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89–479 PDF 2014

S. HRG. 113–364 

EXAMINING THE GAO REPORT ON 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 THE GAO’S REPORT ON THE GOVERNMENT’S EXTRAORDINARY ASSISTANCE TO LARGE BANK HOLDING COMPANIES AND EXPLORING THE AUTHORITIES FEDERAL FINANCIAL REGULATORS HAVE 

TO PREVENT FUTURE ASSISTANCE AT THE COST TO TAXPAYERS 

JANUARY 8, 2014 

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

( 

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

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JOE MANCHIN III, West Virginia 

ELIZABETH WARREN, Massachusetts 

HEIDI HEITKAMP, North Dakota 

MIKE CRAPO, Idaho 

RICHARD C. SHELBY, Alabama 

BOB CORKER, Tennessee 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

TOM COBURN, Oklahoma 

DEAN HELLER, Nevada 

CHARLES YI, Staff Director 

GREGG RICHARD, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

TAYLOR REED, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

SHERROD BROWN, Ohio, Chairman 

PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

JON TESTER, Montana 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

ELIZABETH WARREN, Massachusetts 

RICHARD C. SHELBY, Alabama 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

JERRY MORAN, Kansas 

DEAN HELLER, Nevada 

BOB CORKER, Tennessee 

GRAHAM STEELE, Subcommittee Staff Director 

TONNIE WYBENSINGER, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

WEDNESDAY, JANUARY 8, 2014 

Page 

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

Opening statements, comments, or prepared statements of: 

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

Senator Manchin .............................................................................................. 4 

WITNESSES 

Lawrance L. Evans, Jr., Director, Financial Markets and Community Investment, Government Accountability Office ........................................................... 5 

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

Responses to written questions of: 

Senator Vitter ............................................................................................ 128 

Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and 

Finance, University of Chicago Booth School of Business ................................ 7 

Prepared statement .......................................................................................... 45 

Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT Sloan 

School of Management ......................................................................................... 8 

Prepared statement .......................................................................................... 117 

Harvey Rosenblum, Adjunct Professor of Finance, Cox School of Business, 

Southern Methodist University, and Retired Director of Research, Federal 

Reserve Bank of Dallas ........................................................................................ 10 

Prepared statement .......................................................................................... 123 

Allan H. Meltzer, The Allan H. Meltzer University Professor of Political 

Economy, Carnegie Mellon University Tepper School of Business .................. 12 

Prepared statement .......................................................................................... 126 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Statement of the Independent Community Bankers of America, submitted 

by Chairman Brown ............................................................................................. 134 

(III)

(1) 

EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT FOR BANK HOLDING COMPANIES 

WEDNESDAY, JANUARY 8, 2014 

U.S. SENATE, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND

CONSUMER PROTECTION, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 10:04 a.m., in room SD–538, Dirksen 

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

OPENING STATEMENT OF CHAIRMAN SHERROD BROWN 

Chairman BROWN. This hearing will come to order. Thank you 

for joining us, Senator Toomey. I particularly appreciate your cooperation in working with this. Senator Reed, I appreciate his 

being here. He has to go to the floor to manage the unemployment 

insurance legislation and will return for questioning. 

Today’s topic is how Government policies support too-big-to-fail 

megabanks. I often said my vote in 2008 for the TARP, for the 

Trouble Asset Relief Program, was both the best vote of my career 

and the worst vote of my career. It was the best vote because we 

simply could not allow the economy to be destroyed, and most of 

us, I think, in the House and Senate thought that is what would 

have happened. It was the worst vote because we allowed Wall 

Street to run wild for too long, and the only option presented to us 

was a $700 billion bailout, with few instructions, frankly. 

Five years later, according to the firm SNL Financial, the four 

largest banks control more than 40 percent of the banking industry, up from less than 10 percent in 1990. What happened? Between 1990 and 2009, 37 financial institutions merged 33 times to 

become the Nation’s four largest bank holding companies. Three of 

1990’s top five banks are now part of our Nation’s largest bank. In 

1995, the top six banks had assets equal to 17 percent of GDP. 

Today they are more than 60—six-zero—percent of GDP. 

While many megabank supporters point out the benefits of large 

banks, a 2011 IMF report also shows that Governments bail out 

bigger banks. So it should come as no surprise that the Congressional Oversight Panel for TARP found that the six biggest Wall 

Street banks received a total of $1.27 trillion—1.27 thousand billion dollars—in Government support, including accounting for 63 

percent of the Fed’s average daily lending. 

2 

There are important lessons in this first Government Accountability Office report. First, megabanks borrowed at a discounted 

rate against assets that the market was not accepting. The result 

is a subsidy for the megabanks. CEOs of the largest banks understood this. According to Secretary Paulson, the Treasury Secretary 

under President Bush, two of these bank CEOs called it ‘‘cheap 

capital.’’ In 2011, Bloomberg estimated that the terms of the Fed 

loans provided the six largest banks with a $4.8 billion profit, an 

amount equal to 23 percent of their combined net during the life 

of the loans. The GAO report we will discuss today also confirms 

that Treasury paid substantially more than market value for the 

assets that it purchased. The Congressional Oversight Panel estimated this provided the six biggest megabanks with a subsidy of 

$25 billion. These are only small parts of the benefits they have 

gotten because of their size. 

Second, megabanks borrowed more than small banks because 

they used more volatile and short-term funding sources, not just 

deposits that community banks tend to rely upon. Support for the 

three largest banks averaged more than 10 percent of their total 

assets, much higher than their capital ratios at the time. 

Finally, we see that walls that were supposed to separate and 

protect traditional banking were ignored, and the safety net was 

stretched as far as possible. With all these benefits, it is no wonder 

the CEO of our Nation’s largest banks said that 2008 was ‘‘the finest year ever.’’ 

Since then, our banking industry has become even more consolidated, not less consolidated. Today the four largest bank holding 

companies are about $2 trillion larger—$2 trillion larger—than 

they were before the financial crisis. The four most complex institutions each have more than 2,000 subsidiaries, only 12 of which are 

commercial banks. More than 11,000—several thousand are 

nonbanks. The first report shows that the largest Wall Street 

banks borrow on favorable terms directly from the Federal Government during turbulent times. I expect the second report will show 

that the Government’s implicit support enables Wall Street banks 

to borrow on favorable terms from the market in ordinary times. 

Two things are clear: The largest Wall Street banks are so much 

larger and more concentrated than they have ever been, and because of their size, both their economic clout and their political 

clout are enhanced. And because of their size, they receive financial 

benefits that are not available to regional and community banks 

like Huntington Bank in Columbus and the First National Bank of 

Sycamore, Ohio. 

There is broad agreement that this is unacceptable. Senator Vitter and I offered an amendment to the Senate budget calling on 

Congress to eliminate this subsidy. It was approved 99–0. However, 

it was stripped from the recent budget deal without explanation. If 

we agree that no institution should be too big to fail, if we agree 

that all bailouts must end, then we must agree that we must do 

something about this. I look forward to hearing the witnesses’ 

views on what that should be. 

Senator Toomey, thank you. 

3 

STATEMENT OF SENATOR PATRICK J. TOOMEY 

Senator TOOMEY. Thanks, Mr. Chairman, and thanks for holding 

this hearing. I cannot help but comment briefly on one observation 

that you made, which is the concentration within the banking sector, and I think any such observation should include a really extraordinary fact, which is the complete—essentially the end of the 

creation of new community banks in America which we are recently living through. After many, many years in which it was common to have dozens or scores, sometimes even hundreds of community banks launched across the country, we went 5 years without 

a single new community bank. I am happy to report that a bank 

in Lancaster County, Pennsylvania, broke that trend just a few 

months ago, but the massive, excessive overregulation, including on 

the smallest banks that have absolutely no systemic importance 

really to the economy, are nevertheless burdened so much that it 

is just not feasible to launch a community bank and provide the 

credit that communities need. And I think that is a terrible development that we need to address. 

But I digress, Mr. Chairman. The point of this hearing, of course, 

is to consider especially the GAO report on the Government support that occurred during the financial crisis, and I do think that 

is a very important topic. We need to understand that. I think it 

would be helpful to understand and quantify the Government support for other industries as well. It would be interesting to look at 

the cost to taxpayers, for instance, of the automakers’ bailout. 

Some of that, of course, the taxpayer never recovered and never 

will. 

And it is important that we understand that, but it is also important to remember that is historical. As you point out, we have got 

a report coming out soon that will look at whether or not and to 

what extent there is an ongoing subsidy, whether it is implied or 

not. 

I am really looking forward to that report. I think we do not yet 

know the answer. I am looking forward to what light the GAO 

study will shed on this. But I want to talk a little bit about this 

because that is what we can still address. We cannot change history, but we could address this. 

So if there is an ongoing subsidy to big banks, the first question 

is how is it manifested, and presumably it is manifested in a lower 

cost of funding. So if that is the case, it will be interesting to see 

how GAO attempts to quantify that, because funding costs are, of 

course, a function of many, many things, and it will be interesting 

to see how those various factors are separated out. Size itself confers benefits like an economy of scale that has nothing to do with 

the Government, and all industries tend to have lower funding 

costs for larger institutions than smaller institutions across different sectors. The quality of management affects the perception of 

creditworthiness, and so that affects funding costs. The amount of 

capital obviously affects funding costs. So there are a lot of factors, 

and it will be interesting to see the analysis as to what their relative contributions are to different funding costs. 

But I am going to suggest, Mr. Chairman, that if there is an ongoing subsidy to the big banks, I think there is a very significant 

likelihood that it arises mostly from Title II of Dodd-Frank. And 

4 

the reason I say that is because Title II of Dodd-Frank, the Orderly 

Liquidation Authority, explicitly grants the power to the FDIC to 

go to the Treasury and to take taxpayer money and use it for the 

support of the creditors of the failing institution. And whether or 

not the purpose of the Orderly Liquidation Authority is to ultimately execute the failing financial institution, the fact that there 

is money made available explicitly in Title II of Dodd-Frank to support creditors, it seems to me, creates some of the moral hazard 

and some of the dangers of the subsidies that we would want to 

avoid. 

In addition, Title II of Dodd-Frank gives the FDIC authority in 

how similarly situated creditors will be treated. Depending on 

whether or not the FDIC determines that some of the creditors 

may have somehow contributed to the failure of the institution 

more than other creditors, how they would determine that is not 

at all clear. 

This I think is very, very problematic, and it is one of the biggest 

flaws, in my view, with Dodd-Frank, the mechanism by which the 

legislation contemplates the liquidation of a failed financial institution. And so I know you have got a bill that addresses this in one 

way. I have got a bill that repeals Title II of Dodd-Frank and make 

the necessary amendments to the Bankruptcy Code so that if a 

large, complex financial institution were to fail, we could manage 

the resolution through a legal process that would be transparent, 

based on clear laws, that would be objective rather than subject, 

and creditors would know exactly what their risks were and would 

not be subject to the discretion of some potentially politically influenced organization. And you could do it with an absolute prohibition on using taxpayer funds, which is what my bill would do. 

So I think that is one way to address a number of problems, not 

the least of which is the possibility that there is some ongoing subsidy. 

So, with that, Mr. Chairman, I appreciate your having this hearing and look forward to hearing from our witnesses. 

Chairman BROWN. Thank you, Senator Toomey. 

Senator Manchin. 

STATEMENT OF SENATOR JOE MANCHIN 

Senator MANCHIN. Mr. Chairman, thank you very much. I am 

not a Member of the Subcommittee, but I am a Member of the 

Committee on Banking, and I am very interested in the health and 

wellness of the banking system in this country but, most importantly, in West Virginia. We are a small State made up mostly of 

community banks. We did not suffer through the mortgage crisis, 

and we had strong banking laws in our State, and still do. 

With that being said, I am just trying to learn as much as possible to understand how we could subsidize some of the largest 

banks that cause the problems that we have in this country and 

be able to be subsidized by the banks or the people that were not 

affected and are being affected now because of the laws that are 

coming down with Dodd-Frank. So we are just trying to find that 

balance, and I am here anxiously to try to learn, so thank you. 

Chairman BROWN. Thank you, Senator Manchin. 

5 

Let me just begin by introducing the panel. Then we will hear 

from each of them, and then I will begin the questions, then Senator Toomey, and we will work our way through the panel. 

Lawrance Evans, Jr., is Director of Financial Markets and Community Investment for the Government Accountability Office, the 

GAO. Mr. Evans, thanks for your service. Thanks for joining us. 

Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance and the David Booth Faculty Fellow at 

the University of Chicago Booth School of Business. Dr. Zingales, 

welcome. 

Simon Johnson is the former chief economist at the International 

Monetary Fund, currently the Ronald Kurtz Professor of Entrepreneurship at MIT Sloan School of Management. Dr. Johnson, welcome. 

Harvey Rosenblum is an adjunct professor at Southern Methodist 

University’s Cox School of Business. He is the former executive vice 

president and director of research at the Federal Reserve Bank of 

Dallas, where he worked for some 40 years. Dr. Rosenblum, welcome. 

And Allan H. Meltzer is, appropriately, the Allan Meltzer University Professor of Political Economy, quite a coincidence, at Carnegie Mellon University Tepper School of Business. Welcome, Dr. 

Meltzer. 

And, Mr. Evans, if you would begin. 

STATEMENT OF LAWRANCE L. EVANS, JR., DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY OFFICE 

Mr. EVANS. Chairman Brown, Ranking Member Toomey, and 

Members of the Subcommittee, it is my pleasure to be here today 

to discuss Government support for financial institutions. 

During the most recent crisis, that support included more than $1 trillion in loans and hundreds of billions of dollars in capital 

and guarantees. While these actions were credited with stabilizing 

the financial system, they also raised concerns about moral hazard 

and the weakening of market discipline. Specifically, such interventions could create expectations of future support that may reduce 

investors’ incentives to monitor and price risk taking appropriately. 

Whether firms receive benefits due to investor perceptions of loss 

protection is largely an empirical question. To those ends, GAO will 

conduct an empirical analysis of any funding costs or other economic advantages large banks may enjoy as a result of expectations 

of public support. Those results will be included in the report to be 

released later this year. 

My remarks today are based on GAO’s November report, which 

focused on actual support provided to institutions over the 2007– 

09 period to address disruptions in important funding markets. 

From participation in these crisis-driven programs, bank holding 

companies and their subsidiaries experienced individual benefits, 

including liquidity benefits from programs that allowed them to 

borrow at lower interest rates, in greater quantities, and at longer 

maturities than potential market alternatives. For example, we 

found program prices were 22 to 92 basis points lower than market 

alternatives, depending on the program and market rates examVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
6 

ined. This finding is consistent with the financial stability goals of 

these programs. 

Assistance was generally made available to institutions of various sizes. However, at the end of 2008, program use on average 

was higher for banking organizations with $50 billion or more in 

total assets than for smaller firms. The six largest bank organizations were significant participants in emergency programs, particularly those targeting short-term funding markets. Some also benefited from institution-specific actions, including additional capital 

injections and guarantees. 

Additionally, the Federal Reserve granted a number of exemptions to allow banks to channel funding support to subsidiaries and 

for other purposes. The Fed also granted bank holding company 

status to several nonbank financial companies to provide those 

firms greater access to Government support, and also extended a 

credit to the London subsidiaries of a few of the largest banking 

organizations. 

Government assistance to prevent the failures of large financial 

institutions like Fannie Mae and AIG also benefited bank holding 

companies and other firms that had large exposures to these institutions. It is important again to emphasize all these actions were 

undertaken to promote stability and confidence in the financial system. 

While the emergency response may have enhanced investor expectations about public support, the Dodd-Frank Act contained provisions intended to restrict future emergency assistance and 

prompt other regulatory changes that will alter the landscape for 

large financial institutions. For example, key provisions of the act 

are designed to reduce the probability of failure of systemically important firms and the risk they pose to the economy. These include 

provisions that restrict proprietary trading and swap transactions, 

among other activities, and require the Federal Reserve to subject 

the largest financial firms to heightened prudential standards and 

regulatory oversight. The act places new restrictions on the Federal 

Reserve and FDIC’s emergency authorities. While the act allows 

the Federal Reserve to use its authority to authorize programs with 

broad-based eligibility, it sets forth new restrictions and requirements for such programs, including a prohibition on lending to insolvent firms. 

As a first step to ensure any future emergency lending complies 

with Dodd-Frank, the Fed recently issued a draft rule and a request for public comment. The act requires resolution planning by 

large firms and grants FDIC new resolution authority to resolve a 

large failing firm outside of the bankruptcy process. FDIC continues to work to implement this authority and has acknowledged 

a number of challenges to its effectiveness. The viability and credibility of the resolution process is a critical part of removing market 

expectations of future extraordinary Government assistance. 

The effectiveness of many of the relevant provisions of the act 

will depend in large part on how agencies implement them. As implementation is incomplete, effectiveness is uncertain. Some aspects of the act, such as resolutions through Title I or Title II, may 

require a market event to fully gauge their efficacy. As such, many 

observers, some of them here, have continued to debate the merits 

7 

of Dodd-Frank in addressing threats to financial stability and market discipline. 

Members of the Subcommittee, this concludes my opening statement. I look forward to any questions you might have. 

Chairman BROWN. Thank you, Mr. Evans. 

Dr. Zingales, welcome. 

STATEMENT OF LUIGI ZINGALES, ROBERT C. MCCORMACK 

PROFESSOR OF ENTREPRENEURSHIP AND FINANCE, UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS 

Mr. ZINGALES. Chairman Brown, Ranking Member Toomey, 

Members of the Subcommittee, thank you for inviting me. 

I have been asked to comment on the GAO study on the Government support of bank holding companies and in particular on my 

estimates of the financial benefits enjoyed by the bank holding 

companies as a result of the extraordinary Government actions 

during the financial crisis, and on my views of how to address the 

issues identified in the GAO report using the authorities provided 

in the Dodd-Frank Act. 

Regarding the estimate of the financial benefits, it is important 

to distinguish two components: pure transfer of value from taxpayers to bank’s investors and value created as a result of a reduction in the probability of a costly bankruptcy. 

Veronesi and Zingales (2010) calculate the expected Government 

cost of the two main programs—the CPP and the TLGP—to be 

roughly $40 billion. By using this estimate and by making reasonable assumptions on the cost of the other programs, I obtain that 

the total expected cost of these programs was between $60 billion 

and $90 billion. This represents the pure transfer of value from 

taxpayers to bank holding companies’ financial claim holders. 

Veronesi and Zingales also estimate that in case of bankruptcy, 

22 percent of the enterprise value of a bank holding company vanishes. Thus, we can assess the value saved by computing the 

changes in the probability of bankruptcy triggered by the Government interventions. These estimates, however, will depend crucially on what counterfactual hypothesis we are willing to entertain, i.e., what we assume would have happened to the bank holding companies had the Government not intervened. 

I present two extreme scenarios. The lower bound, analyzed in 

Veronesi and Zingales, only considers the differential benefit of the 

set of interventions announced Columbus Day weekend 2008. Since 

even before that weekend the market was expecting the Government to intervene, these estimates only capture the effect of an increase in the probability of a Government intervention. Overall, 

this set of Government interventions saves roughly $100 billion, 

setting the total financial benefit enjoyed by the bank holding companies at between $158 billion and $188 billion. 

To obtain an upper bound, I make the Jamie Dimon’s hypothesis 

that without Government intervention all the top 10 bank holding 

companies would have failed. In this case the value saved overall 

would be $1.4 trillion with a total financial benefit by bank holding 

companies between $1.5 and $1.6 trillion. The wide range of these 

estimates shows how dependent the results are on the counterfactual used. 

8 

On the second issue, I would like to classify the Dodd-Frank’s 

interventions in three groups: 

Number one, restrictions to interventions in case a bank holding 

company is in trouble, such as restrictions on the Federal Reserve 

13(3) authority; 

Two, reduction in the potential cost in case of bankruptcy, such 

as living wills; 

Three, restrictions to risk taking in normal conditions, such as 

liquidity requirements and debt to equity ratios. 

I regard the first set of tools to be not only useless but also 

harmful. As the ‘‘no bailout clause’’ of the European Union 

Maastricht Treaty has shown, these restrictions are routinely bypassed when the need arises. If they are not, it can be dangerous, 

since by the time a major holding company is in trouble, the cost 

of not intervening becomes very high. This is exactly the type of 

tradeoff that Senator Brown was describing when he voted for 

TARP. 

I regard the second set of tools as wishful thinking. A bank holding company’s incentive to design a proper ‘‘living will’’ equals the 

desire of a man, sentenced to death by hanging, to find the right 

tree at which to be hanged. 

The only effective tool to eliminate a subsidy to large bank holding companies is to design a mechanism of prompt intervention, 

which is triggered much before a bank holding company becomes 

insolvent. Such mechanism, described in Hart and Zingales (2012), 

can be implemented using the authorities provided in Dodd-Frank. 

It is sufficient that, by using its authority to set leverage standards, the Fed imposes a maximum price for the credit default swap 

of bank holding companies’ junior debt. A CDS price subsumes both 

the leverage position and the riskiness of the underlying assets. 

Every time the CDS price exceeds the predetermined threshold for, 

let us say, 30 days, the bank should be required to issue equity. 

If it does not, it should be taken over by the regulator and liquidated using the Ordinary Liquidation Authority under DoddFrank. The system works like a margin loan, which is made safe 

by the occasional margin calls. This is the most effective way to 

eradicate the too-big-to-fail problem. 

Chairman BROWN. Thank you, Dr. Zingales. 

Dr. Johnson, welcome. 

STATEMENT OF SIMON JOHNSON, RONALD KURTZ PROFESSOR OF ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF 

MANAGEMENT 

Mr. JOHNSON. Thank you, Senator. Let me make three points. 

First of all, I agree, roughly speaking, with the findings of the 

GAO report. There was a large amount of support provided to bank 

holding companies, the very largest banks in the country, during 

the crisis. I have some caveats I would attach to their estimates. 

I put those in my written testimony, but I think, roughly speaking, 

the GAO has got this right. It was a huge amount, unprecedented 

amount of support that was provided. 

The second point is building on what you said, Senator, about the 

cost and the cost to the budget of having a dangerous financial system, which I would emphasize has two components. One is the diVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
9 

rect amount of the subsidy, for example, the kinds of numbers that 

Luigi was talking about, how much are you transferring from the 

official sector to the private sector. But there is also a much bigger 

cost, which is what happens to the budget, what is the damage 

done to public accounts as a result of the crisis. 

Now, you can back that out from some of the work that the Congressional Budget Office has done. Roughly speaking, over the 

cycle, based on their estimates, the severity of this crisis will end 

up increasing public debt by about 50 percent—five-zero percent— 

of GDP. So call that $7 or $8 trillion in today’s money. And I completely agree with you, Senator Brown, that this should be an integral part of our budget thinking, and we should aim to eliminate 

not just the direct subsidy along the lines that you identify, but 

also worry about the broader hit that can potentially come at us 

through our fiscal accounts again. And I think the Senate and others should call on the Congressional Budget Office to make this 

kind of analysis much more central to what they present to you 

when they provide you with their standard analysis, both the baseline scenarios and when they think about various reforms, including the ones that you propose, and including the ones that Senator 

Toomey is proposing. 

And that is my third point, which is I think it is self-evident that 

the problem of too big to fail was exacerbated by the crisis and by 

the bailout measures, and I think both of you are acknowledging 

and recognizing and emphasizing that in a completely appropriate 

way with the legislation that you are putting forward. 

I would also emphasize, at least from my perspective, that you 

are agreeing—Senator Brown, you are emphasizing the crazy increase in concentration in the financial system we have seen over 

the past 20 or 30 years. Senator Toomey, I completely agree with 

you that the independent community banks have had a very rough 

deal, partly as a result of the increasing concentration, but also as 

a result of what happened in the crisis and some of the measures 

that came out of the crisis. 

I completely support, for example, the positions of Cam Fine of 

the Independent Community Bankers of America on this issue, and 

Mr. Fine emphasizes repeatedly the way in which the biggest 

banks, these very large bank holding companies, and the forms of 

implicit Government support they continue to enjoy, the ways that 

have damaged—and continues to damage community banks. 

What should we do about it? Well, I think we have three ideas 

on the table from the two of you. I completely support Senator 

Brown’s proposed Safe Banking Act that would limit the size of the 

banks, particularly the size of their nondeposit liabilities as a percentage of GDP. And I am heartened, as I say in my testimony, by 

indications that Dan Tarullo, a Governor at the Federal Reserve 

Board, and perhaps some other Federal Reserve staff are coming 

around to this way of thinking. I think it is a little late. Hopefully 

they can speed up that process of moving in that direction. 

I also fully support the proposal of Senator Brown and Senator 

Vitter, the TBTF Act, which would impose a more dramatic, drastic 

sliding scale of capital requirements, increasing beyond what is 

currently in the Basel framework or currently envisaged by the ofVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
10 

ficial sector for these very large bank holding companies because 

they pose very big risks. 

Now, I also would like, Senator Toomey, to support you on the 

point of background, and I do completely agree with the point that 

what we need in this economy is for every firm to be able to go 

bankrupt. The idea that somebody is exempt from bankruptcy I 

think is completely unacceptable. 

I also do not find it very appealing that a certain set of firms 

should have their own piece of the Bankruptcy Code. I would prefer 

that everyone go through the same Bankruptcy Code. I recognize 

that the financial sector has built various poison pills into their 

structures that create some difficulties and some concerns. 

I share, by the way, a lot of reservations about the resolution 

powers of the FDIC, and I am on their Systemic Resolution Advisory Committee. We can talk more about that if you want. 

I worry, though, about one piece of your proposal, which is the 

lack of a debtor-in-possession financing mechanism, a backup. Obviously, you want that provided by the private sector ideally. There 

is nothing, I think, in your proposal that provides a backup. And 

when I have talked to people from the Hoover Institution, for example, recently at an FDIC meeting and also at a Richmond Fed 

meeting, they made it very clear that, without that kind of backup 

debtor-in-possession financing, they, the Hoover people who are 

generally supporting this bankruptcy idea, would worry a lot about 

contagion effects and the way in which a single firm can become 

a systemic crisis. 

Thank you, Senator. 

Chairman BROWN. Thank you, Dr. Johnson. 

I would like to ask the Subcommittee unanimous consent that 

the written statement of the Independent Community Bankers of 

America be included in the report. Dr. Johnson had referred to 

Cam Fine and the ICBA report’s too-big-to-fail subsidies exacerbate 

regulatory burden. Without objection, thank you, so ordered. 

Dr. Rosenblum, thank you. Welcome. 

STATEMENT OF HARVEY ROSENBLUM, ADJUNCT PROFESSOR 

OF FINANCE, COX SCHOOL OF BUSINESS, SOUTHERN METHODIST UNIVERSITY, AND RETIRED DIRECTOR OF RESEARCH, FEDERAL RESERVE BANK OF DALLAS 

Mr. ROSENBLUM. Chairman Brown, Ranking Member Toomey, 

and Members of the Subcommittee, I am pleased to be here to testify on this very important subject. 

On the subject of the too-big-to-fail subsidies, let me just say that 

it is big. Most estimates put it between $50 to $100 billion per 

year. It is persistent. It will go on in perpetuity if changes are not 

made in the incentives driving the giant banks. It distorts economic 

behavior. It is difficult to measure. It is one of the problems we 

have to face, and mainly because there is no line item on any bank 

holding company’s balance sheet or income statement that says 

this is a too-big-to-fail subsidy. 

But most important, it is a subsidy that is really an expenditure 

made by the Congress that charges the public taxpayers, and it has 

never been voted on. I repeat, never been voted on by the Congress, 

unlike most other subsidies. 

11 

Furthermore, the attempt to reduce the subsidy in the DoddFrank Act has really not altered the perception that too-big-too-fail 

banks are any less likely to receive extraordinary governmental assistance in the future. As a result, the subsidy remains. It will be 

here in perpetuity, as I mentioned before. 

To address the subsidy, we have to recognize two principles: 

First of all, incentives matter, and Dodd-Frank is putting the incentives in the wrong places. It has not changed the perception of 

future additional Government assistance, number one, and it has 

perpetuated the subsidy. 

The other principle is that initial conditions matter, and as you 

have already pointed out, Senator Brown, we have very high concentration in the banking industry, and it has been getting worse. 

Moreover, the compliance cost of dealing with Dodd-Frank has 

caused a merger wave among the small to medium-size banks. And 

as you pointed out, Senator Toomey, there has been virtually no 

new entry into the banking industry in the last 5 years. So the 

competitive situation gets worse. 

As I think about the subsidy, it relates to something that is even 

more important to me, and that is, what was the cost of the banking crisis, the financial crisis that we just went through as a Nation? We have been talking about the subsidies here, the too-bigtoo-fail subsidy, and using the word ‘‘billions.’’ When I look at the 

costs of the crisis to the United States, we have to measure it in 

trillions, not billions. My own estimates and that of my coauthors 

at the Dallas Fed put the cost of the crisis somewhere between $15 

and $30 trillion per year. That is 1 to 2 years of output down the 

drain. 

To put that into words that the ordinary person on the street can 

understand, the crisis cost a typical household somewhere between 

$50,000 and $120,000. That is no small change indeed. 

The saddest thing is that, unless the incentives are changed in 

the banking industry, we are going to repeat this same scenario 

again. Same tune, second verse. So the issue is: How do we get rid 

of this distortion called the ‘‘too-big-too-fail subsidy’’? 

President Richard Fisher of the Dallas Fed and I came up with 

a plan about a year ago, recently labeled the ‘‘Dallas Fed Plan,’’ 

that would put in place a three-part system that would reduce the 

subsidy, and reduce moral hazard. It would involve restricting the 

safety net to commercial banks and other depository institutions, 

traditional commercial banks. It would require counterparties of 

the nonbank subsidiaries of the financial holding companies to acknowledge in writing that they have no Government guarantee or 

backstop in their dealings with the nonbank entities. And it would 

call for Government policies to get management to streamline and 

right-size the giant institutions. To some extent, the giant institutions have been doing that, but it has been proceeding at a snail’s 

pace. As a result, moral hazard is increasing, not decreasing. 

So the issue is, beyond the Dallas Fed Plan, what else can be 

done? There are two other things I would recommend. One is the 

Subsidy Reserve Plan, put forward by Professor Hurley at Boston 

University, which would bottle up the subsidy and not allow management to squander it. My other recommendation is the BrownVitter bill, which would put the incentives in the right place and 

12 

get the capital of the largest institutions up to where it should be, 

given their systemic risk. 

These three provisions—Brown-Vitter, the Subsidy Reserve Plan, 

and the Dallas Fed Plan—could probably be written into legislation 

that would take less than ten pages. The implementing regulations 

could be written in fewer than ten pages, and I think that would 

go a long way to driving out some of the complexity that is 

perverting the way our banking system is distorting economic activity. 

Chairman BROWN. Thank you, Dr. Rosenblum. 

Dr. Meltzer, welcome. We look forward to your testimony. 

STATEMENT OF ALLAN H. MELTZER, THE ALLAN H. MELTZER 

UNIVERSITY PROFESSOR OF POLITICAL ECONOMY, CARNEGIE MELLON UNIVERSITY TEPPER SCHOOL OF BUSINESS 

Mr. MELTZER. Thank you, Senator. I am very happy to be here. 

Let me start with two statements, one that I have made many 

times, which I will repeat: that capitalism without failure is like 

religion without sin. It does not work. 

The second is a disclaimer. I worked with Senator Vitter and his 

staff when they were writing the Brown-Vitter bill following my 

testimony here several times in 2008 and 2009. 

I am very pleased to testify today. Much has changed since the 

financial crisis of 2008. I will comment on the adequacy of some of 

these measures and propose some more effective procedures, including passage by the Congress of the Brown-Vitter legislation. 

Let me begin by stating two principles that should, indeed must, 

guide your efforts if they are going to be successful. 

The first principle: Legislation should increase the incentives by 

bankers and financial firms to act prudently. In an uncertain 

world, we cannot always know the prudent course. But the owners 

and managers are most likely to act prudently if they bear the cost 

of the errors that they make, the mistakes—from mistakes and 

from unforeseen events. They will be more willing to cushion risks 

and uncertainties if they bear the cost. 

Second principle: Regulation must provide rules that prevent single bank failures from threatening the financial system. More than 

a century ago, careful analysts understood that the public responsibility was to protect the payments system because a breakdown of 

the payments system stops all or most economic activity. That is 

where the heavy costs that Dr. Rosenblum talked about came from. 

Fear and uncertainty cause banks to refuse to accept payments 

drawn on other banks. 

That is what happened in the Great Depression. That was what 

started to happen in 2008 after Lehman Brothers failed. Timely, 

aggressive action by the Federal Reserve prevented the payments 

breakdown. 

The second principle has wrongly devolved—wrongly devolved— 

into actions to protect banks. There is no economic justification for 

that as a public responsibility. I repeat: The public responsibility 

is to protect the payments system, not the banks or bankers. The 

proper way to separate the two is to impose procedures that prevent a failing bank from threatening the payment system. That requires four or five definite actions. 

13 

One, a clearly stated announced rule for the lender of last resort. 

A well-known rule that has been successfully used calls for the 

Federal Reserve to lend freely on good collateral at a penalty rate. 

In its first 100 years, the Federal Reserve has often discussed its 

lender-of-last-resort policy internally, but it has never announced a 

policy. Announcement is important, indeed crucial. It tells potential 

users well in advance how to prepare their balance sheets and to 

hold collateral against which they can borrow from the Federal Reserve in a crisis. It avoids panic by enforcing its announced rule. 

I have been around this issue for 30 or 40 years. I can tell you with 

great certainty there is never a time that a Secretary of the Treasury, as under Article 2 of Dodd-Frank, in the midst of a crisis, is 

going to decide not to do the bailout. That is the wrong time to be 

making the decision. The right time is in advance by making rules 

which tell the banks how they should be prepared to act in a crisis 

and require them to do so. 

Second, it does not wait to choose action until the panic is upon 

us. 

Third, the lender-of-last-resort policy prevents crises from 

spreading and stopping the payments system. It does not save or 

help troubled banks that lack acceptable collateral. 

Fourth, require equity capital at banks sufficient to absorb all 

anticipated losses. The Brown-Vitter bill requires a minimum of 15 

percent equity capital for all banks that hold $500 billion in assets. 

Capital is assessed against all assets, no exceptions or adjustments 

for risk. This avoids circumvention. 

Fifth, if a bank’s equity percentage falls to 10 percent due to 

losses, it must cease paying dividends—and, I would add, bonuses—until the 15 percent equity ratio is reached. 

Sixth, all money market funds should be marked to market. Recent reform required mark-to-market for institutional funds but exempted individual funds. That does not solve the problem. The 

problem of runs is not avoided unless all money market funds are 

covered by a mark-to-market rule. The purpose is to prevent depositor runs against institutions. 

Let me add, community banks and all banks with less than $500 

billion in assets should hold a lower equity capital percentage, say 

8 percent, because they are protected by deposit insurance, which 

is paid for collectively by bankers. 

Thank you. 

Chairman BROWN. Thank you, Dr. Meltzer. I remember a conversation back in maybe 2011 with Dr. Johnson prior to the Fed’s 

decision to allow these banks to pay dividends, and your recommendation, similar to what Dr. Meltzer said, so thank you for 

that. 

I will ask Dr. Zingales this question, but after he answers, I 

would like to just start with Mr. Evans and work your way down 

and answer this. You know, he estimated the banks’ financial benefits conservatively somewhere between $158 billion and $188 billion, the cost to taxpayers somewhere between $59 and $89 billion. 

So the banks benefited, financially benefited somewhere upwards 

of $150 billion, the cost to taxpayers somewhere $60, $70, $80 billion. 

14 

The Treasury Department says it made a profit of more than $28 

billion in its investment of banks. We have heard that a number 

of times. 

How do we reconcile these two positions? And how can a subsidy 

exist even when the Government profits? If you would clear that 

up and reconcile that for this Committee, this Subcommittee, and 

then each of you give us your thoughts. 

Mr. ZINGALES. Sure. If you buy a lottery ticket and you win, it 

is a great investment. But ex ante it is a bad investment. So there 

is a difference between calculating the cost on an expected basis 

and looking at the final outcome. So, yes, things turn out the right 

way, and so the cost might have turned ex post a profit. It depends 

on the way you properly calculate that. But it was not like a large 

cost. But on an ex ante basis, if you had to sort of insure that in 

the market or pay out of your pocket to get that kind of insurance, 

that would be the cost. 

Chairman BROWN. Mr. Evans, the Government made that profit, 

but the banks got those subsidies. Discuss that. 

Mr. EVANS. I agree completely with Professor Zingales. I think 

some of it is a measure of accounting. If we are looking just at the 

loans and guarantees that were provided to institutions, then you 

look at the fees that you generated as a result of that, and the interest, and that gives you an indication of what was received back 

to the Government. But that is different than a subsidy cost, which 

is an estimation that is done based on expected benefits and costs. 

More specifically the subsidy costs reflect the expected lifetime cost 

of these programs on a present value basis, rather than just the 

cash flows as they occur. It also reflects an adjustment for market 

risk—or what the market would have charged for the support. 

Chairman BROWN. Dr. Johnson. 

Mr. JOHNSON. Just to restate but slightly different words from 

what Luigi said, when the Treasury says or when the discussion 

of returns comes from Treasury and from the Fed, they do not discuss risk-adjusted returns. In other words, if you do this 20 times, 

would you expect to make money 20 times? Or will you make 

money once or twice out of the 20? And on a forward-looking basis, 

of course, that is what you care about. There is a lot of risk in this 

investment, and typically, if you look across a broad cross-section 

of experiences around the world with financial crises and with capital injections, including into banks, treasuries do not generally 

make money on those investments. 

So we got lucky, congratulations to us, but it should not make 

us feel at all reassured with regard to the future risks. 

Chairman BROWN. Dr. Rosenblum. 

Mr. ROSENBLUM. Here we have to distinguish between the micro 

and the macro. The subsidy drives micro behavior. It makes banks 

run risky—giant banks run risky balance sheets. They get the profits; the public gets the losses. It drives the behavior of creditors 

and other counterparties of the giant institutions. That drives 

micro behavior. 

On a macro basis, we have to look at the subsidy in a different 

way, and we also have to look at the costs that the GAO measured 

of the rescues during the crisis, and we have to think of the alternative cost or the opportunity cost. What if the bailouts had not 

15 

been there and we had gone into another 1930s-style Great Depression? 

So the sense in which the Treasury profited is they have tax revenues now that they would not otherwise have if we were still in 

a Great Depression. So we have to distinguish the micro, which 

drives individual, personal, and firm behavior, from the macro and 

the economics versus the accounting identities. They are very different. 

Chairman BROWN. Dr. Meltzer. 

Mr. MELTZER. I agree with this last statement. The important 

thing was that we avoided a Great Depression. That was a social 

benefit. The social cost, quite apart from the accounting, the social 

cost is we are—you gave the numbers yourself. We are making the 

banking system much more rigid. We are eliminating the role of 

community banks. They are very important for American capitalism because that is where little businesses startup. They are 

being eliminated. Medium-size banks are almost all gone. They 

have been absorbed by the larger banks. Why were they absorbed 

by the larger banks? Because the larger banks—the largest banks 

have an advantage of being too big to fail, so they borrow at lower 

risk. That is what it is doing to the social structure of the U.S. 

economy, and that is not a good thing. And that is where the real 

costs are. 

Chairman BROWN. Thank you. 

Senator Toomey. 

Senator TOOMEY. Thanks, Mr. Chairman. 

I am wondering if actually each of you could just comment briefly, maybe we will start with Dr. Meltzer and work back. If you believe that Dodd-Frank perpetuates a perception that these banks 

are too big to fail, and if you believe that there is any implicit subsidy that is associated with that, do you believe that Title II in 

Dodd-Frank particularly contributes to that? 

Mr. MELTZER. Absolutely. I can honestly say I have been around 

this problem for a number of times, talked to various Secretaries 

of the Treasury over the years. Imagine—put yourself in the position, eight Assistant Secretaries or somebody like that are going to 

come to you and they are going to tell you what the crisis will be 

if you do not do the bailout. You cannot wait until the last minute 

to decide whether you are going to do the bailout. You have got to 

set up a structure which is going to discourage that sort of behavior. If you do not do that, there is not a person in the world—you 

know, I have been there. When eight Secretaries of the Treasury 

tell the Secretary all the things that can happen, what can you say 

to them? ‘‘Take the risk’’? 

Senator TOOMEY. OK. If we could go down real quickly, because 

I have several other questions I hope to get to. Dr. Rosenblum, do 

you believe that Title II contributes to this problem? 

Mr. ROSENBLUM. The short answer is yes. If you think of the 

three words—orderly liquidation authority—when I first started 

reading about that, I asked a person who was trying to write some 

of the regulations for the Treasury Department at the time, what 

was the operational word there? Was it ‘‘orderly’’? Was it ‘‘liquidation’’? Was it ‘‘authority’’? I was hoping he would say ‘‘liquidation.’’ 

His answer was the emphasis was on ‘‘orderly,’’ the second most 

16 

important word was ‘‘authority,’’ and the least important word was 

‘‘liquidation.’’ 

Then you think about how it is going to work. The debtor-in-possession financing is going to come from the Government, not from 

the private sector. That automatically has subsidies implicit in it. 

And last of all, the fact that these institutions are going to be labeled ‘‘systemically important’’ financial institutions—in Washington they are called ‘‘sif-fees.’’ In Dallas I call them ‘‘sci-fis.’’ It 

is like something out of science fiction. But the fact that they have 

got that ‘‘systemically important’’ label already tells all of their 

counterparties that they are special, that there will be extraordinary Government assistance, or at least a good chance of it, 

should that institution get in trouble. I think it compounds the 

problem. It does not solve the problem. 

Senator TOOMEY. All right. Dr. Johnson. 

Mr. JOHNSON. Senator, I think there are some scenarios in which 

the single point of entry strategy proposed by the FDIC could help. 

I do not think it will help with the very largest bank holding companies, the subject of today’s hearing, because they are inherently 

cross-border, very global, huge businesses, and we do not have a 

cross-border resolution authority. We have a specific liquidation authority in the United States. 

And, by the way, the last FDIC hearing made it clear that the 

plans do not call for liquidation in the sense of closing down the 

business and selling off the assets. It is a legal liquidation in which 

a failing entity has so-called good assets transferred to a new legal 

entity. They might well continue the brand name. They might well 

continue with the management in that scenario. And I share my 

colleague’s concerns that it is possible, particularly for the largest 

category of megabanks, that Title II will not help and may even, 

as you are suggesting, create more difficulties. 

Senator TOOMEY. Thank you. Dr. Zingales. 

Mr. ZINGALES. I agree that Title II contributes to too big to fail. 

However, I think it is important to understand that the solution to 

this problem is not to prevent by legislation any possibility of rescue, because when push comes to shove, eventually everybody will 

do as Senator Brown did in front of TARP. So what we need to do 

is prevent us from reaching that point. It is like with small kids. 

We want them to learn from their mistakes, but we do not want 

them to go into danger, then take away their life. And so in front 

of a danger, the only way to do it is prevent them from going there, 

not sort of saying, ‘‘I am not going to rescue you if you get on fire.’’ 

Senator TOOMEY. So I wanted to follow up with your proposal, 

which, if I understood it correctly, is intriguing and I had not heard 

this articulated before. But if I understood what you are suggesting 

as an alternative, it is a process by which the Fed would monitor 

the price of credit default swaps or subordinated debt, set a ceiling 

essentially that would, as you point out, amount to a margin call, 

right, new capital, and use that as the mechanism by which we 

judge the creditworthiness of the entity? Do I have that about 

right? 

Mr. ZINGALES. Yes, that is absolutely right. 

Senator TOOMEY. OK. Now, you know, the appealing thing about 

that is that we do not have politicians arbitrarily setting a capital 

17 

level. Instead, we have the market telling us something. But we 

still have the Fed arbitrarily deciding what the ceiling is on the 

price of the CDS. So you still end up in the same place in terms 

of, you know, what is the criteria by which you decide what the 

right capital is. So that is one question. 

The second one is: If you have solved the problem with a mechanism like that, then is there a need for all the restrictions on activities? I mean, I find it ironic that, in an interest of presumably 

reducing risk, we adopt a Volcker Rule that, for instance, forbids 

banks from engaging in profitable activity. The last time I checked, 

profitable activity actually enhanced the stability of the institution, 

and we forbid that. 

Would that sort of thing be necessary if you had a mechanism 

to ensure adequate capital? 

Mr. ZINGALES. I think that if this mechanism were implemented, 

the need for restricting activities would be much, much less, because the riskiness of this activity would be reflected in the measure of capital requirements. So the problem today is that we have 

a measure of capital requirements that only looks at one aspect of 

the problem, and we want to look at both. We want to look at leverage, we want to look at riskiness of assets, and the CDS does exactly that. On the level, of course, there is some arbitrariness in 

that, but we can look at the past and say what would it have taken 

during the crisis to recapitalize—or when we should have recapitalized these banks enough so that we would not reach the crisis? And 

so we can easily determine what that threshold should be. 

Senator TOOMEY. Thanks, Mr. Chairman. 

Chairman BROWN. Thank you, Senator Toomey. 

Senator Reed. 

Senator REED. Well, thank you very much, Mr. Chairman. I want 

to commend the Chairman and Senator Toomey for assembling a 

very impressive panel about a very important topic, and let me ask 

just a few questions. 

Dr. Johnson, again, thank you for not only being here but for 

your very perceptive commentary constantly, so thanks. 

Part of this discussion was about TARP. It has been both assailed and commended for what it did in terms of stabilizing the 

banking industry. There was one aspect of TARP, though, which I 

think has to be sort of looked at and emphasized, in my view, and 

maybe because I was involved and put in a provision, and that is, 

the warrants, which has resulted in about $9 billion of proceeds 

going back to taxpayers because they were included in the legislation. 

Dr. Johnson, from your perspective can you comment on just the 

warrant provision and its effect? And, also, was it well managed? 

Could we have done better? And, frankly, is that something that 

has to be the template for any other type of sort of public engagement in a financial operation like TARP? 

Mr. JOHNSON. Yes, Senator, I think it was entirely sensible and 

a very good idea to include the warrant provision in TARP. I understand Treasury was not enthusiastic about it initially, and, 

frankly, subsequently they did not seem to really pursue this, as 

they could have, as a way to get upside for the taxpayer. And I 

think, for example, given the discussion that we are having today, 

18 

it is entirely reasonable that when the Government provides this 

sort of backstop support to the financial system in an emergency 

to prevent a systemic collapse, there should be some upside for the 

taxpayer, and the warrant program is a good way to do it. And I 

would recommend everyone go and review the terms that Mr. 

Buffett got for his support, for example, to Goldman Sachs. If we 

could have done just as well as Warren Buffett, we would have 

done much better than under what the Treasury actually chose to 

do. 

Senator REED. No, I think that is an excellent point. In fact, that 

was one of the things that struck us at the time, is that any serious 

business person investing in a risky enterprise with a potential upside would have taken warrants and would have—you know, directors on the board would have done a lot of things, and at least we 

got some of the warrants in. My recollection is like yours, too. It 

was unenthusiastically embraced, that we probably could have set 

better terms a la Warren Buffett. And, third, in retrospect, it looks 

better and better. So I think the more—you know, as President 

Kennedy said, you know, failure is an orphan, but success has lots 

of parents. So there is a big collection of parents today about the 

warrants provision. 

Just one other quick question. You know, we are really talking 

today about emergency assistance, but there is a built-in support 

system to the Tax Code for assistance to major financial institutions and major institutions in general. We have tried to take some 

steps in the past. For example, we limited the deductibility of chief 

executives’ compensation. What we found is that they have been 

very good about getting around that by bonus compensation, and 

we are putting in legislation. So could you again, Dr. Johnson, comment on the notion of tax supports and tax provisions that really 

are not helpful to the economy overall and are simply another form 

of subsidy to these institutions? 

Mr. JOHNSON. Senator, I am familiar with your proposal on this 

topic, and I think it is a good one. I think to the extent that the 

Tax Code is encouraging either excessive levels of compensation or 

compensation that encourages too much risk taking, as my colleagues have been talking about, I think that is a bad idea. And 

it is entirely appropriate, as you suggested, to limit how much of 

that compensation is deductible because it is a form of subsidy 

through the Tax Code, as you said. 

Senator REED. Well, thank you. Again, just let me open up that 

line of questions to anyone else who might want to comment, which 

is that, you know, some of this risk-based behavior is because we 

incentivize it through the Tax Code and through other provisions, 

and it would be very helpful for me particularly if there are specific 

provisions that you think—and you can respond in writing and answer—are not helpful at all but do encourage excessive risk taking, 

and if we could have a two-fer, if you will, you know, not subsidizing risk and actually raising revenue through a process that 

helps in other ways. So let me open that question up and ask you 

perhaps in writing to respond as my time is expiring. 

Thank you, gentlemen, for your testimony. 

Chairman BROWN. Would anyone care to comment now on that? 

Or you certainly are free to—Dr. Meltzer, yes? 

19 

Mr. MELTZER. Yes, yes. The capital requirements are really crucial. Banks got down to where many of them had 2 percent equity 

capital or less. They had more capital bonds, and they insured the 

bonds, so they had no skin in the game. The way to get the change 

is not by doing it piecemeal on each part of their compensation, because they will find ways to circumvent it. They will get airplanes. 

They will get cars. They will do other things that you do not regulate. 

The way to get it is make them bear the cost of the errors. That 

is what the Brown-Vitter bill does, and I am convinced that that 

is—if you do it so that there is no exception, if you hold an asset, 

you have to hold 15 percent against it if you are of that size. If you 

do not think it is worth 15 percent, sell it. That is what markets 

do. And that way you get the incentives on them, and that is what 

you want to think about. You want to think about what are the 

procedures which are going to give them the incentives that are 

hard to circumvent. 

Senator REED. Thank you. 

Chairman BROWN. Thank you. 

Dr. Rosenblum. 

Mr. ROSENBLUM. Let me put a slightly different twist on it. I 

think of Economics 101. If you want more of something, you subsidize it. If you want less of it, you tax it. And when we think about 

the too-big-too-fail subsidies, it is subsidizing that which we do not 

want. So we know it is perverse. 

But if we want to think about too-big-too-fail subsidies, we want 

a stable financial system, and we may have to, you know, think 

about what is the cost of having that stability and what is the 

backup system you need it for. 

The other place where I think you may want a too-big-too-fail 

subsidy of some kind is for national defense. You know, we cannot 

have the production lines that are going to be used to produce the 

material that is going to defend our country go through bankruptcy. And when I think about General Motors’ bankruptcy, nobody ever talked about the national defense. And if you go back to 

World War II, where were the tanks produced? Converted auto production lines, produced airplanes, tanks, boats, and all those sorts 

of things. 

So we have to think about those critical infrastructure needs that 

we must have—a payments system, a national defense system, et 

cetera, et cetera. And there may be some need to have some subsidies there and the moral hazard that it engenders. Moral hazard 

is the cost we pay for living in a civilized society. Anybody who has 

raised children knows about the moral hazards of raising children 

and the moral hazard of taking care of our next-door neighbor 

when our next-door neighbor is out of work. It is just something 

that we must do, but that is something the United States has done 

reasonably well. 

But getting back to the too-big-to-fail subsidy, it is something we 

do not want. Yet, it is there. The other subsidies that we ought to 

have are those which Congress wants and votes on politically. If we 

want to subsidize food supply or make sure we have a stable food 

production, maybe a corn subsidy or a sugar subsidy is warranted. 

Whatever it is, it may be something you want. But at least it ought 

20 

to be voted on directly. The problem with the too-big-too-fail subsidy, it happened by happenstance. It was never voted on, and it 

keeps getting bigger and bigger in a self-reinforcing mechanism. 

And that I find unconstitutional. 

Senator REED. Thank you. 

Chairman BROWN. Thank you. 

Senator Merkley. 

Senator MERKLEY. Thank you very much, Mr. Chair, and thank 

you to the panel. 

One of my colleagues a few minutes ago said, ‘‘Why would you 

ban an activity that is profitable, like proprietary trading?’’ Mr. 

Johnson, is proprietary trading always profitable? 

Mr. JOHNSON. No, Senator, it is not. Well, perhaps it is profitable 

to the people undertaking it, so this is the issue of compensation 

and the issue of incentives. But it is also possible to lose a great 

deal, and we are obviously talking about companies in this context. 

When an individual company incurs losses, there are big spillover 

effects both directly to the Government in terms of various kinds 

of support provided and, as we are saying, indirectly to the budget 

and to the real economy. And those costs are huge relative to the 

amounts of money that people were going to gain in terms of their 

personal compensation. So I think the Volcker Rule is a very sensible part of our current regulatory approach. 

Senator MERKLEY. My memory is the commercial banks lost 

about half a trillion dollars in proprietary trading, and, of course, 

you have this complex challenge on repurchase agreements in 

which a fire sale at one firm can devalue the asset and create a 

series of dominoes that affects the entire market. One of you spoke 

to the contagion issue. So I just wanted to go back to that point 

for a moment and note that if indeed proprietary trading was riskfree or always profitable, we would not have been having that discussion. But it posed such a systemic risk to the entire order. 

One of the issues that we have struggled with is cross-border resolution, the complexity of international firms, American firms with 

foreign subsidiaries, foreign firms with American operations, and 

that is a key piece of the puzzle. Can anyone who would like speak 

to how satisfied are we with where we have gotten to? Yes, Mr. 

Johnson. 

Mr. JOHNSON. So cross-border resolution remains a huge problem, both for the existing FDIC approach to a single point of entry, 

I think it is the Achilles heel of the entire approach. And when we 

talk about any of the big companies, the subject of today’s hearing, 

they are all so big across borders that this is going to be the entire 

ball game, and this is what will create the pressure for the Secretary of the Treasury and Congress to provide a bailout in the future. 

I would also say—and I am sorry Senator Toomey is not in the 

room at the moment—that this is a key problem for bankruptcy. 

And when you talk to the experts, the proponents, the people who 

would rather get rid of Title II and stick with bankruptcy, for example, at this Richmond Fed conference that I talked about, which 

is a public conference so people can review the tape, it is very clear 

that while cross-border issues are a big problem under Title II, the 

resolution authority, they are an insurmountable obstacle if you 

21 

are going through the bankruptcy courts, because bankruptcy 

courts absolutely cannot and never will cooperate in the fashion 

that will be necessary to have an orderly liquidation, winding 

down, unraveling, call it what you want, if you go in through the 

bankruptcy-only route. 

So cross-border is a huge problem that we have not dealt with 

resolution. It is an insurmountable obstacle for bankruptcy. 

Senator MERKLEY. Does anyone else want to chime in? Yes, Mr. 

Meltzer. 

Mr. MELTZER. Senator, let me suggest to you a way to think 

about that problem. Separate the bank from the holding company. 

Let the holding company incorporate all its subsidiaries in the 

countries of origin so they are subject to the rules of the country 

of origin, not to the U.S. rules, but they are owned by the holding 

company, not by the bank. So the bank can be structured, restructured here. The holding company is a separate entity subject to 

whatever laws are applicable in the foreign countries where the 

subsidiaries are operating. 

Senator MERKLEY. Do you feel, Mr. Meltzer, that that creates a 

sufficient firewall from the risks incurred abroad flowing back into 

the U.S. economy? 

Mr. MELTZER. I have not studied it carefully enough to say definitively, but I believe it certainly moves in that direction; that is, 

you want to keep the problems of the foreign banks out of the domestic banks so that you can regulate the domestic banks and regulate the holding company separately. And if the holding company 

is taking sufficiently large risks, then it wants more capital requirement. 

Senator MERKLEY. Anyone else want to jump into that? Mr. 

Rosenblum. 

Mr. ROSENBLUM. Yes, I want to underscore what Professor 

Meltzer said and come back to what I said earlier about the Dallas 

Fed Plan, which hives off the safety net to the commercial bank 

and legitimate traditional commercial banking activities. Everything else in these holding companies is separate, and every 

counterparty of those nonbank institutions has to sign off and say 

there is no Government guarantee. I get it. Two simple sentences. 

That puts the onus of responsibility on the marketplace and on 

these counterparties to worry about what happens if this company 

gets into trouble. Our deposit insurance system and the lender of 

last resort is really there for the bank, the domestic company, and 

that is where it should be, and everything else, the market, has to 

have incentives to watch over and regulate in its own way with 

threat of losses, be it domestic or be it foreign. But we have to let 

market forces reinforce the limited effectiveness of regulations that 

we have. 

Senator MERKLEY. Thank you all very much. 

Chairman BROWN. Thank you, Senator Merkley. 

Senator Warren. 

Senator WARREN. Thank you very much, Mr. Chairman. Thank 

you, Mr. Evans, for the work you and your staff have put in to put 

this report together. 

The GAO report concludes that it is too early to declare victory 

on the too-big-too-fail problem, and I agree. The four largest banks 

22 

are nearly 40 percent bigger today than they were just 5 years ago. 

The six largest banks now control two-thirds of the banking assets 

in this country, a 37-percent increase over where they were just in 

the last 5 years. These banks, in other words, are a whole lot bigger now than they were when we bailed them out in 2008 because 

they were too big to fail. 

So I get it. Size is not everything, but basically the bigger these 

banks get, the harder it is for the U.S. Government to declare with 

any credibility that it will not bail them out if they get into trouble 

again. 

Now, the GAO report does not consider the impact of the Volcker 

Rule because it was not passed until after the report was issued. 

I think the Volcker Rule is an important step in the right direction 

if it is strongly enforced. But I am interested in your take, Dr. 

Johnson. Does the Volcker Rule solve the too-big-too-fail problem? 

Mr. JOHNSON. The Volcker Rule is helpful in the current context, 

steps in the right direction, as you said, Senator Warren. It, unfortunately, by itself or even if implemented in the most forceful fashion possible, I think is not going to completely end too big to fail. 

Those problems, those subsidies, the systemic risk and the way it 

can damage the budget and the economy, that is going to remain. 

Senator WARREN. So let me just see if I can do this as maybe yes/ 

no so we can get on to other questions. Would you agree with that, 

Dr. Zingales? 

Mr. ZINGALES. Yes. 

Senator WARREN. And, Dr. Rosenblum, do you think that the 

Volcker Rule solves the too-big-too-fail problem? 

Mr. ROSENBLUM. No. 

Senator WARREN. And, Dr. Meltzer. 

Mr. MELTZER. No, and I think it has the added difficulty that you 

will never find a clear-cut definition of what is a hedge and what 

is a speculation. 

Senator WARREN. Good. All right. 

Mr. ZINGALES. Sorry. To be precise, I said no, I do not—you understood. 

Senator WARREN. I had asked the question backwards. That was 

entirely my fault, Dr. Zingales. I should have been consistent in 

how I asked it. 

But let me put it this way. The four of you agree the Volcker 

Rule does not solve the too-big-too-fail problem even if it is vigorously enforced. So let me do the next question on that. Even if the 

regulatory agencies issue all of the Dodd-Frank rules that remain 

and then rigorously enforce all of those rules, do you believe that 

would solve the too-big-too-fail problem? And perhaps I could start 

with you, Dr. Rosenblum. 

Mr. ROSENBLUM. So let me be blunt and do something I should 

never do here when the TV is going. I am going to answer your 

question by saying, ‘‘No,’’ and, ‘‘Hell, no.’’ 

Senator WARREN. And tell me about if you feel strongly about 

this. 

[Laughter.] 

Mr. ROSENBLUM. Well, if we have 14,000 pages of proposed regulations written to implement less than half of the Dodd-Frank provisions, we do not have anything going on that can be enforced. It 

23 

is mind-boggling. It is unenforceable. It is inscrutable. It does more 

harm than good. We need rules that are simple, straightforward. 

If they are to be enforced, they have to be observable. The enforcement has to be observable. As Dr. Meltzer has said, a capital-toasset ratio is measurable, observable, can be looked at sort of in 

real time. It is a beginning. We cannot have this Dodd-Frank— 

which is 850 pages, roughly, probably will be 30,000 pages of regulations to implement it. It is not workable. And when something is 

not workable, you have to admit it and go back to the drawing 

board and try to come up with something simpler and better. Complexity is the enemy, as I said in my written testimony, and we 

have to find some way of addressing it. 

Senator WARREN. So—— 

Mr. ROSENBLUM. Let me add one thing, if I may. When I started 

in the Federal Reserve System 44 years ago, in 1970, I was hired 

to help write the Bank Holding Company Act amendment regulations, and we were sat down in a room, and they told us we could 

write no more than one page of regulations to implement one page 

of statutes. We were held accountable to that criteria. The legislation itself that we had to work on was only a few pages long, and 

our regulations were fewer. It is doable, and it was enforceable, 

and it worked very, very well. And I think we have to get back to 

the drawing board and realize the social costs of what we are 

doing. If we cannot understand the rules that we have to follow, 

nobody is going to follow the rules, whether it is driving at the 

speed limit or whether it is something else, or getting back to 

health care, which is another situation, we have to—we cannot 

write rules this way. And I think if Congress were to give a gift 

to America for 2014, the greatest New Year’s gift they could give 

would be to write legislation in a few pages, with regulations that 

were an equal number of pages, so that every Senator and every 

Congressman can sign off to their constituents and say, ‘‘I read 

every word of this legislation, and I am proud that I signed off on 

it.’’ 

Senator WARREN. From your mouth to God’s ears. 

Could I have your indulgence for just a minute, Mr. Chairman? 

Chairman BROWN. There will be a second round, too. 

Senator WARREN. Actually, I will finish up, if that is OK, because 

I just want to ask—and I will do it the right way, Dr. Zingales. So 

if all of Dodd-Frank were implemented and if it were vigorously enforced, do you believe that would solve the too-big-too-fail problem? 

And maybe we can do these with just yes or no answers to the extent possible. Dr. Zingales. 

Mr. ZINGALES. No, it would not solve it. 

Senator WARREN. Dr. Johnson. 

Mr. JOHNSON. Yes. If vigorously enforced, Title I says that the 

living wills lay out how your firm is going to go bankrupt, and if 

that plan is not credible—and I am confident those plans are not 

credible and will not be credible, with the current level of complexity, then the Federal Reserve and other authorities should take 

remedial actions, including much higher capital requirements, including breaking up the banks, as you proposed, along the new 

Glass-Steagall lines. All of those possibilities are contained within 

Dodd-Frank, but I agree that is not the current interpretation of 

24 

the law, particularly from the Board of Governors of the Federal 

Reserve. 

Senator WARREN. So if amended my question to be ‘‘as currently 

interpreted,’’ then you answer would be—— 

Mr. JOHNSON. Then the answer is no. 

Senator WARREN. Then the answer would be no. And, Dr. 

Meltzer. 

Mr. MELTZER. No, it certainly does not, and I believe when you 

said we have not won the battle, I think we have lost the battle 

against too big to fail because—mainly because we put the burden 

on the regulators instead of putting it on the people who make the 

loans and make the mistakes. And if you do that, you know, look 

what happened before the regulation—before 2008. The SEC cut 

the requirement for capital in the investment banks to 3 percent, 

allowed them to leverage 30 times. The Federal Reserve allowed 

banks to incorporate subsidiaries without capital to hold mortgages. I mean, I had a meeting here—— 

Senator WARREN. Dr. Meltzer, I am going to have to cut you off. 

Thank you very much. The Chair has been very indulgent. But if 

the Chair will indulge me one more minute, I just want to ask one 

very quick question because I wanted that time, and that is, so 

does it make sense to wait until all of the Dodd-Frank rules have 

been put in place and are vigorously enforced before we consider 

further legislative actions to address the too-big-too-fail problem? 

And if I could just have a yes or no on that, does it make sense 

to wait? Dr. Zingales. 

Mr. ZINGALES. No. 

Senator WARREN. Dr. Johnson. 

Mr. JOHNSON. No. 

Senator WARREN. Dr. Rosenblum. 

Mr. ROSENBLUM. No. 

Senator WARREN. Dr. Meltzer. 

Mr. MELTZER. No. 

Senator WARREN. Good. So I just want to say thank you very 

much, Mr. Chairman, and conclude with the notion, back in July 

Secretary of the Treasury Lew said that if we got to the end of 

2013 and could not say that we had ended too big to fail, it was 

time, in his words, ‘‘to look at other options to end it.’’ Then in December, he said we had met the test, that existing reforms were 

enough to address too big to fail. 

I think the Secretary laid out the right timeline, but based on 

this GAO report and the testimony we have heard today, I just do 

not think we can declare confidence that too big to fail is over. I 

believe it is time to start looking seriously at other options. Too big 

to fail is just too dangerous for us to cross our fingers and hope for 

the best. 

So thank you very much for having this hearing, and thank you 

for your indulgence on the time. 

Chairman BROWN. Thank you, Senator Warren. 

Let me start a second round. I appreciate the comments. One of 

the things that has come through in this hearing in so many ways, 

especially on capital requirements, is the simplicity of your proposals and the simplicity of your explanations, and I thank all five 

of you for that. 

25 

Dr. Rosenblum, I appreciate also the Dallas Fed Plan, Mr. Fisher 

working with us and his office working with us on Brown-Vitter 

and a host of other issues, and I want to sort of focus on one of 

those. 

You propose restricting the so-called Government safety net to 

traditional depository institutions, but rather than narrowing the 

scope, as you know, the bailouts and Dodd-Frank have expanded 

that safety net by bringing in nonbanks and companies like clearinghouses into the system. I want to talk for a moment about Section 23A of the Federal Reserve Act. It was supposed to protect insured depositories and prevent institutions from transferring that 

safety net subsidy to nonbanks. 23A, while perhaps not written as 

succinctly as you called for from your graduate studies and since, 

23A was ineffective during the crisis because of the routine exemption that regulators granted to too many of these institutions. My 

legislation with Senator Vitter strengthens 23A by enacting legal 

firewalls between banks and nonbanks and prohibits Federal assistance to those nonbanks. 

Give me your views—and then after you answer, Mr. Rosenblum, 

I will start with Mr. Meltzer and work my way down. What are 

your views on the importance and the effectiveness of 23A? How 

do we strengthen those firewalls between banks and nonbanks? 

Mr. ROSENBLUM. You hit on a point that I have not written about 

extensively. When Richard Fisher and I came up with the Dallas 

Fed Plan, we wanted to keep it down to three points. If we allowed 

ourselves a fourth point, 23A would have been the fourth point. 

The ability of a nonbank sub to put bad assets into the bank and, 

therefore, put it into the FDIC safety net and/or the discount window borrowing provisions I find abhorrent. So that would have 

been the fourth point that I would have made. So I would toughen 

up 23A and say that any exception to 23A that is made has to be 

done in advance with written notice and absolute complete transparency on the part of the Federal Reserve that it is making an 

exception. Every one of those assets has to be listed in public, and, 

therefore, I think it is much less likely to happen if you have those 

kinds of restrictions there. 

There may be some cases when an exception needs to be made, 

but it should be few and far between, extremely rare, and I believe 

that the General Counsel of the Federal Reserve Board needs to 

have some restrictions on the ability to grant those special provisions in private. 

Chairman BROWN. Could you work with us on what—or let me 

ask it this way: Are you satisfied with the provisions in Brown-Vitter that the restrictions are tight enough but the discretion is given 

to the Fed for extraordinary cases but cannot be abused, for want 

of a better term, or more liberally given by the Fed than we would 

want? 

Mr. ROSENBLUM. I think we have to realize what the Federal Reserve is, and one of the things it was created to be is a lender of 

last resort, which has taken on new meaning in the 21st century. 

You need that safety valve there, and people have to recognize that 

there is a safety valve; otherwise, panic takes over. What the Federal Reserve’s job is to do in times like that is when everybody in 

the private sector is trying to take the sell side, somebody in the 

26 

Government or in the Federal Reserve has to take the buy side; 

otherwise, prices go to zero. That is what the Federal Reserve was 

created to do. That is what the Bagehot Principle is all about. And 

I would not like to see the Federal Reserve’s hands totally tied 

from being able to exercise its prerogative to use lending as a 

means to saving the system at the right time. I would like to see 

more checks and balances. I agree with Professor Meltzer. We need 

rules clearly stated in advance that are comprehensible. And I 

agree that the Federal Reserve has never really put those rules forward on how the lender of last resort is going to work. But if nobody knows what the rules are, that is when panic really can set 

in. So those rules have to be specified. 

My criticism to Professor Meltzer is—he has been advising the 

Fed to write those rules. Those are tough rules to write, and neither I nor Professor Meltzer have actually written out what that 

rule should be that would be clearly there in advance. But I think 

it is something the Federal Reserve does need to work on. But you 

do need some political checks and balances to make sure that the 

Federal Reserve is not exceeding its authority, but there can be 

provisions written in so that would not happen. 

Chairman BROWN. Before—Dr. Meltzer, I know you want to answer this, too, and I want you to. Before answering the 23A question, I want to put another part of the safety net in this question 

and then answer them together, the rest of you, if you would. Section 716 of Dodd-Frank requires banks to move their derivatives 

out of their insured banks, but the GAO report notes that regulators have given large banks an extension. Right now the four 

bank holding companies that are most active in derivatives hold 

more than 90 percent of their derivatives in their insured bank. 

Two of these companies plan to move more derivatives into their 

insured banks in response to a credit downgrade, asking taxpayers 

to subsidize their risk. Clearly that suggests a problem. 

So if you would comment on both of those, Dr. Meltzer, and 

then—— 

Mr. MELTZER. Sure. Let me step back and say the economics literature is full of things about capture, how the regulator gets captured by the regulated. So you are not going to make effective rules 

that way. If you think that there is a problem with derivatives or 

with these loans or subsidiaries, put on a cash requirement for 

banks. Add to the capital requirement a requirement which says 

you have to hold cash, negotiable assets, short term, that you can 

discount at the Fed when you need to. That is a way to go. 

Think not about what rules can you put on the regulator to get 

them to do the right thing, because that does not seem to work. Put 

the rules on the regulated, which makes them want to do. The essence of regulation, if we strip it way back to simple economics, is 

there is a social cost and a private cost. You want to drive the private cost up to where it is clearly close to the social cost. That 

means you want to make them see what the social benefits are, not 

what the private benefits are. They see the private benefits. You 

have to make them want to behave in a way, in a simple, direct, 

observable, transparent, and enforceable way that sees those costs. 

Chairman BROWN. And the simplest and most workable is capital 

requirements on real assets—— 

27 

Mr. MELTZER. Absolutely. 

Chairman BROWN. ——risk weighting and all of that. 

Mr. MELTZER. Right. Now, they will say that is going to reduce 

lending. That is baloney. The Federal Reserve decides how much 

lending there is in the economy, and they can easily make it more 

or less, and do. So we do not need banks to decide that. Banks decide who gets the credit. The Federal Reserve decides how much 

credit there is. 

Chairman BROWN. And I have certainly heard that said many 

times in response to Brown-Vitter, and much we work on here—— 

Mr. MELTZER. It just is not true. 

Chairman BROWN. ——we will not lend, there will not be capital 

available. 

Mr. MELTZER. Baloney. 

Chairman BROWN. OK. We will quote you on that. Thank you. 

Dr. Johnson, your thoughts? 

Mr. JOHNSON. Well, I certainly agree, Senator Brown, that 23A 

has become a problem, and I think the problem is located on the 

staff of the Federal Reserve Board of Governors, particularly in the 

Office of the General Counsel. I think they have been allowing 

these bank holding companies to move risky assets, problematic assets into the bank and, therefore, benefit from the safety—— 

Chairman BROWN. Does that—sorry to interrupt. Does that follow with Dr. Meltzer’s comments about regulatory capture? Is that 

primarily the reason? Or are there other reasons that these waivers and these exceptions tend to be the matter of course? 

Mr. JOHNSON. That is a great question. You should ask the Federal Reserve staff, Senator, not me. Certainly there has been a history of capture in our regulatory agencies with which you are very 

familiar, and the Board of Governors has not been exempt from 

that in the past. 

Chairman BROWN. People at the Peterson Institute called it—one 

day we were talking about this with Sheila Bair and some others, 

and Governor Huntsman called it ‘‘cognitive capture,’’ that it is a 

little bit different but it is sort of the culture of many of these regulatory bodies. 

Mr. JOHNSON. Yes, it is exactly in the tradition of George Stigler 

and the Chicago School. Cognitive capture is just one application 

of that. You are captivated by the mystique of Wall Street—sorry, 

not you, Senator, but a lot of other people are captivated by that 

mystique and, therefore, think that what these large bank holding 

companies want to do is somehow, if it is good for them, they want 

to do it, it is good for the economy. I think that that is an extension, very straightforward extension of the Stigler capture idea. 

But just also to go on to the point you made about Dodd-Frank 

and the point about moving derivatives around within the bank 

holding company structure, I do worry, Senator, that in addition to 

the 23A problem you are identifying, there is a problem emerging 

that will emerge from the Title II resolution application of the single point of entry, because through this mechanism the FDIC—if 

it is believed that this is going to work and that support will be 

provided, it is ultimately backing up the entire portfolio of the bank 

holding company, and it is transferring losses that would be incurred, for example, in an operating subsidiary that loses big 

28 

money on derivatives. Those losses get pushed up to the holding 

company level where the FDIC gets involved in deciding who gets 

the losses, deciding who gets—what kind of debt gets converted to 

equity or gets wiped out, and also providing backstop financing. 

So I think we are in danger of enlarging this problem beyond the 

scale that already exists, and it is already problematic. 

Chairman BROWN. Dr. Zingales, comments? 

Mr. ZINGALES. I very much agree with what Meltzer and 

Rosenblum said. I think that the problem is all these rules are very 

complex and they give ample space for regulators to do what the 

regulated want. So I think that we need to simplify these rules to 

make it more difficult for this to happen and to give less discretion 

to the regulatory authorities, because I think that they have too 

much discretion, and this discretion is always used in one direction, 

and it is generally the wrong one. 

Chairman BROWN. Mr. Evans, comments? 

Mr. EVANS. I think I will take a little bit of time just to plug our 

ongoing work, because at the end of the day this is about investor 

perceptions or investor expectations about how regulators, will behave in the instance of distress. In our work, we will be looking at 

how any subsidy that we estimate might change over time, because, again, it is, I think, an empirical question to ask whether 

investors’ expectations have been changed as a result of DoddFrank. And we will also be talking to large investors and other 

market participants. So there are a lot of things in Dodd-Frank, including 23A, but our question that we are going to concern ourselves with is whether it changes investor expectations. 

Chairman BROWN. OK. Thank you, Mr. Evans. 

We talk about capital and leverage. In July, the OCC, FDIC, and 

the Fed, as you all know, proposed a special higher leverage ratio 

for the largest banks, not as high as I would have liked, not as 

high, I assume from my conversations with some of you and my 

staff’s conversation, as some of you would have liked. Even that 

said, the New York Times noted just 3 days ago that the Federal 

Reserve has said we should not finalize this rule until foreign regulators have finished their capital rules. Give me your comments on 

what that means to our financial system. Should we finish our supplemental leverage ratio now? Should we wait for other countries? 

What impact will waiting have? What should we do? Mr. Evans, do 

you feel free to comment on that? 

Mr. EVANS. I will punt mostly to my colleagues here. I think 

there are pros and cons to both approaches. You know, we are good 

at laying out those pros and cons. As you noticed, we were only an 

inch deep in the report. We talk about the intent of the various 

provisions and the challenges they face, but we do not have an 

opinion at this time on that. 

Chairman BROWN. OK. Dr. Zingales, I bet you do. 

Mr. ZINGALES. Yes, I do, and I would like to stress the example 

of Switzerland. Nobody doubts that Switzerland is a capitalist 

country and a country that generally has been sort of quite interested in the welfare of banks. But because banks in Switzerland 

are too big to be saved, because they are bigger than what the fiscal authority of the country can do, the regulatory approach in that 

country has been much more severe in terms of capital requireVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
29 

ments. So I think that we should follow the Swiss example as fast 

as possible because nobody can say that this is not a legislation 

done against the banks. It is simply a legislation done without 

banks pressuring to have an implicit guarantee, because in Switzerland they do not bother to pressure because they know that it 

would not be there. So this is the example to follow. 

So if the Fed and Treasury want to follow a lead, they should follow the Swiss lead. 

Chairman BROWN. Dr. Johnson. 

Mr. JOHNSON. Well, Senator, I am very much disconcerted by the 

news that we are going to wait for the Basel Committee—and that 

means most immediately for the Europeans—before we decide on 

a supplemental leverage ratio. I agree with you that the leverage 

ratio should be higher, more strict. We should require more equity 

relative to debt for these large bank holding companies, more than 

currently proposed. The Basel framework and this entire mechanism through which we there to unify or agree or harmonize with 

our European friends has not been helpful over the past 30 years, 

and it is not helpful at the moment. Secretary Lew said back in the 

summer—and I believe he reiterated this also in the fall—that we 

are supposedly not going to wait for other countries, that we are 

going to impose rules that make sense for ourselves. And I do not 

see how this deferral to the Basel community on the supplemental 

leverage ratio is helpful in that regard. 

Chairman BROWN. It does make you wonder if Secretary Lew’s 

comments in the summer that if we have not fixed too big—about 

fixing too big to fail, then saying we have by December, if he was 

including in that these higher capital requirements, which have not 

been finalized. To be continued. 

Dr. Rosenblum, your thoughts? 

Mr. ROSENBLUM. Somebody has to be the leader and the exemplar, and in this instance I think the leader and the exemplar 

should be the United States. We are the largest economy and the 

most important economy in the world with the financial system 

that the rest of the world depends upon, and we need the healthiest and safest banking and financial system in the world in order 

to lead the world. And, therefore, I do not think we should wait on 

the least common denominator coming up with what they think is 

right. We ought to do what we think is right, and the others I 

think will have to follow. 

Chairman BROWN. Thank you. 

Dr. Meltzer, a comment? 

Mr. MELTZER. I agree with what the others have said. The 

United States should lead and not follow. The argument that the 

bankers make is that it will put them at a competitive disadvantage. That is hard to accept. They have subsidiaries overseas, so if 

the rules in the United States are strict and prevent them from 

making loans overseas, they can make them from their overseas 

subsidiaries. So it is hard to see how they are going to be—why 

that should be a critical reason why we should not lead the world 

toward a better solution. As Professor Zingales said, the Swiss have 

already taken, I believe, 19 percent capital requirements on assets. 

Chairman BROWN. Thank you. 

30 

A comment and then I wanted to do two more sort of quick 

rounds. Dr. Rosenblum’s written testimony compared megabanks to 

semi-trucks that need lower speed limits than passenger vehicles, 

something we are familiar with. If people would look at the chart 

to your right, to my left, Government assistance exceeds banks’ 

capital. The Government’s investments, loans, and guarantees to 

the three largest banks were significantly higher than the banks’ 

equity. However, if they had had 15 percent equity, they could have 

suffered—as Mr. Meltzer has said over and over and over again, to 

his credit, they could have suffered deep losses and still been solvent. So I think that speaks for itself. 

Mr. Evans, Professor Johnson notes that the GAO weights all socalled expert opinion equally regardless of whether the work is 

being produced in the public interest or Wall Street’s behest. You 

may remember—I think we are all fairly familiar with that—after 

Dodd-Frank was signed by the President of the United States, one 

of the leading lobbyist for the financial service industry said, ‘‘Now 

it is half time.’’ So you know the influence that Wall Street has. 

Their economic power has been enhanced. Their political power has 

been enhanced. 

So the question is—Professor Johnson said we need to sort out 

sensible analysis from sophisticated lobbying, his words. How is 

GAO doing that? 

Mr. EVANS. Thank you very much. I am happy to be able to address that particular issue. I do not think, first of all, that is a fair 

criticism based on this report because where we draw from some 

of the experts is just in identifying some of the challenges to implementing some of the provisions of Dodd-Frank. But how are we 

doing that? We do it how we typically do it. We are balanced, and 

fact-based in our approach. We reach out to all stakeholders. We 

talk to all affected parties. We do speak with banks about how they 

fund themselves. We speak with investor groups. 

And so our objective scope and methodology sections for all of our 

reports are clear about how we go about doing our work. And at 

the end of the day, we have to be able to make conclusions that 

are based on facts. And if we cannot do that, then we do not attach 

a GAGAS statement to our reports. So, again, we talk to everyone. 

Now, we are looking at academic research. Our economists are 

being quite rigorous in terms of which ones would qualify as reasonable estimates or reasonable approaches to estimating any subsidy that exists. 

We are aware of lobbying power. We are aware of conflicts of interest. In fact, when we reached out to academics to look at our 

model and our model specification, one of the things that we explored was conflicts of interest. We wanted to make sure that these 

individuals were free from those type of influences. 

Chairman BROWN. Well, I think some of you saw an article recently, I think a front-page piece in the New York Times in the last 

couple of weeks, about the conflicts of interest so often from academicians who speak with authority—— 

Mr. EVANS. That is right. 

Chairman BROWN. ——but that so often do not disclose their conflicts. And I hope that GAO will be acutely aware of that. 

31 

Mr. EVANS. For sure. That is why we did that rigorous exercise. 

And to be fair, you know, there are folks who believe they know 

whether a subsidy exists on both sides. In fact, some of the research assumes it and then estimates—or assumed that it does not 

exist and then comes out with estimates. 

Chairman BROWN. Dr. Johnson, a comment on that? 

Mr. JOHNSON. Well, just an observation to you, Senator. I have 

talked to the GAO. They reached out to me. They asked me my 

opinion and my assessment of the numbers and the work involved. 

They did not ask me if I have a conflict of interest. They did not 

ask me who pays for various parts of my activity. I mean, I would 

be happy to tell them. In fact, I put a lot of disclosures on my Web 

site. I hope that that was an exception, an aberration. I hope that 

they are ascertaining this information when they speak to other 

people. Maybe they will call me up tomorrow and get that part of 

the record straight. It does worry me that a lot of people work for 

the industry explicitly. I think that is not so problematic. But I 

know quite a few people who work for the industry without necessarily fully volunteering in all instances the full extent of the income and other benefits they derive from those interactions. 

Chairman BROWN. Some may be setting themselves up for future 

employment, to be cynical for a moment. 

Mr. Evans, you would like to comment on Dr. Johnson’s comment? 

Mr. EVANS. Yes. To be fair, certain folks we reach out to have 

an existing large body of work, like Professor Johnson. We do not 

always, you know, do it ahead of time. But ex post we know where 

folks are coming from. But, again, that is for our interview purposes. We reach out to a wide range of stakeholders. We are interested in their opinions. Those opinions do not influence what we 

saw or what we think at the end of the day. And, again, the academic studies have clear methodologies, so you can tell when they 

are using untoward assumptions or undertaking methodologies 

that raise questions about the validity of the estimates. So I think 

that is my response to Dr. Johnson. No, we did not ask him, but 

he has a body of research that we look at. 

Chairman BROWN. I hope that—and, again, thank you for your 

evenhandedness, Mr. Evans, and your public service and for the report and the report to come. I do hope that you heard loud and 

clear from me, from Dr. Johnson, and from others—and I think we 

cannot certainly speak for the public, but I think it is pretty clear 

that people want to make sure who these people are that are talking to you and who is paying whom and that you work even harder 

at doing that. But thank you for that. 

Mr. EVANS. I think that is fair. Thank you. 

Chairman BROWN. The last question to all of you is about investor disclosures. Section 50106C of the SEC’s codification of financial reporting policies requires that any financial assistance ‘‘that 

has materially affected or are reasonably likely to have a material 

future effect upon financial condition or results of operations 

should provide disclosure of the nature, amounts, and effects of 

such assistance.’’ It is difficult to argue that loans from the Fed, 

guarantees from the FDIC, capital injections from Treasury, it is 

hard to argue that they do not materially affect the future financial 

32 

conditions of these institutions. But during the bailouts, many 

large financial firms made representations about their financial 

conditions, failing to disclose, or they made vague disclosures regarding assistance provided to them by the Fed or Treasury or 

FDIC. This appears to be another example of regulatory forbearance, not requiring them to disclose what they should have, the 

regulatory forbearance that benefited the large banks, this time at 

investors’ expense. 

Just give me thoughts on how that needs to be—I assume you 

all think disclosure—I mean, that kind of goes without saying. How 

do we build accountability in this so there is not this lack of disclosure for investors? Dr. Zingales, do you want to start? 

Mr. ZINGALES. Yes. I think that I can see an argument for delayed disclosure. I can see that in some moments disclosing help 

in the moment as help takes place might create more financial instability, but I do not see any argument for not disclosing, let us 

say, 2 years later what the problem is. And I think that this delayed disclosure should be much more pervasive. For example, the 

Fed rates banks with some internal ratings called CAMELS ratings. Again, I think it is very useful not to disclose them at the 

time, but I do not see any reason why not disclose to the public 

subsequently so that we can assess how good the Fed is in disclosing—in measuring the solvency of banks, and we can improve 

if we find mistakes. 

Chairman BROWN. Dr. Johnson. 

Mr. JOHNSON. Senator, I think we should be trying to disclose as 

much as possible, subject to not destabilizing the world’s economy, 

obviously. And in this context, I would flag living wills for you. 

Now, some of these living wills are reportedly in the tens of thousands of pages—and those are the short ones—and we learn very 

little about what is in those living wills, either immediately or with 

some time delay. So I would reinforce Luigi’s suggestion just now 

that, with some time delay, the Fed should make more of that information public so we can go back and look and have some additional assessment of whether those living wills were indeed realistic plans that would lay out a road map through which bankruptcy could take place without causing global financial instability, 

which is the mandate. 

Chairman BROWN. Dr. Rosenblum. 

Mr. ROSENBLUM. I would agree with Simon on this accountability 

issue and a lot of information being disclosed with a lag. In real 

time, however, it can exacerbate the financial crisis to disclose too 

much. That is one of the dangers when you have to go to the lender 

of last resort. It is called the lender of last resort for a reason. 

Again, we have to take two steps back and put it into everyday language. If one of my children comes to me for help, they usually do 

not want their sibling knowing about it. They had to go to the 

Bank of Mom and Dad. That is what the Federal Reserve is, the 

lender of last resort, or we can think of it as the pawnbroker for 

the Nation. It is a collateralized loan. Nobody really wants it revealed in real time that they had to go there. But when you do go 

there, I agree—and the law is now explicit—it does have to be acknowledged and made public, but with a lag. 

33 

So there is a delicate balance there, but I come back to what Professor Zingales also said. I think there is a lot of bank examination 

information that is valuable that should be disclosed with a 2-year 

lag, maybe a 3-year lag. I am not sure what the right number is, 

but if the Comptroller of the Currency and the FDIC and the Fed 

are going to do their job, it has to be—I think disclosure and transparency would make them more accountable and have them do a 

better job than they are doing now and make capture, which is a 

word we were using before, less likely. 

Chairman BROWN. Dr. Meltzer. 

Mr. MELTZER. I will be very brief. I agree with what Professor 

Zingales said. 

Chairman BROWN. Thank you. That was very brief. You were always very brief, Dr. Meltzer. Thank you. 

Mr. MELTZER. Thank you. 

Chairman BROWN. Thank you all for your testimony and for your 

candor. Some Subcommittee Members may have written questions 

for you. Please answer those as quickly as possible. I appreciate the 

service that all of you have provided. 

The Subcommittee is adjourned. 

[Whereupon, at 11:48 a.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 

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PREPARED STATEMENT OF LAWRANCE L. EVANS, JR. 

DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT

ACCOUNTABILITY OFFICE

JANUARY 8, 2014 

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1Pietro Veronesi and Luigi Zingales, ‘‘Paulson’s Gift’’, Journal of Financial Economics, 2010: 

97(3):339–368. 2 Andrew Ross Sorkin, ‘‘Too Big To Fail’’, Penguin Books, October 20, 2009. 

3Oliver Hart and Luigi Zingales, ‘‘A New Capital Regulation for Large Financial Institutions’’, 

American Law and Economic Association Review, 2012. 

PREPARED STATEMENT OF LUIGI ZINGALES 

ROBERT C. MCCORMACK PROFESSOR OF ENTREPRENEURSHIP AND FINANCE, UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS

JANUARY 8, 2014 

Chairman Brown, Ranking Member Senator Vitter, Members of the Committee, 

thank you for inviting me. 

I have been asked to comment on the GAO study on the Government support of 

bank holding companies (BHCs)and in particular (1) on my estimates of the financial benefits enjoyed by the BHCs as a result of the extraordinary Government actions during the financial crisis; (2) on my views of how to address the issues identified in the GAO report using the authorities provided in the Dodd-Frank Act. 

Regarding the estimate of the financial benefits it is important to distinguish two 

components: pure transfer of value from taxpayers to bank’s investors and value created as a result of a reduction in the probability of a costly bankruptcy. 

Veronesi and Zingales (2010) calculate the expected Government cost of the two main programs (CPP and TLGP) to be $39.9bn. 1 By using this estimate and by 

making reasonable assumptions on the cost of the other programs, I obtain that the 

total expected cost of these programs was between $59bn and $89bn (see Table 1). 

This represents the pure transfer of value from taxpayers to BHC financial 

claimholders. 

Veronesi and Zingales (2010) also estimate that in case of bankruptcy, 22 percent 

of the enterprise value of a BHC vanishes. Thus, we can assess the value saved by 

computing the changes in the probability of bankruptcy triggered by the Government interventions. These estimates, however, will depend crucially on what 

counterfactual hypothesis we are willing to entertain, i.e., what we assume would 

have happened to the BHCs had the Government not intervened. 

I present two extreme scenarios. The lower bound, analyzed in Veronesi and 

Zingales (2010), only considers the differential benefit of the set of interventions announced Columbus day weekend 2008. Since even before that weekend the market 

was expecting the Government to intervene, these estimates only capture the effect 

of an increase in the probability of a Government intervention. Overall, this set of 

Government interventions saves $99bn, setting the total financial benefit enjoyed by 

BHCs at between $158bn and 188bn. 

To obtain an upper bound, I make the Jamie Dimon’s hypothesis that without 

Government intervention all the top ten BHCs would have failed (see Ross Sorkin 

(2009)). 2 In this case the value saved overall would be $1,461bn, with a total financial benefit enjoyed by BHCs between $1,520bn and $1,550bn. The wide range of 

these estimates shows how dependent the results are on the counterfactual used. 

On the second issue, I would like to classify the Dodd-Frank’s interventions in 

three groups: 

• Restrictions to interventions in case a BHC is in trouble (such as restrictions 

on the Federal Reserve 13(3) authority); 

• Reduction in the potential cost in case of bankruptcy (such as Living Wills); 

• Restrictions to risk taking in normal conditions (such Liquidity Requirements 

and Debt to Equity Ratio). 

I regard the first set of tools to be not only useless, but also harmful. As the ‘‘no 

bailout clause’’ of the European Union Maastricht Treaty has shown, these restrictions are routinely bypassed when the need arises. If they are not, it can be dangerous, since by the time a major BHC is in trouble, the cost of not intervening becomes very high. 

I regard the second set of tools as wishful thinking. A BHC’s incentive to design 

a proper ‘‘living will’’ equals the desire of a man, sentenced to death by hanging, 

to find the right tree at which to be hung. 

The only effective tool to eliminate a subsidy to large BHCs is to design a mechanism of prompt intervention, which is triggered much before a BHC becomes insolvent. Such mechanism, described in Hart and Zingales (2012), can be implemented 

using the authorities provided in Dodd-Frank. 3 It is sufficient that, by using its authority to set leverage standards, the Fed imposes a maximum price for the Credit 

Default Swap of BHC’s junior debt. A CDS price subsumes both the leverage posiVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00049 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
46 

tion and the riskiness of the underlying assets. Every time the CDS price exceeds 

the predetermined threshold for, let’s say, 30 days, the bank should be required to 

issue equity. If it does not, it should be taken over by the regulator and liquidated 

using the Ordinary Liquidation Authority under Dodd-Frank. The system works like 

a margin loan, made safe by the occasional margin calls. This is the most effective 

way to eradicate the ‘‘Too Big To Fail’’ problem. 

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1Simon Johnson is also a member of the Systemic Risk Council, a member of the Congressional Budget Office’s Panel of Economic Advisers, and a member of the FDIC’s Systemic Resolution Advisory Panel. All views expressed here are personal. For additional affiliations and disclosures, please see this page: http://BaselineScenario.com/about/. 

PREPARED STATEMENT OF SIMON JOHNSON 

RONALD KURTZ PROFESSOR OF ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF

MANAGEMENT

JANUARY 8, 2014 

A. Summary 1

1. The U.S. Government Accountability Office Report ‘‘Government Support for 

Bank Holding Companies: Statutory Changes to Limit Future Support Are Not 

Yet Fully Implemented’’ (GAO-14-18) provides some useful detail on the wide 

variety of support provided by the official sector to large bank holding companies during the financial crisis of 2007–10. The GAO is also correct that, even 

under the most favorable interpretation, there has been slow implementation of 

various key measures designed subsequently to make the financial system less 

risky. More than 5 years after the worst crisis since the 1930s, it is remarkable 

how little has been achieved by regulators. 

118 

2This point is mentioned in the report, but there is no attempt to provide a quantitative value 

for this important dimension of support. The firms involved, including Goldman Sachs and Morgan Stanley, may well have failed without this change in their legal status, which signaled that 

it would now be much easier for them to borrow from the Fed. 3 In fairness, the GAO has attempted to deal with this broader issue in other work (e.g., see 

http://www.gao.gov/products/GAO-13-180). 4Most of this fiscal impact is not due to the Troubled Assets Relief Program—and definitely 

not due to the part of that program which injected capital into failing banks. Of the change in 

CBO baseline, 57 percent is due to decreased tax revenues resulting from the financial crisis 

2. The GAO report makes it clear that official sector support was provided disproportionately to some of the largest bank holding companies (and other large 

financial institutions) in the United States, because these firms faced very large 

(relative to firm size and relative to the macroeconomy) liquidity and solvency 

issues. 

3. However, the report has seven prominent limitations that should be considered 

when we reflect on potential policy for the future: 

a. There is insufficient consideration given to risk-adjusted returns. The GAO 

seems to accept at face value the Federal Reserve and Treasury position that 

‘‘all of the Federal Reserve and FDIC assistance was fully repaid with interest.’’ 

But evaluating any such support as an investment should also involve consideration of the risks involved. For example, we could reasonably ask—what would 

the private sector have charged to provide this amount of funding under such 

terms, and on a risk-adjusted basis, what was the effective subsidy provided to 

big banks? 

b. It does not consider the full scope of support provided by the Federal Reserve 

System, including the dollar value of allowing some financial sector firms to 

convert to bank holding companies at the height of the crisis. 2

c. It is also mostly silent on the ways in which monetary policy has become a 

mechanism for transferring wealth from savers to financial intermediaries, 

through very low interest rates. 

d. There were alternative ways for the Government to support the economy, including through ‘‘liquidity loans’’ to households who were underwater on mortgages. Was it cost effective for the Government support banks directly and not 

provide substantial assistance to homeowners—many of whom would have experienced a recovery in asset values if they had been afforded loans on the kinds 

of terms available to large complex financial institutions? 

e. It does not fully explore the full scope of U.S. official support provided more 

indirectly to large foreign banks (e.g., through ensuring that AIG counterparties 

were paid in full), and the ways in which this did or did not help parts of the 

U.S. financial sector. 

f. It does not integrate a full analysis of the fiscal costs of the crisis, i.e., how 

much the Government’s debt increased as a result of lost revenue and other impacts. 3 The GAO report should therefore be read as measuring some ‘‘direct’’ 

costs of intervening to help large financial institutions, rather than as measuring the full cost to the taxpayer of the downside insurance provided by the 

official sector. 

g. Perhaps most worryingly for the validity of future analysis, the GAO seems 

to weight all ‘‘expert’’ opinion equally, irrespective of whether the work in question was undertaken by people who work for big banks. In this context, I would 

flag the specific mention of work by the Bipartisan Policy Center on p. 51, but 

this issue seems to come up throughout the report. If the GAO cannot sort out 

sensible analysis from sophisticated lobbying, then its important follow-up report on the current value of implicit subsidies to large banks is unlikely to have 

much value. The negative reputational effect on the credibility of the GAO, Congress, and the executive branch (including the Fed) would be considerable and 

most unfortunate. 

4. To understand the full fiscal impact of the deep finance-induced recession, look 

at changes in the CBO’s baseline projections over time. In January 2008, the 

CBO projected that total Government debt in private hands—the best measure 

of what the Government owes—would fall to $5.1 trillion by 2018 (23 percent 

of GDP). As of January 2010, the CBO projected that over the next 8 years debt 

will rise to $13.7 trillion (over 65 percent of GDP)—a difference of $8.6 trillion. 

Over the cycle, therefore, these CBO projections imply that debt relative to GDP 

will be 50 percentage points higher than it would be otherwise, as a direct result of the severity of the crisis. 4

119 

and recession; 17 percent is due to increases in discretionary spending, some of it the stimulus 

package necessitated by the financial crisis (and because the ‘‘automatic stabilizers’’ in the 

United States are relatively weak); and another 14 percent is due to increased interest payments on the debt—because we now have more debt. 5 I’m a member of the committee, and these points were covered in the first session of the 

committee’s discussion on that day. 

5. Excessive risk taking by large financial firms—including but not limited to 

U.S. bank holding companies—was a central element of both the global credit 

boom in the years prior to 2008 and why the U.S. (and the world) experienced 

such a severe crisis after the collapse of Lehman Brothers. 

6. Bailouts and myriad forms of downside protection extended to creditors, shareholders, and executives of large bank holding companies—and to nonbanks that 

were allowed to become bank holding companies during the crisis—confirmed 

that some of these firms have become ‘‘too big to fail.’’ In the fall of 2008, top 

officials became convinced that allowing these firms to default on their obligations and potentially go bankrupt would worsen the global panic and damage 

the U.S. real economy. 

7. Measures taken subsequently—including the Dodd-Frank financial reform legislation and actions by regulators—have been intended to reduce systemic risk 

and end the phenomenon of ‘‘too big to fail.’’ Unfortunately, as the GAO points 

out, relatively little progress has been made even within the framework of 

Dodd-Frank. 

8. The remainder of this testimony assesses what should be done within or beyond the Dodd-Frank framework. Specifically, what we have learned over the 

past decade suggests that: 

a. Requiring that all failing financial institutions go through bankruptcy, without any form of Government support, is appealing but not likely to work with 

the current scale, scope, and complexity of large international financial institutions. Changing the bankruptcy code is unlikely to provide the kind of systemic 

stability that is desirable in a crisis—unless the official sector is again willing 

to step in with financing. 

b. The Federal Deposit Insurance Corporation has made some progress with its 

Single Point of Entry approach to bank resolution. This could be helpful in some 

situations, but the FDIC is also likely to encounter serious implementation 

problems due to the difficulties of cross-border cooperation. 

c. The living wills provision of Dodd-Frank has so far been interpreted very 

narrowly by regulators. The intent of the law is that every financial institution 

should be able to go bankrupt within the existing code, without that destabilizing the world economy. This is already the case for small and medium-sized 

financial institutions in the U.S.; the problem is the largest handful of banks. 

d. The logical requirement is that these banks should be limited in their scale, 

with a cap on the size of their nondeposit liabilities as a percent of GDP. There 

are some encouraging indications that the Federal Reserve is moving in this direction, but the pace of sensible change remains glacial. 

B. The Problem With Bankruptcy 

It is very appealing to simply say: we will never provide support to a failing financial company; all such companies must go through bankruptcy, just as nonfinancial 

companies do. And this is exactly the intent of Title I in Dodd-Frank. 

Unfortunately, with the current scale, scope and complexity of very large financial 

institutions in the United States, this threat is not credible—meaning that it will 

likely not be carried out because it is not ‘‘time consistent.’’ Promises made today 

will not be implemented in a serious crisis because the consequences of following 

through would be too severe—and therefore officials will seek alternatives that involve some form of bailout. 

These points became clear beyond a reasonable doubt at a public meeting at of 

the Federal Deposit Insurance Corporation’s Systemic Resolution Advisory Committee on December 11, 2013. Proponents of bankruptcy-as-a-viable-option acknowledged that this would require substantial new legislation, implying a significant 

component of Government support (or what would reasonably be regarded as a form 

of ‘‘bailout’’ to a failing company and its stakeholders). 5

In other words, as matters currently stand—under the existing code or under any 

potential version of a ‘‘Chapter 14’’ that would preclude official financial support— 

bankruptcy for a big financial company would imply chaotic disaster for world markets (as happened after Lehman Brothers failed). 

120 

The proponents of bankruptcy readily acknowledged that handling the collapse of 

such a company in an ‘‘orderly’’ fashion—i.e., without causing global panic—would 

require a large amount of credit being made available to the relevant bankruptcy 

judge (or to some form of a court-appointed trustee). 

But who could possibly provide the amount of credit necessary to be stabilizing, 

particularly at a moment of systemic nervousness or potential panic? The only potential credit source available would be the United States Government, either 

through the Treasury Department or the Federal Reserve. 

Under current legislation, providing such funding to a specific firm would be illegal. It would also be very awkward politically. Remember the justifiable resentment 

when Congress was asked to fund the $700 billion Troubled Asset Relief Program 

in September 2008, to be run with the Treasury—initially with very little accountability. Now we are being asked to fund activities that are being overseen by bankruptcy judges (and trustees), who could decide, for example, to keep on current management. How would that play politically? 

One argument is that such official loans would be ‘‘safe’’ because the Government 

will definitely not lose the principal of its loan. But such assertions are not justified. 

Sometimes Government emergency financial support can earn a decent risk-adjusted return, if troubled assets sufficiently recover their value. More often, the Government ends up handing over a very large subsidy. 

Bankruptcy cannot work for big banks—the largest half-dozen or so—at their current scale and level of complexity. It is not a viable option under current law. And 

changing the law to add a bailout component to bankruptcy—but only for very large 

complex financial institutions—does not pass the laugh test. 

It is completely unrealistic to propose ‘‘fixing’’ this problem with legislation that 

would create a new genre of bailouts (or the pretense of ‘‘no bailout’’, until the next 

crisis, where there would again be bailouts of the Paulson-Bernanke-Geithner variety). 

Under current law—and as a matter of common sense—the Federal Reserve 

should take the lead in forcing megabanks to become smaller and simpler. 

The legal authority for such action is clear. Under Section 165 of the 2010 DoddFrank financial reform legislation, large nonbank financial companies and big banks 

are required to create and update ‘‘the plan of such company for rapid and orderly 

resolution in the event of material financial distress or failure.’’ The design is that 

this plan—known now as a ‘‘living will’’—should explain how the company could go 

through bankruptcy (i.e., reorganization of its debts under Chapter 11 or liquidation 

under Chapter 7 of the Bankruptcy Code) without causing the kind of collateral 

damage that occurred after the failure of Lehman Brothers. 

This bankruptcy should not involve any Government support. It is supposed to 

work for these large financial companies just as it would for any company, with a 

bankruptcy judge supervising the treatment of creditors. Existing equity holders, of 

course, are typically ‘‘wiped out’’—the value of their claims is reduced to zero. 

The full details of these living wills are secret, known only to the companies and 

the regulators. (The Systemic Risk Council, chaired by Sheila Bair, has called for 

greater disclosure of important details. I am a member of that Council.) 

The discussion at the FDIC in December helped make clear that these living wills 

cannot be credible—either from a bankruptcy or resolution perspective—because the 

big banks are incredibly complex, with cross-border operations and a web of interlocking activities. 

When one legal entity fails, this leads to cross-defaults—and then the seizure of 

assets around the world by various authorities and enormous confusion regarding 

who will be paid what. When any single megabank starts to go down, others will 

certainly come under intense market pressure, in part because the value of their 

assets will fall and in part because a sense of panic will spread—this is how such 

crises become ‘‘systemic.’’ 

All of these effects are exacerbated by the fact that these companies are also highly leveraged, with much of this debt structured in a complex fashion (including 

through derivatives). The bankruptcy experts at the FDIC meeting stressed these 

points in fascinating detail. 

What then are the implications? The Dodd-Frank Act has some specific language 

about what happens if the resolution plan of a nonbank financial company supervised by the Board of Governors or a bank holding company described in subsection 

(a) is not credible or would not facilitate an orderly resolution of the company. 

Cross-border issues would be an insurmountable obstacle for bankruptcy with the 

current structure of large global financial firms. They would likely also create a 

121 

6The FDIC has received an expression of potential cooperation from the Bank of England. 

Unfortunately, this and other vague statements are unlikely to hold up under the pressure of 

many real world situations. Only a binding treaty on cross-border resolution could really make 

a difference and this is unlikely for the foreseeable future. 7For the FDIC’s approach to resolution to work, there has to be enough ‘‘bailinable debt’’ and 

equity at the holding company level. The Federal Reserve has yet to issue proposed rules for 

comment on this key topic—and their slowness on this issue is a matter for grave concern. It 

is also remains to be seen what is really ‘‘bailinable debt’’—what kinds of investors can own 

this without raising concerns of contagion and systemic risk when and if this debt is converted 

to equity (or is just wiped out) in a crisis. 

major problem for any attempt to apply the FDIC’s preferred Single Point of Entry 

approach. 6

Not unreasonably, under Section 165 of Dodd-Frank, the Fed and the FDIC may 

jointly impose more stringent capital, leverage, or liquidity requirements, or restrictions on the growth, activities, or operations of the company, or any subsidiary 

thereof, until such time as the company resubmits a plan that remedies the deficiencies. 7

The company may also be required ‘‘to divest certain assets or operations identified by the Board of Governors and the corporation, to facilitate an orderly resolution.’’ 

The retort of the big banks is, ‘‘We can skip bankruptcy and go directly to Title 

II resolution,’’ which allows the FDIC to step in and take charge of a failing financial company. But the Title II (of Dodd-Frank) authority is intended as a back-up— 

to be used only if, contrary to expectations, bankruptcy does not work or chaos 

threatens. 

If it is clear ex ante that bankruptcy cannot work—and this is now completely 

clear—then the implications of the statute are not controversial. The Fed and the 

FDIC must require remedial action, meaning that something about the size, structure, and strategy of the megabanks must change. 

This is the logic of our current situation. Section 165 is potentially valuable, but 

only if the relevant officials recognize this reality and act on it—precisely with the 

goal of making bankruptcy under the existing code into a feasible option for all 

firms in the U.S. economy. 

C. Assessment of the Volcker Rule 

The announcement in December 2013 of the Volcker Rule, restricting proprietary 

trading and limiting other permissible investments for very large banks, is a major 

step forward. Almost exactly 4 years after the general idea was first proposed by 

Paul A. Volcker, the former chairman of the Federal Reserve, and nearly 31⁄2 years 

since it became law, the regulators have finally managed to produce a rule. 

This rule could be meaningful, and this is why there has already been so much 

pushback from the big banks. Their main strategy so far—denial that there is a 

problem to be addressed—has failed completely. Their legal challenges are also unlikely to succeed. The main issue now is whether the regulators force enough additional transparency so that it is possible to see the new ways that proprietary bets 

are hidden. 

The Volcker Rule is intended to impact only the very largest banks—the material 

impact will be mostly on JPMorgan Chase, Bank of America, Citigroup, Goldman 

Sachs, and Morgan Stanley. The goal is simple and sensible. Given that these banks 

are supported by large implicit Government backstops (e.g., from the Federal Reserve), they should be more careful in their activities and should not engage in 

large-scale bets that have the potential to cause insolvency for them and disruption 

for the rest of the global financial system. 

These companies could choose to become smaller, with the constituent pieces operating under fewer restrictions. But their managements want to stay big, so they 

should face additional constraints. 

The first pushback strategy—and the main focus of big bank efforts to date—is 

to deny that the Volcker Rule is needed at all. This line has been pushed hard over 

the last 4 years, including at a Senate hearing in February 2010. 

Barry Zubrow, then chief risk officer at JPMorgan Chase, testified that the 

Volcker Rule was not needed, as risk controls in big banks were sufficient to the 

task. (I also testified at the hearing, in favor of the rule.) The extent to which 

JPMorgan Chase subsequently managed its own risks—including proprietary trading-type activities run out of its chief investment office—has been called into question. Mr. Zubrow retired at the end of 2012, telling his colleagues, ‘‘We have learned 

from the mistakes of our recent trading losses.’’ 

I hope that is true, but it seems unlikely, because the name of the game for very 

large banks is leverage, i.e., taking big bets using a lot of borrowed money and very 

122 

8On this point, see Anat Admati and Martin Hellwig, ‘‘The Bankers’ New Clothes: What’s 

Wrong With Banking and What To Do About It’’, Princeton University Press, 2013. A close reading of this book suggests that the recently proposed supplemental leverage ratio is a step in 

the right direction—but only a small step that is likely to prove insufficient. The increase in 

capital requirements under Basel III is also unlikely to make much difference—one senior official recently described this as moving maximum permissible leverage (debt relative to total assets) from 98–99 percent pre-2008 to around 97 percent for the future. 9See http://www.federalreserve.gov/newsevents/speech/tarullo20121010a.htm. He made 

similar points in a speech at the Brookings Institution in December 2012 and in testimony before the Senate Banking Committee in February 2013. 

little equity. 8 This is how to boost your return on equity, unadjusted for risk, which 

is what financial analysts (and the related news coverage) focus on. Most regulators 

now have this point much more clearly in their minds. 

At the same time, Mr. Zubrow and others asserted that the introduction of any 

kind of Volcker Rule would have a big negative effect on financial markets and the 

economy. But as the adoption of the rule has approached, financial markets have 

taken that news completely in stride. Yes, we have lower employment levels than 

we would like, but that’s primarily due to the large financial crisis since the Great 

Depression, brought on by excessive risk-taking (for example, at Citigroup). 

The conceptual fight against the Volcker Rule has been lost by the big banks, at 

least in part because of the London Whale losses overseen by Mr. Zubrow and his 

colleagues—but also because enough regulators have finally wised up to how the big 

banks really operate and why that can damage the real economy. 

Treasury Secretary Jack Lew also deserves credit for pushing the rule toward the 

finish line and for insisting that top management be held accountable for whether 

companies comply with the law. 

The second pushback strategy is legal—to bring one or more cases through the 

courts that will challenge key aspects of the Volcker Rule. Eugene Scalia, the son 

of Supreme Court Justice Antonin Scalia, has had some success with this strategy 

on other financial regulatory matters. 

But, as former Congressman Barney Frank has pointed out, the new Senate rules 

mean that we should expect confirmation of three new judges on the U.S. Court of 

Appeals for the District of Columbia Circuit, which is where the Volcker Rule would 

need to be challenged. The chances of a successful legal case have therefore receded, 

although what happens when and if such a matter reaches the Supreme Court remains unclear. 

The third strategy is to find new ways to hide the essence of proprietary trading— 

and this is an important open issue. Will there be enough disclosure and observable 

behavior for either the regulators or people on the outside to see whether the spirit 

of the Volcker Rule is being followed? For example, how exactly will traders be compensated and how much of this will be disclosed? Will data be available on trading 

activities, allowing independent researchers to look for patterns that might otherwise elude officials? 

The Volcker Rule could be a major contribution to financial stability. Or it could 

still flop. The devil now is in the details of implementation and compliance—and 

how much of this becomes public information and why what time lag. 

D. Some Limited Grounds for Optimism 

There are some recent indications of changes in thinking at the most senior levels 

of the Federal Reserve System. 

Specifically, beginning in October 2012, Governor Daniel K. Tarullo has articulated the potential case for limiting the size of our largest banks, measured in terms 

of their nondeposit liabilities as a percent of GDP. 9

First and foremost, the Fed has begun to recognize and discuss publicly the implicit subsidies that large banks continue to receive, 

To the extent that a growing systemic footprint increases perceptions of at 

least some residual too-big-to-fail quality in such a firm, notwithstanding 

the panoply of measures in [the] Dodd-Frank [Act] and [Federal Reserve] 

regulations, there may be funding advantages for the firm, which reinforces 

the impulse to grow. There is, then, a case to be made for specifying an 

upper bound [on size]. 

The implication is that we should not allow the size of our largest bank holding 

companies to increase further, although Mr. Tarullo seems to want to pass the buck 

back to Congress. 

In these circumstances, however, with the potentially important consequences of such an upper bound and of the need to balance different inVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00126 Fmt 6621 Sfmt 6621 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
123 

10See the proposed SAFE Banking Act proposal and TBTF Act. 1The views expressed are my own and are not necessarily those of the Federal Reserve Bank 

of Dallas or the Federal Reserve System where I worked for over 40 years before retiring on 

Nov. 1, 2013. 

terests and social goals, it would be most appropriate for Congress to legislate on the subject. If it chooses to do so, there would be merit in its adopting a simpler policy instrument, rather than relying on indirect, incomplete 

policy measures such as administrative calculation of potentially complex financial stability footprints. The idea along these lines that seems to have the 

most promise would limit the nondeposit liabilities of financial firms to a 

specified percentage of U.S. gross domestic product, as calculated on a 

lagged, averaged basis. In addition to the virtue of simplicity, this approach 

has the advantage of tying the limitation on growth of financial firms to 

the growth of the national economy and its capacity to absorb losses, as 

well as to the extent of a firm’s dependence on funding from sources other 

than the stable base of deposits. While Section 622 of Dodd-Frank contains 

a financial sector concentration limit, it is based on a somewhat awkward 

and potentially shifting metric of the aggregated consolidated liabilities of 

all ‘financial companies.’ [emphasis added] 

Hopefully, there will be support for legislation along exactly these lines—as proposed by Senator Sherrod Brown and by Senator Brown with Senator David Vitter. 10

The Federal Reserve could help articulate the case for such legislation with greater clarity. 

It would also be most helpful if a vice chairman for supervision could be appointed 

to the Federal Reserve Board. The creation of this position is a requirement of the 

Dodd-Frank Act that, rather inexplicably, remains completely unaddressed by the 

Obama administration. 

PREPARED STATEMENT OF HARVEY ROSENBLUM 

ADJUNCT PROFESSOR OF FINANCE, COX SCHOOL OF BUSINESS, SOUTHERN METHODIST

UNIVERSITY, AND RETIRED DIRECTOR OF RESEARCH, FEDERAL RESERVE BANK OF

DALLAS

JANUARY 8, 2014 

Chairman Brown, Ranking Member Toomey, and Members of the Subcommittee: 

I am pleased to testify on Too Big to Fail (TBTF) subsidies and related issues stemming from the 2008–09 Financial Crisis. In doing so, I will indirectly comment on 

some of the more glaring inadequacies of the Dodd-Frank Act which, though wellintentioned, simply will not end TBTF. 1 Dodd-Frank leaves the U.S. and global financial systems more crisis-prone than previously. To end TBTF and the financial 

instability it engenders, it is necessary that Congress amend the laws and incentives governing the provision of financial services by following a few basic principles. 

First, incentives matter. Dodd-Frank has done little to alter the widespread perception that the U.S. Treasury and the Federal Reserve will once again provide extraordinary Government assistance to giant financial institutions that get themselves into financial trouble. Promises to end TBTF are easy to make, but like all 

promises, are difficult to keep in the face of a financial crisis. The stockholders, 

creditors, and other counterparties of giant financial institutions know this—and act 

accordingly. This perception enables giant financial institutions to grow faster, larger and more dangerously than smaller institutions and provides a distinct cost advantage to the giants. This is the source of a huge $50–100 billion annual subsidy 

that flows to the giant financial institutions in perpetuity [Bank for International 

Settlements, 2012]. 

Congress has never voted to approve this annual expenditure; it came about inadvertently as technology changed, Congress allowed interstate banking, and Congress 

ended the separation between investment banking, insurance and commercial banking. The net result is that public policy now subsidizes the growth of large, risky, 

and unmanageable financial institutions that create systemic financial instability, 

the opposite of what public policy professes to seek to achieve. 

Second, initial conditions matter. Fewer than a dozen giant banking institutions 

control around 70 percent of industry assets, up considerably from the years just 

prior to the financial crisis. Our financial services industry has gotten more concentrated; the playing field is less level; and Government policy, perhaps unintentionally, will continue to foster ever more consolidation, concentration, and reduced 

124 

competition in financial services. To believe otherwise requires a willful blindness 

to what should be obvious to observers of our financial system. As Yogi Berra once 

said: ‘‘Sometimes you can observe a lot, just by looking.’’ 

Competition is being further reduced by a merger and acquisition wave among 

small-to-medium size banking institutions in response to the enormity of the regulatory compliance costs of dealing with Dodd-Frank. In addition, new entry into 

banking has been at a near-standstill for the last 5 years. In these circumstances, 

it would be wishful thinking on my part to believe that the normal forces exerted 

by capitalism and free markets are capable of reversing these competitive imbalances. Economics 101 teaches us that proper incentives and competition allow market 

forces to solve most economic problems. Banking is plagued by the perverse incentives of TBTF, combined with ever-diminishing competition. 

When all of the costs of the 2008–09 Financial Crisis are added up, the costs to the United States will amount to $15–30 trillion [Atkinson, Luttrell, and 

Rosenblum, 2013]. Yes, I said trillion. This is 1-to-2 years of U.S. output down the 

drain. Allow me to translate this into everyday language the average person can understand; a conservative estimate is that the crisis cost $50 thousand to $120 thousand for every U.S. household [Luttrell, Atkinson, and Rosenblum, 2013]. Many of 

these costs were largely avoidable. What is worse, unless Government policies and 

incentives on TBTF subsidies are changed, another financial crisis, likely worse 

than the last one, may occur in the not-too-distant future. 

The TBTF Subsidy. I commend the recent GAO study of the TBTF subsidy [GAO, 

2013]. As you know, the GAO’s study is part one of a two-part study quantifying 

the subsidy received by the surviving TBTF firms. The study quantifies the financial 

benefits conferred on the TBTFs during the financial crisis. Part two, the more important study, will measure the ongoing subsidy received by the TBTFs postcrisis. 

This subsidy is large, though its exact size varies from year-to-year and business 

cycle to business cycle. The subsidy grossly distorts normal market forces. As one 

observer has noted, the subsidy serves as a ‘‘shadow poison pill’’ not only making 

the TBTF firm immune to corporate threats but degrading the customary governance forces that would lead to the rightsizing of the firm [Roe, 2013]. 

The subsidy, moreover, enables the giant banks to grow larger and more dangerous to our economic system; but it is difficult to measure precisely. There is no 

line item on a bank’s balance sheet or income statement labeled ‘‘TBTF Subsidy’’. 

But it exists and it is pernicious in its impact. It is legal; the giant financial institutions are merely responding to the incentives presented to them, not necessarily violating any laws. 

The TBTF subsidy, in theory, should accrue to the equity shareholders of the 

giant banking institutions. In practice, a substantial portion of the TBTF subsidy 

is dissipated away in the form of higher management salaries, bonuses, and perquisites; inefficient operations; and corporate waste. Unlike other industries, hostile 

takeovers by corporate raiders, hedge funds, and private equity firms are impossible 

in the case of giant banking institutions. Short of a Government-ordained merger 

in the face of an impending failure, there is simply no market mechanism to effectuate a change in corporate control at the largest banking institutions. 

Restoring Competition and Reducing TBTF Subsidies. Recently, I was the coauthor of a plan that sought to utilize market forces to reduce the TBTF subsidy, 

level the competitive playing field in banking, and most importantly, lessen the likelihood of incurring another round of horrendous costs from another avoidable financial crisis [Fisher and Rosenblum, 2013a]. As a Nation, we simply cannot afford to 

repeat previous mistakes. 

The reform plan we advocated—which has since become known as ‘‘the Dallas Fed 

Plan’’—would: (1) restrict the Federal safety net of deposit insurance and access to 

the Federal Reserve’s lender of last resort facilities to traditional depository institutions; (2) require every customer of nonbank financial institutions to acknowledge 

in writing that the U.S. Government provides absolutely no backstop or financial 

guaranty for their transactions; and (3) call for Government policies that strongly 

encourage the managements of the Nation’s largest banking institutions to streamline, simplify, and downsize their companies so that any and all banking affiliates 

of the financial holding company would be certified by the FDIC as ‘‘Too Small to 

Save’’ in the event of failure. These three steps would realign incentives away from 

the current perverse TBTF mindset and would reestablish a more competitive 

framework within the banking industry. Dallas Fed President Richard Fisher continues to advocate the Dallas Fed Plan. To some extent, several of the giant institutions have begun downsizing and streamlining, but at a snail’s pace [Fisher and 

Rosenblum, 2013b], a process that the stock market, by way of price-to-tangible 

book value ratios, is urging management to pursue [Fisher and Rosenblum, 2013c]. 

125 

Would the Dallas Fed Plan end banking and financial crises? Probably not; financial crises have characterized the global banking and financial system for over three 

centuries and will likely continue to do so. However, I firmly believe that the Dallas 

Fed Plan, which operationally could be thought of as a plan to mitigate moral hazard, would considerably reduce the frequency and severity of financial crises in the 

United States. No financial reform plan is perfect, but we should not let our quest 

for perfection distract us from making significant improvements to the architecture 

of our financial system. 

Alternative Means to Reduce the Impact of TBTF Subsidies. I believe the Dallas 

Fed Plan is the best financial reform plan. But there are several other good reform 

plans worthy of consideration. I will mention two that would reinforce the virtues 

of the Dallas Fed Plan by helping to get the incentives right and by having the additional benefit of enforceability due to their transparency and simplicity. 

One is the Subsidy Reserve Plan advocated by Boston University Professor 

Cornelius Hurley. This plan is the subject of legislation (H.R. 2266) filed by Congressman Michael Capuano in 2013. 

Professor Hurley’s plan would require the GAO, together with the Federal Reserve and the Office of Financial Research to determine the size of the TBTF subsidy for each of the giant banking institutions, and then lock up that amount so that 

it could only be distributed to shareholders and other stakeholders in connection 

with the downsizing of the TBTF firms [Hurley, 2013]. The appeal of this plan is 

its reliance on market discipline as opposed to arbitrary break-up plans and caps 

on growth. 

While I can imagine intense debate over determining the acceptable methodology 

for measuring the TBTF subsidy, I still believe the Subsidy Reserve Plan has a lot 

of merit. Part two of the GAO’s study due later this year may be an important milestone in advancing our understanding of the TBTF subsidy. 

In any event, recent-day banking regulation is plagued by endless debate over 

how much bank capital is ‘‘adequate,’’ as well as which categories of capital qualify 

for covering losses. After more than a century, measuring the adequacy of bank capital remains a continuing debate. As with capital requirements, the most important 

thing is not that we measure the subsidy with scientific precision but that we ensure that our quantification of the subsidy is directionally accurate. 

In this context, I should mention the Brown-Vitter Bill, which seeks to impose a 

15 percent capital-to-assets ratio on all giant banking institutions, a ratio much 

higher than has been imposed or voluntarily adhered to by banking institutions for 

over half a century, if not longer [Brown and Vitter, 2013]. For most banking institutions, a 15 percent capital-to-assets ratio seems to me to be too high. For the giant 

banking institutions, however, a 15 percent capital-to-assets ratio seems to be barely 

adequate given the systemic repercussions that would follow the failure of such a 

giant banking institution. 

We sometimes set different highway speed limits for 18-wheelers carrying hazardous substances than we do for automobiles carrying a few passengers. We also 

do not encourage self-regulation of speed limits by drivers. Perhaps this analogy 

provides some lessons for the necessary transparency, simplicity, and enforceability 

of capital regulations for banks. Let me conclude with a sweeping but appropriate 

generalization: when it comes to regulation of the banking industry in general, and 

capital in particular: complexity is the enemy. Complexity makes regulation unintelligible and thereby unenforceable; it can sometimes be worse than no regulation at 

all. Let me be more specific—the Basel rules on bank capital regulation and DoddFrank have caused more harm than good. Basel rules have encouraged institutions 

to load up on ‘‘safe’’ assets like mortgage securities and sovereign debt, and DoddFrank, 31⁄2 years after being signed into law, is only about halfway through its regulation-writing phase and has already produced more than 14,000 pages of proposed 

regulations. 

Back to the Drawing Board: If It Is Not Workable, It Simply Will Not Work. I 

know it is difficult for those who supported Dodd-Frank to acknowledge its largely 

unworkable nature. Delegating rulewriting responsibility to more than a dozen 

agencies has produced irrational unaccountability. The perverse incentives of TBTF 

have been perpetuated and hidden within thousands of pages of inscrutable regulations confounded by conflicts and complexity. The regulations are simply a kaleidoscopic reflection of the underlying statutes. 

There is a simpler and better alternative. The Dallas Fed Plan, perhaps combined 

with the Subsidy Reserve Plan and the Brown-Vitter Bill, could postpone the next 

financial crisis for a decade or two. This would require, however, that the resulting 

statute is no more than about 10 pages long, with the added requirement that its 

resulting regulations must be written using fewer words than the statute. 

126 

References 

Atkinson, Tyler, David Luttrell, and Harvey Rosenblum, ‘‘How Bad Was It? The 

Costs and Consequences of the 2007–09 Financial Crisis’’, Federal Reserve Bank 

of Dallas, Staff Papers, July 2013. 

Bank for International Settlements, BIS Annual Report 2011/12, June 24, 2012, pp. 

75–76. 

Brown, Sherrod, and David Vitter, ‘‘Terminating Bailouts for Taxpayer Fairness Act 

(TBTF Act)’’, S.798, 2013. 

Fisher, Richard, and Harvey Rosenblum (2013a), ‘‘Vanquishing Too Big to Fail’’, 

Federal Reserve Bank of Dallas, 2012 Annual Report. 

Fisher, Richard, and Harvey Rosenblum (2013b), ‘‘Why We Must Downsize Banking 

Behemoths Into ‘Too Small To Save’ Entities’’, Dallas Morning News, Sept. 12, 

2013. 

Fisher, Richard, and Harvey Rosenblum (2013c), ‘‘A Credible Path for Ending Too 

Big to Fail’’, Business Economics, Vol. 48, No. 3, pp. 167–73. 

GAO, ‘‘Government Support for Bank Holding Companies: Statutory Changes To 

Limit Future Support Are Not Yet Fully Implemented’’, GAO-14-18, November 

2013. 

Hurley, Cornelius, ‘‘End ‘Too Big to Fail’ by Making It Shareholders’ Problem’’, 

American Banker, January 23, 2013. 

Luttrell, David, Tyler Atkinson, and Harvey Rosenblum, ‘‘Assessing the Costs and 

Consequences of the 2007–09 Financial Crisis and Its Aftermath’’, Federal Reserve Bank of Dallas, Economic Letter, Vol. 8, No. 7, September 2013. 

Roe, Mark J., ‘‘Structural Corporate Degradation Due to Too-Big-To-Fail Finance’’, 

University of Pennsylvania Law Review, forthcoming, (Draft dated November 7, 

2013). 

PREPARED STATEMENT OF ALLAN H. MELTZER 

THE ALLAN H. MELTZER UNIVERSITY PROFESSOR OF POLITICAL ECONOMY, CARNEGIE

MELLON UNIVERSITY TEPPER SCHOOL OF BUSINESS

JANUARY 8, 2014 

I am very pleased to testify on financial soundness before this Committee. Much 

has changed since the financial crisis of 2008. I will comment on the adequacy of 

some of the measures and propose some more effective procedures including passage 

by the Congress of the Brown-Vitter legislation. 

Let me begin by stating two principles that should guide your efforts. 

First principle: legislation should increase incentives by bankers and financial 

firms to act prudently. In an uncertain world, we cannot always know the prudent 

course. Owners and managers are most likely to act prudently, if they bear the cost 

of errors, mistakes, and unforeseen events. They will be more willing to cushion 

risks and uncertainties. 

Second principle: regulation must provide rules that prevent single bank failures 

from threatening the financial system. More than a century ago, careful analysts 

understood that the public responsibility was to protect the payments system because a breakdown of the payments system stops all or most economic activity. Fear 

and uncertainty cause banks to refuse to accept payments drawn on other banks. 

That is what happened in the Great Depression. That was what started to happen 

in 2008 after Lehman Brothers failed. Timely, aggressive action by the Federal Reserve prevented the payments breakdown. 

The second principle has wrongly devolved into actions to protect banks. There 

is no economic justification for that as a public responsibility. I repeat: The public 

responsibility is to protect the payments system, not the banks or bankers. The proper 

way to separate the two is to impose procedures that prevent a failing bank from 

threatening the payment system. That requires four or five actions. 

1. A clearly stated announced rule for the lender-of-last resort. A well-known rule 

that has been used successfully calls for the Federal Reserve to lend freely on 

good collateral at a penalty rate. In its first hundred years, the Federal Reserve 

has often discussed its lender-of-last-resort policy internally, but it has never 

announced its policy. Announcement is important, indeed crucial. It tells potential users well in advance how to prepare their balance sheets and to hold collateral against which they can borrow from the Federal Reserve in a crisis. It 

avoids panic by enforcing it announced rule. 

2. It does not wait to choose action until the panic is upon us. 

127 

3. The lender-of-last-resort policy prevents crises from spreading and stopping the 

payments system. It does not save or help troubled banks that lack acceptable 

collateral. 

4. Require equity capital at banks sufficient to absorb all anticipated losses. The 

Brown-Vitter bill requires a minimum of 15 percent equity capital for all banks 

that hold $500 billion in assets. Capital is assessed against all assets, no exceptions or adjustments for risk. This avoids circumvention. 

5. If a bank’s equity percentage falls to 10 percent due to losses, it must cease 

paying dividends until the 15 percent equity ratio is reached. 

6. All money market funds should be marked to market. Recent reform required 

mark-to-market for institutional funds but exempted individual funds. The 

problem of runs is not avoided unless all money market funds are covered by 

a mark to market rule. The purpose is to prevent depositor runs. 

Community banks and all banks with less than $500 billion in assets should hold 

a lower equity capital percentage, say 8 percent, because they are protected by deposit insurance. 

Banks as a group pay the cost of deposit insurance. It has worked well for all but 

the largest banks. 

The Brown-Vitter bill recognizes that the way to prevent bailouts using taxpayer 

funding is to make the bankers have an incentive to be prudent. The 15 percent 

equity requirement is based on the minimum equity capital ratio held by major New 

York City banks during the worst financial crisis in our history, 1929–32. By requiring banks to pay for their mistakes, the system gave bankers strong incentives to 

lend prudently. No major New York bank failed. 

Bankers make two principal arguments against this proposal. They say it would 

reduce credit availability and would encourage greater risk taking to restore earnings. Both claims are wrong. The Federal Reserve determines the volume of lending; 

banks decide who gets the credit. As to increased risk taking, the banks bear the 

cost of bad decisions, not the public. Large stockholders would quickly replace managers who caused them heavy losses and jeopardized their dividend. 

Dodd-Frank gives the Treasury Secretary the power to decide too-big-to-fail. Since 

TBTF started, it has always been the Treasury Secretary. The mistake in DoddFrank is that the Treasury Secretary makes the decision in the midst of a crisis. 

That’s much too late. No one should believe that any Treasury Secretary will risk 

a bigger crisis at that time. The only way to end too-big-to-fail is to adopt and enforce rules that give the bankers much greater incentives to be prudent and avoid 

failure. The Brown-Vitter bill does just that. 

Finally, consider the complex Volcker rule that requires regulators to decide what 

is a hedge done to reduce risk and what is a speculation that banks choose to increase risk. Compare that to the much simpler Brown-Vitter requirement that 

makes the bankers pay for their mistakes and gives them a strong incentive to 

avoid making them. Which do you think is mostly likely to prevent crises and to 

reward safety and soundness? 

128 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM LAWRANCE L. EVANS, JR. 

Q.1. One of the criticisms of this study is despite the fact that 

there are a number of tables in the back, there are not easy top 

line numbers as to how much economic assistance each large financial institution (over $500 billion in assets) received and what discount of the market rate was provided to those large financial institutions by the taxpayers. Why did you not provide those top line 

numbers in the study and can you do so now for the record? 

A.1. Our decisions about how to present data on the amount and 

pricing of the emergency Government assistance reflect our judgments about how best to present informative measures while being 

mindful of the limitations of these types of measures. Appendix IV 

of our report contains data tables and figures intended to facilitate 

a comparison of the amount of assistance received by banking organizations of various sizes. For the six largest bank holding companies (over $500 billion in assets), table 7 shows the total dollar 

amount outstanding at year-end for 2008 through 2012 for programs administered by the Federal Reserve System, the Federal 

Deposit Insurance Corporation (FDIC), and the Department of the 

Treasury (Treasury). For these dates, this table also shows this 

total amount outstanding under each program as a percentage of 

the institution’s total consolidated assets. This percentage calculation provides a measure of assistance that is more comparable 

across institutions of different sizes by showing how much of the 

institution’s balance sheet was assisted by each program. In table 

7 and other figures in this appendix, we did not sum program totals across the different programs to arrive at a ‘‘top line’’ measure. 

Such an aggregate measure, presented on its own, would obscure 

important differences in the composition of assistance across firms 

and the value provided by different forms of assistance (i.e., loans, 

liabilities guaranteed, and capital investments). Accordingly, in figures 3, 4, and 5 in appendix IV, we aggregated measures of total 

assistance from programs that provided similar forms of assistance, 

but not measures of the total assistance from all of the programs. 

In response to your request for more information on the total assistance provided to the largest bank holding companies, in Table 

1 below, we show the total term-adjusted assistance provided to 

these six firms through selected programs. These term-adjusted 

measures account for differences in the time period over which assistance was outstanding by multiplying the dollar amount of the 

assistance by the number of days it was outstanding and dividing 

this amount by the number of days in a year (365). While the termadjusted amounts provide one measure of the total assistance received under these programs, they have limitations. For example, 

they do not account for differences in firm size that could have contributed to differences in the dollar amounts firms received and 

therefore do not allow for a fair comparison of the relative amounts 

of assistance received by firms of different sizes. In addition, as 

with the measures shown in our report, totaling these measures 

across programs that provided very different forms of assistance 

would give an incomplete picture of the composition and value of 

assistance received by different firms. 

129 

With respect to our analyses of emergency program pricing, these 

analyses cannot be used to calculate a ‘‘top line’’ estimate of the 

total dollar value benefit for individual bank holding companies. 

For selected programs, we compared program pricing to indicators 

of pricing for market alternatives. The market interest rates we 

used as benchmarks provide a general indication of market alternatives that could have been available to program participants. As 

our report notes, however, these market rates are unlikely to reflect available alternatives for all participants at all points in time 

during the crisis and cannot be used to produce a precise quantification of the benefits that accrued to individual participating institutions. In addition, pricing data were not available for market 

alternatives to all programs, such as interest rates for many types 

PDCF and TSLF collateral. To soundly estimate the benefits to individual institutions, we would need to know the individual 

counterfactual prices for each institution for each program, and 

that information is not observable. 

130 

131 

1See Government Auditing Standards: 2011 Revision, GAO-12-331G. 

Q.2. How have you explored whether these studies and reports you 

are relying on been ‘‘sponsored’’ by entities that, directly or indirectly, have a financial interest in the outcome of the Part II study? 

A.2. GAO operates under strict professional standards that require 

our staff to exercise objectivity and professional skepticism in all 

the work that they do. Simon Johnson’s written statement and 

opinions expressed during the hearing reflect a fundamental misunderstanding of how GAO does its work. To be clear, GAO adheres to generally accepted Government auditing standards 

(GAGAS) in developing its products. 1 Among other things, these 

standards require GAO staff working on audit engagements to consider possible bias in the sources of the evidence collected. We take 

steps to identify and address bias and other threats to independence throughout all of our audits—including threats resulting from 

undue external influence from interested parties. 

It is important to emphasize that GAO is relying principally on 

its own empirical research for the Part II study. We plan to supplement our analyses with documentary evidence (studies) and testimonial evidence (interviews). To the extent we leverage outside research, quality, validity, and reliability will determine whether a 

study is included in our findings. As we indicated during the hearing, rigorous review of methodologies, assumptions, and limitations 

of each study allows us to distinguish high-quality studies from 

weaker ones. Any review will be conducted in accordance with our 

professional standards that require us to plan and perform the 

audit to obtain sufficient, appropriate evidence that would provide 

a reasonable basis for our findings and conclusions. The staff assigned to the Part II study collectively possesses adequate professional competence and technical skill needed to undertake this difficult study, including exercising judgment on the quality of external research. The exercise of this professional judgment allows us 

to review the relevant literature including studies conducted by interested parties and eliminate those where bias compromises the 

validity of the study. 

The same is true with respect to stakeholders we identify for 

interview purposes. For example, Mr. Johnson—who does not have 

an empirical study relevant to Part II of our engagement and is not 

among those experts reviewing our model—is among a number of 

interested parties we have approached who are knowledgeable and 

have strong views on one side of the issue. We routinely engage 

such interested parties to gather information and opinions on any 

number of matters. Meeting with interested parties that span the 

ideological spectrum helps to ensure that we are balanced and objective in our approach, while our professional standards and ethical principles assure that we retain professional skepticism and 

weigh evidence appropriately. 

Q.3. You have indicated that with respect to persons consulted in 

connection with the study, ‘‘one of the things that we explored was 

conflicts of interest.’’ Please describe for the Committee how you 

went about the task of unearthing potential conflicts of interest involving those individuals with which you and your staff have 

interacted. 

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A.3. To be clear, these interactions refer to external experts we 

sought out to review aspects of our model and identify threats to 

validity or otherwise opine on ways to improve the robustness of 

our methodological approach. Utilizing experts in this manner is an 

important quality assurance step we take when appropriate. When 

external experts contribute to the planning and conducting of our 

engagement, in accordance with our professional standards, we are 

required to assess their independence and apply and document any 

safeguards deemed necessary to mitigate any threats. In this specific case, we reviewed the external experts’ affiliations, activities, 

and research where appropriate. We also asked the academic experts to raise any potential conflicts of interest that might impinge 

upon their ability to render impartial conclusions about our empirical work. 

When we interview individuals and they are used as sources of 

testimonial or other evidence, GAO’s standards of evidence also 

apply. Among other things, these standards require that we consider possible bias in the source of the evidence. While we do background research on the individuals we contact for interviews, we do 

not necessarily ask the external sources questions about funding or 

sources of income. In most cases, their biases and interests are 

quite clear. As discussed above, in cases where we are merely seeking views or opinions, information from these individuals is used 

in ways that does not require a rigorous evaluation of independence. In fact we may reach out to interested parties to ensure we 

heard perspectives from a balanced group of experts. 

Q.4. Are any of the members of your staff who are working on the 

Part II study customers of or investors in any of the financial institutions with assets in excess of $500 billion? 

A.4. As mentioned above, GAO adheres to GAGAS in developing its 

audit products, including this engagement. These standards require 

that GAO staff working on audits maintain both independence of 

mind and independence in appearance. Correspondingly, none of 

the staff working on the Part II study have direct investments in 

bank organizations. We do note, however, that a GAO employee 

with direct investments in banks with assets below $500 billion or 

even in nonbank financial companies could also have a threat to 

independence. As a result, no employee on this engagement has 

any reported direct investment in any financial company, and employees working on GAO’s financial markets work are generally 

prohibited from holding any asset in the financial sector. As a result of these and other actions we take to preserve our independence, we believe our opinions, findings, conclusions, judgments, and 

recommendations are impartial and can be viewed as impartial by 

reasonable and informed third parties. 

GAO is not only concerned with actual independence but also 

how others might perceive our independence. However, it is important to emphasize that the reference point for ‘‘independence in appearance’’ is a reasonable objective third party. We don’t believe 

that maintaining a customer relationship with a financial institution on the same terms as are available to the general public 

threatens the independence of auditors assigned to this engageVerDate Nov 24 2008 09:42 Oct 30, 2014 Jkt 046629 PO 00000 Frm 00136 Fmt 6602 Sfmt 6602 L:\HEARINGS 2014\01-08 EXAMINING THE GAO REPORT ON GOVERNMENT SUPPORT 
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ment or should be perceived to be a threat by a reasonable, objective third party. 

Q.5. Does GAO have a policy in place that would preclude anyone 

working on the Part II study from accepting employment at an institution with assets in excess of $500 billion? 

A.5. Although there are no postemployment restrictions on our employees that would prevent GAO’s auditors from seeking private 

employment with one of these institutions, no employee who is 

seeking employment with one of these institutions would be permitted to work on the Part II study. Our policies require employees 

who are seeking employment with an entity that could be affected 

by an engagement to notify management so that any threat to 

independence can be evaluated and if significant, an appropriate 

safeguard applied—often the reassignment of the employee to other 

duties. In addition, most senior GAO employees are required by 

law to file a statement within three calendar days after beginning 

job negotiations or after entering into an employment agreement 

with a private employer. 

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

STATEMENT OF THE INDEPENDENT COMMUNITY BANKERS OF 

AMERICA, SUBMITTED BY CHAIRMAN BROWN 

135 

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