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S. HRG. 112–456 

ENHANCED SUPERVISION: A NEW REGIME FOR 

REGULATING LARGE, COMPLEX FINANCIAL 

INSTITUTIONS 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS AND CONSUMER 

PROTECTION 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING ENHANCED SUPERVISION FOR REGULATING LARGE, 

COMPLEX FINANCIAL INSTITUTIONS 

DECEMBER 7, 2011 

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 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

RIKER VERMILYE, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

SHERROD BROWN, Ohio, Chairman 

BOB CORKER, Tennessee, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JERRY MORAN, Kansas 

MIKE CRAPO, Idaho 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

GRAHAM STEELE, Subcommittee Staff Director 

MICHAEL BRIGHT, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

WEDNESDAY, DECEMBER 7, 2011 

Page 

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

Opening statements, comments, or prepared statements of: 

Senator Hagan .................................................................................................. 3 

WITNESSES 

Sheila C. Bair, Senior Advisor, Pew Charitable Trusts ....................................... 5 

Prepared statement .......................................................................................... 37 

Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan 

School of Management ......................................................................................... 7 

Prepared statement .......................................................................................... 44 

The Honorable Phillip L. Swagel, Professor of International Economic Policy, 

University of Maryland School of Public Policy ................................................. 9 

Prepared statement .......................................................................................... 48 

Arthur E. Wilmarth, Jr., Professor of Law and Executive Director of the 

Center for Law, Economics and Finance (C-LEAF), George Washington 

University Law School ......................................................................................... 11 

Prepared statement .......................................................................................... 54 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Three Years Later: Unfinished Business in Financial Reform by Paul A. 

Volcker .................................................................................................................. 128 

Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket or Is Lap-Band 

Surgery Required? by Richard W. Fisher ........................................................... 161 

(III)

(1) 

ENHANCED SUPERVISION: A NEW REGIME 

FOR REGULATING LARGE, COMPLEX FINANCIAL INSTITUTIONS 

WEDNESDAY, DECEMBER 7, 2011 

U.S. SENATE, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND

CONSUMER PROTECTION, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 2:04 p.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. The Banking Subcommittee on Financial Institutions and Consumer Protection will come to order. 

Thank you to the four very distinguished witnesses who have 

played a very positive role in helping this country work our way 

through this terrible mess of the last 5 years, and thank you very 

much for joining us. Senator Corker, I understand, is on his way 

and was very cooperative in this hearing. Thank you, Professor 

Swagel. I know he invited you, and I appreciate that. 

Three years ago, we experienced what can happen when excessive risk taking and lax oversight are concentrated in our Nation’s 

largest financial institutions. The result, as we painfully know, was 

the near collapse of our entire economy. In response to the financial crisis of 2008, we passed Dodd-Frank. This legislation provides 

regulators with significant authority to oversee U.S. megabanks’ 

should they choose to use them, the power to curtail the use of leverage and increase equity funding; at the largest financial companies, the ability to preemptively downsize risky companies. Thanks 

to the efforts of my colleague Senator Corker, it gave the ability 

and power to resolve large, complex companies that are on the 

brink of failure and restrictions on the ability of large banks and 

financial companies to engage in risky proprietary trading and investment fund activities. 

Important questions remain, and that is what we will discuss 

today. Have we provided the regulators with adequate authority to 

address the cause of the financial crisis? Will regulators use these 

authorities that we have provided them to downsize those institutions in order to prevent the next financial crisis, particularly when 

they had similar powers prior to the 2008 financial crisis? Will the 

markets force these institutions to increase their equity funding or 

2 

exit risky lines of business? Is it even possible to understand or unwind trillion-dollar institutions that have had hundreds of diverse 

lines of business and operate in sometimes as many as 100 countries? Should we continue to put all our faith in regulators, or is 

it time to address too big to fail by putting some more fundamental 

reforms into law? 

Last year, Senator Kaufman and I offered an amendment to 

Dodd-Frank that would have sent the clear message that Congress 

believes that too big to fail means simply too big. It would have 

broken up the six biggest U.S. megabanks. In the past 15 years, 

these banks have grown in total assets from 15 percent of our Nation’s GDP 15 years ago to 63 percent of our Nation’s GDP today. 

The amendment failed, but much has changed since then that 

should make us reconsider this and similar proposals. 

We have seen that a small U.S. broker-dealer, MF Global, can go 

bankrupt without taking the entire financial system with it while 

a nearly $700 billion Belgian bank, Dexia, with assets that make 

up over 150 percent of that nation’s economy, had to be bailed out 

by three countries 3 months after they passed their regulator’s 

stress test. 

Last week, we found out that the six biggest megabanks bor- rowed as much as $400 billion in secret, low-cost loans from the 

Fed, accounting for 63 percent of the average daily debt. These 

loans accounted for 23 percent of the combined net income for these 

megabanks 23 percent during the time they were occurring. We 

know this assistance also helped these institutions to grow even 

bigger, and that is another thing the financial crisis did. 

In today’s Wall Street Journal, over the last 5 years, they pointed 

out, the four largest banks in this country have grown from 54 percent to 62 percent of all commercial banking assets. At the time we 

considered the Brown-Kaufman amendment, many people pointed 

to European banks as the model for ours in arguing against the 

amendment. But recent events have shown it would be unwise to 

replicate their banking system. 

While we have chosen to empower our regulators, other nations, 

including England, are proposing to restrict the activities that their 

banks can engage in. Maybe it is time we begin to seriously consider that option. 

I look forward to hearing from our panelists and look forward to 

hearing Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and I think you 

know I am not much for opening comments. I look forward to hearing from our witnesses and asking questions, but I thank you all 

for being here. 

Chairman BROWN. I like it. You give really good opening comments. Thank you. 

[Laughter.] 

Chairman BROWN. Senator Hagan, you have an opening statement, I understand. 

3 

STATEMENT OF SENATOR KAY HAGAN 

Senator HAGAN. I do. Thank you, Mr. Chairman. I appreciate 

that. But before I turn to the issue of enhanced supervision, I did 

want to talk briefly about the upcoming vote on the nomination of 

Richard Cordray. I know, Senator Brown, that you have definitely 

been a tireless advocate for Mr. Cordray. I was proud to support 

his nomination to become the first Director of the Consumer Financial Protection Bureau when it was considered by the Banking 

Committee. I will be proud to do so again later on this week when 

his nomination is brought before the full Senate. 

For too long, Americans have fallen victim to schemes at the 

hands of predatory lenders. As a State Senator, I remember witnessing payday lenders in North Carolina, who would trap many, 

many families in endless long-term debt before we put a stop to 

predatory lending practices in North Carolina. 

There was a woman, Sandra Harris, who was a Head Start employee from Wilmington. When her husband lost his job, she got a 

$200 payday loan to help pay for car insurance. When she went to 

repay the loan, she was told that she could renew it. She really 

found herself at her wits’ end when she ended up having six different payday loans and paid some $8,000 in fees. 

Well, there are many more of these individuals across the country that I think would greatly benefit from the Consumer Financial 

Protection Bureau. We cannot afford to continue to leave these 

families at risk. We need a strong Director to help improve the 

oversight over these predatory lenders who continue to prey on 

American families across our country. This is not about financial 

interest versus consumer protection. North Carolina is home to 

some of the largest financial institutions in our country and a vibrant network of community banks. We are a banking State, and 

I am very proud of that. 

We also understand that responsible financial regulation also 

protects consumers and businesses. That is why I supported the 

creation of the CFPB and why I believe it is well past time that 

we put a strong director in place. I believe Mr. Cordray is that 

strong Director. 

Mr. Chairman, I know that today we are here to talk about another immensely important topic—the supervision of large, complex 

financial institutions. Dodd-Frank represents a major step forward 

on this issue by granting important new authorities to our prudential regulators. Living wills, orderly liquidation authority, and enhanced prudential standards give financial regulators the tools to 

make our financial system safer. 

Chairman Bair, it is good to have you back with us today. I think 

everybody knows that you were instrumental in crafting the rules 

that we are talking about. In April, under your leadership the 

FDIC released a study that examined how the FDIC could have 

successfully used Dodd-Frank’s orderly liquidation authority to execute a cross-border resolution of Lehman Brothers, a systemically 

important financial institution. It found that with the new authorities, the FDIC could have ‘‘promoted systemic stability while recovering substantially more for creditors than the bankruptcy proceedings.’’ 

4 

In addition to the FDIC study, the Economist recently gathered 

Larry Summers, Rudgin Cohen, Donald Kohn, and others to demonstrate how the orderly liquidation of a large, systemically important financial institution would be successful under Dodd-Frank’s 

new authorities. 

Chairman Bair, I know that you have also advocated for a robust 

cross-border resolution framework. It appears that those efforts are 

bearing fruit in crucial jurisdictions such as Japan, the United 

Kingdom, and the EU—where comment is currently being sought 

on a regime akin to Title II. I will be interested in how you respond 

to Simon Johnson’s comments about the cross-border resolution. 

Finally, I wanted to comment briefly on the work of the Basel 

Committee as it relates to enhanced prudential regulation. Yesterday, Governor Tarullo testified that capital requirements are of 

paramount importance in the future of our financial system. I could 

not agree with him more. Domestic implementation of Basel III deserves a thorough review so that it does not become a Euro-centric 

rule book. I was glad to hear that the Federal Reserve is looking 

closely at the example of liquidity cover ratios. These rules will 

need to adequately account for the unique components of our domestic banking system such as the Federal Home Loan Bank System, agency debt, and the lack of a legislative framework for covered bonds. 

Again, Senator Brown, I appreciate you holding this hearing, and 

I look forward to our witnesses’ testimony. 

Chairman BROWN. Thank you, Senator Hagan, and just to follow 

up briefly on your comments, I probably know Richard Cordray better than any Member of the Senate. I knew him when he was a 

State representative and county treasurer and State treasurer and 

Attorney General and have continued to work with him, and there 

is no question of his qualification. Sometime ago I asked the Senate 

historian if this has ever happened that a political party has 

blocked the nomination of someone because they did not like the 

construction of the agency, and he said no, it has never happened. 

And I am hopeful that this will be different. 

Let me introduce the four witnesses, and we will hear from them, 

and Senator Corker and Senator Hagan and I will have questions. 

Sheila Bair is certainly—a cliche among cliches—no stranger to 

this Committee, she really is not, and has served, has given great 

public service from her work with Senator Dole to her work with 

the FDIC from 2006 to 2011. She is now a senior advisor at Pew 

Charitable Trusts, working on a book, and she has assumed a 

prominent role in the Government’s response to the recent financial 

crisis, including bolstering public confidence and system stability 

that resulted in no runs on bank deposits. Thank you, Ms. Bair. 

Simon Johnson is the Ronald Kurtz Professor of Entrepreneurship at MIT Sloan School of Management, senior fellow at the Peterson Institute for International Economics. He is the former chief 

economist at the IMF and coauthor with James Kwak of the book 

‘‘13 Bankers’’—and it is a terrific book—and the financial blog ‘‘The 

Baseline Scenario.’’ 

The Honorable Phillip Swagel is professor of international economic policy at the Maryland School of Public Policy. Professor 

Swagel was Assistant Secretary for Economic Policy at Treasury 

5 

from 2006 to 2009, a rather crucial time in that period, and in that 

position he advised Secretary Paulson on economic policy and also 

on the Troubled Asset Relief Program. 

Arthur Wilmarth is professor of law and executive director of the 

Center for Law, Economics and Finance at George Washington 

University here. He is the author of publications in the fields of 

banking law and American constitutional history and the coauthor 

of a book on corporate law. In 2005, the American College of Consumer Financial Services Lawyers awarded him its prize for the 

best Law Review article published in the field of consumer financial services law during the year 2004. 

Ms. Bair, if you would begin. 

STATEMENT OF SHEILA C. BAIR, SENIOR ADVISOR, PEW 

CHARITABLE TRUSTS 

Ms. BAIR. Chairman Brown, Ranking Member Corker, and Senator Hagan, it is my pleasure to address you today at this hearing 

entitled ‘‘A New Regime for Regulating Large, Complex Financial 

Institutions.’’ 

There is no single issue more important to the stability of our financial system than the regulatory regime applicable to large, complex financial institutions. I hope that by now there is general recognition of the role certain large, mismanaged institutions played 

in the lead-up to the financial crisis and the subsequent need for 

massive, governmental assistance to contain the damage caused by 

their behavior. The disproportionate failure rate of large, so-called 

systemic entities stands in stark contrast to the relative stability 

of smaller, community banks of which less than 5 percent have 

failed. As our economy continues to reel from the financial crisis, 

with high unemployment and millions losing their homes, we cannot afford a repeat of the regulatory and market failures which allowed this debacle to occur. 

There is nothing inherently wrong with size in and of itself. However, size should be driven by market forces, not implied Government subsidies. With the implied Government support provided to 

Fannie Mae, Freddie Mac, and so-called too-big-to-fail financial institutions, the smart money fed the beasts and the smart money 

proved to be right. As failures mounted, the Government blinked 

and opened up its checkbook. Creditors and trading partners were 

made whole. Many executives and board members survived. In 

most cases, the Government did not even wipe out shareholders. 

Regulators for the most part did not try to constrain these 

trends, but left the market largely to regulate itself. In some cases, 

such as derivatives, Congress explicitly told the regulators ‘‘hands 

off.’’ As free markets became free-for-all markets, compensation 

rose, skyrocketing past wages paid to equally skilled employees in 

other fields. This enticed many of our best and brightest to forgo 

careers in areas like engineering and technology to heed the siren 

song of quick, easy money from an overheated, overleveraged financial industry. 

In recognition of the harmful effects of too-big-to-fail policies, a 

central feature of Dodd-Frank is the creation of a resolution framework which will impose losses and accountability on shareholders, 

creditors, boards, and executives when mismanaged institutions 

6 

fail. We cannot end too big to fail unless we can convince the market that shareholders and creditors will take losses if the institution in which they have invested goes down. 

An essential component of resolution authority is the requirement that large bank holding companies and nonbank systemic entities submit resolution plans demonstrating how they could be resolved during a crisis without systemic disruptions. The DoddFrank standard of resolvability in bankruptcy is very tough, and 

my sense is that all the major banks will need to make significant 

structural changes to achieve it. They will need to do much more 

to rationalize their business lines with their legal entities to make 

it much easier for the FDIC—or a bankruptcy court—to hive off 

and sell healthy operations, while maintaining troubled operations 

in a ‘‘bad bank.’’ Rationalizing and simplifying legal structures will 

improve the ability of boards and management to understand and 

monitor activities in these large banks’ far-flung operations. I hope 

regulators will consider requiring strong intermediate boards and 

managers to oversee major subsidiaries. Many of these centralized 

boards and management do not have a comprehensive understanding of what is going on inside their organizations. This was 

painfully apparent during the crisis. 

One element of Dodd-Frank’s living will provision that has not 

yet been implemented is the requirement for credit exposure reports. Credit exposure reports are essential to make sure regulators understand crucial interrelationships between distress at one 

institution and its potential to cause major losses at other institutions. This type of information was lacking during the crisis. For 

those concerned about the potential domino effect of a large bank 

failure, it is essential not only to identify, understand, and monitor 

these exposures but also to limit them in advance. I would urge the 

FDIC and the Federal Reserve Board to complete this final piece 

of the living will rule as soon as possible. 

Another benefit of resolution authority emanates from the harshness of the process, and it is a harsh process, particularly for certain board members and senior management who not only lose 

their jobs but are subject to a 2-year clawback of all their compensation. This will give them strong incentives to avoid resolution 

by raising capital or selling their operations, even if the terms 

seem unfavorable. With this new resolution, the management of 

large financial firms now know what their fate will be, and it is not 

a pretty one. Bailouts are prohibited and there will be no exceptions. If they cannot right their own ship, they will sink with it. 

As important as it is, resolution authority obviously cannot substitute for high-quality prudential supervision. Excessive leverage 

was a key driver of the 2008 crisis as it has been for virtually all 

financial crises. This was forgotten in the early 2000s when regulators stood by and effectively lowered capital minimums among 

U.S. investment banks through implementation of Basel II. 

We need to correct those mistakes through timely implementation of Basel III and the SIFI surcharges which strengthen the definition of high-quality capital and substantial raise risk-based capital ratios for large institutions. Regulators also need to focus on 

constraining absolute leverage through an international leverage 

7 

ratio that is significantly higher than the Basel Committee’s proposed 3-percent standard. 

Many industry advocates continue to argue that higher capital 

requirements will inhibit lending. It is fallacy to think that thinly 

capitalized institutions will do a better job of lending. A large financial institution nearing insolvency will quickly pull credit lines 

and cease lending to maintain capital. On the other hand, a wellcapitalized bank will keep functioning even when the inevitable 

business cycle turns downward. 

Liquidity also needs more attention from regulators, both in the 

U.S. and abroad. We need to dramatically toughen the types of collateral than can be used to secure repos and other short-term 

loans. We should also think about caps on the amount of shortterm debt that financial institutions can use, as well as the establishment of minimum requirements for the issuance of long-term 

debt. And money market mutual funds should be required to use 

a floating NAV which should substantially reduce this highly volatile source of short-term funding. 

Finally, I hope that regulators will give high priority to finalizing 

simple, enforceable rules to implement the Volcker provision of the 

Dodd-Frank statute, rules that focus on the underlying economics 

of a transaction as opposed to its label or accounting treatment. If 

the transaction will make money by the customer paying for a service through fees, interest, and commissions, it should pass the test. 

But if profitability or loss is driven by market movements, then it 

should fail. And gray areas associated with market making and investment banking should be done outside of the insured bank and 

supported by high levels of capital. 

Much work remains to be done to rein in the types of activities 

that caused our 2008 financial crisis. It is my hope that the Fed 

will soon issue its long-anticipated rules on heightened prudential 

standards for large financial institutions. Robust implementation of 

a credible resolution mechanism, strong capital and liquidity requirements, and curbs on proprietary trading can once again make 

our financial system the envy of the world and an engine of growth 

for the real economy. 

Thank you very much. 

Chairman BROWN. Thank you, Ms. Bair. 

Mr. Johnson, welcome. 

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

MANAGEMENT 

Mr. JOHNSON. Thank you very much, Senator. 

I think the Brown-Kaufman amendment, which would have imposed a hard cap on the size of banks relative to the economy, was 

exactly right when it was proposed. I think that is exactly what we 

need today, and I would like to point out to the Committee that 

this is absolutely not a partisan issue. Presidential candidate Jon 

Huntsman in his financial reform program has endorsed exactly 

this approach, perhaps even wants to go a little bit further than 

you, Senator Brown, in terms of making this actually happen immediately. And his point and I think the point that resonates 

across the political spectrum is the arrangements we have right 

8 

now are not a market. We are looking at—with the continued existed of too-big-to-fail banks, we have an unfair, nontransparent, 

and extremely dangerous Government subsidy scheme. I think sensible people on the right and on the left recoil in horror when they 

see the details of this scheme, and we should work to end it. And 

I think the Brown-Kaufman amendment is the best workable bipartisan idea that we have before us. 

Now, to answer your four questions directly, Senator Brown: Did 

you grant enough authority under Dodd-Frank? No, I am afraid 

you did not, and the problem, Senator Hagan, is exactly the global 

nature of these businesses. Let me use two quotes that are in my 

written testimony. One was a senior—I have heard the same things 

from many people in private. These are on-the-record remarks. A 

senior Federal Reserve Board regulator said in, apparently 2011, 

post-Dodd-Frank, ‘‘Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and settlement systems . . . .We think 

we’re going to effectively resolve that using Dodd-Frank? Good 

luck!’’ 

I think the problem relative to the Economist simulation, Senator Hagan, which I have also paid attention to, is they were doing 

a very simple business there. They said it was a trillion-dollar 

bank. They had a U.S. and U.K. operation. There was a deus ex 

machina, a sleight of hand. They assumed a stay on the U.K. business, derivative business, that actually would be illegal. Anyone operating a U.K. business on that basis would go to jail. But they 

used that in their simulation, in one country. There is no cross-border authority you can grant. The U.S. Congress cannot do that. 

You need an intergovernmental agreement. There is no such agreement. There is nobody at the level of the G20 with whom I am familiar who is pushing for such agreement. It is not going to happen. Despite all the very hard and great work done by Ms. Bair 

and her colleagues, you cannot do cross-border resolution, and that 

is the issue for the big six megabanks. 

Your second question was: Will the regulators use the authority 

which you granted them? I do not think so, and I would turn specifically, not to single them out but it is a graphic case, to Bank 

of America, the exemption they apparently received from Section 

23A that allowed them to transfer the derivative business to the 

deposit side of the bank, insured by the FDIC. We are just encouraging the same sort of risk taking, but an egregious, dangerous 

level. This is the taxpayer subsidy at work in our faces. And what 

do the regulators say about this? I understand the matter is still 

being discussed, but as far as I hear, they are just going to let it 

go. So you gave them the authority to stop exactly this kind of activity, and they will not stop it. 

Your third question, Senator, was: Will the market increase the 

equity funding? Will there be more capital in these banks due to 

market pressure? And I think the answer to that is obviously no. 

The externalities, the spillover effects are what this game is all 

about. That is how you get the subsidies. These executives are paid 

on a return-on-equity basis unadjusted for risk. They like leverage. 

This is the mechanism. And the regulators, again, will not move 

sufficiently—Anat Admati, for example, a professor at Stanford, 

has been pressing very hard on the basis of deep knowledge of corVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
9 

porate finance—and absolutely unanswerable arguments. She has 

been pressing for the suspension of dividends by these banks until 

they have reached a much higher level of capital. And she has not 

just been rebuffed by the regulators. Typically, they will not even 

speak to her. 

What kind of process is this? If you want to see where this is 

going, Senators, I suggest you look carefully at Europe. The European banking system is in a slow, dramatic meltdown because of 

insufficient capital. Their banks, of course, are likely beyond too big 

to fail. They are in the too-big-to-save, which is the Irish experience. That is where we are heading, too. 

Your last question, Senator, was: Will the market force these 

banks to exit their lines of business? Will we have any version of 

the Volcker Rule as proposed by Senators Merkley and Levin? Will 

that really come into force? I do not think so. I think that that 

amendment—the legislation as drafted is exactly on target, but 

what we are seeing now come out of the regulatory process is not 

convincing, and I have the details in my written testimony. 

Thank you, Senator. 

Chairman BROWN. Thank you, Mr. Johnson. 

Mr. Swagel, welcome. 

STATEMENT OF THE HONORABLE PHILLIP L. SWAGEL, PROFESSOR OF INTERNATIONAL ECONOMIC POLICY, UNIVERSITY OF MARYLAND SCHOOL OF PUBLIC POLICY 

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

Corker, and Members of the Committee. Thank you for the opportunity to testify today. 

The diversity of firm sizes in the U.S. financial system is an important strength of the U.S. economy. I would say that both small 

banks and large financial institutions play an important role in fostering a strong U.S. economy. 

As discussed in my written testimony, I believe it would be a 

mistake to break up large, complex financial institutions. This 

would sacrifice considerable benefits to the U.S. economy and to 

broader society without a commensurate gain in terms of a safer 

financial system. 

The Dodd-Frank Act takes a better approach, which is to 

strengthen regulation and oversight of large, complex financial institutions, including with features that will help regulators detect, 

avoid, and respond to future crises. The Financial Stability Oversight Council, the FSOC, in particular will help avoid a repetition 

of the problems in which no regulator had clear responsibility for 

AIG. 

Increased capital and liquidity requirements on large financial 

institutions will better allow firms to absorb losses and weather 

market strains. But there will be an impact on financial intermediation, and thus on the economy. Real-world banks react to binding 

capital requirements by making fewer loans, and increased capital 

requirements could again drive activity into the less regulated 

shadow banking system. Higher capital standards are useful, but 

they do not escape the tradeoff between stability and economic vitality. 

10 

The new regulatory regime in Dodd-Frank does not break up 

large financial institutions or reinstate the Glass-Steagall separation of commercial and investment banking. I think this is appropriate. The repeal of Glass-Steagall is not well correlated with failures in the recent crisis. Bear Stearns and Lehman Brothers, for 

example, both remained investment banks and failed, while 

JPMorgan Chase crossed the Glass-Steagall line, combining investment banking and commercial banking, but weathered the strains 

of the crisis. I would focus instead on the characteristics of firms, 

assets, liabilities, and activities. 

As I said, small banks play a vital role in our economy. At the 

same time, there are important benefits to the U.S. economy from 

having financial institutions with large and diverse balance sheets 

that can best make liquid markets for large transactions and across 

a broad range of assets. Large banks are best able to serve large 

clients in trade finance, global lending, cash management, and 

other aspects of capital markets. 

My view is that it is a reality that large financial institutions are 

the ones that are best able to undertake commercial transactions 

for the large multinational clients that are a hallmark of the 

globalized economy. 

Now, having said that, my view is that the Title II resolution authority in Dodd-Frank is an important step forward in addressing 

the phenomenon of too big to fail. Title II puts bond holders firmly 

on notice that they will take losses when a firm is resolved. It 

would be desirable for this resolution to proceed as much as possible along the lines of a bankruptcy proceeding and with as little 

interference from the Government as possible. And in this I would 

include that the Government should refrain from propping up firms 

for an extended period of time, and especially refrain from ordering 

firms that fall into Government control from taking actions for policy purposes. 

Finally, the unfinished business of financial regulatory reform includes the future of Fannie Mae and Freddie Mac, regulation of 

money market mutual funds, and improvements to the international coordination of bankruptcies of financial firms. And I 

would just note that an event in the week that Lehman and AIG 

failed that especially deepened the severity of the crisis was the 

breaking of the buck by a large money market mutual fund. It was 

a very large fund but very far from a complex one. It was almost 

the simplest asset class you could imagine. And yet that was really 

the spark that greatly increased the severity of the crisis. 

The new regulatory regime for large, complex financial institutions represents progress, but much of the new regime remains a 

work in progress. 

Thank you very much. 

Chairman BROWN. Thank you, Mr. Swagel. 

Mr. Wilmarth, welcome. 

11 

STATEMENT OF ARTHUR E. WILMARTH, JR., PROFESSOR OF 

LAW AND EXECUTIVE DIRECTOR OF THE CENTER FOR LAW, 

ECONOMICS AND FINANCE (C-LEAF), GEORGE WASHINGTON 

UNIVERSITY LAW SCHOOL 

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

Corker, distinguished Members of the Subcommittee, thank you for 

allowing me to participate in this important hearing. 

In an article published in 2002, I warned that too big to fail was 

the great unresolved problem of bank supervision because it undermined both supervisory and market discipline. I noted that Congress’ enactment of the Gramm-Leach-Bliley Act allowed financial 

conglomerates to span the entire range of our financial markets. I 

warned that these financial giants would bring major segments of 

the securities and life insurance industries within the scope of too 

big to fail, thereby expanding the scope and cost of Federal safety 

net subsidies. 

I predicted that financial conglomerates would take advantage of 

their new powers under Gramm-Leach-Bliley and their too-big-tofail status by pursuing risky activities in the capital markets and 

by increasing their leverage through capital arbitrage. 

In another article written 7 years later, I pointed out the financial crisis confirmed all of my earlier predictions. As I explained, 

regulators in developed nations encouraged the expansion of large 

financial conglomerates and failed to restrain their pursuit of 

short-term profits through increased leverage and high-risk activities. As a result, those institutions were allowed to promote an 

enormous credit boom that precipitated a worldwide financial crisis. 

Private sector debt in this country increased from $10 trillion in 

1991 to $40 trillion in 2007, and the majority of that increase took 

place in the household and financial sectors. That unhealthy credit 

expansion, in my view, could not have happened without the financial conglomerates that Gramm-Leach-Bliley made possible. 

In order to avoid a complete collapse of global financial markets, 

central banks and Governments in the U.S. and Europe provided 

more than $10 trillion of support for major banks, securities firms, 

and insurance companies. Those support measures, which are far 

from over, established beyond any doubt that too big to fail now 

embraces the entire financial services industry. 

The Dodd-Frank Act does improve the regulation of systemically 

important financial institutions, or SIFIs, and certainly Chairman 

Bair deserves great credit for her role in making that possible. 

However, Dodd-Frank does not completely shut the door to future 

Government bailouts for creditors of SIFIs. The Fed can still provide emergency liquidity assistance through discount window lending and, in my view, through group liquidity facilities similar to the 

primary dealer credit facility, designed to help the largest financial 

institutions. 

Federal home loan banks can still make collateralized advances. 

The FDIC can potentially use its Treasury borrowing authority and 

the systemic risk exception to the Federal Deposit Insurance Act to 

protect uninsured creditors of failed SIFIs and their subsidiary 

banks. 

12 

Dodd-Frank has made too-big-to-fail bailouts more difficult, but 

the continued existence of these avenues for financial assistance indicates that Dodd-Frank has not eliminated the possibility of toobig-to-fail bailouts. And certainly Standard & Poor’s agreed with 

that view recently in a July 2011 report. 

Dodd-Frank also relies heavily on the same supervisory tools— 

capital regulation and prudential supervision—that failed to prevent the banking and thrift crises of the 1980s and the current financial crisis. As you have explained, Chairman Brown, one other 

approach would be to break up in a mandatory way the largest 

banks. I am sympathetic to that approach, but I think it is unlikely, given the megabanks’ enormous political clout, that Congress would vote to require involuntary break-ups absent a second 

and perhaps cataclysmic crisis. Professor Johnson has pointed out 

that it took the panic of 1907 and the Great Depression to produce 

the Glass-Steagall Act. I hope we do not have a second bite of the 

same poisoned apple. 

The third possible approach, and the one I advocate, is to impose 

structural requirements and activity limitations that would prevent 

SIFIs from using the Federal safety net to subsidize their speculative activities in the capital markets and would also make it easier 

for regulators to separate banks from their nonbank affiliates if a 

SIFI fails. First, I propose a prefunded orderly liquidation fund 

that would require all SIFIs to pay risk-based assessments to finance the future costs of resolving failed SIFIs. We would not accept a postfunded deposit insurance fund. We know that would be 

far too hazardous to the welfare of bank depositors. Why should we 

accept a postfunded orderly liquidation fund that will deal with 

much more massive potential payments? 

Second, we should repeal the systemic risk exception to the Federal Deposit Insurance Fund. That provides a very large potential 

bailout fund for uninsured creditors of failed megabanks. We 

should not allow that backdoor bailout device to exist. The Deposit 

Insurance Fund should not be exposed to that risk. Community 

banks cannot benefit from it. Why should they have to pay for it? 

Last—and I can explain this more in response to questions—I believe we should adopt a two-tiered system of financial regulation. 

Traditional banks could operate much the way they do now, but 

they would have to restrict their activities to those that are closely 

related to banking. Financial conglomerates would have to adopt a 

narrow bank structure that would rigorously separate the FDIC-insured bank subsidiary from all of their nonbank affiliates and all 

their capital markets activities. That would prevent SIFIs from 

using FDIC-insured, low-cost funds to cross-subsidize risky speculative capital markets activities. The danger of cross-subsidization 

is certainly raised by exactly the derivatives transfer issue that 

Professor Johnson pointed out with Bank of America. 

In conclusion, my proposed reforms would strip away many of 

the safety net subsidies currently exploited by SIFIs and would 

subject SIFIs to the market discipline that investors have applied 

in breaking up many commercial and industrial conglomerates over 

the past 30 years. SIFIs have never demonstrated that they can 

provide beneficial services to customers and attractive returns to 

investors without relying on safety net subsidies during good times 

13 

and Government bailouts during crises. It is long past time for financial conglomerates to prove, based on a true market test, that 

their claimed synergies are real and not mythical. If, as I believe, 

SIFIs cannot produce favorable returns when they are deprived of 

their current too-big-to-fail subsidies, market forces should compel 

them to break up voluntarily. 

Thank you again for the opportunity to present this testimony. 

Chairman BROWN. Thank you very much, Mr. Wilmarth, for your 

testimony. 

I would first like to ask the Subcommittee’s unanimous consent 

to include two excellent speeches on too big to fail in the hearing 

record. Former Fed Chair Paul Volcker wrote, ‘‘Three Years Later: 

Unfinished Business Of Financial Reform’’, and Federal Reserve 

Bank of Dallas President and CEO Richard Fisher wrote, ‘‘Taming 

the Too Big to Fails: Will Dodd-Frank Be the Ticket or is Lap-Band 

Surgery Required?’’ With no objection, so ordered. 

I will start the questioning, and if we need to do certainly two 

rounds, if the witnesses are willing, we would probably like to do 

that. 

I would like to address an issue that Senator Vitter raised at the 

hearing in the full Committee yesterday. Tom Hoenig points out, 

the just recently retired Kansas City Fed President, that the biggest banks enjoy funding advantages over their community bank 

competition and regional bank competition. Chairwoman Bair has 

shown that the biggest banks operate with less capital and more 

leverage. 

Each of you, if you would give your opinion on the question, is 

this—the advantages they have to attract capital—is it due to Government support for these institutions, explicit or implicit support? 

Think about that question for a moment. And also, does it seem 

fair that Government is intervening that way, implicitly or explicitly in the market by providing the biggest banks with those subsidies? I will start with Mr. Wilmarth, if you would. 

Mr. WILMARTH. I absolutely agree. I discuss this issue in my 

written testimony, particularly on pages six and seven. A recent 

study by Joseph Warburton and Deniz Anginer, ‘‘The End of Market Discipline’’, gives the following figures. They calculate that the 

implicit too big to fail subsidy gave the largest banks an annual average funding cost advantage of approximately 16 basis points before the financial crisis, increasing to 88 basis points during the 

crisis, peaking at more than 100 basis points in 2008. The total 

value of the subsidy amounted to about $4 billion per year before 

the crisis, increasing to $60 billion annually during the crisis, topping at $84 billion in 2008. 

And they also found that the passage of Dodd-Frank did not take 

that subsidy away. In fact, expectations of Government support 

rose in 2010 compared to 2009. That study provides dramatic evidence of the size and magnitude of the subsidy that SIFIs enjoy 

today and have enjoyed for a number of years. Their study covered 

20 years, from 1990 to 2010. 

Chairman BROWN. Mr. Swagel. 

Mr. SWAGEL. This is an area in which the situation is changing 

and will change as a result of Dodd-Frank. When I look at the 

funding of small banks and of large banks, and every bank is difVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
14 

ferent, so this is a very broad statement, small banks generally 

fund themselves with deposits, a good thing, covered by FDIC Insurance for which they pay premiums and with FHLB advances, 

which are covered by a Government guarantee. So that is the funding, the main funding sources for smaller banks. 

Large banks, on the other hand, pay premiums on their funding 

that are not deposits. So nondeposit funding now requires a premium to be paid to the FDIC even though it is not actually covered 

by the Deposit Insurance Fund. Then looking forward, there will be 

a capital surcharge for systemically important banks. And then importantly, as I discuss in my written testimony, the resolution authority under Title II is really a regime change. That will say to 

bondholders in the future, you will take losses. If a bank goes 

down, you bondholders, there are no more bailouts. There is no 

more 100 cents on the dollar. You will take losses. I expect, going 

forward, that to have a big change on funding, as well. 

Chairman BROWN. Mr. Johnson. 

Mr. JOHNSON. Reasonable estimates of the funding advantage for 

large banks range between 25 and 75 basis points, 0.25 percentage 

point to 0.75 percentage point. This is the same sort of funding advantage that Fannie Mae and Freddie Mac had. I do not think 

Fannie and Freddie were the primary cause of the financial crisis 

in 2008, but there is no question that they took excessive risks. 

They had far too much leverage. They were too powerful politically 

and they blew themselves up at great cost to the American taxpayer. Who are the Government Sponsored Enterprises of today? It 

is the too-big-to-fail banks with a massive, unfair, nontransparent, 

and extremely dangerous funding advantage. 

Chairman BROWN. Ms. Bair. 

Ms. BAIR. Yes. We have been—I have been personally concerned 

about this for a long time and the funding differentials remain 

much worse after 2008 as a result of the crisis and the bailout 

strategies that were employed. 

Phil is right. There is a difference in how small banks fund 

themselves and large banks, but even if you look at the comparative costs that they pay for deposits, there is a differential, and so, 

clearly, we have a problem. I think we do not end too big to fail 

until we convince the market and specifically the bondholders that 

they are not going to get bailed out anymore. That cheap debt that 

the large banks can issue right now is a big driver of their funding 

advantages. The rating agencies have eliminated some of the 

bump-up that they give large banks now based on the assumptions 

of implied Government support, but we still have a long ways to 

go. We do not end too big to fail until we convince the market that 

it is gone. 

I would also add, to echo Art’s comments during his opening 

statement, I also supported a prefunded reserve during DoddFrank and one of the reasons we wanted to do that, we wanted to 

calibrate the assessment based on the funding differential. And as 

we ended too big to fail over time, that funding difference would 

have narrowed the assessment. But in the near term, it could have 

helped end this advantage that they had. We got the fund through 

the House, not through the Senate. But I do think that would have 

been an advantage of having the prefunded reserve. 

15 

Chairman BROWN. OK. Thank you. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman. 

Mr. Johnson, you, I know, have made quite a name for yourself 

talking about this issue. You are somewhat entertaining. I would 

say on the 23(a) issue you mentioned, that actually is not the case, 

just for what it is worth. The transfer from Merrill Lynch to B of 

A was actually below the 10 percent threshold. But you might just 

want to take note of that. 

But let me, Sheila, you feel like that we, based on the Title II 

resolution, you feel like that we have solved the too-big-to-fail 

issue, is that correct? 

Ms. BAIR. I think the tools are there to end too big to fail. 

Senator CORKER. But you would agree that if we had a systemic 

failure where multiple institutions, we have not dealt with that, is 

that correct? 

Ms. BAIR. Well, I think Dodd-Frank provides the ability for the 

Fed under 13(3) to provide systemic support to solvent institutions 

if you have some type of external shock, for instance, if the European banking system goes down—— 

Senator CORKER. Right. 

Ms. BAIR. ——I do not think we should hold our banks for 

that—— 

Senator CORKER. And there is almost no regime that can deal 

with systemic—— 

Ms. BAIR. Right. You have to have some flexibility for that. We 

would have liked actually higher hurdles for 13(3), but it is much 

better now. There are much better disclosure requirements and required explanations to Congress, so it has improved a bit. 

Senator CORKER. Good. Thank you. You, like me, answer fully. 

On the Volcker issue we were talking about where banks at the 

end should not make or lose money off transactions, it was interesting to me that Volcker excluded Treasury. So do you include 

Treasuries in that, that banks should not buy Treasuries and make 

or lose money off of that, and why did we exclude Treasuries? Is 

that because the Treasury Department actually hated Volcker and 

they did not want to be impacted themselves by it? Why did we do 

that, briefly, if you could. 

Ms. BAIR. I do not know, maybe because it has traditionally been 

a fairly—not a highly—— 

Senator CORKER. Well, you can make or lose a lot of money on 

Treasuries. 

Ms. BAIR. You can, and certainly if interest rates start going 

north at some point, which they probably will, you could probably 

lose a lot of money. So I do not know the rationale. We were not 

there—— 

Senator CORKER. So, really, banks, though, should not own 

Treasuries to make or lose. They should not own—— 

Ms. BAIR. Well, I think if they are buying a lot of Treasuries as 

a speculative bet, they should not, absolutely not. If they are buying Treasuries to keep liquid assets on hand, if they are using it 

to collateralize repos, that is probably OK. But, no, if they are taking big positions in Treasuries to make money, they should not do 

that. 

16 

Senator CORKER. So I am actually still trying to understand 

where we need to be on the size of these institutions, and I did 

think that the amendment offered on the floor, had no hearings 

and was not well thought out at the time, but I think we are all 

kind of evolving and learning. 

How small is small? I mean, we have 15—of the 15 largest banks 

in the world, we have two of those and we have a Government that 

borrows huge amounts of monies nonstop because of our lack of discipline and we need banks to actually buy those Treasuries for us. 

We need primary dealers. 

So, Mr. Johnson, briefly, what size should be the right size when 

we have—you know, we dominate the world as far as GDP. We 

have two of the largest 15 banks in the world, not the top. What 

is the right size? 

Mr. JOHNSON. Well, Senator, on the size comparisons, I would 

urge us all to be careful, because if you are comparing banks under 

U.S. GAAP with European banks, for example, under IFRS, their 

accounting system, for a bank that has a large derivative book, 

that would be understanding the U.S. GAAP bank. So I think if 

you do the correct numbers, and I am happy to go through this 

with your staff, we actually have many more of the big banks—we 

have some of the biggest banks in the world on that basis. 

On size, I believe the Brown-Kaufman amendment would have 

rolled back the largest six banks to, roughly speaking, the size they 

had in the mid-1990s. Goldman Sachs, for example, in 1998 was a 

$200 billion bank. It was about $280 billion in today’s money. It 

was one of the world’s leading investment banks, absolutely great 

business—— 

Senator CORKER. So give me the number. I mean, what is the 

size? 

Mr. JOHNSON. Two percent of GDP was the size cap for investment-type banks under Brown-Kaufman and 4 percent of GDP was 

the size cap proposed for retail-type banks and that is eminently 

sensible. Between 300—this is not risk-weighted. There is no riskweighting gaming here because that gets out of hand. So let us say 

between $300 billion and $600 billion total assets. 

Senator CORKER. And Mr. Swagel, I know that I personally was 

highly involved in Title II and worked closely with Chairman Bair. 

One of the pieces we did not really ever have the opportunity to 

deal with properly was bankruptcy. Are there things in Title II 

that you think ought to be altered to take into account a large 

highly complex bankruptcy? 

Mr. SWAGEL. Thank you. I worry about the amount of discretion 

that is left to Government policy makers within Title II. One can 

look at the derivative book, and there are proposals about whether 

derivatives should be stayed or not stayed and essentially kept out 

of the resolution—a change in the bankruptcy code, so that is one 

area to look at. 

One other area that I am really the most concerned about is, as 

I said, the discretion that policy makers have within the resolution 

authority. It is meant to follow a bankruptcy-like proceeding with 

an order of priority for creditors, and the FDIC has said that they 

will do that. But ultimately, it is really up to the discretion of the 

17 

regulator, and it is really the difference between a judicial system 

like bankruptcy and a political one, which ultimately Title II is. 

Senator CORKER. Thank you. I know my time is up and look forward to the second round. 

Chairman BROWN. Thank you. 

Senator Merkley. 

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

I wanted to turn, Ms. Bair, to page two of your testimony, when 

you note essentially that—let me see here—shareholders were not 

wiped out before the Government took exposure. I think people still 

kind of wonder why, even under those emergency circumstances, 

why did shareholders not take a loss before the taxpayer did? And 

as we look back on it with a little bit of distance now, is there a 

clear explanation that, a sort of explanation I can share with my 

constituents when they ask the question why their task funds were 

put at risk but shareholders did not take a loss? 

Ms. BAIR. Well, I think that is what it means to bail out an institution. You keep the institution open. You preserve value even at 

the shareholder—the common equity level. And shareholders did 

take loss when the market punished them, but the Government did 

not impose losses. That is what a bailout is. You keep the institution open. And I think we did it because we did not have tools outside of insured banks. We did not have tools to resolve the entity 

in a holistic way. Lehman did obviously wipe out the shareholders, 

but the bankruptcy was highly disruptive. WAMU, the shareholders were wiped out. That was a good example of the FDIC resolution process working in a way that imposed discipline on shareholders and bondholders, took a haircut, as well. But I think the 

legal tools were not there. 

I think looking back, hindsight is always 20/20, and I say this 

because I want to make sure we do not make the same mistakes 

again going forward if we ever, God forbid, get into a kind of situation like that again. But I think perhaps the Government could 

have been a little more muscular. There was no obligation on the 

Government to come in and bail out an AIG or whoever, and so, 

you know, insisting that at least counterparties who were made 

whole or bondholders who were made whole as well as shareholders should have voluntarily taken some additional losses or set 

up bad bank structures where their liabilities would have funded 

the bad assets, I think those were mechanisms that we did not explore. We did not have time, and I just wish we had. But the point 

is, we were behind the curve and we did not have a lot of information and had to make decisions quickly and the easiest thing to do 

was just to keep the institution open and prop it up. 

Senator MERKLEY. Well, thank you. The reason I raised that is 

because later in your testimony, you flag it as a key indicator related to too big to fail, and hopefully I am not pulling this out of 

context, but we cannot end too big to fail unless we can convince 

the market that shareholders and creditors will take losses if the 

institution in which they have invested fails. So I just wanted to 

flag that as an indication of the future. 

You also note in your testimony that many large financial institutions found trading assets, that is proprietary trading, to be 

much easier and more profitable than going through the hard work 

18 

of developing and writing standards for loans that the institutions 

plan to keep on their books. And this is kind of—this goes right to 

the heart of the Volcker Rule. Do we provide a discount window 

and insurance for depositors in order to have and support institutions that provide loans to maintain liquidity to families and businesses, or are these type of advantages going to be applied to carry 

advantages into the high-risk trading world, and does that highrisk trading, as important as it is in aggregating capital and allocating capital, belong outside of that framework. 

I believe I am reading into your comments that you believe it 

should be outside that framework, but I wanted to make sure that 

you had a chance to comment on that. 

Ms. BAIR. Well, I think—well, trading assets can be a broad category, and not all trading assets would be viewed as proprietary 

under the Volcker Rule. But I think securitization, for instance, a 

lot of this is driven by securitization, so you are originating loans 

or buying loans, mortgage loans originated by others, but 

securitizing them and then buying back the securities. A lot of that 

is responsible for the growth in trading assets, and, of course, that 

process is accompanied by a loss of underwriting discipline in the 

process. 

So I do think that insured losses are there to extend credit to the 

real economy and I think that makes loans and services that are 

incidental to the provision of credit to the real economy. And if it 

does not pass that test, then no, I would rather it not be outside 

of insured banks, and I know Dodd-Frank is what it is and the 

Volcker Rule provisions are as they are, but it might have been 

easier in retrospect to try to think, instead of trying to say what 

we do not want insured banks and affiliates to do, try to think 

what we want insured banks to do and recognize that there are 

some legitimate functions, financial services functions performed by 

securities affiliates that do involve some position taking, Market 

making and investment banking are two prime examples, but make 

sure those are kept outside—insulated from the insured institution 

and, frankly, supported by higher capital, not lower capital. 

So I do. I am a traditionalist and I think insured deposits should 

be there for credit support for the real economy and things that go 

beyond that should not be in the bank. 

Senator MERKLEY. Do I have time to restate my understanding 

of what Sheila just said? Do I understand you to say it would have 

been easier, if you will, to say this is the business, the business of 

lending, is what the commercial banks are in—— 

Ms. BAIR. Right. 

Senator MERKLEY. ——and that if you want to do wealth management, if you want to do market making, if you want to do those 

things, all of that should be outside the framework, and then we 

should not have the complexities of trying to distinguish market 

making from proprietary trading. 

Ms. BAIR. I think that is right. It is very difficult, I think, to 

know where that line is. You are going to have gray areas, so I 

would force those outside the insured bank. I think you can keep 

them within the larger holding company structure so long as there 

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19 

tivity. But, again, my preference would be to force them outside of 

the insured bank, yes. 

Senator MERKLEY. Thank you, and I know you have thoughts on 

this which I hope to come back to during additional time. Thank 

you. 

Chairman BROWN. Thanks, Senator Merkley. 

Senator Moran. 

Senator MORAN. Chairman Brown, thank you. Thank you all for 

your presence here today. I wish we would do more of this in which 

we take a broader picture, a more, perhaps, thoughtful opportunity 

to discuss these issues. They are somewhat new to me in the sense 

I have never been on the Banking Committee before and I want to 

raise just a couple of topics in the time that I have. 

This may be for you, Mr. Secretary, and really for any panel 

member who would like to respond, but you indicate in your testimony the key element for addressing too big to fail is that bondholders take losses. Is there anything in Dodd-Frank that now 

causes investors in banks in the United States to believe that they 

will take a loss should a failure occur? What did Dodd-Frank do to 

emphasize that message? So the question, I guess, is are we better 

off with Dodd-Frank than we were before on this issue? 

Mr. SWAGEL. I will be very quick. I think the answer is yes, that 

the orderly liquidation authority means that the equity holders, the 

shareholders will be wiped out and then if the Government puts 

money in and there are any losses to the Government, bondholders 

will get clawbacks retroactively. So I think that is it. 

Senator MORAN. So is there evidence that bondholders, investors, 

and, therefore, the management of financial institutions are behaving differently because they now believe that potential exists? What 

evidence is there that that message has been received and, therefore, conduct has changed? 

Mr. SWAGEL. Right. So the evidence I know of is the one that 

Chairman Bair mentioned, that the rating agencies have said, we 

are changing our view of these institutions because of less support 

as a result of OLA, orderly liquidation authority. I think it is too 

early to say that funding is more expensive. Now, that is something 

that we are all going to be looking at going forward. 

Senator MORAN. But nothing, no evidence at this point that management would have a different discussion. In a board room, you 

are going to have a different conversation about the risk that the 

bank is willing to take because, oh my gosh, Dodd-Frank passed 

and our bondholders or investors may be at risk. I mean, are we 

at that level? 

Mr. SWAGEL. I think we are. Again, it is hard to know because 

it is so new and it has never been used so we do not know exactly 

how it is going to take place. But I think going forward, bondholders, especially of risky institutions, will exercise much more 

scrutiny. In a sense, there will be more of a ‘‘let us flee to the exit.’’ 

As soon as a firm gets into trouble, bondholders are going to say, 

hey, we are getting close to the red line. We want to be out of here. 

Senator MORAN. Sheila Bair, being a Kansan, demonstrated her 

agreement with you by body language—— 

[Laughter.] 

20 

Senator MORAN. ——but I also think that Mr. Johnson perhaps 

indicated that that was not the case. Did I read your body language? Do you have something that you would like to—— 

Mr. JOHNSON. Yes, Senator. I strongly disagree. I talk to people—I agree that this is new territory and I agree with the intention here. But I talk to a lot of people in the financial sector, including people who work in and around these big banks. I do not 

think their attitudes have changed at all. There is still the perception of too big to fail. As Ms. Bair said, it is all about the market 

perception. Does the market think that JPMorgan Chase or Bank 

of America or Citigroup or Wells Fargo or Goldman or Morgan 

Stanley could fail, and I talk to people in the market and they tell 

me no. 

I ask audiences whenever I address them, who in the room 

thinks that Goldman Sachs, for example—a hypothetical example— 

who thinks Goldman Sachs could fail so the bondholders lose their 

money? I asked it at a conference recently that Professor Wilmarth 

organized. Typically, no more than one person in the audience 

raises his or her hand, and it turns out that one person is engaging 

in wishful thinking. 

Senator MORAN. Let me ask perhaps what I hope is not a timely 

question, but very well may turn out to be. My assumption would 

be that financial institutions in Europe are at some risk. What has 

happened as a result of Dodd-Frank that limits the ability for U.S. 

banks to also become more at risk because of the challenges of the 

financial circumstances in Europe or elsewhere in the world? 

I asked a slightly different question yesterday of Government officials. I was trying to figure out, it seems to me just a perspective 

that too big to fail, there are still institutions that are just as large 

as they ever were, perhaps even larger, so that the common perception of too big to fail has not changed. I mean, I do not know that 

Kansans would see the evidence that we have a lot of smaller institutions. In fact, as Sheila Bair would have—could testify, we have 

fewer smaller institutions as a result of bank closures, and it often 

seems that it is the small banks that are, in many ways, paying 

the price, even though they present no systemic risk. 

And so my question is, have we done something that reduces the 

chances that what happens elsewhere in the world affects our financial institutions, and at the same time, is there a regulatory arbitrage—there is probably a better phrase for that than what I 

have said—between the two, between banking institutions or financial institutions that are chartered in the United States and chartered someplace else in the world? Do we get all the burden of the 

additional regulations but still have to worry about the consequences of a bank failure that is less regulated, perhaps, elsewhere in the world, but we get the stuff that flows from their failure? Anyone. 

Mr. JOHNSON. Senator, I would commend to your attention 

Taunus Corporation, which is the eighth or ninth largest bank 

holding company in the United States. It is a wholly owned subsidiary of Deutsche Bank. It is 77-to-one times leveraged. Deutsche 

Bank itself is a very highly leveraged global corporation. Public 

news reports say that the U.S. regulators have asked for additional 

capital to be put into Taunus because they regard the leverage as 

21 

excessive in today’s environment because of the situation in Europe. It has not happened. 

And I think the problem is exactly what you just put your finger 

on, that we are no less vulnerable, perhaps more vulnerable now 

to this incredible disaster in and around the banking system in Europe. It is going to spill over to us in many ways through 

counterparty risk in derivatives, for example. But Taunus Corporation is a spectacular in our faces demonstration of these risks becoming bigger, not getting smaller. 

Senator MORAN. Mr. Chairman, I do not know whether your 

rules are that they get to answer my question as long as I ask it 

within the 5 minutes, or if my 5 minutes is up before they respond, 

but—— 

Chairman BROWN [gesturing]. 

Senator MORAN. Mr. Chairman, thank you. I know the Professor 

was nodding and—— 

Mr. SWAGEL. I will be very brief. I think two things have 

changed. One is Dodd-Frank, the Financial Stability Oversight 

Council, and again, I think that can get somewhat at the AIG problem of cracks in the system, in the regulatory system. I suspect the 

regulators, the members of the FSOC, have been very diligent 

about looking at the exposure of American banks to European problems. I would have hoped they would have done that before DoddFrank, but I suspect they are really on top of it now to the extent 

they can be. 

Number two is not Dodd-Frank but our financial system is better 

capitalized, is in better shape, is less risky than it was before the 

crisis. That is not a solution, but at least it is progress. 

Ms. BAIR. May I say something? Just a couple of things. I think 

Simon and I are talking to different people. I talk to a lot of bondholders and I think they are very aware of Dodd-Frank and very 

aware of the strong rules that the FDIC has put forward and the 

strong rhetoric coming out of a lot of the leadership, not just from 

me, when I was in my Government position. I think they are very 

focused on this and understanding what the ramifications will be 

and understanding that they will be at risk of loss. I think the rating agencies are reflecting that by providing downgrades. They 

used to give a bump-up and there is still a little bit of that left. 

But I think it is starting to change the mindset of bondholders. 

With regard to Europe, I would just say that Dodd-Frank cannot 

fix everything that is beyond our borders. I do think that certain 

jurisdictions, like the United Kingdom, are serious about resolution 

authority and I think we are making progress there. The FSB just 

recently came out, with heavy input from the FDIC, with a framework for a multinational resolution regime. There are tools that 

can be used now for cross-border failures and the Lehman paper, 

I think, is instructive in terms of one of the approaches that could 

be used for cross-border resolution, pending development of a 

broader multinational resolution regime. 

I would also say that there were some regulators warning early 

on about problems in Europe. Back in 2006, my first Basel Committee meeting as Chairman of the FDIC, I went to them and I 

said, you need to have a leverage ratio. They had started implementing the Basel II advanced approaches and they were lowering 

22 

the capital levels substantially with what is called a risk-weighted 

approach. Leverage ratios are an absolute constraint on leverage. 

We have had one here for a long time and it really—it saved our 

bacon during the crisis. 

But Europe has refused to do that. They have quite different attitudes about the relationship between regulators and banks and 

what is appropriate in terms of the capital regime and I think they 

are learning now, but I think there were U.S. regulators who were 

trying to advocate and prevent some of the problems we are seeing 

now in Europe many years ago. 

Chairman BROWN. Thank you, Senator Moran. 

We will begin a second round of questions, if my colleagues want 

to join in that. 

I assume some of you saw or at least heard of the ‘‘60 Minutes’’ 

piece on Sunday might. They ran two segments of the three segments on the show questioning the whole issue of whether—why 

none of these bank executives from Countrywide to any of the larger institutions went to prison, raising the question of the complexity of these institutions. Is the Government too timid, in part 

because they do not want to lose a case? Was there outside pressure on the Justice Department? That seemed to be answered probably no on that, but no one knows for sure, I guess, or we do not 

know for sure. Was the Government simply the—when you think 

of a Government lawyer making $150,000 matched up against a 

battery of lawyers making significantly more money than that and 

more experienced in dealing with the complexity of these institutions. 

It sort of brings me to this next question. The Financial Crisis 

Inquiry Commission report noted that the largest U.S. bank in 

2007 had a $2 trillion balance sheet with more than 2,000 subsidiaries. Today, that bank is now under $2 trillion, but there are now 

two banks that, I guess, JPMorgan Chase is over $2 billion as is 

Bank of America. Andy Haldane from the Bank of England said 

that calculating the regulatory capital ratio of the average large 

bank under the Basel regime would require over 200 million calculations. 

Professor Wilmarth cited a study that investors tend to look at 

banks’ credit ratings, which include the likelihood of Government 

support, to make their investment decisions. Chairman Bair mentions that the rating agencies have begun to remove the bump-up 

they assign to the credit ratings of large financial institutions 

based on their previous assumption of Government support. 

It may lead to the conclusion that too big to fail just means too 

big to manage, too big to regulate. Are the markets, when making 

investment decisions, are they looking at the perceived level of 

Government support for these banks when they make these decisions? Is it too complicated for the market to make it any other 

way? Chairman Bair. 

Ms. BAIR. Well, I think that—I think there is not—or we are 

transitioning out of that, but I think in the lead-up to the crisis, 

too big to fail was very much a factor in making investment decisions. And then, of course, in 2009 with the stress test, we pretty 

much told everybody, if you are above $100 billion, we are going 

23 

to backstop these institutions. And so, clearly, that capital raising 

was based on an assumption of Government protection. 

So now in Dodd-Frank we are trying to transition back out of 

that and get rid of all that moral hazard that we created with the 

bailouts that continued well into 2009, but it is going to take some 

time. My sense is that if we can convince the market that it is 

gone, you are going to see market pressure for these institutions 

to downsize because these bondholders cannot understand everything that is going on inside of a multinational entity with over 

2,000 legal entities. 

And as a parallel process to that, I hope that the Fed and the 

FDIC will be very aggressive in requiring structural changes so 

that some of them have 20 legal entities as opposed to 2,000 and 

making sure those legal entities are rationalized with their business lines, so if they need to break off and sell the mortgage servicing operation or the credit card operation or the derivatives dealer or whatever, it is feasible to do that if the institution comes 

under distress. 

Chairman BROWN. Do you think that is a natural evolution, natural in the sense within the—— 

Ms. BAIR. I think it is—— 

Chairman BROWN. ——context of what we did with Dodd-Frank? 

Ms. BAIR. I think shareholders and bondholders, to some extent, 

have seen value in these large institutions based on their implied 

Government subsidies. Once that is gone, I am not so sure they are 

going to see value anymore with these very large institutions, and 

you might even see shareholders think that they can unlock value 

if some of these entities are broken up. They might be worth more 

in separate entities that are easier to manage and easier to understand on the investing—— 

Chairman BROWN. Is that happening, Mr. Johnson, in your 

mind? 

Mr. JOHNSON. No, sir—— 

Chairman BROWN. Or will it happen? 

Mr. JOHNSON. Well, not until you end too big to fail, effectively. 

I agree with Ms. Bair totally on the objective here and exactly on 

the mechanism. But if you read the speeches of the CEOs, what do 

the CEOs say to their shareholders? What do they communicate to 

the market? And I cover these in detail and I am happy to send 

you and your staff examples. Mr. Vikram Pandit, for example, the 

head of Citigroup, says he wants to make Citi bigger, more global, 

operate in more markets, and from the, again, the on-the-record 

comments of Mr. Timothy Geithner, the Treasury Secretary, he 

thinks that having our banks go out and become more global, take 

more risk in emerging markets, for example, he thinks that is a 

good idea. 

Well, it was not a good idea in the 1970s when Citigroup under 

Walter Wriston bulked up on loans to Latin America, Communist 

Poland, and Communist Romania, leading in large part to the crisis of 1982 in this country and around the world. Citibank back 

then was a much smaller bank. It is more than five times the size 

now. But that is what they want—that is what the executives want 

to do. That is what they are saying to the market. And I do not 

24 

yet see the market pressure on them to break up. Ms. Bair is absolutely correct. That is the litmus test. 

Chairman BROWN. Ms. Bair, do executives not want to do that? 

They all want to grow their institutions. They all want bigger market share. So why is Dodd-Frank pushing them in the other direction through their shareholders and bondholders? 

Ms. BAIR. Well, if you increase their capital requirements, I 

would like to have higher capital requirements. I would like to 

have at least another 10 percent of the long-term unsecured debt 

on top of the higher capital requirements. I think you make it more 

expensive for them to fund themselves, that is going to make it 

more difficult to grow. It is going to make it more expensive to attract investment dollars. They are going to have to have really good 

management and convince the investment community that the 

management knows what they are doing and they have control of 

their institution and are managing the risk of that institution well. 

And I think all but the very best managed are not going to be able 

to make that kind of showing. 

So it is hard and I do think it is important for the Government 

to be sending all the signals, the right signals. And I do not think 

there should be any ambiguity by anybody in the U.S. Government, 

wherever they are, that we do not view it as a good in and of itself 

to keep these institutions alive just because they are big and we 

do not—— 

Chairman BROWN. Are we sending those messages? 

Ms. BAIR. Well, I think Simon has referred to some of the statements that I think send mixed signals to the market and I do think 

it is important for the Government to speak with one voice on this. 

Again, I want the market to drive this. I think—and I would certainly have no objection to your amendment, and given where we 

are, maybe that is the fastest way to eliminate this threat. But I 

would prefer that the market drive the appropriate size of these institutions and my sense is if we can convince the market there are 

no more Government subsidies, you will get significant pressure for 

them to downsize and break up on their own. 

Chairman BROWN. Professor Wilmarth, you have something to 

say to that? 

Mr. WILMARTH. I want to reiterate the importance of the 2009 

stress tests, because not only did Federal regulators say, ‘‘we will 

provide any capital needed to allow 19 largest banks to survive,’’ 

and they actually put capital into GMAC when GMAC could not 

raise any, they also said, ‘‘we are not going to apply the prompt 

corrective action sanctions against these banks for being undercapitalized,’’ even though those are nondiscretionary sanctions that 

must be applied by statute. In contrast, there have been hundreds 

of PCA orders issued against community banks. Unlike the 

megabanks, community banks got no wiggle room if they were 

undercapitalized. 

Now, the other thing I want to say is that the Dexia rescue 

which just happened in Europe, provide strong evidence that we 

have not ended too big to fail. Every time we see the markets 

under stress, and when major banks that are heavily involved in 

the markets are under stress, the Governments do everything possible to maintain stability, to prop them up. The Fed just opened 

25 

major swap lines to get dollars to European banks. We now know 

that the Fed not only provided help to European banks by bailing 

out AIG, they were also giving huge amounts of liquidity assistance 

to European banks throughout the financial crisis. So this European crisis has been bubbling along under the surface ever since 

2008, 2009, but it was kept relatively quiet until last year. 

Everything we see the Fed doing is designed to prop up and stabilize and make sure none of these large institutions go down. And 

so I align myself with Professor Johnson. When I see Federal regulators actually force a bank of the size of Citigroup or Bank of 

America into what looks like nationalization, where all the shareholders are gone, and where bondholders take major haircuts, then 

I will begin to believe that too big to fail has ended. But I do not 

think you can find such an example, other than Lehman, which I 

think everyone now admits they are sorry they allowed to fail. 

Other than Lehman, where can you find an example where an institution was taken that way? RBS in Britain, yes, was nationalized. We have not done it here. We have not done the complete nationalization, wipe out the shareholders, impose major haircuts on 

bondholders, for any of the top six banks. 

Chairman BROWN. Mr. Swagel. 

Mr. SWAGEL. I would just add, another way to demonstrate to 

markets that firms will be allowed to fail is to take the living will 

process seriously, to say, we do not want a firm to fail, but we are 

ready. We as a Nation, we as regulators, and the firms themselves 

have to be ready, as well. 

Chairman BROWN. Well said. Last comment, then Senator Corker. 

Mr. JOHNSON. You could simplify these banks massively under 

the living will provision so that you could make it easier for them 

to fail, simple enough to fail as a criteria. I do not think we have 

seen any progress yet on that front either. 

Chairman BROWN. Thanks. Senator Corker. 

Senator CORKER. I think this has been interesting. Mr. 

Wilmarth, are you saying then that you do not think the Fed 

should open swap lines right now to Europe? I think if Europe 

failed, it would be a little bit of an issue for us. Are you saying that 

is what you would like to see happen? 

Mr. WILMARTH. No. I am not opposed to it. I am just saying that 

as long as these behemoths exist, it is inevitable that regulators 

will feel they have to support them. In other words, it is a chickenand-egg problem. 

Senator CORKER. But is it really the behemoths, or is it the countries? We in essence have urged all banks to buy sovereign debt. 

Mr. WILMARTH. Well, I think you are right. The problem is, as 

financial institutions become very large—and Professor Johnson 

has explained this eloquently—there becomes a synergistic relationship between Governments and these major banks. And not 

surprisingly, the Governments support the banks, and then they 

want the banks to buy the sovereign debt. And it becomes, I think, 

an incestuous relationship. 

I thought letting Lehman fail was a terrible mistake. I think 

when you are in the soup, you should not turn up the heat and 

make things worse. But the problem is, can we begin to change the 

26 

system going forward? The United Kingdom, as I mentioned in my 

written testimony, through the report of the Independent Commission on Banking, which the Cameron government has pledged to 

enact, they would ring-fence the insured depositories from everything else, and they would say, ‘‘We are going to make sure there 

is no cross-subsidization.’’ The ICB has also indicated that they 

want to make sure that the market will force nonbank capital market subsidiaries to increase their capital because investors in those 

subsidiaries will know that they are not going to get protection 

from deposit insurance and other aspects of the safety net. 

We could do that here. I think that is the way going forward to 

actually convince the market. We should protect the so-called utility banks, as the English call them. The utility banks which take 

deposits, make loans to households and small- and medium-sized 

enterprises, do traditional fiduciary services, we should protect 

those. But everything else in the financial conglomerate should not 

be protected and investments in nonbank affiliates will have to be 

priced at market. 

And so I think going forward we could change, but we have not 

gone to the extent where the market believes that, in fact, we 

would separate the institutions in that manner. 

Senator CORKER. Mr. Johnson. 

Mr. JOHNSON. Senator, I am opposed to the swap lines. This is 

the euro zone. It is a reserve currency area. They have one of the 

most credible central banks in the world. They are basically trying—they are transferring credit risk to the Federal Reserve, and 

they hope to do it to the U.S. taxpayer. You will, I think, shortly 

see stories about ECB loans to the IMF that will be turned around 

and lent back to Europe. The IMF’s capital—16 percent of it is your 

capital, the U.S. taxpayers’ capital—is absolutely on the line here. 

It is a culture of bailouts. 

Now, I agree with you that we have encouraged banks to lend 

to sovereigns, and that is part of the irresponsibility, and the Europeans have done that in a—— 

Senator CORKER. Well, they have to set aside no capital for that. 

I mean, it is totally— 

Mr. JOHNSON. It is ludicrous, Senator. No argument. But my 

point is they should sort this out for themselves. It is their problem. They got themselves into it. We have created a culture of bailouts at the level of the major central banks in the world in this instance where we are providing them with these swap lines so that 

we can keep it off their balance sheet so they will not be accountable to their taxpayers fully for the mess they have gotten themselves into. It is crazy. It makes no sense. We should not be participating on that basis. 

Senator CORKER. Do you agree with that, Chairman? 

Ms. BAIR. Actually, I would be more sympathetic to what the Fed 

is doing here. I do think that there is a broader economic reason. 

As demand for dollars has increased, that has a potential to hurt 

our export market. A lot of international trade—most of it is done 

with U.S. dollars. Europe is a huge export market, and we want 

to make sure that there is plenty of dollar credit availability in Europe. Also many European banks lend to developing countries in 

dollars that buy our exports. 

27 

So I do think that there is a reason beyond just stabilizing the 

financial sector that can help the real economy, and I think that 

is what drove the Fed’s decision. So on that I—as much as I abhor 

bailouts, I do not really view that as a bailout move, and I have 

some sympathy for what the Fed did there. 

Senator CORKER. So as I listen, it seems to me that, you know, 

when we talk about too big to fail, we are talking about several different things. One—and I do not think we have answered this in 

our country—are there institutions that are allowed to get too big 

and too complex that they threaten our system? And I do not think 

that has been dealt with, and nobody has come up with the right 

answer. Do they add more merit than negative? And, obviously, 

there are people here on the panel that think yes, some people say 

no. 

It seems to me, though, when you talk about failing, it means 

lots of things. I really do not have a question that in a one-off situation, a bank, no matter how big it is, fails, my sense is that the 

bond holders and certainly the equity know they are toast. I mean, 

I do not think that—is there somebody that disagrees with that, 

that if we have a one-off situation, not a systemic failure but a oneoff situation, X large bank fails, are there people here that believe 

that Title II would not be instituted in a one-off situation? 

Mr. JOHNSON. Yes, Senator, I believe that if Goldman Sachs 

would have failed, hypothetically, right now this week, the Government, the Federal Reserve, the authorities, would do whatever it 

could in this environment, with the economy as it is, with elections 

coming up, all of these people would work very hard to make sure 

that—they would take out management and shareholders possibly 

this time. I agree with that. But—— 

Senator CORKER. Well, now—— 

Mr. JOHNSON. No, no, but the key question, Senator, is the creditors. Do the creditors face losses, the bond holders? As you and 

your—— 

Senator CORKER. So you are saying that you do not believe if the 

U.S. taxpayers had a loss the clawback position would be taken 

into account? You do not think that would happen? 

Mr. JOHNSON. I do not believe the creditors of Goldman Sachs 

would lose any money. 

Senator CORKER. Chairman? 

Ms. BAIR. I absolutely think and know it would be used in a oneoff situation. There is no doubt in my mind. And, you know, I 

think, you know, when I hear Title II does not work, the resolution 

authority does not work, I hear that from two sides. I hear it from 

Simon, whom I respect deeply, who really wants to just break up 

the banks now, so, you know, let us say resolution authority does 

not work, and really the only solution is to break up the banks. 

Then I hear it from some of the weaker institutions who want to 

continue the assumption of Government bailouts so it cannot work. 

It can work in a one-off situation, it absolutely can, and would be 

used. 

I would also like to echo—and I have been saying this for a long 

time. The living will rule is a tremendous tool to get these institutions to restructure themselves, to create more operating subsidiaries that would be smaller, that might align themselves more with 

28 

your idea of what the appropriate size of a financial institution 

should be, which would make it much easier to resolve them, much 

less costly, and efficient to resolve them. And I do think this is a 

powerful tool over time to—these large institutions can be resolved 

now in a one-off situation, but going forward, it will make it less 

costly and more efficient if we can get them to rationalize their 

business lines with their legal entities and simplify their legal 

structures. 

Senator CORKER. Yes, sir? 

Mr. WILMARTH. I would caution that as we have allowed the 

banks to get larger, more complex, more interconnected, you do not 

get one-off problems, because when one of these big guys gets in 

trouble, inevitably either through spillover or contagion or because 

they are all pursuing the same high-risk activities, they are all in 

trouble. When you look at the history of the 1970s, the 1980s, the 

early 1990s, the 2000s, banks during those periods did not get into 

trouble one at a time. They got in trouble in groups, and the problem is now that the group has gotten smaller in number and bigger 

in size and more interconnected, more opaque, and so my view is 

that inevitably we will not have a problem with just one big financial conglomerate. We will have a problem with multiple conglomerates. And we will not be able to allow any of them to fail in your 

definition under those circumstances. 

Senator CORKER. Well, but I would say then, if you broke up, let 

us say, the largest institutions, you created thirty $400 to $500 billion institutions, if you had a systemic crisis, you would do exactly 

the same thing. They would be incredibly interconnected, even 

maybe more so at that size. And so are you telling me that if we 

had a systemic crisis in this country and every bank in the country 

was under $500 billion, you are telling me that we would not do 

exactly the same thing you would with four or five large banks? I 

absolutely believe we would do exactly the same thing. Somebody 

argue against that. 

Ms. BAIR. I think that if we had a repeat of the 2008 situation, 

with the authorities we have now, you would have a combination. 

It is pretty obviously the outliers—the multiple doses of bailout assistance, and those that really just needed liquidity support. The 

ones that were insolvent would go into a resolution. The ones that 

were not would get liquidity support under 13-3 from the Fed, possibly debt guarantees from the FDIC as approved by Congress, and 

I think you would have a combination. 

But you are right, if the system is having wider problems, there 

are going to be some subset of insolvent institutions that should go 

into a bankruptcy-like resolution and the rest should get liquidity 

support until we get out of it. 

Mr. JOHNSON. Senator, the evidence from banking crises around 

the world is typically—yes, a meteor can strike the Earth, I grant 

you that. But typically it is not the case that all of the mediumsize financial institutions fail at the same time. Their portfolios do 

differ. 

So I think this hypothetical that if we broke them up they would 

all become exactly the same and fail at exactly the same moment 

is extreme. 

29 

Senator CORKER. I am just saying that a systemic crisis, a systemic crisis, when you say the big guys all do the same size, well, 

you know, the banks that are all $500 billion are going to be doing 

the same thing, too. You are not going to change human behavior. 

You are not going to change the market. 

And so all I am saying is that—and I am not arguing against— 

by the way, I am still learning on the size issue. I do not think we 

as a country have come to grips with large, highly complex, systemic risk organizations. But I am just saying that if you have a 

systemic crisis, like Europe totally fails and contagion comes this 

way, if every bank in our country was under $500 billion or were 

under the construct we are in right now, you would still have the 

same issues to deal with, is all I am saying. Do you agree or disagree? 

Mr. JOHNSON. I agree with that statement, Senator. 

Senator CORKER. OK. 

Chairman BROWN. Senator Moran. 

Senator MORAN. I do not know exactly my question here, but to 

follow up on what Senator Corker is talking about, everything that 

I have read about the discussions about the collapse in 2008 suggests to me that the Federal Reserve, perhaps the FDIC, the Treasury Department were all worried about the confidence of others. 

And so they all were interrelated, even though each bank may have 

been different. And so to separate the financial institutions, if I am 

right in what I have read, the goal being of those who saw that we 

needed to bail out the financial institutions, it was that we cannot 

let this spread so that there is a lack of confidence in the system. 

And so you have got to take care of this institution because if it 

goes, there is going to be a run on the next institution. Again, I 

do not know what went on in those discussions in those rooms, but 

at least what I read as being reported as to what occurred suggests 

that a failure of one—it is perhaps what the professor was saying, 

that it does not happen in isolation, that you cannot have the—you 

would not have the scenario, the example that you described in 

which one major financial institution failed with no consequence to 

anyone else, if there is this genuine concern about the confidence 

in the system with a failure. 

And so I do not know how you separate—how you get rid of the 

systemic risk when you have so few large players, all of which 

seem to be interrelated, at least in the psyche of those who do business with that institution. Professor. 

Mr. WILMARTH. Yes. In thinking about the possibility of encouraging banks to slim down and to become less complex, in other 

words, to break up—we should go back to the 1980s and 1990s 

when we had a very thriving investment banking industry and a 

commercial banking industry, and they actually tended to offset 

each other. When one was in trouble, the other could help. And you 

saw that in 1987, for example, with the stock market crash, and 

you saw it going the other way during the 1998 Asian crisis, that 

each side could offset each other, and they were not all in the same 

things, that the securities firms tended to do something different 

from what commercial banks were doing. And so you did not have 

huge chunks of the system all exposed to the same risk. 

30 

Senator MORAN. Is that not an argument then against the 

Volcker Rule, which then would spread the risks among two separate kinds of banking activities? 

Mr. WILMARTH. No, the idea is that you do not want to have all 

the capital markets risks and all the lending risks residing together, which is what we now have. Under the ICB’s proposal in 

the U.K., if capital markets mistakes are made, they will not automatically take down your so-called utility banking. 

Of course, the other thing is if creditors believe that there will 

not be any cross-subsidization from utility banking and from the 

FDIC, the Federal safety net, over to what the English call ‘‘casino 

banking,’’ which is wholesale capital markets, then investors who 

put money into the capital markets through bonds and whatever 

are going to price that risk much differently than if they think the 

Government is going to cross-subsidize from utility banking into casino banking. 

So, I agree that we are in a bad space right now, and we have 

to decide how we get out of that space so we are in a better position next time. I believe that if we move the two segments apart 

into utility and casino with strong firewalls in between, first of all, 

you would not get cross-subsidization. Second, I think eventually 

specialist institutions would begin to reemerge. People would conclude that there is no advantage to being tied to a bank if I am 

a capital markets guy; let us go back to being the old Goldman 

Sachs. 

In the 1990s, our pure investment banks were beating the pants 

off everybody in Europe. They were the best at what they did. 

Senator MORAN. What is the advantage of being tied together? 

Mr. WILMARTH. Cross-subsidization, in my view. 

Senator MORAN. So we know it happens. That is—— 

Mr. WILMARTH. That is my view. It is pure cross-subsidization, 

the fact that too big to fail is not just covering banks. 

Senator MORAN. When you say cross-subsidization, you mean the 

support by the Federal Government, the FDIC—— 

Mr. WILMARTH. Yes. 

Senator MORAN. The Federal Reserve. 

Mr. WILMARTH. Too big to fail covers this. Until 1999, at least 

you could argue that too big to fail only covered the banking system. After 1999, it became clear that it covered all segments of the 

financial markets. 

Senator MORAN. I am happy as long as the Chairman allows you 

to—— 

Mr. SWAGEL. I was going to add, I am as puzzled as you are by 

some of that, that it seems like it is an argument not just against 

the Volcker Rule but also against the repeal of—the reinstitution 

of Glass-Steagall since, you know, the activities that cross the 

Glass-Steagall line can balance each other out, and that would suggest that it is useful to have them under the same roof. 

Just the other thought I had was on your original question about 

confidence and the discussions inside the Treasury. It is exactly 

right that banks exist, financial institutions exist on confidence, 

and imagine if Lehman and/or Bear Stearns has 2 percentage 

points more capital, or 4 or 5. It would not have mattered. I mean, 

once markets lost confidence—and that really was the point of the 

31 

TARP, of the CPP, the capital injections, and the FDIC’s loan guarantees at the same time, was to boost confidence in the entire system as a whole. 

Mr. JOHNSON. Just to add, Senator, the Europeans are on their 

way to nationalizing their banking system. It is a complete disaster. These are nationalized universal banks that are going to try 

and do everything—these slimmed down or more specialized American investments banks that Professor Wilmarth wants to take us 

back to will absolutely dominate that market. Of course they will. 

It is American capitalism at work. Taking away the cross-subsidization is going to help them be tougher and win in that global 

marketplace. The Europeans have no chance. 

Chairman BROWN. Ms. Bair, last word. 

Ms. BAIR. Yes, I just wanted to get back to your earlier comment 

about the arguments used during 2008. I must say, to be honest, 

I think those arguments were overused, and it was frustrating to 

me that we did not have good analysis. I kept hearing this, we cannot let one institution go down, everybody else is going to go down. 

I never really got what I considered hard analysis to back that up. 

But in a crisis situation, you err on the side of doing more as opposed to doing less because if you do not do enough, you could have 

a very big problem on your hand. But one of the things I emphasized in my testimony was the credit exposure report provision of 

Dodd-Frank. This is part of the living will requirement as well as 

the heightened prudential supervision standards the Fed is supposed to impose on large institutions. Under the credit exposure reports, the institutions have to identify their major credit exposures. 

In other words, they have to say, ‘‘If I go down, who else is going 

to go down? Or what other institutions are out there if they get in 

trouble, it is going to get me into trouble?’’ We did not have that 

kind of information. It is essential—I think that is one of the priority items in Dodd-Frank to get that rule out there and get that 

information and limit those exposures as a preventative measure. 

Senator MORAN. Mr. Chairman, thank you. Let me critique your 

selection of witnesses to your face. 

Chairman BROWN. Yes, sir. 

Senator MORAN. You could not have made it more difficult by 

finding sides that do not agree at all with each other. I am looking 

for the answer, and I get the arguments. 

Chairman BROWN. But they all look good. 

Senator MORAN. Agreed. 

Chairman BROWN. All right. We are going to do something a little unorthodox here. I have to leave. Senator Corker has a couple 

more questions that he is going to ask, so thank you for joining us. 

If the witnesses can stay another 5 or 10 minutes. I have got a conference call I have got to do. And I appreciate it so much. If there 

are any questions from the Committee, any letters or any questions 

to submit in writing, if you will give up to 5 business days, if you 

would answer those, and I turn it over to Senator Corker. 

Senator CORKER [presiding]. Thank you. I appreciate it. 

You know, I think if you went and talked to Goldman today, they 

would tell you they would be more than glad to move back to the 

way things were and only went public because of what occurred. I 

32 

mean, my sense is they would strongly love to see us in Washington separate the two as it was pre-1999. 

But let me just ask a question. Pre-1999, there still existed prop 

trading on the banking side, right? I mean, I think that is a myth 

that people have that prop trading did not occur in the banking 

side. Go ahead. 

Mr. WILMARTH. Yes, I have been a big critic for a long time of 

the fact that we allow derivatives in the insured bank. Financial 

derivatives are synthetic securities. 

Senator CORKER. But they were there, prerepeal of GlassSteagall. 

Mr. WILMARTH. Yes, and I think that was one of the big things 

that broke down Glass-Steagall. I think the Fed and the OCC were 

quite intentional in allowing the spreading and proliferation of derivatives as synthetic securities and synthetic insurance to break 

down both the Glass-Steagall Act and the Bank Holding Company 

Act barriers between insurance, securities, and banking. 

My proposal is that if you adopt my narrow bank utility/casino 

approach, derivatives do not belong on the utility side of banking. 

They belong on the casino side because they are a capital markets 

activity. 

Senator CORKER. So you would actually propose something more 

stringent than where we were in 1998. 

Mr. WILMARTH. Yes, certainly in the sense that if you want to 

do both—if you want to be a financial conglomerate doing both traditional banking and wholesale banking, yes, I am being tougher 

in the derivatives area than the Fed and the OCC were in the 

1990s. But I think, frankly, since derivatives have ended up being 

in the midst of every one of these big crises going back to the 

1980s, somewhere you find a derivatives connection, it seems to me 

it is about time we took that step. 

Senator CORKER. So you used the words ‘‘straight banking’’ and 

‘‘casino.’’ I assume the casino piece is a pejorative term. 

Mr. WILMARTH. That is what the English call it. ‘‘Wholesale 

banking’’ is a more neutral term. Thank you. 

Senator CORKER. Which is more risky? I mean, it is a serious 

question. It seems to me the lending piece is a more risky side of 

the equation, is it not? 

Mr. WILMARTH. We have certainly seen that if you do not supervise lending well, you will come to regret it. And certainly part of 

the story of the last crisis, as well as the previous ones, is a failure 

to supervise lending by regulators. But I think the key point that 

made everything worse is that we have allowed our desire to protect the traditional banking function to cross-subsidize the capital 

markets. And so the capital markets no longer price bonds of financial institutions in the way that they would if it was truly a market 

and risk was priced without a Government subsidy. The pricing 

has been distorted because if you are dealing with the largest institutions, bond holders will not price that risk the way they would 

if you were dealing with a pure Goldman Sachs without any banking connection, just a pure wholesale merchant bank, as Professor 

Johnson has explained. 

Senator CORKER. Go ahead, sir. 

33 

Mr. JOHNSON. Senator, I think you asked the right question: 

Which is more risky? We have seen cycles where it goes either way, 

absolutely. But, remember, part of the argument for the development of these megaconglomerates was this would diversify risk. We 

have not seen that. In fact, they have actually concentrated risk. 

And I think Professor Wilmarth has a very important point when 

he says you want to have different players, a more decentralized 

system actually, to go back to one of the points Mr. Swagel made 

at the beginning, a more decentralized system with more different 

people. You cannot just have one group or one person or one small 

set of executives make these big mistakes, if they are mistakes, 

that bring down the system or threaten to bring down the system 

or put a credible threat on Sheila Bair’s desk. That is what you 

want to avoid. 

And in terms of the value of these conglomerates to society, what 

have they brought to the table? I know of no study, none, that 

shows economies of scale or scope in banking above $100 billion in 

total assets. And we are talking about $1, $2, $3 trillion banks. So 

we have gone way beyond where the economies of scale and scope 

are. And it would be great—perhaps that you should bring Goldman Sachs down here to testify under oath that they would be delighted to go back to a broken-up smaller bank system. That would 

be incredibly helpful. 

Senator CORKER. I am, by the way, surmising. I am not speaking 

on their behalf. 

Mr. JOHNSON. I understand. But that would be a very helpful 

statement if they would like to go on the record. 

Senator CORKER. Let me ask a question. On the issue of 

Volcker—I know that is not the subject of this, but I know Sheila 

brought it up in her testimony. It does appear to me that Volcker 

as written is not written in a way that really deals with the issue 

in an appropriate manner. Is that agreed by all four panelists? 

Ms. BAIR. Yes, I do, I think it is somewhat at cross purposes. I 

really do. I think there are two different issues. There are safety 

and soundness issues. Obviously, you do not want any kind of highrisk activity, whether it is lending or anything else. But there is 

a separate question of what Government wants—what is the appropriate use of insured deposits? I think we would all agree that if 

the FDIC got a deposit insurance application of somebody wanting 

to bring in broker deposits to take speculative bets on Greek debt, 

we would not view that as an appropriate business plan for insured 

depository institutions. 

There has been a long-standing understanding that pure prop 

trading or speculative trading is not an appropriate use of deposits, 

and I think over time it has become harder and harder to know 

where the line is, and the fact that Volcker goes—to not only to the 

insured bank but to the affiliates of insured banks, which can be 

securities firms when we got rid of Glass-Steagall, I think that is 

extremely hard. But there are really two separate issues. One is 

safety and soundness. We have got that covered. The other is: 

What is the appropriate use of insured deposits? And I am not sure 

there is clarity on that point in the framework now. 

Mr. JOHNSON. Senator, I worked with proprietary trading in a 

major global investment bank in 1997 and 1998, and I would 

34 

strongly urge you not to have those activities in an important part 

of the financial system. It was pure speculation, and they lost a lot 

of money. ‘‘Other people’s money’’ was their attitude. I think that 

is—— 

Senator CORKER. But do you think Volcker as written addresses 

that issue? 

Mr. JOHNSON. I think the act is fine. I think what we are seeing 

coming from the regulators is not going to do as much good at all, 

unfortunately. That is my read of the process. 

Senator CORKER. Yes, I sure would love your written comments 

about a better way for the regulators to deal with the text. 

Mr. JOHNSON. I would be happy to provide those. 

Senator CORKER. Yes sir? 

Mr. SWAGEL. I just think that the Volcker Rule is meant to solve 

a problem that did not really matter in the crisis and does not 

clearly exist and would be very difficult to solve even if it did exist 

because it is so difficult to tell what is prop trading from what is 

normal market making. And I think the hundreds of pages from 

the regulators, they are doing their best, but in some sense that 

reflects it. 

Senator CORKER. You think that is one of the reasons treasurys 

were excluded? 

Mr. SWAGEL. Exactly. I mean, in some sense, the U.S. Government is in the business of selling Treasury securities and it would 

be kind of awkward to exclude a big demander, a big buyer of 

Treasuries. 

Senator CORKER. Yes, sir? 

Mr. WILMARTH. It seems to me that the ring-fencing approach 

advocated by the Independent Commission on Banking, like the 

narrow banking approach I have talked about, attacks the issue 

from the other way around, which is exactly the issue that Chairman Bair has identified. We should define the activities that we 

think are so important to the unique functions of banks that they 

deserve Federal safety net protection. We should put those activities within the ring-fenced, insulated bank. And then, I do not 

think repeal of Glass-Steagall would be necessary because if you 

did what the Independent Commission on Banking has proposed, 

or my narrow bank approach has proposed, the market will determine whether, in fact, it makes sense to keep these two different 

functions together. If the market does not believe that financial 

conglomerates provide attractive returns to investors without Government subsidies, conglomerates will break up voluntarily. It is 

essential that you put all the capital markets activities, including 

market making, including underwriting, including prop trading, including derivatives, in the wholesale bank, which cannot be subsidized by the Federal safety net. You have to make people believe 

that investors will bear the risks of those activities and the market 

will price those risks. I am not saying it is simple. But it is much 

more conceptually straightforward to view it that way. And since 

the U.K. is moving in that direction, and London and New York are 

the two leading financial markets, why shouldn’t we join in? If the 

two markets that dominate the world adopted that approach, Europe might also do so because it has to figure out a new way forward. I think we have a chance to convince people that there is a 

35 

better way to attack these issues and begin to restrain the safety 

net instead of wrapping the entire financial markets with the toobig-to-fail guarantee. 

Senator CORKER. So that Chairman Brown allows me to do this 

again when he has to make a conference call, I just want to ask 

one more question. It seems to me that the risk-weighted nature 

of the way we look at assets that we are—that Governments put 

in place through regulators, that has driven us to where we are. 

And I am wondering how you all would feel about just doing away 

with risk weighting period where we do not drive people to 

sovereigns saying they are risk free, we do not drive people to 

mortgage-backed securities where it is 50-percent risk weighted. 

What would be your response to that? And, Sheila, you are giving 

me no body language, so answer the question. 

[Laughter.] 

Ms. BAIR. OK. Well, I am a big fan of leverage ratio. I would like 

to see—it is 5 percent here. I would love to see it higher, and I 

would certainly love the international leverage ratio to be higher, 

which it is not being implemented in Europe, and there is no sign 

that it will be anytime soon. 

I think leverage ratios can be gamed, too. I think you need both. 

But absolute constraints on leverage should be your starting point, 

and then any capital additive to that should be based on if there 

is excessive risk on the bank’s balance sheet or riskier assets on 

the bank’s balance sheet. 

If you do not have some type of risk measure for capital as well 

with the leverage ratio, you will provide incentives for them to use 

the highest-risk, highest-yielding assets. So you need a combination. But the constraint on absolute leverage should be the starting 

point and risk-based should be above that. 

Mr. JOHNSON. I agree with you completely, Senator, on this 

point. I think we should have a 30-percent capital requirement 

where capital is not relative to risk-weighted assets. And I hear 

laughter around me, but—— 

Senator CORKER. It sounds like a railroad. 

Mr. JOHNSON. If you go back historically, the history of U.S. 

banking, before we had Federal guarantees of any kind, before the 

creation of the Federal Reserve, these are the kinds of capital levels that we used to have across the country in small banks and in 

big banks. This is what commodity trading firms with a lot of risk 

and no Government guarantee have in terms of capital. It is just 

equity funding. We are asking them to be more funded with equity, 

less funded with debt. We have become a very debt-centric society, 

Senator, and I think we should back away from that. 

Senator CORKER. We give tax benefits to debt and penalize equity, no question. 

Yes, sir? 

Mr. SWAGEL. I would just note that in the pre-FDIC era, it is 

true banks had a lot more capital. They had signs in the windows 

saying here is how much surplus capital we have. And we still had 

banking panics and banking crises, and really that is why the 

FDIC was created, to prevent that. You know, I think the crisis 

showed us we need more capital, and we definitely do not want to 

36 

follow the Europeans in there and sort of march—the race to the 

bottom in less capital. 

What the right number is, that is the key question. And my point 

is that there is an effect on activity. Going from where we are now 

to 30 percent or 50 or whatever it is, that would have an effect, 

and it is really the tradeoff between safety and economic vitality. 

Mr. WILMARTH. I think your instinct is absolutely right. I think 

the risk weightings have done much more mischief than good. It 

seems to me that a very strong leverage ratio focused on equity 

capital as opposed to all these hybrid instruments that do not 

stand up under stress is the most important thing. 

The second most important thing is to adopt a very good approach that would prevent excessive credit exposures or excessive 

credit concentrations or asset concentrations. That is harder to legislate across the board, but if supervisors were given strong tools 

to work with in controlling credit concentrations, asset concentrations, and they were able to enforce those against specific banks, 

then, if you trust your regulators and give them enough power, 

they should be able to see that particular banks are too much focused on one asset class or one type of credit exposure. But it is 

hard to legislate a mathematical formula and say that all 

sovereigns are risk free or all mortgages are only 50-percent risk 

weighted. We have seen what those types of formulas did. 

It seems to me the whole Basel II methodology needs to be taken 

back down to the foundation, and we need to think again about 

how we assess the risks of individual institutions. 

Senator CORKER. Well, listen, you all have been great witnesses. 

I thank you for your time. I thank the majority Committee for 

being sports and letting me do this, and the meeting is adjourned. 

Thank you. 

[Whereupon, at 3:48 p.m., the hearing was adjourned.] 

[Prepared statements and additional material supplied for the 

record follow:] 

37 

PREPARED STATEMENT OF SHEILA C. BAIR 

SENIOR ADVISOR, PEW CHARITABLE TRUSTS

DECEMBER 7, 2011 

Chairman Brown, Ranking Member Corker, and distinguished Members of this 

Subcommittee: It is my pleasure to address you today at this hearing entitled ‘‘A 

New Regime for Regulating Large, Complex Financial Institutions’’. 

There is no single issue more important to the stability of our financial system 

than the regulatory regime applicable to large financial institutions. I would hope 

that by now there is general recognition of the role certain large, mismanaged institutions played in the lead-up to the financial crisis, and the subsequent need for 

massive, governmental assistance to contain the damage caused by their behavior. 

The disproportionate failure rate of large, so-called systemic entities stands in stark 

contrast to the relative stability of smaller, community banks of which less than 5 

percent have failed. As our economy continues to reel from the financial crisis, with 

high unemployment and millions losing their homes, we cannot afford a repeat of 

the regulatory and market failures which allowed this debacle to occur. 

There is nothing inherently wrong with size in and of itself. In many business 

areas, large institutions can achieve significant economies and public benefits. However, size should be driven by market forces, not implied Government subsidies. 

Capital allocation should be determined by investors pursuing sound, innovative 

business models which promise sustainable returns based on acceptable risk tolerances. It should not be based on highly leveraged bets which promise privatization 

of benefits but socialization of losses if those bets fail. With the implied Government 

support provided to Fannie Mae, Freddie Mac, and so-called too-big-to-fail financial 

institutions, the smart money fed the beasts and the smart money proved to be 

right. As failures mounted, the Government blinked and opened up its check book. 

Creditors and trading partners were made whole. Many executives and board members survived. In most cases, the Government didn’t even wipe out shareholders before taking exposure. 

Implied Government subsidies of large financial institutions not only produce an 

unstable financial system, but they also skew allocation of capital away from other, 

more stable business sectors. As the charts in the appendix to my testimony show, 

beginning in the mid-1990s, the assets of financial firms grew much more rapidly 

than ‘‘real economy’’ assets, with financial firm assets peaking in 2007. Most of this 

growth was concentrated in the 30 largest institutions. From 2000 to 2008, leverage 

increased dramatically among large U.S. investment banks and large European and 

U.K. institutions. Fortunately, for U.S. commercial banks, leverage remained flat— 

primarily because the FDIC successfully blocked implementation of the Basel II advanced approaches for setting bank capital. These trends in growth and leverage 

were not accompanied by increases in traditional lending to support the nonfinancial sector. Rather, portfolio lending fell significantly as many large financial 

institutions found trading assets to be much easier and more profitable than going 

through the hard work of developing and applying sound underwriting standards for 

loans these large financial institutions planned to keep on their books. Regulators 

for the most part did not try to constrain these trends, but left the market largely 

to regulate itself. In some cases, for instance with the repeal of Glass-Steagall and 

passage of the Commodity Futures Modernization Act, Congress explicitly told the 

regulators ‘‘hands off.’’ As free markets became free-for-all markets, compensation 

rose, skyrocketing past wages paid to equally skilled employees in other fields. This 

enticed many of our best and brightest to forego careers in areas like engineering 

and technology to heed the siren song of quick, easy money from an overheated, 

over-leveraged financial industry. 

In recognition of the harmful effects of too big to fail policies, a central feature 

of the Dodd-Frank statute is the creation of a resolution framework which going forward will impose losses and accountability on shareholders, creditors, boards, and 

executives when mismanaged institutions fail. Under Title II of Dodd-Frank, the 

Government can now resolve systemic bank holding companies and nonbank entities 

using the same time tested tools the FDIC has used to resolve failing banks for decades. Such tools were not available during the 2008 crisis. I am very proud of the 

fact that the FDIC has already put into place regulations spelling out the process 

that will be used under Title II to resolve large financial institutions, including 

making clear the bankruptcy-like claims priority schedule that will impose losses on 

shareholders and creditors, not on taxpayers. We cannot end too big to fail unless 

we can convince the market that shareholders and creditors will take losses if the 

institution in which they have invested fails. For this reason, when I chaired the 

FDIC, we made the claims priority rules a first order of business after Dodd-Frank 

38 

was enacted, and I am very pleased that the ratings agencies have begun to remove 

the ‘‘bump up’’ they assign to the credit ratings of large financial entities based on 

their previous assumption of Government support. 

Another central feature of ending too big to fail is the Dodd-Frank requirement 

that large bank holding companies and nonbank systemic entities submit to both 

the Federal Reserve Board and the FDIC their resolution plans demonstrating how 

those financial firms could be resolved in a bankruptcy proceeding during a crisis 

without systemic disruptions. Rules implementing this so-called ‘‘living will’’ requirement were recently finalized by the FDIC and the FRB, with the first round 

of living will submissions required of the largest institutions next summer. The 

Dodd-Frank standard of resolvability in bankruptcy is a very tough one, and my 

sense is that all of the major banks will need to make significant structural changes 

to achieve it. In particular, they will need to do much more to rationalize their business lines with their legal entities, which will make it much easier for the FDIC— 

or a bankruptcy court—to hive off and sell healthy operations, while maintaining 

troubled operations in a ‘‘bad bank’’ which can be worked off over time. Aligning 

business lines with legal entities will also have important safety and soundness benefits. In particular, it will make it easier for distressed banks to sell operations to 

either raise capital or wind themselves down absent Government intervention. Finally, rationalizing and simplifying legal structures will improve the ability of 

boards and management to understand and monitor activities in these large banks’ 

far-flung operations. In this regard, I hope regulators will also give some consideration to requiring strong intermediate boards and managers to oversee major subsidiaries. Many of these centralized boards and management do not have a comprehensive understanding of what is going on inside their organizations. This was 

painfully apparent during the crisis. 

One element of Dodd-Frank’s living will provision that has not yet been implemented by the agencies is the requirement for credit exposure reports. Credit exposure reports are also required as part of Dodd-Frank’s mandate to the Federal Reserve Board to impose heightened prudential standards on large bank holding companies and other systemic entities. Credit exposure reports are essential to make 

sure regulators understand crucial interrelationships between distress at one institution and its potential to cause major losses at other institutions. This type of information was missing during the crisis. I know that many Members of this Subcommittee heard the same arguments that I heard during the crisis—that bailouts 

were necessary or the ‘‘entire system’’ would come down. But we never really had 

good, detailed information about the derivatives counterparties, bondholders, and 

others who we were ultimately benefiting from the bailouts and why they needed 

protecting. For those concerned about the potential ‘‘domino’’ effect of a large bank 

failure, it is essential not only to identify, understand, and monitor these exposures 

but also to limit them in advance to contain any possible contagion. I would urge 

the FDIC and FRB to complete this final piece of the living will rule as soon as possible. 

Resolution authority and planning are important to make sure the Government 

is prepared and has the right legal tools to handle a large institution when it fails. 

And make no doubt; there will always be failures, though hopefully they will be 

rare. No amount of prudential regulation will be able to eliminate the risk of failures. As I have discussed, resolution authority and planning also entail prophylactic 

benefits by improving regulatory and management understanding of these large institutions and by giving the investor community stronger incentives to conduct 

stringent due diligence before committing their investment dollars. A final prophylactic benefit emanates from the harshness of the resolution process, and it is a 

harsh process, particularly for boards and management who not only lose their jobs 

but are subject to a 2-year clawback of all of their compensation. This will give them 

strong incentives to avoid Title II resolution by raising capital or selling their operations, even if the terms seem unfavorable. More than one commentator has observed that Lehman Brothers’ management had multiple opportunities to sell the 

firm, albeit at punitive pricing, but refused to do so because they thought—unrealistically—that their firm was worth more and that. also, the Government would 

come in and provide assistance, as it had with the much smaller Bear Sterns. With 

Title II, large financial firms now know their fate if they fail, and it is not a pretty 

one. Bailouts are prohibited and there will be no exceptions. If they can’t right their 

own ship, they will sink with it. 

As important as resolution authority is, it obviously cannot substitute for high 

quality prudential supervision. We must do all that we can to prevent failures while 

at the same time recognizing that a healthy financial services sector needs reasonable latitude to innovate and take risks. Recognizing that there will always be some 

measure of risk taking in any profit-making endeavor, it is essential that we make 

39 

sure our financial institutions have thick enough cushions of capital to absorb unexpected losses when they occur. Excessive leverage was a key driver of the 2008 crisis 

as it has been for virtually every financial crisis in history. The perils of too much 

borrowing in creating asset bubbles, and the massive credit contractions that occur 

once the bubbles pop, have been learned and then forgotten throughout every major 

financial cycle. These perils were forgotten again in the early 2000s during the socalled golden age of banking when instead of acting to raise capital requirements 

and implement strong mortgage lending standards, regulators stood by and effectively lowered capital minimums among U.S. investment banks and European institutions through implementation of Basel II. 

We need to correct those mistakes through timely implementation of Basel III and 

the so-called ‘‘SIFI surcharges’’ which taken together, strengthen the definition of 

high quality capital and also impose risk based ratios as high as 9.5 percent on our 

largest institutions. In the near term, given the obvious flaws in the way banks riskweight assets under Basel II, regulators’ primary focus should be on constraining 

absolute leverage through an international leverage ratio that is significantly higher 

than the Basel Committee’s proposed 3 percent standard. We must also not backtrack on agreements to maintain stringent standards for true tangible common equity. Both Basel III as well as the Collins amendment in Dodd-Frank phase-out the 

use of hybrid debt instruments for Tier 1 capital because these instruments proved 

to have no real loss absorbing capacity during the crisis. Fortunately, in the U.S. 

at least, there seems to be emerging consensus that convertible debt instruments 

should also not count as Tier 1 capital. I deeply fear that so-called ‘‘cocos,’’ if ever 

triggered, would likely cause a run on the issuing bank instead of stabilizing it. 

Many industry advocates continue to argue that higher capital requirements will 

inhibit lending. It is true that equity capital is marginally more expensive than 

debt. This is due, in part, to the ‘‘too big to fail’’ doctrine as well as the favored tax 

treatment of debt over equity. But this is not a reason to allow them to keep 

leveraging up. It is fallacy to think that thinly capitalized institutions will do a better job of lending. Throughout the crisis, better capitalized community banks maintained stronger loan balances than their large bank competitors. A large financial 

institution nearing insolvency will quickly pull credit lines and cease lending to 

maintain capital. This is why we had such a severe recession. On the other hand, 

a well capitalized bank will keep functioning even when the inevitable business 

cycle turns downward. There may be some small, incremental increase in the cost 

of credit from higher capital levels in good times, but the benefit of stability in bad 

times more than outweighs those costs. 

If there is any question as to why we need strongly capitalized banks, one need 

look no further than Europe where lax capital regulation has resulted in a highly 

leveraged banking system that is poorly positioned to absorb losses associated with 

its sovereign debt crisis. I know some American bank CEOs have complained about 

the higher capital standards we have in the U.S.—and they are right—in part. Capital regulation is much tougher here and I hope it’s going to get even tougher. But 

do we want the European banking system? That system is now so fragile it is doubtful that even the strongest banks could raise significant new capital from nongovernment sources. The choices in Europe are not pretty. They can let a good portion of their banking system fail or they can commit to massive financial assistance 

through a combination of ECB bond buying and loans and guarantees from the IMF 

and stronger Eurozone countries. Frankly, I don’t know which is worse. 

Liquidity is another area which needs more attention from regulators, both in the 

U.S. and internationally. In the years leading up to the crisis, financial institutions 

became more and more reliant on cheap, short-term credit, which they would use 

to fund longer term, illiquid mortgage-related assets. Much of this credit was provided by money market mutual funds. As the market began to lose confidence in 

the values of those assets, creditors refused to keep extending credit which caused 

widespread funding shortages. Money market mutual funds in particular took flight 

at the first sign of trouble to keep from ‘‘breaking the buck.’’ 

Though financial institutions have made significant progress in extending the average maturities of their liabilities, this has been driven in part by market conditions. We need to put strong rules in place on the liability side of the balance sheet 

to prevent a recurrence of the liquidity failures of 2008. For instance, we need to 

dramatically toughen the types of collateral than can be used to secure repos and 

other short term loans. We should also think about caps on the amount of short 

term debt that financial institutions can use to fund their balance sheets, as well 

as the establishment of minimum requirements for the issuance of long term debt. 

And finally, money market mutual funds should be required to use a floating NAV 

which should substantially reduce this highly volatile source of short term funding. 

40 

A final preventative measure I would like to discuss is the Volcker Rule. The basic 

construct of the Volcker Rule is one that I strongly support. FDIC insured banks 

and their affiliates should make money by providing credit intermediation and related services to their customers, not by speculating on market movements with the 

firm’s funds. However, to some extent this basic construct is at odds with Congress’ 

1999 repeal of Glass-Steagall, which allowed insured banks to affiliate with securities firms, and—let’s be honest—making money off of market movements is one of 

the things that securities firms have long done. Recognizing these competing policy 

priorities, Congress recognized exceptions from the Volcker Rule for traditional securities activities such as market making and investment banking. But the line between these exceptions and prohibited proprietary trading is unclear. 

I fear that the recently proposed regulation to implement the Volcker Rule is extraordinarily complex and tries too hard to slice and dice these exceptions in a way 

that could arguably permit high risk proprietary trading in an insured bank while 

restricting legitimate market making activities in securities affiliates. I believe that 

the regulators should think hard about starting over again with a simple rule based 

on the underlying economics of the transaction, not on its label or accounting treatment. If it makes money from the customer paying fees, interest, and commissions, 

it passes. If its profitability or loss is based on market movements, it fails. And the 

inevitable gray areas associated with market making and investment banking 

should be forced outside of the insured bank and supported by higher capital given 

the greater risk profile of those activities. 

In addition, the new rules should require executives and boards to be personally 

accountable for monitoring and compliance. Bank leadership needs to make it clear 

to employees that they are supposed to make money by providing good customer 

service, not by speculating with the firm’s funds. 

Complex rules are easy to game and difficult to enforce. We have too much complexity in the financial system already. If regulators can’t make this work, then 

maybe we should return to Glass-Steagall in all of its 32 page simplicity. 

Much work remains to be done to rein in the types of activities undertaken by 

large financial institutions that caused our 2008 financial crisis. However, through 

robust implementation of a credible resolution mechanism, strong capital and liquidity requirements, and curbs on proprietary trading, we can once again make our financial system the envy of the world and an engine of growth for the real economy. 

That concludes my testimony. Thank you again for the opportunity of testifying. 

41 


12711001.eps

Appendix: 

Financial service firm assets have grown faster than nonfinancial service firm assets 

Total assets for FS firms' and non-FS firms' (1990 - 2010) 

FS firm assets ($8) 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

Non-FS firm assets 

Total non-FS firms (RHS) 

Total FS firms (LHS) 

GSE's 

REITs! oll1er Real Estate 

ThriftsZl'ld MCftgage 

Consumer Finance 

capital Markets 

Insurance 

Commerdal Banks 

()versifiedFS 

::~~~;t~~ .14 .18.20 .24 .28 .29 .30 .33 .32 .30 .26 .26 .24 .24 .22 .22 .21 .18 .19 .19 .23 

= , 

11% 

14% 

22% 

39% 

13% 

59% 

16% 

21% 

7% 

16% 

1. In,ludes all pub~c~~ traded lInanclal saMeellrms8s well 8S GSE's (FICO and FCS .. eluded due to lack of dalal. 2. Includes .1 pulllically traded non·ftnanclal service firms. 3. C~GR 

slandslorcompoundannual grov.lhrale,Source:CapliaIIO. 

Growth in financial service firm assets has been driven by 

the largest firms 

Total assets for FS firms' by size (1990 - 2010) 

$Bassets 

20,000 

15,000 

10,000 

5,000 

1990 1995 ;ro) 2005 

1. lncludesallpubNclItytradedl'lllanclalseMc. ftrms,bulexcludesGSEs,FIrm size mt nured by 2010 nstts Sourct :CapflllQ 

R.~ 

Top-50 

Top-30 

Top-1 0 

2010 

3% 14% 

14% 6% 

24% 17% 

24% 62% 
42 


12711002.eps

During the 2000s, asset growth was fueled by leverage, 

both in the US and in Europe 

Leverage at US and European LCFls' (2000 - 2010) 

Leverage ratio2 

50 

45 

40 

35 

30 

25 

20 -1-=::::------

'5 r-----------------,, __ --____ --------~ 10 

2000 2001 2002 2003 2004 2005 

1. lCFI$1and$forla'ge, complexfinanclallnsllllJl ion 

Z. Leverageequalsassetsoverloialshareholderequnynelofmlnorilym1erests 

Nole:AnalyslsdoesnoiadJuslfo,nccounllngdifrerences 

Sourc. : Haldane, B,ennan. Madouros (2010j 

2000 2007 2008 2009 2010 

European LCFls 

Major UK banks 

US securities houses 

US commercial banks 

Primarily, asset growth resulted from increases in trading 

assets and not loans to customers 

LCFls' trading assets and loans to customers as a share of assets 

% of total assets 

50 

45 

40 

35 

30 

25 

Total loans to customers as a 

proportion of total assets 

Total trading assets as a 

proportion of total assets 

'5 +--~--~--~-~--~--~-~--_--r--~ 

2000 2001 2002 2003 

Not, : Includes all US comm ercial bank LeFt •. European LCFts, end UK LeFts 

SQurc.:H.ldane. Brennan , Madou,cs (2010) 

2004 2005 2006 2007 2008 2009 2010 

2 
43 


12711003.eps

FS industry's relative wage responds to regulatory and 

deregulatory actions 

Relative wages in the financial services industry (1910 - 2006) 

1.7 

1.6 

15 

1.4 

13 

12 

1.1 

1.0 

1910 1920 1930 1940 1950 1960 1970 1980 

NoIe:Relall\tewage:lherallooflheaclualwageslntheFlnantlaISedorlolheNon Farm PrtvaieSeclor 

Source:"Wages & Human capnalln the US Flnanclallnduslry: 1909·2006" by Thomas Phillppen and Mell Reshe!, December 2008 

1990 2000 

o Regulatory legislation 

• Deregulatory legislation 

Relative wages 

FS industry wages are high both in a historic sense as well 

as relative to their estimated benchmark level 

Relative wages in the financial services industry (1910 - 2006) 

Relative financial wage 

1.7 Rei wage in FS 

1.6 

1.5 

1.4 

1.3 

Benchmark 

1.2 

1.1 

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2006 

Note: Relative wage = the ratio of the actual wages In the Financial Sedor to lhe Non Farm Priltale Sedor 

SourcI:"Wages & Humen cap~alln the US Flnanclallnduslry: 1909·2006" by Thomas Philippen and Anell Reshe!, December 2008 
44 

1Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; Senior Fellow, Peterson Institute for International Economics; and cofounder of http:// 

BaselineScenario.com. This testimony draws on joint work with James Kwak, particularly 13 

Bankers: The Wall Street Takeover and The Next Financial Meltdown, and Peter Boone, including Europe on the Brink. Please access an electronic version of this document, e.g., at http:// 

BaselineScenario.com, where we also provide daily updates and detailed policy assessments. For 

additional affiliations and disclosures, please see: http://baselinescenario.com/about/. 

PREPARED STATEMENT OF SIMON JOHNSON 

RONALD A. KURTZ PROFESSOR OF ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF

MANAGEMENT

DECEMBER 7, 2011 

Main Points 

1. Recent adjustments to our regulatory framework, including the ‘‘Dodd-Frank 

Wall Street Reform and Consumer Protection Act’’, have not fixed the core 

problems that brought us to the brink of complete catastrophe in fall 2008: 1

• Powerful people at the heart of our financial system still have the incentive 

and ability to take on large amounts of reckless risk—through borrowing 

large amounts relative to their equity. When things go well, a few CEOs and 

a small number of others get huge upside—estimated at over $2 billion from 

2000 to 2008 at the top 14 U.S. financial institutions. 

• When things go badly, society, ordinary citizens, and taxpayers get the downside, including more than 8 million jobs lost and a medium-term increase in 

debt-to-GDP of at least $7 trillion (roughly 50 percent of GDP). 

2. This is a classic recipe for financial instability and fiscal calamity. 

3. Our six largest bank holding companies currently have assets valued at close 

to $9.5 trillion, which is around 62.5 percent of GDP (using the latest available 

data, from end of Q3, 2011). The same companies had balance sheets worth 

around 55 percent of GDP before the crisis (e.g., 2006) and no more than 17 

percent of GDP in 1995. 

4. With assets ranging from around $800 billion to nearly $2.5 trillion (under 

U.S. GAAP), these bank holding companies are perceived by the market as ‘‘too 

big to fail,’’ meaning that they are implicitly backed by the full faith and credit 

of the U.S. Government. They can borrow more cheaply than their competitors—estimates place this advantage between 25 and 75 basis points—and 

hence become larger. 

5. In public statements, top executives in these very large banks discuss their 

plans for further global expansion—presumably increasing their assets further 

while continuing to be highly leveraged. In its public statements, the U.S. 

Treasury appears to endorse this strategy. 

6. In this context, the Troubled Asset Relief Program (TARP) played a significant 

role preventing the deep recession of 2008–09 from becoming a full-blown 

Great Depression, primarily by providing capital to financial institutions that 

were close to insolvency or otherwise under market pressure. But these actions 

further distorted incentives at the heart of Wall Street. Neil Barofsky, the Special Inspector General for the Troubled Assets Relief Program put it well in 

his January 2011 quarterly report, emphasizing: ‘‘perhaps TARP’s most significant legacy, the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to 

fail.’ ’’ 

7. To see just the fiscal impact of the finance-induced recession, consider 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 would 

rise to $13.7 trillion (over 65 percent of GDP)—a difference of $8.6 trillion. 

8. Most of this fiscal damage 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 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 

45 

2See also, the May 2010 edition of the IMF’s cross-country fiscal monitor for comparable data 

from other industrialized countries, http://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf. 

The box on debt dynamics shows that mostly these are due to the recession; fiscal stimulus only 

accounts for 1⁄10 of the increase in debt in advanced G20 countries. Table 4 in that report compares support by the Government for the financial sector across leading countries; the U.S. provided more capital injection (as a percent of GDP) but lower guarantees relative to Europe. 

United States are relatively weak); and another 14 percent is due to increased 

interest payments on the debt—because we now have more debt. 2

9. In effect, a financial system with dangerously low capital levels—hence prone 

to major collapses—creates a nontransparent contingent liability for the Federal budget in the United States. It also damages the nonfinancial sector both 

directly—when there is a credit crunch, followed by a deep recession—and indirectly through creating a future tax liability. 

10. In principle, Section 165 of Dodd-Frank strengthens prudential standards for 

large, interconnected financial institutions—including ‘‘nonbanks.’’ In practice, 

all the available evidence suggests that big banks and other financial institutions are still seen as Too Big To Fail. This is not a market; it is a largescale, nontransparent, and unfair Government subsidy scheme. It is also very 

dangerous. 

11. There is nothing in the Basel III accord on capital requirements that should 

be considered encouraging. Independent analysts have established beyond a 

reasonable doubt that substantially raising capital requirements would not be 

costly from a social point of view (e.g., see the work of Anat Admati of Stanford University and her colleagues). 

12. But the financial sector’s view has prevailed—they argue that raising capital 

requirements will slow economic growth. This argument is supported by some 

misleading so-called ‘‘research’’ provided by the Institute for International Finance (a lobby group). The publicly available analytical work of the official 

sector on this issue (from the Bank for International Settlements and the New 

York Fed) is not convincing—if this is the basis for policymaking decisions, 

there is serious trouble ahead. 

13. Even more disappointing is the failure of the official sector to engage with its 

expert critics on the issue of capital requirements. This certainly conveys the 

impression that the regulatory capture of the past 30 years (as documented, 

for example, in 13 Bankers) continues today—and may even have become 

more entrenched. 

14. There is an insularity and arrogance to policy makers around capital requirements that is distinctly reminiscent of the Treasury-Fed-Wall Street consensus regarding derivatives in the late 1990s—i.e., officials are so convinced 

by the arguments of big banks that they dismiss out of hand any attempt to 

even open a serious debate. 

15. The purpose of the Volcker Rule (section 619 of Dodd-Frank, but also sections 

620 and 621) is to restrict activities by large banks that have implicit Government support. The legislative intent is to create an eminently sensible failsafe 

mechanism—to prevent speculative ‘‘proprietary trading’’ by banks that have 

implicit Government support. 

16. Unfortunately, the draft Volcker Rule-related regulations give undue primacy 

to preserving market structure ‘‘as is.’’ In particular, the Federal Reserve 

seems inclined to keep universal banks engaged in securities trading, regardless of the consequences for systemic risk. There are too many regulator created loopholes and exemptions. Systemically important nonbank financial 

companies should be included within the scope of the Rule. There should be 

better communication of what is and what is not proprietary trading—to ensure consistency across firms and integration with their reporting systems. 

There needs to be guidance on what constitutes significant loss and substantial risk. We also have no clear picture regarding how compliance would be 

enforced. 

17. In any case, the Volcker Rule is a complement not a substitute for any other 

reasonable measures taken to reduce the dangers inherent in large-scale financial institutions. 

18. Section 622 of Dodd-Frank, ‘‘Concentration Limits on Large Financial Firms’’ 

also held considerable promise—aiming to ensure that no one firm be able to 

46 

3See, http://baselinescenario.com/2010/05/26/wall-street-ceos-are-nuts/, which contains this 

quote from an interview in New York Magazine: ‘‘ ‘If enacted, Brown-Kaufman would have broken up the six biggest banks in America,’ says the senior Treasury official. ‘If we’d been for it, 

it probably would have happened. But we weren’t, so it didn’t.’ ’’ 

‘‘merge and consolidate’’ in such a way as to raise its share of ‘‘aggregate consolidated liabilities of all financial companies’’ above 10 percent. Unfortunately, there appears to be little or no willingness on the part of regulators 

for turning this in real rules that can be enforced. Big is still beautiful, it appears, in the eyes of key members of the Financial Stability Oversight Council. 

19. Next time, when our largest banks get into trouble, they may be beyond Too 

Big To Fail. As seen recently in Ireland and as may now happen in other 

parts of Europe, banks that are very big relative to an economy can become 

‘‘too big to save’’—meaning that while senior creditors may still receive full 

protection (so far in the Irish case), the fiscal costs overwhelm the Government and push it to the brink of default (or beyond). 

20. The fiscal damage to the United States in that scenario would be immense, 

including through the effect of much higher long term real interest rates. It 

remains to be seen if the dollar could continue to be the world’s major reserve 

currency under such circumstances. The loss to our prestige, national security, and ability to influence the world in any positive way would presumably 

be commensurate. 

21. In 2007–08, our largest banks—with the structures they had lobbied for and 

built—brought us to the verge of disaster. TARP and other Government actions helped avert the worst possible outcome, but only by providing unlimited 

and unconditional implicit guarantees to the core of our financial system. At 

best, this can only lead to further instability in what the Bank of England 

refers to as a ‘‘doom loop.’’ At worst, we are heading for fiscal disaster and 

the loss of reserve currency status. 

22. During the Dodd-Frank legislative debate, there was an opportunity to cap 

the size of our largest banks and limit their leverage, relative to the size of 

the economy. Unfortunately, the Brown-Kaufman Amendment to that effect 

was defeated on the floor of the Senate, 33–61, in part because it was opposed 

by the U.S. Treasury. 3

Resolution Under Dodd-Frank 

The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small- or medium-sized financial institutions. It 

does not yet have a similarly effective way to deal with the insolvency of large financial institutions. The dire implications of this gap in our system have become much 

clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table. 

In fact, our underlying banking system problems are likely to become much worse. 

In spring 2010, during the Dodd-Frank financial reform debate—Senator Ted 

Kaufman of Delaware emphasized repeatedly on the Senate floor that the proposed 

‘‘resolution authority’’ was an illusion. His point was that extending the established 

Federal Deposit Insurance Corporation (FDIC) powers for ‘‘resolving’’ (jargon for 

‘‘closing down’’) financial institutions to include global megabanks simply could not 

work. 

At the time, Senator Kaufman’s objections were dismissed by ‘‘experts’’ both from 

the official sector and from the private sector. The results are reflected in Title II 

of Dodd-Frank, ‘‘Orderly Liquidation Authority.’’ 

Now these same people (or their close colleagues) are arguing resolution cannot 

work for the country’s giant bank holding companies. The implication, which these 

officials and bankers still cannot grasp, is that we need much higher capital requirements for systemically important financial institutions. 

Writing in the March 29, 2011, edition of the National Journal, Michael Hirsch 

quotes a ‘‘senior Federal Reserve Board regulator’’ as saying: 

Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and 

settlement systems,’’ and, ‘‘We think we’re going to effectively resolve that 

using Dodd-Frank? Good luck! 

The regulator’s point is correct. The FDIC can close small- and medium-sized 

banks in an orderly manner, protecting depositors while imposing losses on shareVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00050 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
47 

holders and even senior creditors. But to imagine that it can do the same for a very 

big bank strains credulity. 

And to argue that such a resolution authority can ‘‘work’’ for any bank with significant cross-border is simply at odds with the legal facts. The resolution authority 

granted under Dodd-Frank is purely domestic, i.e., it applies only within the United 

States. The U.S. Congress cannot make laws that apply in other countries—a crossborder resolution authority would require either agreement between the various 

Governments involved or some sort of synchronization for the relevant parts of commercial bankruptcy codes and procedures. 

There are no indications that such arrangements will be made—or that there are 

serious intergovernmental efforts underway to create any kind of cross-border resolution authority, for example, within the G20. 

For more than a decade, the International Monetary Fund has been on the case 

of the eurozone to create a cross-border resolution mechanism of some kind within 

their shared currency area. But European (and other) Governments do not want to 

take this kind of step. Rightly or wrongly, they do not want to credibly commit to 

how they would handle large-scale financial failure—preferring instead to rely on 

various kinds of ad hoc and spontaneous measures. The adverse consequences are 

apparent for all to see in Europe at present; yet there is still no move to establish 

a viable cross-border resolution authority. 

I have checked these facts directly and recently with top Wall Street lawyers, with 

leading thinkers from left and right on financial issues (U.S., European, and others), 

and with responsible officials from the United States and other relevant countries. 

That Senator Kaufman was correct is now affirmed on all sides. 

Even leading figures within the financial sector are candid on this point. Hirsch 

quotes Gerry Corrigan, former head of the New York Federal Reserve Bank, and 

an executive at Goldman Sachs since the 1990s. 

In my judgment, as best as I can recount history, not just the last 3 years 

but the history of mankind, I can’t think of a single case where we were 

able execute the orderly wind-down of a systemically important institution—especially one with an international footprint. 

It is most unfortunate that Mr. Corrigan did not make the same point last year— 

for example, when he and I both testified before the Senate Banking Committee on 

the Volcker Rule (in February 2010). 

In fact, rather ironically in retrospect, Mr. Corrigan was among those arguing 

most articulately that some form of ‘‘Enhanced Resolution Authority’’ (as he called 

it) could actually handle the failure of Large Integrated Financial Groups (again, 

his terminology). 

The ‘‘resolution authority’’ approach to dealing with very big banks has, in effect, 

failed before it even started. 

And standard commercial bankruptcy for global megabanks is not an appealing 

option—for reasons that Anat Admati has explained. The only people who are 

pleased with the Lehman bankruptcy are bankruptcy lawyers. Originally estimated 

at over $900 million, bankruptcy fees for Lehman Brothers are now forecast to top 

$2 billion (more detail on the fees here). 

It’s too late to reopen the Dodd-Frank debate—and a global resolution authority 

is a chimera in any case. But it’s not too late to affect policy that matters. The lack 

of a meaningful resolution authority further strengthens the logic behind the need 

for larger capital requirements, as these would provide stronger buffers against 

bank insolvency. 

The Federal Reserve has yet to announce the precise percent of equity funding— 

i.e., bank capital—that will be required for systemically important financial institutions (so-called SIFIs). Under Basel III, national regulators set an additional SIFI 

capital buffer. The Swiss National Bank is requiring 19 percent capital and the 

Bank of England is moving in the same direction. The Fed should also move towards such capital levels or—preferably—beyond. 

Unfortunately, there are clear signs that the Fed’s thinking—both at the policy 

level and at the technical level—is falling behind this curve. 

It is not too late to listen to Senator Kaufman. In his capacity as chair of the Congressional Oversight Panel for TARP during 2011 (e.g., in this hearing), Mr. Kaufman argued consistently and forcefully for higher capital requirements. This would 

work as a global approach to make banking safer. Unfortunately, making progress 

on this issue with European countries will be much delayed—at least until the 

eurozone has sorted out its combined fiscal-monetary-financial disaster. 

The best approach for the United States today would be to make all financial institutions small enough and simple enough so they can fail—i.e., go bankrupt—without adversely affecting the rest of the financial sector. The failures of CIT Group 

48 

in fall 2009 and MF Global in fall 2011 are, in this sense, encouraging examples. 

But the balance sheets of these institutions were much smaller—about $80 billion 

and $40 billion, respectively—than those of the financial firms currently regarded 

as Too Big To Fail. 

PREPARED STATEMENT OF THE HONORABLE PHILLIP L. SWAGEL 

PROFESSOR OF INTERNATIONAL ECONOMIC POLICY, UNIVERSITY OF MARYLAND

SCHOOL OF PUBLIC POLICY

DECEMBER 7, 2011 

Chairman Brown, Ranking Member Corker, and Members of the Committee, 

thank you for the opportunity to testify on the new regime for regulating large, complex financial institutions. I am a professor at the University of Maryland’s School 

of Public Policy and a faculty affiliate of the Center for Financial Policy at the Robert H. Smith School of Business at the University of Maryland. I am also a visiting 

scholar at the American Enterprise Institute and a senior fellow with the Milken 

Institute’s Center for Financial Understanding. I was previously Assistant Secretary 

for Economic Policy at the Treasury Department from December 2006 to January 

2009. 

Failures in the regulation of large complex financial institutions played an important role in the financial crisis. Many large American financial firms required substantial assistance from the Federal Government, including capital injections and 

asset guarantees through the TARP and access to a range of liquidity facilities from 

the Federal Reserve. At the same time, the main problems in subprime housing that 

gave rise to the crisis arose outside the most heavily regulated parts of the financial 

system among nonbank mortgage originators, Fannie Mae and Freddie Mac, and 

participants in the so-called shadow banking system. 

Indeed, a broad view of the crisis shows failures by market participants at all levels of the financial system: sophisticated asset managers who bought subprime 

mortgage-backed securities (MBS) without understanding what was inside or demanding more information; securitizers who put those faulty securities together; 

rating agencies that stamped them as AAA; bond insurers who covered them; originators who made the bad loans in the first place; mortgage brokers who facilitated 

the process; and so on, including crucial deficiencies at the Government-Sponsored 

Enterprises (GSEs) of Fannie Mae and Freddie Mac. (Unfortunately one must also 

add to the list of failures the actions of some home buyers in providing inaccurate 

information on mortgage applications or in signing on the dotted line for a house 

they could not afford—though of course there was someone on the other side of each 

of these transactions willing to extend the loan.) 

Moreover, the severe credit strains that ensued following the failure of Lehman 

Brothers in September 2008 were made considerably worse by problems in money 

market mutual funds—large, to be sure, but hardly a complex type of financial institution. The new regulatory regime for large, complex financial institutions is a vital 

part of lessening the likelihood of future crises, but it is important to keep in mind 

that there were many contributors to recent events beyond these firms and that an 

undue focus on this one element risks missing out on others. 

Getting the right balance between financial market regulation and dynamism, including the possibility of failure and creative destruction, is an essential element of 

fostering a more robust economic recovery and a strong U.S. economy into the future. The slow recovery from the recent recession reflects many factors, including 

the drag on demand from deleveraging by consumers and firms, the negative impact 

of policy and regulatory decisions, and the overhang of uncertainty about future 

taxes, health and energy costs, and so on. But drag from the financial system is 

likely playing a role as well, with many families and businesses still finding constrained access to credit. While loans were too readily available before the crisis, 

a danger today is that the pendulum has swung too far in the other direction. The 

caution of market participants in putting capital at risk could be exacerbated by uncertainty over the impact of ongoing financial regulatory changes. This uncertainty 

will weigh on the financial sector and the economy. 

Detecting and Avoiding Future Problems in the New Regulatory Regime 

Regulators did not detect problems in the financial system and act upon the 

mounting stresses in time to avert the crisis. This reflects failures by the regulators 

(as was evident in the problems at institutions such as Countrywide, WAMU, 

IndyMac, and many other firms) and shortcomings and gaps in the regulatory system (as revealed, for example, in the case of AIG, in which no regulator had an adequate line of sight over the activities of the financial products division). This latter 

49 

problem of the fragmented nature of the U.S. regulatory system was long-understood; indeed, the Treasury Department under the direction of Secretary Paulson in 

early 2008 put out a thoughtful blueprint to reshape U.S. regulatory system by function. 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) 

includes important provisions that will help avoid future problems and improve the 

likelihood of detecting them as they arise. Dodd-Frank further provides authorities 

with tools to deal with severe problems when necessary. The new regulatory regime 

has the promise of improvement over the one that failed to prevent the recent financial crisis. But much of the change embodied in Dodd-Frank remains to be finalized 

by regulators, some provisions of the Act do not seem to contribute positively to an 

improved regulatory regime, and there are still important missing elements in the 

legislation, notably with respect to reform of the housing finance system and of 

money market mutual funds. 

Improved capital standards and more robust liquidity requirements in both the 

Dodd-Frank Act and through the Basel III process will help make large, complex 

financial institutions more robust to losses and thereby help to avoid future crises. 

While it is hard to imagine that 2 or 4 percentage points of additional capital would 

have saved Lehman Brothers or Bear Stearns once investors lost confidence in those 

institutions, more capital will help deepen the buffer in the future before confidence 

is lost. As discussed below, however, there are costs as well as benefits to increased 

capital requirements—the challenge for regulators (and for society) is to find the 

balance. 

The establishment of the Financial Stability Oversight Council (FSOC) and the 

Office of Financial Research (OFR) make it more likely that regulatory authorities 

will detect building problems. The FSOC in particular will help avoid a repetition 

of the problems evident in oversight of AIG, where risky activities at one division 

slipped between the cracks in the sense that no regulator had clear responsibility. 

Going forward, all systemically important financial institutions will be subject to 

bank-like regulation. Dodd-Frank further empowers the regulatory agencies acting 

jointly, but especially the Federal Reserve, to look across firm activities and across 

industry participants to watch for mounting risks. This will help get at the issue 

that subprime lending was not necessarily a problem for many individual industry 

participants (though it was for some such as Countrywide and WAMU), but 

subprime lending taken together across firms posed a risk to the financial sector. 

The Office of Financial Research likewise has the potential to help regulators obtain and analyze information across firms and asset classes. Asking for information 

involves costs, however, and it will be important for the OFR to avoid overly burdensome requests. But the potential is there to help detect systemic risk. Moving forward with a system for a uniform legal entity identifier would help foster greater 

transparency and allow regulators and firms themselves to better measure and 

monitor risks. Such transparency can help beyond just immediate tracking of performance because improved availability of information would be expected to affect 

firms’ reputational capital. For example, information that allows investors to more 

readily link, say, poorly performing loans back to particular originators would provide powerful reputational incentives for better lending performance. 

It is impossible to avoid or detect all problems—regulators are only human after 

all—but these provisions will help. 

The benefits of other aspects of the Dodd-Frank Act are less clear in terms of 

helping to safeguard the financial system against future crises. I would see the socalled Volcker Rule as falling into this category. Proprietary trading does not appear 

to have a contributing factor in the crisis, and indeed, revenues from this activity 

helped to offset losses in other areas and thus stabilize some financial firms. It is 

difficult in practice to distinguish proprietary trading from the normal market-making activities of a broker dealer—a difficulty that is perhaps reflected in the voluminous attempt of the regulatory agencies to define the rule. A poorly implemented 

Volcker Rule could reduce liquidity in financial markets and thus raise costs and 

decrease investment in the broader economy. Indeed, the flat exemption of trading 

in Treasury securities from the rule illustrates the potential downside. Removing 

this activity from large financial institutions could have had a meaningful negative 

impact on demand for Treasury securities and thus lead to increased yields and 

higher costs for public borrowing. The same concern applies to other activities that 

will be affected by the rule—all investors and savers will be affected. And investors 

and savers are not just large, complex financial institutions, but include workers 

whose pension funds and 401(k)s invest in these securities. Families will have less 

access to credit and thus less ability to buy homes, cars, and put children through 

college. Businesses will find it harder to borrower, which will make it harder for 

them to do research and development, make capital investments, and create jobs. 

50 

Asset prices will be pushed down, which will punish investors and savers. It is not 

clear what problem this rule is meant to solve, making it likely that this aspect of 

the new regulatory regime for large, complex financial institutions strikes a poor 

tradeoff between the gains from the regulation and the impairment to markets and 

overall economic vitality. 

The impact of many other provisions is unclear because rules are still to be determined or finalized. The new regime for derivatives, including the increased role for 

clearinghouses and exchanges in derivative transactions, has the potential to usefully strengthen transparency and thus improve the overall financial regulatory regime, including for large, complex financial institutions. On the other hand, it difficult to understand the benefits of the so-called Lincoln Amendment that requires 

some derivatives-related activities to be spun off into separately capitalized entities. 

Part of the value of large financial institutions to markets and the broader economy 

is the ability to conduct a wide range of transactions, including making markets in 

derivatives. Indeed, the decision by the Obama administration to exempt the foreign 

exchange market from these aspects of Dodd-Frank suggests that the Administration shares the concern that these provisions likewise do not strike an appropriate 

balance between the benefits and the costs in terms of diminished economic vitality. 

The Benefits of Large Financial Institutions 

The tradeoff between increased regulation and economic vitality applies as well 

to regulations under Section 165 of the Dodd-Frank Act relating to enhanced supervision and prudential standards (many of which are not yet final). Heightened capital requirements provide an increased margin of safety for firms to absorb losses 

(though this does not necessarily reduce the impact of the failure on the broader 

financial system once a large firm burns through the added capital). But requiring 

firms to hold more capital is not free—there is an impact on financial intermediation and thus on the economy that must be kept in mind. Importantly, the empirical evidence is that real-world banks react to binding capital requirements mainly 

by reducing assets—by making fewer loans—rather than by adding capital. There 

is a tradeoff, unlike in the theoretical construct in which there are no frictions and 

a firm’s capital structure (the mix of debt and equity in the enterprise) does not 

matter. In the real world, the tax system favors debt over equity and the bankruptcy system (including the new resolution mechanism discussed below) imposes 

costs on market participants. These realities are at odds with the assumptions in 

recent academic work calling for considerably higher capital requirements. 

An overly large increase in required capital might impose considerable costs on 

financial firms and the broader economy without a commensurate increase in financial stability. Banks with very high capital requirements would be less apt to perform the role of providing liquidity services such as through demand deposits and 

other types of short-term financing. Moreover, increased capital requirements would 

drive lending activity once again out of the banking system into the less-regulated 

‘‘shadow banking system.’’ Increased capital would make banks safer, but these 

firms would no longer perform the functions that society expects of them and risktaking will migrate outside the regulated banking sector. 

The new regulatory regime should also pay attention to the differential impact of 

financial reforms proceeding at different paces and in various ways across countries. 

Capital requirements are measured against risk-weighted assets, but financial institutions in Europe (especially) appear to have considerably more aggressive 

weightings in terms of denoting assets as less risky than is the case in the United 

States. This means that European firms hold less capital than U.S. competitors with 

similar assets, thus distorting the competitive balance between firms across borders. 

This is not to say that the United States should follow Europe in a race-to-the-bottom of lower risk weightings and less capital. The Basel process would be a natural 

channel through which to ensure that U.S. firms are not disadvantaged. 

Similar considerations apply to new liquidity standards, which should take into 

account the actual characteristics of assets during the recent crisis. GSE securities, 

for example, have been essentially guaranteed by the Federal Government since 

Fannie Mae and Freddie Mac were taken into conservatorship in September 2008 

and thus remained liquid throughout the crisis. Advances from the Federal Home 

Loan Banks (FHLBs) were likewise important sources of liquidity for many U.S. financial institutions during the crisis. Until there is a change in the GSEs or 

FHLBs, these recent experiences should inform the use of such assets in meeting 

heightened liquidity requirements. 

The process by which large, complex financial institutions will undergo annual 

capital assessments (stress test) has already proved a valuable addition to the prudential regulatory toolkit. The 2009 stress tests, for example, provided an important 

signal to market participants that key financial institutions would not be nationalVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00054 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
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1The study is available on http://www.theclearinghouse.org/index.html?f=073071. 

ized and thus lifted a barrier to renewed private sector investment in financial 

firms. The key going forward is to develop realistic scenarios against which to test 

bank balance sheets. An overly optimistic scenario is not a test, while an unduly 

pessimistic one could turn into a nontransparent mechanism by which to restrict financial firms’ capital distributions—which would ultimately affect firms’ ability to 

attract capital. 

Similarly, the process of drawing up so-called living wills could be useful (so long 

as the undertaking is not extraordinarily burdensome), even though it is inevitable 

that plans made ahead of time will not be perfectly applicable in a crisis. 

The Value of Large, Complex Financial Institutions 

The regulatory regime brought about by the Dodd-Frank Act places new burdens 

on large firms and requires them to hold more capital and have more robust access 

to liquidity. But the Act does not seek to break up large financial institutions or 

to reinstitute broader barriers to their activities such as by reinstituting the GlassSteagall separation of commercial and investment banking. This is appropriate. 

The end of the Glass-Steagall restrictions is not well correlated with the failures 

evident in the recent financial crisis. Bear Stearns and Lehman Brothers both 

failed, but these firms had remained investment banks. JPMorgan Chase, on the 

other hand, combined investment banking and commercial banking and yet weathered the strains of the crisis relatively well. The problems revealed by the crisis 

seem to be in the riskiness of the activities themselves—subprime lending, for example—and not in the combination of commercial and investment banking. 

The aftermath of the crisis has meant increased scale for the largest of the surviving institutions. This has both benefits and costs. Among the potential costs are 

that the failure of a large financial institution could have important impacts on 

markets and the broader economy. At the same time, there are benefits to the U.S. 

economy from having large financial institutions, including important advantages to 

society arising from economies of scope and of scale. A recent study from the Clearing House Association (for which I am a member of the academic advisory committee) discusses and quantifies these benefits. 1 The benefits of scope and scale go 

together, as banks that are large banks in both size (scale) and footprint (scope) are 

best able to undertake commercial transactions for large multinational corporations. 

This reflects the evolution of the globalized economy, as large banks have a relatively strong ability to offer financial products to large customers with specific 

needs, including in trade finance, global lending, and cash management. Smaller 

banks can offer these services, but the Clearing House Association study shows that 

there are benefits to having banks large enough to do them on a scale commensurate with the largest corporate customers. 

Similar benefits of scope and scale apply to capital market activities outside of 

commercial banking, including offering and arranging derivatives-related transactions and investment banking. These benefits reflect the fact that firms with large 

and diverse balance sheets can best make liquid markets for large transactions and 

across a broad range of assets. Large financial institutions are best positioned to 

stand ready as a market-maker to buy and sell assets, including derivatives that 

allow the beneficial transfer of risk by end users. Sometimes it is helpful and necessary to have a large balance sheet to put to work. Taken together, the benefits 

for society through increased economic efficiency resulting from the scale and scope 

of large banks are estimated at 50 to 100 billion dollars per year. 

The diversity of small and large institutions and in other dimensions is a feature 

of the U.S. financial system. Different sizes of U.S. financial institutions stand ready 

to deal with different types of customers and products. Large banks are essential 

for firms requiring large amounts of financing—transactions undertaken by large 

global companies involving multiple billions of dollars of financing. Foreign banking 

systems are typically far more concentrated than that of the United States—and 

large foreign banks would stand ready to serve U.S. multinationals in the event that 

the larger U.S. banks were dismantled. And as with excessive capital requirements, 

policy actions that diminished the capacities of large U.S. banks could well lead 

some financial business to move to the less-regulated shadow banking system. 

It should be kept in mind that smaller banks present risks—something illustrated 

in the U.S. savings and loan crisis of the late 1980s and reflected in other countries 

in the more recent crisis. In Spain, for example, the large banks have been broadly 

stable (perhaps more so than the sovereign), while smaller and less-diversified financial institutions have been in severe distress. 

The diversity of the U.S. financial system is reflected in the different ways that 

institutions fund themselves. Smaller banks tend to fund their activities using lowVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00055 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
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cost deposits that benefit from the FDIC guarantee and with FHLB advances that 

likewise have a Federal guarantee. Larger institutions that fund with a greater diversity of sources now pay deposit insurance premiums on nondeposit liabilities 

even though these liabilities are not actually covered by the FDIC. Larger institutions, especially the so-called globally systemically important banks but also possibly including U.S. banks that are not designated as globally systemic, will face increased capital requirements. The diversity of funding sources is again a strength 

of the U.S. system; the point here is that it is important to avoid overstating the 

potential funding advantage of larger financial institutions. This is especially the 

case going forward with the new resolution authority in the Dodd-Frank Act that 

makes meaningful changes to the notion that some institutions will be rescued by 

Government action and thus that market participants will be willing to fund these 

firms at lower costs. This idea of ‘‘too big to fail’’ is discussed next. 

Dealing With a Future Financial Crisis: Resolution Authority 

The Title II resolution authority will have important effects on large, complex financial institutions and on the providers of funding to these institutions. For bondholders and other nondeposit funders, the Dodd-Frank resolution authority puts 

them on notice that they should expect to take losses in the event that a firm fails 

and is taken into resolution. Resolution authority could well involve the deployment 

of Government resources (later to be repaid by market participants) to support a 

firm and slow its demise. But the outcome is virtually certain to involve losses for 

bondholders, unlike what generally happened during the crisis. 

For better or worse, the Title II authority will be used in the event that a large 

complex financial institution fails. After all, it is difficult to imagine another TARP 

facility to intervene in the financial sector. The authorities in Title II give Government officials some TARP-like ability to put money into failing firms, and the experience of the recent crisis is that policy makers are likely to use these authorities 

to avoid the full impact of the collapse of a large systemically significant firm. This 

likelihood in turn will affect the behavior of market participants today. In this way, 

Title II makes for a profound change in the regulatory environment facing large, 

complex financial institutions, including a meaningful change from the past belief 

that institutions were too big to fail. 

It is hard to know precisely how the resolution authority will be used, notably because the authority is likely to be exercised in a time of broad financial market 

stress when regulators face a variety of challenges. For making changes to the concept of too big to fail, what matters most is the ability of the FDIC in undertaking 

the resolution to make ex post clawbacks from bondholders to cover losses after 

shareholder equity is wiped out. Indeed, the FDIC has been clear that bondholders 

should not expect to get additional payments through use of the Dodd-Frank resolution authority—it is more likely the opposite. This can take place even if the FDIC 

initially uses Government funds to keep a firm in operation in resolution—this 

might occur, for example, if the FDIC seeks to preserve the ‘‘franchise value’’ of a 

large firm while it arranges a sale of the firm or of components to new owners. Another possible outcome is that the FDIC uses the Title II authorities to arrange a 

debt-for-equity swap that recapitalizes the failing firm (or perhaps some parts of it) 

in a new form and with new management and shareholders (namely, the former 

bondholders). Such a debt-for-equity recapitalization would be similar to a prepackaged Chapter 11 reorganization under the bankruptcy code, though the Title II 

authorities would allow this to be done faster and with funding provided by the Government (though eventually paid back by private market participants). It should be 

noted that much of this was already possible with the regular bankruptcy process 

and that it remains an open question as to whether Title II will make policy makers 

more likely to intervene in markets. That is, Title II could help limit the notion of 

too big to fail but give rise to more Government interference that has other negative 

impacts on the economy. 

The key element for addressing too big to fail is that bondholders take losses. This 

is likely to be the case, given that the ability to do this is clear in the legislation. 

In contrast to the resolution of WAMU by the FDIC in the fall of 2008, the imposition of (possibly substantial) losses will not be a surprise to bondholders and therefore should not cause massive spillover effects that adversely impact the ability of 

other firms to fail. The key is that Title II makes clear that bondholders will take 

losses. 

It must be kept in mind that there are other, possibly troublesome, effects from 

the new authority. The certainty of losses in resolution will give providers of funding to banks an incentive to flee at early signs of trouble. This sort of run from failing institutions is an important disciplining device, but the regime change could 

mean a more hair trigger response than previously and thus inadvertently prove deVerDate Nov 24 2008 13:38 Jan 11, 2013 Jkt 048080 PO 00000 Frm 00056 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\12-07 DISTILLER\74837.TXT JASON
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stabilizing. This would be the case if market participants move away from long-term 

funding of financial institutions because of the increased possibility of losses. 

The ability of policy makers to deploy public resources in the resolution process 

also gives rise to concerns that firms taken into resolution could be used for policy 

purposes. Losses to the Government are ultimately borne ex post by the bondholders 

once the equity of the firm is exhausted, which seems likely to be the case. The legislation seeks to narrow the scope of action for the FDIC in resolution by guaranteeing bondholders that they will receive as much in resolution as would have been 

the case under bankruptcy, but this still gives scope for actions to use the firm 

under resolution. In a sense, the resolution authority provides Government officials 

with an open checkbook to act through the troubled firm, with bondholders picking 

up the tab. This is not an empty concern; witness, for example, efforts to have the 

GSEs undertake loss-making policy activities which would then be offset by new 

capital injections from the Treasury. The funds under Title II would come first from 

bondholders and then from assessments on other market participants rather than 

from taxpayers, but the concern is over the ability of the Government to act and 

transfer resources without a vote of the Congress. This concern remains even if it 

bondholders on the hook rather than taxpayers. 

Finally, the resolution authority will be incomplete and perhaps unworkable until 

there is more progress on the international coordination of bankruptcy regimes. 

Conclusion 

The new regulatory regime for large, complex financial institutions will be a vast 

change from the system before the financial crisis. Important aspects of the change 

are for the good, including changes that address the phenomenon under which some 

firms were too big to fail. But there is still much that is unclear in the workings 

of the new regulatory regime and much rulemaking to be done. 

It is important to keep in mind that many of the changes will involve costs as 

well as benefits. Higher capital and liquidity requirements, for example, will impose 

costs on financial institutions that will affect lending activity and thus the overall 

economy. Changes are still desirable in the wake of the crisis; the key is to be cognizant of the tradeoffs involved and avoid regulatory requirements that provide inadequate benefits relative to the costs involved. 

This tradeoff applies to discussions about the role of large, complex financial institutions in the U.S. financial system and the broader economy. These institutions 

provide important benefits for financial markets and for the economy. Changes that 

lessen their role or impair their functioning would have meaningful costs to society. 

Finally, there are important aspects of financial regulatory reform that were not 

accomplished in the Dodd-Frank legislation and that pertain to the regulatory regime for large, complex financial institutions. The unfinished business of regulatory 

reform notably includes the future of the housing finance system, including Fannie 

Mae and Freddie Mac, reforms to money market mutual funds, and changes to the 

oversight of broader aspects the collateralized lending that takes place in the socalled shadow banking system. If anything, some provisions of Dodd-Frank could 

make the shadow banking system larger as activities migrate (or are forced to migrate) out of the more heavily regulated large financial institutions. 

54 

PREPARED STATEMENT OF ARTHUR E. WILMARTH, JR. 

PROFESSOR OF LAW AND EXECUTIVE DIRECTOR OF THE CENTER FOR LAW, ECONOMICS

AND FINANCE (C-LEAF), GEORGE WASHINGTON UNIVERSITY LAW SCHOOL

DECEMBER 7, 2011 


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their "casino" wholesale activities in the capital markets, and (b) proposed "core banking" 

legislation introduced by Senator (then-Representative) Charles Schumer in 1991. 

1. TBTF Financial Institutions Received Extraordinary Governmental Assistance 

during the Financial Crisis 

The federal government provided massive amounts of financial assistance to LCFIs during 

the financial crisis. The Troubled Asset Relief Program ("TARP") provided $290 billion of 

capital assistance to the 19 largest U.S. banks (each with more than $100 billion of assets) and 

the largest U.S. insurance company, American International Group ("AIG"). Federal regulators 

enabled the same 19 banks and GE Capital (a huge finance company owned General Electric) to 

issue $290 billion of FDIC-guaranteed, low-interest debt. In contrast, smaller banks (with assets 

under $100 billion) received only $41 billion ofTARP capital assistance and issued only $11 

billion of FDIC-guaranteed debt. l 

The Federal Reserve System ("Fed") also provided massive amounts of credit assistance to 

financial institutions through a series of emergency lending programs. The total amount of Fed 

emergency credit reached a single-day peak of $1.2 trillion in December 2008. The Fed 

extended the vast majority of this emergency credit to large U.S. and European banks and 

provided very little help to smaller institutions. The highest daily amount of the Fed's 

1 Arthur E. Wilmarth, Jr., "Refonning Financial Regulation to Address the Too-Big-to-Fail Problem," 35 

Brooklyn Journal of International Law 707, 737-38 (20 10) [hereinafter Wilmarth, "Refonning Financial 

Regulation"]' available at http://ssm.com/abstract=1645921. Federal regulators took an extraordinary 

step in allowing GE Capital to issue $55 billion of FDIC-guaranteed, low-interest debt securities. GE 

Capital issued the debt securities by virtue of its ownership of two FDIC-insured depository institutions (a 

thrift and an industrial bank) located in Utah. Regulators granted GE Capital special pennission to 

participate in the FDIC's debt guarantee program even though GE Capital was not a bank holding 

company and therefore did not meet the general tenns and conditions for participation in the program. 

Indeed, GE Capital could not become a bank holding company because its parent, General Electric, is an 

industrial conglomerate that is barred by statute from owning banks. Id at 738 n.122, 774 n.260. 

2 
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emergency credit to the ten largest US. commercial and investment banks reached $669 billion, 

representing more than half of the daily peak amount for all Fed lending programs2 

The Fed and the Treasury also supported financial institutions and the financial markets by 

purchasing more than $1.5 trillion of direct obligations and mortgage-backed securities ("MBS") 

issued by government-sponsored enterprises ("GSEs"). In combination, the federal government 

provided more than $6 trillion of support to financial institutions during the financial crisis, if 

such support is measured by the peak amounts of outstanding assistance under TARP capital 

programs , Fed emergency lending programs, FDIC debt guarantees, and other asset purchase 

and guarantee programs] European nations similarly provided more than $4 trillion offinancial 

support to their financial institutions by the end of20094 

Federal regulators acted most dramatically in rescuing LCFIs that were threatened with 

failure. US. authorities bailed out two of the three largest US. banks- Bank of America 

("BofA") and Citigroup - as well as AIG. In addition, federal regulators provided financial 

support for emergency acquisitions of two other major banks (Wachovia and National City), the 

two largest thrifts (Washington Mutual ("WaMu") and Countrywide), and two of the five largest 

securities firms (Bear Stearns and Merrill Lynch). Regulators also approved emergency 

conversions of two other leading securities firms (Goldman Sachs and Morgan Stanley) into 

2 Bradley Keoun & Phil Kuntz, 'Wall Street Aristocracy Got $1.2 Trillion in Secret Fed Loans," 

Bloomberg. com, Aug. 22, 2011 ; Bob Ivry, Bradley Keoun & Phil Kuntz, "Secret Fed Loans Helped 

Banks Net $13 Billion," Bloomberg. com, Nov. 27, 2011. 

3 The '11igh-water mark" of the combined programs, based on the largest outstanding amount of each 

program at anyone time, was $6.3 trillion. The federal government's maximum potential exposure under 

those programs was $23.9 trillion. Office of the Special Inspector General for the Troubled Asset Relief 

Program ("SIGTARP"), Quarterly Report to Congress, July 21, 2010, at 116-19, 118 tbl. 3.1. 

4 Adrian Blundell-Wignall et al , ''The Elephant in the Room: The Need to Deal with What Banks Do," 2 

Organization/or EconomiC Co-operation & Development Journal: Financial Market Trends, Vol. 2009, 

No.2, at 1, 4-5, 14, 15 tbl.4, available at http://www.oecd.org/dataoecd/I3/8/44357464.pdf(statingthat 

the U.S. provided $6.4 trillion of assistance to financial institutions through capital infusions, asset 

purchases, asset guarantees, and debt guarantees as of October 2009, while the United Kingdom and 

European nations provided $4.3 trillion of such assistance). 

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bank holding companies ("BHCs"), thereby placing those institutions under the FRB's protective 

umbrella5 

The federal government further publicly guaranteed that none of the 19 largest banks 

would be allowed to fail. When federal regulators announced their "stress tests" in early 2009, 

they declared that the Treasury Department would provide any additional capital that was needed 

to ensure the survival of all 19 banks. Regulators also stated that they would not impose 

regulatory sanctions on the top 19 banks under the "prompt corrective action" ("PC A") regime 

established by Congress in 1991 , despite the non-discretionary nature of those sanctions. Instead 

of issuing public enforcement orders, regulators entered into private and confidential 

"memoranda of understanding" with BofA and Citigroup despite the gravely weakened 

conditions of both banks. Thus, federal regulators gave white-glove treatment to the 19 largest 

banks and unequivocally promised that they would survive6 

In stark contrast, federal regulators imposed PCA orders and other public enforcement 

sanctions on hundreds of community banks and allowed many of those institutions to fail. 7 

Almost 350 FDIC-insured depository institutions failed between January I, 2008 and March 31 , 

2011 8 Only one of those institutions - WaMu, a large thrift institution - had more than $50 

billion of assets 9 In view of the massive TBTF assistance that the federal government provided 

to our largest banks, it is small wonder that those banks enjoy a decisive advantage in funding 

costs over smaller banks. As FDIC Chairman Sheila Bair pointed out in a speech on May 5, 

5 Arthur E. Wilmarth, If., "The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-toFail Problem," 89 Oregon Law Review 951 , 958-59, 983 (2011) [hereinafter Wilmarth, "Dodd-Frank"], 

available at http://ssm.com/abstract=1719126. 

6Id. at 958-59, 983; Wilmarth, "Reforming Financial Regulation," supra note 1, at 712-13, 743-44. 

1 Wilmarth, "Reforming Financial Regulation," supra note 1, at 744, 744 n.145. 

8 5 FDIC Quarterly No.2 (2011), at 16 (Table II-B) 

9 2 FDIC Quarterly NO.4 (2008), at 14 (referring to the failure of Washington Mutual Bank, with $307 

billion of assets, on Sept. 25, 2008). 

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2011, "In the fourth quarter of[2010], the average interest cost offunding earning assets for 

banks with more than $100 billion in assets was about half the average for community banks 

with less than $1 billion in assets ,,10 

When the federal government finally promised to help community banks, it failed to 

deliver. On February 2, 2010, President Obama announced a new program that would use $30 

billion ofTARP funds to assist community banks in making small business loans. I I However, in 

September 2011, the Treasury Department shut down the Small Business Lending Fund after 

providing only $4.2 billion - just 14% of the promised amount - to community banks. Members 

of Congress strongly criticized the Treasury Department for long delays in approving 

applications by community banks and for imposing onerous conditions on applicants. 12 

2. TBTF Subsidies Distort Our Financial Markets and Create Perverse Incentives for 

Excessive Risk-Taking and Unhealthy Consolidation 

At the height of the financial crisis in March 2009, Fed Chairman Ben Bernanke admitted 

that "the too-big-to-fail issue has emerged as an enormous problem" because "it reduces market 

discipline and encourages excessive risk-taking" by TBTF firms. 13 Several months later, 

Governor Mervyn King of the Bank of England condemned the perverse incentives created by 

TBTF subsidies in even stronger terms. Governor King maintained that "[t]he massive support 

extended to the banking sector around the world, while necessary to avert economic disaster, has 

10 Sheila C. Bair, "We Must Resolve to End Too Big to Fail," 5 FDIC Quarterly No.2 (2011), at 25, 26 

(reprinting speech delivered on May 5, 2011). 

I I Cheryl Bolen, "Troubled Asset Relief Program: White House Explains $30 Billion Plan To Expand 

Bank Loans to Small Businesses," 94 BNA 's Banking Report 262 (Feb. 9, 2010) 

12 Kevin Wack, "Lending Fund Puts Geithner on the Defensive," American Banker, Oct. 19,2011. 

IJ Ben S. Bernanke, Chainnan, Board of Governors of the Federal Reserve, Financial Refonn to Address 

Systemic Risk, Speech at the Council on Foreign Relations (Mar. 10, 2009), available at 

http://wlVw.federalreserve.gov/newsevents/speechlbernanke20090310a.htm . 

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created possibly the biggest moral hazard in history." 14 He further argued that TBTF subsidies 

provided a likely explanation for decisions by LCFIs to engage in high-risk strategies during the 

credit boom: 

Why were banks willing to take risks that proved so damaging to themselves and 

the rest of the economy? One of the key reasons - mentioned by market 

participants in conversations before the crisis hit - is that incentives to manage 

risk and to increase leverage were distorted by the implicit support or guarantee 

provided by government to creditors of banks that were seen as 'too important to 

fail.' ... Banks and their creditors knew that if they were sufficiently important to 

the economy or the rest of the financial system, and things went wrong, the 

government would always stand behind them. And they were right 15 

Industry studies and anecdotal evidence confirm that TBTF subsidies create significant 

economic distortions and promote moral hazard. In recent years, and particularly during the 

present crisis, LCFIs have operated with much lower capital ratios and have benefited from a 

much lower cost of funds, compared with smaller banks. In addition, credit ratings agencies and 

bond market investors have given preferential treatment to TBTF institutions because of the 

explicit and implicit government backing they receive.

16 

A recent study shows that large banks have received huge benefits from the implicit 

TBTF subsidy over the past two decades. 17 This study, which anal yzed publicly-traded bonds 

issued by u.s. banks between 1990 and 2010, concluded that bond investors expected the federal 

government to support the largest banks throughout that period. Although the largest banks 

14 Mervyn King, Governor of the Bank of England, Speech to Scottish Business Organizations in 

Edinburgh 4 (Oct 20, 2009), available at 

httpJ/www. bankofengland.co.uk/publications/speeches/2009/speech406.pdf [hereinafter King 2009 

Speech]. See also Richard S. Carnell, Jonathan R. Macey & Geoffrey P. Miller, The Law a/Banking and 

Financial Institutions 326 (4thed. 2009) (explaining that "moral hazard" results from the fact that 

"[i]nsurance changes the incentives of the person insured .... [I]f you no longer fear a harm [due to 

insurance], you no longer have an incentive to take precautions against it"). 

15 King 2009 Speech, supra note 144, at 3. 

16 Wilmarth, "Dodd-Frank," supra note 5, at 981-84 (citing studies and other evidence). 

1 J A. Joseph Warburton & Daniz Anginer, "The End of Market Discipline? Investor Expectations of 

Implicit State Guarantees" (Nov. 18, 2011), available at httpJ/ssrn .com/abstract=1961656. 

6 
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pursued riskier strategies, they issued bonds with significantly lower yield spreads over Treasury 

bonds, compared to bonds issued by smaller banks.18 Additionally, the authors found that bond 

investors responded significantly to Fitch's "issuer" ratings that included the expectation of 

governmental support for the biggest banks, but bond investors did not respond significantly to 

Fitch's "individual" ratings based on the standalone strength of the same banks. In other words, 

"investors do not price the true, intrinsic ability of a [big] bank to repay its debts, but instead 

price implicit government support for the bank.,,19 

The authors determined that the implicit TBTF subsidy gave the largest banks 

an annual [average] funding cost advantage of approximately 16 basis points before 

the financial crisis, increasing to 88 basis points during the crisis, peaking at more 

than 100 basis points in 2008. The total value of the subsidy amounted to about $4 

billion per year before the crisis, increasing to $60 billion [annually] during the 

crisis, topping $84 billion in 200820 

Moreover, the authors found that "[t]he passage of Dodd-Frank in July of2010 did not eliminate 

investors' expectations of government support. In fact, expectations of government support rose 

in 2010 [compared to 2009].,,21 The authors concluded that the value of the implicit TBTF 

subsidy to large banks was highest during times of financial crisis (i.e. , the 1980s, 1997-98, 

2000-02, and 2007-10). However, the subsidy "persists even during times of relative tranquility" 

and therefore represents "an ongoing wealth transfer" from taxpayers to large banks22 

The financial crisis has vividly illustrated the tendency of LCFls to exploit their explicit 

safety net subsidies (i.e., federal deposit insurance and access to the Fed's discount window) and 

their implicit TBTF subsidy by using their access to low-cost funds to finance high-risk 

1SId at 3, 10-11, 14-15. 

19ld at 3, 15-17. 

7JJ fd at 4, 12. 

21 ld at 19, 33 (Figure 4). 

22 fd at 18-20, 33 (Figure 4). 

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activities 23 As I have explained in previous articles, LCFIs were "the primary private-sector 

catalysts for the destructive credit boom that led to the subprime financial crisis, and they 

[became] the epicenter of the current global financial mess."Z4 Eighteen major LCFls -

including ten leading u.s. financial institutions and eight giant foreign banks - were the 

dominant players in global securities and derivatives markets during the credit boom2 5 Those 18 

LCFls included most of the top underwriters for nonprime MBS, other types of asset-backed 

securities (" ABS") and leveraged buyout ("LBO") loans, as well as related collateralized debt 

obligations ("CDOs") and credit default swaps ("CDS"). Although Fannie Mae and Freddie Mac 

funded about a fifth of the nonprime mortgage market between 2003 and 2007, they did so 

primarily by purchasing nonprime mortgages and private-label MBS that were originated or 

underwritten by LCFls. LCFls provided most of the rest of the funding for nonprime home 

23 A recent study explains that "[a] nation's financial safety net consists of whatever array of programs it 

uses to protect bank depositors and to keep systemically important markets and institutions from breaking 

down in difficult circumstances." The study further points out that, during the current financial crisis, 

government agencies in the U.S. and the European Union "exercised a loss-shifting 'taxpayer put' that 

converted most of the losses incurred by insolvent [TBTF] firms into government debt." Edward J. Kane 

et al., Safety-Net Benefits Conferred on Difficult-to-Fail-and-Unwind Banks in the U.S. and EU Before 

and During the Great Recession at 2, 4 (July 1, 20 II), Paolo Baffi Center Research Paper No. 2011-95, 

available at http://ssrn.com/abstract=1884131. 

24 Wilmarth, "Dodd-Frank," supra note 5, at 977 (quoting Arthur E. Wilmarth, Jr., 'The Dark Side of 

Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis," 41 

Connecticut Law Review 963, 1046 (2009) [hereinafter Wilmarth, "Financial Conglomerates"]' available 

at http://ssrn.com/abstract=1403973). 

25 During the credit boom that led to the financial crisis, the 18 leading LCFls in global and U.S. markets 

for securities underwriting, securitizations, structured-finance products and over-the-counter derivatives 

(the "big eighteen") included the four largest U.S. banks (BofA, lP Morgan Chase ("Chase"), Citigroup 

and Wachovia), the five largest U.S. securities firms (Bear Steams ("Bear"), Goldman Sachs 

("Goldman"), Lehman Brothers ("Lehman"), Merrill Lynch ("Merrill") and Morgan Stanley), the largest 

U.S. insurance company (AIG), and eight foreign universal banks (Barclays, BNP Paribas, Credit Suisse, 

Deutsche, HSBC, Royal Bank of Scotland ("RBS"), Societe Generale and UBS) See Wilmarth, "DoddFrank," supra note 5, at 966 n.45. 

8 
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mortgages, as well as much of the financing for risky credit card loans, commercial real estate 

("CRE") loans and LBO loans 26 

I have estimated that LCFIs were responsible for financing about $9 trillion of risky 

private-sector debt that was outstanding in U.S. financial markets in 2007 in the form of 

nonprime home mortgages, credit card loans, CRE loans, LBO loans and junk bonds. Even 

worse, LCFIs underwrote some $25 trillion of structured-finance securities and derivatives 

whose value depended on the performance of that risky debt, including MBS, ABS, cash flow 

CDOs, synthetic CDOs and CDS. Thus, LCFIs created "an invested pyramid of risk," which 

allowed investors to place "multiple layers of financial bets" on the performance of high-risk 

loans in securitized pools. Consequently, when the underlying loans began to default, the 

leverage inherent in this "pyramid of risk" produced losses that were much larger than the face 

amounts ofthe defaulted 10ans 27 

The central role of LCFIs in the financial crisis is confirmed by the enormous losses they 

suffered and the huge bailouts they received. The "big eighteen" LCFIs accounted for threefifths of the $1.5 trillion of total worldwide losses recorded by banks, securities firms and 

insurers between the outbreak of the financial crisis in mid-2007 and the spring of20102 8 The 

list of leading LCFIs is "a who's who of the current financial crisis" that includes "[m]any of the 

26 Id at 977-78; see also Phil Angelides, "Fannie, Freddie and the Financial Crisis," Bloomberg com, 

Aug. 3, 2011 (summarizing report prepared by the staff of the Financial Crisis Inquiry Commission 

("FCIC"), and stating that Fannie and Freddie were "disasters" but not the "primary cause of the crisis" 

because (i) the GSEs "purchased the highest-rated portions of 'private label' mortgage securities 

produced by Wall Street," (ii) "[w]hile such purchases added helium to the housing balloon, they 

represented just 1 OJ percent of 'private-label' subprime-mortgage-backed securities in 2001 , then rose to 

40 percent in 2004, and fell back to 28 percent in 2008," (iii) "[p]rivate investors gobbled up the lion's 

share of those securities, including the riskier portions," and (iv) "data compiled by the FCTC for a subset 

of borrowers with [credit] scores below 660 shows that by the end of 2008, far fewer GSE mortgages 

were seriously delinquent than non-GSE securitized mortgages: 6.2 percent versus 283 percent"). 

27 Wilmarth, "Dodd-Frank," supra note 5, at 966-67; Wilmarth, "Financial Conglomerates," supra note 

24, at 988-96, 1024-4 L 

28 Wilmarth, "Dodd-Frank," supra note 5, at 978. 

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finns that either went bust ... or suffered huge write-downs that led to significant government 

intervention.,,29 Lehman failed, while two other members of the "big eighteen" LCFIs (AIG and 

RBS) were nationalized and three others (Bear, Merrill, and Wachovia) were acquired by other 

LCFIs with substantial governmental assistance. Three additional members of the group 

(Citigroup, BofA, and UBS) survived only because they received costly government bailouts. 30 

Chase, Goldman Sachs and Morgan Stanley received substantial infusions ofT ARP capital, and 

Goldman and Morgan Stanley quickly converted to BHCs to secure permanent access to the 

FRB's discount window as well as "the Fed's public promise ofprotection.,,31 

Thus, only Lehman failed of the "big eighteen" LCFIs, but the US , the UK and 

European nations provided massive financial assistance to ensure the survival of at least twelve 

other members of the group.32 Studies have shown that the T ARP capital infusions and FDIC 

debt guarantees announced in October 2008 represented very large transfers of wealth from 

taxpayers to the shareholders and creditors of the largest US. LCFIs33 In addition, a recent 

29 Id. (quoting study by Dwight Jaffee). 

JO Id. ; Wilmarth, "Financial Conglomerates," supra note 24, at 1044-45 (explaining that Citigroup and 

BofA "received huge bailout packages from the US government that included $90 billion of capital 

infusions and more than $400 billion of asset price guarantees," while UBS "received a $60 billion 

bailout package from the Swiss govemment"). 

31 David Wessel, In Fed We Trust: Ben Bernanke 's War on the Great Panic 217-18, 227, 236-40 (2009) 

(noting that Chase received $25 billion ofT ARP capital while Goldman and Morgan Stanley each 

received $10 billion); see also Ivry, Keoun & Kuntz, supra note 2 (stating that BofA's acquisition of 

Merrill Lynch was supported by more than $60 billion of Fed emergency credit, while Wells Fargo's 

takeover ofWachovia was helped by $50 billion of Fed emergency credit and Chase's acquisition of Bear 

was assisted by $30 billion of Fed emergency credit). 

32 Wilmarth, "Dodd-Frank," supra note 5, at 978-79. 

33 Elijah Brewer III & Anne Marie Klingenhagen, "Be Careful What You Wish for: TIle Stock Market 

Reactions to Bailing Out Large Financial Institutions," 18 Journal of Financial Regulation and 

Compliance 56, 57-59, 64-66 (2010) (finding significant increases in stock market valuations for the 25 

largest U.S banks as a result of Treasury Secretary Paulson's announcement, on Oct. 14, 2008, of$250 

billion ofTARP capital infusions into the banking system, including $125 billion for the nine largest 

banks); Pietro Veronesi & Luigi Zingales, "Paulson's Gift," 97 Journal of Financial Economics 339, 340-

41 ,364 (2010) (concluding that the TARP capital infusions and FDIC debt guarantees annowlced in 

October 2008 produced $130 billion of gains for holders of equity and debt securities of the nine largest 

U.S. banks, at an estimated cost to taxpayers of$21 to $44 billion); Eric de Bodt et aI. , The Paulson 

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study concluded that the "below-market rates" charged by the Fed on its emergency credit 

programs produced $13 billion of profits for the banks that participated in those programs, 

including $4.8 billion of earnings for the six largest U.S. banks 3 4 

Given the major advantages conferred by TBTF status, it is not surprising that LCFls 

have pursued aggressive growth strategies during the past two decades to reach a size at which 

they would be considered TBTF. All oftoday's four largest U.S. banks (Chase, BofA, Citigroup 

and Wells Fargo) are the products of serial acquisitions and explosive growth since 1990. 

BofA's and Citigroup's rapid expansions led them to brink offailure, from which they were 

saved by huge federal bailouts. Wachovia (the fourth-largest U.S. bank at the beginning of the 

financial crisis) pursued a similar path of frenetic growth until it collapsed in 2008 and was 

rescued by Wells Fargo in a federally-assisted merger. A comparable pattern of rapid expansion, 

collapse and bailout occurred among RBS, UBS and other European LCFls 35 

By helping major banks to acquire troubled LCFls, U.S. regulators have produced 

domestic financial markets in which the largest banks enjoy an unhealthy dominance. In 2009, 

the four largest U.S. banks (BofA, Chase, Citigroup and Wells Fargo) controlled 56% of 

domestic banking assets, up from 35% in 2000, while the top ten U.S banks controlled 75% of 

domestic banking assets, up from 54% in 2000. The four largest banks also controlled a majority 

Plan's Competitive Effects (May 2011), at 2-4, 15-21 (finding that TARP capital infusions between 

October 2008 and December 2009 produced significant gains for shareholders of the largest banks but 

imposed losses on shareholders of smaller banks by injuring the competitiveness of those banks); 

Congressional Oversight Panel, February Oversight Report: ValUing Treasury's Acquisitions (Feb 6, 

2009), at 4-8, 26-29, 36-38 (presenting a valuation study concluding that (i) TARP capital infusions into 

eight major banks (BotA, Citigroup, Chase, Goldman, Morgan Stanley, US Bancorp and Wells Fargo) 

provided an average subsidy to those banks equal to 22% of the Treasury's investment, and (ii) additional 

capital infusions into AIG and Citigroup under TARP provided an average subsidy to those institutions 

equal to 59% of the Treasury's investment), available at http://cop.senate.gov/documents/cop-020609-

report.pdf. 

J4 Ivry, Keoun & Kuntz, supra note 2 (reporting that "[d]uring the crisis, Fed loans were among the 

cheapest around, with funding available for as low as 0.01 percent in December 2008"). 

J5 Wilmarth, "Dodd-Frank," supra note 5, at 984-85; Wilmarth, "Reforming Financial Regulation," supra 

note I, at 746 n.153. 

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ofthe product markets for home mortgages, home equity loans, and credit card loans. The same 

four banks and Goldman accounted for 97% of the aggregate notional values of OTC derivatives 

contracts written by U.S. banks 36 

The combined assets of the six largest banks - the foregoing five institutions plus Morgan 

Stanley - were equal to 63% of U.S. GDP in 2009, compared with only 17% ofGDP in 1995 37 

Nomi Prins has observed that, as a result of the financial crisis, "we have larger players who are 

more powerful, who are more dependent on government capital and who are harder to regulate 

than they were to begin with.,,38 Similarly, Simon Johnson and James Kwak maintain that "the 

problem at the heart of the financial system [is] the enormous growth of top-tier financial 

institutions and the corresponding increase in thei r economic and political power,,39 

3. The Dodd-Frank Act Does Not Solve the TBTF Problem 

In two articles written in 2002 and 2009, I warned that "the TBTF policy is the great 

unresolved problem of bank supervision" because it "undermines the effectiveness of both 

supervisory and market discipline,,4o As I pointed out in both articles, Congress' decision to 

enact the Gramm-Leach-Bliley Act ("GLBA") and repeal the Glass-Steagall Act in 1999 

authorized the creation of large financial conglomerates that spanned the entire range of our 

36 Wilmarth, "Dodd-Frank," supra note 5, at 985 . 

37 Simon Johnson & James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial 

Meltdown 202-03, 217 (20 I 0); Peter Boone & Simon Johnson, "Shooting Banks," New Republic, Mar. 

11 , 2010, at 20. See also Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City, "It's Not 

Over 'Til It's Over: Leadership and Financial Regulation" (William Taylor Memorial Lecture, Oct. 10, 

2010) (noting that "the largest five [U.S. BHCsJ control $8.4 trillion of assets, nearly 60 percent ofGDP, 

and the largest 20 control $12.8 trillion of assets or almost 90 percent ofGDP"), available at 

http://www.kansascityfed.org/speechbio/hoenigpd£'william-taylor-hoenig-IO-I O-IO.pdf; Ivry, Keoun & 

Kuntz, supra note 2 (reporting that "[tJotal assets held by the six biggest U.S. banks increased 39 percent 

to $9.5 trillion on Sept. 30, 20 II, from $6.8 trillion on the same day in 2006"). 

38 Wilmarth, "Dodd-Frank," supra note 5, at 985-86 (quoting Ms. Prins). 

39 Johnson & Kwak, supra note 37, at 191 . 

40 Arthur E. Wilmarth, Jr., "The Transformation of the U.S. Financial Services Industry: Competition, 

Consolidation, and Increased Risks," 2002 University of Illinois Law Review 215, 475 [hereinafter 

Wilmarth, "Transformation"]' available at http://ssm.comiabstract=315345;see also Wilmarth, 

"Financial Conglomerates, supra note 24, at 1049. 

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financial markets. I warned that the emergence of these new financial giants would bring "major 

segments of the securities and life insurance industries .. within the scope of the TBTF 

doctrine, thereby expanding the scope and cost offederal 'safety net' subsidies." I also warned 

that big financial conglomerates would take advantage of their new powers under GLBA and 

their presumed TBTF status by pursuing risky activities involving complex securities and 

derivatives, and by increasing their leverage through "capital arbitrage.,,41 As I pointed out in 

2009 

Unfortunately, the [current] financial crisis has confirmed all of the 

foregoing predictions. Over the past decade, regulators in developed nations 

encouraged the expansion of large financial conglomerates and failed to restrain 

their pursuit of short-term profits through increased leverage and high-risk 

activities. As a result, LeFIs were allowed to promote an enormous credit boom, 

and that boom precipitated a worldwide financial crisis. In order to avoid a 

complete collapse of global financial markets, central banks and governments 

have already provided almost $9 trillion of support. for major banks, securities 

firms and insurance companies. Those support measures - which are far from 

over - establish beyond any doubt that the TBTF policy now embraces the entire 

financial services industry42 

The financial crisis has demonstrated that TBTF subsidies create dangerous distortions in 

our financial markets and our general economy, and those subsidies must be eliminated (or at 

least significantly reduced) in order to restore a more level playing field for smaller financial 

41 Wilmarth, "Transformation," supra note 40, at 444-476 (quotes at 447, 476); see also Wilmarth, 

"Financial Conglomerates," supra note 24, at 1049. 

42 Wilmarth, "Financial Conglomerates," supra note 24, at 1049-50. In a subsequent article, I described 

the unprecedented credit boom that occurred in the U.S. economy between December 31 , 1991 and 

December 31 , 2007: 

Nominal domestic private-sector debt nearly quadrupled, rising from $1 OJ trillion to $39.9 

trillion [between 1991 and 2007], and the largest increases occurred in the financial and 

household sectors. Total U.S. private-sector debt as a percentage of gross domestic product 

("GOP") rose from 150 % in 1987 to almost 300 % in 2007 and, by that measure, exceeded even 

the huge credit boom that led to the Great Depression. Financial sector debt as a percentage of 

GOP rose from 40 % in 1988 to 70 % in 1998 and 120 percent in 2008. Meanwhile, household 

sector debt grew from two-thirds of GOP in the early 1990s to 100 % of GOP in 2008. 

Wilmarth, "Dodd-Frank," supra note 5, at 970. 

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institutions and to encourage the voluntary breakup of inefficient and risky financial 

conglomerates4 3 The financial crisis has also proven, beyond any reasonable doubt, that large 

financial conglomerates operate based on a hazardous business model that is riddled with 

conflicts of interest and prone to speculative risk-taking44 Accordingly, U.S. and European 

governments must adopt reforms to ensure that effective supervisory and market discipline is 

applied against LCFIs, 

A few months before Dodd-Frank was enacted, I wrote an article proposing five key 

reforms to accomplish these objectives. My proposed reforms would have (1) strengthened 

existing statutory restrictions on the growth of LCFIs, (2) created a special resolution process to 

manage the orderly liquidation or restructuring of systemically important financial institutions 

("SIFIs"), (3) established a consolidated supervisory regime and enhanced capital requirements 

for SIFIs, (4) created a special insurance fund to cover the costs of resolving failed SIFIs, and (5) 

rigorously insulated FDIC-insured banks that are owned by LCFIs from the activities and risks of 

their nonbank affiliates45 

The following sections of my testimony discuss my proposed reforms and compare those 

proposals to relevant provisions of Dodd-Frank. As shown below, Dodd-Frank includes a portion 

of my first proposal as well as the major components of my second and third proposals. 

However, Dodd-Frank omits most of my last two proposals. In my opinion, Dodd-Frank's 

omissions are highly significant and raise serious doubts about the statute's ability to prevent 

43 Jd at 987. Large financial conglomerates have never proven their ability to achieve superior 

perfonnance without the extensive TBTF subsidies they currently receive. Wilmarth, "Refonning 

Financial Regulation," supra note I, at 748-49. 

44 Wilmarth, "Financial Conglomerates," supra note 24, at 970-72, 994-1002, 1024-50; Johnson & 

Kwak, supra note 37, at 74-87, 120-41 , 193, 202-05; John Kay, Narrow Banking.· The Reform of 

Financial Regulation 12- 16, 41-44, 86-88 (Sept 15,2009) (unpublished manuscript), available at 

http://wwwjohnkay.com/wp-contentluploads/2009/ 12/) K -Narrow-Banking. pdf. 

4S Wilmarth, "Refonning Financial Regulation," supra note I, at 747-79. 

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TBTF bailouts in the future. As explained below, a careful reading of Dodd-Frank indicates that 

Congress has left the door open for taxpayer-funded protection of creditors of SIFIs during future 

financial crises. 

a. Dodd-Frank Modestly Strengthened Existing Statutory Limits on the Growth of 

LCFIs But Did Not Close Significant Loopholes 

Congress authorized nationwide banking - via interstate branching and interstate 

acquisitions of banks by BHCs - when it passed the Riegle-Neal Interstate Banking and 

Branching Act of 1994 ("Riegle-Neal Act,,)46 To prevent the emergence of dominant 

megabanks, the Riegle-Neal Act imposed nationwide and statewide deposit concentration limits 

("deposit caps") on interstate expansion by large banking organizations47 Under the RiegleNeal Act, a BHC may not acquire a bank in another state, and a bank may not merge with 

another bank across state lines, if the resulting banking organization (together with all affiliated 

FDIC-insured depository institutions) would hold (i) 10% or more of the total deposits of all 

depository institutions in the U.S, or (ii) 30% or more of the total deposits of all depository 

institutions in a single state48 

Unfortunately, Riegle-Neal's nationwide and statewide deposit caps contained three 

major loopholes. First, the deposit caps applied only to interstate bank acquisitions and interstate 

bank mergers, and the deposit caps therefore did not restrict combinations between banking 

organizations headquartered in the same state. Second, the deposit caps did not apply to 

acquisitions of, or mergers with, thrift institutions and industrial banks, because those institutions 

were not treated as "banks" under the Riegle-Neal Act. Third, the deposit caps did not apply to 

46 Pub. L. No. 103-328, 108 Stat. 2338, Sept. 29, 1994. 

47 See House Report No. 103-448, at 65-66 (1994) (additional views of Rep. Neal and Rep. McCollum) 

(explaining that the Riegle-Neal Act "adds two new concentration limits to address concerns about 

potential concentration of financial power at the state and national levels"), reprinted in 1994 

U.S .C.C.A.N. 2039, 2065-66. 

48 Wilmarth, "Dodd-Frank," supra note 5, at 988. 

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acquisitions of, or mergers with, banks that are "in default or in danger of default" (the "failing 

bank" exception)49 

The emergency acquisitions of Countrywide, Merrill, WaMu and Wachovia in 2008 

demonstrated the significance of Riegle-Neal's loopholes and the necessity of closing them. In 

reliance on the "non-bank" loophole, the FRB allowed BofA to acquire Countrywide and Merrill 

even though (i) both firms controlled FDIC-insured depository institutions (a thrift, in the case of 

Countrywide, and a thrift and industrial bank, in the case of Merrill), and (ii) both transactions 

allowed BofA to exceed the 10% nationwide deposit cap. Similarly, after the FDIC seized 

control ofWaMu as a failed depository institution, the FDIC sold the giant thrift to Chase even 

though the transaction enabled Chase to exceed the 10% nationwide deposit cap. Finally, 

although the FRB determined that Wells Fargo's acquisition ofWachovia gave Wells Fargo 

control of just under 10% of nationwide deposits, the FRB probably could have approved the 

acquisition in any case by designating Wachovia as a bank "in danger of default."so 

As a result of the foregoing acquisitions, BofA, Chase and Wells Fargo each surpassed 

the 10% nationwide deposit cap by October 2008. To prevent further breaches of the Riegle-Neal 

concentration limits, I proposed that Congress should extend the nationwide and statewide 

deposit caps to cover all intrastate and interstate transactions involving any type of FDIC-insured 

depository institution, including thrifts and industrial banks. In addition, I proposed that 

Congress should significantly narrow the failing bank exception by requiring federal regulators 

to make a "systemic risk determination" ("SRD") in order to approve any acquisition involving a 

failing depository institution that would exceed either the nationwide or statewide deposit caps5l 

49 Jd. at 988-89. 

50 Jd. at 989. 

51 Jd. at 989-90. 

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Under my proposed standard for an SRD, the FRB and the FDIC could not invoke the 

failing bank exception unless they determined jointly, with the concurrence of the Treasury 

Secretary, that the proposed acquisition was necessary to avoid a substantial threat of severe 

systemic injury to the banking system, the financial markets or the national economy. In 

addition, each SRD would be audited by the Government Accountability Office ("GAO") to 

determine whether regulators satisfied the criteria for an SRD, and would also be reviewed in a 

joint hearing held by the House and Senate committees with oversight of the financial markets 

(the "SRD Review Procedure"). My proposed SRD requirements would ensure much greater 

public transparency of, and scrutiny for, any federal agency order that invokes the failing bank 

exception to the Riegle-Neal deposit caps52 

Section 623 of Dodd-Frank does extend Riegle-Neal's 10% nationwide deposit cap to 

reach all interstate acquisitions and mergers involving any type of FDIC-insured depository 

institution. Thus, interstate acquisitions and mergers involving thrift institutions and industrial 

banks are now subject to the nationwide deposit cap to the same extent as interstate acquisitions 

and mergers involving commercial banks. However, § 623 leaves open the other Riegle-Neal 

loopholes because (1) it does not apply the nationwide deposit cap to intrastate acquisitions or 

mergers, (2) it does not apply the statewide deposit cap to interstate transactions involving thrifts 

or industrial banks or to any type of intrastate transaction, and (3) it does not impose any 

enhanced substantive or procedural requirements for invoking the failing bank exception. 

Hence, § 623 of Dodd-Frank closes one important loophole but fails to close other significant 

exemptions that continue to undermine the effectiveness of Riegle-Neal's deposit caps53 

52 ld at 990. As discllssed below, § 203 of Dodd-Frank establishes a similar "Systemic Risk 

Determination" requirement and procedure for authorizing the FDIC to act as receiver for a failing SIFt 

53 Id at 990-91. 

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Section 622 of Dodd-Frank authorizes federal regulators to impose a separate 

concentration limit on mergers and acquisitions involving "financial companies." As defined in 

§ 622, the term "financial companies" includes insured depository institutions and their holding 

companies, nonbank SIFIs and foreign banks operating in the U.S. Subject to two significant 

exceptions described below, § 622 potentially bars any acquisition or merger that would give a 

"financial company" control of more than 10% of the total "liabilities" of all financial 

companies. This limitation on control of nationwide liabilities ("liabilities cap") was originally 

proposed by former FRB Chairman Paul Volcker5 4 

The liabilities cap in § 622 provides an additional method for restricting the growth of 

very large financial companies (e.g., Citigroup, Goldman, and Morgan Stanl~) that rely mainly 

on funding from the capital markets instead of deposits5 5 However, the liabilities cap has two 

significant exceptions. First, it is subject to a "failing bank" exception (similar to the "failing 

bank" loophole in Riegle-Neal), which regulators can invoke without making any SRD. Second, 

and more importantly, the liabilities cap is not self-executing. Section 622 requires the Financial 

Stability Oversight Council CFSOC") to consider (based on a cost-benefit analysis) whether the 

statutory liabilities cap should be modified. Section 622 also requires the FRB to implement the 

liabilities cap in accordance with any modifications recommended by FSOC. 56 

Thus, § 622 allows the FSOC and FRB to weaken (and perhaps even eliminate) the 

liabilities cap if they determine that the cap would have adverse effects that outweigh its 

potential benefits. Consequently, it is doubtful whether Dodd-Frank will impose any meaningful 

new limit on the growth of LCFls beyond the statute's beneficial extension of the nationwide 

deposit cap to reach all interstate acquisitions and mergers involving FDIC-insured institutions. 

54 1d. at 991. 

" ]d at 991-92. 

56 ld. at 992. 

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12711022.eps

b. Dodd-Frank Establishes a Special Resolution Regime for Systemically Important 

Financial Institutions But Allows the FDIC to Provide Full Protection for Favored 

Creditors of Those Institutions 

i. Dodd-Fmnk's Orderly Liquidation Authority Does Not Preclude Full 

Protection of Favored Creditors of SIFIs 

Dodd-Frank establishes an Orderly Liquidation Authority ("OLA"), which seeks to 

provide a "viable alternative to the undesirable choice .. . between bankruptcy of a large, 

complex financial company that would disrupt markets and damage the economy, and bailout of 

such financial company that would expose taxpayers to losses and undermine market 

discipline.,,57 In some respects, the OLA for SIFIs - which is similar to the FDIC's existing 

resolution regime for failed depository institutions58 - resembles my earlier proposal for a special 

resolution regime for SIFIs59 However, contrary to the statute's stated purpose,60 Dodd-Frank's 

OLA does not preclude future bailouts for favored creditors ofTBTF institutions. 

Dodd-Frank establishes FSOC as an umbrella organization with systemic risk oversight 

authority. FSOC's voting members include the leaders of nine federal financial regulatory 

agencies and an independent member having insurance experience. By a two-thirds vote, FSOC 

may determine that a domestic or foreign nonbank financial company should be subject to DoddFrank's systemic risk regime, which includes prudential supervision by the FRB and potential 

liquidation by the FDIC under the OLA. In deciding whether to impose Dodd-Frank's systemic 

risk regime on a nonbank financial company, the crucial question to be decided by FSOC is 

57 Senate Report No. 111-176, at 4 (2010). 

58 See Carnell, Macey & Miller, supra note 14, ch. 13 (describing the FDIC's resolution regime for failed 

banks); Fed. Deposit Ins. Corp., "Notice of Proposed Rulemaking Implementing Certain Orderly 

Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act," 

75 Federal Register 64173, 64175 (Oct. 19, 2010) (stating that "[p]arties who are familiar with the 

liquidation of insured depository institutions. . will recognize many parallel provisions in Title II" of 

Dodd-Frank) [hereinafter FDIC Proposed OLA Rule]. 

59 See Wilmarth, "Reforming Financial Regulation," supra note I, at 754-57. 

fIJ See Dodd-Frank (preamble) (stating that the statute is designed "to end 'too big to fail ' [and] to protect 

the American taxpayer by ending bailouts"). 

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whether "material financial distress at the ... nonbank financial company, or the nature, scope, 

size, scale, concentration, interconnectedness, or mix of the activities of the ... nonbank 

financial company, could pose a threat to the financial stability of the United States.,,61 

Dodd-Frank does not use the term "systemically important financial institution" to 

describe a nonbank financial company that is subject to the statute's systemic risk regime, but I 

will generally refer to such companies as SIFIs. Dodd-Frank treats BHCs with assets of more 

than $50 billion as SIFIs, and those BHCs are also subject to enhanced supervision by the FRB 

and potential liquidation by the FDIC under the OLA6 2 Dodd-Frank properly recognizes that -

absent mandatory breakups of LCFIs - the best way to impose effective discipline on SIFIs, and 

to reduce the federal subsidies they receive, is to designate them publicly as SIFIs and to impose 

stringent regulatory requirements that force them to internalize the potential costs of their TBTF 

status 6 3 However, it is noteworthy - and disturbing - that FSOC has not yet publicly designated 

ill!Y large nonbank financial firm as a SIFI, even though almost 18 months have gone by since 

Dodd-Frank's enactment. 

As I and many others have proposed, Article II of Dodd-Frank establishes a systemic 

resolution process - the OLA - to handle the failures of SIFIs64 In order to invoke the OLA for 

a "covered financial company," the Treasury Secretary must issue an SRD, based on the 

recommendation of the FRB together with either the FDIC or the SEC (if the failing company's 

largest subsidiary is a securities broker or dealer) or the Federal Insurance Office (if the failing 

company's largest subsidiary is an insurance company). The Treasury Secretary's SRD must find 

that (i) the covered financial company's failure and resolution under otherwise applicable 

61 Wilmarth, "Dodd-Frank," supra note 5, at 993-94. 

62 Id. at 994 (discussing §§ 115 and 165 ofDodd-Frank). 

63 Id. at 994-95. 

64 Senate Report No. 111-176, at 4-6, 57-65 (2010); Wilmarth, "Reforming Financial Regulation," supra 

note I, at 756-57. 

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insolvency rules (e.g, the federal bankruptcy laws) would have "serious adverse effects on 

financial stability," (ii) application of the OLA would "avoid or mitigate such adverse effects," 

and (iii) "no viable private sector alternative is available to prevent" the company's failure 65 

I have argued that the systemic resolution process for SIFIs should embody three core 

principles in order to create a close similarity between that process and Chapter 11 of the federal 

Bankruptcy Code. Those core principles are: (A) requiring equity owners in a failed SIFI to lose 

their entire investment if the SIFI's assets are insufficient to pay all valid creditor claims, (B) 

removing senior managers and other employees who were responsible for the SIFI's failure, and 

(C) requiring unsecured creditors to accept meaningful "haircuts" in the form of significant 

reductions of their debt claims or an exchange of substantial portions of their debt claims for 

equity in a successor institution66 

Dodd-Frank incorporates the first two of my core principles. It requires the FDIC to 

ensure that equity owners of a failed SIFI do not receive any payment until all creditor claims are 

paid, and that managers responsible for the failure are removed. At first sight, Dodd-Frank also 

seems to embody the third principle by directing the FDIC to impose losses on unsecured 

creditors if a failed SIFI's assets are insufficient to pay all secured and unsecured debts. 

However, a careful reading of the statute reveals that Dodd-Frank allows the FDIC to provide 

full protection to favored classes of unsecured creditors offailed SIFIs67 

In its capacity as receiver for a failed SIFI, the FDIC may provide funds for the payment 

or transfer of creditors' claims in at least two ways. First, the FDIC may provide funding directly 

to the SIFI's receivership estate by making loans, purchasing or guaranteeing assets, or assuming 

or guaranteeing liabilities. Second, the FDIC may provide funding to establish a "bridge 

65 Dodd-Frank, supra note 5, at 996 (quoting § 203(b) ofDodd-Frank). 

66 ld. at 996-97; Wilmarth, "Reforming Financial Regulation," supra note I, at 756-57. 

6J Wilmarth, "Dodd-Frank," supra note 5, at 997. 

21 
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financial company" ("BFC"), and the FDIC may then approve a transfer of designated assets and 

liabilities from the failed SIFI to the BFC. In either case, the FDIC may (i) take steps to 

"mitigate[] the potential for serious adverse effects to the financial system," and (ii) provide 

preferential treatment to certain creditors if the FDIC determines that such treatment is necessary 

to "maximize" the value of a failed SIFI's assets or to preserve "essential" operations of the SIFI 

or a successor BFC. Subject to the foregoing conditions, the FDIC may give preferential 

treatment to certain creditors as long as every creditor receives at least the amount she would 

have recovered in a liquidation proceeding under Chapter 7 of the federal Bankruptcy Code68 

In October 2010, the FDIC issued a proposed rule to implement its authority under the 

OLA. In January 2011 , the FDIC approved the proposed OLA rule as an interim final rule69 

Under the OLA rule, the FDIC may provide preferential treatment to certain creditors in order 

"to continue key operations, services, and transactions that will maximize the value of the [failed 

SIFI's] assets and avoid a disorderly collapse in the marketplace.,,7o The OLA rule excludes the 

following classes of creditors from any possibility of preferential treatment: (i) holders of 

unsecured senior debt with a term of more than 360 days, and (ii) holders of subordinated debt. 

Accordingly, the OLA rule would allow the FDIC to provide full protection to short-term, 

unsecured creditors of a failed SIFI whenever the FDIC determines that such protection is 

"essential for [the SIFI's] continued operation and orderly liquidation.,,71 

The OLA rule would allow the FDIC to give full protection to short-term liabilities of 

SIFIs, including commercial paper and securities repurchase agreements. Those types of 

68 ld. at 997-98 (citing and quoting various provisions of Article II of Dodd-Frank) See also FDIC 

Proposed OLA Rule, supra note 171 , at 64175, 64177 (explaining Dodd-Frank's minimum guarantee for 

creditors of a failed SIFI). 

69 Fed. Deposit Ins. Corp., Interim final rule, 76 Fed. Reg. 4267 (Jan. 25, 20 II) (adopting regulations to 

be codified at 12 C.PR Part 380) [hereinafter FDIC Final OLA Rule]. 

70 FDIC Proposed OLA Rule, supra note 58, at 64175; FDIC Final OLA Rule, supra note 69, at 4211. 

71 FDIC Proposed OLA Rule, supra note 58, at 64177-78; FDIC Final OLA Rule, supra note 69, at 4211. 

22 
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wholesale liabilities proved to be highly volatile and prone to creditor "runs" during the financial 

crisis72 Unfortunately, by stating that the FDIC reserves the right to provide preferential 

treatment to short-term creditors of failed SIFIs, but will never provide such treatment to holders 

oflong-term debt or subordinated debt, the OLA rule is likely have at least two perverse results. 

The OLA rule (i) creates the appearance of an implicit subsidy to short-term creditors of SIFIs, 

and (ii) encourages SIFIs to rely even more heavily on vulnerable, short-term funding strategies 

that led to repeated disasters during the financial crisis73 

As indicated by the OLA rule, Dodd-Frank gives the FDIC considerable leeway to 

provide de facto bailouts for favored creditors offailed SIFIs. Dodd-Frank also provides a 

funding source for such bailouts. Section 201(n) of Dodd-Frank establishes an Orderly 

Liquidation Fund COLF") to finance liquidations of SIFIs. As discussed below, Dodd-Frank 

does not establish a pre-funding mechanism for the OLF. However, the FDIC may obtain funds 

for the OLF by borrowing from the Treasury in amounts up to (i) 10% of a failed SIF!' s assets 

within thirty days after the FDIC's appointment as receiver, plus (ii) 90% of the "fair value" of 

the SIF!'s assets that are "available for repayment" thereafter.,,74 The FDIC's authority to 

borrow from the Treasury provides an immediate source of funding to protect unsecured 

creditors that are deemed to have systemic significance. In addition, the "fair value" standard 

potentially gives the FDIC considerable discretion in appraising the assets of a failed SIFI, since 

12 See Zoltan Pozsar et ai., "Shadow Banking" (Federal Reserve Bank ofN Y Staff Report No. 458, July 

2010), at 2-6, 46-59, available at http://ssm.comlabstract=1645337. 

J3 Wilmarth, "Dodd-Frank," supra note 5, at 998-99. 

74 Dodd-Frank, § 210(n)(5), (6). In order to borrow funds from the Treasury to finance an orderly 

liquidation, the FDIC must enter into a repayment agreement with the Treasury after consulting with the 

Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial 

Services. Jd § 210(n)(9). 

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the standard does not require the FDIC to rely on current market values in measuring the value of 

a failed SIPI's assets75 

Dodd-Frank generally requires the FDIC to impose a "claw-back" on creditors who 

receive preferential treatment if the proceeds of liquidating a failed SIPI are insufficient to repay 

the full amount that the FDIC borrows from the Treasury to conduct the liquidation. However, 

Dodd-Frank authorizes the FDIC to exercise its powers under the OLA (including its authority to 

provide preferential treatment to favored creditors of a failed SIPI) for the purpose of preserving 

"the financial stability of the United States" and preventing "serious adverse effects to the 

financial system.,,76 Therefore, the FDIC could conceivably assert the power to waive its right of 

"claw-back" against a failed SIPI's creditors who received preferential treatment if the FDIC 

determines that such a waiver is necessary to maintain the stability of the financial markets77 

ii. Dodd-Frank Does Not Prevent Federal Regulators from Using Other Sources 

of Funding to Protect Creditors of SIFIs 

Dodd-Frank could potentially be interpreted as allowing the FDIC to borrow an 

additional $100 billion from the Treasury for use in accomplishing the orderly liquidation ofa 

failed SIP!. Dodd-Frank states that the FDIC's borrowing authority for the OLF does not 

"affect" the FDIC's authority to borrow from the Treasury Department under 12 U.S.C. § 

IS24(a)78 Under §IS24(a), the FDIC may exercise its "judgment" to borrow up to $100 billion 

from the Treasury "for insurance purposes," and the term "insurance purposes" appears to 

include functions beyond the FDIC's responsibility to administer the Deposit lnsurance Fund 

JS Wilmarth, "Dodd-Frank," supra note 5, at 999. 

76 Dodd-Frank § 206(1). See also § 21 0(a)(9)(E)(iii). 

JJ Wilmarth, "Dodd-Frank," supra note 5, at 1000. 

78 Dodd-Frank § 20 I (n)(8)(A). 

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("DIF") for banks and thrifts79 Dodd-Frank bars the FDIC from using the DIF to assist the OLF 

or from using the OLF to assist the DIF80 However, the FDIC could conceivably assert that it 

has authority to borrow up to $100 billion from the Treasury under § I 824(a) for the "insurance 

purpose" of financing an orderly liquidation of a SIF! olltside the normal funding parameters of 

the OLF. Assuming that such supplemental borrowing authority is available to the FDIC, the 

FDIC could use that authority to protect a SIFI's uninsured and unsecured creditors as long as 

such protection "maximizes" the value of the SIFI's assets or "mitigates the potential for serious 

adverse effects to the financial system. ,,81 

The "systemic risk exception" ("SRE") to the Federal Deposit Insurance Act ("FDIA") 

provides a further potential source of funding to protect creditors offailed SIFTs 82 Under the 

SRE, the Treasury Secretary can authorize the FDIC to provide full protection to uninsured 

creditors of a bank in order to avoid or mitigate "serious effects on economic conditions or 

financial stability.,,83 Dodd-Frank amended and narrowed the SRE by requiring that a bank must 

be placed in receivership in order for the bank's creditors to receive extraordinary protection 

under the SRE84 Thus, if a failing SIF! owned a bank that was placed in receivership, the SRE 

would permit the FDIC (with the Treasury Secretary's approval) to provide full protection to 

79 Under § 1824(a), the FDIC may borrow up to $100 billion "for insurance purposes" and such borrowed 

funds "shall be used by the [FDIC] solely in carrying out its functions with respect to such insurance." 12 

US.c. § 1824(a) Section 1824(a) further provides that the FDIC "may employ any funds obtained under 

this section for purposes of the [DIF] and the borrowing shall become a liability of the [DIF] to the extent 

funds are employed therefor." ld. (emphasis added). The foregoing language strongly indicates that 

funds borrowed by the FDIC under § IS24(a) do not have to be used exclusively for the DIF and can be 

used for other "insurance purposes" in accordance with the ') udgment" of the Board of Directors of the 

FDIC. It could be argued that borrowing for the purpose offunding the OLF would fall within such 

"insurance purposes 

80 Dodd-Frank, § 21O(n)(S)(A). 

81 1d. § 21O(a)(9)(E)(i), (iii). 

82 Wilmarth, "Dodd-Frank," supra note 5, at 1001 (referring to the SRE under 12 U.S.c. § 1823(c)(4)(G), 

as originally enacted in 1991 and as invoked by federal regulators during the financial crisis) 

83 In order to invoke the SRE, the Treasury Secretary must receive a favorable recommendation from the 

FDIC and the FRB and consult with the President 12 UB.C. § IS23(c)(4)(G)(i) 

84 See Dodd-Frank, § 1106(b) (amending 12 UB.C. § IS23(c)(4)(G)) 

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creditors of that bank in order to avoid or mitigate systemic risk By protecting a SIFI-owned 

bank's creditors (which could include the SIFI itself), the FDIC could use the SRE to extend 

indirect support to the SIFI's creditors. 

Two provisions of Dodd-Frank limit the authority of the FRB and the FDIC to provide 

financial support to failing SIFIs or their subsidiary banks outside the OLA or the SRE. First, 

§1101 of Dodd-Frank provides that the FRB may not extend emergency secured loans under 

§13(3) of the Federal Reserve Act85 except to solvent firms that are "participant[sJ in any 

program or facility with broad-based eligibility" that has been approved by the Treasury 

Secretary and reported to Congress. 86 Second, § 1105 of Dodd-Frank forbids the FDIC from 

guaranteeing debt obligations of depository institutions or their holding companies or other 

affiliates except pursuant to a "widel y available program" for "solvent" institutions that has been 

approved by the Treasury Secretary and endorsed by a joint resolution of Congress87 

In light of the foregoing constraints, it is difficult to envision how the FRB or the FDIC 

could provide loans or debt guarantees to individual failing SIFIs or their subsidiary banks under 

85 12 U.S.C. § 343. See Wilmarth, "Dodd-Frank," supra note 5, at 1002 (referring to § 13(3) as amended 

in 1991 and as applied by the FRB to provide emergency credit to particular firms and segments of the 

financial markets during the financial crisis). 

86 Dodd-Frank, § 1101(a) (requiring the Fed to use its § 13(3) authority solely for the purpose of 

establishing a lending "program or facility with broad-based eligibility" that is open only to solvent firms 

and is designed "for the purpose of providing liquidity to the financial system, and not to aid a failing 

financial company"). See Senate Report No. 111-176, at 6, 182-83 (2010) (discussing Dodd-Frank's 

restrictions on the FRB's lending authority under § 13(3)). 

87 Dodd-Frank, § 1105. In addition, § lI06(a) ofDodd-Frank bars the FDIC from establishing any 

"widely available debt guarantee program" based on the SRE under the FDI Act In October 2008, federal 

regulators invoked the SRE in order to authorize the FDIC to establish the Debt Guarantee Program 

CDGP") The DGP enabled depository institutions and their affiliates to issue more than $300 billion of 

FDIC-guaranteed debt securities between October 2008 and the end of2009. See FCIC PSR on TBTF, 

supra note 122, at 29-32. Section 1106(a) of Dodd-Frank prohibits the use of the SRE to establish any 

program similar to the DGP. See Senate Report No. 111-176, at 6-7, 183-84 (discussing Dodd-Frank's 

limitations on the FDIC's authority to guarantee debt obligations of depository institutions and their 

holding companies). 

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§ 1101 or § 1105 ofDodd-Frank88 However, the FRB could conceivably use its remaining 

authority under § 13(3) to create a "broad-based" program similar to the Primary Dealer Credit 

Facility CPDCF") in order to provide emergency liquidity assistance to a selected group of 

LCFls that the FRB deems to be "solvent.,,89 As shown by the events of 2008, it is extremely 

difficult for outsiders (including members of Congress) to second-guess a regulator's 

determination of solvency in the midst of a systemic crisis. Moreover, regulators are strongly 

inclined during a crisis to make generous assessments of solvency in order to justify their 

decision to provide emergency assistance to troubled LCFIs.

90 Thus, during a financial crisis the 

FRB could potentially assert its authority under amended § 13(3) to provide emergency loans to 

a targeted group of troubled LCFIs that it claimed to be "solvent." 

Moreover, Dodd-Frank does not limit the ability of individual LCFls to receive liquidity 

support from the FRB's discount window or from Federal Home Loan Banks CFHLBs"). The 

FRB's discount window (often referred to as the FRB's "lender oflast resort" facility) provides 

short-term loans to depository institutions secured by qualifying collateral. Similarly, FHLBs -

sometimes described as "lender[sl of next-to-last resort" - provide collateralized advances to 

member institutions, including banks and insurance companies91 

During the financial crisis, banks did not borrow significant amounts from the discount 

window due to (i) the perceived "stigma" of doing so and (ii) the availability of alternative 

88 Wilmarth, "Dodd-Frank, supra note 5, at 1002. 

89 The FRB established the PDCF in March 2008 (at the time of its rescue of Bear) and expanded that 

facility in September 2008 (at the time of Lehman's failure). The PDCF allowed the 19 primary dealers in 

government securities to make secured borrowings from the FRB on a basis similar to the FRB's discount 

window for banks. The 19 primary dealers eligible for participation in the PDCF were securities brokerdealers; however, all but four of those dealers were affiliated with banks. As of March 1, 2008, the FRB's 

list of primary dealers included all of the "big eighteen" LCFIs except for AIG, Societe Generale and 

Wachovia. Wilmarth, "Dodd-Frank," supra note 5, at 1002-03 n.214. 

OJ Jd at 1002-03. 

91 Jd at 1003-04. 

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sources of credit through FHLBs and several emergency liquidity facilities that the FRB 

established under its § 13(3) authority. The FHLBs provided $235 billion of advances to 

member institutions during the second half of 2007, following the outbreak of the financial crisis. 

During that period, FHLBs extended almost $150 billion of advances to ten major LCFIs. Six of 

those LCFIs incurred large losses during the crisis and failed, were acquired in emergency 

transactions, or received "exceptional assistance" from the federal government. Accordingly, 

FHLB advances provided a significant source of support for troubled LCFIs, especially during 

the early phase of the financial crisis. During future crises, it seems likely that individual LCFIs 

will use the FRB's discount window more frequently, along with FHLB advances, because 

Dodd-Frank prevents the FRB from providing emergency credit to individual institutions under § 

13(3)92 

Discount window loans and FHLB advances cannot be made to banks in receivershi p, 

but they do provide a potential source of funding for troubled SIFIs or SIFI-owned banks as long 

as that funding is extended prior to the appointment of a receiver for either the bank or the SIFt 

To the extent that the FRB or fHLBs provide such funding, at least some short-term creditors of 

troubled SIFIs or SIFI-owned banks are likely to benefit by obtaining full payment of their 

claims before any receivership is created. 93 

Thus, notwithstanding Dodd-frank's explicit promise to end bailouts of SIFIs, federal 

agencies retain several powers that will permit them to protect creditors of weakened SIFIs. A 

more fundamental problem is that Dodd-frank's "no bailout" pledge does not bind future 

Congresses. When a future Congress confronts the next systemic financial crisis, that Congress 

may well decide to abandon Dodd-frank's "no bailout" position either explicitly (by amending 

92 Wilmarth, "Dodd-Frank," supra note 5, at 1004. 

93 Jd at 1004-05; see also 12 U.S.c. § 347b(b) (allowing the FRE to make discount window loans to 

"undercapitalized" banks subj ect to specified limitations). 

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or repealing the statute) or implicitly (by looking the other way while regulators expansively 

construe their authority to protect creditors of SIFls). For example, Congress and President 

George H.w. Bush made "never again" statements when they rescued the thrift industry with 

taxpayer funds in 1989, but those statements did not prevent Congress and President George W. 

Bush from using public funds to bailout major financial institutions in 200894 As Adam Levitin 

has observed: 

Law is an insufficient commitment device for avoiding bailouts altogether. It is 

impossible to produce binding commitment to a preset resolution process, irrespective of 

the results. The financial Ulysses cannot be bound to the mast .. . Once the ship is 

foundering, we do not want Ulysses to be bound to the mast, lest [we 1 go down with the 

ship and drown. Instead, we want to be sure his hands are free - too bail 95 

Similarly, Cheryl Block has concluded that "despite all the ... 'no more taxpayer-funded 

bailout' clamor included in recent financial reform legislation, bailouts in the future are likely if 

circumstances become sufficiently severe.,,96 Accordingly, there is a substantial probability that 

future Congresses will relax or remove Dodd-Frank's constraints on TBTF bailouts, or will 

permit federal regulators to evade those limitations, if such actions are deemed necessary to 

prevent failures of SIFIs that could destabilize our financial system97 

c. Dodd-Frank Subjects SIFIs to Enhanced Supervisory Standards, But Those 

Provisions Are Not Likely to Prevent Future Bailouts of SIFIs 

Dodd-Frank provides the FRB with consolidated supervision and enforcement authority 

over nonbank SIFIs comparable to the FRB's umbrella supervisory and enforcement powers with 

respect to BHCs and financial holding companies ("FHCs"). Dodd-Frank also requires the FRB 

94 Wilmarth, "Dodd-Frank," supra note 5, at 1005. 

95 Adam J. Levitin, "In Defense of Bailouts." 99 Georgetown Law Review 435, 439 (2011) 

96 Cheryl D. Block, "Measuring the True Cost of Govemment Bailout," 88 Washington University Law 

Review 149,224 (2010); see also id. at 227 ("pretending that there will never be another bailout simply 

leaves us less prepared when the next severe crisis hits"). 

97 See Levitin, supra note 95, at 489 ("[i]fan OLA proceeding would result in socially unacceptable loss 

allocations, it is likely to be abandoned either for improvised resolution or for the statutory framework to 

be stretched ... to permit outcomes not intended to be allowed"). 

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(either on its own motion or on FSOC's recommendation) to adopt enhanced prudential 

standards for nonbank SIFIs and large BHCs "[i]n order to prevent or mitigate risks to the 

financial stability of the United States.,,98 The enhanced standards must be "more stringent" than 

the ordinary supervisory rules that apply to nonbank financial companies and BHCs that are not 

Dodd-Frank requires the FRB to adopt enhanced risk-based capital requirements, 

leverage limits, liquidity requirements, overall risk management rules, risk concentration limits, 

requirements for resolution plans ("living wills") and credit exposure reports. In addition, the 

FRB may, in its discretion, require SIFIs to satisfy contingent capital requirements, enhanced 

public disclosures, short-term debt limits, and additional prudential standards. loo 

It may be very difficult for SIFIs to reach agreement with outside investors on terms for 

contingent capital that are mutually satisfactory. Institutional investors are not likely to purchase 

debt securities that will be compelled to convert into equity stock when an SIFI is in trouble 

unless those convertible debt securities offer comparatively high yields and/or other investorfriendly features that may not be attractive to LCFIs. IOI 

Whether or not contingent capital proves to be a feasible option for attracting investment 

by outside investors, I believe that contingent capital should become a significant component of 

future compensation packages for senior managers and other key employees (e.g., risk managers 

and traders) ofLCFIs. In contrast to outside investors, senior managers and key employees are 

"captive investors" who can be required, as a condition of their continued employment, to accept 

convertible subordinated debentures in payment of a significant portion (e.g., one-third) of their 

98 Wilmarth, "Dodd-Frank," supra note 5, at 1006-07 (discussing §§ 115 and 165 of Dodd-Frank) 

99 Dodd-Frank § 16 I (a)(l)(A), (d). 

](») Dodd-Frank § 165(b)(I)(B). 

IOJ Wilmarth, "Dodd-Frank," supra note 5, at 1008. 

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annual compensation. Managers and key employees should not be allowed to make voluntary 

conversions of their subordinated debentures into common stock until the expiration of a 

minimum holding period (e.g., three years) after the termination date of their employment. Such 

a minimum post-employment holding period would discourage managers and key employees 

from taking excessive risks to boost the value of the conversion option during the term of their 

employment. At the same time, their debentures should be subject to mandatory conversion into 

common stock upon the occurrence of a designated "triggering" event of financial distress. 

Requiring managers and key employees to hold a significant portion of contingent capital could 

give them positive incentives to manage their LCFI prudently in accordance with the interests of 

creditors as well as longer-term shareholders. Such a requirement would also force managers 

and key employees to share a significant portion of the loss if their LCFI is threatened with 

failure. 102 

Dodd-Frank's provisions requiring consolidated FRB supervision and enhanced 

prudential standards for SIFIs represent valuable improvements. For at least five reasons, 

however, those provisions are unlikely to prevent future failures of SIFIs with the attendant risk 

of governmental bailouts for systemically significant creditors. First, like previous regulatory 

reforms, Dodd-Frank relies heavily on the concept of stronger capital requirements. 

Unfortunately, capital-based regulation has repeatedly failed in the past. 103 As regulators learned 

during the banking and thrift crises of the 1980s and early 1990s, capital levels are "lagging 

indicators" of bank problems 104 because (i) "many assets held by banks ... are not traded on any 

organized market and, therefore, are very difficult for regulators and outside investors to value," 

102 Wilmarth, "Dodd-Frank," supra note 5, at 1008-09. 

IOJ Jd at 1009-10. 

104 1 Fed. Deposit Insurance Corp., History of the Eighties: Lessons for the Future 39-40, 55-56 (1997) 

[hereinafter FDIC History Lessons]. 

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and (ii) bank managers "have strong incentives to postpone any recognition of asset depreciation 

and capital losses" until their banks have already suffered serious damage. 105 

Second, LCFIs have repeatedly demonstrated their ability to engage in "regulatory capital 

arbitrage" in order to weaken the effectiveness of capital requirements. 106 For example, the 

Basel II international capital accord was designed to prevent the arbitrage techniques (including 

securitization) that banks used to undermine the effectiveness of the Basel I accord. 107 However, 

many analysts concluded that the Basel II accord (including its heavy reliance on internal riskbased models developed by LCFIs) contained significant flaws and allowed LCFIs to operate 

with seriously inadequate capital levels during the period leading up to the financial crisis. lOS 

Third, the past shortcomings of capital-based rules are part of a broader phenomenon of 

supervisory failure. Regulators did not stop large banks from pursuing hazardous (and in many 

cases fatal) strategies during the 1980s, including rapid growth with heavy concentrations in 

high-risk assets and excessive reliance on volatile, short-term liabilities. During the 1980s, 

regulators proved to be unwilling or unable to stop risky behavior as long as banks continued to 

report profits. 109 Similarly, there is wide agreement that federal banking and securities regulators 

failed to restrain excessive risk-taking by LCFIs during the two decades leading up to the 

financial crisis1lO 

105 Wilmarth, supra note 40, at 459; see also Daniel K. rarullo, Banking on Basel: The Future 0/ 

International Financial Regulation 171-72 (2008). 

106 Johnson & Kwak, supra note 37, at 137-41 ; Wilmarth, supra note 40, at 457-61. 

101 rarullo, supra note 105, at 79-83. 

108 1d. at 139-214 (identifying numerous shortcomings in the Basel II accord); Wilmarth, "Dodd-Frank," 

supra note 5, at 1010. 

109 FDIC History Lessons, supra note 104, at 39-46, 245-47, 373-78. 

110 See, e.g. , Kathleen C. Engel & Patricia A. McCoy, The Subprime Vinls 157-223 (2011); Johnson & 

Kwak, supra note 37, at 6-10, 120-50; Arthur E. Wilmarth, Jr., "The Dodd-Frank Act's Expansion of 

State Authority to Protect Consumers of Financial Services," 36 Journal o/Corporation Law 895, 897-

918 (2011), available at http:/ ssm.comfabstract~1891970.SeealsoJohnC.Coffee Jr. Bail-Ins Versus 

Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk (Columbia Law School Center for Law & 

Economic Studies, Working Paper No. 380, 2010), at 17-18 (stating that "[algreement is virtually 

32 
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Fourth, repeated regulatory failures during past financial crises reflect a "political 

economy of regulation" III in which regulators face significant political and practical challenges 

that undermine their efforts to discipline LCFIs. A full discussion of those challenges is beyond 

the scope of this testimony. For present purposes, it is sufficient to note that analysts have 

pointed to strong evidence of "capture" of financial regulatory agencies by LCFIs during the two 

decades leading up to the financial crisis, due to factors such as (i) large political contributions 

made by LCFIs, (ii) an intellectual and policy environment favoring deregulation, and (iii) a 

continuous interchange of senior personnel between the largest financial institutions and the top 

echelons of the financial regulatory agencies. 112 Commentators have also noted that LCFIs 

skillfully engaged in global regulatory arbitrage by threatening to move operations from the U.S. 

to London or other foreign financial centers ifU.S. regulators did not make regulatory 

concessions. lll 

Fifth, Dodd-Frank does not provide specific instructions about the higher capital 

requirements and other enhanced prudential standards that the FRB must adopt. Instead, DoddFrank sets forth general categories of supervisory requirements that the FRB either must or may 

address. Thus, the actual achievement of stronger prudential standards will depend upon 

implementation by the FRB through rulemaking, and LCFIs have marshaled an imposing array 

universal that lax regulation by all the financial regulators played a significant role in the 2008 financial 

crisis"). 

III Jeffrey N. Gordon & Christopher Muller, Confronting Financial Crisis: Dodd-Frank's Dangers and the 

Case for a Systemic Emergency Insruance Fund (Columbia Law School Center for Law & Economic 

Studies, Working Paper No. 374), at 26. 

112 Johnson & Kwak, supra note 37, at 82-109, 118-21 , 133-50; see also Deniz Igan et aI., A Fistful of 

Dollars: Lobbying and the Financial Crisis (lnt'! Monetary Fund Working Paper 09/287, Dec. 2009), 

available at http://ssm.com/abstract=1531520; Sold Gut: How Wall Street and Washington Betrayed 

America (Essential Infonnation & Consumer Education Foundation, Mar. 2009), available at 

http://www.wallstreetwatch.org/reports/sold_out.pdf. 

113 Coffee, supra note 110, at 18-21; Gordon & Muller, supra note III, at 27. 

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of lobbying resources to persuade the FRB to adopt more lenient rules. 114 When Congress 

passed Dodd-Frank, the head of a leading Wall Street trade association declared that "[t]he 

bottom line is that this saga will continue," and he noted that there are "more than 200 items in 

[Dodd-Frank]l where final details will be left up to regulators.,,1l5 Domestic and foreign LCFIs 

have already succeeded in weakening and delaying the imposition of enhanced capital standards 

under the Basel III accord, and they are determined to prevent U.S. regulators from adopting 

stronger capital requirements that would go beyond Basel III. 116 

For all of the foregoing reasons, as John Coffee has noted, "the intensity of regulatory 

supervision is likely to follow a sine curve: tight regulation after a crash, followed by gradual 

relaxation thereafter" as the economy improves and the crisis fades in the memories of regulators 

and the public. 11 7 When the next economic boom occurs, regulators will face escalating political 

pressures to reduce the regulatory burden on LCFIs in order to help those institutions continue to 

finance the boom. Accordingly, while Dodd-Frank's provisions for stronger supervision and 

enhanced prudential standards represent improvements over prior law, they are unlikely to 

prevent future failures of SIFIs and the accompanying pressures for governmental protection of 

systemically important creditors. I IS 

d. Dodd-Frank Does Not Require Sll'Is to Pay Insurance Premiums to Pre-Fund the 

Orderly Liquidation Fund 

As noted above, Dodd-Frank establishes an Orderly Liquidation Fund COLF") to provide 

financing for the FDIC's liquidation offailed SIFIs. However, Dodd-Frank does not require 

II' Wilmarth, "Dodd-Frank," supra note 5, at 1012. 

li S Randall Smith & Aaron Lucchetti, "The Financial Regulatory Overhaul: Biggest Banks Manage to 

Dodge Some Bullets," Wall Street Journal, June 26, 2010, at AS (quoting, in part, Timothy Ryan, chief 

executive of the Securities and Financial Markets Ass'n). 

116 Wilmarth, "Dodd-Frank," supra note 5, at 1010-11, 1013. 

III Coffee, supra note 110, at 20-21. 

II' Gordon & Muller, supra note Ill, at 22-23 ; Johnson & Kwak, supra note 37, at 205-08. 

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LCFIs to pay any assessments to pre-fund the OLF. Instead, Dodd-Frank authorizes the FDIC to 

borrow from the Treasury to provide the necessary funding for the OLF after a SIFI is placed in 

receivership.1 19 

The FDIC must normally repay any borrowings from the Treasury within five years, but 

the Treasury may extend the repayment period in order "to avoid a serious adverse effect on the 

financial system of the United States.,,120 Dodd-Frank authorizes the FDIC to repay borrowings 

from the Treasury by making ex post assessments on (i) creditors who received preferential 

payments (to the extent of such preferences), (ii) nonbank SIFIs supervised by the FRB under 

Dodd-Frank, (iii) BHCs with assets of $50 billion or more, and (iii) other financial companies 

with assets of $50 billion or more.

121 

Thus, Dodd-Frank relies on an ex post funding system for financing liquidations of SIFIs. 

That was not the case with early versions of the legislation. The financial reform bill passed by 

the House of Representatives would have authorized the FDIC to pre-fund the OLF by collecting 

up to $150 billion in risk-based assessments from nonbank SIFIs and large BHCs. The bill 

reported by the Senate Committee on Banking, Housing, and Urban Affairs would also have 

established a pre-funded OLF, albeit with a smaller "target size" of $50 billion. FDIC Chairman 

Sheila Bair strongly championed the concept of a pre-funded OLF.122 

Senate Republicans repeatedly blocked consideration of the financial reform bill on the 

Senate floor until Senate Democrats agreed to remove the pre-funding provision. The Obama 

Administration never supported the pre-funding mechanism and urged Senate leaders to remove 

119 Wilmarth, "Dodd-Frank," supra note 5, at 1015. 

120 Dodd-Frank, §§ 210(n)(9)(B), 21O(0)(1)(B), (C) (quote). 

121 Id. § 210(0)(1). 

122 Wilmarth, "Dodd-Frank," supra note 5, at 1015-16. 

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it from the bill. During the House-Senate conference committee's deliberations on Dodd-Frank, 

House Democratic conferees tried to revive the pre-funding mechanism but their efforts failed. 12l 

It is contrary to customary insurance principles to establish an OLF that is funded only 

after a SIFI fails and must be liquidated. 124 When commentators have considered analogous 

insurance issues created by the DIF, they have recognized that moral hazard is reduced when 

banks pay risk-based premiums that compel "each bank [to] bear the cost of its own risktaking.,,125 No one advocates a post-funded DIF today; indeed, analysts have generally argued 

that the DIF needs a higher level of pre-funding in order to respond adequately to systemic 

banking crises. 126 

In stark contrast to the FDI Act - which requires banks to pay deposit insurance 

premiums to pre-fund the DIF - Dodd-Frank does not require SIFIs to pay risk-based premiums 

to pre-fund the OLF. As a result, SIFIs receive an implicit subsidy and benefit from lower 

funding costs due to the protection their creditors expect to receive from the Treasury-backed 

OLP SIFIs will pay nothing for that subsidy until the first SIFI fails. 127 Not surprisingly, LCFIs 

viewed the removal of pre-funding for the OLF from the Dodd-Frank Act as a significant 

"victory," because it relieved them of the burden of paying an "upfront fee" to cover the 

potential costs of their implicit subsidy.128 

123 Id. at 1016-17. 

124 See Carnell, Macey & Miller, supra note 14, at 535 (noting that ordinarily "an insurer collects, pools, 

and invests policyholders' premiums and draws on that pool to pay policyholders' claims"). 

125 1d. at 328. 

126 See, e.g., Viral V. Acharya, loao A.C. Santos & Tanju Yorulmazer, "Systemic Risk and Deposit 

Insurance Premiums," Economic Policy Review (Fed. Res. Bank of NY, Aug. 2010), at 89. 

127 Wilmarth, "Dodd-Frank," supra note 5, at 1017. 

128 Mike Ferrulo, "Regulatory Refoml: Democrats Set to Begin Final Push to Enact Dodd-Frank Financial 

Overhaul," 94 Banking Report (BNA) 1277 (June 29, 20 I 0) (reporting that the elimination of a prefunded OLF "is seen as a victory for large financial institutions," and quoting analyst Jaret Seiberg's 

comment that "[t]he key for [the financial services] industry was to avoid the upfront fee"). 

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The Congressional Budget Office estimated that Dodd-Frank would produce a ten-year 

net budget deficit of $19 billion, due primarily to "potential net outlays for the orderly 

liquidation of [SIFIs} , measured on an expected value basis ,,!29 To offset that deficit, the 

House-Senate conferees proposed a $19 billion tax on financial companies with assets of $50 

billion or more and on hedge funds with managed assets of$10 billion or more. LCFIs strongly 

objected to the tax, and Republicans who had voted for the Senate bill threatened to block final 

passage of the legislation unless the tax was removed. To ensure Dodd-Frank's passage, the 

House-Senate conference committee reconvened and removed the $19 billion tax while 

substituting other measures that effectively shifted most of the legislation's estimated net cost to 

taxpayers and midsized banks.!lO 

Thus, LCFIs and their allies were successful in defeating the $19 billion tax as well as the 

pre-funded OLF. As I observed in a contemporaneous blog post, "[t]he biggest banks have once 

again proven their political clout ... [and] have also avoided any significant payment for the 

subsidies they continue to receive.,,!l! 

A pre-funded OLF is essential to shrink TBTF subsidies for LCFIs. The FDIC should 

assess risk-adjusted premiums over a period of several years to establish a pre-funded OLF with 

financial resources that would provide reasonable protection to taxpayers against the cost of 

resolving failures of SIFIs during a future systemic financial crisis. As noted above, federal 

regulators provided $290 billion of capital assistance to the 19 largest BHCs - each with assets 

of more than $100 billion - and to AIG during the current crisis. Accordingly, $300 billion 

129 Congressional Budget Office, Cost Estimate, HR. 4173. Restoring Financial Stability Act 0/2010: As 

passed by the Senate on May 20, 2010 (June 9, 2010), at 6. 

130 Wilmarth, "Dodd-Frank," supra note 5, at 1018, 1018-19 n.287. 

131 Arthur E. Wilmarth, Jr., "Too Big to Fail=Too Powerful to Pay," Credit Slips (blog post on July 7, 

20 I 0), available at http://www.creditslips.org/creditslipsI20 I 0107/too-big-to-fail-too-powerful-topay.html#more. 

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(appropriately adjusted for inflation) would be the minimum acceptable size for a pre-funded 

OLF, and OLF premiums should be paid by all BHCs with assets of more than $100 billion (also 

adjusted for inflation) and by all designated nonbank SIFls. The FDIC should impose additional 

assessments on SIFls in order to replenish the OLF within three years after the OLF incurs any 

loss due to the failure of a sIFr 132 

There are four essential reasons why Congress should amend Dodd-Frank to require 

SIFls to pay risk-based insurance premiums to pre-fund the OLF. First, it is unlikely that most 

SIFls would have adequate financial resources to pay large OLF assessments after one or more 

of their peers failed during a financial crisis. SIFls are frequently exposed to highly correlated 

risk exposures during a serious financial disruption, because they followed similar high-risk 

business strategies ("herding") during the credit boom that led to the crisis. Many SIFls are 

therefore likely to suffer severe losses and to face a substantial risk offailure during a major 

disturbance in the financial markets. Consequently, the FDIC (i) probably will not be able in the 

short term to collect enough premiums from surviving SIFls to cover the costs of resolving one 

or more failed SIFIs, and (ii) therefore will have to borrow large sums from the Treasury to cover 

short-term resolution costs. Even if the FDIC ultimately repays the borrowed funds by imposing 

ex post assessments on surviving SIFls, the public and the financial markets will rightly 

132 Wilmarth, "Dodd-Frank," supra note 5, at 1019-20. Jeffrey Gordon and Christopher Muller have 

proposed a similar "Systemic Risk Emergency Fund" with a pre-funded base of $250 billion to be 

financed by risk-adjusted assessments paid by large financial fimls. They would also provide their 

proposed fund with a supplemental borrowing authority of up to $750 billion from the Treasury. Gordon 

& Muller, supra note III, at 51-53. See also Xin Huang et ai., "A Framework for Assessing the 

Systemic Risk of Major Financial Institutions," 33 Journal a/Banking & Finance 2036 (2009) 

(proposing a stress testing methodology for calculating an insurance premium sufficient to protect a 

hypothetical fund against losses of more than 15% of the total liabilities of twelve major U.S. banks 

during the period 2001-2008, and concluding that the hypothetical aggregate insurance premium would 

have had an "upper bound" of $250 billion in July 2008) 

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conclude that the federal government (and, ultimately, the taxpayers) provided bridge loans to 

pay the creditors of failed SIFlsl 33 

Second, under Dodd-Frank's post-funded OLF, the most reckless SIFls will effectively 

shift the potential costs of their risk-taking to the most prudent SIFls, because the latter will be 

more likely to survive and bear the ex post costs of resolving their failed peers. Thus, a postfunded OLF is undesirable because "firms that fail never pay and the costs are borne by 

surviving firms.,,1 34 

Third, a pre-funded OLF would encourage each SIFI to monitor other SIFls and to alert 

regulators to excessive risk-taking by those institutions. Every SIFI would know that the failure 

of another SIFI would deplete the OLF and would also trigger future assessments that it and 

other surviving SIFls would have to pay. Thus, each SIFI would have good reason to complain to 

regulators if it became aware of unsound practices or conditions at another SIFt 135 

Fourth, the payment of risk-based assessments to pre-fund the OLF would reduce TBTF 

subsidies for SIFls by forcing them to internalize more of the "negative externality" (i .e. , the 

potential public bailout cost) of their activities. A pre-funded OLF would provide a reserve fund, 

paid for by SIFls, which would shield governments and taxpayers from having to incur the 

expense of underwriting future resolutions offailed SIFIS.136 Jeffrey Gordon and Christopher 

Muller also point out that a pre-funded OLF would reduce the TBTF subsidy by making DoddFrank's "liquidation threat more credible." 137 In their view, a pre-funded OLF would encourage 

regulators to "impos[e 1 an FDIC receivership" on a failing SIFIl 38 In contrast, Dodd-Frank's 

\J3 Wilmarth, "Dodd-Frank," supra note 5, at 1020-2 L 

134 1d at 1021 (quoting testimony by FDIC Chairman Sheila Bair). 

135 Id. 

136 1d at 1021-22. 

137 Gordon & Muller, supra note III, at 55. 

138 Id 

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post-funded OLF creates a strong incentive for regulators to grant forbearance in order to avoid 

or postpone the politically unpopular step of borrowing from the Treasury to finance a failed 

SIFI's liquidation. 139 

To further reduce the potential TBTF subsidy for SIFls, the OLF should be strictly 

separated from the DIF, which insures bank deposits. As discussed above, the "systemic-risk 

exception" ("SRE") in the FDI Act is a potential source of bailout funds for SIFI-owned banks, 

and those funds could indirectly support creditors of SIFls.!40 Congress should repeal the SRE 

and should designate the OLF as the exclusive source of future funding for all resolutions of 

failed SIFls. By repealing the SRE, Congress would ensure that (i) the FDIC must apply the FDI 

Act's least-cost test in resolving all future bank failures, (ii) the DIF must be used solely to pay 

the claims of bank depositors, and (iii) non-deposit creditors of SIFls could no longer view the 

DIF as a potential source of financial support By making those changes, Congress would 

significantly reduce the implicit TBTF subsidy currently enjoyed by SIFls.!4! 

e. The Dodd-Frank Act Does Not Prevent Financial Holding Companies from Using 

Federal Safety Net Subsidies to Support Risky Nonbanking Activities 

Dodd-Frank contains three sections that are intended to prevent the federal "safety net" 

for banks!42 from being used to support risky nonbanking activities connected to the capital 

markets. As discussed below, none of those sections is likely to be effective. The first provision 

(the Kanjorski Amendment) is unwieldy and constrained by stringent procedural requirements. 

The other two provisions (the Volcker Rule and the Lincoln Amendment) are riddled with 

139 Jd at 41, 55-56. 

140 Wilmarth, "Dodd-Frank," supra note 5, at 1022-23. 

141 Jd at 1023. 

14'The federal "safety net" for banks includes (i) federal deposit insurance, (ii) protection of uninsured 

depositors and other uninsured creditors in TBTF banks under the SRE, and (iii) discount window 

advances and other liquidity assistance provided by the FRB as lender of last resort. See Wilmarth, 

"Dodd-Frank," supra note 5, at 1023 n308. 

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loopholes and have long phase-in periods. In addition, the implementation of all three provisions 

is subject to broad regulatory discretion and is therefore likely to be influenced by aggressive 

industry lobbying. 

(a) The Kanjorski Amendment 

Section 121 of Dodd-Frank, the "Kanjorski Amendment," was originally sponsored by 

Representative Paul Kanjorski. Section 121 provides the FRB with potential authority to require 

large BHCs (with more than $50 billion of assets) or nonbank SIFIs to divest high-risk 

operations. However, theFRB may exercise its divestiture authority under § 121 only if(i) the 

BHC or nonbank SIFI "poses a grave threat to the financial stability of the United States" and (ii) 

the FRB's proposed action is approved by at least two-thirds ofFSOC's voting members. 143 

Additionally, the FRB may not exercise its divestiture authority unless it has previously 

attempted to "mitigate" the threat posed by the BHC or nonbank SIFI by taking several, less 

drastic remedial measures. 144 If, and only if, the FRB determines that i!ll of those remedial 

measures are "inadequate to mitigate [the] threat," the FRB may then exercise its residual 

authority to "require the company to sell or otherwise transfer assets or off-balance-sheet items 

to unaffiliated parties. ,, 145 

The FRB's divestiture authority under § 121 is thus a last resort, and it is restricted by 

numerous procedural requirements (including, most notably, a two-thirds FSOC vote). The 

Bank Holding Company Act ("BHC Act") contains a similar provision, under which the FRB 

can force a BHC to divest a nonbank subsidiary that "constitutes a serious risk to the financial 

143 Dodd-Frank, § 121(a). 

144 Under § 121(a) of Dodd-Frank, before the FRB may require a breakup of a large BHC or nonbank 

SIFl, the FRB must first take all of the following actions with regard to that company: (i) imposing 

limitations on mergers or affiliations, (ii) placing restrictions on financial products, (iii) requiring 

termination of activities, and (iv) imposing conditions on the manner of conducting activities. 

145 Dodd-Frank, § 121(a)(5). See Senate Report No. 111-176, at 51 -52 (explaining § 121). 

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safety, soundness or stability" of any ofthe BHC's banking subsidiaries. 146 The FRB may 

exercise its divestiture authority under the BHC Act without the concurrence of any other federal 

agency, and the FRB is not required to take any intermediate remedial steps before requiring a 

divestiture. However, according to a senior Federal Reserve official, the FRB's divestiture 

authority under the BHC Act "has never been successfully used for a major banking 

organization.,,147 In view of the much greater procedural and substantive constraints on the 

FRB's authority under the Kanjorski Amendment, the prospects for an FRB-ordered breakup of a 

SIFI seem remote at best. 

(b) The Volcker Rule 

Section 619 of Dodd-Frank, the "Volcker Rule," was originally proposed by former FRB 

Chairman Paul Volcker. 148 As approved by the Senate Banking Committee, the Volcker Rule 

would have generally barred banks and BHCs from (i) sponsoring or investing in hedge funds or 

private equity funds and (ii) engaging in proprietary trading - i.e , buying and selling securities, 

derivatives and other tradable assets for their own account. Thus, the Volcker Rule sought to 

prohibit equity investments and trading activities by banks and BHCs except for "market 

making" activities conducted on behalf of c1ients. 149 

The Senate committee report explained that the Volcker Rule would prevent banks 

"protected by the federal safety net, which have a lower cost of funds, from directing those funds 

to high-risk uses.,,150 The report endorsed Mr. Volcker's view that public policy does not favor 

having "public funds - taxpayer funds - protecting and supporting essentially proprietary and 

146 12 U.Sc. § 1844(e)(l). 

147 Hoenig October 10, 2010 Speech, supra note 37, at 4. 

148 Wilmarth, "Dodd-Frank," supra note 5, at 1025 . 

149 The Senate committee bill required the FSOC to conduct a study and to make recommendations for 

implementation of the Volcker Rule through regulations to be adopted by the federal banking agencies. 

Senate Report No. 111-176, at 8-9, 90-92 (2010). 

150 Id. at 8-9. 

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speculative activities."lsl The report further declared that the Volcker Rule was directed at 

"limiting the inappropriate transfer of economic subsidies" by banks and "reducing inappropriate 

conflicts of interest between [banks] and their affiliates."ls2 Thus, the Senate report made clear 

that a primary goal of the Volcker Rule was to prevent banks from spreading their federal safety 

net subsidies to nonbank affiliates engaged in capital markets activities. 

LCFls vehemently opposed the Vo1cker Rule as embodied in the Senate committee 

bill.IS3 However, the Volcker Rule - and the financial reform bill as a whole - gained significant 

political momentum from two events related to Goldman. First, the SEC filed a lawsuit on April 

16, 2010, alleging that Goldman defrauded two institutional purchasers of interests in a CDO that 

Goldman structured and marketed. The SEC charged that Goldman did not disclose to the 

CDO's investors that a large hedge fund, Paulson & Co., helped to select the CDO's portfolio of 

MBS while intending to short the CDO by purchasing CDS from Goldman. The SEC alleged that 

Goldman knew, and did not disclose, that Paulson & Co. had an "economic incentive" to select 

MBS that it expected to default within the near-term future. The institutional investors in the 

CDO lost more than $1 billion, while Paulson & Co. reaped a corresponding gain. Goldman 

subsequently settled the SEC's lawsuit by paying restitution and penalties of $550 million. ls4 

Second, on April 27, 2010, the Senate Permanent Subcommittee on Oversight 

interrogated Goldman's chairman and several of Goldman's other current and former officers 

during an eleven-hour hearing. The Subcommittee also released a report charging, based on 

151 1d. at 91 (quoting testimony by Mr. Volcker). The Senate report also quoted Mr. Volcker's contention 

that "conflicts of interest [are] inherent in the participation of commercial banking organizations in 

proprietary or private investment activity .... When the bank itself is a 'customer,' i.e., it is trading for its 

own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to 

the interests ofan unrelated commercial customerofa bank." ld. (same). 

152 1d. at 90. 

1S3 Wilmarth, "Dodd-Frank," supra note 5, at 1026. 

154 Wilmarth, "Dodd-Frank," supra note 5, at 1026-27. 

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internal Goldman documents, that Goldman aggressively sold nonprime mortgage-backed 

investments to clients in late 2006 and 2007 while Goldman was "making huge and profitable 

bets against the housing market and acting against the interest of its clients." The allegations 

against Goldman presented in the SEC's lawsuit and at the Senate hearing provoked widespread 

public outrage and gave a major political boost to the Volcker Rule and the reform legislation as 

a whole1 55 

Nevertheless, large financial institutions continued their aggressive lobbying campaign to 

weaken the Volcker rule during the conference committee's deliberations on the final terms of 

Dodd-frank. The conference committee accepted a last-minute compromise that significantly 

weakened the Volcker Rule and "disappointed" Mr. Volcker. 156 The final compromise inserted 

exemptions in the Volcker Rule that allow banks and BRCs (i) to invest up to 3% oftheir Tier 1 

capital in hedge funds or private equity funds (as long as a bank's investments do not exceed 3% 

of the total ownership interests in any single fund), (ii) purchase and sell government securities, 

(iii) engage in "risk-mitigating hedging activities," (iv) make investments through insurance 

company affiliates, and (v) make small business investment company investments. The 

compromise also delayed the Volcker Rule's effective date so that banks and BRCs will have 

(A) up to seven years after Dodd-frank's enactment date to bring most of their equity investing 

and proprietary trading activities into compliance with the Volcker Rule, and (B) up to twelve 

years to bring "illiquid" investments that were in existence on May 1, 2010, into compliance 

with the Rule1 57 

155 Jd at 1027. 

156 1d at 1028 (quoting John Cassidy, "The Volcker Rule: Obama's economic adviser and his battles over 

the financial-reform bill," New Yorker, July 26, 2010, at 25). 

157 Id (discussing § 13(d) of the BHC Act, added by Dodd-Frank, § 619). 

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Probably the most troublesome aspect of the Volcker Rule is that the Rule attempts to 

distinguish between prohibited "proprietary trading" and permissible "market making." The 

Rule defines "proprietary trading" as "engaging as a principal for the trading account of the 

banking entity," but the Rule allows "[t]he purchase, sale, acquisition, or disposition of securities 

and other instruments. . on behalf of customers.,,158 Distinguishing between proprietary trading 

and market making is notoriously difficult,159 and analysts predict that large Wall Street banks 

will seek to evade the Volcker Rule by shifting their trading operations into so-called "clientrelated businesses.,,16o Moreover, the parameters of "proprietary trading," "market making" and 

other ambiguous terms in the Volcker Rule - including the exemption for "[r]isk-mitigating 

hedging activities,,161 - are yet to be determined. Those terms will be defined in regulations to 

be issued jointly by the federal banking agencies, the CFTC and the SEC. 162 

Mr. Volcker has urged regulators to adopt "[c]lear and concise definitions [and] firmly 

worded prohibitions" to carry out "the basic intent" of § 619. 163 However, LCFIs have deployed 

formidable political and regulatory influence in pursuit of the opposite result. 164 Given the 

158 Dodd-Frank, § 619 (enacting new § 13(d)(I)(D) & (h)(4) of the BHC Act). 

159 See Carnell, Macey & Miller, supra note 14, at 130, 528-29 (describing the roles of "dealers" (ie , 

proprietary traders) and "market makers" and indicating that the two roles frequently overlap). 

160 Nelson D. Schwartz & Eric Dash, "Despite Reform, Banks Have Room for Risky Deals," New York 

Times, Aug. 26, 2010, at AI; see also Michael Lewis, "Wall Street Proprietary Trading Under Cover," 

Bloombergcom, Oct. 26, 20 I 0; Jia Lynn Yang, "Major banks gird for 'Volcker rule,'" Washington Post, 

Aug. 14,20 I 0, at A08. 

161 Dodd-Frank, § 619 (adding new § 13(d)(l)(C) of the BHC Act). See Dash & Schwartz, supra note 160 

(reporting that "traders [on Wall Street] say it will be tricky for regulators to define what constitutes a 

proprietary trade as opposed to a reasonable hedge against looming risks. Therefore, banks might still be 

ab le to make big bets by simply classifying them differently"). 

162 Dodd-Frank § 619 (adding new § 13(b) of the BHC Act). 

163 Cheyenne Hopkins, "Volcker Wants a Clear, Concise Rule," American Banker, Nov. 3,20 10, at 3. 

164 Cheyenne Hopkins, "Bankers Seek Ways to Gut Prop Trading Ban," American Banker, Nov. 19,2010, 

at I ("If the banking industry has its way, regulators would give financial institutions so many exceptions 

from the Volcker Rule 's limits on risky activities that it might as well not exist at all"). Cj Cassidy, 

supra note 156 (quoting Anthony Dowd, Mr. Volcker's personal assistant, who stated that the financial 

services industry deployed "fifty-four lobbying finns and three hundred million dollars ... against us" 

during congressional consideration of Dodd-Frank). 

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Volcker Rule's ambiguous terms and numerous exemptions that rely on regulatory 

implementation, as well as its long phase-in period, many commentators believe that the Rule 

probably will not have a significant impact in restraining risk-taking by major banks or in 

preventing them from exploiting their safety net subsidies to fund speculative activities. 165 

(c) The Lincoln Amendment 

Section 726 of Dodd-Frank, the "Lincoln Amendment," was originally sponsored by 

Senator Blanche Lincoln. In April 20 I 0, Senator Lincoln, as chair of the Senate Agriculture 

Committee, included the Lincoln Amendment in derivatives reform legislation, which was 

passed by the Agriculture Committee and subsequently was combined with the Senate Banking 

Committee's regulatory reform bill. As adopted by the Agriculture Committee, the Lincoln 

Amendment would have barred dealers in swaps and other OTC derivatives from receiving 

assistance from the DIF or from the Fed's discount window or other emergency lending 

facilities. 166 

Senator Lincoln designed the provision to force major banks to "spin off their derivatives 

operations" in order "to prevent a situation in which a bank's derivatives deals failed and forced 

taxpayers to bailout the institution.,, 167 The Lincoln Amendment was "also an effort to crack 

down on the possibility that banks would use cheaper funding provided by deposits insured by 

165 Cassidy, supra note 156 (stating that "[wJithout the legislative purity that Volcker was hoping for, 

enforcing his rule will be difficult, and will rely on many of the sanle regulators who did such a poor job 

the last time around"); Christine Harper & Bradley Keoun, "Financial Refonn: The New Rules Won't 

Stop the Next Crisis," Bloomberg Business Week, July 6-11 , 2010, at 42,43 (quoting William T. Winters, 

fonner co-chief executive officer of Chase's investment bank, who remarked: "I don't think [the Volcker 

Rule 1 will have any impact at all on most banks"); Simon Johnson, "Flawed Financial Bill Contains Huge 

Surprise," Bloomberg com, July 8, 2010 (stating that the Volcker Rule was "negotiated down to almost 

nothing"); Bradley Keoun & Dawn Kopecki, "JP Morgan, Citigroup, Morgan Stanley Rise as Bill Gives 

Investment Leeway," Bloombergcom, June 25, 2010 (quoting analyst Nancy Bush's view that the final 

compromise on the Volcker Rule meant that "the largest banks' operations are largely left intact"). 

166 Wilmarth, "Dodd-Frank," supra note 5, at 1030. 

167 Richard Hill, "Derivatives: Conferees Reach Compromise: Banks Could Continue to Trade Some 

Derivatives," 42 Securities Regulation & Law Report (BNA) 1234 (June 28, 20 I 0). 

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the FDIC, to subsidize their trading activities.,,168 Thus, the purposes of the Lincoln Amendment 

- insulating banks from the risks of speculative activities and preventing the spread of safety net 

subsidies - were similar to the objectives of the Volcker Rule, but the Lincoln Amendment 

focused on dealing and trading in derivatives instead of all types of proprietary trading. 169 

The Lincoln Amendment provoked "tremendous pushback ... from Republicans, fellow 

Democrats, the White House, banking regulators, and Wall Street interests." 170 Large banks 

claimed that the provision would require them to furnish more than $100 billion of additional 

capital to organize separate derivatives trading subsidiaries. 171 A prominent industry analyst 

opined that the provision "eliminates all of the advantages of the affiliation with an insured 

depository institution, which are profound.,,172 Those statements reflect a common understanding 

that, as discussed below, bank dealers in aTC derivatives enjoy significant competitive 

advantages over nonbank dealers due to the banks' explicit and implicit safety net subsidies. The 

Lincoln Amendment was specifically intended to remove those advantages and to force major 

banks to conduct their derivatives trading operations without reliance on federal subsidies. 173 

168 Robert Schmidt & Phil Mattingly, "Banks Would Be Forced to Push Out Derivatives Trading Under 

Plan," Bloombergcom, April 15, 2010. 

169 Wilmarth, "Dodd-Frank, supra note 5, at 1031. 

170 Hill, supra note 167; see also Stacy Kaper & Cheyenne Hopkins, "Key Issues Unresolved as Refoml 

Finishes Up," American Banker, June 25, 20 I 0, at I (reporting that "banks have vigorously opposed [the 

Lincoln Amendment], arguing it would cost them millions of dollars to spin off their deriviatives units. 

Regulators, too, have argued against the provision, saying it would drive derivatives trades overseas or 

underground, where they would not be regulated"). 

171 Agnes Crane & Rolfe Winkler, "Reuters Breakingviews: Systemic Risk Knows No Borders," New 

York Times, May 3, 2010, at B2. 

172 Schmidt & Mattingly, supra note 168 (quoting Karen Petrou). 

173 Id. ; see also Crane & Winkler, supra note 335 (observing that "Senator Blanche Lincoln ... says there 

should be a clear division between banking activities that the government should support or at least 

provide liquidity to, and riskier business that it should not"). 

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As was true with the Volcker Rule, the House-Senate conference committee agreed to a 

final compromise that significantly weakened the Lincoln Amendment 174 As enacted, the 

Lincoln Amendment allows an FDIC-insured bank to act as a swaps dealer with regard to (i) 

"[h]edging and other similar risk mitigating activities directly related to the [bank's] activities," 

(ii) swaps involving interest rates, currency rates and other "reference assets that are permissible 

for investment by a national bank," including gold and silver but not other types of metals, 

energy, or agricultural commodities, and (iii) credit default swaps that are cleared pursuant to 

Dodd-Frank and carry investment-grade ratings. 17i In addition, the Lincoln Amendment allows 

banks up to five years to divest or spin off nonconforming derivatives operations into separate 

affiliates. 176 

Analysts estimate that the compromised Lincoln Amendment will require major banks to 

spin off only ten to twenty percent of their existing derivatives activities into separate 

affiliates. 177 In addition, banks will able to argue for retention of derivatives that are used for 

"hedging" purposes, an open-ended standard that will require much elaboration by regulators. 178 

As in the case of the Volcker Rule, commentators concluded that the Lincoln Amendment was 

174 Devlin Barrett & Damien Paletta, 'The Financial-Regulation Overhaul: A Fight to the Wire as ProBusiness Democrats Dig In on Derivatives," Wall Street Journal, June 26, 20 I 0, at A I 0; David Cho et a!., 

"Lawmakers guide Wall Street reform into homestretch: Industry left largely intact," Washington Post, 

June 26, 20 I 0, at AO I; Edward Wyatt & David M. Herszenhom," Accord Reached for an Overhaul of 

Finance Rules," New York Times, June 26, 2010, at AI. See also supra notes 156-57 and accompanying 

text (discussing last-minute compromise that weakened the Volcker Rule). 

175 Dodd-Frank, § 716(d); see also Hill, supra note 167; Heather Landy, "Derivatives Compromise Is All 

About Enforcement," American Banker, June 30, 2010, at I;Wyatt & Herszenhom, supra note 174. 

176 See Dodd-Frank, § 716(h) (providing that the Lincoln Amendment will take effect two years after 

Dodd-Frank's effective date); id. § 716(f) (permitting up to three additional years for banks to divest or 

cease nonconforming derivatives operations). 

\JJ Harper & KeoUll, supra note 165; Smith & Lucchetti, supra note 115. 

178 Wyatt & Herszenhom, supra note 174. 

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"greatly diluted,,,179 "significantly weakened," 180 and "watered down,,,181 with the result that "the 

largest banks' [derivatives] operations are largely left intac!." 182 

The requirement that bank must clear their trades of CDS in order to be exempt from the 

Lincoln Amendment is potentially significant. 183 However, there is no clearing requirement for 

other derivatives (e.g., interest and currency rate swaps) that reference assets permissible for 

investment by national banks ("bank-eligible" derivatives). Consequently, banks may continue 

to trade and deal in OTC derivatives (except for CDS) without restriction under the Lincoln 

Amendment if those derivatives are bank-eligible184 In addition, as discussed above, all 

"proprietary trading" by banks in derivatives must comply with the Volcker Rule as 

implemented by regulators. 

4. Banks Controlled by Financial Holding Companies Should Operate as "Narrow 

Banks" so that They Cannot Transfer Their Federal Safety Net Subsidies to Their 

Nonbank Affiliates 

As explained above, a fundamental purpose of the Volcker Rule and the Lincoln 

Amendment is to prevent LCFIs from using federal safety net subsidies to support their 

speculative activities in the capital markets. As enacted, however, both provisions have 

numerous gaps and exemptions that undermine their stated purpose. 

179 Johnson, supra note 165. 

ISO Hill, supra note 167 (quoting the Consumer Federation of America). 

18 1 Smith & Lucchetti, supra note 115 . 

182 Keoun & Kopecki, supra note 165 (quoting analyst Nancy Bush). 

183 Title VII of Dodd-Frank establishes comprehensive clearing, reporting and margin requirements for a 

wide range of derivatives. See H.R Rep. No. 111-517, at 868-69 (2010) (Conf. Rep.), reprinted in 2010 

U.S .C.C.A.N. 722, 725-26; Senate Report No. 111-176, at 29-35, 92-101 (2010); Alison Vekshin & Phil 

Mattingly, "Lawmakers Agree on Sweeping Wall Street Overhaul," Bloombergcom, June 25, 2010 

(summarizing Title VU). Major financial institutions have engaged in heavy lobbying since DoddFrank's enactment to weaken the regu latory implementation of Title VII. See, e.g., Robert Schmidt & 

Sial Brush, "Banks Seek Exemption from Dodd-Frank for Foreign-Exchange Swaps," Bloomberg com, 

Nov. 24, 20 I 0; "Wall Street Lobbyists Besiege CFTC to Shape Derivatives Trading Regulation," 

Bloombergcom, Oct. 14, 2010. 

184 Wilmarth, "Dodd-Frank," supra note 5, at 1034 (discussing Dodd-Frank, § 716(d)(2». 

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As shown below, a highly effective way to prevent the spread offederal safety net 

subsidies from banks to their affiliates involved in the capital markets would be to create a twotiered structure of bank regulation and deposit insurance. The first tier of "traditional" banking 

organizations would provide a relatively broad range of banking-related services, but those 

organizations would not be allowed to engage, or affiliate with firms engaged, in securities 

underwriting or dealing, insurance underwriting, or derivatives dealing or trading. In contrast, 

the second tier of "narrow banks" could affiliate with "nontraditional" financial conglomerates 

engaged in capital markets activities (except for private equity investments). However, "narrow 

banks" would be prohibited from making any extensions of credit or other transfers of funds to 

their nonbank affiliates, except for lawful dividends paid to their parent holding companies. The 

"narrow bank" approach provides the most politically feasible approach for ensuring that banks 

cannot transfer their safety net subsidies to affiliated companies engaged in speculative activities 

in the capital markets, and it is therefore consistent with the objectives of both the Volcker Rule 

and the Lincoln Amendment. 185 

a. The First Tier of Traditional Banking Organizations 

Under my proposal, the first tier of regulated banking firms would be "traditional" 

banking organizations that limit their activities (including the activities of all holding company 

affiliates) to lines of business that satisfy the "closely related to banking" test under Section 

185 The following description of my proposal for a two-tiered structure of bank regulation and deposit 

insurance is adapted from Wilmarth, "Dodd-Frank," supra note 5, at 1034-52. For discussions ofsimilar 

"narrow bank" proposals, see. e.g.. Robert E. Litan, What Should Banks Do ? 164- 89 (1987). Kay, supra 

note 44, at 39-92; Ronnie J. Phillips & Alessandro Roselli, How to Avoid the Next Taxpayer Bailout of 

the Financial System: The Narrow Banking Proposal (Networks Fin. Instit. Pol 'y Brief2009-PB-05, 

2009), available at http://ssm.comiabstracUd=1459065. 

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4(c)(8) of the BHC Act. 186 For example, this first tier of traditional banks could take deposits, 

make loans, offer fiduciary services, and act as agents in selling securities, mutual funds and 

insurance products underwritten by non-affiliated firms. Additionally, they could underwrite and 

deal solely in "bank-eligible" securities that national banks are permitted to underwrite and deal 

in directly.1 87 First-tier banking organizations could also purchase, as end-users, derivatives 

transactions that (i) hedge against their own firm-specific risks, and (ii) qualify for hedging 

treatment under Financial Accounting Standard ("FAS") Statement No. 133. 188 

Most first-tier banking firms would probably be small and midsized community-oriented 

banks. In the past, those banks typically have not engaged as principal in insurance 

underwriting, securities underwriting or dealing, derivatives dealing or trading, or other capital 

markets activities. Community banks should be encouraged to continue their primary business 

of attracting core deposits, providing "high touch," relationship-based loans to consumers and to 

small and medium-sized enterprises ("SMEs"), and offering wealth management and other 

fiduciary services to local customers. (In sharp contrast to traditional communi ty banks, TBTF 

megabanks provide impersonal, highly automated lending and deposit programs to SMEs and 

consumers, and megabanks also focus on complex, higher-risk transactions in the capital 

markets)189 Traditional, first-tier banks and their holding companies should continue to operate 

186 See 12 U.S.c. § IS43(c)(S) (2006); Carnell, Macey & Miller, supra note 14, at 442- 44 (describing 

"closely related to banking" activities that are permissible for nonbank subsidiaries of BHCs under § 

4(c)(S)). 

187 See Wilmarth, "Transformation," supra note 40, at 225, 225-26 n.30 (discussing "bank-eligible" 

securities that national banks are authorized to underwrite or purchase or sell for their own account); 

Canlell, Macey & Miller, supra note 14, at 132-34 (same). 

188 Wilmarth, "Dodd-Frank," supra note 5, at 1036. 

189 For discussions of the sharply different business models adopted by community banks and megabanks, 

see Wilmarth, "Dodd-Frank," supra note 5, at 1035-3S; Wilmarth, "Transformation," supra note 40, at 

261-70, 372-407. 

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under their current supervisory arrangements, and all deposits of first-tier banks (up to the 

current statutory maximum of $250,000) should be covered by deposit insurance. 

In order to provide reasonable flexibility to first-tier banking organizations, Congress 

should amend § 4(c)(8) of the BHC Act by permitting the FRB to expand the list of "closely 

related" activities that are permissible for holding company affiliates of traditional banks. 190 

However, Congress should prohibit first-tier BHCs from engaging as principal in underwriting or 

dealing in securities, underwriting any type of insurance (except for credit insurance), dealing or 

trading in derivatives, or making private equity investments. 

b. The Second Tier of Nontraditional Banking Organizations 

Unlike first-tier banking firms, the second tier of "nontraditional" banking organizations 

would be allowed to engage, through nonbank subsidiaries, in (i) underwriting and dealing (i.e., 

proprietary trading) in "bank-ineligible" securities,191 (ii) underwriting all types of insurance, and 

(iii) dealing and trading in derivatives. Second-tier banking organizations would include: (A) 

FHCs registered under §§ 4(k) and 4(/) of the BHC Act,l92 (B) holding companies owning 

grandfathered "nonbank banks," and (C) grandfathered "unitary thrift" holding companies.193 In 

I'" GLBA prohibits the FRB from approving any new "closely related" activities for bank holding 

companies under § 4(c)(8) of the BHC Act See Carnell, Macey & Miller, supra note 14, at 444 

(explaining that GLBA does not permit the FRB to expand the list ofpemlissible activities under Section 

4(c)(8) beyond the activities that were approved as of Nov. II, 1999). Congress should revise § 4(c)(8) 

by authorizing the FRB to approve a limited range of new activities that are "closely related" to the 

traditional banking functions of accepting deposits, extending credit, discounting negotiable instruments 

and providing fiduciary services. See Wilmarth, "Dodd-Frank," supra note 5, at 1036-37 nJ75. 

191 See Wilmarth, "Transformation," supra note 40, at 219-20, 225-26 nJO, 318-20 (discussing distinction 

between (i) "bank-eligible" securities, which banks may underwrite and deal in directly, and (ii) "bankineligible" securities, which affiliates of banks may underwrite and deal in under GLBA, but banks may 

not). 

192 12 U.S.c. § 1843(k), (I) (2006). See Carnell, Macey & Miller, supra note 118, at 467-70 (describing 

"financial " activities, including securities underwriting and dealing and insurance underwriting, that are 

authorized for FHCs under the BHC Act, as amended by GLBA). 

193 See Arthur E. Wilmarth, Jr, "Wal-Mart and the Separation of Banking and Commerce," 39 

Connecticut Law Review 1539, 1569-71, 1584-86 (2007) (explaining that (i) during the 1980's and 

1990's, many securities firms, life insurers and industrial firms used the "nonbank bank" loophole or the 

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addition, finns controlling industrial banks should be required either to register as FHCs or to 

divest their ownership of such banks if they cannot comply with the BHC Act's prohibition 

against commercial activities. 194 Second-tier holding companies would thus encompass all of the 

largest banking organizations, most of which are heavily engaged in capital markets activities, as 

well as other financial conglomerates that control FDIC-insured depository institutions. 

i. Congress Should Require a "Narrow Bank" Structure for 

Second-Tier Banks 

Under my proposal, FDIC-insured banks that are subsidiaries of second-tier holding 

companies would be required to operate as "narrow banks." The purpose of the narrow bank 

structure would be to prevent a "nontraditional" second-tier holding company from transferring 

the bank's federal safety net subsidies to its nonbank affiliates. 

Narrow banks could offer FDIC-insured deposit accounts, including checking and 

savings accounts and certificates of deposit. Narrow banks would hold all of their assets in the 

fonn of cash and marketable, short-term debt obligations, including qualifying government 

securities, highly-rated commercial paper and other liquid, short-term debt instruments that are 

eligible for investment by money market mutual funds ("MMMFs") under the SEC's rules. 

"unitary thrift" loophole to acquire FDIC-insured institutions, and (ii) those loopholes were closed to new 

acquisitions by a 1987 statute and by GLBA, respectively), available at http://ssm.com/abstract=984103 

[hereinafter Wilmarth, "Wal-Mart"]' 

194 Industrial banks are exempted from treatment as "banks" under the BHC Act. See 12 U.S.c. § 

1841(c)(2)(H). As a result, the BHC Act allows commercial (i.e., nonfinancial) firms to retain their 

existing ownership of industrial banks. However, § 603 of Dodd-Frank imposes a three-year moratorium 

on the authority of federal regulators to approve any new acquisitions of industrial banks by commercial 

firms. In addition, § 603 requires the GAO to conduct a study and report to Congress on whether 

commercial firms should be permanently barred from owning industrial banks. See Senate Report No. 

111-176, at 83 (2010). See also Wilmarth, "Wal-Mart," supra note 193, at 1543-44, 1554- 1620 (arguing 

that Congress should prohibit commercial firms from owning industrial banks because such ownership 

(i) undermines the long-established U.S. policy of separating banking and commerce, (ii) threatens to 

spread federal safety net subsidies to the commercial sector of the U.S. economy, (iii) threatens the 

solvency of tile DlF, (iv) creates competitive inequities between commercial firms that own industrial 

banks and other commercial firms, and (v) increases the likelihood of federal bailouts of commercial 

companies). 

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Narrow banks could not hold any other types of loans or investments, nor could they accept any 

uninsured deposits. Narrow banks would present a very small risk to the DIF, because (i) each 

narrow bank's non-cash assets would consist solely of short-term securities that could be 

"marked to market" on a daily basis, and the FDIC could therefore readily determine whether a 

narrow bank was threatened with insolvency, and (ii) the FDIC could promptly convert a narrow 

bank's assets into cash if the FDIC decided to liquidate the bank and payoff the claims of its 

insured depositors. 195 

Thus, narrow banks would effectively operate as FDIC-insured MMMFs. To prevent 

unfair competition with narrow banks, and to avoid future government bailouts of uninsured 

MMMFs, MMMFs should be prohibited from representing, either explicitly or implicitly, that 

they will redeem their shares based on a "constant net asset value" ("NA V") of $1 per share. 

Currently, the MMMF industry (which manages about $3 trillion of assets) leads investors to 

believe that their funds will be available for withdrawal (redemption) based on "a stable price of 

$1 per share."I96 Not surprisingly, "the $1 share price gives investors the false impression that 

money-market funds are like [FDIC-insured] banks accounts and can't lose money.,,197 

However, "[t]hat myth was shattered in 2008" when Lehman's default on its commercial paper 

caused Reserve Primary Fund (a large MMMF that invested heavily in Lehman's paper) to suffer 

large losses and to "break the buck.,,198 Reserve Primary Fund's inability to redeem its shares 

based on aNA V of $1 per share caused an investor panic that precipitated runs on several 

MMMFs. The Treasury Department responded by establishing the Money Market Fund 

195 See Wilmarth, "Dodd-Frank," supra note 5, at 1038; Kenneth E. Scott, "Deposit Insurance and Bank 

Regulation: The Policy Choices," 44 Business Lawyer 907, 921-22, 928- 29 (1989) 

196 David Reilly, "Goldman Sachs Wimps Out in Buck-Breaking Brawl," Bloomberg. com, Feb. 3, 2010. 

197 Id. See also Kay, supra note 44, at 65 (arguing that an MMMF with a constant NA V of $1 per share 

"either confuses consumers or creates an expectation of government guarantee"). 

198 Reilly, supra note 196 . 

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Guarantee Program ("MMFGP"), which protected investors in participating MMMFs between 

October 2008 and September 2009. 199 

Critics ofMMMFs maintain that the Treasury's MMFGP has created an expectation of 

similar government bailouts ifMMMFs "break the buck" in the future 200 In addition, former 

FRB chairman Paul Volcker has argued that MMMFs weaken banks because of their ability to 

offer bank-like products without equivalent regulation. MMMFs typically offer accounts with 

check-writing features, and they provide returns to investors that are higher than bank checking 

accounts because MMMFs do not have to pay FDIC insurance premiums or to comply with other 

bank regulations 201 A Group ofThirty report, which Me Volcker spearheaded, proposed that 

MMMFs that wish to offer bank-like services, such as checking accounts and withdrawals at a 

stable NAV of $1 per share, should reorganize as "special-purpose banks" with appropriate 

governmental supervision and insurance. 202 In contrast, MMMFs that do not wish to operate as 

banks should be required to base their redemption price on a floating NA V, so that investors are 

not misled into believing that they can always redeem their MMMFs shares at par203 

199 Wilmarth, "Dodd-Frank," supra note 5, at 1039. 

200 Jane Bryant Quinn, "Money Funds Are Ripe for 'Radical Surgery'," Bloomberg com, July 29, 2009. 

See also Reilly, supra note 196 (arguing that the failure of federal authorities to reform the regulation of 

MMMFs "creates the possibility of future market runs and the need for more government bailouts"). 

201 Wilmarth, "Dodd-Frank," supra note 5, at 1040. 

202 Group of Thirty, Financial Reform: A Frameworkfor Financial Stability 29 (2009) (recommending 

that "[mJoney market mutual funds wishing to continue to offer bank-like services, such as transaction 

account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value 

(NAV) at par, should be required to reorganize as special-purpose banks, with appropriate prudential 

regulation and supervision, government insurance, and access to central bank lender-of-Iast resort 

facilities") (Recommendation 3.a.), available at http://www.group30.org/pubs/reformreport.pdf. 

203 ld at 29 (Recommendation 3.b., stating that MMMFs "should be clearly differentiated from federally 

insured instruments offered by banks" and should base their pricing on "a fluctuating NA V"). See also 

Reilly, supra note 196 (supporting the Group ofThirty's recommendation that MMMFs "either use 

floating values - and so prepare investors for the idea that these instruments can lose money - or be 

regulated as if they are bank products"); Kay, supra note 44, at 65 (similarly arguing that "[iJt is 

important to create very clear blue water between deposits, subject to government guarantee, and 

[uninsured MMMFs], which may be subject to market fluctuation"). 

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If Congress required nonbank MMMFs to base their redemption price on a floating NAY 

and also adopted my proposal for a two-tiered structure of bank regulation, many MMMFs 

would voluntarily reorganize as FDIC-insured narrow banks and would become subsidiaries of 

second-tier FHCS204 As explained above, rules restricting the assets of narrow banks to 

commercial paper, government securities and other types of marketable, highly-liquid 

investments would protect the DIF from any significant loss if a narrow bank failed. 

ii, Four Additional Rules Would Prevent Narrow Banks from 

Transferring Safety Net Subsidies to Their Affiliates 

Congress should adopt four supplemental rules to prevent second-tier holding companies 

from exploiting their narrow banks' safety net subsidies. First, narrow banks should be 

absolutely prohibited - without any possibility of a regulatory waiver - from making any 

extensions of credit or other transfers offunds to their affiliates, except for the payment oflawful 

dividends out of profits to their parent holding companies205 Currently, transactions between 

FDIC-insured banks and their affiliates are restricted by §§ 23A and 23B of the Federal Reserve 

Act2 06 However, the FRB has repeatedly waived those restrictions during recent financial crises. 

The FRB's waivers have allowed bank subsidiaries ofFHCs to provide extensive support to 

affiliated securities broker-dealers and MMMFs. By granting those waivers, the FRB has 

enabled banks controlled by FHCs to transfer the safety net subsidy provided by low-cost, FDICinsured deposits to their nonbank affiliates2 07 

204 See Quinn, supra note 200 (describing strong opposition by Paul Schott Stevens, chainnan of the 

Investment Company Institute (the trade association representing the mutual fund industry), against any 

rule requiring uninsured MMMFs to quote floating NAYs, because "[i]nvestors seeking guaranteed safety 

and soundness would migrate back to banks" and "[t]he remaining funds would become less attractive 

because of their fluctuating price"). 

205 Scott, supra note 195, at 929; Wilmarth, "Dodd-Frank," supra note 5, at 1041 . 

206 12 USc. §§ 371c, 37ic-1 (2006). 

201 Wilmarth, "Dodd-Frank," supra note 5, at 1042 n.395 (referring to (i) the FRB's waiver of § 23A 

restrictions so that major banks could make large loans to their securities affiliates following the terrorist 

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Dodd-Frank limits the authority of the FRB to grant future waivers or exemptions under 

§§ 23A and 23B, because it requires the FRB to obtain the concurrence of either the OCC (with 

respect to waivers granted by orders for national banks) or the FDIC (with respect to waivers 

granted by orders for state banks or exemptions granted by rulemaking). Z08 Even so, it is unlikely 

that the OCC or the FDIC would refuse to concur with the FRB's proposal for a waiver under 

conditions of financial stress. Accordingly, Dodd-Frank does not ensure that the restrictions on 

affiliate transactions in §§ 23A and 23B will be adhered to in a crisis setting. 

For example, the FRB recently permitted BofA to evade the restrictions of § 23A by 

transferring an undisclosed amount of derivatives contracts from its Merrill broker-dealer 

subsidiary to its subsidiary bank. The transfer materially increased the potential risk to the DIF 

and taxpayers from any losses that BofA might incur on those derivatives. However, the transfer 

reportedly enabled BofA - which has been struggling with a host of problems - to avoid a 

requirement to post $3.3 billion in additional collateral with counterparties, due to the fact that 

BofA's subsidiary bank enjoys a significantly higher credit rating than Merrill 209 One 

commentator noted that "the Fed's priorities seem to lie with protecting [BofA] from losses at 

Merrill, even if that means greater risks for the FDIC's insurance fund."z!O 

attacks on September 11 , 2001 ; (ii) the FRB's decisions, after the subprime financial crisis began in 

August 2007, to grant exemptions from § 23A restrictions so that six major U.S. and foreign banksBofA, Citigroup, Chase, Barclays, Deutsche and RBS - could provide loans to support their securities 

affiliates; and (iii) the FRB's decisions to waive §§ 23A and 23B in 2008 and 2009 so that banks could 

purchase asset-backed commercial paper CABCP" ) from affiliated MMMFs in order to mitigate 

"ongoing dislocations in the financial markets, and the impact of such dislocations on the functioning of 

ABCP markets and on the operation of [MMMFs n. 208 Dodd-Frank, § 608(a)(4) (amending 12 U.S.c. § 37Ic(t)).id § 608(b)(6) (amending 12 U.S.c. § 371cI (e)(2)). 

2(f1 Kate Davidson, "Democrats Raise Red Flag on BofA Derivatives Transfer," American Banker, Oct. 

28, 2011 ; Simon Johnson, "Bank of America Is Too Much ofa Behemoth to Fail," Bloomberg com, Oct. 

23, 2011 ; Jonathan Weil, "Bank of America Bosses Find Friend in the Fed," Bloombergcom, Oct. 19, 

2011. 

21° Weil, supra note 209. 

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My proposal for second-tier narrow banks would replace §§ 23A and 23B with an 

absolute rule. That rule would completely prohibit any extensions of credit or other transfers of 

funds by second-tier banks to their nonbank affiliates (except for lawful dividends paid to parent 

holding companies). Under that rule, federal regulators would be barred from approving any 

transfers of safety net subsidies by narrow banks to their affiliates. An absolute bar on affiliate 

transactions is necessary to prevent FDIC-insured banks from being used as backdoor bailout 

devices for nonbank affiliates ofLCFls. 

Second, as discussed above, Congress should repeal the "systemic risk exception" 

("SRE") currently included in the FDI Act By repealing the SRE, Congress would require the 

FDIC to follow the least costly resolution procedure for every failed bank, and the FDIC could 

no longer rely on the TBTF policy as ajustification for protecting uninsured creditors of a failed 

bank or its nonbank affiliates. Repealing the SRE would ensure that the DIF could not be used 

to support a bailout of uninsured creditors of a failed or failing SIFt Removing the SRE from the 

FDIA would make clear to the financial markets that the DIF could only be used to protect 

depositors of failed banks. Uninsured creditors of SIFls and their nonbank subsidiaries would 

therefore have stronger incentives to monitor the financial operations and condition of such 

entities. 211 

Additionally, a repeal of the SRE would mean that smaller banks would no longer bear 

any part of the cost of protecting uninsured creditors of TBTF banks. Under current law, all 

FDIC-insured banks must pay a special assessment (allocated in proportion to their total assets) 

to reimburse the FDIC for the cost of protecting uninsured claimants of a TBTF bank under the 

SRE2 12 A 2000 FDIC report noted the unfairness of expecting smaller banks to help pay for 

21 1 Wilmarth, "Dodd-Frank," supra note 5, at 1042-43. 

212 12 U.Sc. § 1823(c)(4)(G)(ii). 

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"systemic risk" bailouts when "it is virtually inconceivable that they would receive similar 

treatment if distressed.,,213 The FDIC report suggested that the way to correct this inequity is "to 

remove the [SRE],,,214 as I have proposed here. 

Third, second-tier narrow banks should be barred from purchasing derivatives except as 

end-users in transactions that qualify for hedging treatment under FAS 133. Thus, my proposal 

would require all derivatives dealing and trading activities of second-tier banking organizations 

to be conducted through separate nonbank affiliates, in the same manner that GLBA currently 

requires all underwriting and dealing in bank-ineligible securities to be conducted through 

nonbank affiliates ofFHCS215 Prohibiting second-tier banks from dealing and trading in 

derivatives would accomplish an essential goal of the Volcker Rule and the Lincoln Amendment, 

because it would prevent FHCs from continuing to exploit federal safety net subsidies by 

conducting speculative trading activities within their FDIC-insured bank subsidiaries. 

BofA's recent transfer of derivatives from Merrill to its bank subsidiary demonstrates that 

bank dealers in OTC derivatives enjoy significant competitive advantages over nonbank dealers, 

due to the banks' explicit and implicit safety net subsidies. Banks typically borrow funds at 

significantly lower interest rates than their holding company affiliates because (i) banks can 

obtain direct, low-cost funding through FDIC-insured deposits, and (ii) banks present lower risks 

to their creditors because of their direct access to other federal safety net resources, including (A) 

the FRB's discount window lending facility, (B) the FRB's guarantee of interbank payments 

213 Federal Deposit Ins. Corp., Options Paper, Aug. 2000, at 33, available at 

http://www . fdic .gov/deposi IIi nsurance/i nitiativel Options _ 080700m. pdf 214 Id 

'IS See Carnell, Macey & Miller, supra note 14, at 27, 130-34, 467-70, 490-91 (explaining that, under 

GLBA, all underwriting and dealing of bank-ineligible securities by FHCs must be conducted through 

nonbank holding company subsidiaries or through nonbank fmancial subsidiaries of banks); Wilmarth, 

"Transformation," supra note 40, at 219-20, 225-26 nJO, 318-20 (same). 

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made on Fedwire, and (C) the greater potential availability ofTBTF bailouts for uninsured 

creditors of banks (as compared to creditors ofBHCs)216 

The OCC has confirmed that FHCs generate higher profits when they conduct derivatives 

activities directly within their banks, in part because the "favorable [funding] rate enjoyed by the 

banks" is lower than "the borrowing rate of their holding companies ,,217 Such an outcome may 

be favorable to FHCs, but it is certainly not beneficial to the DIF and taxpayers. The DIF and 

taxpayers are exposed to a significantly higher risk oflosses when derivatives dealing and 

trading activities are conducted directly within banks instead of within nonbank holding 

company affiliates. Congress must terminate this artificial, federally-subsidized advantage for 

bank derivatives dealers21 8 

Fourth, Congress should prohibit all private equity investments by second-tier banks and 

their holding company affiliates. To accomplish this reform - which would be consistent with 

the Volcker Rule as originally proposed - Congress should repeal Sections 4(k)(4)(H) and (I) of 

the BHC Act,219 which allow FHCs to make merchant banking investments and insurance 

company portfolio investments220 Private equity investments involve a high degree of risk and 

have inflicted significant losses on FHCs in the past. 221 In addition, private equity investments 

threaten to "weaken the separation of banking and commerce" by allowing FHCs "to maintain 

216 Carnell, Macey & Miller, supra note 14, at 492; Wilmarth, "Dodd-Frank," supra note 5 at 1044. 

217 Office of the Comptroller of the Currency, OCC Interpretive Letter No. 892, at 3 (2000) (from 

Comptroller of the Currency John D. Hawke, Jr., to Rep. James A Leach, Chainnan of House Committee 

on Banking & Financial Services), available at http://www.occ.treas.govlinterp/sepOO/int892.pdf 

218 Wilmarth, "Dodd-Frank," supra note 5, at 1044-45. 219 12 U.S.c. § 1 843(k)(4)(H), (D (2006) 

220 See Carnell, Macey & Miller, supra note 14, at 483-85 (explaining that "through the merchant banking 

and insurance company investment provisions, [GLBA 1 allows significant nonfinancial affiliations" with 

banks) 

221 Wilmarth, "Transfonnation," supra note 40, at 330-32,375-78. 

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long-term control over entities that conduct commercial (i.e., nonfinancial) businesses,,222 Such 

affiliations between banks and commercial firms are undesirable because they are likely to create 

serious competitive and economic distortions, including the spread of federal safety net benefits 

to the commercial sector of our economy223 

In combination, the four supplemental rules described above would help to ensure that 

narrow banks cannot transfer their federal safety net subsidies to their nonbank affiliates. 

Restricting the scope of safety net subsidies is of utmost importance in order to restore a more 

level playing field between small and large banks, and between banking and nonbanking firms. 

Safety net subsidies have increasingly distorted our regulatory and economic policies over the 

past three decades. During that period, nonbanking firms have pursued every available avenue to 

acquire FDIC-insured depository institutions so that they can secure the funding advantages 

provided by low-cost, FDIC-insured deposits. At the same time, nonbank affiliates of banks 

have made every effort to exploit the funding advantages and other safety net benefits conferred 

by their affiliation with FDIC-insured institutions224 

The most practicable way to prevent the spread of federal safety net subsidies - as well as 

their distorting effects on regulation and economic activity - is to establish strong barriers that 

prohibit narrow banks from transferring their subsidies to their nonbanking affiliates, including 

those engaged in speculative capital markets activities. The narrow bank structure and the 

supplemental rules described above would force financial conglomerates to prove that they can 

produce superior risk-related returns to investors without relying on explicit and implicit 

"' Wilmarth, 'Wal-Mart," supra note 193, at 1581-82. 

223 For further discussion of this argument, see id. at 1588-1613. 

224 ld at 1569-70, 1584-93; see also Kay, supra note 44, at 43 (stating: "The opportunity to gain access to 

the retail deposit base has been and remains irresistible to anlbitious deal makers. That deposit base 

carries an explicit or implicit government guarantee and can be used to leverage a range of other, more 

exciting, financial activities. 1111e alchetype of these deal-makers was Sandy Weill, the architect of 

Citigroup"). 

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government subsidies. Economic studies have failed to confirm the existence offavorable 

economies of scale or scope in giant financial conglomerates, and those conglomerates have not 

been able to generate consistently positive returns, even under the current regulatory system that 

allows them to capture extensive federal subsidies225 

In late 2009, a prominent bank analyst suggested that if Congress prevented nonbank 

subsidiaries ofFHCs from relying on low-cost deposit funding provided by their affiliated banks, 

large FHCs would not be economically viable and would be forced to break up voluntarily226 

Many of the largest commercial and industrial conglomerates in the US. and Europe have been 

broken up through hostile takeovers and voluntary divestitures during the past three decades 

because they proved to be "less efficient and less profitable than companies pursuing more 

focused business strategies ,,227 It is long past time for financial conglomerates to be stripped of 

their safety net subsidies and their presumptive access to TBTF bailouts so that they will be 

subject to the same type of scrutiny and discipline that the capital markets have applied to 

commercial and industrial conglomerates during the past thirty years. The narrow bank concept 

provides a workable plan to impose such scrutiny and discipline on FHCs. 

c. Responses to Critiques of the Narrow Bank Proposal 

Critics have raised three major objections to the narrow bank concept. First, critics point 

out that the asset restrictions imposed on narrow banks would prevent them from acting as 

22S Wilmarth, "Reforming Financial Regulation," supra note I, at 748-49; see also Johnson & Kwak, 

supra note 37, at 212-13. 

226 Karen Shaw Petrou, the managing partner of Federal Financial Analytics, explained that 

"[iJnteraffiliate restrictions would limit the use of bank deposits on nonbanking activities," and "[yJou 

don't own a bank because you like branches, you own a bank because you want cheap core funding." Ms. 

Petrou therefore concluded that an imposition of stringent limits on affiliate transactions, "really strikes at 

the heart of a diversified banking organization" and "I think you would see most of the very large banking 

organizations pull themselves apart" if Congress passed such legislation. Stacy Kaper, "Big Banks Face 

Most Pain Under House Bill," American Banker, Dec. 2, 2009, at I (quoting Ms. Petrou). 

227 Wilmarth, "Dodd-Frank," supra note 5, at 1047. 

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intermediaries offunds between depositors and most borrowers. Many narrow bank proposals 

(including mine) would require narrow banks to invest their deposits in safe, highly marketable 

assets such as those permitted for MMMFs. Narrow banks would therefore be largely or entirely 

barred from making commercial loans. As a result, critics warn that a banking system composed 

exclusively of narrow banks could not provide credit to small and midsized business firms that 

lack access to the capital markets and depend on banks as their primal)' source of outside 

credit 228 

However, my two-tiered proposal would greatly reduce any disruption of the traditional 

role of banks in acting as intermediaries between depositors and bank-dependent firms, because 

my proposal would allow first-tier "traditional" banks (primarily community-oriented banks) to 

continue making commercial loans that are funded by deposits. Community banks make most of 

their commercial loans in the form of longer-term "relationship" loans to SMEs. Under my 

proposal, community banks could continue to carry on their deposit-taking and lending activities 

as first-tier banking organizations without any change from current law, and their primary 

commercial lending customers would continue to be smaller, bank-dependent firms 2 29 

In contrast to community banks, big banks do not make a substantial amount of 

relationship loans to small firms. Instead, big banks primarily make loans to large and wellestablished firms, and they provide credit to small businesses mainly through highly automated 

programs that use impersonal credit scoring techniques. Under my proposal, as indicated above, 

most large banks would operate as subsidiaries of second-tier "nontraditional" banking 

organizations. Second-tier holding companies would conduct their business lending programs 

through nonbank finance subsidiaries that are funded by commercial paper and other debt 

228 See, e.g., Neil Wallace, "Narrow Banking Meets the Diamond-Dybvig Model," 20 Quarterly Review 

(Fed. Res. Bank of Minneapolis, Winter 1996), at 3. 

229 Wilmarth, "Dodd-Frank," supra note 5, at 1048. 

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instruments sold to investors in the capital markets. This operational structure should not create 

a substantial disincentive for the highly automated small business lending programs offered by 

big banks, because most loans produced by those programs (e.g., business credit card loans) can 

be financed by the capital markets through securitization.230 

Thus, my two-tier proposal should not cause a significant reduction in bank loans to 

bank-dependent firms, because big banks have already moved away from traditional 

relationship-based lending funded by deposits. If Congress wanted to give LCFIs a strong 

incentive to make relationship loans to small and midsized firms, Congress could authorize 

second-tier banks to devote a specified percentage (e.g. , ten percent) of their assets to such loans, 

as long as the banks held the loans on their balance sheets and did not securi tize them. By 

authorizing such a limited "basket" of relationship loans, Congress could allow second-tier banks 

to use deposits to fund those loans without exposing the banks to a significant risk offailure, 

since the remainder of their assets would be highly liquid and marketable. 

The second major criticism of the narrow bank proposal is that it would lack credibility 

because regulators would retain the inherent authority (whether explicit or implicit) to organize 

bailouts of major financial firms during periods of severe economic distress. Accordingly, some 

critics maintain that the narrow bank concept would simply shift the TBTF problem from insured 

banks to their nonbank affiliates 231 However, the force of this objection has been weakened by 

the systemic risk oversight and resolution regime established by Dodd-Frank. Under DoddFrank, LCFIs that might have been considered for TBTF bailouts in the past will be designated 

and regulated as SIFIs and will also be subject to resolution under Dodd-Frank's OLA. As 

230 ld. . 

231 See Scott, supra note 195, at 929-30 (noting the claim of some critics that there would be "irresistible 

political pressure" for bailouts of uninsured "substitute-banks" that are created to provide the credit 

previously extended by FDIC-insured banks). 

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shown above, the potential for TBTF bailouts of SIFIs would be reduced further if (i) Congress 

required all SIFIs to pay risk-based premiums to pre-fund the OLF, so that the OLF would have 

the necessary resources to handle future resolutions offailed SIFIs, and (ii) Congress repealed 

the SRE so that the DIF would no longer be available as a potential bailout fund for TBTF 

institutions. 

Thus, if my proposed reforms were fully implemented, (i) the narrow bank structure 

would prevent SIFI-owned banks from transferring their safety net subsidies to their nonbank 

affiliates, and (ii) the systemic risk oversight and resolution regime would require SIFIs to 

internalize the potential risks that their operations present to financial and economic stability. In 

combination, both sets of regulatory reforms would greatly reduce the TBTF subsidies that might 

otherwise be available to large financial conglomerates. Moreover, the narrow bank structure 

would advance the purpose of "living wills" (resolution plans) by making it much easier for 

regulators to separate banks owned by failed SIFIs from their nonbank affiliates. As discussed 

above, narrow banks would not be allowed to become entangled with their nonbank affiliates 

through extensions of credit and other transfers offunds 2 32 

The third principal objection to the narrow bank proposal is that it would place U.S. 

FHCs at a significant disadvantage in competing with foreign universal banks that are not 

required to comply with similar constraints. 233 Again, there are persuasive rebuttals to this 

objection. For example, the u.K. Independent Commission on Banking recently issued a report 

(the "Vickers Report") that presents a reform program analogous to my proposal. The Vickers 

Report has proposed a regime that would force large financial conglomerates to adopt a "ringfenced" structure that would separate their retail "utility" banking operations - including 

232 Wilmarth, "Dodd-Frank," supra note 5, at 1050-51 .. 

233 See Kay, supra note 44, at 71-74; Scott, supra note 195, at 931. 

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financial services provided to consumers and SMEs - from their wholesale "casino" activities in 

the financial markets234 UK analysts noted that the Vickers plan would require financial 

conglomerates to "build firewalls between their consumer units and investment banks" and likely 

cause "a jump in the cost of funding for their investment-banking divisions as the implicit [UK] 

government guarantee is removed.,,235 The Cameron government has pledged to implement the 

recommendations of the Vickers Report by the end of the current Parliamentary session in 

2015 236 

If the US. and the UK. both decide to implement a narrow banking structure 

(supplemented by strong systemic risk oversight and resolution regimes), their combined 

leadership in global financial markets would (i) eliminate claims by global SIFls that they would 

face an unlevel playing field if they competing in both the New York and London financial 

markets, and (ii) place considerable pressure on other major global financial centers to adopt 

similar financial reforms. 237 The financial sector accounts for a large share of the domestic 

economies of the US. and u.K. Both economies were severely damaged by two financial crises 

during the past decade (the dotcom-telecom bust and the subprime lending crisis). Both crises 

were produced by the same set of LCFIs that continue to dominate the financial systems in both 

nations. Accordingly, regardless of what other nations may do, the US. and the UK have 

234 Howard Mustoe & Gavin Finch, "Banks in UK Have to Insulate Consumer Units in $11 Billion 

Vickers Plan," Bloomberg.com, Sept. 12, 2011; see also Kay, supra note 44, at 51-69 (advocating 

adoption by the U.K. of a narrow banking plan that would accomplish "the separation of utility from 

casino banking"). 

23; Liam Vaughan, Howard Mustoe & Gavin Finch, "UK Bank Investors Chided as Vickers Returns 

Firms to 1950s," Bloomberg.com, Sept. 13, 20 II. 

236 Mustoe & Finch, supra note 234. 

237 Wilmarth, "Dodd-Frank," supra note 5, at 1051 ; Kay, supra note 44, at 74. 

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compelling national reasons to make sweeping changes to their financial systems in order to 

protect their domestic economies from the threat of a similar crisis in the future. 2l8 

The view that the US and the UK must refrain from implementing fundamental 

financial reforms until all other major developed nations have agreed to do so rests upon two 

deeply flawed assumptions: (i) the US. and the UK. should allow foreign nations with the 

weakest systems of financial regulation to dictate the level of supervisory constraints on LCFIs, 

and (ii) until a comprehensive international agreement on reform is achieved, the U.S and the 

UK. should continue to provide TBTF bailouts and other safety net subsidies that impose huge 

costs, create moral hazard and distort economic incentives simply because other nations provide 

similar benefits to their LCFls239 Both assumptions are unacceptable and must be rejected. 

d. The Relevance of the Schumer "Core Banking" Proposal of 1991 

In 1991, Congress considered, but did not pass, legislation proposed by the Treasury 

Department to allow banks to affiliate with securities firms and insurance companies by 

organizing financial holding companies. During the House debates on the 1991 legislation, 

which was essentially a forerunner ofGLBA,24o then-Representative Charles Schumer offered an 

amendment that incorporated a narrow banking proposal similar to the one I have presented in 

this testimony241 Representative Schumer argued that Congress should not authorize financial 

holding companies unless it adopted his amendment, which he described as a "core bank 

proposal.,,242 His proposal sought to guarantee that "insured deposits [are] used for low-risk, 

traditional banking activities, and then if our large financial institutions wish to invest in high238 See e.g. , King 2009 Speech, supra note 14; Kay, supra note 44, at 71-74; Wilmarth, "Dodd-Frank," 

supra note 5, at 1051-52. 

239 See e.g , Kay, supra note 44, at 42-46, 57-59, 66-75 ; Wilmarth, "Dodd-Frank," supra note 5, at 1052 .. 

240 Wilmarth, "Reforming Financial Regulation," supra note I, at 780. 

241 See 137 CONG o REc. 29359- 29367 (1991). 

242 1d. at 29361 (remarks of Rep. Schumer). 

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risk activities, they do not use the depositors' money, they do not use insured dollars, but they go 

to the markets for money. ,,243 

Representative Schumer maintained that the FDIC and taxpayers should not be insuring 

such risky activities as "huge bridge loans to LBO's, . equity investments in real estate[,] 

foreign currency trading and trading in ... , derivatives, which is betting on futures,,244 He 

noted that "[ m lost of the large banks are opposed because they do not want to take the necessary 

medicine to make them better," but he argued that "[t]hey need strong medicine, and only core 

banking provides it.,,245 Representative Marge Roukema supported the proposal because "the 

core bank concept is the only proposal before us to insulate the deposit insurance fund and 

protect the taxpayer from future bailouts.,,246 She agreed that "insured deposits should only be 

used to finance [the] traditional business of banking" and should not be used to "finance highly 

speculative lending, equity investments or other activities which should be done outside the 

Federal safety net.,,247 

Representative Schumer's core banking proposal was defeated248 However, he was 

undoubtedly correct in saying that his proposal was the "only amendment on the floor today that 

says we will not do what we did during the S&L crisis, and that is [to] use insured dollars for 

243 Id. at 29360. 

244 Id. 

245 !d. at 29361 (remarks of Rep. Schumer). 

246 Id. at 29366 (remarks of Rep. Roukema). 

247 Id. at 29363 (remarks of Rep. Roukema) See also id at 29365 (remarks of Rep. Slattery) (arguing that 

the "core-bank proposal offers real refonn" because "it will say to the big banks in this country that. 

you can speculate in the monetary markets, you can speculate in real estate, you can speculate in highyield junk bonds, but you cannot do it with the taxpayers' insured deposits"); id at 29366-29367 

(remarks of Rep. Weiss) (explaining that "the core bank proposal" would ensure that financial institutions 

interested in "underwriting, trading, and investment banking activities ... would have to raise funds in the 

marketplace," and contending that "it would be unconscionable to expand bank powers without enacting 

major safeguards to the American taxpayer"). 

248 Id. at 29367 (reporting that Rep. Schumer's amendment was defeated by a vote of 106-312) 

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riskyactivities.,,249 He argued that Congress had grievously erred in 1982, when it allowed 

federal thrifts to "expand into new businesses with the taxpayers' dollars.,,25o He further warned 

that Congress would be confronted with a future bailout of the banking system that could cost 

"$300 billion" 

unless we reform the system today. Do not put it off. Do not delay. The 

taxpayers cannot afford it. Only [the] core bank [proposal] will protect the 

insured deposit system once and for a1l 251 

Unfortunately, Representative Schumer's warning not only proved to be prescient but 

also underestimated the potential cost of allowing banks to expand into capital markets activities 

while relying on federal safety net subsidies. As the current financial crisis has made clear, 

Congress must mandate narrow banking in order to prevent FDIC-insured banks from being used 

to subsidize similar high-risk underwriting, trading and investment activities in the future. 

CONCLUSION 

Dodd-Frank makes meaningful improvements in the regulation of large financial 

conglomerates. Dodd-Frank establishes a new umbrella oversight body - the FSOC - that will 

designate nonbank SIFIs and make recommendations for the supervision of those institutions and 

large BHCs. Dodd-Frank also empowers the FRB to adopt stronger capital requirements and 

other enhanced prudential standards for both types of SIFIs. Most importantly, Dodd-Frank 

2491d. at 29360 (remarks of Rep. Schumer). See also id at 29366 (remarks of Rep. Schumer) (contending 

that his proposal was the "only ... amendment on the floor today that learns from history"). 

250 ld. at 29366. See also id. at 29360 (remarks of Rep. Schumer) (contending that congressional 

"deregulation" of thrift powers meant that "we ... were insuring crazy, and risky and wild investments in 

the S&L industry to an enonnous extent"); Wilmarth, "Wal-Mart," supra note 193, at 1574- 79 

(explaining that (i) Congress' expansion of the powers offederal thrifts in 1982 caused many states to 

"liberalize their own laws in order to keep state thrift charters attractive," and (ii) federal and state 

deregulation allowed many thrifts to expand aggressively into "nontraditional activities," including real 

estate development and investments in equity securities and junk bonds, which helped to cause "[s]ome of 

the largest and most costly thrift failures"). 

251 137 CONGo REc. 29366 (1991) (remarks of Rep. Schumer) See also id. at 29363 (remarks of Rep. 

Bacchus) (advocating the core banking proposal as the best way to "limit the risk [to] the taxpayers of a 

bank bailout that could cost hundreds of billions of dollars"). 

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establishes a new systemic resolution regime - the OLA - that should provide a superior 

altemative to the "bailout or bankruptcy" choice that federal regulators confronted when they 

dealt with failing SIFIs during the financial crisis. However, the OLA's feasibility remains 

unproven with regard to global SIFIs that operate across multiple national borders, since most 

foreign countries do not have resolution procedures that are congruent with the OLA.252 

In addition, as explained above, the OLA does not completely shut the door to future 

government rescues for creditors of SIFIs. The FRB can still provide emergency liquidity 

assistance to troubled LCFIs through the discount window and (perhaps) through "broad-based" 

liquidity facilities like the Primary Dealer Credit Facility, which are designed to help targeted 

groups of the largest financial institutions. FHLBs can still make advances to LCFIs. The FDIC 

can potentially use its Treasury borrowing authority and the SRE to protect uninsured creditors 

offailed SIFIs and their subsidiary banks. While Dodd-Frank has undoubtedly made TBTF 

bailouts more difficult, the continued existence of these avenues for financial assistance indicates 

that Dodd-Frank is not likely to prevent future TBTF rescues during future episodes of systemic 

financial distress. A recent report by Standard & Poor's ("S&P") concluded that Dodd-Frank 

does not eliminate the TBTF problem. S&P determined that "under certain circumstances and 

with selected systemically important financial institutions, future extraordinary government 

support is still possible.,,253 

Dodd-Frank also relies heavily on the same supervisory tools - capital-based regulation 

and prudential supervision - that failed to prevent the banking and thrift crises of the 1980s as 

well as the current financial crisis. The reforms contained in Dodd-Frank depend for their 

252 See, e.g. , Simon Johnson, "The Myth of the Resolution Authority," Baseline Scenario (blog), Mar. 31 , 

20 II, available at httpllbaselinescenario.com120 I 110313 IIthe-myth-of-the-resolution-authorityl. 

253 Standard & Poor's, "The U.S. Govemment Says Support for Banks Will Be Different 'Next Time' -

But Will It? (July 12,2011), at 2 

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effectiveness on many of the same federal regulatory agencies that failed to stop excessive risktaking by financial institutions during the credit booms that preceded both crises. As Simon 

Johnson and James K wak observe: 

[Sjolutions that depend on smarter, better regulatory supervision and corrective action 

ignore the political constraints on regulation and the political power of the large banks. 

The idea that we can simply regulate large banks more effectively assumes that regulators 

will have the incentive to do so, despite everything we know about regulatory capture and 

political constraints on regulation254 

The future effectiveness of the FSOC is also open to serious question in light of the agency turf 

battles and other bureaucratic failings that have plagued similar multi-agency oversight bodies in 

other fields of regulation (e.g., the Department of Homeland Security and the Office of the 

Director of National Intelligence)2;; 

As an alternative to Dodd-Frank's regulatory reforms, Congress could have addressed the 

TBTF problem directly by mandating a breakup oflarge financial conglomerates. That is the 

approach advocated by Johnson and K wak, who have proposed maximum size limits of four 

percent ofGDP (about $570 billion in assets) for commercial banks and two percent ofGDP 

(about $285 billion of assets) for securities firms. Those size caps would require a significant 

reduction in size for the six largest U.S. banking organizations (BofA, Chase, Citigroup, Wells 

Fargo, Goldman and Morgan Stanley)256 Like Joseph Stiglitz, Johnson and Kwak maintain that 

254 Johnson & Kwak, supra note 37, at 207 

255 See, e.g , Dara Kay Cohen et aI., "Crisis Bureaucracy: Homeland Security and the Political Design of 

Legal Mandates," 59 Stanford Law Review 673, 675-78, 718-20, 738-43 (2006) (analyzing organizational 

problems and operational failures within the Department of Homeland Security); Dana Priest & William 

M. Arkin, "A hidden world, growing beyond control," Washington Post, July 19, 2010, at AOI 

(discussing organizational problems and operational failures within the Office of the Director of National 

intelligence); Paul R. Pillar, "Unintelligent Design," The National Interest, July-August 2010 (same) 

(available on Lexis). 

256 Johnson & Kwak, supra note 37, at 214-17. 

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"[tJhe best defense against a massive financial crisis is a popular consensus that too big to fail is 

too big to exist,,257 

Congress did not follow the approach recommended by Johnson, Kwak and Stiglitz. In 

fact, the Senate rejected a similar proposal for maximum size limits by almost a two-to-one 

vote258 As noted above, Congress modestly strengthened Riegle-Neal's 10% nationwide deposit 

cap. However, that provision does not restrict "failing bank" mergers, intrastate mergers or 

acquisitions, or organic (internal) growth by LCFls. In addition, Congress gave FSOC and the 

FRB broad discretion to decide whether to impose a 10% nationwide liabilities cap on mergers 

and acquisitions involving financial companies. LCFls will undoubtedly seek to block the 

adoption of any such liabilities cap. 

I am sympathetic to the maximum size limits proposed by Johnson and Kwak. However, 

it seems highly unlikely - especially in light of megabanks' enormous political clout - that 

Congress could be persuaded to adopt such draconian limits, absent a future disaster comparable 

to the present financial crisis259 

A third possible approach - and the one I advocate - would be to impose structural 

requirements and activity limitations that would (i) prevent LCFIs from using the federal safety 

257 ld. at 221. See also id. at 217 ("Saying that we cannot break up our largest banks is saying that our 

economic futures depend on these six companies (some of which are in various states of ill health). That 

thought should frighten us into action"); Joseph E. Stiglitz, Freefall: America, Free Markets, and the 

Sinking of the World Economy 165-66 (2010) ("There is an obvious solution to the too-big-to-fail banks; 

break them up. If they are too big to fail, they are too big to exist"). 

258 A proposed amendment by Senators Sherrod Brown and Ted Kaufinan would have imposed the 

following ma;"imum size limits on LCFIs: (i) a cap on deposit liabilities equal to 10 percent of nationwide 

deposits, and (ii) a cap on nondeposit liabilities equal to two percent ofGDP for banking institutions and 

three percent ofGDP for nonbanking institutions. The size caps proposed by Brown and Kaufinan would 

have limited a single institution to about $750 billion of deposits and about $300 billion of nondeposit 

liabilities. The Senate rejected the Brown-Kaufman amendment by a vote of61-33. Wilmarth, "DoddFrank," supra note 5, at 1055 n.454. 

259 See Johnson & Kwak, supra note 37, at 222 ("The Panic of 1907 only led to the reforms of the 1930s 

by way of the 1929 crash and the Great Depression We hope that a similar [second] calamity will not be 

a prerequisite to action again"). 

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net protections for their subsidiary banks to subsidize their speculative activities in the capital 

markets, and (ii) make it easier for regulators to separate banks from their nonbank affiliates if 

FHCs or their subsidiary banks fail. As originally proposed, the Volcker Rule and the Lincoln 

Amendment would have barred proprietary trading and private equity investments by banking 

organizations and would have forced banks to spin off their derivatives trading and dealing 

activities into nonbank affiliates. However, the House-Senate conferees on Dodd-Frank greatly 

weakened both provisions and postponed their effective dates. In addition, both provisions as 

enacted contain potential loopholes that will allow LCFIs to lobby regulators for further 

concessions. Consequently, neither provision is likely to be highly effective in restraining risktaking or the spread of safety net subsidies by LCFIs. 

My proposals for a pre-funded OLF, a repeal of the SRE, and a two-tiered system of bank 

regulation would provide a simple, straightforward strategy for accomplishing the goals of 

shrinking safety net subsidies and minimizing the need for taxpayer-financed bailouts of SIFIs. 

A pre-funded OLF would require all SIFIs to pay risk-based assessments to finance the future 

costs of resolving failed SIFIs. A repeal of the SRE would prevent the DIF from being used as a 

backdoor mechanism to protect uninsured creditors of mega banks. A two-tiered system of bank 

regulation would (i) restrict traditional banking organizations to deposit-taking, lending, 

fiduciary services and other activities that are "closely related" to banking, and (ii) mandate a 

"narrow bank" structure for banks owned by financial conglomerates. In tum, the narrow bank 

structure would (A) insulate narrow banks and the DIF from the risks of capital markets 

activities conducted by nonbank affiliates, and (B) prevent narrow banks from transferring their 

low-cost funding and other safety net subsidies to nonbank affiliates. 

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In combination, my proposed refonns would strip away many of the safety net subsidies 

that are currently exploited by LCFIs and would subject them to the same type of market 

discipline that investors have applied to commercial and industrial conglomerates over the past 

thirty years. Financial conglomerates have never demonstrated that they can provide beneficial 

services to their customers and attractive returns to their investors without relying on safety net 

subsidies during good times and massive taxpayer-funded bailouts during crises. It is long past 

time for LCFIs to prove - based on a true market test - that their claimed synergies and their 

supposedly superior business model are real and not mythical 2 60 If, as I suspect, LCFIs cannot 

produce favorable returns when they are deprived of their current subsidies and TBTF status, 

market forces should compel them to break up voluntarily. 

Thank you again for the opportunity to present this testimony. 

Arthur E Wilmarth, Ir. (12/5111) 

260 See Johnson & Kwak, supra note 37, at 212-13 (contending that "[t]here is little evidence that large 

banks gain economies of scale above a very low size threshold," and also questioning the existence of 

favorable economies of scope for LCFls); Stiglitz, supra note 257, at 166 (maintaining that "[t]he muchvaunted synergies of bringing together various parts of the financial industry have been a phantasm; more 

apparent are the managerial failures and conflicts of interest"). 

74 
128 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

‘‘Three Years Later: Unfinished Business in Financial Reform’’ by Paul A. 

Volcker 


12711078.eps

Three Years Later 

Unfinished Business in Financial Reform 

Paul A. Volcker 

Group of Thirty, Washington, DC 
129 


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About the Author 

In the course of his career, Paul A. Volcker worked in the Federal 

Government for almost thirty years, culminating in two terms as 

Chairman of the Board of Governors of the Federal Reserve System 

from 1979 to 1987. Most recently, he was Chairman of President Barack 

Obama's Economic Recovery Advisory Board. Pursuing his many 

continuing interests in public policy, Mr. Volcker is associated with the 

Japan Society, the Institute of International Economics, the American 

Assembly, and the American Council on Germany. He is Honorary 

Chairman of the Trilateral Commission and the Group of Thirty. He is 

also Chairman of the Trustees of International House in New York City. 

ISBN I-56708-155-X 

Copies of this paper are available for $10 from: 

The Group of Thirty © 

1726 M Street, N.W, Suite 200 

Washington, D.C. 20036 

Tel.: (202) 331 -2472 

E-mail: info@group30.org 

www.group30.org 
130 


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The William Taylor Memorial Lecture Series No. 13 

Three Years Later 

Unfinished Business in Financial Reform 

Paul A. Volcker 

Published by 

Group of Thirty© 

Washington, DC 

2011 
131 


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The William Taylor Memorial Lecture 

This lecture se ries is dedicated to the memory of William Taylor 

(1933 -1 992). William Taylor's career in Washington, D.C. included 

15 years at the Board of Governors of the Federal Reserve, where 

he rose to the position of Staff Director of Banking Supervision and 

Regulation, and culminated in his appointment as Chairman of the 

Federal Deposit Insurance Corporation in 1991. The lecture series is 

dedicated to honoring his long career of distinguished public service 

and to recognizing his dedication to ensuring the strength and stability 

of the financial system. 

The lectures have traditionally been offered either at the biennial 

meeting of the International Conference of Banking Supervisors 

or, in intervening years, at the time of the annual meetings of the 

International Monetary Fund and the World Bank in Washington, D.C. 

3 
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REMARKS OF 

Paul A. Volcker 

William Taylor Memorial Lecture 

Washington, DC 

September 23, 2011 
133 


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Introduction 

For the past eighteen years, lectures in honor of William Taylor have 

been presented around the time of the IMF /World Bank meetings. 

They collectively provide a record of expert commentary by those 

engaged in finance during a period of turbulent change, culminating 

in a destructive crisis. 

This last of the Taylor Lectures is both symbolic and appropriate: 

Symbolic in the sense that the financial institutional markets in which 

Bill lived and worked have been transformed, and appropriate in that is 

time to think hard about new market structures and new approaches 

to regulation. 

Bill's life was cut short well before securitization reached a full head 

of steam. Complex financial engineering and active derivative trading 

was in its infancy. Collateralized Debt Obligations, Credit Default Swaps, 

Structure Investment Vehicles and mysterious conduits simply didn't 

exist. Commercial banks hadn't yet become investment banks and 

investment banks hadn't yet acquired banking licenses. The innately 

conservative organizing principle for investment houses as partnerships 

has been dropped and increasingly aggressive and risky trading practices 

have come to take center stage. 

In the process the major financial institutions have grown larger and 

larger, a lot more complicated, international in scope, interdependent, 

5 
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impenetrable to outsiders and I fear to directors and many senior 

managers as well. I know all that because I've been re-reading past 

Taylor Lectures. 

Those essays have been individually and collectively remarkable. 

Long before the financial crisis broke, several of the authors expressed 

strong concerns about the implications of the greater complexity, the 

need to develop more sophisticated and effective approaches toward 

risk management, and the difficult challenges for supervisors. I There 

were concerns about the incentives toward risk-taking embedded in new 

compensation practices (and especially stock options). Significantly, as 

early as the mid-1990's a senior European commercial banker raised 

questions about the seeming decline in ethical standards. 2 A decade 

later an experienced American central banker reiterated those concerns, 

suggesting that moral as well as practical issues were involved.3 

More than a decade ago, a highly respected European official, 

Tommaso Padoa-Schioppa, raised questions about the implications for 

financial stability of tl1e diminishing role for traditional (and highly 

regulated) commercial banking. The unspoken assumption of many 

was that the new investment bankers and both hedge and equity 

funds would in combination be capable of providing more competitive 

and stable markets and a more effective allocation of capital. But, the 

author asked, what about a stable core for the payments system, for the 

provision of liquidity, and for consumer services?4 

One thing I found missing from the old lectures was a clear 

expression of an intellectual rationale for all the changes in the financial 

environment. Theorizing was lacking about market efficiency and 

rational expectations, which together would lead to stability and the 

optimal allocation of resources. The Taylor authors, after all, were not 

academics steeped in mathematical abstractions. They were central 

bankers, regulators, and market participants used to coping with the 

imperfections, excesses, and the frailties of human behavior. None were 

prepared to accept a "hands off" regulatory philosophy. 

The "old world", the world in which Bill Taylor worked, surely had 

financial crises enough. The Latin American debt crisis of the 1980's, 

the savings and loan debacle, and the subsequent commercial bank 

See, e.g Caltellieli 1996; Crockett 1998; Fischer 2002. 

2 Cartelliert 1996. 

3 McDonough 2002. 

4 Padoa-Schioppa 2000. 

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failures were no simple matters. Bill's leadership was critical through 

those years. A progressive breakdown in markets and lasting damage 

to the real economy was avoided. 

That was not easy. The costs were significant. And those crises, 

in their severity, were a reminder of the simple fact that traditional 

banking, while providing essential public functions, necessarily entails 

risk. Those risks are inherent in intermediation between borrowers 

and lenders, between investors seeking longer-term funds and lenders 

placing priority on liquidity, and between obligations denominated 

in different currencies. It was the effort to deal with those risks that 

propelled much of the new financial architecture. But somehow in 

the effort to define, separate and diffuse those risks, with its familiar 

slogan of "slicing and dicing", sight was lost of the fact that this risk 

ultimately remained, however much it was relocated and re -priced. In 

fact, risk sometimes ended up in new concentrations, hidden from the 

view of supervisors, and too often from boards of directors and even 

top executives. 

I well recall a conversation with Bill Taylor near the end of my 

Federal Reserve time. In stark terms he set out his concerns. As I recall 

the words, he put the point forcibly: "If you permit banks to securitize 

and sell their loans, they will lose interest in maintaining a strong 

credit culture and controls. And you are going to end up with even 

bigger crises." 

Welt I shortly after left office. Bill, soon Chair of the FDIC, remained 

to cope with the increasingly complex world of finance. Of course, no 

single man, no single institution, could stand in the way of the powerful 

technical and political forces pushing for change-change that had the 

potent combination of strong intellectual support and prospects for high 

compensation. For all the cautions expressed, the succession of Taylor 

Lectures did not counsel resistance to the deep-seated structural changes 

taking place. Rather, they called for better, more disciplined management 

and supervision, most particularly a review of capital standards.

5 

Now, we know all the seeming mathematic precision brought to task, 

epitomized by calculations of Value at Risk, complicated new structured 

products, the explosion of derivatives, all intended to diffuse and 

minimize risk, did not bear out the hopes. Instead the vaunted efficiency 

helped justify exceedingly narrow credit spreads and exceedingly 

5 Crockett 1998 and Fischer 2003 . 

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large compensation. By now it is pretty clear that it was faith in the 

techniques of modern finance, stoked in part by the apparent huge 

financial rewards, that enabled the extremes of leverage, the economic 

imbalances, and the pretenses of the credit rating agencies to persist 

so long. A relaxed approach of regulators and important legislative 

liberalization reflected the new financial Zeitgeist. 

If those remarks sound critical-and they are meant to inspire 

caution-let me emphasize that the breakdown in financial markets 

and the" Great Recession" are the culmination of years of growing, and 

ultimately unsustainable, imbalances between and within national 

economies. These are matters of national policy failures and the absence 

of a disciplined international monetary system. 

Take the most familiar and egregious case. The huge external 

surpluses of China reflect its perceived desirability of rapidly growing 

export industries to support employment growth. Its willingness to 

build up trillions of short-term dollar assets at low interest rates to 

finance its surpluses kept the process going. Conversely, the United 

States happily utilized that inflow of low interest dollars to sustain 

heavy consumer spending, a growing budget deficit, and eventually an 

enormous housing bubble. Or, look to the current European crisis. At 

its roots are years of growing imbalances within the Euro Zone. As in 

other parts of the world, the ability to borrow at low rates bridged for 

a while the proclivities of some countries to spend and import beyond 

their means, while others saved and invested, tending to reinforce an 

underlying gap in productivity. 

Those were fundamentally matters of public policy-taxing, 

spending, and exchange rate decisions, not a reflection of financial 

market characteristics. But neither can we ignore the fact that financial 

practices h elped extend the imbalances. In the end, the build-up 

in leverage, the failure of credit discipline, and the opaqueness of 

securitization-all the complexity implicit in the growth of so-called 

"shadow banking" -helped facilitate accommodation to the underlying 

imbalances and to the eventual bubbles to a truly dangerous extent. 

In the end, the consequence was to intensify the financial crisis and 

to severely wound the real world economy. Even today, four years 

after the first intimations of the sub-prime mortgage debacle, high 

indebtedness and leverage, impaired banking capital, and a pervasive 

loss of confidence in a number of major financial institutions constrict 

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an easy flow of credit to smaller businesses, potential homebuyers and 

consumers alike. 

By coincidence of timing, writing in the midst of the acute crisis in 

September and October of 2008, two Taylor lecturers set out perceptive 

analyses of the problems and anticipated the substance of much of the 

ensuing discussion of reform in the United States and other countries. 6 

Just before the crisis, insightful questions were raised about what we 

really mean, or should mean, when we talk about financial stabilitywhat's a reasonable objective, and how to reasonably align supervisory 

responsibilities.7 

6 Se e Conigan 2008; Ludwig 2008. 

7 Davies 2005. 

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So, where do we stand? 

The first international response has been to review collectively the 

capital standards of comlnercial banks. That's an old story. Shortly 

after I left office a generation ago, Basel I was completed, setting out 

so-called risk-based capital standards to be adopted by all financially 

important countries. That was, indeed, a success. Standards were raised 

and a degree of international consistency achieved. Those goals remain 

critically important, and by and large, capital standards can be agreed 

upon and enforced by regulators rather than be dependent on legislation 

in individual countries. 

Review of those capital standards for banks-now with the further 

consideration of standards for liquidity-is widely perceived as a 

central element in the current reform effort-some would contend it 

is the central elelnent. I do not want to discount the importance of the 

work. We do need, however, to be conscious of its practical difficulties 

and limitations. Those problems have long been evident in the effort 

to enforce the established standards. Not surprisingly, they reappear 

in the negotiations to strengthen the standards. 

There are differences in national perceptions, reinforced by intense 

lobbying by affected institutions. The tendency may be to bend toward 

a least common denominator, weakening the standards, and to 

uneven application. Resistance to those pressures must be a priority 

for regulation. 

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There is the larger conceptual and unsettled question of the extent to 

which such standards should be applied to "shadow banks" and what do 

we precisely mean by "systemically important" shadow banks, worthy 

of regulation. Those are matters for legislation, complicated again by the 

need for enough international consistency to resist "forum shopping". 

The need for regulators and supervisors to take account of new 

institutions and markets has spawned the new phrase "macroprudential", to me among the most cumbersome words with obscure 

operational content spawned by the crisis. "Systemic surveillance" 

or "broad market oversight" seem to better convey what is necessary 

and desirable. Someone, some agency, some group should be charged 

with taking a holistic view toward assessing financial markets and 

institutions, particularly alert to the interconnections. Potentially 

dangerous inconsistencies and instabilities need to be recognized and 

assessed. Whether that function need carry with it specific regulatory 

responsibilities and enforcement authority (for instance, setting and 

enforcing capital standards for "non-banks") will likely vary country 

by country. But there can't be much doubt that success will require 

international consultation, exchanges of information, and in some 

areas coordinated action. 

These days, finance flows far more freely across national borders 

than trade. Technology tightly links the operations of big banks and 

markets. Hedge funds and equity funds, securitized products-even 

equity markets-are more and more international by nature. Only 

the most draconian and destructive regulatory measures could stop it. 

Today in Europe we see all those realities play out in real time in 

extreme form. Even among nations dedicated to a common market and 

a common currency, the tensions are great. The plain implication, to 

me, is not to retreat from an integrated Euro Zone, but to develop a new 

institutional structure to enforce greater consistency in banking and 

financial standards and more broadly to require a certain discipline in 

fiscal and economic policies. 

There is no compulsion to carry that process of integration so far in 

the world more generally. The financial breakdown and the resulting 

severe impact on economic activity does, however, point to the need for 

coordination beyond the accepted need for common capital standards. 

Among the more obvious areas is agreement on international 

accounting standards. The ground work has been well advanced over 

a decade. Full success, however, still awaits a definitive decision by 
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the SEC in the United States. I would add to that a more elusive but 

equally important consideration: true auditor independence. Required 

rotation and other means to that end are now under consideration by 

American authorities. 

Given the weaknesses and conflicts exposed by the crisis, the role 

and structure of credit rating agencies needs further review. So far, no 

fully satisfactory approach has been set out, but surely this is a matter for 

international consideration. Current efforts toward reform within the 

major firms should help, but other approaches need emphasis. Reliance 

on the formal ratings by an oligopoly could be reduced both by greater, 

perhaps more focused, competition and by placing more emphasis on 

the need for "in house" credit competence, matters touched upon by 

the Dodd-Frank legislation. 

More immediately important, and it seems to me more amenable 

to structural change, is the role of money market mutual funds in the 

United States. By grace of an accounting convention, shareholders 

in those funds are permitted to meet requests for withdrawals upon 

demand at a fixed dollar price so long as the market valuation of fund 

assets remains within a specified limit around the one dollar "par" 

(in the vernacular, "the buck"). Started decades ago essentially as 

regulatory arbitrage, money market funds today have trillions of dollars 

heavily invested in short-term commercial paper, bank deposits, and 

notably recently, European banks. 

Free of capital constraints, official reserve requirements, and deposit 

insurance charges, these money market mutual funds are truly hidden 

in the shadows of banking markets. The result is to divert what amounts 

to demand deposits from the regulated banking system. While generally 

conservatively managed, the funds are demonstrably vulnerable in 

troubled times to disturbing runs, highlighted in the wake of the 

Lehman bankruptcy after one large fund had to suspend payments. The 

sudden impact on the availability of business credit in the midst of the 

broader financial crisis compelled the Treasury and Federal Reserve to 

provide hundreds of billions of dollars by resorting to highly unorthodox 

emergency funds to maintain the functioning of markets. 

Recently, in an effort to maintain some earnings, many of those 

funds invested heavily in European banks. Now, without the backstop 

official liquidity, they are actively withdrawing those funds adding to 

the strains on European banking stability. 

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The time has clearly come to harness money market funds in a 

manner that recognizes both their structural importance in diverting 

funds from regulated banks and their destabilizing potential. If indeed 

they wish to continue to provide on so large a scale a service that mimics 

commercial bank demand deposits, then strong capital requirements, 

official insurance protection, and stronger official surveillance of 

investment practices is called for. Simpler and more appropriately, they 

should be treated as an ordinary mutual funds, with redemption value 

reflecting day by day market price fluctuations. 

14 
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"Too Big To Fail"-the Key Issue 

in Structural Reform 

The greatest structural challenge facing the financial system is how to 

deal with the wide-spread impression-many would say convictionthat important institutions are deemed "too large or too interconnected" 

to fail. During the crisis, creditors- and to some extent stockholderswere in fact saved by injection of official capital and liquidity in the 

aggregate of trillions of dollars, reinforcing the prevailing attitudes. 

Few will argue that the support was unwarranted given the severity 

of the crisis, and the danger of financial collapse in response to 

contagious fears, with the implication of intolerable pressures on the real 

economy. But there are real consequences, behavioral consequences, 

of the rescue effort. The expectation that taxpayers will help absorb 

potential losses can only reassure creditors that risks will be minimized 

and help induce risk-taking on the assumption that losses will be 

socialized, with the potential gains all private. Understandably the body 

politic feels aggrieved and wants serious reforms. 

The issue is not new. The circumstance in which occasional official 

rescues can be justified has long been debated.s What cannot be in 

question is that the prevailing attitudes and uncertainties demand an 

answer. And that answer must entail three elements: 

8 Greenspan 1996. 

15 
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First, the risk of failure of "large, interconnected firms" must 

be reduced, whether by reducing their size, curtailing their 

interconnections, or limiting their activities. 

Second, ways and means must be found to manage a prompt and 

orderly financial resolution process for firms that fail (or are on the 

brink of failure), minimizing the potential impact on markets and the 

economy without massive official support. 

Third, key elements in the approach toward failures need to be 

broadly consistent among major financial centers in which the failing 

institutions have critical operations. 

Plainly, all that will require structural change embodied in legislation. 

Various approaches are possible. Each is difficult intellectually, 

operationally, and politically, but progress in these areas is the key to 

effective and lasting financial reform. 

I think it is fair to say that in passing the Dodd-Frank legislation, the 

United States has taken an important step in the needed directions. Some 

elements of the new law remain controversial, and the effectiveness of 

some of the most important elements is still subject to administrative 

rule writing. Most importantly, a truly convincing approach to deal 

with the moral hazard posed by official rescue is critically dependent 

on complementary action by other countries. 

In terms of the first element I listed to deal with "too big to fail"-

minimizing the size and "interconnectedness" of financial institutionsthe U.S. approach sets out limited but important steps. The size of 

the major financial institutions (except for "organic" growth) will be 

constrained by a cap on assets as a percent of the U.S. GDP. That cap 

is slightly higher than the existing size of the largest institutions, and 

is justified as much to limit further concentration as by its role as a 

prudential measure. 

The newly enacted prohibitions on proprietary trading and strong 

limits on sponsorship of hedge and equity funds should be much more 

significant. The impact on the sheer size of the largest U.S. commercial 

banking organizations and the activities of foreign banks in the United 

States may be limited. They are, however, an important step to deal with 

risk, conflicts of interest and, potentially, compensation practices as well. 

The recent trading losses in Europe illustrate the case for restrictions 

on proprietary trading and limiting participation in sponsoring private 

pools of capital beyond American institutions. At its root, it is a matter 

of the culture of the banking institution. 

16 
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The justification for official support and protection of commercial 

banks is to assure maintenance of a flow of credit to businesses and 

individuals and to provide a stable, efficient payment system. Those 

are both matters entailed in continuing customer relations and 

necessarily imply an element of fiduciary responsibility. Imposing on 

those essential banking functions a system of highly rewarded-very 

highly rewarded-impersonal trading dismissive of client relationships 

presents cultural conflicts that are hard-I think really impossible-to 

successfully reconcile within a single institution. In any event, it is 

surely inappropriate that those activities be carried out by institutions 

benefiting from taxpayer support, current or potential. 

Similar considerations bear upon the importance of requiring 

that trading in derivatives ordinarily be cleared and settled through 

strong clearing houses. The purpose is to encourage simplicity and 

standardization in an area that has been rapidly growing, fragmented, 

unnecessarily complex and opaque and, as events have shown, risk prone. 

There is, of course, an important legitimate role for derivatives and 

for trading. The question is whether those activities have been extended 

well beyond their economic utility, driven by what one astute observer 

has expressed as "trying to extract pennies from a roller coaster". 

There is one very large part of American capital markets calling 

for massive structural change that so far has not been touched by 

legislation. The mortgage market in the United States is dominated 

by a few government agencies or quasi-governmental organizations. 

The financial breakdown was in fact triggered by extremely lax, 

government-tolerated underwriting standards, an important ingredient 

in the housing bubble. The need for reform is self-evident and the 

direction of change is clear. 

We simply should not countenance a residential mortgage market, the 

largest part of our capital market, dominated by so-called Government 

Sponsored Enterprises. Collectively, Fannie Mae, Freddie Mac and the 

Home Loan Banks had securities and guarantees outstanding that exceed 

the amount of marketable U.S. Treasury securities. The interest rates 

on GSE securities have been close to those on government obligations. 

That was possible because it was broadly assumed, quite accurately 

as it has turned out, that in case of difficulty those agencies would be 

supported by the Treasury to whatever extent necessary to maintain 

their operations. That support was triggered in 2008, confirming the 

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moral hazard implicit in the high degree of confidence that governmentsponsored enterprises would not be allowed to fail. 

The residential mortgage market today remains almost completely 

dependent on government support. It will be a matter of years 

before a healthy, privately supported market can be developed. But 

it is important that planning proceed now on the assumption that 

Government Sponsored Enterprises will no longer be a part of the 

structure of the market. 

We cannot, and should not, contemplate a financial world so 

constrained by capital requirements and regulation that all failures are 

avoided and innovation and risk-taking is lost. As I noted earlier, we 

need to develop arrangements to deal with such failures that do occur 

in a manner that will minimize market continuity and contagion. 

Success will be dependent on complementary approaches in major 

markets-New York, London, Continental European centers and 

Tokyo, Hong Kong and before long other growing Asian markets. In 

essence, the authorities need to be able to cut through existing and 

typically laborious national bankruptcy procedures. The need is for new 

"resolution authorities" that can maintain necessary services and the 

immediate need for day-to-day financing while failing organizations 

are liquidated, merged or sold, whether in their entirety or piece by 

piece. Shareholders and management will be gone. Creditors will be 

placed at risk. 

Such arrangements are incorporated in Dodd-Frank. I think it 

fair to say that there is a great deal of skepticism as to whether such 

arrangements will be effective in the midst of crises, and whether market 

participants will continue to presume that governments will again "ride 

to the rescue". Surely, that skepticism is likely to remain until the most 

important of jurisdictions can be brought into reasonable alignment. 

My sense is that efforts are, in fact, well underway to clear away some 

of the technical underbrush and to agree on procedures for intervention 

and exchanging information. An important element in that effort is the 

concept of requiring institutions to develop "living wills". The idea is 

to have clarity as to the parts of their operations that could stand alone 

or be sold or merged as part of an orderly and rapid resolution process. 

It is evident that there is not yet full agreement on elements of the 

basic structural framework for banking and other financial operations. 

Some jurisdictions seem content with what is termed "universal banks", 

whatever the conflicting risks and cultural issues involved. In the 

18 
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United States, there are restrictions on the activities of commercial 

banking organizations, particularly with respect to trading and links 

with commercial firms. 

Financial institutions not undertaking commercial banking activities 

will be able to continue a full range of trading and investment banking 

activities, even when affiliated with commercial firms. When deemed 

"systemically significant", they will be subject to capital requirements 

and greater surveillance than in the past. However, there should be 

n o presumption of official support-access to the Federal Reserve, 

to deposit insurance, or otherwise. Presumably, failure will be more 

likely than in the case of regulated commercial banking organizations 

protected by the official safety net. Therefore, it is important that the 

new resolution process be available and promptly brought into play. 

The Independent Commission on Banking in the United Kingdomthe so-called Vickers Committee-two weeks ago proposed a more 

sweeping structural change for organizations engaged in commercial 

banking. In essence, within a single organization the range of ordinary 

banking operations-deposit taking, lending, and payments-would 

be segregated in a "retail bank". That bank will be overseen by its own 

independent board of directors and "ring fenced" in a manner designed 

to greatly reduce relations with the rest of the organization. 

Apparently, customers could deal with both parts of the organization, 

and some limited transactions would be permitted between them. But as 

I understand it, the "retail bank" would be much more closely regulated, 

with relatively high capital and other stringent requirements. The 

emphasis is to insulate the bank from failures of the holding company 

and other affiliates. There seems to be at least a hint that public support 

may be available in time of crisis. That presumably would be ruled out 

for other affiliates of the institution. 

I frankly have not absorbed all the practical and legal implications 

of the U.K. proposal. Surely problems abound in trying to separate 

the fortunes of different parts of a single organization, reflected in 

the length and detail of the Commission's Report (which may come 

to rival Dodd-Frank!). Perhaps most fundamentally, directors and 

managements of a holding company are ordinarily assumed to have 

responsibility to the stockholders for the capital, profits and stability 

of the whole organization, which doesn't fit easily with the concept 

that one subsidiary, the "retail bank", must have a truly independent 

board of its own. 

19 
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As an operational matter, some interaction between the retail and 

investment banks is contemplated in the interest of minimizing costs 

and facilitating full customer service. American experiences with 

"fire walls" and prohibitions on transactions between a bank and its 

affiliates have not been entirely reassuring in practice. Ironically, the 

philosophy of u.s. regulators has been to satisfy itself that a financial 

holding company and its non-bank affiliates should be a "source of 

strength" to the commercial bank. That principle has not been highly 

effective in practice. 

20 
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Conclusion 

In any event, while there are differences in the structural approaches 

in the u.s. and U.K., they are in fundamental agreement on the key 

importance of protecting traditional commercial banking from the risks 

and conflicts of proprietary activity. Both are consistent with developing 

a practical resolution authority. Widely agreed upon internationally, 

that will be the keystone in a stronger international financial system. 

One thing is for sure, we have passed beyond the stage in which we 

can expect a new 'Bill Taylor'-and his successors in central banks, 

regulatory authorities and Treasuries-to rely on ad hoc responses in 

dealing with what have become increasingly frequent, complex and 

dangerous financial breakdowns. Structural change is. necessary. 

As it stands, the reform effort is incomplete. 

It needs fresh impetus. I challenge governments and central banks 

to take up the unfinished agenda. Only then can our recollections of 

Bill Taylor be appropriately rewarded. 

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Referenced Williall1 Taylor Lectures, 

published by the Group of Thirty: 

Cartellieri, Ulrich and Alan Greenspan. 1996. Global Risk Management. 

Corrigan, E. Gerald. 2008. The Credit Crisis: The Quest for Stability and Reform. 

Crockett, Andrew. 1998. Banking Supervision and Financial Stability. 

Davies, Sir Howard. 2005. Two Cheers for Financial Stability. 

Fischer, Stanley. 2002. Implications of Basel IIfo r Emerging M arket Countries. 

Ludwig, Eugene. 2008. Lessons Learnedfrom the 2008 Financial Crisis. 

McDonough, William. 2002. Issues in Corporate Governance . 

Padoa-Schioppa, Tommaso. 2000. Licensing Banks: Still Necessary? 

22 
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Group of Thirty Members 201P 

Paul A. Volcker 

Chairman of the Board of Trustees, Group of Thirty 

Former Chaimlan, President Barack Obama's Economic Recovery Advisory Board 

Former Chairman, Board of Governors of the Federal Reserve System 

Jacob A. Frenke l 

Chairman and CEO, Group of Thirty 

Chairman, JPMorgan Chase International 

Former Governor, Bank of Israel 

Former Professor of Eamomics, University of Chicago 

Former Counselor, Director of Research, International Monetary Fund 

Ge offre y L. Be ll 

Executive Secretary, Group of Thirty 

President, Geoffrey Bell & Company, Inc. 

Abdlatif AI-Ham.ad 

Chairman, Arab Fund for Economic and Social Development 

Former Minister of Finance and Minister of Planning, Kuwait 

Le szek Balcerowicz 

Professor, Warsaw Schoo l of Economics 

Chairman of the Board, Bruegel 

Former President, National Bank of Poland 

Former Deputy Prime Minister and Minister of Finance, Poland 

Mark Carney 

Governor, Bank of Canada 

Member, Board of Directors, Bank for International Settlements 

Jaim.e Caruana 

General Manager, Bank for International Settlements 

Former Financial Counsellor, InternationalMonetary Fund 

Former Governor, Banco de Espana 

Former Chairman, Basel Committee on Banking Supervision 

Dom.ingo Cavallo 

Chairman and CEO, DFC Associates, LLC 

Former Minister of Economy, Argentina 

E. Gera ld Corrigan 

Managing Director, Goldman Sachs Group, Inc. 

Former President, Federal Reserve Bank of New York 

Guillerm.o de la Dehe sa Rom.e ro 

Diredor and Member of the Executive Committee, Grupo Santander 

Former Deputy Managing Director, Banco de Espana 

Former Secretary of State, Ministry of Economy and Finance, Spain 

Mario Draghi 

Governor, Banca d'Italia 

Chairman, Financial Stability Board 

Member of the Governing and General Councils, European Central Bank 

Former Vice Chairman and Managing Director, Goldman Sachs International 

9 As of October 14, 201 1. 

2 3 
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William Dudle y 

President, Federal Reserve Bank of New York 

Martin Feldstein 

Professor of Economics, Harvard University 

President Emeritus, National Bureau of Economic Research 

Former Chairman, Council of EconomicAdvisers 

Ro ger W. Fergu son, Jr. 

President and CEO, TIAA-CREF 

Former Chairman, Swiss Re America Holding Corporation 

Former Vice Chairman, Board of Governors of the Federal Reserve System 

Stanle y Fisch er 

Governor, Bank of Israel 

Former First Managing Director, International Monetary Fund 

A rminio Fraga N e to 

Founding Partner, Gdvea Investimentos 

Chairman of the Board, BM&F-Bovespa 

Former Governor, Banco Central do Brasil 

Gerd Hausl er 

Chief Executive Officer, Bayerische Landesbank 

Member of the Board of Directors and Senior Advisor, RHJ International 

Former Managing Director and Member of the Advisory Board, Lazard & Co. 

Former Counselor and Director, International Monetary Fund 

Former Managing Director, Dresdner Bank 

Philipp Hildebrand 

Chairman of the Governing Board, Swiss National Bank 

Former Partner, Moore Capital Management 

Mervy n King 

Governor, Bank of England 

Former Professor of Eamomics, London School of Economics 

Paul Krugman 

Professor of Economics, Woodrow Wilson School, Princeton University 

Former Member, Council of Economic Advisors 

Guillermo Orti z Martine z 

President and Chairman, Grupo Finaciero Banorte 

Former Governor, Banco de Mexico 

Chairman of the Board, Bank for International Settlements 

Former Secretary of Finance and Public Credit, Mexico 

K enne th Rogoff 

Thomas D. Cabot Professor of Public Policy and Economics, Harvard University 

Former Chief Economist and Director of Research, IMF 

Tharman Shanmugaratnam 

Deputy Prime Minister & Minister for Finance & Manpower, Singapore 

Chairman, Monetary Authority of Singapore 

Chairman of International Monetary & Financial Committee, IMF 

Masaaki Shirakaw a 

Governor, Bank of Japan 

Former Professor, Kyoto University School of Government 

24 
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Lawrence H. SUIllIlle r s 

Charles W Eliot University Professor at Harvard University 

Former Director, National Economics Councilfor President Barack Obama 

Former President, Harvard University 

Former Secretary of the Treasury 

Jean-Claude Trichet 

President, European Central Bank 

Former Governor, Banque de France 

Lord Adair Turner 

Chainnan, Financial Services Authority 

Member of the House of Lords, United Kingdom 

David Walke r 

Senior Advisor, Morgan Stanley International, Inc. 

Former Chainnan, Morgan Stanley International, Inc. 

Former Chainnan, Securities and Investments Board, U.K. 

Yutaka YaIllaguchi 

Former Deputy Governor, Bank of Japan 

Former Chainnan, Euro Currency Sta nding Commission 

Ernesto Zedillo 

Director, Yale Center for the Study of Globalization, Yale University 

Former President of Mexico 

Zhou Xiaochuan 

Governor, People's Bank of China 

Former President, China Construction Bank 

Former Assistant Minister of Foreign Trade 

SEN IOR MEMBERS 

WilliaIll R. Rhodes 

President and CEO, William R. Rhodes Global Advisors 

Senior Advisor, Citigroup 

Former Senior Vice Chairman, Citigroup 

Marina v N. WhitIllan 

Professor of Business Administration & Public Policy, University of Michigan 

Former Member, Council of Economic Advisors 

EMERITUS M EM BERS 

Jacques de Larosiere 

President, Eurofi 

Conseiller, BNP Paribas 

Former President, European Bankfor Reconstruction and Development 

Former Managing Director, International Monetary Fund 

Former Governor, Banque de France 

Richard A . Debs 

Advisory Director, Morgan Stanley 

Former Presiden t, Morgan Stanley International 

Former COO, Federal Reserve Bank of New York 

25 
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12711105.eps

Gerhard Fels 

Former Director, Institut der deutschen Wirtschaft 

TOYoo Gyohten 

President, Institute for International Monetary Affairs 

Former Chairman, Bank of Tokyo 

John G. Heimann 

Senior Advisor, Financial Stability Institute 

Former U.S. Comptroller of the Currency 

Erik Hoffmeyer 

Chairman, Politiken·Fonden 

Former Chairman, Danmarks Nationalbank 

Peter B. Kenen 

Walker Professor of Economics & International Finance Emeritus, Princeton University 

Former Senior Fellow in International Economics, Council on Foreign Relations 

William McDonough 

Former Vice Chairman, Bank of America/ Merrill Lynch 

Former Chairman, Public Company A=unting Oversight Board 

Former President, Federal Reserve Bank of New York 

Ernest Stern 

Partner and Senior Advisor, The Rohatyn Group 

Former Managing Director, JPMorgan Chase 

Former Managing Director, World Bank 

Shijuro Ogata 

Deputy Chairman, Pacific Asia Region, the Trilateral Commission 

Former Deputy Governor, Bank of Japan 

Former Deputy Governor, Japan Development Bank 

Sylvia Ostry 

Distinguished Research Fellow, Munk Centre for International Studies, Toronto 

Former Ambassador for Trade Negotiations, Canada 

Former Head, OECD Economics and Statistics Department 

26 
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Group Of Thirty Publications Since 1990 

REPORTS 

Sharing the Gains from Trade: Reviving the Doha 

Study Group Report. 2004 

Key Issues in Sovereign Debt Restructuring 

Study Group Report. 2002 

Reducing the Risks of International Insolvency 

A Compendium of Work in Progress. 2000 

Collapse: The Venezuelan Banking Crisis of '94 

Ruth de Krivoy. 2000 

The Evolving Corporation: Global Imperatives and National Responses 

Study Group Report. 1999 

International Insolvencies in the Financial Sector 

Study Group Report. 1998 

Global Institutions, National Supervision and Systemic Risk 

Study Group on Supervision and Regulation. 1997 

Latin American Capital Flows: Living with Volatility 

Latin American Capital Flows Study Group. 1994 

Defining the Roles of Accountants, Bankers 

and Regulators in the United States 

Study Group on Accountants, Bankers and Regulators. 1994 

EMU after Maastricht 

Peter B. Kenen. 1992 

Sea Changes in Latin America 

Pedro Aspe, A ndres Bianchi, and Domingo Cavallo, 

with discussion by S.T. Beza and William Rhodes. 1992 

The Summit Process and Collective Security: Future Responsibility Sharing 

The Summit Reform Study Group. 1991 

Financing Eastern Europe 

RichardA. Debs, Harvey Shapiro, and Charles Taylor. 1991 

The Risks Facing the World Economy 

The Risks Facing the World Economy Study Group . 1991 

THE WILLIAM TAYLOR MEMORIAL LECTURES 

It's Not Over 'Til It's Over: Leadership and Financial Regulation 

Thomas M. Hoenig. 2010 

The Credit Crisis: The Quest for Stability and Reform 

E. Gerald Corrigan. 2008 

Lessons Learned from the 2008 Financial Crisis 

Eugene A. Ludwig. 2008 

27 
155 


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Two Cheers for Financial Stability 

Howard Davies. 2006 

Implications of Basel II for Emerging Market Countries 

Stan ley Fischer. 2003 

Issues in Corporate Governance 

William J. McDonough. 2003 

Post Crisis Asia: The Way Forward 

Lee Hsien Loong. 2001 

Licensing Banks: Still Necessary? 

Tommaso Padoa-Schioppa. 2000 

Banking Supervision and Financial Stability 

Andrew Crockett. 1998 

Global Risk Management 

Ulrich Cartellieri and Alan Greenspan. 1996 

The Financial Disruptions of the 1980s: A Central Banker Looks Back 

E. Gerald Corrigan. 1993 

SPECIAL REPORTS 

Enhancing Financial Stability and Resilience: 

Macroprudential Policy, Tools, and Systems for the Future 

Macroprudential Policy Working Group. 2010 

The Reform of the International Monetary Fund 

IMF Reform Working Group . 2009 

Financial Reform: A Framework for Financial Stability 

Financial Reform Working Group. 2009 

The Structure of Financial Supervision: 

Approaches and Challenges in a Global Marketplace 

Financial Regulatory Systems Working Group . 2008 

Global Clearing and Settlement: Final Monitoring Report 

Global Monitoring Committee . 2006 

Reinsurance and International Financial Markets 

Reinsurance Study Group . 2006 

Enhancing Public Confidence in Financial Reporting 

Steering & Working Committees on Accounting. 2004 

Global Clearing and Settlement: A Plan of Action 

Steering & Working Committees of Global Clearing & Settlements Study. 2003 

Derivatives: Practices and Principles: Follow-up Surveys of Industry Practice 

Global Derivatives Study Group. 1994 

Derivatives: Practices and Principles, 

Appendix III: Survey of Industry Practice 

Global Derivatives Study Group . 1994 

28 
156 


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Derivatives: Practices and Principles, Appendix II: 

Legal Enforceability: Survey of Nine Jurisdictions 

Global Derivatives Study Group. 1993 

Derivatives: Practices and Principles, Appendix I: Working Papers 

Global Derivatives Study Group. 1993 

Derivatives: Practices and Principles 

Global Derivatives Study Group. 1993 

Clearance and Settlement Systems: Status Reports, Autumn 1992 

Various Authors. 1992 

Clearance and Settlement Systems: Status Reports, Year-End 1990 

Various Authors. 1991 

Conference on Clearance and Settlement Systems. 

London, March 1990: Speeches 

Various Authors. 1990 

Clearance and Settlement Systems: Status Reports, Spring 1990 

Various Authors. 1990 

OCCASIONAL PAPERS 

83. Macroprudential Policy: Addressing the Things We Don't Know 

Alastair Clarke and Andrew Large. 2011 

82. The 2008 Financial Crisis and Its Aftermath: 

Addressing the Next Debt Challenge 

Thomas A. Russo and Aaron J. Katze!. 2011 

81. Regulatory Reforms and Remaining Challenges 

Mark Carney. Paul Tucker. Philipp Hildebrand. Jacques de Larosiere, 

William Dudley, Adair Turner, and Roger W Ferguson, Jr. 2011 

80. 12 Market and Government Failures Leading to the 2008-09 Financial Crisis 

Guillermo de la Dehesa. 2010 

79. Lessons Learned from Previous Banking Crises: 

Sweden, Japan, Spain, and Mexico 

Stefan Ingves, Goran Lind, Masaaki Shirakawa, Jaime 

Caruana, and Guillermo Ortiz Martinez. 2009 

78. The G30 at Thirty 

Peter Kenen. 2008 

77. Distorting the Micro to Embellish the Macro: The Case of Argentina 

Domingo Cavallo and Joaquin Cottani. 2008 

76. Credit Crunch: Where Do We Stand? 

Thomas A. Russo. 2008 

75. Banking, Financial, and Regulatory Reform 

Liu Mingkang. Roger Ferguson. and Guillermo Ortiz Martinez. 2007 

74. The Achievements and Challenges of European Union Financial 

Integration and its Implications for the United States 

Jacques de Larosiere. 2007 

29 
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73. Nine Common Misconceptions about Competitiveness and Globalization 

Guillermo de la Dehesa. 2007 

72. International Currencies and National Monetary Policies 

Barry Eichengreen. 2006 

71. The International Role of the Dollar and Trade Balance Adjustment 

Linda Goldberg and Cedric Tille. 2006 

70. The Critical Mission of the European Stability and Growth Pact 

Jacques de Larosiere. 2005 

69. Is it Possible to Preserve the European Social Model? 

Guillermo de la Dehesa. 2005 

68. External Transparency in Trade Policy 

Sylvia Ostry.2004 

67. American Capitalism and Global Convergence 

Marina VN. Whitman. 2003 

66. Enron et al.: Market Forces in Disarray 

Jaime Caruana, Andrew Crockett, Douglas Flint, Trevor Harris, and Tom Jones. 2002 

65. Venture Capital in the United States and Europe 

Guillermo de la Dehesa. 2002 

64. Explaining the Euro to a Washington Audience 

Tommaso Padoa-Schioppa. 2001 

63. Exchange Rate Regimes: Some Lessons from Postwar Europe 

Charles Wyplosz. 2000 

62. Decisionmaking for European Economic and Monetary Union 

Erik Hoffmeyer. 2000 

61. Charting a Course for the Multilateral Trading System: 

The Seattle Ministerial Meeting and Beyond 

Ernest Preeg. 1999 

60. Exchange Rate Arrangements for the Emerging Market Economies 

Felipe Larrain and A ndriEs Velasco. 1999 

59. G3 Exchange Rate Relationships: A Recap of the 

Record and a Review of Proposals for Change 

Richard Clarida. 1999 

58. Real Estate Booms and Banking Busts: An International Perspective 

Richard Herring and Susan Wachter. 1999 

57. The Future of Global Financial Regulation 

Sir Andrew Large. 1998 

56. Reinforcing the WTO 

Sylvia Ostry. 1998 

55. Japan: The Road to Recovery 

Akio Mikuni. 1998 

54. Financial Services in the Uruguay Round and the WTO 

Sydney J. Key. 1997 

53. A New Regime for Foreign Direct Investment 

Sylvia Ostry. 1997 

30 
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52. Derivatives and Monetary Policy 

Gerd Hausler. 1996 

51. The Reform of Wholesale Payment Systems 

and Impact on Financial Markets 

David Folkerts·Landau, Peter Garber, and Dirk Schoenmaker. 1996 

50. EMU Prospects 

Guillermo de la Dehesa and Peter B. Kenen. 1995 

49. New Dimensions of Market Access 

Sylvia Ostry. 1995 

48. Thirty Years in Central Bankirtg 

Erik Hoffmeyer. 1994 

47. Capital, Asset Risk and Bank Failure 

Linda M. Hooks. 1994 

46. In Search of a Level Playirtg Field: The Implementation of the 

Basle Capital Accord in Japan and the United States 

Hal S. Scott and Shinsaku Iwahara. 1994 

45. The Impact of TI-ade on OECD Labor Markets 

Robert Z. Lawrence. 1994 

44. Global Derivatives: Public Sector Responses 

James A. Leach, William J. McDonough, David W M ullins, and Brian Quinn. 1993 

43. The Ten Commandments of Systemic Reform 

Vaclav Klaus. 1993 

42. TI-ipolarism: Regional and Global Economic Cooperation 

Tommaso Padoa·Schioppa . 1993 

41. The Threat of Managed TI-ade to TI-ansformirtg Economies 

Sylvia Ostry. 1993 

40. The New TI-ade Agenda 

Geza Feketekuty. 1992 

39. EMU and the Regions 

Guillermo de la Dehesa and Paul Krugman. 1992 

38. Why Now? Change and TUrmoil in U.S. Bankirtg 

Lawrence J. White. 1992 

37. Are Foreign-owned Subsidiaries Good for the United States? 

Raymond Vernon. 1992 

36. The Economic TI-ansformation of East Germany: Some Preliminary Lessons 

Gerhard Fels and Claus Schnabel. 1991 

35. International TI-ade in Bartking Services: A Conceptual Framework 

Sydney J. Key and Hal S. Scott. 1991 

34. Privatization irt Eastern and Central Europe 

Guillermo de la Dehesa. 1991 

33. Foreign Direct Investment: The Neglected Twin of TI-ade 

DeAnne Julius. 1991 

32. Interdependence of Capital Markets and Policy Implications 

Stephen H. Axilrod. 1990 

3 1 
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31. Two Views of German Reunification 

Hans Tietmeyer and Wilfried Guth. 1990 

30. Europe in the Nineties: Problems and Aspirations 

Wilfried Guth. 1990 

29. Implications of Increasing Corporate Indebtedness for Monetary Policy 

Benjamin M. Friedman . 1990 

28. Financial and Monetary Integration in Europe: 1990, 1992 and Beyond 

Tommaso Padoa-Schioppa. 1990 

32 
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GROUP OF THIRTY 

1726 M Street, N.W, Suite 200 

Washington, DC 20036 

ISBN I-56708-155-X 
161 

‘‘Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket or Is LapBand Surgery Required?’’ by Richard W. Fisher 


12711114.eps

Taming the Too-Big-to-Fails: 

Will Dodd-Frank Be the Ticket 

or Is Lap-Band Surgery Required? 

(With Reference to Vinny Guadagnino, Andrew 

Haldane, Paul Volcker, John Milton, Tom Hoenig 

and Churchill's 'Terminological Inexactitude') 

Remarks before Columbia University 's Politics and Business Club 

Richard W. Fisher 

President and CEO 

Federal Reserve Bank of Dallas 

New York City 

November 15, 20 11 

The views expressed are my own and do not necessarily reflect official positions of the Federal Reserve System. 
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Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket 

or Is Lall-Band Surgery Required? 

(With Reference to Vinny Guadagnino, Andrew Haldane, Paul Volcker, 

John Milton, Tom Hoenig and Chu rchill', 'Terminological Inexactitude') 

Richard W. Fisher 

It is bracing to be with bright, young students here at the Politics and Business Club of Columbia 

University. I understand I have a high bar today: I need to surmount the heights reached in the 

insightful lecture recently given your undergraduate students by Vinny Guadagnino from the 

show Jersey Shore. I'll do my best. 

Executive Summa ry 

Today, I will speak to the issue of depository institutions considered ''too big to fail" and 

"systemically important." I will argue that, just as health authorities in the United States are 

waging a campaign against the plague of obesity, banking regulators must do the same with 

regard to oversized banks that undennine the nation's financial health and are a potential threat 

to economic stability. I shall speak of the difficulty of treating this pernicious problem in a 

culture held hostage by concerns for "contagion," "systemic risk" and "unique solutions." 1 will 

posit that preoccupation with these concerns leads to an ethic that coddles survival of the fattest 

rather than promoting survival of the fittest, to the detriment of social welfare and economic 

efficiency.' 1 will express my hope that, properly implemented, the capstone of financial 

oversight, the Dodd- Frank Wall Street Refornl and Consumer Protection Act (Dodd- Frank), 

might assist in reining in the pernicious threat to financial stability that megabanks or 

"systemically important financial institutions"-the SIFIs-have become. But I will also express 

concern about the difficulty of doing so, concluding with a suggestion that perhaps the financial 

equivalent of irreversible lap-band or gastric b)'lJass surgery is the only way to treat the 

pathology of financial obesity, contain the relentless expansion of these banks and downsize 

them to manageable proportions. 

The Problem with SIFls 

Aspiring politicians in this audience do not have to be part of the Occupy Wall Street movement, 

or be advocates for the Tea Party, to recognize that govenullent-assisted bailouts of reckless 

financial institutions are sociologically and politically offensive; they stand the concept of 

Ameri can social justice on its head. Business school students here will understand that bailOlns 

of errant banks are questionable from the standpoint of the efficient workings of capitalism, for 

they run the risk of institutionalizing a practice that distorts the discipline of the marketplace and 

interferes with the transmission of monetary policy. 

To this last point, my colleague and director of research at the Dallas Fed, Harvey Rosenblum, 

and I have written about how too-big-to-fai l banks disrupt the transmission of policy initiatives. I 

refer you to the article we jointly authored fo r the Wall Street Journal in September 2009, titled 

"The Blob 111at Ate rv!onetary Policy." Our thesis was that as their losses mounted, the too-bigto-fails, or SIFIs, were forced to cut back their lending and gummed up the nation's capital 
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markets in general. TIlliS, before the Dodd- Frank Act was even proposed, we wrote that 

"guarding against a resurgence of the omnivorous TBTF Blob [must] be among the goals of 

financial refoml.,,2 

In previous speeches I have taken note of another dimension to the problem of sustaining 

behemoth financial institutions, and that is the cost of doing so. Andrew Haldane, executive 

director for financial stability and a member of the Financial Policy Committee at the Bank of 

England, provides some rough estimates of the subsidy that flows to banks from govemments 

following a too-big-to-fail policy. With markets working under the assumption that they will 

invariably be protected by government, the cost of flUlds is measurabl y less, according to 

Haldane's work, giving them preferential access to investment capital. He estimates the global 

subsidies enjoyed by the too-big-to-fails in 2009 ranged up to a staggering $2.3 trillion.

3 

TIms, I argue that sustaining too-big-to-fail-ism and maintaining the cocoon of protecti on of 

SIFis is counterproductive, expensive and socially questionable. 

As students, you should know that financial booms and busts are a recurring theme throughout 

history and that bankers and their regulators suffer from recurring amnesia. They periodically 

forget the past and all the lessons of history, tuck into some new financial, quick-profit 

fa ntasy-like the slicing and dicing and packaging of mortgage financing- and Imderestimate 

the risk of growing into unmanageable and unsustainable size, scale and complexity as they 

overindulge in that new financial fantasy. Invariably, these behemoth institutions use their size, 

scale and complexity to cow politicians and regulators into believing the world will be placed in 

peril should they attempt to discipline them. They argue that disciplining them will be a trip wire 

for financial contagion, market disruption and economic disorder. Yet failing to discipline them 

only delays the inevitable-a bursting of a bubble and a financial panic that places the economy 

in peril. This phenomenon most recently manifested itself in the Panic of 2008 and 2009. 

Paul Volcker states the probl em thus: "The greatest structural chall enge facing the financial 

system is how to deal with the widespread impression-many would say conviction-that 

important institutions are deemed 'too large or too interconnected' to fail."'" 

Paul 'Moses' and John Millon 

On previous occasions, I have referred to Paul Voicker as the Moses of central bankers. He is an 

iconic figure who led us out of the desert of inflation and economic stagnation in the 1980s. Mr. 

Voicker is a man of principle and probity; is selfless and indifferent to financial gain; and is wise 

to the political shenanigans of powerful lobbies that perpetuate structural distortions that 

interfere with the public good. (In short, he is the perfect stuff of a central banker.) Most 

importantly, he understands the necessity of allowing for failure as a part of the process of 

creative destruction, especially so in the world of finance. 

Having referred to Moses, I trust that in this academic setting, I might be forgiven if I draw upon 

one of my fa vorite literary references to failure, albeit one that is other-worldly. In Paradise 

Lost, Jolm Milton has God telling us why he created men and angels, both of whom could betray 

Him: 

" .. .1 made [mankind]just and rigllt, 

2 
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Sufficient to have stood, though free to fa iL 

Such I created all th ' ethereal Powers 

And Spirits, both them who stood and them who failed; 

Freely they stood who stood, and fe ll who fell ... ,,5 

Milton considered the issue of failure on a much higher plane than the realm of bank regulatory 

policy. But the principle, expressed in that stanza of his paean to God's creation of the "ethereal 

Powers," applies equally to banking. Banks are created and given powers as mechanisms of 

credit intemlediation, in order to allow an economy to grow and become prosperous. Yet, if 

regulators-who oversee the creation of banks and monitor their business-can't secure capital 

structures at our largest financial institutions that are "just and right," and do not allow for 

institutions that "betray" their creators to be "free to fall," it is unlikely those financial 

institutions will fulfill their proper intemlediary role and be agents of economic prosperity. 

Thus far, regulators have failed in their mission of warding ofT betrayal. 

Perpetuating Obesity 

With each passing year, the banking industry has become more concentrated. Half of the entire 

banking industry'S assets are now on the books of fi ve institutions. Their combined assets 

presently equate to roughly 58 percent of the nation's gross domestic product (GDP). The 

combined assets of the 10 largest depository institutions equate to 65 percent of the banking 

industry's assets and 75 percent of our GDP. 

Some of this ongoing consolidation is the result of a dynamic set in place by Congress' passage 

of interstate branching legislation in 1994 and repeal of Glass- Steagall provisions in 1999. But 

some of it also reflects the result of the recent financial crisis. When difficulties began to appear 

at large financial institutions, resolution policies often entailed their merger or acquisition with 

other large institutions. Add to this the regulatory forbearance and financial backstops that tend 

to be granted to the largest banks in exigent circumstances, and the end result is a few financial 

behemoths, each with well over a trillion dollars in assets and a heavy concentration of power. In 

fact, the top three U.S. bank holding companies each presently have assets of roughly $2 trillion 

or more. 

Of course, problems in the banking sector have not been exclusively confined to large financial 

institutions. Regional and community banks have faced their own problems, especially 

connected to construction lending. But here is the rub: When smaller banks get in trouble, 

regulators step in and resolve them. The tenll "reso lve" in the conte;o..1 of smaller banks is a fancy 

way of saying their demise was quickly and nondisruptively arranged- they were disposed of. 

We might have expected equal treatment of big banks, but, of course, that did not happen.6 To be 

sure, some very large financial finns have ceased to exist or have been through a corporate 

reorganization with soIlle of the characteristics ofa Chapter II bankruptcy. But these institutions 

deemed ''100 big to fail," and deemed to be "systemically" important due to their size and 

complexity, were given preferential treatment. Many were absorbed by still larger financial 

institutions, thus perpetuating and exacerbating the phenomenon of 100 big to faiL 

This problem of supersized and hypercomplex banks is not unique to the United States. Europe is 

struggling today with how to cushion its megabanks from excessive exposure to intra-European 
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sovereign debt. And Japan is still feeling the negative impacts of not successfully resolving the 

financial difficulties at its megabanks two decades ago. 

A Penerse Lake Wobegon 

Why are too-big-to-fail institutions treated differently than smaller banks? Even Vinny 

Guadagnino knows the obvious answer to that question: In a system of large and/or 

intercolUlected banks, difficulties at one institution can easily spill over and take down other 

banks or even the entire industl)'. Fear of "systemic risk" conditions the treatment of financial 

behemoths. 

In today's intercolUlected, globalized financial system, systemic risk is more pronounced than 

ever. And we know that when a systemic crisis occurs-as it did in the Panic of 2008-09-the 

results can be catastrophic to the economy. Small wonder that in commenting on the problems 

currently besetting Europe, the U.S. Treasury secretary recently stated, "The threat of cascading 

default, bank nuts and catastrophic risk must be taken ofT the table. ,,7 This has become dogma 

among banking regulators and their minders. Thus, in the recently announced Greek bond deal, 

the Euro Summit Statement tells us that "Greece requires an exceptional and unique solution. ',s 

Such a solution is certainly in the interest of American bankers. In Saturday'S New Yo rk Times, it 

was reported that the Congressional Researc h Service has estimated that the exposure of U.S. 

banks to Portugal, Italy, Ireland, Greece and Spain amounted to $64 1 billion; American banks' 

exposure to Gemlan and French banks was in excess of an additional $1.2 trillion. According to 

the Bank for International Settl ements, U.S. banks have $757 billion in derivative contracts and 

$650 billion in credit commitments from European banks. Thus, the Congressional Research 

Service concluded that "a collapse of a major European bank could produce similar problems in 

U.S. institutions. ,,9 

In the land of the too-big-to-fails, we find ourselves in something akin to a perverse financial 

Lake Wobegon: All crises are "exceptional," and all require "unique solution(s)." 

Yet, it seems to me that in our desire to avoid "cascading default" and "catastrophic risk," and in 

our search for "exceptional and unique solution(s)," we may well be compounding systemic risk 

rather than solving it. By seeking to postpone the comeuppance of investors, lenders and bank 

managers who made imprudent decisions, we incur the wrath of ordinal)' citizens and smaller 

entities that resent this favorable treatment, and we plant the seeds of social unrest. We also 

impede the ability of the market to clear or, to paraphrase Milton, allow the marketplace to 

distinguish "freely" those who should stand and those who should fall. 

Enter Dodd- Frank 

I said earlier that financial crises are nothing new. Nor is the response to them: a flurry of 

legislation that ends up giving more power to regulators in the hope of preventing the ne:>..1 crisis. 

The Glass- Steagall Act was enacted during the Great Depression, the FDIC Improvement Act 

after the banking and savings-and-Ioan troubl es in the late 1980s. And now, in response to the 

Panic of 2008-09, we are implementing the Dodd-Frank Act. 

4 
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Dodd- Frank-which is OVer 2,000 pages long, contains 16 titles, 38 subtitles and a total of 541 

sections-is the most complex document ever written in the history of efforts to change the 

financial regulatory landscape. A cheeky historian might recall French Prime lini ste r Georges 

Clemenceau's reaction to Woodrow Wilson's 14 points, proposed as a safeguard for world peace 

after World War I: Clemenceau is reported to have thought that God did a pretty good job with 

only 10. 

Whether it is through 10 commandments or 14 points, or over 2,000 pages, the question is: Does 

Dodd- Frank appropriately confront systemic risk and the associated problem of too big to fail? 

Its preamble certainly states a desire to do so, declaring boldly that its purpose is to "end 'too big 

to fa il '" and "protect the American taxpayer by ending bailouts. "lo 

Dodd- Frank does, in fact, contain a munber of measures that attempt to address too-big-to-failism. It creates a Financial Stability Oversight COlUlcil----or FSOC-composed of the major 

financial-sector regulators charged with overseeing the entire financial system. TIle FSOC can 

recommend that important nonbank finns be brought under the regulatory umbrella. Those who 

will be brought under that umbrella will be subjected to periodic stress tests to make sure they 

can withstand reversals in the economy and other adverse developments. Dodd- Frank calls for 

enhanced capital requirements for SIFIs. And it provides for a new authority for resolving bank 

holding companies and other financial institutions that wasn't available to authorities during the 

recent crisis. 

Implementing Dodd- Frank 

Will it work? Will Dodd- Frank achieve the desired goals declared in its preamble? TIle devil, as 

always, is in the details of how the legislation is implemented. 

At the most basic level, the legislation leaves many of the details to rulemakings by various 

regulatory agencies; more than one year after enactment, there is still much work to be done in 

actually implementing the act. On Nov. I, the law finn of Davis Polk & Wardwell released its 

monthly progress report on Dodd- Frank implementation. According to that report, of the 400 

rulings required by the legislation, 173, or rough ly 43 percent, have not yet been proposed by 

regulators. Of the 141 rulemakings required of bank. regulators-the Federal Reserve, Federal 

Deposit Insurance Corp. and Office of the Comptroller of the Currencey-58, or about 41 

percent, have not yet been proposed. H 

Capital Requirements and an Atomic Reaction 

Whil e acknowledging that the specific regulations spawned by Dodd- Frank have yet to be 

perfected, one of the harshest criticisms of its treatment of SIFIs has come from my fornler 

colleague and president ofthe Kansas City Fed, Tom Hoenig, who is now the nominee to be vice 

chair of the FDIC. He has argued that the very existence of SIFls is "fundamentally inconsistent 

with capitalism" and "inherently destabilizing to global markets and detrimental to world 

growth.,,12 Moreover, according to Mr. Hoenig-who had unquestionably the greatest depth of 

regulatory experience of all the Federal Reserve presidents and govemors-even with the 

completion of Dodd- Frank, the existence of too-big-to-fai l institutions will likely remain and 

"poses the greatest risk to the U.S. economy. "J3 
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One might COIUlter that the enhanced capital requirements envisioned by Dodd- Frank-being 

negotiated presently by the Fed and other regulators nationally and internationally-will be a 

fitting treatment for too-big-to-fail-ism. In theory, it certainly sounds good. But as Paul Volcker 

has pointed out, "That's an old story.,,14 We 've had a system of international risk-based capital 

requirements in place for some time under the auspices of the Bank for International Settlements, 

beginning with Basel I in the early 1990s. TIlat Illorphed into Baseill in the early 2000s, and 

now we are introducing Basel III. In fact, in the U.S., we can go all the way back to the National 

Bank Act of 1864 to find a system of capital requirements on banks. 

Capital requirements are indeed important. A strong capital base protects a business when times 

get tough, giving it reserves to draw upon so that it can wait out a stornI. Applied to banks, it also 

should mitigate risk-taking incentives that are an inevitable by-product of our too-big-to-fail 

system: lf you put meaningful shareholder money directly at risk, managers of banks beholden to 

those shareholders wi ll be less tempted to take pie-eyed risks.ls 

TIle operative word in the previous sentence is "meaningful. " The existing regulatory measures 

were found wanting on measures of meaningful capital. For example, at the height of the crisis in 

mid-200S, two of the largest, most troubled institutions-Citigroup and Bank. of America-were 

considered "adequately capitalized" (or even higher), according to the then-prevailing regulatory 

criteria. The Belgian bank Dexia is another case in point. In a press release issued just last May, 

it highlighted its regulatory capital ratio of 13.4 percent as "confinning our Group's high level of 

solvency.,,16 

Winston Churchill used the phrase "ternlinological inexactitude" to suggest a certain lack of 

directness; one might easily conclude that there was some "inexactitude" surrounding the capital 

stmctures ofCiti, Bank of America and Dexia. 

I relum to Andrew Haldane of the Bank of England. Haldane makes an intriguing parallel 

between the financial system and epidemiological networks. Conventional capital requirements 

seek to equalize fa ilure probabilities across institutions to a certain threshold, say 0. 1 percent. 

But using a systemwide approach would result in a different calibration, if the objective were to 

set a firm's capital requirements equal to the marginal cost of its fai lure to the system as a whole. 

Regulatory capital requirements would then be higher for banks posing the greatest risk to the 

system, which is what Dodd-Frank proposes, and what the current Basel III requirements are 

also considering. 

To Haldane, this is a new approach in banking, but not in epidemiol ogy where "focusing 

preventive action on 'super-spreaders' within the network to limit the potential for systemwide 

spread" is the noml. As Haldane emphasizes, "If anything, this same logic applies with even 

greater force in banking.,,17 To me, treating too-big-to-fail institutions as potential "superspreaders" of financial gemls has a great deal of appeal. 

TIle latest round of international capital standards is seeking to correct for "tenninological 

inexactitude" and tighten up the definition of what banks can count as capital, so as to prevent 

"super-spreading." 11lat's good news. Yet, this effort is being met with fierce resistance from the 

SIFIs. Tom Hoenig once suggested that when regulators begin the process of tightening up the 

latitude granted the megabanks, they will find themselves "fac ing an atomic force of 

resistance.,,18 He appears to have been spot 011. The head of one of the major U.S. financial 

6 
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institutions has called these new proposals "anti-American.',19 Last Thursday, the Wall Street 

Journal wrote of "bankers seething over rising ... capital requirements.',2o Such is the intensity 

of emotion to resist the work of the Fed and other regulators as they seek to protect the system 

from the pernicious risk inherent in the existence of megabanks. 

We cannot let that resistance prevail. 

And we mllst insist, as Dodd- Frank does, that SIFls be required to submit a "living will " that 

describes their orderly demise. Credit exposure reports must also be submitted periodicall y to 

estimate the e:-.1ent of SIFl interconnectedness. We must see to it that the FDIC "ensure(s) that 

the shareholders of a covered financial company ... not receive payment until after all other 

claims ... are fully paid.,,21 nlis is essential to restoring the discipline of the marketplace and is 

what d.le F~d ex e~ts to achieve when it fi.na Jizes.its work on Se.ction 165 a.nd o~ler as,gects of 

the legIslatIOn, as discussed last week by VIce Chalf Janet Yellen III a speech III Chlcago"-

An AchilJes' Heel 

For all that it specifi cs to treat the unhealthy obesity and complexity of too-big-to-fails, DoddFrank has an Achilles' heel. It states that in the disposition of assets, the FDIC shall ''to the 

greatest e>..1ent practi cable, conduct its operations in a maIUler that ... mitigates the potential for 

serious adverse effects to the financial system.',23 111is is entirely desirable; nobody wants to 

initiate serious financial disnlption. But directing the FDIC to mitigate the potential for serious 

adverse effects leaves pl enty of wiggle room for fears of "cascading defaults" and "catastrophic 

risk" to perpetuate "exceptional and unique" treatments, should push again come to shove. 

I may be excessively skeptical on this front. Vigilantes of the bond and stock market, of which I 

was once a part, have been demanding greater transparency in reporting the exposures of the 

megabanks, including a more fulsome account of both gross and net exposures of credit default 

swaps. And Moody's has recently downgraded the long-Ienn debt of major U.S. and u.K. banks. 

This is oddly reassuring. Moody's said that "actions already taken by U.K. authorities have 

significantly reduced the predi ctability of support over the medium to long ternl,,,24 whereas in 

the U.S., it found "a decrease in the probability that the U.S. government would support [major 

banksj.',25 

Of course, the ratings agencies did not exactly cover themselves in glory during the crisis. Let 's 

hope their assessment of at least somewhat more limited government support fo r the megabanks 

proves more accurat e than the triple-A ratings they gave to so many mortgage-backed securities. 

The Alternative: Radical Surgery 

In short, progress is being made in the direction of treating the pathology of SIFIs and the 

detailing of enhanced prudential standards governing their behavior. Yet, in my view, there is 

only one fail-safe way to deal with too big to fail. I believe that too-big-to-fail banks are toodangerous-to-pennit. 26 As Mervyn King, head of the Bank of England, once said, "If some banks 

are thought to be too big to fail, then ... they are too big." I favor an international accord that 

would break up these institutions into morc manageable size. More manageable not only for 

regulators, but also for the executives of these institutions. For there is scant chance that 

managers of $1 trillion or $2 trillion banking enterprises can possibly "IOlOW their customer," 

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follow time-honored principles of banking and fashion reliable risk management models for 

organizations as complex as these megabanks have become. 

Am I too radical? I think not. I find myself in good company-Paul Volcker, for example, 

advocates "reducing their size, curtailing their intercomlectedness, or limiting their activiti es. "n 

In my view, downsizing the behemoths over time into institutions that can be pmdently managed 

and regulated across borders is the appropriate policy response. 111en, creative destmction can 

work its wonders in the financial sector, just as it does elsewhere in our economy. 

We shouldn't just pay lip service to letting the discipline of the market work. Ideally, we should 

rely on market forces to work not only in good times, but also in times of difficulties. Ult imately, 

we should move to end too big to fa il and the apparatus of bailouts and do so well before bankers 

lose their memory of the recent crisis and embark on another round of excessive risk taking. 

Only then will we have a financial system fit and proper for servicing an economy as dynamic as 

that of the United States. 

Thank you. 

Notes 

I I am thankful to Andrew Haldane of the Bank of England for coining this phrase. "Systemic 

Risk in Banking Ecosystems," by Andrew G. Haldane and Robert M. May, Nature, Jan. 20, 

2011, pp. 351- 55. 

2 "The Blob That Ate Monetary Policy," by Richard W. Fisher and Harvey Rosenblum, Wall 

Street Journal, Sept. 28, 2009. 

3 "Control Rights (and Wrongs)," speech by Andrew O. Haldane, executive director for financial 

stability and member of the Financial Policy Committee, Bank of England, Oct. 24, 20 11, Table 

1. 

4 "Thrce Years Latcr: Unfinishcd Business in Financial Rcform," by Paul Volcker, the William 

Taylor Memorial Lecture, Scpt. 23, 20 11, Washington, D.C., p. 8. 

5 Paradise Lost, Book III, by John Milton, New York: W.W. Norton and Co., 1993, lines 98-

102. 

6 "Financial Rcfoml or Financial Demcntia?," specch by Richard W. Fisher, June 3, 2010. 

7 Statcment by Trcasury Sccretary Timothy F. Oeitimcr, 24th Mccting of the hltemational 

Monetary and Financial Committee, Sept. 24, 2011, U.S. Department of the Treasury, Press 

Center. 

8 See "Euro Summit Statement," Bmssels, Oct. 26, 2011, p. 5. 

9 "European Tunnoil Could Slow U.S. Recovery," by Arulie Lowrey, New York Times, Nov. 12, 

2011. 

10 See the Dodd- Frank Wall Street Refoml and Consumer Protection Act, 

http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname= 111_ cong_ bills&docid 

h4173enr. xt. pdf 

II See "Dodd- Frank Progress Report," Davis Polk & Wardwell, November 201 1, 

www.davispolk.com/fileslPublication/c3379fb6-ab9d-4ed8-b873-0877696a80051 

Presentat ion/Pub I icat ionAttacrunentl690 13 Obe-02e6-403 7 -88e8-0 1 648c94664fl 

November20 II_Dodd. Frank.Progress. Report.pdf. 

12 "Do SIFIs Have a Future?," speech by 1110mas M. Hoenig, president and chief executive 

officer, Federal Reserve Bank of Kansas City, July 27, 2011. 

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i3 "Financial Refonn: Post Crisis?," speech by Thomas M. Hoenig, president and chief executive 

officer, Federal Reserve Bank of Kansas City, Feb. 23, 2011 . 

14 See note 4, p. 5. 

15 Given the opacity of bank balance sheets and the arcane accolUtting practices whereby very 

similar assets can be valued differently in many circumstances, the discipline imposed on bank 

managers by shareholders has been limited, in both megabanks and smaller banks. 

16 "Net Profit of EUR 69 Million in IQ2011. Strong Operational Perfonnance by the 

Commercial Business Lines. Transfornlation Plan Ahead of Schedule," Dexia press release, May 

1I, 201L 

17 See note 1. 

18 "It's not Over 'Til II 's Over: Leadership and Financial Regulation," speech by lllOmas M. 

Hoenig, president and chief executive officer, Federal Reserve Bank of Kansas City, Oct. 10, 

2010. 

19 "JPMorgan Chief Says Bank Rules' Anti-US, '" by Tom Braithwaite and Patrick Jenkins, 

Financial Times, Sept. 11 , 2011 . 

20 "Fed Governor Al lays Banks," by Victoria McGrane, Wall Street Journal, Nov. 10, 2011. 

21 Dodd- Frank Act, Section 206. 

22 "Pursuing Financial Stability at the Federal Reserve," speech by Janet Yellen, vice chair of the 

Federal Reserve Board of Governors, Nov. 11, 2011 , www.federalreserve.gov/newsevents/ 

~feec ye ll en20 111111 a:htm . 

• Dodd- Frank Act, Seclion 21O. 

24 "Rating Action: Moody's Downgrades 12 UK Financial Institutions, Concluding Review of 

Systemic Support," Moody's Investors Service, Oct. 7, 2011. 

25 "Rating Action: Moody's Downgrades Wells Fargo & Company Rating," Moody's Investors 

Senrice, Sept. 21 , 2011 (similar rdeases appeared on the same date for Citigroup and Bank of 

America). 

26 See "Lessons Learned, Convictions Confirnled," speech by Richard W. Fisher, March 3, 2010, 

and "Minsky Moments and Financial Regulatory Refonn," speech by Richard W. Fisher, April 

14, 2010. 

27 See note 4, p. 9. 

9