenders and potentially distorts the investments and funding decisions made by borrowers once 

debt is in place. Overhanging debts create inefficiencies when borrowers—or managers in an indebted corporation acting in the interests of shareholders—make decisions in their own interest and do not take into account the impact of their actions 

on creditors or third parties. For example, borrowers may underinvest in worthy 

projects if they expect the returns to accrue in part to their creditors or they may 

make excessively risky investments if they expect the downside of the risks to be 

borne by creditors, or by deposit insurance institutions and taxpayers. 15

As a result of these distortions and other costs associated with distress or bankruptcy, heavy borrowing can actually reduce the total value of a firm (i.e., the sum 

of the values of all claims, including debt and equity). Borrower-creditor conflicts 

also create an ‘‘addiction’’ to debt on the part of heavy borrowers, biasing subsequent funding decisions towards more debt and away from equity that makes existing creditors safer. 16 As mentioned above, the conflicts are particularly intense 

when corporations are in a state of distress or insolvency, which for most corporations are rare but which in fact are considered normal in banking. 

Without any regulation of their funding, and despite a (distortive) tax code that 

subsidizes borrowing and penalizes the use of equity, most corporations do not borrow heavily. 17 Even those who tend to use more debt, including private equity firms 

or Real Estate Investment Trusts, rarely have less than 30 percent equity in their 

funding mix. As discussed above, prudent creditors write restrictive covenants that 

constrain dividend payouts and other decisions by the borrower, and adjust the cost 

of borrowing to reflect anticipated legal costs and delays should the borrower go into 

bankruptcy, as well as the possibility that the borrower would take additional debt 

that might dilute their claims. 

Banks, however, can persist in distress because they do not experience the ‘‘dark 

side of borrowing,’’ including the increased costs and harsh terms that naturally prevent other corporations from heavy borrowing. Although they use a lot of debt, much 

of this debt comes with fewer strings attached than those other borrowers face (and, 

indeed, the terms the banks often place those to whom they lend). Deposit insurance 

and implicit guarantees lighten the burden of debt, allowing banks to continue to 

borrow and take risks without much effect on the terms of their debts. Supports and 

guarantees enable, encourage, and feed this addiction to debt. 18

Guarantees can also exacerbate the inefficiencies and distortions in banks’ investment decisions. If you could use borrowed money in a casino, keep the winnings and 

continue to borrow when you lose, you would certainly love gambling even if the 

odds were significantly against you. Chapter 9 of Admati and Hellwig (2013a), 

whose text is attached to this testimony, provides an accessible explanation. 

The fact that banks choose to rely so much on debt does not mean that their indebtedness levels are essential or efficient. These levels are the result of a failure 

of internal governance and a failure of normal credit markets to constrain the love 

of borrowing by banks and bankers. Compensation structures that reward return on 

equity (ROE), which are pervasive in banking, effectively pay bankers to gamble at 

the expense of creditors or taxpayers who are exposed to greater risks. Even shareholders may be exposed to risks for which they are not properly compensated. 19

Few benefit while the rest are harmed by this situation. When markets fail, effecVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00140 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
137 

20Despite the emphasis often placed on banks as sources of credit for firms, lending is actually a small part of what the largest bank holding companies do (see Admati and Hellwig 

(2013a, chapter 6). On the evolution of business of banking in the U.S., see Omarova (2013). 21 In chapter 11 of Admati and Hellwig (2013a) we outline briefly how better regulation can 

be designed and how to transition to a better system. 22These issues are discussed in detail in Admati and Hellwig (2013a, chapter 10). 23For example, in the Swedish crisis of 1992–1994, Government support for the banks necessitated cutbacks in other Government spending, which greatly contributed to the sharp economic 

recession. Citizens in Ireland and Iceland are still suffering. 

tive laws and regulations must correct the distortions. Otherwise laissez faire can 

become crony capitalism. 

The idea of finding ways for banks to fail, discussed above, is obviously meant to 

bring back market discipline into banking. However, given the collateral damage 

from the failure of one or more institutions, and the fact that disruptions and harm 

start even before an actual default, the primary focus should be on prevention. 

Much more can be done on this front. There is simply no justification for the current 

inefficient levels of indebtedness in banking. Reducing it will achieve major benefits 

for society at virtually no relevant costs. 

The inefficiencies of heavy borrowing in banking also distort the provision of credit in the economy. Making loans is a critical contribution banks can make to the 

economy. 20 Heavily indebted banks, however, may make too few worthy (but relatively ‘‘boring’’) business loans that don’t have much upside, while at the same time 

making too many risky loans, including credit card loans, which may lead others 

to borrow too much and suffer the consequences. The distortions create cycles of 

booms, busts and crises. Regulations based on risk weights exacerbate these distortions. 

It is possible and highly beneficial to transition to a system in which banks use 

significantly more equity, thus reducing the likelihood of costly failures or bailouts 

and at the same time permitting banks to invests more efficiently on behalf of all 

its investors, thus supporting the economy better and with fewer distortions. 

Whereas many extol the importance of increasing equity requirements, the status 

quo seems to be the benchmark against which changes are measured. This benchmark is entirely inappropriate. Banks are as fragile as they are only because those 

who make decisions in the banks benefit from the status quo and they have so far 

gotten away with maintaining it, even after the most recent crisis. 

Requiring that banks use more equity is not a silver bullet, and much depends 

on the details of the regulations and its implementation and enforcement, but effective regulation of banks’ indebtedness can make other, more costly, regulations less 

important or necessary. 21 Liquidity breakdowns are less likely if banks can trust 

each other to be solvent, and the liquidity offered by deposits and other short term 

debt by banks would only be enhanced if banks have more equity. 22

Existing laws still allow regulators to revise capital regulation. Title 1, specifically 

in the context of the living wills requirements, allows significant increases in equity 

requirements for institutions deemed systemic, if regulators admit that bankruptcy 

is not a viable option. 

Comments on Measuring the Value of the Implicit Subsidies 

As discussed at the start of this document, it is very difficult to measure the value 

of the implicit subsidy associated with guarantees. Because there are no markets 

for these guarantees, assumptions must be made about the underlying forces and 

the data being used. One can also try to focus on the cost to taxpayers or in terms 

of benefits to banking institutions who receive the subsidies. In fact, these two need 

not be the same because of the collateral impact of the banks’ choices of investment 

and funding, and especially of their distress and failure scenarios. 

In assessing the costs to taxpayers, it is important to realize that expenses for 

supporting financial institutions in a systemic crisis occur at the every moment 

when the macro-economy is doing poorly, the country’s fiscal situation is very tight 

and money is sorely needed in many places. 23 Similarly, in assessing the benefits 

to banks, it is important to realize that Government guarantees are most useful in 

times of crisis, when private protection schemes are breaking down and the very 

survival of the institution is at stake. As discussed above, banks’ decisions about 

lending and investments are most distorted at that time, and bailouts that do not 

reduce indebtedness and thus do not alleviate banks’ distress may keep banks going 

but be unhelpful to the rest of the economy. (Ineffective banking regulations have 

caused much harm in Europe in recent years; many problems can be traced to a 

weak and bloated banking system and the politics of banking.) 

With these caveats, I will make a few observations about attempts to estimate the 

size of the subsidy, but I do not wish to focus on this technical issue. As I will argue 

138 

24 In one example, Kelly, et al. (2014) document the fact that during the recent financial crisis, (out-of-the-money) index put options that provide protection against large drops in the value 

of the entire financial sector were surprisingly cheap compared to the individual options of the 

financial institutions that are part of this index. This finding is consistent with the notion that 

the Government will not tolerate large equity losses for the financial sector as a whole. As a 

result, the market underprices the cost of insurance against these sector-wide losses for financials. 25On the poor disclosures of the banks and investors’ inability to assess their risk, see for 

example Jesse Eisinger and Frank Partnoy, ‘‘What’s Inside America’s Banks’’, The Atlantic, January 2, 2013. 

below, the size of the subsidy does not actually matter much to the policy recommendation. 

1. There is compelling evidence that the Government provided a sector-wide collective bailout guarantees to the financial sector in 2007–2009. 24

2. The value of the subsidy, if thought of as the amount the banks would have 

to pay to receive perpetual (even partial) insurance for their debts in the private markets, is sensitive to many variables and can change dramatically over 

time depending on the level of uncertainty, the state of the local and global 

economy, and various fragilities in the financial system. The value is highest 

when uncertainty is large and when the economy and/or the financial sector 

are weak, and especially in a crisis. Boom times, however, when the value of 

the subsidy might be thought low, can quickly turn to bust. For example, uncertainty indicators were low in 2006 and through summer 2007 only to explode in late 2008 and 2009.) 

3. When focusing on the funding costs of the institutions, particularly their borrowing costs, the relevant thought experiment in trying to assess the value of 

the implicit subsidies to the institutions who receive them from an ex ante perspective, i.e., when institutions fund their investments in light of the expectations of support, is to consider how institutions would have fared in the hypothetical scenario in which they tried to raise funding, such as unsecured, junior 

debt, without any chance of a guarantee, and specifically in a world in which 

the full costs of any failure, including bankruptcy costs and the distortions of 

distress and insolvency, would fall on shareholders and creditors. This counterfactual scenario cannot be observed, thus comparison requires many assumptions. One approach is to use credit ratings uplifts. The approach makes sense 

if the uplifts actually capture the true distinctions in the context of an individual institution and specific bond issuance. 

4. None of the approaches takes into account the extreme opacity of the large 

banking institutions’ and the difficulty in assessing their risks, including those 

lurking off their balance sheets and in derivatives markets. 25 Many banks use 

derivatives to get certain risks off their balance sheets. But then the counterparties on these derivatives might fail. If the counterparties have many parallel positions, as was the case when AIG wrote credit default swaps for $500 

billion on mortgage-backed securities, CDOs, and the like, the risk that the 

counterparty might fail is correlated with the underlying risk, i.e., the attempt 

to hedge risks through derivatives may end up being ineffective. In the case 

of AIG, fear of systemic fallout from such a failure was a major reason for the 

bailout. 

5. Correlations of risks, i.e., the risk that the same event affects multiple institutions, are notoriously difficult to measure. This is especially true of the correlations among the risks against which derivative contracts are written and the 

default risks on these contracts. If these correlations are improperly measured, 

however, credit ratings and credit ratings uplifts are unlikely to be reliable. If 

these correlations are neglected, as has been the case in the past (for example 

the possibility that housing price declines will affect numerous mortgages at 

the same time), the estimates of the total risk in banks’ assets are likely to 

be too low, and so are all estimated of the value of Government guarantees protecting against such risks. 

6. In this context, it is also important to appreciate the role played by Government guarantees for counterparties of banking institutions. In a financial system with a complex network of inter-institution contracts, the individual institution benefits not only from Government guarantees protecting its own creditors but also from Government guarantees protecting the counterparties of 

those in which it invested. For example, the AIG bailout benefited many 

counterparties of AIG, not the least of these being the many banks that had 

purchased credit insurance from AIG. The benefit of such protection for AIG 

139 

26DFA directs the FDIC to cover any shortfall by charging the surviving institutions, but 

doing so might be difficult if they too are experiencing losses. 27Gandhi and Lustig (2014) find that over the past four decades the stock returns realized 

on the largest U.S. commercial banks, after adjusting for risk differences, are abnormally low 

compared to the stock returns on the smallest U.S. commercial banks. These differences are 

large (around 6 percent per year). The authors also provide evidence that large bank stocks are 

significantly less exposed to losses during recessions and financial crises, even though these 

large banks are typically much more heavily indebted. These findings are consistent with the 

notion that Government guarantees are perceived by investors to protect shareholders in large 

banks, but not in small banks, in financial disasters. 28See, for example, Stefan Nagel, ‘‘Too Big To Fail Is Bigger Than You Think’’, Bloomberg, 

March 2, 2014. 29See, for example, Brandao et al. (2013) for evidence on excessive risk taking as a result 

of expectations and support. Section 5 in Admati et al. (2014) which discusses the why the leverage ratchet effect (addiction to borrowing by heavy borrowers) is particularly relevant in banking and exacerbated by guarantees, and this effect exacerbates other distortions. Admati and 

Continued 

to, say, Goldman Sachs, however, cannot be assessed merely by looking at data 

for Goldman Sachs and relating the interest Goldman Sachs must pay to the 

risks they are taking. The embeddedness of their activities in a system to 

which the Government provides comprehensive support can hardly be gathered 

from data about individual institutions. 

7. Even a resolution process such as under Title 2 of DFA may offer guarantees 

to some of the institutions’ debt in order to avoid disruptions or runs, which 

would transfer some downside risk to the Government at least temporarily. 26

8. Being able to borrow at below-market rates relative to the risk taken with the 

investments provides a subsidy that affects the institutions’ stock price and can 

favorably affect the terms at which the institution can raise equity. When an 

insolvent institution is given supports and does not fail, its shareholders are 

not wiped out. Other things equal, therefore, a systemic institution’s stock 

price is higher in reality than in the hypothetical without support. Indeed, raising equity has been surprisingly cheap for the largest U.S. banks over the past 

four decades, but expensive for the smallest banks, because large bank stocks 

are priced under the assumption that they are relative safe while the stocks 

of small banks are not, despite the fact that large banks tend to be more heavily indebted. 27 The fact that guarantee become an asset, and the fact that commonly used assumptions about the risks banks are subject to may well be inappropriate, may lead the value of the subsidies in some studies to be under-estimated. 28

9. Comparisons between the interest charged on debt of large and small banks 

may not be informative because the large banks may well have significant 

risks that are harder to assess due to their more opaque disclosures. As mentioned earlier, this applies particularly to banks heavily involved in derivatives 

trading. The larger banks also tend to have more complex structures, more 

lines of business, and more off-balance sheet exposures than small banks. 

These factors would affect funding costs in the hypothetical scenario without 

support and thus the comparison between large and small banks, and they 

might not be sufficiently observable to correct for. Similar considerations apply 

to comparisons of large banks with other large corporations, whose disclosures, 

and business models are often simpler and less opaque. 

The challenges in measuring how the banking industry as a whole, and especially 

the largest institutions, benefit from the possibility of future support do not change 

my bottom line, that the subsidy is perverse and insidious, rewarding and encouraging recklessness and excessive use of debt which endangers the public while allowing banks to make investments of many kinds to maximize their own profits that 

may not always benefit society. 

Because the public pays for any subsidy, and the result of implicit supports is a 

dangerous and distorted system, these subsidies are, on net, enormously costly for 

society. Even if banks were to pay in full for the guarantees, at least collectively— 

similar to how deposit insurance works—the impact of the implicit support is harmful and distortive. The same institutions whose failure would cause significant collateral damage—individually and when they fail at the same time—have incentives 

to borrow too much, take too much risk, and become more highly interconnected, 

so as to increase the likelihood of Government support. In responding to these incentives, they can put us at yet more harm, unless these incentives are countered 

effectively by regulations. 29

140 

Hellwig (2013a, chapter 9) provide additional references. See also Anat Admati, ‘‘Bank Immensity Undermines Responsibility’’, New York Times Room for Debate, May 16, 2014. 30Davis and Tracey (2014) use estimates of the subsidies based on credit rating uplifts and 

argue that, once the effect of subsidies is controlled for, the largest institutions are ‘‘too large 

to be efficient.’’ 31For example, Mayo (2011) describes excessive growth that appears inefficient, for example 

in Citigroup. A recent book (Fraser, 2014) describes the recklessness of the Royal Bank of Scotland and its CEO, which led to its spectacular failure and bailout by UK taxpayers. 32For example, the report by the Senate Committee on Investigation chaired by Senator Carl 

Levin on ‘‘London Whale’’ scandal, entitled ‘‘JPMorgan Chase Whale Trades: A Case History of 

Derivatives Risks and Abuses’’, reveals serious control problems in our largest banks. Suspicion 

of fraud and other evasion of laws and regulations appear routinely in the press. 33 Additional benefits are outlined in Admati et al. (2013, section 2) and Admati (2014). 34This is explained in details in Admati et al. (2013, see especially section 4); see chapter 

9 of Admati and Hellwig (2013a) Claim 11 in Admati and Hellwig (2014), both in attached documents. Taxes are public funds, and the tax impact of higher equity requirements can easily be 

neutralized, as explained in Admati et al., (2013, section 4.1). 

Among the perverse consequences of implicit guarantees is that they encourage 

and enable the largest institutions to grow even to inefficiently large sizes. There 

is no valid evidence of true scale economies for banks as they grow to trillions in 

assets. Such sizes are unseen in the rest of the economy. 30 Indeed, the problem of 

‘‘empire building’’ by managers to benefit themselves appears particularly severe in 

banking. 31 The largest institutions seem to suffer from serious governance and control problems, as evidenced by repeated scandals and fines. 32 However, because the 

status of being too big to fail confers significant benefits and better access to funding, the largest institutions are unlikely to shrink naturally (as conglomerates often 

do). 

These perverse effects undermine any notion of market discipline and they breed 

recklessness, even lawlessness, on the part of those within the largest institutions 

who benefit the most from the guarantees and subsidies, whose compensation reward gambling, and who rarely pay a personal price when charges for wrongdoings, 

including crimes, are settled by authorities or when excessive risks that harm the 

public, and even the shareholders of the corporations, are taken. Both corporate governance and regulations appear to fail. It is essential to take steps to counter these 

perverse incentives of the implicit subsidies and reduce their impact. 

Fortunately, there is a straightforward and cost-effective way to do just that while 

reaping other critical benefits; that is to reduce banks’ excessive use of debt and requiring significantly more equity than banks are currently required to have. 33

There is no reason for banks to live so dangerously. Importantly, aside from possibly 

losing subsidies associated with borrowing, the overall funding costs of banks would 

not increase if they use more equity and less debt. 34 Since subsidies come from public funds, reducing them does not represent a social cost. 

Encouraging and subsidizing banks to fund themselves with as much debt as is 

currently allowed (up to 95 percent for the large bank holding companies) as perverse as encouraging and subsidizing reckless speed for trucks or rewarding the captains of large oil tankers to go ever closer to the coast. More equity would force 

banks to stand more on their own when they take risk, rather than shift some of 

the risk and cost of bearing it to others. Shareholders who benefit from the upside, 

and not creditors or taxpayers, should be the ones to bear the downside. 

Whatever else is done to reform the financial system so it works better for the 

rest of the economy, bringing banks’ indebtedness to more reasonable levels appears 

enormously cost-beneficial. With the perverse incentives banks have, and their ability to get away with harmful actions, many of the problems will not be corrected 

by markets. Making the system safer requires focused and effectively enforced regulation. If the size of individual banks, or of the banking industry, shrinks as a result, the resulting size would likely be more appropriate. The size and structure of 

firms and industries should be determined by undistorted markets, but the markets 

we have are entirely distorted. Bloated and inefficient, the financial industry may 

be able to attract talented workforce that may be more productive elsewhere in the 

economy. This system works for few and harms all the rest. When regulations fail 

to correct such distortions and harm, the public pays the price. Because the issues 

are misunderstood and the harm from excessive risk in finance, unlike that from 

exploding trucks, is abstract, the public may not fully realize the situation, particularly with the extent of lobbying by the industry. 

141 

35This is the title of chapter 11 in Admati and Hellwig (2013a), whose epigraph is ‘‘time has 

a trick of getting rotten before it gets ripe.’’ For an excerpt, see Anat Admati and Martin 

Hellwig, ‘‘Must Financial Reform Await Another Crisis?’’ Bloomberg View, February 6, 2013. 36Warren Buffett’s company Berkshire Hathaway, for example, rarely makes payouts to its 

shareholders, continuing to invest on their behalf and retained earnings are considered first in 

the ‘‘pecking order’’ of funding. See Admati et al. (2014), for example. 37See Claims 13–14 in Admati and Hellwig (2014), attached, for a brief discussion. 38 In that case, the only private cost is that banks might have to pay more corporate taxes, 

but, as explained in Admati et al. (2013, section 4.1), this is not a social cost, and the effect 

can anyway be neutralized. 39 I have written many commentaries on this issue, see Anat Admati, ‘‘Dividends Can Wait 

Until the Banks Are Stronger’’, Financial Times, January 19, 2011, ‘‘Only Recapitalized Banks 

Should Pay Dividends’’, a letter signed by 16 academics, Financial Times, February 15, 2011, 

Continued 

Summary: If not Now, When?35

In March, 2013, the Senate voted unanimously to approve an amendment proposed by Senators Brown and Vitter to eliminate the too-big-to-fail subsidies. As discussed above, among the many benefits of forcing the large banks to use more equity and less debt is that any subsidy they benefit from is immediately reduced. 

This benefit is obtained without having to break up the banks, and is realized in 

addition to all the other benefits of preventing their failure and reducing the distortions in their lending. 

The focus on making the failure option palatable is as misguided as a focus on 

preparing ambulances for a possible explosion while police allows loaded trucks to 

drive at 95 miles an hour in residential neighborhoods. Whoever pays for the ambulances, explosions harm innocent people. Requiring that banks fund themselves so 

that those who benefit from the upside of risk bear more of its downside brings 

about more safety and corrects distortions. 

In the exchange on July 15, 2014, between Senator Warren and Chair Yellen referred to earlier, Senator Warren pointed out that under Title 1 of DFA, the Fed 

has authority to break up the largest bank holding companies if it finds that bankruptcy is not a viable option if they fail. The Fed certainly has authority to ban dividends and other payouts to shareholders until banks are better prepared to absorb 

losses from risks they take without failing or becoming distressed. 

As it goes through the ‘‘iterative process’’ of the living wills, and while it is not 

ready to assert that the failure of the largest bank holding companies will not harm 

the economy, the Fed must act prudently and protect the public. Corporations routinely retain their profits to fund investments, and banks should do the same. Retained profits would enable banks to make more worthy loans, and may increase 

their incentives to actually make them. The profits from any investments belong to 

shareholders as long as debt is paid. 36

Not only do banks have access to their own profits to become more resilient, they 

can sell shares to investors at appropriate prices. Other companies may be forced 

by debt covenants or prohibitive borrowing costs to raise equity when they are distressed. For banks, action must come from regulators. Banks unable to raise equity 

at any price fail a basic market ‘‘stress tests’’ and might be too opaque or not viable 

without subsidies. Such banks are unhealthy and must be dealt with promptly. 

The Fed justifies allowing banks to make payouts to their shareholders on the 

basis of ‘‘stress tests.’’ This methodology uses models to predict regulatory capital 

levels that mean little in actual distress and especially in a crisis. The models are 

incapable of predicting the within-system dynamics that might follow adverse scenarios because the Fed does not have sufficient information on the many layers of 

interconnectedness that go beyond single counterparty exposures. Trusting models 

that should not be trusted has contributed to the causes of the financial crisis. The 

lesson from the failures of these models must be learned, particularly when there 

is no scarcity of equity just for banks, and no justification for allowing them to live 

as dangerously as they do. 37

If banks deny that they benefit from implicit subsidies, moreover, they cannot at 

the same time complain that their funding costs would increase significantly if they 

must use more equity. 38 The fact that banks are anxious to make payouts to their 

shareholders rather than use their profits for making worthy loans, even at their 

very low equity levels, calls into question their motives and exposes the disconnect 

between claims that higher equity requirements would prevent lending and making 

payout to shareholders instead of using the funds to make loans. 

It is baffling that the Fed finds it appropriate, before it can assert that the largest 

bank holding companies would not harm the economy if they fail, to allow these institutions to make payouts to shareholders that deplete their most reliable loss-absorbing capacity, namely their equity. 39 A significant increase in equity requireVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00145 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
142 

Anat Admati, ‘‘Fed Runs Scared With Boost to Bank Dividends’’, Bloomberg View, February 24, 

2011, and ‘‘Why the Bank Dividends Are a Bad Idea’’, Reuters, March 14, 2012. Admati and 

Hellwig (2011, chapter 11) provide a more detailed explanation. 40Other claims are made in response to such recommendations, such as concerns about the 

so-called shadow banking system or about the competitiveness of our banks. These concerns are 

invalid excuses, as explained in Admati and Hellwig (2013a, chapters 12 and 13) and Claims 

26–28 in Admati and Hellwig (2014), attached. 41Most of the references (at least in working paper form) are available online. My own academic papers and other writings on the topic are posted at http://www.gsb.stanford.edu/news/ 

research/admati.etal.html. 

ments must be considered the most cost-effective way to make it less likely that we 

face difficult choices when institutions become weak, as well as to reduce the fragility of the system and many distortions. The Fed has the responsibility and the 

ability to protect the public, yet as a regulator, it has failed the public. On behalf 

of the public, I hope you will take my comments into consideration and implore it 

to do better. 40

References41

Admati, Anat R. (2014), ‘‘The Compelling Case for Stronger and More Effective Leverage Regulation in Banking’’, Journal of Legal Studies, forthcoming. 

Admati, Anat R., Peter M., DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013), 

‘‘Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: 

Why Bank Equity Is Not Socially Expensive’’, Working paper; and (2014), ‘‘The 

Leverage Ratchet Effect’’, Working paper. 

Admati, Anat R., and Martin F. Hellwig (2013a), ‘‘The Bankers’ New Clothes: 

What’s Wrong With Banking and What To Do about It’’, Princeton University 

Press. (Excerpts and links available at http://bankersnewclothes.com/.) 

Admati, Anat R., and Martin F. Hellwig (2013b), ‘‘Does Debt Discipline Bankers? 

An Academic Myth About Bank Indebtedness’’, Working paper (based on a chapter omitted from Admati and Hellwig (2013a). 

Admati, Anat R., and Martin F. Hellwig (2014), ‘‘The Parade of Bankers’ New 

Clothes Continues: 28 Flawed Claims Debunked’’, available at http:// 

bankersnewclothes.com/wp-content/uploads/2014/07/Parade-continues-July2014.pdf. 

Bair, Sheila (2012), ‘‘Bull by the Horns: Fighting To Save Main Street From Wall 

Street and Wall Street from Itself’’, Free Press. 

Barofsky, Neil (2012), ‘‘Bailout: An Inside Account of How Washington Abandoned 

Main Street While Rescuing Wall Street’’, Free Press. 

Brandao, Luis Marques, Ricardo Correa, and Horacio Sapriza (2013), ‘‘International 

Evidence on Government Support and Risk Taking in the Banking Sector’’, IMF 

Working Paper WP/13/94. 

Cole, Rebel A. (2013), ‘‘How Did the Financial Crisis Affect Business Lending in the 

U.S.?’’ Working paper. 

Davies, Richard, and Belinda Tracy (2014), ‘‘Too Big To Be Efficient? The Impact 

of Implicit Subsidies on Estimates of Scale Economies in Banking’’, Journal of 

Money, Credit and Banking, 219–253. (Working paper version dated 2012 available online.) 

Fraser, Ian (2014), Shredded: Inside RBS, the Bank That Broke Britain, Birlinn; 

‘‘Too Big To Be Efficient? The Impact of Implicit Subsidies on Estimates of Scale 

Economies in Banking’’, Journal of Money, Credit and Banking. 

Gandhi, Priyank, and Hanno Lustig (2014), ‘‘Size Anomalies in U.S. Bank Stock Returns’’, Journal of Finance, Forthcoming. (Working paper dated 2012 available on 

SSRN.com.) 

Kelly, Bryan, Hanno Lustig, and Stijn Van Niewerburgh (2012), ‘‘Too-Systemic-ToFail: What Option Markets Imply About Sector-Wide Government Guarantees’’, 

Working paper. 

Mayo, Mike (2011), ‘‘Exile on Wall Street: One Analyst’s Fight To Save the Big 

Banks From Themselves’’, John Wiley and Sons. 

Omarova, Saula T. (2013), ‘‘The Merchants of Wall Street: Banking, Commerce, and 

Commodities’’, Minnesota Law Review, 2–78. 

Onaran, Yalman (2011), ‘‘Zombie Banks: How Broken Banks and Debtor Nations 

Are Crippling the Global Economy’’, Bloomberg. 

Skeel, David A., Jr. (2014), ‘‘Single Point of Entry and the Bankruptcy Alternative’’, 

Working paper. 

Skeel, David A., Jr., and Thomas H. Jackson (2012), ‘‘Transaction Consistency and 

the New Finance in Bankruptcy’’, Columbia Law Review, 152–202. 

White, Lawrence J. (2014), ‘‘The Basics of ‘Too Big To Fail’ ’’, Forthcoming in Paul 

H. Schultz, ed. Dodd-Frank and the Future of Finance, MIT Press. 

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1 A longer discussion of these issues can be found in Satya Thallam, ‘‘Reconsidering Too Big 

To Fail’’, American Action Forum, Research, March 12, 2014, http://americanactionforum.org/ 

research/reconsidering-too-big-to-fail. 2 Here I use the phrase ‘‘too big to fail’’ or ‘‘TBTF’’. 

3Supra, n. 1. 

4 Narayana Kocherlakota, ‘‘Too-Big-To-Fail: The Role of Metrics’’, Speech delivered at ‘‘Quantifying the ‘Too Big to Fail’ Subsidy Workshop’’, Federal Reserve Bank of Minneapolis, Minneapolis, Minnesota, November 18, 2013, http://www.minneapolisfed.org/newslevents/pres/ 

speechldisplay.cfm?id=5203. 

PREPARED STATEMENT OF DOUGLAS HOLTZ-EAKIN 

PRESIDENT, AMERICAN ACTION FORUM

JULY 31, 2014 

Chairman Brown, Ranking Member Toomey, and Members of the Subcommittee, 

I am grateful for the privilege of appearing today. In my brief testimony today I 

would like to make four main points: 

• Any expectations of Government support for bank holding companies is at root 

a problem created by policymakers’ discretionary actions; 

• The history of Federal Government assistance is not a pattern of consistent 

intervention on behalf of large firms, but rather an erratic and unpredictable 

series of interventions on behalf of firms large, small, financial, and nonfinancial; 

• Attempts to measure any ‘‘implicit too-big-to-fail (TBTF) subsidy’’ is an elusive 

quest due to the many confounding factors; and 

• Any market TBTF expectation is hardly fixed, but is necessarily a changing reality. 

To start, I should stipulate that I do not seek in this testimony to specifically criticize or address the Government Accountability Office report on Government support 

for bank holding companies, nor the several other reports from other institutions on 

the same topic. Let me also stipulate that no firm (financial or otherwise) should 

ever benefit from an unfair advantage owing to policy-induced bias. Herein I only 

hope to provide the Committee with a brief conceptual discussion of some of the 

issues surrounding the question too big to fail (TBTF) and implicit subsidies. 1

The Policymaker–Creditor Nexus 

What is too big to fail? 2 It is not a market failure, like an externality; it ‘‘is a 

rational market response to expectations set by Government policy.’’ 3 The proximate 

beneficiaries of any perceived bailout expectations (the banks) benefit passively—the 

ultimate source of any implicit subsidy exists at the nexus of the banks’ creditors 

and expectations imputed from policymaker choices. As Minneapolis Fed President 

Narayana Kocherlakota put it, the proper conception of too big to fail ‘‘emphasizes 

the role of creditor beliefs . . . The beliefs of other parties are much less relevant.’’ 4

A creditor’s belief that an institution will receive Government support will be rooted in an expectation that policymakers will take extraordinary steps to prevent contagion from one firm’s failure to spread to others. Financial interdependencies may 

be the transmission mechanism for shocks to spread throughout a system, but policymakers make the ultimate decision to intervene, creating the ex ante expectation 

in the first place. Thus policymakers attempting to eliminate any implicit TBTF 

subsidy will need to look to themselves—or more specifically they will need to consider the rules and regulations which open the door to future intervention, or even 

lead creditors to believe intervention is forthcoming. 

Unpredictability 

The Federal Government has a dubious history of intervening in times of economic distress to save certain firms or otherwise mitigate their losses. Unfortunately for analysts and policymakers seeking to determine the financial effects of 

these interventions, this history is inconsistent, not hewing to any rule or regularity. In the most recent financial crisis, the Federal Government’s response swung 

from pillar to post, intervening (Bear Stearns), then not (Lehman Brothers), intermittently providing assistance to investment banks, banks large and small (TARP), 

investment funds, and automakers (GM and Chrysler). If we go further back, we 

see intervention on behalf of a large, conventional commercial bank (Continental Illinois), a not particularly large or major money center institution (Long Term CapVerDate Nov 24 2008 11:42 Feb 25, 2015 Jkt 046629 PO 00000 Frm 00199 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\07-31 PM ZDISTILLER\73114PM.TXT JASON
196 

5 Jesse Nankin and Krista Kjellman Schmidt, ‘‘History of U.S. Gov’t Bailouts’’, ProPublica 

April 15, 2009, http://www.propublica.org/special/government-bailouts. 6Todd Zywicki, ‘‘The Auto Bailout and the Rule of Law’’, National Journal, No. 7, Spring 

2011, http://www.nationalaffairs.com/publications/detail/the-auto-bailout-and-the-rule-of-law. 7 Randall Kroszner, ‘‘A Review of Bank Funding Differentials’’, Presented at ‘‘Too Big to Fail 

and Its Implications on Bank Funding Costs’’, NYU School of Business, October 8, 2013, http:// 

www.stern.nyu.edu/cons/groups/content/documents/webasset/conl044532.pdf. 8Steve Strongin, et al., ‘‘Measuring the TBTF Effect on Bond Pricing’’, Goldman Sachs Global 

Markets Institute, May 2013, http://www.goldmansachs.com/our-thinking/public-policy/regulatory-reform/measuring-tbtf-doc.pdf. See also Kroszner 2013, supra. 9Kenichi Ueda and Beatrice Weder di Mauro, ‘‘Quantifying Structural Subsidy Values for 

Systemically Important Financial Institutions’’, IMF Working Paper 12/128, May 2012, http:// 

www.imf.org/external/pubs/ft/wp/2012/wp12128.pdf. 

ital Management), savings and loans, airlines, and even a city (New York City). 5

It’s the very breadth and variety of these interventions (not to mention the extreme 

infrequency relative to the gross number of large firm failures during the same period) that should lead one to be skeptical of claims purporting a robust relationship 

between certain firms’ insolvency and Government rescue. 

And yet, even this incomplete list understates the highly heterogeneous nature of 

interventions. Loans, loan guarantees, capital infusions, stock purchases and warrants, direct transfers—all interventions are not born the same, and more to the 

point, have differing effects on different parties. 

The larger point is that if, for example, investors in a bank holding company’s 

bonds are pricing in a discount (lower yield) owing to some probability of a bailout 

conditional on insolvency, we must presume those investors have determined the 

likelihood not only that policymakers will in fact intervene, but that they have also 

correctly identified the firm that will receive assistance, and that the intervention 

will benefit them as opposed to shareholders, executives, employees, or even other 

classes of debtholders. Indeed, as we saw in the Chrysler bailout, some bondholders 

were in fact made worse off. 6

Confounding Factors 

One prevailing line of thinking points to the fact that large financial institutions 

can borrow more cheaply relative to smaller ones, and thus this differential is evidence of TBTF. But there are many factors that affect the funding costs of various 

institutions. This large-small differential in fact exists across most industries, with 

the banking industry somewhere near the middle. 7 Differences in the liquidity of 

debt, risk diversification, information limitations, and other factors may explain 

much or all of the differential. That said, there still might be a part of the differential that cannot be explained by size-dependent factors—a TBTF subsidy may still 

be embedded. But any attempt to quantify the TBTF subsidy using cost of funding 

will need to successfully separate out the non-TBTF factors, which is exceedingly 

difficult and perhaps even impossible. 

If a TBTF subsidy does exist, it stands to reason that it exists on a continuum, 

rather than simply as a binary condition between those firms that are TBTF and 

those that are absolutely not. Thus properly determining the subsidy portion of the 

differential is beside the point if one cannot properly identify the two categories of 

institutions. 

Changing Expectations 

The yield spread between firms may be ever changing; indeed, it has at times 

even become negative. 8 As it changes, one must conclude either that: (1) the TBTF 

subsidy is in fact changing and transferring among institutions over time; 9 (2) the 

yield spread attributable to TBTF is being swamped by other effects; or (3) the yield 

spread is not a reliable measure of the TBTF subsidy. 

Consider what bank investors and creditors must have thought about the likelihood of rescue following the collapse of Bear Stearns as compared to after the collapse of Lehman Brothers. In just 1 year, real-time policy choices must have drastically changed the implied TBTF subsidy. Thus the outcome of any TBTF study will 

be directly affected by the window of time chosen to examine. But the larger point 

is that any policy chosen now or in the near future as a TBTF corrective may be 

(in the best case scenario) appropriately targeted for some fixed state of the world, 

but cannot easily adjust to changing conditions. In the extreme, would such a policy 

corrective (such as a tax) become a refund if and when the TBTF subsidy reverses? 

Final Thoughts 

Two wrongs do not make a right. Even if we presume the existence of a consistent 

and significant TBTF subsidy, one must consider the net effect of applying another 

distortion on top of the first. That is, proposed solutions such as a bank tax or a 

197 

10See Finn Kydland and Edward Prescott, ‘‘Rules Rather Than Discretion: The Inconsistency 

of Optimal Plans’’, Journal of Political Economy, Vol. 85, Iss. 3, pp. 473–492, June 1977. The 

difficulty of time-consistent plans are illustrated by a recent report which stated: ‘‘If the only 

choices are between bailout and fire-sale liquidations or value-destroying reorganizations that 

can result in a contagious panic and collapse of the financial system, responsible policymakers 

typically choose bailout as the lesser of two evils.’’ John Bovenzi, Randall Guynn, and Thomas 

H. Jackson, ‘‘Too Big to Fail: The Path to a Solution’’, Report of the Failure Resolution Task 

Force of the Financial Regulatory Reform Initiative, Bipartisan Policy Center, May 2013, p. 43. 

financial transactions tax applied to TBTF institutions are attempting to counteract 

a distorting dynamic created by policymaker expectations and creditors’ response 

with a punitive measure which works along a somewhat different channel. 

Discretion is the handmaiden of bailouts. Time consistency in policymaking is an 

age-old problem and is not limited to financial crises. 10 Congress should focus its 

energy on those mechanisms which: (1) make bank failures easier and predictable; 

and (2) limit policy choices even in a time of crisis. 

One particularly promising avenue in this regard is to replace Title II of the 

Dodd-Frank Act with a bankruptcy process for banks. This would place decisions in 

the hands of a court, and not either an agency or the Congress. In the process it 

would limit discretion and clarify the outlook for creditors. 

The Dodd-Frank Act happened. Whether one considers the Dodd-Frank Act a positive or negative change to financial regulation, there is little argument that it has 

a significant effect on financial institutions. This includes numerous new requirements and restrictions on the industry, many of them directed specifically at the 

largest bank holdings companies. The upshot is that any perceived advantages must 

be considered on net with any of these new costs. 

Thank you and I look forward to answering your questions. 

198 

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we selected for interview. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN 

FROM LAWRENCE EVANS 

Q.1. GAO used wide-ranging data and a number of models to estimate the various funding cost differences in its study. Will GAO 

make the full documentation of its data, coding, methodology, etc., 

available to third parties—either for free or at cost—so that independent experts can examine the data a processes to make their 

own evaluations and draw their own conclusions? 

A.1. While GAO is not subject to the Freedom of Information Act, 

its disclosure policy follows the spirit of the act consistent with 

GAO’s duties and responsibilities to the Congress. Upon written request, GAO may provide GAO records associated with this engagement to parties wishing to replicate our work. However, please be 

advised that certain exemptions to disclosure apply and GAO does 

not release certain information including proprietary and trade secret data. See 4 CFR §81.5 and 4 CFR §81.6. 1 Interested parties 

should submit their request in writing to GAO’s Chief Quality Officer. The request may be emailed to recordsrequest@gao.gov, faxed 

to (202) 512–5806, or mailed by traditional mail. 

Q.2. Has GAO released any information—such as a list of meetings, conference calls, and other conversations—regarding the parties with whom you consulted in preparing this report? 

A.2. No, GAO has not released indentifying information on the parties interviewed for the report. 2 The Objectives Scope and Methodology section of the report discloses only that we conducted interviews with representatives from credit rating agencies, investment 

firms, and corporations that are customers of banks, bank holding 

companies of various sizes, bank industry associations, public interest groups, academics, and other experts. 

Q.3. Would you be willing to provide such information, including 

the party initiating the contact? 

A.3. Yes, GAO will grant Members, upon their written request, access to the available information at GAO offices or will provide copies of such lists. The Objectives, Scope, and Methodology Section of 

the report details the criteria we used to select parties to interview. 

Additional Information To Correct the Record 

During the hearing Chairman Brown stated, 

GAO used three industry-funded studies to design this report . . . 

For the record, this is inaccurate. To inform our econometric approach and understand the breadth of results and methodological 

approaches, we reviewed 16 studies—1 of which was conducted by 

researchers at a large bank holding company and two others that 

199 

were sponsored by a trade group representing large commercial 

banks. Taking into consideration the strengths and limitations of 

different methodologies, we developed our own econometric approach. We then selected three experts with relevant expertise to 

review our methodology and assess its strengths and limitations. 

These experts reviewed our approach before we implemented it and 

provided comments. In many instances, we made changes or additions to our models to address their comments, and in other instances, we disclosed additional limitations of the models. Before 

selecting these experts, we reviewed potential sources of conflicts 

of interest, and we determined that the experts we selected did not 

have any material conflicts of interest for the purpose of reviewing 

our work. Note well, the GAO approach was influenced most significantly by the research conducted by Dr. and his colleagues. 

During the hearing Chairman Brown stated 

. . . and the GAO arranged meetings with corporate treasurers of companies suggested exclusively—I believe exclusively—by the U.S. Chamber of Commerce . . . 

GAO—not the Chamber of Commerce—indentified firms we 

planned to contact. At GAO’s request, the Chamber informed its 

members that GAO was reaching out to corporate customers of 

banks. GAO then contacted and interviewed four of the member 

firms that expressed interest and met our criteria. We subsequently selected two additional firms to achieve further diversity 

across industry sectors. Note, GAO selected U.S. corporations from 

different industry sectors and with a range of banking needs. These 

corporate treasurers provided a diverse set of views on the issue. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN 

FROM DOUGLAS HOLTZ-EAKIN 

Q.1. During the hearing, I asked all of the witnesses about the ratings ‘‘uplift’’ given to banks by ratings agencies as a result of perceived Government support. In response, you said that ‘‘recently 

most if not all the major credit agencies have removed the credit 

uplifts . . . If you care about ‘too big to fail’ now and 2013, ’14, it’s 

gone from that perspective.’’ 

It is true that Moody’s recently removed the uplift for the holding 

company debt of the eight U.S. G–SIBs, while maintaining its assumption of support for bank-level senior debt. However, S&P released a report on August 4th—after the Subcommittee hearing— 

titled ‘‘U.S. Banks: Government Support Is Fading But Not Gone— 

Yet.’’ In it, they maintain a 1-2 notch uplift for the U.S. G–SIBs. 

In March, Fitch Ratings also released support ratings for some U.S. 

G–SIBs that ‘‘reflect Fitch’s expectation that there remains an extremely high probability of support from the U.S. Government 

(rated ‘AAA’, Rating Outlook Stable) if required. This expectation 

reflects the U.S.’s extremely high ability to support its banks especially given its strong financial flexibility, though propensity is becoming less certain.’’ 

Would you care to amend or revise your response to the question 

in any way? 

200 

A.1. Thank you for bringing these more recent data to my attention. The Moody’s report indicates that the basic trend toward no 

Government support remains, but that the pace is slower than I 

had estimated and markets may not as yet have fully reflected 

these developments as I had anticipated. 

201 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

CHARTS SUBMITTED BY CHAIRMAN SHERROD BROWN 


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REPORT SUBMITTED BY THE GOVERNMENT ACCOUNTABILITY 

OFFICE 


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STATEMENT SUBMITTED BY THE AMERICAN BANKERS ASSOCIATION 


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COMMENTS REGARDING THE ‘‘GAO REPORT ON LARGE BANK 

HOLDING COMPANIES’’, BY ALLAN H. MELTZER 


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