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53–822 PDF 2010

S. HRG. 111–179 

REGULATION AND RESOLVING INSTITUTIONS 

CONSIDERED ‘‘TOO BIG TO FAIL’’ 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

REGULATING AND RESOLVING INSTITUTIONS WHOSE FAILURE WOULD 

POSE A RISK TO THE FINANCIAL SECTOR AND UNDERLYING ECONOMY IN THE UNITED STATES 

MAY 6, 2009 

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

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

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 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

EDWARD SILVERMAN, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

AMY FRIEND, Chief Counsel 

DEAN SHAHINIAN, Senior Counsel 

MARK OESTERLE, Republican Chief Counsel 

DAWN RATLIFF, Chief Clerk 

DEVIN HARTLEY, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

(II)

C O N T E N T S 

WEDNESDAY, MAY 6, 2009 

Page 

Opening statement of Senator Dodd ...................................................................... 1 

WITNESSES 

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation .................... 3 

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

Response to written questions of: ....................................................................

Senator Vitter ............................................................................................ 108 

Gary H. Stern, President and Chief Executive Officer, Federal Reserve Bank 

of Minneapolis ...................................................................................................... 5 

Prepared statement .......................................................................................... 56 

Response to written questions of: ....................................................................

Senator Vitter ............................................................................................ 112 

Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute ..................................................................................... 32 

Prepared statement .......................................................................................... 80 

Response to written questions of: ....................................................................

Senator Vitter ............................................................................................ 114 

Martin Neil Baily, Senior Fellow, Economic Studies Program, the Brookings 

Institution ............................................................................................................. 33 

Prepared statement .......................................................................................... 91 

Response to written questions of: ....................................................................

Senator Vitter ............................................................................................ 116 

Raghuram G. Rajan, Eric J. Gleacher Distinguished Service Professor of 

Finance, University of Chicago, Booth School of Business ............................... 35 

Prepared statement .......................................................................................... 102 

(III)

(1) 

REGULATION AND RESOLVING INSTITUTIONS 

CONSIDERED ‘‘TOO BIG TO FAIL’’ 

WEDNESDAY, MAY 6, 2009 

UNITED STATES SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, D.C. 

The Committee met, pursuant to notice, at 9:05 a.m., in room 

SD–538, Dirksen Senate Office Building, Senator Christopher J. 

Dodd (Chairman of the Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD 

Chairman DODD. The Committee will come to order. 

Let me apologize to my colleagues and the witnesses as well. It 

was a late hour last night when we changed the schedule, but as 

I am sure my colleagues are aware, anyway, we are going to have 

about six votes beginning around 10:30 to try and finish up the 

housing bill. And, therefore, I thought we would try to move this 

up a half an hour so we could have at least a good hour and a half 

with you. 

I am going to ask my colleagues to restrain themselves, if they 

can, in opening statements so we can get right to the witnesses and 

hear their thoughts. 

Sheila, welcome. Nice to have you back before the Committee. 

Let me just share some opening comments. Senator Shelby has 

a meeting. He will be here shortly. He had something around 9:10, 

so he will be coming along. I am going to begin. Normally, of 

course, I would wait for my colleague from Alabama, but in light 

of the fact of the change in the time here, we are going to begin, 

anyway, on this. So let me share some opening thoughts on this 

subject matter, and then we will go right to the witnesses. 

This morning is the 13th in a series of hearings since January 

to identify causes of the financial crisis and specific responses that 

will guide the Committee’s formulation of the new architecture for 

21st century financial services regulation. I welcome all of our witnesses. 

This morning, we are going to discuss regulating and resolving 

institutions whose failure would pose a risk to the financial sector 

and our underlying economy. To be sure, we meet at a moment 

when many of these so-called ‘‘too-big-to-fail’’ institutions are under 

a microscope, and for good reason. Consider for a moment the following financial institutions: Bear Stearns, Fannie and Freddie, 

Lehman Brothers, AIG, Washington Mutual, Wachovia, Citigroup, 

Bank of America. Inside of 14 months, every one of these institutions either failed or posed a risk of failing absent Government 

2 

intervention. Some were sold under duress; others failed outright. 

Many were saved because the Government resorted to an array of 

loans, guarantees, and capital injections to keep these large, complex financial firms afloat. 

But, regardless, the result of this turmoil is clear, with 20,000 

layoffs and 10,000 homeowners entering into foreclosure each and 

every day. As this Committee works to modernize our financial architecture, I believe it is essential that we identify ways to give the 

Government the tools it needs to unwind troubled, systemically important institutions in an orderly way that will put adequate safeguards in place to prevent unwarranted risky behavior on the part 

of the largest market actors and puts our economy at risk. And I 

would commend the administration again for sharing my belief 

that the resolution authority be given to the FDIC, with whom the 

expertise of unwinding failed institutions clearly lies. 

To be sure, we have seen unprecedented consolidation in the 

banking industry over the last few decades. In 1992, the 25 largest 

insured depository institutions accounted for a quarter of banking 

industry assets. As of 2008, the top 25 held over 60 percent of industry assets. Four U.S. bank holding companies now have over $1 

trillion each in banking assets. 

At the same time the industry became increasingly consolidated, 

the institutions themselves became more interconnected, and as 

many of these failures have illustrated, their relationships with one 

another even more complex. The growth of the largely unregulated 

credit derivatives market and the ability to process transactions 

with increasing speed added to the unprecedented level of complexity as well. 

But it was the performance of our regulators, in my view, that 

spun this all out of control, allowing these financial institutions to 

take on more and more risk, more and more leverage, with far too 

much autonomy and far too little accountability. Essentially, regulators took our largest financial institutions at their word that they 

understood what they were doing, and clearly they did not. In fact, 

some had no idea at all. 

The question before this Committee today is how to prevent this 

from happening again and how do we create an architecture to 

allow for wealth creation and for productivity to be restored. 

Some have looked at the failure of many large, complex financial 

firms to manage their risks and the failure of regulators to adequately supervise them. They concluded that we can no longer afford to let institutions grow to a point where they put our financial 

system at risk. As economist Joseph Stiglitz has put it, many of 

these institutions became not just ‘‘too big to fail,’’ but also too big 

to save and too big to manage. 

Some would strictly limit the size of balance sheets or restore 

some of the restrictions on business line affiliations lifted a decade 

ago. Another option would be to impose more stringent capital requirements, deposit insurance assessments, and other costs to provide disincentives to becoming either too big or to complex. And 

still others suggest that it is unrealistic to believe that we could 

somehow abolish large, complex financial organizations. They suggest designing a regulatory framework that would make sure that 

taxpayers are not on the hook each time one of these companies 

3 

gets in trouble. That would mean finding ways to ensure that the 

creditors as well as the shareholders can suffer losses when these 

companies get in trouble. 

As Warren Buffett said last week, the key to ensuring large financial institutions are run well is not only proper incentives for 

success, but also severe disincentives for failure. 

The truth is, unlike the average family in my State or my colleagues’ States who has no choice but to live within their means, 

the large institutions throughout the crisis were always able to borrow more, draw down more, and relax their underwriting standards as their regulators stood by. Whatever else we do, that has 

to stop, in my view. Large financial companies may well need a different set of capital rules to ensure that they will have sufficient 

funds to absorb large, unprecedented losses. They may need new 

disclosure and responding requirements that would enable regulators to close them in an orderly way if they become troubled. If 

the AIG contemporary mess that this Committee helped to expose 

has taught us anything, it is that regulators need a much clearer 

picture of the arrangement that these firms get themselves into, 

not only to regulate them better but to extricate them from those 

arrangements if need be. 

Each of these approaches that I have mentioned this morning 

has merit, and it is my hope that today’s hearing will offer an opportunity to fully explore each of these options. 

I will say again that I believe there is a need for systemic risk 

regulation to ensure that we no longer need to treat any institution 

as ‘‘too big to fail.’’ It is my preference that that authority not lie 

in one body. We cannot afford to replace Citi-sized financial institutions with Citi-sized regulators. The goals of our financial modernization efforts must be more transparency, more accountability, 

and more checks and balances. Today’s witnesses I think will help 

us become better informed as to these steps. 

With that, I thank again everyone for being here, and, Sheila, we 

will begin with you. 

STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL 

DEPOSIT INSURANCE CORPORATION 

Ms. BAIR. Good morning, Chairman Dodd, members of the Committee. Thank you for the opportunity to testify on the need to address the issue of systemic risk and the existence of financial firms 

that are deemed ‘‘too big to fail.’’ 

The financial crisis has taught us that too many financial organizations have grown in both size and complexity to the point that 

they pose systemic risk to the broader financial system. In a properly functioning market economy, there will be winners and losers. 

When firms are no longer viable, they should fail. Unfortunately, 

the actions taken during the recent crisis have reinforced the idea 

that some financial organizations are ‘‘too big to fail.’’ The most important challenge now is to find ways to impose greater market discipline on systemically important financial organizations. Taxpayers have a right to question how extensive their exposure 

should be to such entities. 

A strong case can be made for creating incentives that reduce the 

size and complexity of financial institutions. A financial system 

4 

characterized by a handful of giant institutions with global reach, 

even with a single systemic regulator, is making a huge bet that 

they will always make the right decisions at the right time. 

There are three key elements to addressing the problem of ‘‘too 

big to fail.’’ First, financial firms that pose systemic risks should 

be subject to regulatory and economic incentives that require these 

institutions to hold larger capital and liquidity buffers to mirror 

the heightened risk they pose to the financial system. In addition, 

restrictions on leverage and the imposition of risk-based assessments on institutions and their activities would act as disincentives 

to the types of growth and complexity that raise systemic concerns. 

The second important element in addressing ‘‘too big to fail’’ is 

an enhanced structure for the supervision of systemically important institutions. This structure should include both the direct supervision of systemically significant financial firms and the oversight of developing risks that may pose risks to the overall U.S. financial system. 

Centralizing the responsibility for supervising these institutions 

in a single systemic risk regulator would bring clarity and accountability to the efforts needed to identify and mitigate the build-up 

of risk at individual institutions. In addition, a systemic risk council could be created to address issues that pose risks to the broader 

financial system by identifying cross-cutting practices and products 

that create potential systemic risk. 

The third element to address systemic risk is the establishment 

of a legal mechanism for quick and orderly resolution of these institutions similar to that which we use for the FDIC-insured banks. 

Over the years we have used this to resolve thousands of failed 

banks and thrifts. The purpose of the resolution authority should 

not be to prop up a failed entity indefinitely or to insure our liabilities, but to permit a timely and orderly resolution and the reabsorption of assets by the private sector as quickly as possible. Done 

correctly, the effect of the resolution authority will be to increase 

market discipline and protect taxpayers. 

For example, our good bank/bad bank model would allow the 

Government to spin off the healthy parts of an organization while 

retaining the bad assets that we could work out over time. To be 

credible, the resolution authority must be exercised by an independent entity with powers similar to those available to the FDIC 

to resolve banks and clear direction to resolve firms as quickly and 

inexpensively as possible. 

To enable the resolution authority to be exercised effectively, 

there should be a resolution fund paid for by fees or assessments 

on large, complex financial organizations. To ensure fairness, there 

should be a clear priority system for stockholders, creditors, and 

other claimants to distribute the losses when a financial company 

fails. 

Finally, separate and apart from establishing a resolution structure to handle systemically important institutions, our ability to resolve non-systemic bank failures would be greatly enhanced if Congress provided the FDIC with the authority to resolve bank and 

thrift holding companies affiliated with a failed institution. By giving the FDIC authority to resolve a failing bank’s holding company, 

Congress would provide the FDIC with a vital tool to deal with the 

5 

increasingly complicated and highly symbiotic business structures 

in which banks currently operate. 

The choices facing Congress in addressing ‘‘too big to fail’’ are 

complex, made more so by the fact that we are trying to address 

problems while dealing with one of the greatest economic challenges we have seen in decades. The FDIC stands ready to work 

with Congress to ensure that the appropriate steps are taken to 

strengthen our supervision and regulation of all financial institutions—especially those that pose systemic risk. 

Thank you. 

Chairman DODD. Thank you very much. 

Mr. Stern, who is the President, I should point out, of the Federal Reserve Bank of Minneapolis, welcome to the Committee this 

morning, and thank you for accommodating the change in time as 

well. 

STATEMENT OF GARY H. STERN, PRESIDENT AND CHIEF EXECUTIVE OFFICER, FEDERAL RESERVE BANK OF MINNEAPOLIS 

Mr. STERN. Chairman Dodd, members of the Committee, thank 

you for the opportunity to review the ‘‘too-big-to-fail’’ problem with 

you today. The key to addressing ‘‘too big to fail’’ is to reduce substantially the negative spillover effects stemming from the failure 

of a systemically important financial institution. Before briefly 

going into specifics, I want to emphasize that these remarks reflect 

my views and not necessarily those of the Federal Reserve. 

To address the ‘‘too-big-to-fail’’ problem, we must understand the 

incentives of uninsured creditors of systemically important financial institutions, the incentives of the management of such institutions, and the incentives of policymakers responsible for economic 

and financial stability. We have a ‘‘too-big-to-fail’’ problem because 

creditors of such financial institutions expected, on the basis of relatively well-established precedents and on an understanding of policymakers’ motivations, that protection would be provided if failure 

threatened. As a consequence, they had a most modest incentive to 

monitor the condition and prospects of these large institutions, 

leading to underpricing of risk taking. With risk underprices, and 

for a variety of other reasons as well, these institutions took on excessive amounts of it, leading eventually to the precarious position 

of some of them. And policymakers, fearing massive negative spillover effects to other institutions, financial markets more generally, 

and the economy itself, provided protection and validated creditor 

expectations. 

Just as incentives are at the heart of the ‘‘too-big-to-fail’’ problem, they necessarily must be at the heart of the solution. To address incentives, policymakers must deal with them at their core. 

Creditors must be put at risk of loss. 

Once uninsured creditors face appropriate incentives and change 

their behavior, the risk taking of systemically important institutions should diminish, reducing policymakers’ concerns about 

spillovers. I have long maintained that ‘‘too-big-to-fail’’ bailouts are 

driven by concerns about potentially serious spillover effects. As a 

result, I recommend reforms that reduce the perceived or real 

threat of the spillovers that motivate after-the-fact protection of unVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
6 

insured creditors, recognizing that policymakers first need to address the short-term problems in the financial system. 

I would start with three reforms that combined I call ‘‘systemically focused supervision.’’ 

First, I would increase supervisory focus on preparation for the 

potential failure of a large financial institution. This preparation 

will reveal the interconnections between firms and markets that 

may produce serious spillovers and identify the steps policymakers 

must take to address them. 

Second, I would enhance the existing prompt correct action regime by including forward-looking market data. This would help 

identify weak institutions that need early closure, which should reduce the losses and spillovers such institutions impose on others. 

Finally, I would advocate forthright communication of efforts to 

put creditors of systemically important firms at risk of loss. Creditors are not mind readers, and policymakers cannot expect them to 

divine the intention to put them at risk absent clear communication to that effect. 

I also support Government pricing through insurance premiums, 

for example, of the activities of systemically important financial institutions that potentially create significant negative spillovers. 

This seems like an efficient method for taking costs imposed on society and putting them rightly back on the firms to influence their 

behavior. I have considered other options as well for taking on ‘‘too 

big to fail’’ and discuss them in the written testimony. 

In contrast to these proposals, increasing the intensity of traditional supervision and regulation of large institutions has no clear 

ability to improve incentives and ultimately imposes losses on 

creditors. While I support efforts to improve it, I recognize that the 

recent record of traditional supervision and regulation in preventing excessive risk taking by systemically important firms is not 

encouraging. 

I have the same general reaction to proposals to reduce the size 

of large financial institutions. I have no particular empathy for 

managers and equity holders of large firms, but think efforts to 

break up these organizations will result in a focus on a very small 

number, thereby leaving many systemically important firms as is. 

Moreover, I am skeptical for the reasons noted previously that policymakers will effectively prevent the newly constituted smaller 

firms from taking on risks that can bring down others. In short, 

this reform does not seem to alter incentives sufficiently. 

I am more supportive of efforts to bring bank-like resolution regimes to non-bank but systemically important financial institutions. These proposals address some important spillovers and likely 

would work best if combined with the reforms I have already advocated. 

In closing, maintaining the status quo with regard to ‘‘too big to 

fail’’ could impose large costs on the U.S. economy. The economy 

cannot afford and does not have to ensure such costs. I encourage 

you to focus on proposals that address the underlying reason for 

protection of creditors of ‘too-big-to-fail’’ financial institutions, 

namely, policymaker concerns about financial spillovers. I have offered a plan to address this crucial point. Absent this or a similar 

7 

approach, I am concerned that we will not make significant 

progress against ‘‘too big to fail.’’ 

Thank you. 

Chairman DODD. Thank you very much, Mr. Stern. We appreciate it. We appreciate both of you being with us. 

I will have the clerk turn on the clock. We will take about 5 minutes apiece or so as we move along here. I will not be rigid about 

it, but I will try to make sure everyone here—we have only a few 

members here this morning. 

Let me begin with you, Mr. Stern. You addressed this at least 

in your opening comments, and I wonder if you might be a bit more 

specific about it, and that is, this resolution mechanism we are 

talking about. I mentioned in my opening comments about the 

Treasury sort of embracing the idea that the FDIC probably has, 

of the existing regulatory agencies, the expertise and the background given their experience in dealing with banks to move in 

this direction. I wonder how you might react to it. Is there some 

idea of a bankruptcy court idea that may be more appealing? Can 

the FDIC, in your view, fill this function? What are your more specific—— 

Mr. STERN. Well, I am in favor of a bank-like resolution process 

for systemically important non-bank financial firms. I have been 

giving more thought, rather than to who, to how, and what I mean 

by that is it seems to me it is important that the resolution regime 

be established in a way that losses can, in fact, be put on uninsured creditors. And that requires, it seems to me, preparation in 

advance. That is, it gets to the spillover question I alluded to in 

my testimony. 

Policymakers will be unwilling to impose losses on creditors if 

they think the spillovers are going to do significant damage to 

other financial institutions, markets more generally, and the economy. So you want to prepare in the sense of both identifying, limiting, containing, and other ways of constraining the potential for 

spillovers. That has to be part of the preparation, in my judgment, 

for the effectiveness of that kind of resolution regime. 

Chairman DODD. Okay. Let me raise this with both of you, if I 

can. Peter Wallison is going to testify in our second panel, be a witness in the second panel, and he raises an interesting concern: that 

a new system that tries to identify, regulate, resolve systemically 

important financial institutions may create a new class of protected 

companies that enjoy lower funding costs due to perceived Government backing and the like. I find that idea he has is intriguing, one 

that needs to be addressed. He sees this framework as expanding 

the safety net and adding moral hazard to the financial system in 

a way. 

Sheila, how do you react to that? 

Ms. BAIR. I think the concern relates to what we are talking 

about. We are talking about a resolution mechanism, not a bailout 

mechanism, and we think if you are going to create a new systemic 

risk regulator and identify it, particularly if that will involve identifying in advance institutions that could be systemic, that to do 

that without a separate resolution mechanism would dramatically 

increase moral hazard, because then you would be anointing instiVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
8 

tutions as those that the Government would continue to step in 

and support. 

So we think there needs to be a resolution mechanism that takes 

care of that, but we would certainly hope that Congress, if you took 

this step, would clearly set out a claims priority and say that the 

private stakeholders—the shareholders, and the unsecured creditors—would take losses and the priority for collateralized counterparties, et cetera. Also, the direction should be to resolve the institution promptly, not to just keep it going, but to break it up. I 

think a good bank/bad bank model would be a good one. We are 

set up already with our bridge bank authority to do that type of 

model. 

There was a good op-ed in the Wall Street Journal yesterday by 

Glenn Hubbard outlining that type of approach. Others have talked 

about it as well. But I think we need to be very clear that we are 

talking about a resolution mechanism, not a bailout mechanism, if 

we do that. 

Chairman DODD. Mr. Stern, do you want to comment on that? 

Mr. STERN. Sure. I think that the issue that Peter Wallison identified is a serious and potential concern, and that is why I put my 

emphasis on imposing losses on creditors and making it known 

well in advance not only that you intend to do it, but you have put 

yourself in a position where you are, in fact, able to do it. So I—— 

Chairman DODD. Yes, is this sort of the Warren Buffett disincentives, the thing he talked about, having the serious—there are incentives to do things, and then there ought to be disincentives. 

Mr. STERN. Sure. 

Chairman DODD. Go ahead. I did not mean to interrupt. 

Mr. STERN. No. That was the sum and substance of my comment. 

Chairman DODD. Okay. Let me, if I can—by the way, I want to 

raise, Sheila, with you the issue of the idea of looking at—we are 

having a lot of conversations among ourselves and others about 

this structure and architecture. Nothing has been decided firmly, 

but there is a lot of conversation, obviously, about how to approach 

this. 

One of the conversations that we are having among ourselves is 

this systemic risk regulator and the idea of having maybe more of 

a council idea rather than a single regulator. And, again, the single 

regulator idea has a certain amount of appeal because there is an 

existing structure. It is the known. If we start talking about a 

council or a collegial approach, you are talking about something 

new. And, obviously, when you start talking about things new and 

how does it work—without trying to express the views of all of my 

colleagues, those who are sort of attracted to this idea, it is a multiple set of eyes looking at something, rather than a single set of 

eyes. I wonder if you might share some thoughts on that. 

Ms. BAIR. Well, yes. We make a distinction between the potential 

oversight of systemic institutions, and the broader need for a coordinating body to be looking at the system for risk, for interrelationships among securities firms, banks, hedge funds and insurance companies. That is really where we saw some serious 

shortcomings. 

So we think for that latter issue, a council is much better 

equipped to deal with those types of systemwide issues that cross 

9 

markets and cross different types of institutions. We think that 

would work, and the President’s working group could transition 

into something like that. But it should be a real authority with the 

ability to set rules, for instance, set capital standards that might 

be across markets to make sure there is no arbitrage of capital 

standards, which we have had. The council should have the ability 

to write rules and collect data—those types of legal authorities. 

Yes, we think a council is much better suited for addressing that 

type of risk. 

Chairman DODD. Do you have any quick comments on that, Mr. 

Stern? I do not know if you have heard—— 

Mr. STERN. I think if we established a systemic risk regulator, 

it would be very important what we ask them to do, and I would 

put at least a good deal of emphasis on making sure that we identified and understood the interconnections, the large exposures 

among important firms, large reliance on particular markets, what 

happens if a particular market were, for whatever combination of 

reasons, to shut down and so on and so forth. 

Exactly who ought to do it, I might have a preference for having 

only one or two institutions do it as opposed to a council because 

of accountability. But I must admit I do not have a firm conviction 

about that. 

Chairman DODD. Thank you. 

Senator Johanns? 

Senator JOHANNS. Thank you, Mr. Chairman. 

Let me, if I could, think out loud for a second, and then I would 

like your reaction to this. As I have sat through these hearings, 

there are dozens of complicated issues. You mentioned holding companies, for example. That in itself you could spend weeks on trying 

to figure that out. But I agree with you there needs to be something done here. There seems to be a real lack of ability to deal 

with that issue. 

But, in my mind, when I kind of think about what we are trying 

to figure out here, I am thinking about three areas, kind of three 

umbrella areas. The first one is oversight. When you are dealing 

with systemic risk, how do you put in place the oversight to deal 

with that? 

The second piece of this is the bailout piece. I would like to be 

able to sit here today and say to the American public this is never 

going to happen again, thank goodness that is behind us. But the 

reality is we have to have something in place because the oversight 

will not be effective if you do not have the next step. 

And then the third piece of this or the third umbrella is exit 

strategy. Once you are entangled in oversight bailout, how do you 

get yourself out of it? I would tell you personally I am personally 

appalled by this discussion by the Treasury Secretary, even the 

President has acknowledged, well, there may be other CEOs that 

get fired, and I am using my own words there. I never thought I 

would live long enough to see the day that somebody walked into 

the White House, a CEO in a private company, and left without 

their job. I just find that very, very troubling in terms of governmental intervention. 

Now, the first question about the first umbrella, the oversight. I 

like this idea of the panel, a group versus a person. Let me ask you 

10 

this: Is there a governmental structure in place where that panel 

would fit? And I must admit I have the FDIC in my mind, and so, 

Sheila, I am just going to ask you directly: Is that something that 

fits within the FDIC? 

Ms. BAIR. It could fit within the FDIC. We already have two 

other principals on our board. The head of the OCC and the OTS 

are, by statute, on our board. We already have all but one of the 

banking regulators represented on our board, so it could be modeled along those lines. 

We think the President’s Working Group may be another model. 

That is an informal group that was set up by Executive Order after 

the 1987 market breakdown, and it has been a more informal way 

for regulators to have discussions and information sharing. That 

might be another model. 

Gary is right, it creates a little more complexity if you have a 

number of different people involved. But, this is so important, especially rearding the decision to resolve a systemically important institution. If you have the resolution authority, too, having multiple 

players involved in that decision is key. I am assuming that there 

will be some consolidation among banking regulators. So we suggest in the testimony that the Federal Reserve Board, the U.S. 

Treasury, the FDIC, and the SEC would be a good starting point. 

But, yes, the FDIC Board currently has the principals of other 

agencies on it, and it works pretty well. 

Senator JOHANNS. The FDIC seems to work very well. You go in 

and you make very tough decisions, and yet it does not disrupt our 

economy. 

Ms. BAIR. Right. Well, we think so. It is a painful process to close 

a bank, there is no doubt about it. And, we kind of joke internally 

about who else would want this responsibility. Who would you give 

it to? It is hard. You do get rid of management, and sometimes the 

lower-level employees lose their jobs, too. For the smaller banks, 

we always try to sell the whole bank to another local institution 

to provide that continuity of customer services and employees. 

But, it is a painful process. It does involve some specialized expertise, some specialized public relations in dealing with the communities that are impacted. But, we are well equipped. We have 

contractors in place that deal with asset management and auctioning assets or auctioning whole banks. I think we already have 

much of the talent that is out there now to deal with troubled institutions. We have been doing this for 75 years. We have resolved 

thousands of institutions. 

Senator JOHANNS. Gary, now if I could turn to you, and I am just 

about out of time, so I will have to urge you to answer a very complex question very, very quickly. But on the bailout and exit, what 

role do you see for the Federal Reserve in those areas? For example, yesterday Chairman Bernanke provided us with the balance 

sheets showing the various things that had been done. Is this a 

matter where in these two areas if we work to clean up their authority and deal with those kinds of issues, is that a workable approach? 

Mr. STERN. Well, let me be brief and just make two comments. 

I think one of the objectives should be to reduce the probability 

and magnitude of bailouts going forward. 

11 

Senator JOHANNS. I agree. 

Mr. STERN. And I think we can reduce the probability. I think 

we can reduce the extent of coverage, both who is covered and the 

amount of coverage. But it is going to take preparation and some 

of the steps I mentioned at the outset in terms of dealing with the 

incentives that uninsured creditors and policymakers confront. 

That is really all about preparation at the end of the day. It needs 

to be done in stable, relatively tranquil times. Obviously, in the 

midst of the crisis, it is very hard to work on those kinds of things. 

As far as exit strategy, I guess I would make one comment, and 

that is, I think that is mostly about credibility, and what I mean 

by that is we have to try to put ourselves in a position so that even 

if you do have to bail somebody out because the cost/benefit calculation suggests that is the right thing to do for the economy as 

a whole, so even if you do that, you want to make sure that the 

next steps you take reduce the probability that you will have to do 

it again. 

Senator JOHANNS. Thank you. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator, very much. 

Senator Bennet. 

Senator BENNET. Thank you, Mr. Chairman. Thank you for holding the hearing, and thank you for your testimony. 

Mr. Stern, I wanted to come back to something you said a minute 

ago; when we think about the systemic risk regulator, that it is important that we think about what we are asking them to do. One 

of the things that I have been struck by in my conversations with 

people in the financial industry is not just that this is a leverage 

problem, a ‘‘too-big-to-fail’’ problem, but it may also be a complexity 

problem, particularly in a rising market, the tendency to create 

more and more complex instruments that people cannot necessarily 

keep track of, either in their scope or in their relationships among 

various financial institutions. 

I wonder in the context of thinking about—and I guess the other 

thing I would say is it makes a person somewhat skeptical that an 

incentive and disincentive regime is ever going to be strong enough 

to counteract those temptations. 

I guess my question to you is how do we manage to keep up with 

that level of complexity without diminishing the innovation that all 

of us need to see in our financial markets, but at the same time 

prospectively protect us from the kind of collapse that we have just 

faced? 

Mr. STERN. Well, I think there are several aspects to that. One 

is, certainly, I am not trying to curtail appropriate innovation in 

the financial markets. I think, to the extent that we get the incentive—improve the incentives, we will get better pricing of risk. And 

that will deal directly with some of the concerns you have and the 

development of some of these instruments that, obviously, with the 

benefit of hindsight anyway, contained a good deal more risk than 

was appreciated at the outset. So I think that is one way to go. 

I think something we can also probably do in the supervisory 

area is where we see a very complex structure of an organization, 

ask about the economic rationale for that structure. And it is very 

good economic rationale for having X-hundred subsidiaries, for exVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
12 

ample. And if not, we could ask for streamlining of that kind of 

structure. So I think that is something else that could be done to 

help clarify the situation. 

I should also add—and this will be my final comment right now 

on this—is I think it is not just a question of incentives. I think 

‘‘too big to fail’’ is a big, challenging problem. We need to improve 

incentives where we can. We also need to improve capital where we 

can. We should charge institutions some kind of insurance premiums, as I commented, where they are of systemic importance 

and pose systemic risks. I think we really need to address this on 

a number of fronts. 

Senator BENNET. Chairwoman Bair, I do not know if you would 

like to add anything to that. As I have puzzled through the news 

accounts of this, one of the things you are really struck by is how 

evolutionary all of this is. You start out with credit default swaps 

that are based on one set of assets, and then you move over time 

to another set of assets, mortgages. And people lose track; the risk 

gets higher. 

I just wonder how we are going to write those rules in such a 

way that we are going to stay ahead of the curve rather than following behind. 

Ms. BAIR. Well, it is a challenge. And that is why we think there 

is a need to have greater market discipline. Too big to fail has diluted market discipline. There is only so much regulators can do, 

and you really need the market. You need people who want to invest or extend credit to these institutions, looking at their balance 

sheet, looking at their management, looking at the sophistication 

of their management and the risk management systems. What are 

their off-balance sheet exposures—are they done with proprietary 

trading, structured finance? All the things that we have seen have 

posed heightened risks for these larger institutions. 

You want the private sector in there looking at that as well. If 

they think the institution is ‘‘too big to fail,’’ you are going to dilute 

market discipline. And that is why we think it is particularly important to have a resolution authority. 

We also think that an assessment system can complement and 

enhance regulation. We have risk-based insurance assessments 

now for depository institutions. So there are certain categories of 

higher risk activity where we charge them a higher insurance assessment, for instance, for excessive reliance on broker deposits. 

This can also influence behavior, and I think this would be another 

tool that should be used for the systemic institutions. 

Senator BENNET. I am going to ask the Chairman’s indulgence 

because while I have got you here, I want to ask a slightly unrelated question about New Frontier Bank in Greeley, Colorado, 

which I know you are aware of. I wonder if you might say a word 

about where we are with that; and, also, more broadly, in the context of a region like that, a rural part of my state, where the local 

economy is heavily reliant on one institution, namely that one. 

That carries with it its own systemic risk for that little corner of 

the world. 

I wonder if you might talk a little about that situation; also, 

more broadly, the FDIC’s approach in an area like that versus one 

where there are many other options. 

13 

Ms. BAIR. Well, we did. We had a nice chat with Congresswoman 

Markey yesterday, too, about this. 

For the depositors, we have arranged for another bank to take 

over their accounts and help them transition into a new deposit account relationship. And for the loans, we are trying very hard to 

find other lenders to refinance those loans or to purchase them. 

I think one of the things where we engaged Congresswoman 

Markey, and I will take the opportunity to engage you as well, is 

to encourage other local lenders in the area to work with us and 

help these borrowers find new lending relationships. We are working very hard on that, and have been providing some additional financing out of the receivership to borrowers as we seek to transition them to lenders that are stronger. 

But we would love to work with your office. We talked with her 

about maybe having a town hall meeting. So we would be happy 

to work with you on that. 

Senator BENNET. Thank you. I would appreciate that. 

Mr. Chairman, thank you very much. 

Chairman DODD. Thank you, Senator. 

Senator Bunning? 

Senator BUNNING. Thank you, Mr. Chairman. 

Mr. Stern, do you think the market disruption, following Bear 

Stearns’ bailout and Lehman Brothers’ failure, in other words, the 

government picking a winner and a loser, was because of the bankruptcy itself or because everybody expected the creditors would be 

saved and the market had to adjust their expectations when they 

let Lehman go? 

Mr. STERN. I do think that when Lehman was let go, that probably came as a surprise to at least some of the creditors of Lehman, 

even though, of course, I think it was widely known in the financial 

marketplace that Lehman was experiencing some funding and 

other difficulties. 

Having said that, I think it is worth adding that, clearly, in the 

wake of Lehman, AIG and—the difficulties of AIG were revealed, 

and Merrill Lynch was purchased by Bank of America. So I think 

the—— 

Senator BUNNING. Under the gun. 

Mr. STERN. So I think the whole scale of the problem turned out 

to be much greater than anticipated by people in the markets. And 

AIG was a AAA rated company. I think that came as a genuine 

and sizable shock. 

Senator BUNNING. But the AIG was rated a AAA company with 

the hedge fund in England not being attached. They are insurance 

companies. 

Mr. STERN. You will have to ask AAA. You will have to ask the 

rating agencies. 

Senator BUNNING. Yeah, the rating—that is who I really need to 

ask, is the rating agencies. 

Mr. Stern, you mentioned that regulators needed to be better understood, the connection between firms. 

Do you think there are some types of connections or products 

that should be limited or banned? 

Mr. STERN. I am not knowledgeable enough a priori to say that 

we ought to ban some interconnections or some products. What I 

14 

would say is if we identified interconnections and exposures and 

potential vulnerabilities that looked like they would lead to serious 

problems at a number of institutions—that is, if one institution got 

into serious difficulty, it would spread in substantial ways to others—then it is an opportunity to do one or both of two things; either to push to reduce those exposures as a regulator and/or to figure out how you are going to deal with the spill-over effect should 

problems arise. That is, how are you going to contain the problems. 

So I do think that would be a very valuable, important exercise. 

That is part of my proposal when I talk about—— 

Senator BUNNING. I complimented you in my opening statement, 

but I did not get to make it. 

Mr. STERN.——preparing for these kinds of problems. Thank you. 

Senator BUNNING. That is all right. 

For either of the witnesses, what specifically in the bankruptcy 

laws is not sufficient for resolving financial institutions? 

Ms. BAIR. Well, I go into that in a little more detail in my testimony. I think there are a couple of things. First, there is the ability 

to set up a bridge bank. I think continuity of operations, especially 

for the systemic functions, is important to a resolution mechanism. 

We have it now with banks. We think that works well. 

Another key difference is how derivative contracts are treated. In 

a bankruptcy, the derivatives counterparties have the immediate 

right to close out their position. With Lehman Brothers, you saw 

a situation where everyone was doing that, grabbing the collateral, 

selling it off and going out and re-hedging. 

Senator BUNNING. Can I just interrupt you a second? 

Ms. BAIR. Sure. 

Senator BUNNING. Because we had testimony from the Secretary 

of the Treasury, past and present, and the head of the Federal Reserve, both present and past, that we should not involve ourselves 

in overseeing derivatives and credit-default swaps. 

Ms. BAIR. Well, yes. 

Senator BUNNING. I mean, sitting right where you sat—— 

Ms. BAIR. You never heard that from me, Senator. No. And I 

would say, high on the priority of this body should be to review the 

Commodity Futures Modernization Act. I think that has shackled 

the ability of regulators to provide greater oversight of those markets. I do not know what they said, but I feel strongly we need 

greater oversight of those markets. 

Senator BUNNING. So do I. 

Ms. BAIR. Okay. But our resolution mechanism allows us to accept or reject those contracts. We can require the counterparties to 

continue to perform in those contracts instead of grabbing the collateral. I think that is another key advantage of our process. 

Senator BUNNING. Mr. Sterns, just hold on just a second, while 

I have Sheila. 

When do you expect to end the TLGP, and can all banks survive 

without it? 

Ms. BAIR. We have been trying to ease out of that program. We 

have put surcharges on the program, and are putting those surcharges into the Deposit Insurance Fund to try to reduce pressure 

on the special assessment. 

Senator BUNNING. To other banks. 

15 

Ms. BAIR. Yes, exactly, the smaller institutions. 

We are working to stabilize the situation. We very much want to 

end it on October 31st. 

Senator BUNNING. Are you going to be able to do that? 

Ms. BAIR. I am optimistic that we will. We will have to wait and 

see where we are, but I am optimistic that we will. 

Mr. Sterns, would you like to say something about bankruptcy? 

Mr. STERN. No. The only thing I would add to Chairman Bair’s 

comments is with regard to some of the derivatives and credit-default swaps, obviously, we are moving to central counterparties’ 

clearinghouses. I think that is a very important step. I think that 

will help to standardize the products. It will take a good deal of 

risk out of the business. And I am cautiously optimistic that that 

will turn out to be a way to effectively address at least some of 

your concerns. 

Senator BUNNING. In other words, we were just a little behind 

the curve in regulatory oversight by the advice of the Federal Reserve chief, both Chairman Greenspan and Chairman Bernanke. 

And both Treasury secretaries said they did not need those oversights. 

Senator BUNNING. Well, you know, all I can say at this point is 

it has been a difficult lesson. 

Mr. STERN. It certainly has, and an expensive one. Thank you. 

Chairman DODD. Thank you very much. 

By the way, on that clearinghouse idea, I know of no dissenting 

voices, at least on this Committee or others I have talked to about 

it. It is going to be very much a part of that architecture we are 

talking about. 

Senator Warner? 

Senator WARNER. Thank you, Mr. Chairman. Thank you for the 

hearing. 

Let me move to a slightly different subject as well. I want to 

come back to systemic regulator, but I would like to hear Ms. Bair 

and Mr. Stern—we all have been waiting for some time for the release of the so-called stress test results. And we have heard Treasury say that none of the 19 banks are going to ‘‘fail.’’ 

One, I would like to get your evaluation of have these tests been 

rigorous enough, number one. Two, what additional steps can you 

or we take to give confidence to the markets the analysis has been 

rigorous enough? And, three, what else can we do to encourage 

these institutions that need additional capital to push and prod 

them into hopefully finding that in the private sector? 

Ms. BAIR. All of these institutions that exceed regulatory standards are well capitalized. The stress test really was to determine, 

if we have a more adverse economic scenario over the next couple 

of years, will the banks have adequate capital buffers now to withstand that more adverse economic scenario. So in that sense, the 

stress test is more rigorous than the current regulatory standards 

for being well capitalized. 

Senator WARNER. Although, again, we are rapidly approaching 

the outer reaches of—— 

Ms. BAIR. Well, that is true. 

Senator WARNER.——the downside. 

16 

Ms. BAIR. I think that is right. This is something that needs to 

continue to be monitored. And we do this all the time, and we will 

continue to do so. 

But I think even though the unemployment rate used in the 

more adverse scenario could have been a little bit higher, I think 

on home price declines, we have been pretty aggressive. So I am 

hoping that all nets out. But, clearly, it needs to continue to be 

monitored. I think this will be a confidence-instilling announcement. There will be additional needs for capital buffers for some institutions, but I think there will be mechanisms to do that within 

the next six months. 

And, yes, certainly I would agree, those institutions need to look 

to non-government sources first. The Treasury can be there as a 

backstop, but they should look to non-government sources, first and 

foremost to raise new equity, if possible. If they cannot do that, or 

in conjunction with that, banks can consider converting some of 

their other securities in their capital structure into common stock 

to increase the level of tier 1 common equity, which is very important for market perception right now. 

Senator WARNER. And you are confident that there will be 

enough data released that will result in a confidence building rather than a confidence weakening? 

Ms. BAIR. Well, I hope so. This is an interagency process, and it 

is a holding company process. It has been led by the Federal Reserve as it should be. They are the holding company regulator. I 

think they have done an outstanding job. They have a great staff. 

And so I think that it will be confidence instilling. 

Obviously, there are judgment calls that have to be made on all 

of this, and I am sure there will be some that say we are being too 

tough, and there will be analysts that say we are not being tough 

enough. But, hopefully, we are in the middle there, at the right 

place. But a lot of it is just judgment. 

Senator WARNER. Mr. Stern, do you have a comment? 

Mr. STERN. I think Chairman Bair covered it thoroughly. And I 

would prefer not—until the results are out, I would prefer not to 

go further. 

Senator WARNER. I would like to go back, on my own remaining 

time, to the notion that the Chairman raised in terms of systemic 

risk and the idea of a council, which I think has some 

attractiveness but also some challenges. 

What guidance/advice would you have if we were to, at least, continue to pursue the possibilities of this option, of how we would 

make sure that information would actually be forced up and truly 

shared? Number one. 

Two, how would we ensure, and what structural advice could you 

give us to ensure that this council would not end up becoming simply a debating society? 

And number three, when this council or group reach some conclusion, how could we ensure that it could act with some force? 

I would love you to comment on all three. 

Ms. BAIR. Well, I think accountability will be key. The statute 

needs to put accountability for systemic risk with this council. It 

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17 

ards, to collect information, and make sure it is shared with the 

other regulators. 

If you provide that mandate and that accountability, as well as 

real legal authority, I think you will get the result that you want. 

There is nothing perfect about supervision, and this is why we 

have also suggested a resolution mechanism to enhance market 

discipline as well as protect taxpayers. In addition, we have suggested an assessment system that the resolution authority would 

have as well to provide disincentives for higher risk behavior. I 

think with those three steps in combination, you would dramatically improve the situation. 

Part of the problem is nobody really has the mandate right now 

for the entire system. There were problems. For instance, capital 

arbitrage between investment banks and commercial banks—different capital standards. That is exactly the kind of issue this type 

of council could have not only identified but also addressed. 

Senator WARNER. But one of the things we need to do is make 

sure that that information that may currently reside in the day-today prudential regulator actually would get pushed up and actually 

shared, which—— 

Ms. BAIR. That is right. 

Senator WARNER.——seems in the past that some of this information has been out there, but it has not been—— 

Ms. BAIR. That is exactly right. There needs to be clear authority 

to collect and to force the sharing of the information. We give the 

SEC our bank data; they give us their trading data. You need a 

mechanism to do that. 

Right now, sometimes it eventually happens, but it can be a long 

process, and it is not a coordinated, systematic process. Establishing a council with the mandate and the legal authority to carry 

out that mandate would dramatically improve the situation. 

Senator WARNER. Mr. Chairman, I know I have gone beyond my 

time, but if I could have Mr. Stern answer the question, too, sir? 

Mr. STERN. Yes. Well, I think two things are going to be very important in that regard. One is authority to act. And I would add 

that working with the supervisors is very important because they 

have a lot of on-the-ground information that would be valuable in 

this process. 

But I also would think that for systemic supervision to be effective, this group, whether it is an institution or whether it is a council, or whatever it is, would have to have the ability, under the 

right circumstances, to intervene if they thought that the consolidated supervisor, whether it was a bank supervisor or an insurance 

company supervisor or whatever, was not doing an adequate, sufficient job. 

So from their judgment, if the job that was being done by the 

principal supervisor just was not adequate, they could step in and 

ask for more forceful action, and I think that would be important. 

Senator WARNER. Thank you, Mr. Chairman. 

Chairman DODD. That is a very important point because that 

gets central to the debate, in a sense, whether or not you have sort 

of the corporate model or you have a risk assessment officer that 

is watching everything and advises the corporation when they 

think things are straying off or actually has the authority to reach 

18 

in and stop something from happening. And that debate is one we 

have not resolved. 

That is a very critical moment, as to what kind of authority you 

actually invest, whether it is the individual or whether it is the 

council. And I am more attracted to the council idea. 

Senator Corker? 

Senator CORKER. Mr. Chairman, thank you. Thanks for having 

this hearing. I appreciate our witnesses coming in and thank them 

for their testimony, which I read this morning early. I have to tell 

you that I especially—— 

Excuse me, Gary. But I especially liked the testimony by our 

FDIC leader. And I find it to be just an absolute stunning rejection 

of the policies that have been put forth by our Treasury Secretary. 

And I very much like what you had to say. There might be some 

details. 

But I find it amazing that your embrace of the free market is so 

different from our Treasury Secretary, who, in essence, has come 

up here talking about wanting the powers, in perpetuity, to invest 

taxpayer money in entities that pose systemic risks, forever. In essence, creating another Fannie or a Freddie in the process. So it 

is an amazing thing to me. And, also, by the way, sharing with the 

public who those entities are by causing them to pay higher premiums so that everybody understands that they are never going to 

fail. 

So I just want to thank you for bringing sanity into this discussion. I very much appreciate your presentation, and very much appreciate your willingness to take something that is more the American way into your thinking here and certainly presenting to us. 

Now, let me ask you a question. Timing. We have had—I actually 

appreciate the way our chairman has handled this in that he has 

not tried to rush through this. I know that he and the ranking 

member agree on that. I know that this resolution authority, 

though, is important right now. Okay? 

The other pieces of it do not have to come into play necessarily. 

We are not going to solve this problem through regulation we put 

in place today. But I would love to hear about the resolution authority piece, number one, if you feel it can be done separately and 

what the timing of that should be. 

Ms. BAIR. Well, I think that just giving us the authority to resolve bank and thrift holding companies could be done more quickly. You do not need to decide what is systemic and what is not, nor 

who is going to be providing the broader systemic regulation. That 

would be a huge contribution to the tools that we have in dealing 

with the current situation. So I think that this could be addressed 

separately, and it would be very helpful to have. 

Senator CORKER. I do hope there is some—that you will coach us 

and help us figure out a way to maybe deal with the resolution 

issue and let the other be dealt with when there is not a crisis; otherwise, we will probably not end up with a cause-neutral solution. 

Okay? We will be focused on CDS’s and everything else. But thank 

you. 

Let me ask you this. Many of our institutions have talked about 

wanting to leave the TARP program, but one of the most beneficial 

pieces of what we have done is the TGLP program, TLGP program, 

19 

where, in essence, they are able, through government guarantees, 

to borrow money. 

If we cause these folks—if we allow these folks to leave the 

TARP program, should we also make them leave this other thing 

that is actually a greater benefit to them, a government guarantee 

for their debt? Should we also cause them to leave at the same 

time? 

Ms. BAIR. I would point out that the TLGP program has been a 

moneymaker for us. We have collected over $7 billion in premiums 

from it, and we have had no losses. That has helped. Some of the 

surcharges on that program are now helping to replenish the Deposit Insurance Fund, where we have losses through our normal 

resolution activity. So I think there have been some benefits to the 

government and the FDIC for that program. 

Senator CORKER. So now you are moving the free enterprise into 

government and we are making money—— 

Ms. BAIR. I do not. We would like to get out of that program October 31st, and that is the plan right now. We had an opt-in or optout procedure when we instituted the program. I was worried 

about adverse selection. 

So I think we would like the institutions that are in the TLGP 

now to stay in it until October 31st under the current terms. But 

then after that, we would like to end the program. 

Senator CORKER. Is that possible? 

Ms. BAIR. I sure hope so, Senator. I think we will know more in 

the third quarter. But that is the current strategy. I will guarantee 

you that if we cannot end the TLGP for everybody, the fees will go 

up. 

Something we had originally talked about, which we did not do 

because the markets were under such stress, would be to only 

guarantee a percentage, say 90 percent or 80 percent, to start 

weaning the private markets off of this and take some percentage 

of the risk. So there are different ways we can exit if we cannot 

by October 31st. But our strong preference is just to get out on October 31st. 

Senator CORKER. This is, apparently, going to be my last question. 

If we end the program on October 31st, my sense is that we, potentially, may need this resolution ability in place prior to then because it would be my sense that there are a lot of institutions in 

this country that cannot survive without that program being in 

place. I am just wondering if you might respond to that. 

Ms. BAIR. I think that is a valid observation. The flexibility and 

the tools we have to deal with this, have been hampered by our 

lack of ability to deal with structures at the holding company level. 

So a lot of this open institution assistance has been needed because 

we do not have other tools available. It would be helpful to give us 

flexibility. It is the kind of thing you hope you will never have to 

use. But I think having it now would be extremely helpful. 

Also, we find with the smaller institutions that just a thread of 

resolution authority can trigger actions that might not otherwise 

take place. And so, for a variety of reasons, it will be a helpful tool 

to have. 

20 

Senator CORKER. We appreciate your willingness to talk with us 

on the telephone from time to time, and I hope that will continue. 

And, again, I know that you have spent most of your life in government. I thank you for proposing something that is sane, that actually alleviates the moral hazards that our Treasury Secretary has 

tried to lay out. 

I would love to hear of you-all’s interpersonal conversation some 

time, but I will not ask for that now. Thank you very much. 

Chairman DODD. You are really treading on thin ice there. 

Thank you. 

By the way, the resolution mechanism is something we all feel 

pretty strongly about, and whether or not we are able to move forward with a larger proposal, including the resolution mechanism, 

is a good point. And this is something I have to take the temperature of my colleagues on as to how they feel about it. But I hear 

what you are saying, and I do not disagree with my friend and colleague from Tennessee about the importance of that issue, having 

a mechanism in place. I regret we do not now. It would have been 

a very different situation, in many ways, if we had such. 

So I will be in conversations with my colleagues, certainly Senator Shelby, about the best way to proceed on that. And I invite 

the comments of my colleagues and thoughts on this matter as 

well, as to whether or not we ought to proceed with that or whether or not we will be in a position where we can actually accommodate that as part of a larger proposal. 

With that, Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Chairlady Bair, let me thank you for all your work. I think it has 

been extraordinary. And I was listening to my dear friend and colleague, Senator Corker, laud your proclivities to the free market, 

which we share. But you are not for a free-for-all market, are you? 

Ms. BAIR. No, no. 

Senator MENENDEZ. That is what I thought. So let me ask you 

a couple of questions. One of the fundamental questions—I know 

we have talked about how we regulate and how we look at systemic 

risk and systemic regulators. I would like to take a step back from 

that because I think you have some testimony that maybe you did 

not do in your oral presentation that is very important for the 

Committee to be considering as well, and that is, if we have gotten 

to the point that an institution is ‘‘too big to fail,’’ haven’t we in 

some respects already failed? 

Ms. BAIR. I think that is right. It has diluted market discipline 

and helped contribute to getting us into this situation, and we need 

to end it. I think that is true. 

Senator MENENDEZ. So in that respect, because it poses potentially such risk to the overall system and the economy, how do 

we—I think you had some very interesting suggestions. One is that 

in your testimony on page 4, you say that ‘‘the academic evidence 

suggests that benefits from economies of scale are exhausted at levels far below the size of today’s largest financial institutions.’’ And 

then you went on, on page 6, to talk about some of those things 

that we might do prospectively and preventively to not only regulate the system, but to create, I would say, safeguards from maybe 

21 

getting to that point where we might be ‘‘too big to fail.’’ Can you 

talk about some of those? 

Ms. BAIR. Right. We charge premiums for deposit insurance on 

a, risk-adjusted basis. We charge a higher assessment for institutions that engage in behaviors that we know are higher risk and 

that can increase our resolution costs. 

I think you could have an assessment system that would help 

build up a fund so that if a very large, complex organization got 

itself into trouble, you could put it into a resolution process. If the 

Government had to absorb losses as part of that resolution, you 

could fall back on this fund as opposed to going to the taxpayer, 

which is what is happening now. 

I think that type of process could provide economic disincentives 

for higher-risk behavior. That might be preferable to just trying to 

say you cannot do this or you cannot do that. Frequently, when you 

try to just ban certain products or practices, people find a way 

around the ban, or you can create an arbitrage in an unintended 

fashion. So I think creating the economic disincentives so banks 

pay a much higher assessment for actions that post more systemic 

risk would be a powerful tool. 

There are certain areas where it is quite obvious that the activities were higher risk—for example, structured finance, and credit 

dafault swaps. This would be one additional tool that could be 

used. 

Senator MENENDEZ. How about graduated capital reserve requirements? 

Ms. BAIR. Yes, absolutely. There is broad consensus on having 

countercyclical capital requirements. During good times, the larger 

institutions in particular must build up their capital so that they 

can draw down upon those in bad times. That is absolutely essential. I think there is broad international consensus on that point. 

Senator MENENDEZ. You also said here, ‘‘there firms’’— referring 

to the ones who create some higher risk—‘‘should be subject to 

higher Prompt Corrective Action . . . limits under U.S. laws.’’ 

Ms. BAIR. Right. 

Senator MENENDEZ. ‘‘Regulators also should take into account 

off-balance-sheet assets and conduits as if these risks were on-balance-sheet.’’ 

Ms. BAIR. Yes. That is right. 

MENENDEZ. Something that you promote as well. 

Ms. BAIR. Yes, absolutely. The off-balance-sheet exposures where 

institutions were not required to maintain capital against those exposures were found very quickly when those off-balance-sheet vehicles got into trouble. They came back on-balance-sheet pretty fast. 

I think the accounting industry is moving in that direction as well. 

Those exposures should be reflected on-balance-sheet and capital 

should be held against them. 

Senator MENENDEZ. Let me ask you one question that is not per 

se on topic, but since you are here: Since we seem like we are moving in the direction of giving you the higher borrowing authority, 

and I continue to hear from all those community banks who were 

not really part of our challenge in this economy, how quickly, assuming that it is signed into law, do you anticipate that the FDIC 

will be able to stabilize or lower the fees it is charging these banks? 

22 

Ms. BAIR. I think we will do it very quickly, certainly before the 

end of the month, assuming this authority goes through, and it 

looks like it will. And thank you all for your leadership in getting 

this done. It will be before the end of the month. We will make an 

announcement on that. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. And let me say just on 

that point, we thank you, Ms. Bair, for the work of the FDIC and 

the communication with the Committee. We have had a good debate this week on the subject matter and have expanded the legislation, but I think on the central points regarding the deposit insurance and the lending authority, borrowing authority, there is 

pretty much consensus—not everyone, but pretty much consensus 

on this. But there has been some debate about other matters before 

the floor, but we have resolved at least some of those and are moving forward. 

Senator Shelby. 

Senator SHELBY. Thank you. Thank you, Mr. Chairman. 

I would like to ask—this may have been asked earlier. I was not 

here early this morning. A threshold question comes to me: What 

constitutes ‘‘too big to fail’’? What constitutes that? 

Ms. BAIR. Right. 

Senator SHELBY. How do you define that? 

Ms. BAIR. It is difficult to define. I think it is market perception 

as much as a precise definition. It is not just a function of size, it 

is really a function of interrelationship. In general, an institution 

would be ‘‘too big to fail’’ if, in a situation where it did fail and repudiated all its various obligations, there would be collateral systemic impact so that other firms would start being brought down 

because of that. That is how I look at it, and I think that is why 

we found ourselves in a box with some of these financial institutions. Because of the potential domino effect, that Government 

intervention was deemed necessary. 

Senator SHELBY. Mr. Stern, President Stern. 

Mr. STERN. My definition would be similar. I think of it in terms 

of an institution who, if it ran into substantial difficulty, would impose significant spillover effects on other significant institutions 

and/or a range of financial markets as well. So I would define it 

in that kind of very practical, operational way having to do with 

significant spillovers. 

Senator SHELBY. Could a hands-on regulator or regulators— 

hands-on—help prevent this, in other words, from becoming too 

interconnected, see what is going to happen or could happen down 

the road? Because if you can prevent something, it is a lot better 

than picking up the pieces, is it not? 

Mr. STERN. Yes, I would say two things about that. I think it 

would take a reorientation of traditional supervision and regulation. Rather than worrying principally about the safety and soundness of the institution per se, you have to broaden your perspective 

to think about who would be affected and to what magnitude if the 

institution got into serious difficulty. But even if you did that, I 

would be concerned that that by itself would not be sufficient without going the next step and preparing, one way or the other, to 

limit, to diminish the potential for spillovers. 

23 

Senator SHELBY. Mr. Stern, the idea of imposing higher capital 

requirements—this has been talked about here, alluded to this 

morning—on ‘‘too-big-to-fail’’ institutions has some appeal. Your 

testimony advocates, as I understand it, capital tools that create 

capital when firms need it most. You need it most, it seems to me, 

when you do not have it, so to speak, when you are in a downturn. 

What type of capital tools were you referring to in your testimony? And how would these additional tools be put in place? And 

could regulators take action under existing authority to require 

those types of tools? Or will it be something we will have to address in legislation? 

Mr. STERN. Well, one suggestion that has a lot of appeal to me 

is something called ‘‘contingent capital,’’ where a firm would issue 

a debt instrument which would have, as its capital diminished at 

some point, with a formal trigger or perhaps under regulatory instructions, that debt instrument would convert to equity. That is 

why it is called ‘‘contingent capital.’’ So you would have additional 

capital, in fact, when you needed it most, when your capital was 

diminishing and your position was deteriorating. And I think that 

is an attractive idea, and I would certainly advocate and support 

it. 

Senator SHELBY. In your tenure as President of the Reserve 

Bank there, have you known any banks in the area to fail that 

were well capitalized, well managed, and well regulated? 

Mr. STERN. Well, I think with the benefit of hindsight, the answer to that is no. But, occasionally—usually I think it is fair to 

say, especially if it is a relatively small, straightforward institution, 

the problems are well recognized in a timely way. I think the problem is with large, complex institutions that is a much more significant challenge, especially to do it in a timely way. And even if you 

identify the problems in a timely way, taking corrective action in 

a timely way is a very significant challenge, in my judgment. 

Senator SHELBY. To both of you, is there really in the banking 

business any substitute for capital, real capital? 

Ms. BAIR. Well, I think capital is absolutely central in its importance, and we need more capital now and in the future. And we 

need countercyclical capital requirements, and I like the contingent 

debt concept. It is a good idea as well. 

I think you need market discipline, too. If an institution is undertaking very high risk activities, even at a 20-percent capital level— 

and we have seen this in smaller institutions—it can go pretty fast. 

So I think you need good, common-sense oversight, but you also 

need that complemented by market discipline, which, again, ‘‘too 

big to fail’’ has diluted. 

Mr. STERN. Yes, market discipline and capital are complements, 

not substitutes. I think they are both critical here. 

Senator SHELBY. They work together. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you. I am glad you made that point, 

Sheila, because I can think of several institutions today that have 

very high capital standards but are in trouble. And the assumption 

because they have a lot of capital that they are not in trouble is 

the conclusion, and that is not the case. But I agree with my friend 

from Alabama that is an important—capital standards are critiVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
24 

cally important, but I am glad you mentioned the market discipline 

as well in all of that. 

Senator Reed. 

Senator REED. Thank you, Mr. Chairman. 

Thank you both not only for your testimony but particularly, 

Chairwoman Bair, for your very effective leadership. Do you think 

we should return to something much closer to Basel I capital 

standards rather than continue the Basel II regime? 

Ms. BAIR. Well, I absolutely think that the structure of Basel II, 

the Advanced Approaches, continues to be highly problematic. 

There has been a lot of work to try to fix it. At some point you wonder, well, should we just start over as opposed to trying to fix it? 

Thank goodness we have always maintained the leverage ratio in 

the United States, and that we are still under Basel I. 

I think there is increasing international agreement that we need 

an international leverage ratio. We are calling it a ‘‘supplemental 

capital standard’’ now, but that is in essence what we are talking 

about. And, in terms of the capital standard based on risk-weighted 

assets, it could be made more nuanced and more granular. But we 

can do that by building on the Basel I framework of buckets of different asset categories with hard and fast risk weights and capital 

requirements as opposed to this more subjective model-based regimen that we had with the Advanced Approaches under Basel II. 

The basic approach under Basel I is workable. It needs to be improved. It needs to be more granular. But, making enhancements 

to Basel I might be more productive at this point than continuing 

to try to work with Basel II. 

Senator REED. We have operated under Basel I. It is a known entity. Rather than inventing a new third approach, it might be better to return back to something that we have operated under. 

Ms. BAIR. I think that would be a very viable path. It is just one 

opinion. Obviously, there are a lot of voices on capital standards. 

But I think that would be faster and get us to a stronger capital 

regime. Yes, I do. 

Senator REED. Mr. Stern, do you have any views? 

Mr. STERN. Yes, I think it is very important that we get capital 

right, and I certainly think that Basel II ought to undergo a very 

thorough review, and we should ask ourselves if that is going to 

take us where we want to go. And as I have already suggested, I 

think while we need to get the capital right, I think that the ‘‘toobig-to-fail’’ problem is sufficiently challenging, that capital by itself 

is not likely to be the entire solution. And so that is the reason I 

have suggested a number of other initiatives as well. 

Senator REED. Do you believe that the Federal Reserve has the 

authority to require a regulated entity to divest itself of an operation or enterprise because they do not have the managerial capacity to do it correctly? 

Mr. STERN. As a legal matter, I do not know if we have the authority for that. As a practical matter, I think that is a very difficult thing to do. You might prevail. But, obviously, if the organization thought it was integral to its operations and to its profitmaking opportunities, it would undoubtedly want to resist such action. 

25 

Senator REED. Well, if you are the authority and you have the— 

since I am continually impressed with the authority of the Federal 

Reserve over the last few weeks and months to do things, I think 

you are not giving yourself enough credit for the leverage you 

might have. But one of the issues of not only correcting a situation 

but preventing a situation is having perhaps the authority to step 

in and say these activities are great, but they are just—you are not 

managing them well—which would send a stronger signal to management than simply saying we know we cannot do anything, but 

we wish you were better managers. 

Mr. STERN. Yes, and, you know, as I commented a little bit earlier, I do think that identifying those situations is an important responsibility and a challenging one. But as I commented, even when 

you identify those things, taking timely action is very challenging, 

especially in good times, by the way, when it looks as if everything 

is operating smoothly, and the rationale for such a divestiture, for 

example, would not be immediately accepted. 

Senator REED. I think you are absolutely right. I mean, I think 

that the irony here is it is the good times where the seeds are sown 

for the bigger harvest of the future, and it is hard in practice. 

Let me ask just a final point. One of the problems we have is 

we have talked about the leverage and the capital ratios of regulated entities. But what about the embedded leverage of some of 

their counterparties, the hedge funds, so that what looks like an 

appropriate loan based on the capital of the regulated entity becomes, you know, much less acceptable? How do we deal with that? 

Ms. BAIR. Hopefully, if it is a regulated bank, they should be 

looking at their counterparty exposure. If their counterparty is 

overleveraged, then that might not be a transaction they should do. 

One area that a systemic risk council, with the regulators coming 

together, should look at is how leverage constraints apply across 

the board. It is very difficult to have even higher capital standards 

than we have now for banks. If there are other major parts of the 

banking sector that can lever up much higher, you are going to be 

creating incentives to drive activity into less regulated venues. 

We need some minimal standards that apply across markets, and 

leverage is probably one area we need to review. 

Senator REED. Let me just follow up quickly. This systemic council of regulators I think—well, let me ask you: Should they also 

have sort of the responsibility to have an analytical staff that 

would try to anticipate issues? Coming from my other Committee, 

the Armed Services Committee, we spend a lot of time and a lot 

of money gaming what could happen, what might not happen, what 

are the pressures on systems? That I do not believe exists in any 

sort of consistent way within financial regulation. 

Ms. BAIR. We do it within our respective spheres. We do that internally at the FDIC with insured depository institutions. So I absolutely think that there should be an analytical staff. That would 

be a key part of the council to enable it to collect the data and analyze it and identify issues to try to get ahead of them. 

Senator REED. Thank you very much. 

Thank you, Mr. Chairman. 

Chairman DODD. Just on that point, that is a very good point. 

I was thinking when you were defining it, giving your definition of 

26 

‘‘systemic risk,’’ and I agree with you, size alone is—if we gravitate 

on that, we are going to miss an awful lot. But one thing I did not 

hear you say, and that is, products. What is maybe a relatively 

small product can migrate very quickly through the system, and 

that product can become a source of tremendous systemic risk. And 

so in addition to the entity itself having tentacles that reach out 

that cause problems, we need to be looking—I think Jack’s point 

is a good one—an analytical staff that is looking at what products 

are and can that product pose systemic risks. 

Ms. BAIR. I agree. 

Chairman DODD. While it may be innocent enough or small 

enough, at some juncture the analysis that that product could create problems I think is a very important issue as well. 

Ms. BAIR. I agree. 

Chairman DODD. Senator Merkley. 

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

I want to ask—and this question is more directed to Mr. Stern, 

but, Sheila, please feel free to chime in here. 

Mr. Stern, in your writings, you have noted the unintended side 

effects of stepped-up prudential capital requirements may encourage banks with those stepped-up requirements to actually increase 

their risk to gain the same returns, and this raised kind of an inherent dilemma, if you will, of that strategy. And how does that 

play out in terms of the pros and cons of public policy? 

Mr. STERN. Well, I think that is a potential reaction and something of potential concern, and that is why I have advocated not 

relying just on capital or just on one or two approaches to dealing 

with ‘‘too big to fail.’’ I think this has to be a multifaceted approach 

with a number of initiatives that straighten out the best we can 

the incentives and improved market discipline as well as doing 

things like improving capital and so forth, because this is a difficult 

issue to address. Its consequences are potentially very serious, and 

so I think we need to address it across a number of fronts. 

Senator MERKLEY. Do you wish to add anything on that? 

Ms. BAIR. Well, I think that is a risk. We have capital standards 

based on the riskiness of assets in addition to the leverage ratio, 

which is core capital to total assets. So through our risk-based capital system, we try to address that problem. But it is imprecise, 

necessarily imprecise, and so it is something that supervisors have 

to be constantly vigilant of. 

Senator MERKLEY. To follow on, Mr. Stern, I think another point 

you have made is that we in some degree already have a systematic risk regulator in the Fed. But can the Fed really balance its 

various requirements and play that role? 

Mr. STERN I do not think I have suggested that the Fed is the 

systemic risk regulator. Obviously, that is an issue that is under 

discussion and consideration at the moment. 

I do think the Federal Reserve, because we have longstanding responsibilities in holding computer and bank supervision, as well as 

experience in payment systems and because we are ultimately the 

last provider of liquidity in the system, have a role to play in this, 

clearly. But I have not tried to weigh in exactly on what the exact 

structure of the systemic risk regulator ought to be. 

27 

Senator MERKLEY. And I apologize if you have already been 

asked this question before, but I think you have emphasized—and 

correct me if I am wrong—that policymakers should focus on 

counterparty risk and not risking shareholders, but that one of our 

challenges is to convince uninsured creditors that they will bear 

losses when their financial institution gets into trouble. 

Do we need to do that in a statutory sense to address the moral 

hazard, if you will, of expectations that shareholders will be bailed 

out? 

Mr. STERN. Well, shareholders, of course, in some of these cases 

have lost a lot of money, and that has been appropriate, but it is 

not sufficient to address moral hazard. It is the creditors, the uninsured creditors, that need to take some losses going forward—not 

in the middle of a crisis like this, I will hasten to add, but going 

forward. And so we want to put ourselves in a position to do that. 

The legislation is not up to me, but, obviously, if it is going to 

contain, as it may well appropriately contain, a systemic risk exception so that, you know, if there really is the threat of systemic 

difficulties that would threaten not only the functioning of the financial system but maybe parts of the economy as well, clearly policymakers ought to be able to deal with those. 

What you want to put yourself in the position to do is to invoke 

that systemic risk exception as infrequently with as low a probability as possible. So it seems to me that legislation can help, but 

it is not going to get you the entire way, assuming it has that systemic risk exception—and, indeed, it seems appropriate to have 

such a thing. 

Senator MERKLEY. Sheila, do you wish to add at all to that? 

Ms. BAIR. No. I would agree with that. With the bank resolution 

process we have now, Congress has laid out a very clear claims priority for us. One of the benefits of having a resolution authority for 

holding companies and perhaps non-bank financial institutions is 

that Congress would lay out what the rules of the game are so 

market participants could understand in advance what their losses 

will be if an institution gets into trouble. I think that increases the 

market discipline, which is what we are all trying to get back into 

the system. 

Senator MERKLEY. Well, thank you very much to both of you for 

your testimony and for helping us wrestle with this pretty sizable 

issue. 

Chairman DODD. Thank you very much, Senator. 

Before I turn to Senator Bennett, just to inform my colleagues 

and others who are gathered here today, there has been a little 

change in the order on the floor of the Senate. Several of our colleagues have to be at the White House for a meeting. We are going 

to begin at 10:40 having three votes regarding the housing bill. 

And then there will be a break, and they are going to bring up the 

defense procurement bill for opening statements for an hour. And 

then we will come back to finish up the remaining votes and final 

passage on the housing bill sometime after 11:30, in which case 

what I am going to suggest is that Senator Warner has graciously 

agreed to take over the chair and the gavel—which means you can 

only conduct a hearing. You cannot pass any bills, Mark. Then we 

will start the second panel—obviously complete with this panel, 

28 

and we thank both of our witnesses. We will recess and then come 

back for the second panel. And I apologize to them, but I cannot 

control the order of business on the floor of the Senate. So we will 

come back and have to finish up. But we can get started, anyway, 

with the second panel, if that is appropriate, Mark. 

Senator Bennett. 

Senator BENNETT. Thank you very much, Mr. Chairman, and 

thanks to the two witnesses. I apologize for not having been here 

for your testimony. I had other assignments. 

One of the things that has come out of this experience we are 

going through that I had not realized before—maybe both of you 

did—is that, in addition to bank and traditional kinds of banking 

activities, at least Citi performs a series of functions that are very 

profitable and are systemically absolutely essential—that is, the 

evening sweeps, the transactions that go on, et cetera. 

I understand that as much as 80 percent of some of these almost 

clerical functions worldwide run through Citi in one way or another. And if City were allowed to fail as a bank, it would be unable to perform these services that it performs for the system as 

a whole, and I have been pondering that ever since I found out 

about it as to how that impacts this whole question of what we do 

with City or any other organization. 

Now, as I have talked with some people outside of Citi about it, 

they have said, ‘‘Senator, that is a very profitable business, and 

there would be plenty of people who would step forward and say 

we will be happy to perform it.’’ Well, it is one thing for them to 

say, ‘‘Yes, we will be happy to perform it,’’ and it is another thing 

mechanically for them to be able to perform it in a seamless fashion that does not create tremendous difficulties. So I would like 

your response to that. 

Then the other thing that occurs to me that I have learned about 

all of this, I will not quote the numbers because I will get them 

wrong, but during this period of time, again picking on City, where 

they have taken enormous losses, they have at the same time paid 

a very significant amount of taxes, because the IRS rules are different from the accounting rules, and when you have an enormous 

loss that comes from mark-to-market, the IRS says, no, we will not 

allow that to happen until the assets are actually sold; so that we 

have had, to me, the enormous anomaly of having tremendous injections of cash into City to keep them viable, at the same time 

that Citi is making tremendous contributions or payments into the 

Treasury in the form of taxes. And I have a little bit of a hard time 

understanding why that makes much sense. 

So I would appreciate your responses to those two issues that 

have come up as we have deal with the realities of the meltdown 

that we have experienced. 

Ms. BAIR. Well, I never comment on open, operating institutions, 

so I will try to address some of the issues in a generic way. 

Senator BENNETT. Yes, put them in a generic way. 

Ms. BAIR. Where an institution performs activities that have systemic significance so that if they just ceased and repudiated those 

obligations you would have a systemic situation. Congress long ago 

gave us the authority to set up a bridge bank to maintain functions 

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29 

tinued to avoid systemic risk. This mechanism allows us to move 

good parts of an institution into a bridge bank, which then can be 

sold back to the private sector. The problem assets or other loans 

or securities that may be causing losses are retained in the receivership. 

This kind of generic situation is why bankruptcy does not work, 

because you do not have that bridge bank process. You do not have 

a way to continue these types of important systemic functions as 

you try to wind down and resolve the institution. We do not have 

this authority for holding companies. But we do have that kind of 

mechanism that we use now for banks. 

Mr. STERN. You are clearly right that there are several major financial institutions that are relied upon in financial markets for 

clearing and settlement, sort of the back-office plumbing. And if 

they were to get into various serious difficulty, that could be very 

disruptive, and so it could have certainly systemic repercussions. 

That has been a difficult issue to build an adequate response for 

in advance, although I would note that—gee, this was probably at 

least 15 years or so ago now—one of these institutions experienced 

a very serious computer glitch that threatened— it threatened operations and threatened its liquidity position, and as I recall, the 

Federal Reserve Bank of New York loaned something like $20-some 

billion to it overnight to address that problem, and it was addressed effectively. 

But you are clearly right that this would be something that a 

systemic risk supervisor would want to take a careful look at. 

Senator BENNETT. Can you comment on the disparity between 

accounting mark-to-market and taxes? 

[Laughter.] 

Mr. STERN. I am not knowledgeable about the tax situation, and 

like Chairman Bair, I am more than reluctant to comment about 

a particular institution. 

I would say that as far as mark-to-market accounting is concerned, it is not perfect; although, obviously, in more normal times, 

I think it works reasonably well. When some markets are not functioning, it is difficult to price assets, of course. But it is not clear 

that there is a preferable alternative, and it may be better to, on 

the margin at least, run the risk of overstating the problems rather 

than understating them. 

Ms. BAIR. I think just, generally, having worked at Treasury, the 

inconsistency between tax rules and GAAP accounting rules and 

regulatory treatment has arisen in a lot of contexts. I am uncomfortable with commenting on tax policy. Those laws are out of my 

bailiwick. 

If I could go back to your first question, though, we had a bank 

closing on Friday, Silverton Bank. It was a banker’s bank. It had 

a lot of correspondent accounts with many other banking institutions. It was systemic in its functions for those other institutions, 

so we set up a bridge to preserve those relationships as we try to 

market and unwind them over time. It is a good, real-life example 

of how the bridge bank mechanism works. If you would like a more 

detailed briefing, our staff would be happy to give it to you. 

Senator BENNETT. Well, yeah. I would appreciate it. But there is 

no question, as I think you have said, that there is a systemic risk 

30 

beyond just the safety and soundness of the bank, the function the 

bank performs. 

Mr. Chairman, I still am baffled, the idea that the federal government is injecting money into an institution to help keep it solvent, and at the same time, the federal government is taking 

money out of the same institution in the form of taxes to make sure 

they do not make a profit. Somehow that picture just does not compute for me. 

Senator WARNER. [Presiding.] Senator, we have all heard the 

death and taxes, the comments, and I think it is one more time 

being proven out. I am sorry. 

Ms. Bair? 

Ms. BAIR. Going forward—the situation is what it is, and I think 

steps were taken because there were no good alternatives going forward. I think, again, a resolution mechanism will get you out of 

this. So it would provide an orderly way, providing what we call 

open bank or open institution assistance. It would give you a mechanism where you do not have this kind of incongruity. 

Senator BENNETT. If I could, Mr. Chairman. 

Do you ever consider or run in to a situation where a tax forgiveness would keep the institutions solvent so that you do not have 

to seize it? And if you did, would you have the authority to—— 

Ms. BAIR. We do not. Our statute is very strict. In determining 

what is the least cost resolution, we may not consider tax benefits. 

So Congress has constrained us somewhat in that capacity. I can 

check and see if, prior to that, there were instances in the past 

where a change in tax policy would have kept the institution viable. But I will have to get back to you on that. 

Senator BENNETT. Thank you. 

Senator WARNER. I know we have a second panel, but I have one 

more question for this panel, and I will ask my colleagues if they 

have any more questions, and we can move to the second panel. 

Interesting discussion earlier on resolution authority, and, clearly, I cannot speak for all the colleagues, I have seen a great deal 

of interest in expanding the FDIC’s authority to look at bank holding companies. I guess two quick questions. 

One. Mr. Stern, if we were to move on that action independent 

of the overall financial modernization activities, what would be the 

push back, and would there be reluctance from the Fed of turning 

over a bank holding company’s resolution authority to the FDIC? 

And are there other early warning signs that seems kind of, at 

least to me, logical that we take that step? 

Secondarily, perhaps for both Mr. Stern and Ms. Bair, if we were 

to expedite that independently of the overall financial modernization, would it have any—even before passage of such legislation, if 

we were to advance that, could it have any effect on the current 

crisis? 

Mr. STERN. Well, I will try to be succinct about that. I, obviously, 

will not speak for the Federal Reserve as a whole. I think it could 

be constructive to accelerate that effort with regard to resolution 

authority, staying away from exactly who has responsibility for 

what, for the reasons that have already been covered here. 

The one thing that would concern me about that is it might reduce the urgency of taking other steps that might be appropriate 

31 

and important and necessary as well. And I would be concerned 

that we might think that, well, that addresses the problem and we 

do not need to take actions down the road. And so, there may be 

a value in trying to put together a more comprehensive package 

that would attack the issues that are of concern here and achieve 

the objectives that we have been talking about today in a comprehensive way. 

Senator WARNER. There is a great deal of interest in taking on 

the comprehensive. I wonder if there were any, though, in this moment, at this moment of the crisis, an expedited effort to expand 

to at least the bank holding companies. 

Mr. STERN. Yes. As I said, I think that would be constructive. 

Senator WARNER. Could there be even the advancement of that 

type of legislation? Could that have any short-term, positive—— 

Ms. BAIR. I think it could be an important catalyst, perhaps, for 

more fundamental restructurings or assets sales. It could serve as 

a wake-up call, to perhaps move things along a little faster. 

Senator WARNER. It might force some of our banks to move 

quicker into which assets they might be willing to dispose of. 

Ms. BAIR. Right. Well, in these smaller institutions, we find that 

it is a viable mechanism to use. Just having that there is a good 

catalyst to take more aggressive action, whether it is major 

changes or restructurings, or asset sales or just selling the whole 

institution, which is more practical with the small institution. I 

think, absolutely, just having the lever there can contribute to 

some very constructive activity. 

Senator WARNER. Well, I hope Chairman Dodd and Ranking 

Member Shelby get a chance to weigh in on that. I would love to 

see their sense of whether expedited on that would make some 

sense. 

Again, we will go very quickly, if any other member wants to ask 

this panel. 

Senator Merkley? 

Okay. Then I would then thank the panel for their very productive testimony and, always, your good work. 

Thank you. And we will move now to the second panel. 

Recognizing we have some votes, I will go ahead, and as the 

panel is setting up, I will go through a few introductory comments. 

For our second panel, we will hear from Peter J. Wallison, the 

Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute for Public Policy Research, where his research focuses on banking, insurance and Wall Street regulation. 

Previously, Mr. Wallison served as general counsel to the U.S. 

Treasury, the depository institution’s Deregulation Committee, and 

as White House counsel to President Ronald Reagan. 

After Mr. Wallison, we will hear from the Honorable Martin 

Baily, Senior Fellow in Economics Studies at the Brookings Institution. Mr. Baily served as chairman of the Council of Economic Advisors during the Clinton Administration. 

Finally, we will hear from Mr. Raghuram R.J. Rajan, the Eric J. 

Gleacher Distinguished Service Professor of Finance, University of 

Chicago, Booth School of Business. He served as chief economist at 

the International Monetary Fund. His major research focuses in 

the role of finance, planning and economic growth. 

32 

We were asked for Mr. Wallison to testify first, but we seem to 

be missing Mr. Wallison. 

Mr. BAILY. He was here a minute ago. 

Senator WARNER. Mr. Wallison, you are up first. You have been 

appropriately introduced, and we have said great things about you 

in your absence, and we are anxious to hear your testimony. 

STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE FOR PUBLIC POLICY RESEARCH 

Mr. WALLISON. I appreciate it very much, Mr. Chairman. 

I am very pleased to have this opportunity to appear before the 

Committee. The chairman’s letter of invitation asked four questions, and I have attempted to answer them in detail in my prepared testimony. I will try to summarize both the questions and 

my responses as follows. 

First, is it desirable or feasible to prevent institutions from becoming ‘‘too big to fail’’? I do not believe it is possible to identify 

in advance those institutions that are ‘‘too big to fail’’ because they 

pose systemic risk. Even if we could do that, the current condition 

of the heavily regulated banking sector shows that regulation is not 

an effective way to control growth or risk taking. Only the failure 

of a large commercial bank is likely to create the kind of systemic 

breakdown that we fear. 

Banks are special. Businesses and individuals rely on them for 

ready cash, necessary to meet payrolls, provide working capital, 

and pay daily bills. Small banks deposit funds in large banks. If 

a large bank should fail, that could cause a cascade of losses 

through the economy, and that is the definition, really, of systemic 

risk or a systemic breakdown. 

I doubt, however, that other kinds of financial institutions, insurance companies, securities firms, hedge funds, no matter what 

their size, can cause a systemic breakdown if they fail. This is because creditors of these firms do not expect to have immediate access to the funds that they have lent. 

If a large, non-bank financial firm should fail, its creditors suffer 

its losses over time with no immediate cascade of losses through 

the economy. The turmoil in the markets after Lehman’s bankruptcy was the result of the extreme fragility of the world’s financial system at that time and not the result of any losses actually 

caused by Lehman. 

The failure of a non-bank financial firm is not much different, in 

my view, from the failure of a large operating firm like General 

Motors. If General Motors fails, it will cause many losses throughout our economy, but not even the administration is contending 

that GM is ‘‘too big to fail.’’ The Committee should consider why 

if GM is not ‘‘too big to fail,’’ a large non-bank, financial firm might 

be; or if GM is ‘‘too big to fail,’’ whether we need a government 

agency that will resolve big operating firms, as some are proposing 

to resolve big financial firms. 

Second. Should firms that are ‘‘too big to fail’’ be broken up? This 

would not be good policy. Our large operating companies need large 

banks and other financial institutions for loans, for insurance, for 

funds transfers, and for selling their securities. If we broke up 

33 

large financial institutions on the mere supposition that they might 

cause a systemic event, we would be depriving our economy of 

something it needs without getting anything certain in return. 

Third. What regulatory steps should be taken to address the 

‘‘too-big-to-fail’’ problem? Since I do not think that non-bank financial institutions can create systemic risk, I would not propose new 

regulation for them at all. However, regulation of banks can be improved. We should require higher minimum capital levels. Capital 

should be increased during profitable periods when banks are 

growing in size. Regulators should develop indicators of risk taking 

and require banks to publish them regularly. This would assist 

market discipline. 

Fourth. How can we improve the current framework for resolving 

systemically important non-bank financial firms? There is no need 

to set up a government-run system for resolving non-bank financial 

institutions the way we resolve banks. They do not pose the risks 

that banks do. Giving an agency the power to take them over 

would virtually guarantee more bailouts like AIG with the taxpayers paying the bill. 

The bankruptcy system is likely to work better with greater certainty and with fewer losses. Within two weeks after its bankruptcy filing, Lehman had sold its investment banking, brokerage 

and investment advisory businesses to four different buyers. And 

unlike the $200 billion disaster at AIG, all Lehman’s bankruptcy 

costs are being paid by the shareholders and the creditors of Lehman, not the taxpayers. Because of their special role in the economy, banks must have a special resolution system. I agree with 

that. But there is no reason to do the same thing for the creditors 

of non-bank financial institutions. 

Thank you, Mr. Chairman. 

Senator WARNER. Thank you, Mr. Wallison. Some interesting 

comments. I am anxious to ask a couple of questions. 

Mr. Baily? 

STATEMENT OF MARTIN NEIL BAILY, SENIOR FELLOW, 

ECONOMIC STUDIES, THE BROOKINGS INSTITUTION 

Mr. BAILY. Thank you, Senator, and members of the Committee 

for giving me this opportunity. I am going to make a quick preamble and then get to the same questions that Peter was referring 

to. 

The U.S. economy has been in free-fall. Hopefully, the pace of decline is easing. But in order to get a transition back to sustained 

economic growth, that will not be possible without a restoration of 

the financial sector to health. In this situation, policymakers must 

deal with ‘‘too-big-to-fail’’ institutions because, at this time, we cannot afford to see the disorderly failure of another major financial 

institution that would exacerbate systemic risks and threaten economic recovery. 

The stress tests are being completed and some banks are being 

told how much extra capital they will need. However, I think there 

is a lot more to be done after that because large volumes of troubled or toxic acids remain on the books of the banks, and more 

such acids are being created as the recession continues. 

34 

It is possible that one or more banks will become insolvent and 

will have to be taken over by the authorities. I think it would be 

a terrible mistake, however, any kind of preemptive nationalization 

of other banks. At the same time, getting the U.S. financial sector 

up and running is essential, will be very expensive, and is deeply 

unpopular with the electorate. If Americans want a growing economy next year with an improving labor market, I think Congress 

will have to provide more Treasury TARP funds maybe on a large 

scale. The cost of taxpayers in the country will be lower than a 

deeper recession and lower than nationalization. 

Let me turn now, specifically, to the questions that were asked. 

Should regulation prevent financial institutions from becoming 

‘‘too big to fail’’? I tend to agree with Peter on this one. I think we 

actually need very large financial institutions. New York is really 

the center of the financial world, New York and London, and we 

need large-scale institutions to continue and sustain the process of 

globalization that I think contributes to global prosperity. Well, 

some of the institutions are going to end up being ‘‘too big to fail,’’ 

really, whether we like it or not. 

I do think ‘‘too-big-to-fail’’ institutions, or too interconnected institutions, can be regulated in a way that at least partially offsets 

the risks they pose to the rest of the financial system because of 

their status. We need better capital standards. They need to be increased progressively as a bank increases in size or another financial institution. And I think financial regulators should have special ability to look at these institutions to make sure that their 

portfolios are not unduly taking on too much risk. And I think 

there should also be some restrictions on bank mergers so that we 

are not creating more ‘‘too-big-to-fail’’ institutions than we need to 

have. In other words, ‘‘too big to fail’’ is sort of a necessary evil but 

not something that we should really like. 

Should the existing institutions be broken up? No, I do not think 

so, particularly if they have grown organically. If they have become 

efficient and grown, performing services for the U.S. and the global 

economy, I do not think there is a case for breaking them up. On 

the other hand, if we are—for example, if Sheila Bair is dealing 

with another bank failure, I think it certainly should be part of her 

mandate not to end up with creating a ‘‘too-big-to-fail’’ bank. Again, 

like the previous answer, we are stuck with ‘‘too big to fail,’’ but 

we certainly do not want more of them than we have to. 

Now, what requirements should be imposed on ‘‘too-big-to-fail’’ 

institutions? The one thing I would say about that is that if you 

are a ‘‘too-big-to-fail’’ institution, you have an advantage. Your borrowing costs are lower than they would be otherwise. Alan Greenspan at a meeting at Brookings suggested that that number was 

about 50 basis points. I think we need to take a good, hard look 

at what that number is because I think it actually gives us some 

room to impose on large banks certain additional regulations, additional capital requirements, additional supervision of their portfolios, certain things that we can do. 

You see, there is a concern that if you impose extra regulations 

on large banks, then they become uncompetitive, and then all of a 

sudden, activities migrate out of those banks. They go to the Caribbean or something like that. So we want these big banks to be 

35 

carefully regulated, but at the same time not to have to pay an 

undue penalty that makes them uncompetitive. 

We do need improved resolution procedures. I would be happy to 

talk about that more. I know my colleague is going to say something about that. 

The final point I want to make in this—I will just say I endorse, 

by the way, the idea of this convertible debt. I think that is a good 

way of increasing the capital requirements for some of these large 

banks. 

The last point I want to make in my last second is essentially 

that this crisis, I believe, was a market failure and regulatory failure. And if we try to brand it one or the other, we are not going 

to find the right answer to the problem. Markets fail. People who 

had their own money at risk did stupid things and lost the money. 

So market incentives did not work the way we hoped they would. 

At the same time, we had rooms full of regulators regulating some 

of these banks, and they did not do their job either. 

So what we have to find going forward is a way of combining 

good, well-paid, well-trained regulators with good market incentives to try to improve this system in the future. Thank you. 

Senator WARNER. Thank you, Mr. BAILY. Professor Rajan? 

STATEMENT OF RAGHURAM G. RAJAN, ERIC J. GLEACHER DISTINGUISHED SERVICE PROFESSOR OF FINANCE, UNIVERSITY OF CHICAGO, BOOTH SCHOOL OF BUSINESS 

Mr. RAJAN. Thank you. Mr. Chairman, Senators, there is, in my 

view, a more important concern arising from this financial crisis 

than when private institutions are deemed ‘‘too big to fail.’’ Other 

than the reasons that have already been laid out, let me add one 

more. 

When systemically important institutions are bailed out, it is 

very hard for the authorities to refute allegations of crony capitalism, for the outcomes are observationally equivalent; after all, 

the difference is only one of intent. In this kind of system, the authorities do not want to bail out the systemically important institutions but are forced to, while in crony capitalism they do so willingly. 

The collateral damage in this system to public faith and free enterprise is enormous, especially when the public senses two sets of 

rules, one for the systemically important and another one for the 

rest of us. I have avoided saying ‘‘too big to fail.’’ That is because 

size, in my view, is neither necessary nor sufficient for an institution to be deemed too systemic to fail. 

Given my limited time, let me focus on how we can overcome the 

problems of too systemic to fail institutions in some measure. The 

three obvious possibilities: one, prevent institutions from becoming 

too systemic in the first place; second, create additional private sector buffers that keep them from failing; and, third, make it easier 

for the authorities to fail them when they do become truly distressed. 

Let me explain each in turn. 

I personally believe, like Mr. Baily does, that proposals to prevent institutions from expanding beyond a certain size or to signifiVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
36 

cantly limit the activities of some institutions may be very costly 

without achieving their intent. 

Consider some economic costs. Some institutions get large not 

through unwise acquisitions but through organic growth based on 

superior efficiency. A crude size limit applied across the board will 

prevent the economy from benefiting from such institutions. Furthermore, size can imply greater diversification, which can reduce 

risk. Moreover, the threshold size can vary across activities and 

across time. A trillion dollar mutual fund family may not be a concern, while a $25 billion mortgage guarantor might well be. 

Finally, size itself is hard to define. Do we mean assets, gross derivative positions, net derivative positions, transactions or profitability? Given these difficulties, any legislation on size limits will 

have to give regulators substantial discretion. That creates its own 

problems. 

Similar issues arise with activity limits. What activities will be 

prohibited? Some suggest banning banks from proprietary trading, 

that is trading for their own account. But how would the law distinguish between illegitimate proprietary trading and legitimate 

risk-reducing hedging? 

Many of the activities that were prohibited to commercial banks 

under Glass-Steagall were peripheral to this crisis, and activities 

that did get banks into trouble, such as holding sub-prime mortgage-backed securities, would have been permissible under GlassSteagall. 

Finally, regulating size or activity limits would be a nightmare 

because the regulator would be strongly tempted to arbitrage the 

regulations. I would suggest rather than focusing on these limits, 

we focus on creating stronger private-sector buffers in making institutions easier to fail. 

Now, the traditional buffer is capital, and I do agree that raising 

capital might be a good thing, but one should not put too much 

weight for reasons that have already been stated; in particular, 

that banks will tend to take more risks when they are asked to 

hold more capital. In some ways, I would rather advocate a more 

contingent buffer where systemically important institutions arrange for capital to be infused when the institution or the system 

is in trouble. And the difference between the two is quite important. 

As an analogy, additional capital is like keeping buckets full of 

water ready to douse a potential fire. As the years go by and the 

fire does not appear, the temptation is to use up the water. My contrast, contingent capital is like installing sprinklers. There is no 

water to use up, and when the fire threatens, the sprinklers actually turn on. 

One version of contingent capital, proposed by the nonpartisan 

Squam Lake Group, is for a portion of a bank’s debt to be automatically converted to equity when two conditions are met: one, the 

system is deemed in crisis either based on regulatory assessments 

or based on objective indicators like the size of losses of the system; 

and, second, the bank’s capital ratio falls below a certain value. 

There are other versions of contingent capital, such as requiring 

banks to purchase fail-safe insurance policies from unlevered institutions that will provide them an insurance payment when they 

37 

are in trouble, and there are ways of structuring this that I would 

be happy to go into. 

Let me turn to the other possible remedy, making them easier 

to fail. And here I think that there are a number of issues that 

have been talked about, which makes banks hard to fail. I would 

suggest we also want to recruit banks in the process of making 

themselves easier to fail. And this is why I would suggest that 

banks also be subject to a requirement where they focus on creating a shelf bankruptcy plan, which would focus on how they 

themselves could be made easier to fail. For example, over time, 

the amount of time it will take to fail a bank could be reduced to 

such time as we could actually fail some of these large institutions, 

over a weekend. 

By putting this requirement and stress testing it at regular intervals, I think you would give banks an incentive to become less 

complicated, not to add layers of complexity in the capital structure 

or in the organization structure, and we could well get easier resolution. 

Senator WARNER. Thank you, sir. 

The vote has started, I think, about 10:56. I will try to ask two 

to three minutes worth, and then if Senator Bennett or Senator 

Merkley want to try to get it in before the vote. If not, we will go 

into recess. And I am not sure how many votes there are going to 

be, so we will have to have a little flexibility. 

Very quickly, without lots of extra commentary, Peter, I would 

love to hear your comment about not having the need in terms of 

a non-bank financial systemic risk regulator, where we deal with 

the AIGs of the world. 

For all of the panel, perhaps very briefly, Mr. Baily, Mr. 

Wallison, you both said we do not want to make a line in the sand 

about ‘‘too big to fail,’’ but, in effect, what we want to do is we want 

to try and stop more institutions from becoming ‘‘too big to fail.’’ 

At some point, if we are going to have additional capital requirements, or if we are going to have added insurance fees or other 

kinds of resolution fees, we are going to have make some definition. 

We are still going to be backed into a definition, are we not? 

Third, questions where we are saying we ought to allow these to 

grow organically. But some of the actions of, for example, the combination of Merrill and Bank of America, and some of the other 

things that have taken place in the last six months, I am not sure 

these would have all have been in the normal course of organic 

growth. And does that mean because of the crisis, we have to then 

live with these institutions that were, in effect, created out of the 

crisis? 

I know that is a lot. If you could keep your comments or answers 

fairly short, so, again, my colleagues may get a word in before we 

go to vote. 

Mr. WALLISON. Okay. Well, let me try first. I will go first, and 

let me just talk about two things. First, the idea of being backed 

into a definition, I think it is very dangerous for Congress to say 

to a regulatory agency, ‘‘You make this choice,’’ because the inclination of the regulatory agency under all circumstances will be to be 

very liberal—small ‘‘L’’ here—in choosing because they will get into 

trouble if some of that occurs and they have not put an institution 

38 

within the charmed circle that would be regarded as a systemically 

important or a ‘‘too-big-to-fail’’ institution. 

So Congress has to be very specific, it seems to me, about what 

constitutes systemic risk, what is ‘‘too big to fail,’’ and under what 

circumstances it is possible for an agency to take them over in that 

sense. 

Now, AIG is a really great example of a lot of things, and we do 

not really have time to talk about it all. But AIG probably should 

have gone into bankruptcy, and if they had gone into bankruptcy— 

and I cover this in detail in my prepared statement. If they had 

gone into bankruptcy, there would not have been any substantial 

impacts throughout the rest of the economy. 

We also saw that Lehman did go into bankruptcy, and right after 

that, there was turmoil, but the reason for that is that the market 

was unprecedentedly fragile. I do not think we have ever seen, at 

least certainly in my lifetime, probably not since the Great Depression, a market where almost all of the financial institutions in the 

world were regarded as unstable and possibly insolvent. And 

when—and I think Gary Stern said this. When that institution 

failed, when Lehman was allowed to fail, suddenly everyone said, 

‘‘Oh, there is a different world out here because I had assumed,’’ 

they said to themselves, ‘‘after Bear Stearns that no large institution would be allowed to fail. I now have to look at all of the institutions I deal with.’’ And that is why all the lending came to a halt. 

That was a classic case of moral hazard. 

And if we allow ourselves to get into a position where we are 

bailing out institutions like an AIG on a regular basis—and if we 

give regulators the power to do it, they will do it—then we will 

bring much more moral hazard into our economy. 

Thank you. 

Mr. BAILY. The Volcker Commission used this with SIFIs, or 

‘‘systemically important financial institutions,’’ maybe that is a better word than ‘‘too big too fail,’’ but, anyway, certainly institutions 

in which there is a danger that the whole system will come down. 

How do you define that? I do not know the answer to that. I think 

it has to be done through guidelines provided by Congress with 

some discretion for the regulators. 

In terms of AIG going down and Lehman going down, I disagree 

with Peter fundamentally. I think we had to do what was done 

with AIG to prevent further repercussions. I do think that the failure of Lehman was a mistake, and I think most people looking 

back would agree that it would not have taken that much to prevent the disorderly collapse of Lehman, which had substantial impacts in London and other parts of the world. So I do think we do 

need to make sure not that shareholders benefits—because shareholders go down, as they should, but that some of the fallout from 

those institutions is prevented. 

You mentioned that we have sort of created these monsters now 

by putting together some of the banks. I think the Treasury and 

the Federal Reserve were acting quickly to try to deal with a very 

difficult crisis. I think with the benefit of hindsight, maybe it would 

not have been such a great idea to make Bank of America take 

over Merrill, or whatever. I think some of those mistakes—or some 

of those decisions that were made rather quickly were not always— 

39 

may not have been the best ones. But in point of fact, we are now 

stuck with those institutions. They are SIFIs, and they have to be 

regulated with additional capital requirements and some of the additional requirements so that they do not pose systemic dangers. 

Senator WARNER. We are down to 7 minutes, and we have got 

to get over to the capital, so, Professor, briefly. 

Mr. RAJAN. Very quickly, I think it is a mistake to identify systemically important institutions. Then you make the market actually treat them as systemically important and act accordingly. That 

is a problem. 

I think you can talk about systemically important. You can sort 

of have a broad definition. But, in general, regulations should not 

identify them and create a difference between systemically important and others. 

Perhaps you can have increasing capital requirements based on 

size, but it would not have to be capital requirements which suddenly change when you move from being an ordinary bank to becoming a systemically important bank. I think that will be the 

challenge that Congress has in devising regulations, how to deal 

with systemically important without actually identifying the specific institutions that are systemically important. 

Senator WARNER. If I heard correctly, I think you have all said, 

you know, this is very challenging, do not leave it to the regulator, 

and you better not mess up, Congress. 

Thank you. I think the Committee will stand in recess until we 

are finished voting. 

[Recess.] 

Senator AKAKA. [Presiding.] This hearing, Martin Baily, 

Raghuram Rajan and Peter Wallison, I will begin with you on 

questions to all of you. 

It is pretty clear that our current regulatory system failed to address the risks taken by many large financial organizations that resulted in the current economic crisis. It is equally clear that these 

companies grossly failed to manage their risks. And with all of this, 

we have been making every effort to deal with the problems they 

face and to try to stabilize the problems that we have. 

So, the second panel, I would like to ask you, should Congress 

impose a new regime that would simply not allow financial organizations to become too large or too complex, perhaps, by imposing 

strict size or activity restrictions? 

So let me first all on Mr. Wallison for your response. 

Mr. WALLISON. Yes. In my prepared testimony, Mr. Chairman, I 

said that that would not be a good policy to keep institutions from 

growing. My colleagues here, in answer to questions from the first 

part of this panel before we recessed, took fundamentally the same 

point, saying that, well, if an institution has gotten very large because it is very efficient and a good competitor, then it ought not 

to be penalized and broken up for that reason. 

I want to go just a little bit further and say that we have very 

large operating companies in this country. We are continuing to 

grow these operating companies. And large operating companies 

need—especially if they are operating globally, need large, globally 

operating banks. And if you try to imagine an oil company trying 

to pay all of its employees around the world on the same day, withVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
40 

out a bank that can do all of that in every major area, you can see 

the kind of problem that arises. 

So I do not think it would be good policy to break up companies 

or keep them from getting larger if they are getting larger because 

they are competing well. 

Senator AKAKA. Thank you. 

Mr. Baily? 

Mr. BAILY. Thank you. First of all, I agree with you very much 

that we failed to address the risks and companies failed to manage 

their risks. 

One of the most interesting and revealing documents that I read 

in all of this was written by UBS, the Swiss Bank, at the insistence 

of the Swiss Central Bank, that described its own risk management 

procedures and how they had failed. And it is an extraordinary document of how they did not follow their own internal risk management. They jeopardized their own company. They subsequently had 

to be supported by the Swiss Central Bank, which in turn has had 

to rely, to some extent, on our federal reserve. It is an extraordinary story, which goes to the point that you mentioned. 

I agree with Peter, generally, in the remarks that he made, that 

we require these very large banks. When the crisis hit, for example, there was a huge collapse in global trade. Traders in India 

could not import and export because they had relied on financing 

coming through New York. So I agree with him very much that we 

need these large banks, particularly if they are growing and providing services to the U.S. and the global economy and are doing 

it efficiently. 

At the same time—and I think, again, we have some not complete agreement, but some broad agreement, that as banks become 

bigger or more interconnected—it is not always size, obviously— 

that we need special supervision, either increased cap requirements, increased supervision of their portfolios, or some mechanism 

to make sure that we do not get a repeat of what happened to 

UBS. 

Now, I do not think we are going to get that next year because 

I think a lot of people have learned their lesson. But we have to 

have in place a system that 10 years from now, 20 years from now, 

when some of these lessons have been forgotten, that we have in 

place a better regulatory regime. 

I would say one more thing about that regulatory regime. We 

cannot, probably in this country, ever pay regulators what people 

earn on Wall Street. Some countries pay their regulators very high 

salaries. There are limits to what we can do here. But I do think 

it would make a difference if we could pay reasonably competitive 

salaries, more than they are currently making. We should insist on 

training regulators so we give ourselves the best chance of avoiding 

some of the regulatory failures that happened in the course of this 

crisis. Thank you. 

Senator AKAKA. Thank you very much, Mr. Baily. 

Mr. Rajan. 

Mr. RAJAN. Thank you, Mr. Chairman. I agree substantially with 

my co-panelists that size limits are relatively crude, very hard to 

enforce, because there are also ways around it; very hard to determine ex ante for Congress through legislation. 

41 

Similarly, with activities; again, activity limits, which products 

are you going to limit? The same product can be used in a good and 

purposeful way, and the same product can be used for taking on 

speculative risks of extraordinary levels. And so, given that intent 

is often what distinguishes a product used appropriately and a 

product used inappropriately, it is very hard to have legislation 

governing that. 

So anytime you go into size limits or activity limits, you are 

going to have to give a lot of discretion to regulators. And I think, 

as Mr. Baily pointed out earlier, regulators have to also cover 

themselves with a lot of glory during this crisis, and do we really 

want to put a lot of weight on their judgment. 

I think there is no magic bullet to this problem. I think it is a 

very serious problem. It is a problem we have to deal with. And 

there have been a number of suggestions that have been made by 

this panel. One I would re-emphasize is that in addition to trying 

to find ways to, perhaps, make activities a little safer and create 

some buffers, I think we should also make these institutions easier 

to fail. And that is a focus that is not present in much of the debate; that if we could make these institutions less complex, make 

their capital structures a little easier to resolve, I think that would 

go a long way in reducing the problem. 

One of the suggestions that I would like to emphasize is that if 

we try and enlist these institutions in preparing their own funeral 

plans, get them to talk about business termination, if the authorities had to close them down, how would the authorities go about 

it, and try and get them to start preparing these plans so that, in 

fact, when the authorities intervene, there is already a ready-made 

process. 

I think that would help us also in this. It would also force these 

institutions to stay away from excessively complicated structures or 

excessive derivative positions. And so, that could be part of the legislative agenda, prepare your own business termination plans or 

pre-packaged bankruptcy, which you have to negotiate and discuss 

with regulators on a periodic basis. 

Senator AKAKA. Thank you very much for that. 

Let me give some time back to the panel to make any further 

comments that you would like to make on this. 

Mr. Wallison? 

Mr. WALLISON. Yes. I would like to just address one point that 

I think is fundamental here. And that is, we have to put some 

boundaries around what we mean by ‘‘too big to fail.’’ We have to 

make—Congress has to do something to give guidance to the regulatory agency. 

One of the worst things that could happen here, if legislation is 

adopted, is that we create a system in which companies that should 

fail are bailed out because the regulators decide that they are ‘‘too 

big to fail.’’ And since we do not know what is ‘‘too big to fail,’’ we 

have not really got a definition of that, we cannot even—we know 

that it is out there somewhere, but we cannot define it well. By giving regulatory agencies the opportunity to resolve, it is said, these 

institutions, they will say, in many cases, that the institution is 

‘‘too big to fail.’’ And they will bail out that institution when it 

should have been allowed to fail. 

42 

The result of that, I am afraid, is that whenever an institution 

that should have been allowed to fail continues in life a bad business model and a bad management, is there to continue operating, 

when if it had disappeared, better management and better business 

models would have come up to replace it. So we weaken our entire 

competitive system if we do not allow institutions that should fail 

to fail. 

Senator AKAKA. Thank you. 

Mr. Baily? 

Mr. BAILY. Thank you. First of all, let me talk about the context 

under which an institution becomes ‘‘too big to fail’’ or where we 

decide that it cannot be just allowed to fail. 

I have studied the automobile industry over a number of years, 

and if you had asked me a few years ago if one of our big automobile companies gets into trouble, should we let it fail, I would 

have said let it go down. I am not going to name names, but I 

think there were a lot of failures of management, of workers, of 

technology. So, you know, let the market work. 

When that same question came up in the last year, with great 

reluctance, when I was asked that question, I said, no, I do not 

think we can allow a disorderly bankruptcy of some of our largest 

automobile companies. And it is not because I wanted to do that; 

it is because we are in a time of economic crisis, and I felt that 

such a bankruptcy at that time would have brought the economy 

down. 

So, again, in the case of banks, there may be circumstances 

under which even quite large banks can be allowed to fail. And so 

I agree very much with the sentiment that we would like to have 

kind of plans in place for how we resolve large banks, allow them 

to fail. I do not think they can go through the normal bankruptcy 

process, but they go through a process in which they either go to 

the FDIC or resolved if they are bank holding companies. 

Now, Raghuram has made the suggestion, which he did in a very 

interesting article in The Economist, that we should have these funeral plans, that the banks should set up their own funeral plans. 

So they should be required to say, if we go broke, here is how you 

should go about regulating us. 

I have to say I was a bit skeptical in a comment that I made on 

that. It is sort of not the way businesses really work. Maybe you 

could do it, but I think it is probably more up to the regulators, 

maybe with some insistence from the banks, in figuring out if you 

do have these very large institutions, how interconnected are they, 

what are the counterparties to some of their positions, and what 

would be necessary; can we, in fact, let them go down under normal times without getting lots of taxpayer money caught up in this. 

Senator AKAKA. Mr. Rajan? 

Mr. RAJAN. Yes. The one comment I will make is it seems to me 

that the one concern is that a number of institutions, and the way 

they structure their activities, essentially make themselves ‘‘too big 

to fail.’’ And that is why I think you want to give them incentives 

not to become that way. 

Let me give an example. One of the reasons we worried about 

these large banks is the destruction of the payment and settlement 

system that happens when we fail these banks. Well, there are inVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
43 

tricate ways in which the liability system of these banks is tied to 

the payment and settlement system. Right? 

One example is derivative contracts, which come due and have 

to be replaced if, in fact, the bank cannot make good on its debt. 

When you reduce the value of the debt, immediately, there is a consequence to the derivative contracts that the bank is involved in. 

These kinds of connections, interconnections, actually make the 

bank essentially too complicated, ‘‘too big to fail.’’ And my suggestion of forcing them to think about their own demise and proving 

to regulators that they could be closed in a relatively short time period—a weekend was just a number out of the box; but in a week, 

I think the rationale for that is you want to give these banks an 

incentive to think about not making themselves excessively complicated. And one way to do it is to put the onus on them to make 

their structures more simple, their liability structures, their organizational structures, so that when the regulator actually comes to 

unwind this bank, they have a less complicated entity to deal with. 

It is not going to be the answer by itself, and I think we need 

a lot of proposals on the table to do it, but it could be one piece 

of what we need. 

Senator AKAKA. Thank you. 

This next question is for the panel, again, and has to do with 

about setting standards. 

A lot of commentators criticize our capital standards as being 

pro-cyclical, demanding that financial companies raise expensive 

capital at the worst possible times and too little capital in good 

times. 

What are your views on having regulators set standards that require banks and other financial companies to build capital when 

the economy is strong as a cushion to weather the downturns? 

Mr. Wallison? 

Mr. WALLISON. I will take that first, I think. My view is—first 

of all, I do not—in my prepared testimony and in my oral testimony, I said that I thought that banks were the only organizations 

that really required serious regulation for a variety of reasons. 

They can create systemic risk, but I do not think others can. 

On the question of this capital, what we do about banks that are 

growing and yet they still have the same amount of capital, which 

increases their leverage, I am one who does believe that we ought 

to increase capital requirements as growth occurs. As profitability 

and growth occurs, capital should go up so that it can perform the 

function that it was supposed to perform, which is as a buffer for 

the bad times. 

I think we are seeing today that the 10 percent risk-based capital 

requirement that was imposed in the United States under Basel I 

and Basel II, for well capitalized, was insufficient. Banks should 

have had more capital. But in addition, they should have added to 

their capital positions as a percentage, as they have grown larger 

and larger, and as they have more and more profits. 

That is something that we could very profitably do. And as a 

matter of fact, it would also go some distance to addressing this 

question of institutions getting too large and complex, because if 

additional capital requirements are imposed on them as they get 

larger and more complex, they will not get larger and more comVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 S:\DOCS\53822.TXT SHERYL
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plex. They will make a judgment about what they have to do to be 

profitable rather than just getting larger. 

Senator AKAKA. Mr. Baily? 

Mr. BAILY. I agree with much of what Peter said. I think we do 

need to increase capital requirements, and capital needs to play its 

role as a buffer. When there is a loss of assets, then the capital 

goes down, and now the capital that is left should be enough still 

to satisfy, certainly, the markets and the regulators, who are taking the appropriate cyclical view of capital that the bank is still an 

adequate position. So I think we do need to raise capital requirements and allow it to work appropriately as a buffer. 

One concern about capital is that many of our banks are competing internationally. Even before this crisis, there were many 

complaints that I heard, I think correctly, that U.S. banks were required—not the investment banks, that U.S. banks were required 

to hold more capital than European or other banks, and were having difficulty competing globally. So I think this is something that 

needs to be done with some degree of level cooperation. 

I say that cautiously because global cooperation on financial regulation has been difficult to do and has not worked very well. But 

I think this is an area we need to at least try to keep the playing 

field level in terms of capital. So higher capital requirements. 

It is not just capital requirements, though, obviously, because— 

so you had 20 percent capital requirement, but you had all these 

sub-prime mortgages, and that probably might not well have saved 

you. So I think it is a matter of—and in other cases where there 

was people borrowing—well, banks were borrowing at overnight 

rates or one-week rates and issuing mortgages on the other side of 

that, as Northern Rock in the UK did, for example. 

So it is a combination of more capital, some reasonable level of 

match so that there is not too much of a mismatch on the balance 

sheet, and the quality of the portfolio. So those combinations of 

things I think we need to do. 

Senator AKAKA. Mr. Rajan? 

Mr. RAJAN. This is probably where I part a little with my fellow 

panelists. I think that capital can do a little bit. I would be skeptical about putting too much weight on it. And the reason is simply 

that the market in good times is very tolerant of institutions that 

have very high levels of leverage. As you know, some banks had 

30, 40 to 1 leverage. Some investment banks had that kind of leverage. 

The market was willing to tolerate very low levels of capital. 

When the market is willing to tolerate those very low levels of capital, somebody who is sitting on a lot of capital has an incentive 

to undertake actions, which will reduce that level of capital relative 

to the activities they are taking. 

One example of such actions include creating off-balance sheet 

vehicles, which banks did a lot of. The SIVs and the conduits are 

examples. A second example of that kind of activity is for banks to 

take up risks, which is not penalized. UBS did that when it took 

on all these sub-prime mortgages on its balance sheet. 

So I think capital can help a little, but I think that banks, if the 

market does not require them to hold a lot of capital, banks are 

45 

going to offset the capital requirement in ways that the regulator 

will not see. 

Moreover, this notion that in down times, banks can reduce the 

level of capital because the regulator allows them to, I am skeptical 

about that also because in times like these, this is when the market has taken fright. This is when the market wants banks to hold 

much higher levels of capital. Whatever the regulators say, the 

markets are going to dominate. And so, banks are going to raise 

their capital levels at this point, which is why you see this extreme 

level of de-leveraging taking place in the market, in the banking 

sector. 

So my sense is capital requirements which go against what the 

market wants are going to have limited effect. They will have some 

effect, no doubt, but let’s not be overly convinced about the effect 

it will have. 

Senator AKAKA. Thank you. 

Mr. BAILY. Can you allow me just to respond to that? Because 

I think it is a very interesting question, and I do not think I have 

all the answers by any means. 

But, presumably, if you set a high enough level of capital in the 

good times, then when the losses come in, the bank capital goes 

down. But if you have started high enough, you still have enough 

capital left to satisfy the market that you are still sold on. That is 

the idea of having high capital levels in good times. 

By the way, I agree with you, you need other things besides capital. 

Senator AKAKA. Mr. Rajan? 

Mr. RAJAN. I agree that they could have some effect. But my 

point is when you set capital requirements at 20 percent of bank 

assets, they are going to do a lot of things, which you will be surprised about in bad times because those SIVs, they have created 

the conduits. It will all come back on balance sheets at that point, 

and you will find that even the 20 percent is not enough. That is 

one. 

The second is we also have to worry about costs. When you ask 

banks, which are naturally funded with debt, to take on a lot of 

capital, intermediation is also going to suffer. I mean, I agree with 

you. You could have some benefits, but maybe not that much. 

Senator AKAKA. Thank you. 

Speaking about capital and ensuring adequate capital, Mr. Rajan 

raises the idea of having large, complex financial companies buy 

capital insurance plans or issue bonds that will convert to equity 

if capital deteriorates as a way to guard against the failure of these 

institutions. 

Mr. Rajan, can you elaborate on this idea? 

Mr. RAJAN. Well, this follows on the comments I just made, 

which is that if capital on the balance sheet is not going to work 

that well because banks will find ways to offset it, maybe the idea 

is to get capital which comes only in bad times. It might be cheaper 

to arrange for that kind of capital rather than have capital sitting 

on balance sheets through good times and bad times. And if you 

can do it in a clever enough way, banks will not be able to exploit 

that capital and take on more risks a priori, given that they know 

that capital will come in. 

46 

So two examples of how this could be done. One, which Mr. Baily 

has also talked about, which comes from a common group that we 

work in, is this idea of what is called reversed convertible debt. 

And this convertible debt is debt which will convert into equity in 

times like the current ones. So it is a pre-assured source of buffer 

which will protect the taxpayer from having to fund these institutions. And that debt will convert, provided the bank’s capital ratio 

goes below a certain level. That is one condition. 

The second condition is that this be a systemic crisis so that 

banks do not sort of willfully convert this debt and get additional 

buffers. Another variant of this would be what we call the capital 

insurance plan, which is you issue bonds, which are called capital 

insurance bonds. The bank issues these bonds. The proceeds from 

the bonds are taken and invested in Treasuries. And the holders 

of these bonds get the Treasury rate of return plus an insurance 

premium, which the banks pays. In bad times, when the bank’s 

capital goes below a certain level and there is a systemic crisis, the 

bonds will start, essentially, paying out to the bank. It would be 

equity at that point for the bank, and the bank would be recapitalized. 

So the main difference is, in one, the bonds convert to equity; in 

the other, the bonds just pay in. There is no commensurate equity, 

which is issued. Both have the effect of recapitalizing the bank in 

bad times. 

Senator AKAKA. Thank you. 

Further comment, Mr. Wallison? 

Mr. WALLISON. I think what Raghu has said is a very interesting 

proposal. I have this concern, however. And if we keep our eye on 

the ball, we are talking about systemic risk. And what is systemic 

risk? Systemic risk is the risk that when a large financial institution fails, a large bank fails, it has effects on all others throughout 

the economy, or many others, a contagion, if you will, a cascading 

of losses. 

The idea that we would convert debt into equity is good for the 

bank, but you have to consider what it does to the holders who previously had debt and now have equity; what it does to their balance 

sheets and what it does to their risk profiles. And what it does, of 

course, it make them much more risky. 

So in other words, in a time when we are talking about trying 

to prevent systemic risk, we are also thinking favorably about an 

idea that, actually, encourages, increases the possibility of contagion from a failed institution or a failing institution, to institutions that might otherwise be healthy. 

Mr. RAJAN. Could I respond? 

Senator AKAKA. Mr. Rajan? 

Mr. RAJAN. The quick response is this is a clear problem that Mr. 

Wallison has pointed out. And the answer is that the holders of 

this debt should not be levered financial institutions. It should not 

be other banks. It should not be insurance companies. 

So who would hold? It would be un-levered financial institutions, 

such as pension funds, mutual funds, sovereign wealth funds. 

Now, the immediate question, then, is, well, is there any evidence that there are people who buy this kind of instrument? And 

the answer is yes. There is a very liquid market in credit-default 

47 

swaps on bank debt. That credit-default swap on bank debt has exactly the properties of the kind of insurance we are talking about. 

That is, it pays out when the bank is doing really badly, which 

typically is when the economy is in trouble. And there are people 

who are willing to buy this instrument, so much so, that this market has gone beyond bounds. It has become extremely large and we 

are trying to contain it. 

But it is suggesting demand is not going to be a problem if we 

do this right. And we can try and regulate so that the costs are 

borne by financial institutions that are not levered. And the costs 

are not forced to be borne by the taxpayer, which, to my mind, is 

worse than getting some people who bear it, knowing that they 

have been paid for bearing that risk. 

Senator AKAKA. Mr. Baily? 

Mr. BAILY. I like this proposal. Obviously, we have jointly put 

our names to it. I think it is possible that there could be more severe kinds of systemic crises in which the convertible capital would 

not be adequate, in which case we do need to go to other procedures, processes, for orderly resolution of some of these institutions. But I think having this kind of capital would make that less 

likely and make the system more stable. 

Senator AKAKA. Well, I want to thank you so much. This has 

been stimulating to hear from you. And it, certainly, without question, will help the Committee in its legislative efforts here. 

I want to thank our witnesses for joining us today. I want you 

to know that the hearing record will remain open for a week for 

statements from members or questions that members may have. 

Thank you again. This hearing is adjourned. 

[Whereupon, at 12:11 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions follow:] 

48 

PREPARED STATEMENT OF SHEILA C. BAIR 

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

MAY 6, 2009 

Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the need to address the issue of systemic risk and the existence 

of financial firms that are deemed ‘‘too big to fail.’’ 

It has been a difficult 18 months since the financial crisis began, but despite some 

long weekends and tense moments, government and industry have worked together 

to take extraordinary measures to maintain the stability of our financial system. 

The FDIC has been working with other federal agencies, Congress, and the White 

House to protect insured depositors and preserve the stability of our banking system. We have sought input from the public and the financial industry about our programs and how to structure them to produce the best results to turn this crisis 

around. There are indications that progress is being made in the availability of credit and the profitability of financial institutions. As we move beyond the liquidity crisis of last year, we must examine how we can improve our financial system for the 

future. 

The financial crisis has taught us that many financial organizations have grown 

in both size and complexity to the point that, should one of them become distressed, 

it may pose systemic risk to the broader financial system. The managers, directors 

and supervisors of these firms ultimately placed too much reliance in risk management systems that proved flawed in their operations and assumptions. Meanwhile, 

the markets have funded these organizations at rates that implied they were simply 

‘‘too big to fail.’’ In addition, the difficulty in supervising these firms was compounded by the lack of an effective mechanism to resolve them when they became 

troubled in a way that controlled the potential damage their failure could bring to 

the broader financial system. 

In a properly functioning market economy there will be winners and losers, and 

some firms will become insolvent and should fail. Actions that prevent firms from 

failing ultimately distort market mechanisms, including the market’s incentive to 

monitor the actions of similarly situated firms. Unfortunately, the actions taken 

during the past crisis have reinforced the idea that some financial organizations are 

‘‘too big to fail.’’ The most important challenge now is to find ways to impose greater 

market discipline on systemically important financial organizations. 

My testimony will examine whether large institutions posing systemic risk are 

necessary for the efficient functioning of our financial system—that is, whether they 

promote or hinder competition and innovation among financial firms. I also will 

focus on some specific changes that should be undertaken to limit the potential for 

excessive risk in the system, including identifying systemically important institutions, creating incentives to reduce the size of systemically important firms and ensuring that all portions of the financial system are under some baseline standards 

to constrain excessive risk taking. 

In addition, I will explain why an independent, special failure resolution authority 

is needed for financial firms that pose systemic risk and describe the essential features of such an authority. Finally, independent of the systemic risk issue, I will 

discuss the benefits of providing the FDIC with a statutory structure under which 

we would have authority to resolve a non-systemic failing or failed bank or thrift 

holding company, and how this authority would improve the ability to effect a least 

cost resolution for the depository institution or institutions it controls. 

Do We Need Financial Firms That Are Too Big to Fail? 

Before policymakers can address the issue of ‘‘too big to fail,’’ it is important to 

analyze the fundamental issue of whether there are economic benefits to having institutions that are so large and complex that their failure can result in systemic 

issues for the economy. Because of their concentration of economic power and interconnections through the financial system, the management and supervision of institutions that are large and complex has proven to be problematic. Unless there are 

clear benefits to the financial system that offset the risks created by systemically 

important institutions, taxpayers have a right to question how extensive their exposure should be to such entities. 

Over the past two decades, a number of arguments have been advanced about 

why financial organizations should be allowed to become larger and more complex. 

These reasons include being able to take advantage of economies of scale and scope, 

diversifying risk across a broad range of markets and products, and gaining access 

to global capital markets. It was alleged that the increased size and complexity of 

these organizations could be effectively managed using new innovations in quanVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00052 Fmt 6633 Sfmt 6621 S:\DOCS\53822.TXT SHERYL
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titative risk management techniques. Not only did institutions claim that they could 

manage these new risks, they also argued that often the combination of diversification and advanced risk management practices would allow them to operate with 

markedly lower capital buffers than were necessary in smaller, less-sophisticated institutions. 

Indeed many of these concepts were inherent in the Basel II Advanced Approaches, resulting in reduced capital requirements. In hindsight, it is now clear 

that the international regulatory community over-estimated the risk mitigation benefits of diversification and risk management when they set minimum regulatory 

capital requirements for large, complex financial institutions. 

Notwithstanding expectations and industry projections for gains in financial efficiency, the academic evidence suggests that benefits from economies of scale are exhausted at levels far below the size of today’s largest financial institutions. Also, efforts designed to realize economies of scope have not lived up to their promise. In 

some instances, the complex institutional combinations permitted by the GrammLeach-Bliley (GLB) Act were unwound because they failed to realize anticipated 

economies of scope. Studies that assess the benefits produced by increased scale and 

scope find that most banks could improve their cost efficiency more by concentrating 

their efforts on improving core operational efficiency. 

There also are practical limits on an institution’s ability to diversify risk using 

securitization, structured financial products and derivatives. Over-reliance on financial engineering and model-based hedging strategies increases an institution’s exposure to operational, model and counterparty risks. 

Clearly, there are benefits to diversification for smaller and less complex institutions, but the ability to diversify risk is diminished as market concentration rises 

and institutions become larger and more complex. When a financial system includes 

a small number of very large, complex organizations, the system cannot be well-diversified. As institutions grow in size and importance, they not only take on a risk 

profile that mirrors the risk of the market and general economic conditions, but they 

also concentrate risk as they become the only important counterparties to many 

transactions that facilitate financial intermediation in the economy. These flaws in 

the diversification argument become apparent in the midst of financial crisis when 

large, complex financial organizations—because they are so interconnected—reveal 

themselves as a source of risk to the system. 

Creating a Safer Financial System 

A strong case can be made for creating incentives that reduce the size and complexity of financial institutions as being bigger is not necessarily better. A financial 

system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over 

a long period of time will always make the right decisions at the right time. 

Reliance solely on the supervision of these institutions is not enough. We also 

need a ‘‘fail-safe’’ system where if any one large institution fails, the system carries 

on without breaking down. Financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold 

larger capital and liquidity buffers to mirror the heightened risk they pose to the 

financial system. In addition, restrictions on leverage and the imposition of riskbased premiums on institutions and their activities would act as disincentives to 

growth and complexity that raise systemic concerns. 

In contrast to the standards implied in the Basel II Accord, systemically important firms should face additional capital charges based on both their size and complexity. To address pro-cyclicality, the capital standards should provide for higher 

capital buffers that increase during expansions and are drawn down during contractions. In addition, these firms should be subject to higher Prompt Corrective Action 

(PCA) limits under U.S. laws. Regulators also should take into account off-balancesheet assets and conduits as if these risks were on-balance-sheet. 

One existing example of statutory limitations placed on institutions is the 10 percent nationwide cap on domestic deposits imposed in the Riegle-Neal Interstate 

Banking and Branching Efficiency Act of 1994. While this regulatory limitation has 

been somewhat effective in preventing concentration in the U.S. system, the RiegleNeal constraints have some significant limitations. First, these limits only apply to 

interstate bank mergers. Also, deposits in savings and loan institutions generally 

are not counted against legal limits. In addition, the law restricts only domestic deposit concentration and is silent on asset concentration, risk concentration or product concentration. The four largest banking organizations have slightly less than 35 

percent of the domestic deposit market, but have over 45 percent of total industry 

50 

1FDIC, Call Report data, 4th Quarter 2008. 

assets.1 As we have seen, even with these deposit limits, banking organizations 

have become so large and interconnected that the failure of even one can threaten 

the financial system. 

In addition to establishing disincentives to unchecked growth and increased complexity of institutions, two additional fundamental approaches could reduce the likelihood that an institution will be ‘‘too big to fail.’’ One action is to create or designate a supervisory framework for regulating systemic risk. Another critical aspect 

to ending ‘‘too big to fail’’ is to establish a comprehensive resolution authority for 

systemically significant financial companies that makes the failure of any systemically important institution both credible and feasible. A realistic resolution regime 

would send a message that no institution is really too big to ultimately fail. 

Regulating Systemic Risk 

Our current system has clearly failed in many instances to manage risk properly 

and to provide stability. While U.S. regulators have broad powers to supervise financial institutions and markets and to limit many of the activities that undermined our financial system, there are significant gaps that led to the current crisis. 

First, there were gaps in the regulation of specific financial institutions that posed 

significant systemic risk—most notably very large insurance companies, private equity and hedge funds, and differences in regulatory leverage standards for commercial and investment banks. Second, there were gaps in the oversight of certain types 

of risk that cut across many different financial institutions. A prime example of this 

was the credit default swap (CDS) market which was used to both hedge and leverage risk in the structured mortgage finance market. Both of these aspects of oversight and regulation need to be addressed. 

A distinction should be drawn between the direct supervision of systemically-significant financial firms and the macro-prudential oversight of developing risks that 

may pose systemic risks to the U.S. financial system. The former appropriately calls 

for a single regulator for the largest, most systemically-significant firms, including 

large bank holding companies. The macro-prudential oversight of system-wide risks 

requires the integration of insights from a number of different regulatory perspectives—banks, securities firms, holding companies, and perhaps others. Only through 

these differing perspectives can there be a holistic view of developing risks to our 

system. As a result, for this latter role, the FDIC would suggest creation of a systemic risk council (SRC) to provide analytical support, develop needed prudential 

policies, and have the power to mitigate developing risks. 

Systemic Risk Regulator 

With regard to the regulation of systemically important entities, a systemic risk 

regulator (SRR) should be responsible for monitoring and regulating their activities. 

Centralizing the responsibility for supervising institutions that are deemed to be 

systemically important would bring clarity and focus to the efforts needed to identify 

and mitigate the buildup of risk at individual institutions. The SRR could focus on 

the adequacy of complex institutions’ risk measurement and management capabilities, including the mathematical models that drive risk management decisions. With 

a few additions to their existing holding company authority, the Federal Reserve 

would seem well positioned for this important role. 

While the creation of a SRR would be a significant improvement over the current 

system, risks that resulted in the current crisis grew across the financial system 

and supervisors were slow to identify them and limited in our ability to address 

these issues. This underscores the weakness of monitoring systemic risk through the 

lens of individual financial institutions, and argues for the need to assess emerging 

risks using a system-wide perspective. 

Systemic Risk Council 

One way to organize a system-wide regulatory monitoring effort is through the 

creation of a systemic risk council (SRC) to address issues that pose risks to the 

broader financial system. Based on the key roles that they currently play in determining and addressing systemic risk, positions on this council should be held by the 

U.S. Treasury, the FDIC, the Federal Reserve Board and the Securities and Exchange Commission. It may be appropriate to add other prudential supervisors as 

well. 

The SRC would be responsible for identifying institutions, practices, and markets 

that create potential systemic risks, implementing actions to address those risks, 

ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring 

51 

that the key supervisors with responsibility for direct supervision apply those standards. The standards would be designed to provide incentives to reduce or eliminate 

potential systemic risks created by the size or complexity of individual entities, concentrations of risk or market practices, and other interconnections between entities 

and markets. 

The SRC could take a more macro perspective and have the authority to overrule 

or force actions on behalf of other regulatory entities. In order to monitor risk in 

the financial system, the SRC should also have the authority to demand better information from systemically important entities and to ensure that information is 

shared more readily. 

The creation of a comprehensive systemic risk regulatory regime will not be a 

panacea. Regulation can only accomplish so much. Once the government formally 

establishes a systemic risk regulatory regime, market participants may assume that 

the likelihood of systemic events will be diminished. Market participants may incorrectly discount the possibility of sector-wide disturbances and avoid expending private resources to safeguard their capital positions. They also may arrive at distorted 

valuations in part because they assume (correctly or incorrectly) that the regulatory 

regime will reduce the probability of sector-wide losses or other extreme events. 

To truly address the risks posed by systemically important institutions, it will be 

necessary to utilize mechanisms that once again impose market discipline on these 

institutions and their activities. For this reason, improvements in the supervision 

of systemically important entities must be coupled with disincentives for growth and 

complexity, as well as a credible and efficient structure that permits the resolution 

of these entities if they fail while protecting taxpayers from exposure. 

Resolution Authority 

The most important challenge in addressing the issue of ‘‘too big to fail’’ is to find 

ways to impose greater market discipline on systemically important institutions. 

The solution must involve, first and foremost, a legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks. 

The purpose of the resolution authority should not be to prop up a failed entity indefinitely, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible. Creating a resolution regime that applies to any financial institution that becomes a source of systemic risk should be an urgent priority. 

The ad-hoc response to the current banking crisis was inevitable because no playbook existed for taking over an entire complex financial organization. There were 

important differences in the subsequent outcomes of the Bear Stearns and Lehman 

Brothers cases, and these difference are due, in part, to issues that arise when large 

complex financial institutions are subjected to the bankruptcy process. Bankruptcy 

is a very messy process for financial organizations and, as was demonstrated in the 

Lehman Brothers case, markets can react badly. Following the Lehman Brothers filing, the commercial paper market stopped functioning and the resulting decrease 

in liquidity threatened other financial institutions. 

One explanation for the freeze in markets was that the Lehman failure shocked 

investors because, following Bear Stearns, they had assumed Lehman was too big 

too fail and its creditors would garner government support. In addition, many feel 

that the bankruptcy process itself had a destabilizing effect on markets and investor 

confidence. While the underlying causes of the market disruption that followed the 

Lehman failure will likely be debated for years to come, both explanations point to 

the need for a new resolutions scheme for systemically important non-bank financial 

institutions which will provide clear, consistent rules for all systemically important 

financial institutions, as well as a mechanism to maintain key systemic functions 

during an orderly wind down of those institutions. 

Under the first explanation, investors found it incredible that the government 

would allow Lehman, or firms similar to Lehman, to declare bankruptcy. Because 

the protracted proceedings of a Chapter 11 bankruptcy were not viewed as credible 

prior to the bankruptcy filing, investors were willing to make ‘‘moral hazard’’ investments in the high-yielding commercial paper of large systemic institutions. Had a 

credible resolution mechanism been in place prior to the Lehman bankruptcy, investors would not have made these bets, and markets would not have reacted so negatively to the shock of a bankruptcy filing. 

Under the second explanation, the legal features of a bankruptcy filing itself triggered asset fire sales and destroyed the liquidity of a large share of claims against 

Lehman. In this explanation, the liquidity and asset fire sale shock from the Lehman bankruptcy caused a market-wide liquidity shortage. 

Under both explanations, we are left with the same conclusion—that we need to 

develop a new credible and efficient means for resolving a distressed large complex 

52 

non-bank institution. When the public interest is at stake, as in the case of systemically important entities, the resolution process should support an orderly 

unwinding of the institution in a way that protects the broader economic and taxpayer interests, not just private financial interests, and imposes losses on stakeholders in the institution. 

Unlike the clearly defined and proven statutory powers that exist for resolving insured depository institutions, the current bankruptcy framework available to resolve 

large, complex non-bank financial entities and financial holding companies was not 

designed to protect the stability of the financial system. This is important because, 

in the current crisis, bank holding companies and large non-bank entities have come 

to depend on the banks within their organizations as a source of strength. Where 

previously the holding company may have served as a source of strength to the insured institution, these entities now often rely on a subsidiary depository institution 

for funding and liquidity, but carry on many systemically important activities outside of the bank that are managed at a holding company level or non-bank affiliate 

level. 

In the case of a bank holding company, whether systemically significant or not, 

the FDIC has the authority to take control of only the failing bank subsidiary, 

thereby protecting the insured depositors. However, in some cases, many of the essential services for the bank’s operations lie in other portions of the holding company and are left outside of the FDIC’s control, making it difficult to operate and 

resolve the bank. When the bank fails, the holding company and its subsidiaries 

typically find themselves too operationally and financially unbalanced to continue 

to fund ongoing commitments. In such a situation, where the holding company 

structure includes many bank and non-bank subsidiaries, taking control of just the 

bank is not a practical solution. 

While the depository institution could be resolved under existing authorities, the 

resolution would likely cause the holding company to fail and its activities would 

then be unwound through the normal corporate bankruptcy process. Putting the 

holding company through the normal corporate bankruptcy process may create additional instability as claims outside the depository institution become completely illiquid under the current system. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of a large, complex financial institution includes the risk that it will become a systemically important event. 

If a bank-holding company or non-bank financial holding company is forced into, 

or chooses to enter, bankruptcy for any reason, the following is likely to occur. In 

a Chapter 11 bankruptcy, there is an automatic stay on most creditor claims—with 

the exception of specified financial contracts (futures and options contracts and certain types of derivatives) that are subject to immediate termination and netting provisions. The automatic stay renders illiquid the entire balance of outstanding creditor claims. There are no alternative funding mechanisms, other than debtor-in-possession financing, available to remedy this problem. On the other hand, the bankrupt’s financial market contracts are subject to immediate termination—and cannot 

be transferred to another existing institution or a temporary institution, such as a 

bridge bank. In bankruptcy, without a bridge bank or similar type of option, there 

is really no practical way to provide continuity for the holding company’s or its subsidiaries’ operations. Those operations are based principally on financial agreements 

dependent on market confidence and require continuity through a bridge bank 

mechanism to allow the type of quick, flexible action needed. The automatic stay 

and the uncertainties inherent in the judicially-based bankruptcy proceedings further impair the ability to maintain these key functions. As a result, the current 

bankruptcy resolution options available—taking control of the banking subsidiary or 

a bankruptcy filing of the parent organization—make the effective resolution of a 

large, systemically important financial institution, such as a bank holding company, 

virtually impossible. This has forced the government to improvise actions to address 

individual situations, making it difficult to address systemic problems in a coordinated manner and raising serious issues of fairness. 

Addressing Risks Posed By the Derivatives Markets 

One of the major risks demonstrated in the current crisis is the tremendous expansion in the size, concentration, and complexity of the derivatives markets. While 

these markets perform important risk mitigation functions, financial firms that rely 

on market funding can see it dry up overnight. If the market decides the firm is 

weakening, other market participants can demand more and more collateral to protect their claims. At some point, the firm cannot meet these additional demands and 

it collapses. In bankruptcy, current law allows market participants to terminate and 

net out derivatives and sell any pledged collateral to pay off the resulting net claim. 

53 

During periods of market instability—such as during the fall of 2008—the exercise 

of these netting and collateral rights can increase systemic risks. At such times, the 

resulting fire sale of collateral can depress prices, freeze market liquidity as investors pull back, and create risks of collapse for many other firms. 

In effect, financial firms are more prone to sudden market runs because of the 

cycle of increasing collateral demands before a firm fails and collateral dumping 

after it fails. Their counterparties have every interest to demand more collateral and 

sell it as quickly as possible before market prices decline. This can become a selffulfilling prophecy—and mimics the depositor runs of the past. 

One way to reduce these risks while retaining market discipline is to make derivative counterparties keep some ‘‘skin in the game’’ throughout the cycle. The policy 

argument for such an approach is even stronger if the firm’s failure would expose 

the taxpayer or a resolution fund to losses. One approach to addressing these risks 

would be to haircut up to 20 percent of the secured claim for companies with derivatives claims against the failed firm if the taxpayer or a resolution fund is expected 

to suffer losses. This would ensure that market participants always have an interest 

in monitoring the financial health of their counterparties. It also would limit the 

sudden demand for more collateral because the protection could be capped and also 

help to protect the taxpayer and the resolution fund from losses. 

Powers 

The new resolution entity should be independent of the institutional regulator. In 

creating a new resolution regime, we must clearly define roles and responsibilities 

and guard against creating new conflicts of interest. No single entity should be able 

to make the determination to resolve a systemically important institution. The resolution entity should be able to initiate action, but the final decision should involve 

other affected regulators. For example, the current statute requires that decisions 

to exercise the systemic risk authorities for banks must have the concurrence of several parties. Yet, Congress also gave the FDIC backup supervisory authority, recognizing there might be conflicts between a primary regulator’s prudential responsibilities and its willingness to recognize when an institution it supervises needs to be 

closed. Once the decision to resolve a systemically important institution is made, the 

resolution entity must have the flexibility to implement this decision in the way 

that protects the public interest and limits costs. 

This new resolution authority should also be designed to limit subsidies to private 

investors by assisting a troubled institution. If financial assistance outside of the 

resolution process is granted to systemically important firms, the process should be 

open, transparent and subject to a system of checks and balances that are similar 

to the systemic-risk exception to the least-cost test that applies to insured depository institutions. No single government entity should be able to unilaterally trigger 

a resolution strategy outside the defined parameters of the established resolution 

process. 

Clear guidelines for this process are needed and must be adhered to in order to 

gain investor confidence and protect public and private interests. First, there should 

be a clearly defined priority structure for settling claims, depending on the type of 

firm. Any resolution should be subject to a cost test to minimize any public loss and 

impose losses according to the established claims priority. Second, the process must 

allow continuation of any systemically significant operations. Third, the rules that 

govern the process, and set priorities for the imposition of losses on shareholders 

and creditors should be clearly articulated and closely adhered to so that the markets can understand the resolution process with predicable outcomes. 

The FDIC’s authority to act as receiver and to establish a bridge bank to maintain 

key functions and sell assets offers a good model. A temporary bridge bank allows 

the government to prevent a disorderly collapse by preserving systemically significant functions. The FDIC has the power to transfer needed contracts to the bridge 

bank, including the financial market contracts, known as QFCs, which can be crucial to stemming contagion. It enables losses to be imposed on market players who 

should appropriately bear the risk. It also creates the possibility of multiple bidders 

for the bank and its assets, which can reduce losses to the receivership. The FDIC 

has the authority to terminate contracts upon an insured depository institution’s 

failure, including contracts with senior management whose services are no longer 

required. Through its repudiation powers, as well as enforcement powers, termination of such management contracts can often be accomplished at little cost to the 

FDIC. Moreover, when the FDIC establishes a bridge institution, it is able to contract with individuals to serve in senior management positions at the bridge institution subject to the oversight of the FDIC. The new resolution entity should be granted similar statutory authority as in the current resolution of financial institutions. 

54 

These additional powers would enable the resolution authority to employ what 

many have referred to as a ‘‘good bank-bad bank’’ model in resolving failed systemically significant institutions. Under this scenario, the resolution authority would 

take over the troubled firm, imposing losses on stockholders and unsecured creditors. Viable portions of the firm would be placed in the good bank, using a structure 

similar to the FDIC’s bridge bank authority. The nonviable or troubled portions of 

the firms would remain behind in a bad bank and would be unwound or sold over 

time. Even in the case of creditor claims transferred to the bad bank, these claims 

could be made partially liquid very quickly using a system of ‘‘haircuts’’ tied to 

FDIC estimates of potential losses on the disposition of assets. 

Who Should Resolve Systemically Significant Entities? 

As the only government entity regularly involved in the resolution of financial institutions, the FDIC can testify to what a difficult and contentious business it is. 

Resolution work involves making hard choices between competing interests with 

very few good options. It can be delicate work and requires special expertise. 

In deciding whether to create a new government entity to resolve systemically important institutions, Congress should recognize that it would be difficult to maintain 

an expert and motivated workforce when there could be decades between systemic 

events. The FDIC experienced a similar challenge in the period before the recent 

crisis when very few banks failed during the years prior to the current crisis. While 

no existing government agency, including the FDIC, has experience with resolving 

systemically important entities, probably no agency other than the FDIC currently 

has the kinds of skill sets necessary to perform resolution activities of this nature. 

In determining how to resolve systemically important institutions, Congress 

should only designate one entity to perform this role. Assigning resolution responsibilities to multiple regulators creates the potential for inconsistent resolution results and arbitrage. While the resolution entity should draw from the expertise and 

consult closely with other primary regulators, spreading the responsibility beyond 

a single entity would create inefficiencies in the resolution process. In addition, establishing multiple resolution entities would create significant practical difficulties 

in the effective administration of an industry funded resolution fund designed to 

protect taxpayers. 

Funding 

Obviously, many details of a special resolution authority for systemically significant financial firms would have to be worked out. To be truly credible, a new systemic resolution regime should be funded by fees or assessments charged to systemically important firms. Fees imposed on these firms could be imposed either before 

failures, to pre-fund a resolution fund, or fees could be assessed after a systemic resolution. 

The FDIC would recommend pre-funding the special resolution authority. One approach to doing this would be to establish assessments on systemically significant 

financial companies that would be placed in a ‘‘Financial Companies Resolution 

Fund’’ (FCRF). A FCRF would not be funded to provide a guarantee to the creditors 

of systemically important institutions, but rather to cover the administrative costs 

of the resolution and the costs of any debtor-in-possession lending that would be 

necessary to ensure an orderly unwinding of a financial company’s affairs. Any administrative costs and/or debtor-in-possession lending that could not be recovered 

from the estate of the resolved firm would be covered by the FCRF. 

The FDIC’s experience strongly suggests that there are significant benefits to an 

industry funded resolution fund. First, and foremost, such a fund reduces taxpayer 

exposure for the failure of systemically important institutions. The ability to draw 

on the accumulated reserves of the fund also ensures adequate resources and the 

credibility of the resolution structure. The taxpayer confidence in the Deposit Insurance Fund (DIF) with regard to the resolution of banks is a direct result of the respect engendered by its funding structure and conservative management. The FCRF 

would be funded by financial companies whose size, complexity or interconnections 

potentially could pose a systemic risk to the financial system at some point in time 

(perhaps the beginning of each year). Those systemically important firms that have 

an insured depository subsidiary or other financial entity whose claimants are insured through a federal or state guarantee fund could receive a credit for the 

amount of their assessment to cover those institutions. 

It is anticipated that the number of companies covered by the FCRF would be 

fluid, changing periodically depending upon the activities of the company and the 

market’s ability to develop mechanisms to ameliorate systemic risk. Theoretically, 

as companies fall below the threshold for being potentially systemically important, 

they would no longer be assessed for coverage by the FCRF. Similarly, as companies 

55 

undertake activities or provide products/services that make them potentially more 

systemically important, they would fall under the purview of the FCRF and be subject to assessment. 

Assessing institutions based on the risk they pose to the financial systems serves 

two important purposes. A strong resolution fund ensures that resolving systemically important institutions is a credible option which enhances market discipline. 

At the same time, risk-based assessments are an important tool to affect the behavior of these institutions. Assessments could be imposed on a sliding scale based on 

the increasing level of systemic risk posed by an entity’s size or complexity. 

Resolution of Non-Systemic Holding Companies 

Separate and apart from establishing a resolution structure to handle systemically important institutions, the ability to resolve non-systemic bank failures would 

be greatly enhanced if Congress provided the FDIC the authority to resolve bank 

and thrift holding companies affiliated with a failed institution. The corporate structure of bank and thrift holding companies, with their insured depositories and other 

subsidiaries, has become increasingly complex and inter-reliant. The insured depository is likely to be dependent on affiliates that are subsidiaries of its holding company for critical services, such as loan and deposit processing, loan servicing, auditing, risk management and wealth management. Moreover, in many cases the nonbank affiliates themselves are dependent on the bank for their continued viability. 

It is not unusual for many business lines of these corporate enterprises to be conducted in both insured and non-insured affiliates without regard to the confines of 

a particular entity. Examples of such multi-entity operations often include retail 

and mortgage banking and capital markets. 

Atop this network of corporate relationships, the holding company exercises critical control of its subsidiaries and their mutually dependent business activities. The 

bank may be so dependent on its holding company that it literally cannot operate 

without holding company cooperation. The most egregious example of this problem 

emerged with the failure of NextBank in northern California in 2002. When the 

bank was closed, the FDIC ascertained that virtually the entire infrastructure of the 

bank was controlled by the holding company. All of the bank personnel were holding 

company employees and all of the premises used by the bank were owned by the 

holding company. Moreover, NextBank was heavily involved in credit card 

securitizations and the holding company threatened to file for bankruptcy, a strategy that would have significantly impaired the value of the bank and the 

securitizations. To avert this adverse impact on the DIF, the FDIC was forced to 

expend significant funds to avoid the bankruptcy filing. 

As long as the threats exists that a bank or thrift holding company can file for 

bankruptcy, as well as affect the business relationships between its bank and other 

subsidiaries, the FDIC faces great difficulty in effectuating a resolution strategy 

that preserves the franchise value of the failed bank and so protects the DIF. Bankruptcy proceedings, involving the parent or affiliate of a bank, are time-consuming, 

unwieldy, and expensive. The FDIC as receiver or conservator occupies a position 

no better than any other creditor and so lacks the ability to protect the receivership 

estate and the DIF. The threat of bankruptcy by the BHC or its affiliates is such 

that the Corporation may be forced to expend considerable sums propping up the 

holding company or entering into disadvantageous transactions with the holding 

company or its subsidiaries in order to proceed with a bank’s resolution. The difficulties are particularly egregious where the Corporation has established a bridge 

bank to preserve franchise value, protect creditors (including uninsured depositors), 

and facilitate disposition of the failed institution’s assets and liabilities. By giving 

the FDIC authority to resolve a failing or failed bank’s holding company, Congress 

would provide the FDIC with a vital tool to deal with the increasingly complicated 

and highly symbiotic business structures in which banks operate in order to develop 

an efficient and economical resolution. 

The purpose of the authority to resolve non-systemic holding companies would be 

to achieve the least cost resolution of a failed insured depository institution. It 

would be used to reduce costs to the DIF through a more orderly and comprehensive 

resolution of the entire financial entity. If the current bifurcated resolution structure involving resolution of the insured institution by the FDIC and bankruptcy for 

the holding company would produce the least costly resolution, the FDIC should retain the ability to use that structure as well. Enhanced authorities that allow the 

FDIC to efficiently resolve failed depository institutions that are part of a complex 

holding company structure will provide immediate efficiencies in bank resolutions 

result in reduced losses to the DIF and not require any additional funding. 

56 

* These remarks reflect my views and not necessarily those of others in the Federal Reserve. 

1We discuss other potential motivations that could lead to TBTF support and why we think 

spillovers are the most important motivation in Gary H. Stern and Ron J. Feldman, 2009, Too 

Big To Fail: The Hazards of Bank Bailouts, chapter 5. 

Conclusion 

The current financial crisis demonstrates the need for changes in the supervision 

and resolution of financial institutions, especially changes relative to large, complex 

organizations that are systemically important to the financial system. The choices 

facing Congress in this task are complex, made more so by the fact that we are trying to address problems while dealing with one of the greatest economic challenges 

we’ve seen in decades. While the need for some reforms is obvious, such as a legal 

framework for resolving systemically important institutions, others are less clear 

and we would encourage a thoughtful, deliberative approach. The FDIC stands 

ready to work with Congress to ensure that the appropriate steps are taken to 

strengthen our supervision and regulation of all financial institutions—especially 

those that pose a systemic risk to the financial system. 

I would be pleased to answer any questions from the Committee. 

PREPARED STATEMENT OF GARY H. STERN * 

PRESIDENT AND CHIEF EXECUTIVE OFFICER, FEDERAL RESERVE BANK OF MINNEAPOLIS

MAY 6, 2009 

Chairman Dodd, Ranking Member Shelby, and members of the Committee, thank 

you for the opportunity to review the ‘‘too-big-to-fail’’ (TBTF) problem with you 

today. I will develop a simple conclusion in this testimony: The key to addressing 

TBTF is to reduce substantially the negative spillover effects stemming from the 

failure of a systemically important financial institution. Let me explain how I have 

come to that conclusion. 

The TBTF problem is one of undesirable incentives which we need to address if 

we hope to fix the problem. TBTF arises, by definition, when the uninsured creditors of systemically important financial institutions expect government protection 

from loss when these financial institutions get into financial or operational trouble. 

The key to addressing this problem and changing incentives, therefore, is to convince these creditors that they are at risk of loss. If creditors continue to expect special protection, the moral hazard of government protection will continue. That is, the 

creditors will continue to underprice the risk-taking of these financial institutions, 

overfund them, and fail to provide effective market discipline Facing prices that are 

too low, systemically important firms will take on too much risk. Excessive risk-taking squanders valuable economic resources and, in the extreme, leads to financial 

crises that impose substantial losses on taxpayers. Put another way, if policymakers 

do not address TBTF, the United States likely will endure an inefficient financial 

system, slower economic growth, and lower living standards than otherwise would 

be the case. 

To address TBTF, policymakers must change these incentives, and I recommend 

the following steps to achieve that goal. And let me emphasize that these are my 

personal views. 

First, identify why policymakers provide protection to uninsured creditors. If we 

do not address the underlying rationale for providing protection, we will not credibly 

put creditors of systemically important firms at risk of loss. The threat of financial 

spillovers leads policymakers to provide such protection.1 Indeed, I would define systemically important financial institutions by the potential that their financial and 

operational weaknesses can spill over to other financial institutions, capital markets, and the rest of the economy. As a result, my recommendations to address the 

TBTF problem focus on mitigating the perceived and real fallout from financial 

spillovers. 

Second, enact reforms to reduce the perceived or real threat of the spillovers that 

motivate after-the-fact protection of uninsured creditors. These reforms include, but 

are not limited to, increased supervisory focus on preparation for the potential failure of a large financial institution, enhanced prompt corrective action, and better 

communication of efforts to put creditors of systemically important firms at risk of 

loss. I call this combination of reforms systemic focused supervision (SFS). Other reforms outside of SFS will help address TBTF as well. I also recommend, for example, capital regimes that automatically provide increased protection against loss during bad times and insurance premiums that raise the cost for financial institution 

57 

2More generally, see the testimony of Daniel K. Tarullo on March 19, 2009, before the U.S. 

Senate Committee on Banking, Housing, and Urban Affairs for options for modernizing bank 

supervision and regulation, including many that seek to foster financial stability. 3The appendix includes summaries of the key arguments in our book on TBTF, more recent 

analysis applying the recommendations in the book to the current crisis, and an initial analysis 

of proposals to address TBTF by making large financial institutions smaller. Our writings on 

TBTF can be found at http://www.minneapolisfed.org/publicationslpapers/studies/tbtf/ 

index.cfm. 

activities that create spillovers. I recognize the substantial benefits of highlighting 

a single reform that would fix TBTF, but I believe a variety of steps are required 

to credibly take on TBTF.2

Third, be careful about relying heavily on reforms that do not materially reduce 

spillovers. In particular, 

I do not think that intensification of traditional supervision and regulation of 

large financial firms will effectively address the TBTF problem. In a similar vein, 

while I support the creation of a new resolution regime for systemically important 

nonbank financial institutions, I would augment the new resolution regime with the 

types of reforms I just noted. 

I will now discuss these points quite briefly. I will provide additional detail in the 

appendix to this testimony.3

Spillovers Produce the TBTF Problem 

Uninsured creditors of systemically important firms come to expect protection because they understand the motivation of policymakers. Policymakers provide protection, in my experience, believing that such protection will contain costly financial 

spillovers. Policymakers understand that protecting creditors reduces market discipline, but they judge the costs of such a reduction to be smaller than the fallout 

from the collapse of a major institution. Policymakers worry about spillovers—for 

example, the failure of other large financial firms due to their direct exposure to 

a weak firm or because of a more general panic—and the potential impact they may 

have on the rest of the economy. 

I see three general approaches to addressing concerns over spillovers and thus increasing market discipline (and reducing moral hazard). First, enact reforms that 

make policymakers more confident that they can impose losses on creditors without 

creating spillovers that would justify government protection. Second, reduce the 

losses that failing firms can impose on other firms or markets, which helps reduce 

spillovers. Third, alter payments systems to reduce their transmission of losses suffered by one firm to others. 

Policymakers cannot eliminate spillovers entirely, nor can they credibly commit 

to never providing protection to creditors of systemically important firms. But they 

can make significant progress in reducing the probability of providing protection, reducing the number of creditors who might receive protection, and reducing the 

amount of coverage that creditors receive. These are all valuable results. 

I will now provide several specific examples of approaches to deal with spillovers. 

Examples of Reforms That Credibly Address TBTF by Taking on Spillovers 

To take on spillovers, I recommend starting with SFS, a combination of reforms 

that would identify and better manage spillovers, reduce losses from the failure of 

systemically important financial institutions, and alter uninsured creditor expectations so that they better price risk-taking. To provide a sense for additional reforms 

I have endorsed, I will provide two other examples of reforms you might consider 

beyond SFS. Others have begun endorsing reforms of this type, which indicates that 

attacking spillovers is not considered impossible. 

Systemic Focused Supervision. 

This approach to addressing spillovers has three components. 

Engage in Early Identification. I would focus financial institution oversight, defined broadly, on identifying potential spillovers both in general and for specific 

firms, and offering recommendations to mitigate them. To my mind, this is conceptually similar to the macroprudential or systemic-risk supervision others have supported. I would concentrate such efforts, which would require significant input from 

bank supervisors and others, on carefully mapping out the exposures that systemically important firms have with each other and other basic sources of spillovers. 

Once the responsible supervisory entity documents where and how spillovers might 

arise, it would take the lead in offering recommendations to address them. This effort either would assure policymakers that a perceived spillover did not in fact pose 

a significant threat or would direct resources to fix the vulnerability and generate 

such comfort. 

58 

4 Raghuram Rajan made a similar recommendation in ‘‘The Credit Crisis and Cycle Proof Regulation,’’ the Homer Jones Lecture at the Federal Reserve Bank of St. Louis, April 15, 2009. 5We discuss such a recommendation, based on work by Mark Flannery, briefly on page 128 

of the TBTF book. For a more current discussion of this idea, along with other proposals to address TBTF, see the analysis carried out by the Squam Lake Working Group on Financial Regulation at http://www.cfr.org/thinktank/greenberg/squamlakepapers.html. 6For a fuller discussion, see Appendix C of the TBTF book. 

7For a fuller discussion of limitations of the FDICIA resolution process, see Appendix A of 

the TBTF book. 

Lest such an exercise sound like it would be unproductive, I believe that fairly 

simple failure simulation exercises over the years confirmed the potential spillovers, 

created by the overseas and derivative operations of some large financial firms, that 

now bedevil us. I would also note that macroprudential supervision can and should 

put some of the burden of early identification on the systemically important firms 

themselves by, for example, requiring them to prepare for and explain the challenges of entering what would amount to a prepackaged bankruptcy.4

Enhanced Prompt Corrective Action (PCA). To focus supervisors on closing weak 

institutions early, which reduces the losses they can impose on others, I recommend 

incorporating market signals of firm risk into the current PCA regime. The incorporation would require care. Market signals contain noise, but such signals also offer 

forward-looking measures of firm specific-risk with valuable information for bank 

and other supervisors. 

Improve Communication. The goals here are to establish the credibility of efforts 

to put creditors at risk of loss and to give creditors the opportunity to alter their 

behavior. As a result, I recommend that supervisory and other stability-focused 

agencies clearly communicate the steps in process to avoid full protection. Simply 

put, creditors cannot read minds and will not alter their expectations and behavior 

unless they understand the policy changes under way. 

SFS is not the only approach to addressing spillovers. Let me highlight two other 

reforms by way of example. 

Develop Capital Instruments to Absorb Losses When Problems Arise. Requiring 

firms to hold substantially more capital offers a path to absorb losses before they 

spill over and directly affect other firms. But having to raise expensive capital can 

either encourage firms to avoid socially beneficial lending or to take on more risk 

to generate targeted returns. I urge policymakers to examine capital tools that effectively create capital when firms need it most, which reduces their cost and avoids 

fueling downcycles.5

Price for Spillover Creation. A direct way to discourage the types of activities that 

generate spillovers is to put a price on them because, after all, spillovers impose 

costs on all of us. Using the early-identification approach noted above to identify the 

major causes of spillovers would offer a first step. The actual pricing of such activities could occur via something like an insurance premium. The FDIC already has 

made important progress in creating such an approach for large banks, although the 

price it charges is capped at a low level at this time. 

I now turn to reforms to address TBTF where I am concerned policymakers may 

be asking too much. 

Do Not Rely Too Heavily on Traditional Supervision and Regulation (S&R), 

Resolution Regimes, or Downsizing 

Based on direct observation, I am not convinced that supervisors can consistently 

and effectively prevent excessive risk-taking by the large firms they oversee in a 

timely fashion, absent draconian measures that tend to throw out the good with the 

bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.6 While policymakers should improve S&R by incorporating the lessons learned over the last 

two years, it cannot be the bulwark in addressing TBTF. 

I do see clear benefits in increasing the scope of bank-like resolution systems to 

entities such as bank holding companies. Such regimes would facilitate imposition 

of losses on equity holders, allow for the abrogation of certain contracts, and provide 

a framework for operating an insolvent firm. These steps address some spillovers 

and increase market discipline. But I have long argued that the resolution regime 

created by FDICIA would not, by itself, effectively limit after-the-fact protection for 

creditors of systemically important banks.7 Events over the last two years have 

largely reinforced those concerns. A bank-like resolution regime for nonbanks, which 

creates a systemic-risk exception, leaves some potential spillovers remaining, and so 

it is a necessary but not sufficient reform to address TBTF. 

Finally, there has been increased discussion of efforts to address TBTF by making 

the largest financial firms smaller. My concerns here are practical and do not reflect 

59 

1 Examples include Robert Reich in an Oct. 21, 2008, blog post (‘‘If they’re too big to fail, 

they’re too big period’’), George Shultz in the Aug. 14, 2008, Wall Street Journal (‘‘If they are 

too big to fail, make them smaller’’), Gerald O’Driscoll in the Feb. 23, 2009, Wall Street Journal 

(‘‘If a bank is too big to fail, then it is simply too big’’), Meredith Whitney in a Feb. 19, 2009, 

CNBC interview (reported to advocate ‘‘disaggregating’’ market share of largest banks) and 

Simon Johnson in a Feb. 19, 2009, blog post (‘‘Above all, we need to encourage or, most likely, 

force the large insolvent banks to break up’’). 2The Minneapolis Fed Web site (minneapolisfed.org/publicationslpapers/studies/tbtf/ 

index.cfm) provides access to our fairly extensive prior writing on TBTF. 

any particular empathy for managers or equity holders of large firms. In short, I 

think efforts to break up the firms would result in a focus on a very small number 

of institutions, thereby leaving many systemically important firms as is. Moreover, 

I am skeptical, for the reasons noted above, that policymakers will effectively prevent the newly constituted (smaller) firms from taking on risks that can bring down 

others. 

Conclusion 

Maintaining the status quo with regard to TBTF could well impose large costs on 

the U.S. economy. We cannot afford such costs. I encourage you to focus on proposals that address the underlying reason for protection of creditors of TBTF financial institutions, which is concern for financial spillovers. I have offered examples 

of such reforms. Absent these or similar reforms, I am skeptical that we will make 

significant progress against TBTF. 

ADDRESSING TBTF BY SHRINKING FINANCIAL INSTITUTIONS: AN INITIAL ASSESSMENT

The Region, June 2009 

By Gary H. Stern President Federal Reserve Bank of Minneapolis and Ron Feldman 

Senior Vice President Supervision, Regulation and Credit Federal Reserve Bank 

of Minneapolis 

‘‘If financial institutions raise systemic concerns because of their size, fix the 

TBTF problem by making the firms smaller.’’ A number of prominent observers 

have adopted this general logic and policy recommendation.1 While we’re sympathetic to the intent of this proposal, we have serious reservations about its likely 

effectiveness and associated costs. Our preferred approach to addressing the ‘‘toobig-to-fail’’ problem continues to be better management of financial spillovers.2

In this essay, we review our concerns about this ‘‘make-them-smaller’’ reform. We 

also recommend several interim steps to address TBTF that share some similarities 

with the make-them-smaller approach but do not have the same failings. Specifically, we support (1) imposing special deposit insurance assessments for TBTF 

banks to allow for spillover-related costs, (2) retaining the national deposit cap on 

bank mergers and (3) modifying the merger review process for large banks to provide better focus on reduction of systemic risk. If our suggested reforms prove less 

effective than we believe, policymakers will have to take the make-them-smaller approach seriously. 

The reform 

While its proponents have not provided details, this reform-if taken literallyseems straightforward. Policymakers would demark some firms as TBTF through 

the use of a specific measure, such as share of a given market(s), asset size or revenue. Policymakers would then force those firms to (1) shrink their balance sheets 

organically (that is, not replacing loans or securities after repayment), (2) divest certain operations or assets and/or (3) split them into smaller constituent parts such 

that the resulting firms fall below a specified threshold. (We distinguish such measures from short-term efforts to wind down the operations of a targeted, insolvent 

financial institution to position it for resolution, a reform we support.) 

Rationale for reform 

On its surface, the proposal has two attractive features, both related to simplicity. 

First, size seems to offer an easily measured and verifiable means of identifying financial institutions whose financial or operational failure would raise systemic concern. After all, firms that are frequently identified as posing TBTF concerns are 

large in some important, obvious way. 

Second, implementing this reform appears to be fairly straightforward. The government could simply order across-the-board shrinkage of balance sheets for certain 

firms. Since many larger financial institutions came about through mergers of 

smaller institutions, and because the popularity among corporate leaders of creating 

60 

3For literature that did not find economies of scale for large banks, see Allen N. Berger, Rebecca Demsetz, and Philip E. Strahan, 1999, ‘‘The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future,’’ Journal of Banking and Finance 

23 (2–4), pp. 35–94; and Group of Ten, 2001, ‘‘Report of Consolidation in the Financial Sector,’’ 

p. 253. For summaries of more current research finding economies of scale for larger institutions, see Joseph P. Hughes and Loretta J. Mester, 2008, ‘‘Efficiency in Banking: Theory, Practice and Evidence,’’ Chap. 18 in Oxford Handbook of Banking, Oxford University Press. See also 

Loretta J. Mester, 2008, ‘‘Optimal Industrial Structure in Banking,’’ in Section 3 of Handbook 

of Financial Intermediation and Banking, Elsevier. 4See Raghuram G. Rajan and Luigi Zingales, 2003, ‘‘The Great Reversals: The Politics of Financial Development in the Twentieth Century,’’ Journal of Financial Economics 69, July, pp. 

5–50. 

and then destroying conglomerates tends to wax and wane, a simple ‘‘unbundling’’ 

would merely return the financial world to a period when the TBTF problem did 

not loom as large. 

A third rationale for the reform appears rooted in desperation. Recent events suggest profound failure in the supervision and regulation of large and complex financial institutions. Likewise, a number of observers have long seen the TBTF problem 

as intractable because policymakers will always face compelling incentives to support creditors at the time systemically important firms get into trouble. Society 

therefore appears to have no way to impose meaningful restraint on large or complex financial institutions. An option that makes firms neither large nor complex 

may appear to offer the only real means of imposing either market or supervisory 

discipline. 

The reform’s weaknesses 

Shrinking firms so they don’t pose systemic concern faces static and dynamic challenges that seem to seriously limit its effectiveness as a potential reform. 

The static challenge involves the initial metric used to identify firms that need 

to be made smaller. Given the severity of the punishment (that is, breakup), policymakers will have to use a simple standard they can make public and defend from 

legal challenge. They might consider using, for example, the current limit on bank 

size that can be achieved via merger: 10 percent of nationwide deposits. Importantly, we assume (and again, because of the high-stakes nature of the reform) that 

policymakers would make only a few firms subject to forced contraction. This ‘‘high 

bar’’ raises the stakes in getting the ‘‘right’’ firms cut down to size. 

But such a metric will not likely capture some or perhaps many firms that pose 

systemic risk. Some firms that pose systemic risk are very large as measured by 

asset size, but others—Northern Rock and Bear Stearns, for example—are not. 

Other small firms that perform critical payment processing pose significant systemic 

risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely 

to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms. The dynamic challenge concerns both the 

ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose. 

On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure 

might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and 

thereby enlarging the latter. We would also anticipate firms’ stakeholders, who 

could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic 

benefits of larger size, and those arguments have some heft. Academic research has 

typically found economies of scale exhausted before banks reach the size of the largest banking organizations, although some recent analysis suggests such economies 

may exist at these large sizes as well.3 (Indeed, policymakers will have to consider 

the loss of scale benefits when they determine the net benefits of breaking up firms 

in the first place.) 

Prominent examples suggest our concern about reconsolidation is not theoretical. 

Consider the breakup of the original AT&T and the subsequent mergers among telecommunication firms. Scholars have also highlighted the historical difficulty in limiting the long-run market share of powerful financial firms, including those found 

in the ‘‘zaibatsus’’ of Japan.4

Even if policymakers could get the initial list of firms right and were able to keep 

the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic 

61 

5More generally, George Pennacchi argues that premiums for banks should incorporate a ‘‘systematic risk’’ factor to account for links between a bank’s specific condition and overall economic 

conditions. See George G. Pennacchi, 2009, ‘‘Deposit Insurance,’’ paper for AEI Conference on 

Private Markets and Public Insurance Programs, January. 6Some observers have outlined a broader reform along the same lines that would charge all 

systemically important financial firms an assessment. We focus on banks in the short term because the infrastructure for such charges already exists; charging other systemically important 

financial firms should have similar benefits. For a discussion of the broader change, see Viral 

Acharya, Lasse Pedersen, Thomas Philippon and Matthew Richardson, 2008, ‘‘Regulating Systemic Risk,’’ Chap. 13 in Restoring Financial Stability: How to Repair a Failed System, Wiley. 7See Federal Register, Oct. 16, 2008, p. 61568. 

risk. Newly shrunken firms could, for example, shift their portfolios to assets that 

suffer catastrophic losses when economic conditions fall off dramatically. As a result, 

creditors (including other financial firms) of the ‘‘small’’ firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets 

might question the solvency of other financial firms as a result of such an implosion. 

Such spillovers prompted after-the-fact protection of financial institution creditors 

in the current crisis, and we believe they would do so again, all else equal. One 

might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such 

oversight were thought to work. 

These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effectiveeven impregnable-but in fact it provides only a false sense of security that may lull 

policymakers into inaction on other fronts. In our experience, policymakers would 

likely view this reform as a substitute for other desirable actions, including some 

of the key reforms we think necessary to address spillovers. In the past, policymakers have thought-mistakenly-that the strong condition of banks, the FDICIA 

resolution regime or initiatives around new capital rules all provided rationales for 

not addressing the underlying sources of spillovers and the TBTF problem. If we exclusively embrace a reform that misleadingly promises victory over TBTF by constraining the size of large financial firms, we may squander the time and resources 

needed to address the problem at its roots. 

Interim steps 

While we would not move forward with a plan to make large financial firms 

smaller, we take seriously its intent to put uninsured creditors at risk of loss and 

to address concerns over size, spillovers and government support. In that vein, we 

recommend three interim steps that address concerns that might lead to support for 

the make-them-smaller option. They are (1) modify the FDIC insurance premium to 

better allow for spillover-related charges, (2) maintain the current national deposit 

cap on bank mergers and (3) modify the merger review process for bank holding 

companies to focus on systemic risk. We conclude this section with a brief discussion 

on when the make-them-smaller option might make sense. 

• Expand FDIC insurance premiums 

First, we recommend expanding the ability of the FDIC to charge banks 

(through the deposit insurance premium it levies) for activities that increase potential for spillovers.5 The presence of spillovers makes it more likely that policymakers 

will resolve bank failures in a manner outside of the FDIC’s mandated ‘‘least-cost’’ 

resolution, because those spillovers impose broader costs on society. Premiums offer 

an established mechanism by which society can force banks to internalize potential 

costs.6

We use the term ‘‘expand’’ in referring to the FDIC’s ability to charge banks, 

because the FDIC has already created an infrastructure to facilitate spillover-related charges. In particular, the current premium structure allows under certain 

conditions for a ‘‘large bank [premium] adjustment.’’ The FDIC offers several rationales for the adjustment, including the need ‘‘to ensure that assessment rates take 

into account all available information that is relevant to the FDIC’s risk-based assessment decision.’’7

The FDIC lists the types of information it would consider in setting the adjustment, and several of them provide reasonable proxies for potential spillovers. For 

example, the FDIC would review (1) potential for ‘‘ring fencing’’ of foreign assets 

(which would limit the FDIC’s ability to seize and sell those assets to pay off insured depositors, for example), (2) availability of information on so-called qualified 

financial contracts (which include a wide range of derivatives) and (3) FDIC ability 

62 

8See Federal Register, May 14, 2007, p. 27125. 

9See Federal Register, March 4, 2009, p. 9525. 

10See Gary H. Stern and Ron J. Feldman, 2005, ‘‘Addressing TBTF When Banks Merge: A 

Proposal,’’ The Region, September, Federal Reserve Bank of Minneapolis. 11For discussions of how policymakers should or should not consider TBTF in the antitrust 

review process, see statements by Deborah A. Garza and Albert A. Foer before the House Judiciary Committee, Subcommittee on Courts and Competition Policy, March 17, 2009. 

to take over key operations without paying extraordinary costs.8 We might propose 

that the FDIC include other proxies of systemic risk, including measures of organizational complexity (such as number and type of legal entities) and a supervisory 

‘‘score’’ of each bank’s contingency plan for winding down operations while minimizing spillovers. 

The FDIC apparently believes it can price spillover risk without having to rely 

on size per se (although it limits this assessment adjustment to large institutions). 

Not having to rely on size of financial institutions seems desirable, as it more directly targets activities causing spillovers. And imposing a price on these activities 

would discourage them, which is the point. 

However, the FDIC has limited its ability to fully incorporate such spillover-related factors into its premium. It can, for example, only adjust large bank premiums 

by 100 basis points or less (recently increased from 50 basis points).9 We recommend that the FDIC remove such artificial restrictions so that it can fully price 

the potential costs of spillovers. 

• Keep the cap 

Second, we recommend retaining the current national deposit cap. In general 

terms, Congress forbids authorities from approving mergers or acquisitions if it 

would result in the acquiring bank holding more than 10 percent of U.S. bank deposits. This cap, which applies to M&As across state lines, was put in place by the 

Riegle-Neal Banking Act of 1994. Note that a bank can exceed the national cap if 

its deposit growth comes from a non-M&A source (that is, so-called organic growth). 

Why keep the cap at the current level? We see some serious downsides to lowering 

the cap as a way of addressing TBTF. A lower cap could cause the bank to increase 

its funding from nondeposit sources, which, all else equal, could increase its susceptibility to a run. Or a firm could meet the target by jettisoning its retail banking 

operations and increase its securities, payments or wholesale operations. This outcome, too, would seem to increase systemic risk. 

Lowering the cap effectively taxes deposits, thereby directing energies at the 

wrong target. While this argument might suggest abolishing or increasing the cap, 

we would keep it at its current level at least for the foreseeable future because its 

costs do not seem large. In particular, the cap has not prevented the creation of extremely large and diversified financial institutions through mergers. Thus, we doubt 

it has had significant scale or scope costs. 

Moreover, we think the cap offers some benefits. It provides a binding limit on 

size growth that may offer a marginal contribution to managing TBTF. The cap may 

also have the salutary effect of keeping policymakers’ attention on the TBTF issue 

over time. Because the costs of keeping the cap seem quite low, we feel comfortable 

with our recommendation, even though the benefits seem low as well. 

• Reform the merger review process 

Third, we recommend implementing a reform to the merger reviews that the 

Federal Reserve conducts for large bank holding companies. In 2005, we proposed 

that ‘‘for mergers between two of the nation’s 50 largest banks, the Federal Reserve, 

the Federal Deposit Insurance Corporation (FDIC) and the U.S. Treasury should report publicly on their respective efforts to address and manage potential TBTF concerns.’’10 Such a requirement, which needn’t be restricted to the 50 largest banks 

if policymakers favor another cutoff, would highlight the key policy issues raised by 

the merger itself and provide a communication focus for spillover-reduction efforts. 

We could envision this as an interim approach if spillover reduction does not prove 

possible to achieve. The Federal Reserve may find it appropriate over time to support changes to the statutes governing merger reviews to allow for explicit consideration of potential spillover costs created or made worse by the merger.11

We have confidence in our preferred approach of tackling spillovers directly by 

putting TBTF creditors at credible risk of loss. But others with equally strong convictions have been proven wrong when it comes to financial instability, and we could 

be wrong as well. In that case, we must go with an alternative, and the proposed 

reform to make firms smaller may offer the only promising choice. 

63 

1See Gary H. Stern and Ron J. Feldman, 2004, Too Big to Fail: The Hazards of Bank Bailouts, Washington, D.C.: Brookings Institution. 

Moreover, we view addressing spillovers as the primary motivation for providing 

after-the-fact protection to uninsured creditors. To the degree that other motivations 

drive provision of such protection in the United States (for example, to reward ‘‘cronies’’ of elected officials or other entrenched interests), our reforms may not adequately address the TBTF problem, and other reforms might. That said, we continue 

to strongly believe that spillovers are the salient motivation that policymakers must 

address to fix TBTF (and our prior writings comment extensively on why we do not 

think other motivations have equal weight). 

Conclusion 

There is no easy solution to TBTF. Our longstanding proposal to put creditors at 

risk of loss by managing spillovers will prove challenging to implement effectively. 

Cutting firms down to size may seem easy by comparison. It is not. The high stakes 

of making firms smaller will make it difficult to determine which to shrink, and 

even then, the government will not have an easy time managing risk-taking by 

newly shrunken firms. We do take the aims of the make-them-smaller reform seriously and in that vein suggest options in this regard that we think would be more 

effective, including a spillover-related tax built on the FDIC’s current deposit insurance premiums. 

BETTER LATE THAN NEVER: ADDRESSING TOO-BIG-TO-FAIL

Remarks presented at the Brookings Institution, Washington, DC, March 31, 2009 

By Gary H. Stern, President, Federal Reserve Bank of Minneapolis 

Destiny did not require society to bear the cost of the current financial crisis. To 

at least some extent, the outcome reflects decisions, implicit or explicit, to ignore 

warnings of the large and growing ‘‘too-big-to-fail’’ problem and a failure to prepare 

for and address potential spillovers. While I am, as usual, speaking only for myself, 

there is now I think broad agreement that policymakers vastly underestimated the 

scale and scope of ‘‘too big to fail’’ and that addressing it should be among our highest priorities. 

From a personal point of view, this recent consensus is both gratifying and disturbing. Gratifying because many initially dismissed our book,1 published five years 

ago by Brookings, as exaggerating the TBTF problem and underestimating the 

value of FDICIA in strengthening bank supervision and regulation. In turn, I would 

point out that we identified: 

• virtually all key facets of the growing TBTF problem, including the role that 

increased concentration and increased organizational and product complexity, 

as well as increased reliance on short-term funding, played in creating the current TBTF mess; and 

• important reforms which, if taken seriously, could have reduced the risk-taking 

that produced the crisis. 

But belated recognition of the severity of ‘‘too big to fail’’ is also disturbing because it implies that inaction raised the costs of the current financial crisis, as our 

analyses and prescriptions went unheeded. Despite our warnings, important institutions, public and private alike, were unprepared. And I am quite concerned that policymakers may double-down on previous decisions; some ideas presented in the current environment to address TBTF are unlikely to be effective and, if pursued, will 

waste valuable time and resources. 

In the balance of these remarks, I will principally cover three subjects: (1) the nature of the current TBTF problem; (2) policies essential to addressing the problem 

effectively; (3) policies that, although well intentioned, are unlikely to make a material difference to TBTF at the end of the day. 

The current TBTF problem 

As matters stand today, the risk-taking of large, complex financial institutions is 

not constrained effectively by supervision and regulation nor by the marketplace. If 

this situation goes uncorrected, the result will almost surely be inefficient marshaling and allocation of financial resources, serious episodes of financial instability 

and lower standards of living than otherwise. Certainly, we should seek to improve 

and strengthen supervision and regulation where we can, but supervision and regulation is not a credible check on the risk-taking of these firms. I will go into this 

issue in more detail later and will simply note at this point that the recent track 

64 

2See Gary H. Stern, 2008, ‘‘Too Big to Fail: The Way Forward,’’ Nov.13, 2008. 

3For a discussion of preparing for large bank failure, see Shelia Bair, 2007, ‘‘Remarks,’’ March 

21, and Shelia Bair, 2008, ‘‘Remarks,’’ June 18. 

record in this area fails to inspire confidence. Similarly, market discipline is not now 

a credible check on the risk-taking of these firms; indeed, a critical plank of current 

policy is to assure creditors of TBTF institutions that they will not bear losses. 

Given the magnitude of the crisis, I have supported the steps taken to stabilize the 

financial system by extending the safety net, but I am also acutely sensitive to the 

moral-hazard costs of these steps and have no illusion that losses experienced by 

equity holders and management will somehow resurrect market discipline. 

How did we arrive at such a bleak point in terms of TBTF? Let me make just 

two observations. First, the crisis was made worse, in my view significantly worse, 

by the lack of preparation I mentioned above. To provide some examples, policymakers did not create and/or execute (1) an effective communication strategy regarding government intentions for uninsured creditors of firms perceived as TBTF; 

(2) a program to systematically identify the interconnections between these large 

firms; and (3) systems aimed at reducing the losses that these large firms could impose on other firms. I raise these examples, not surprisingly, because we identified 

these steps as critical to addressing TBTF in the book and related analysis.2

Second, addressing the TBTF problem earlier could have avoided some of the risktaking underlying the current crisis. To be sure, many small institutions have failed 

as a result of the crisis in housing finance but, nevertheless, the bulk of the losses 

seem concentrated in the largest financial institutions. And creditors of these large 

firms likely expected material support, thereby facilitating excessive risk-taking by 

such institutions. Policymakers should correct problems at credit-rating agencies 

with off-balance-sheet financing, mortgage disclosures and the like. But if, fundamentally, TBTF induces too much risk-taking, then these firms will continue to 

find routes to engage in it, other things equal. 

Addressing sources of spillovers 

I have spoken and written about TBTF concerns and policy proposals with sufficient frequency that some observers characterize my views on the topic as 

‘‘boilerplate,’’ a backhanded compliment I presume. Nonetheless, it suggests I only 

judiciously review the key points of the reforms we have long endorsed. The logic 

for our approach is clear. 

In order to reduce expectations of bailouts and reestablish market discipline, policymakers must convince uninsured creditors that they will bear losses when their 

financial institution gets into trouble. A credible commitment to impose losses must 

be built on reforms directly reducing the incentives that lead policymakers to bail 

out, that is provide significant protection for uninsured creditors. The dominant motivation for bailouts is to prevent the problems in a bank or market from threatening other banks, the financial sector and overall economic performance. That is, 

policymakers intervene because of concerns about the magnitude and consequences 

of spillovers. 

Thus, the key to addressing TBTF is to reduce the potential size and scope of the 

spillovers, so that policymakers can be confident that intervention is unnecessary.What specifically should policymakers do to achieve this outcome? To answer 

this question we have taken reforms proposed in the book and combined them in 

a program we call systemic focused supervision (SFS), which we have discussed in 

detail elsewhere. In general, SFS, unlike conventional bank supervision and regulation, focuses on reduction of spillovers; it consists of three pillars: early identification, enhanced prompt corrective action (PCA) and stability-related communication. 

Early identification. As we have described in detail elsewhere, early identification 

is a process to identify and to respond, where appropriate, to the material direct and 

indirect exposures among large financial institutions and between those institutions 

and capital markets.We anticipate valuable progress simply by having central banks 

and other relevant supervisory agencies focus resources on, and take seriously, the 

results of failure simulation exercises, for example. Indeed, such exercises appear 

to have identified the precise type of issues-around derivative contracts, resolution 

regimes and overseas operations-that have plagued policymakers’ ability to adequately address specific TBTF cases.3

In fact, it appears that the policy failure was not primarily in identification of potential spillovers, but rather in making corrective action a sufficiently high priority. 

One constructive option related to early identification would require the relevant 

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4For a similar suggestion, see page 62 of Markus Brunnermeier, Andrew Crockett, Charles 

Goodhart, Avinash D. Persaud, and Hyun Shin, 2009, ‘‘The Fundamental Principles of Financial 

Regulation.’’ 5See Group of Thirty, 2009, ‘‘Financial Reform: A Framework for Financial Stability,’’ p. 41. 

lent of ‘‘prepackaged bankruptcy.’’4 The appropriate regulatory agencies should require TBTF firms to identify current limitations of the resolution regime they face 

and the spillovers that might occur if their major counterparties entered such proceedings. 

Without doubt, implementing early identification will prove challenging. That 

said, recommendations from other knowledgeable observers suggest that the task is 

possible and worthwhile. The G–30 recommendations, for example, would have 

firms continuously monitor and report on the full range of their counterparty exposures, in addition to reviewing their vulnerability to a host of potential risks, many 

related to spillovers.5 These reports are precisely the key supervisory inputs to early 

identification. 

One might reasonably wonder about a plan that seems to give center stage to supervisors, when I earlier noted reservations about supervision and regulation? I 

would point out, however, that here we are emphasizing a role for supervision 

where it in fact has a comparative advantage. In particular, we would focus supervision on collection of private information on financial institutions, looking across 

institutions, and worrying about fallout that potentially affects the public, rather 

than asking supervisors to try to tune risk-taking to its optimal level. Other entities 

have neither the incentive nor the access to carry out the role we envision for supervision. 

Enhanced prompt corrective action. PCA works by requiring supervisors to take 

specified actions against a bank as its capital falls below specified triggers. One of 

its principal virtues is that it relies upon rules rather than supervisory discretion. 

Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way. If a bank’s failure does not impose large losses, 

by definition it cannot directly threaten the viability of other depository institutions 

that have exposure to it. Thus, a PCA regime offers an important tool to manage 

systemic risk. However, the regime currently uses triggers that do not adequately 

account for future losses and give too much discretion to bank management.We 

would augment the triggers with more forward-looking data, outside the control of 

bank management, to address these concerns. 

Communication. The first two pillars of SFS seek to increase market discipline 

by reducing the motivation policymakers have for protecting creditors. But creditors 

will not know about efforts to limit spillovers, and therefore will not change their 

expectations of support and in turn, their pricing and exposures, absent explicit 

communication by policymakers about these efforts. This recommendation highlights 

a key distinction between our approach and that advocated by others: Our approach 

does not simply seek to limit systemic risk, but takes the next step of directly trying 

to address TBTF by putting creditors at risk of loss. If we do not do this, we will 

not limit TBTF. 

Now let me turn to some alternative reforms that have received significant attention recently. 

Reducing the size of (TBTF) financial institutions 

This proposal is straightforward: If financial institutions raise systemic concerns 

because of their size, make them smaller.We intend to discuss this suggestion at 

some length in a separate document, but suffice it to say that we have serious reservations about the ultimate effectiveness of such an approach. And I would note, 

in passing, that it is an idea born of desperation since it seems to admit that large, 

complex organizations cannot be supervised effectively. 

To provide a flavor for our concerns about this proposal, consider the government’s ability to keep the firms ‘‘small’’ after dismantling has occurred. There might, 

for example, be tremendous pressure in the direction of expansion if, in the future, 

the smooth resolution of the failure of a major institution required the sale of assets 

to other significant institutions. Even if this situation can be avoided, these firms 

could still engage in behavior that increases the risk of significant spillovers. They 

could do so, for example, by shifting their portfolios to assets that suffer catastrophic losses only when economic conditions deteriorate dramatically, thus making 

themselves and the financial system vulnerable to cyclical outcomes. 

Reliance on supervision and regulation and/or FDICIA 

The two broad approaches discussed to this point seek both increased market and 

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6For a discussion of improvement efforts under way for both the banking industry and bank 

supervisors, see Roger T. Cole, 2009, Risk Management in the Banking Industry, before the Subcommittee on Securities, Insurance, and Investment, Committee on Banking, Housing, and 

Urban Affairs, U.S. Senate, Washington, D.C., March 18, 2009. 

tions. But some observers do not believe that policymakers can credibly put creditors of these firms at risk of loss. And some analysts do not believe that creditors 

can effectively discipline these oft-sprawling firms even if they had an incentive to 

do so. As a result, some proposals to better limit the risk-taking of firms perceived 

TBTF focus primarily on strengthening conventional supervisory and regulatory discipline. 

Policymakers could pursue this approach in many ways. After identifying TBTF 

firms, a more rigorous supervisory and regulatory regime would be applied to them. 

The tougher approach might include, for example, (a) higher capital requirements, 

(b) requirements that the firms maintain higher levels of liquid assets, (c) additional 

restrictions on the activities in which the firms engage, and (d) a much larger presence of on-site supervisors monitoring compliance with these dictates. 

My concerns about this approach, and they are considerable, center on the heavy 

reliance on supervision and regulation but are not a wholesale rejection of S/R per 

se. Given the distortion to incentives caused by the explicit safety net underpinning 

banking, society cannot rely exclusively on market forces to provide the appropriate 

level of discipline to banks.We must have a system of supervision and regulation 

to compensate. And naturally we should learn from recent events to improve that 

system, a process under way.6

But we must recognize the important limitations of supervision and regulation 

and establish objectives that it can achieve. The owners of systemically important 

financial institutions provide incentives for firm management to take on risk, which 

is the source of the returns to equity holders (risk and return go hand in hand). 

Under a tougher S/R regime, these firms have no less incentive than formerly to 

find ways of assuming risk that generates the returns required by markets and that 

does not violate the letter of the restrictions they face. By way of example, research 

on bank capital regimes finds ambiguous results regarding their ultimate effect, as 

firms can offset increased capital by taking on more risk. 

And, as I noted earlier, the track record of S/R does not suggest it prevents risktaking that seems excessive ex post. True, long shots occasionally come in, and perhaps a regime dependent on conventional S/R would succeed, but it is NCAA Tournament time, and we know that a 15 seed rarely beats a number two. To pick just 

one example from the current episode, supervisors have been unable once again to 

prevent excessive lending to commercial real estate ventures, a well-known, highrisk, high-return business which contributed importantly to the serious banking 

problems of the late 1980s and early 1990s. 

I recognize that creating a new regulatory framework for a small number of very 

large institutions differs from supervising thousands of small banks. But I forecast 

the same disappointing outcome for two reasons. First, we have already applied a 

version of the suggested approach; right now, we have higher standards and more 

intensive supervision for the largest banking firms. Second, the failure of supervision and regulation reflects inherent limitations. Supervisors operate in a democracy and must follow due process before taking action against firms. This means 

that there is an inevitable lag between identification of a problem and its ultimate 

correction. As previously noted, management has ample incentive to find ways 

around supervisory restrictions. Further, the time inconsistency problem frequently 

makes supervisory forbearance look attractive. 

A truly draconian regulatory regime could conceivably succeed in diminishing 

risk-taking but only at excessive cost to credit availability and economic performance. As Ken Rogoff, a distinguished economist at Harvard who has considerable 

public policy experience as well put it: ‘‘If we rebuild a very statist and inefficient 

financial sector—as I fear we will—it’s hard to imagine that growth won’t suffer for 

years.’’ 

Just as we should not rely exclusively, or excessively, on S/R, I do not think that 

imposing an FDICIA-type resolution regime on systemically important nonbank financial institutions will correct as much of the TBTF problem as some observers 

anticipate. To be sure, society will be better off if policymakers create a resolution 

framework more tailored to large financial institutions, in particular one that allows 

operating the firms outside of a commercial bankruptcy regime once they have been 

deemed insolvent. This regime would take the central bank out of rescuing and, as 

far as the public is concerned, ‘‘running’’ firms like AIG. That is a substantial benefit. And this regime does make it easier to impose losses on uninsured creditors 

if policymakers desire that outcome. 

67 

But I am skeptical that this regime will actually lead to greater imposition of 

losses on these creditors in practice. Indeed, we wrote our book precisely because 

we did not think that FDICIA put creditors at banks viewed as TBTF at sufficient 

risk of loss.We thought that when push came to shove, policymakers would invoke 

the systemic risk exception and support creditors well beyond what a least-cost test 

would dictate.We thought this outcome would occur because policymakers view such 

support as an effective way to limit spillovers. I don’t think a new resolution regime 

will eliminate those spillovers (or at least not the preponderance of them), and so 

I expect that a new regime will not, by itself, put an end to the support we have 

seen over the last 20 months. 

Conclusion 

I recognize the limits of any proposal to address the TBTF problem.We will never 

avoid entirely the financial crises that lead to extraordinary government support. 

But that is a weak excuse for not taking the steps to prepare to make that outcome 

as remote as we can. It is with deep regret for damage done to residents of the Red 

River Valley that I note the return of flood season to the Upper Midwest. Many residents have noted that the ‘‘100-year flood’’ has come many more times to this part 

of the country than its designation implies. And these residents have rightly focused 

on preparing to limit the literal spillovers when this extraordinary event becomes 

routine. In contrast, policymakers did not prepare for the TBTF flood; indeed, they 

situated themselves in the flood plain, ignored the flood warning, and hoped for the 

best.We must now finally give highest priority to preparation and take the actions 

required before the next deluge. 

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* The views expressed in this testimony are those of the author alone and do not necessarily 

represent those of the American Enterprise Institute. 

PREPARED STATEMENT OF PETER J. WALLISON * 

ARTHUR F. BURNS FELLOW IN FINANCIAL POLICY STUDIES, 

AMERICAN ENTERPRISE INSTITUTE

MAY 6, 2009 

Chairman Dodd, Ranking member Shelby and members of the Committee: 

I am very pleased to have this opportunity to appear before this Committee to 

discuss one of the most important issues currently facing our country. The financial 

crisis will eventually end. The legislation that Congress adopts to prevent a similar 

event in the future is likely to be with us for 50 years. The terms ‘‘too big to fail’’ 

and ‘‘systemically important’’ are virtually interchangeable. The reason that we 

might consider some financial institutions ‘‘too big to fail’’ (TBTF) is that their failure could produce substantial losses or other ill effects elsewhere in the economy— 

a systemic breakdown of some kind. Thus, if a firm is systemically important, it is 

also likely to be TBTF. 

Understanding the virtual identity between these two terms is essential, because 

we should not be concerned about business failures unless they can have knock-on 

effects that could involve the whole economy or the whole financial system. There 

is real danger that policymakers will confuse efforts to prevent simple business failures with efforts to prevent systemic breakdowns. It is to the credit of the Obama 

administration that they have not claimed that the bankruptcy of General Motors 

would cause a systemic breakdown, even though GM’s failure could cause widespread losses throughout the economy. 

In this testimony, I will discuss the GM case frequently, as a way of testing 

whether we have adequate concepts for determining whether a financial firm is 

TBTF. If GM is not TBTF it raises questions whether any nonbank financial firm— 

no matter how large—is likely to be TBTF. The discussion that follows will specifically address the four issues that Chairman Dodd outlined in his letter of invitation: 

• Whether a new regulatory framework is desirable or feasible to prevent institutions from becoming ‘‘too big to fail’’ and posing the risk of systemic harm to 

the economy and financial system; 

• Whether existing financial organizations considered ‘‘too big to fail’’ should be 

broken up; 

• What requirements under a new regulatory framework are necessary to prevent 

or mitigate risks associated with institutions considered ‘‘too big to fail;’’ for example, new capital and disclosure requirements, as well as restrictions on size, 

affiliations, transactions, and leverage; and 

• How to improve the current framework for resolving systemically important 

non-bank financial companies. 

Is it desirable or feasible to develop a regulatory framework that will prevent firms from becoming TBTF or posing a risk of systemic harm? 

A regulatory framework that will prevent companies from becoming TBTF—or 

causing systemic breakdowns if they fail—is only desirable or feasible if Congress 

can clearly define what it means by systemic harm or TBTF. If Congress cannot describe in operational terms where to draw the line between ordinary companies and 

companies that are TBTF—or if it cannot define what it means by ‘‘systemic 

harm’’—it would not be good policy to give the power to do so to a regulatory agency. 

The standard, ‘‘I know it when I see it’’ may work when a systemic event is imminent, but not for empowering a regulatory agency to designate TBTF or systemically 

important firms in advance. If Congress does so, the likelihood of severe and adverse unintended consequences is quite high. 

First, if a firm is designated in advance as TBTF (that is, as systemically important), it will have competitive advantages over other firms in the same industry and 

other firms with which it competes outside its industry. This is true because the 

TBTF designation confers important benefits. The most significant of these is probably a lower cost of funding, arising from the market’s recognition that the risk of 

loss is significantly smaller in firms that the government will not allow to fail than 

it is in firms that might become bankrupt. Lower funding costs will translate inevitably—as it did in the case of Fannie Mae and Freddie Mac—into market dominance 

and consolidation. Market sectors in which TBTF firms are designated will come to 

be dominated and controlled by the large TBTF firms, and smaller firms will gradually be squeezed out. Ironically, this will also result in consolidation of risk in fewer 

81 

and fewer entities, so that the likelihood of big firm collapses becomes greater and 

each collapse more disruptive. In some markets, status as TBTF has another advantage—the appearance of greater stability than competitors. In selling insurance, for 

example, firms that are designated as systemically important will be able to tell potential customers that they are more likely to survive and meet their obligations 

than firms that have not been so designated. 

Accordingly, if there is to be a system of designating certain firms as systemically 

important, it is necessary to be able to state with some clarity what standards the 

agency must use to make that decision. Leaving the agency with discretion, without 

definitive standards, would be courting substantial unintended consequences. The 

natural tendency of a regulator would be to confer that designation broadly. Not 

only does this increase the regulator’s size and power, but it also minimizes the likelihood—embarrassing for the regulator—that a systemic event will be caused by a 

firm outside the designated circle. Accordingly, the ability of Congress to define 

what it means by a TBTF firm would be important to maintain some degree of competitive vigor in markets that would otherwise be threatened by the designation of 

one or more large firms as systemically important and thus TBTF. 

Second, apart from competitive considerations, it is necessary to consider the possibility that ordinary business failures might be prevented even though they would 

not have caused a systemic breakdown if they occurred. Again, the tendency of regulators in close cases will be to exercise whatever power they have to seize and bail 

out failing firms that might be TBTF. The incentives all fall in this direction. If a 

systemic breakdown does occur, the regulator will be blamed for failing to recognize 

the possibility, while if a firm is bailed out that would not in fact have caused a 

systemic breakdown, hardly anyone except those who are forced to finance it (a matter to be discussed later) will complain. This makes bailouts like AIG much more 

likely unless Congress provides clear guidelines on how a regulator is to identify a 

TBTF or systemically important firm. 

The stakes for our competitive system are quite high in this case, because bailouts 

are not only costly, but they have a serious adverse effect on the quality of companies and managements that continue to exist. If firms are prevented from failing 

when they are not TBTF or otherwise systemically important, all other firms are 

weakened. This is because our competitive market system improves—and consumers 

are better served—through the ‘‘creative destruction’’ that occurs when bad managements and bad business models are allowed to fail. When that happens, the way 

is opened for better managements and business models to take their place. If failures are prevented when they should not be, the growth of the smaller but better 

managed and more innovative firms will be hindered. Overall, the quality and the 

efficiency of the firms in any market where this occurs will decline. 

Finally, setting up a mechanism in which companies that should be allowed to 

fail are rescued from failure will introduce significant moral hazard into our financial system. This is true even if the shareholders of a rescued firm are wiped out 

in the process. Shareholders are not the group whose views we should be worried 

about when we consider moral hazard. Shareholders, like managements, benefit 

from risk-taking, which often produces high profits as well as high rates of failure. 

The class of investors we should be thinking about are creditors, who get no benefits 

whatever from risk-taking. They are the one who are in the best position to exercise 

market discipline, and they do so by demanding higher rates of interest when they 

see greater risk-taking in a potential borrower. To the extent that the wariness of 

creditors is diminished by the sense that a company may be rescued by the government, there will be less market discipline by creditors and increased moral hazard. 

The more companies that are added to the list of firms that might be rescued, the 

greater the amount of moral hazard that has been introduced to the market. The 

administration’s plan clearly provides for possible rescue, since it contemplates either a receivership (liquidation) or a conservatorship (generally a way to return a 

company to health and normal operations). 

Accordingly, although it is exceedingly important for Congress to be clear about 

when a company may be designated as TBTF, it will be very difficult to do so. This 

is illustrated by the GM case. GM is one of the largest companies in the U.S.; its 

liquidation, if it occurs, could cause a massive loss of jobs not only at GM itself but 

at all the suppliers of tires, steel, fabrics, paints, and glass that go into making a 

car, all the dealers that sell the cars, all the banks that finance the dealers, and 

all the communities, localities, and states throughout the U.S. that depend for their 

revenues on the taxes paid by these firms and their employees. In other words, 

there would be very serious knock-on effects from a GM failure. Yet, very few people 

are suggesting that GM is TBTF in the same way that large financial institutions 

are said to be TBTF. What is the difference? 

82 

This question focuses necessary attention on two questions: what it means to be 

TBTF and the adequacy of the bankruptcy system to resolve large firm failures. If 

GM is not TBTF, why not? The widespread losses throughout the economy would 

certainly suggest a systemic effect, but if that is not what we mean by a systemic 

effect, what is it that we are attempting to prevent? On the other hand, if that is 

what we mean by a systemic effect, should the government then have the power to 

resolve all large companies—and not just financial firms—outside the bankruptcy 

system? The fact that GM may ultimately go into bankruptcy and be reorganized 

under Chapter 11 suggests that the bankruptcy system is adequate for large financial nonbank institutions, unless the propensity of nonbank financial institutions to 

create systemic breakdowns can be distinguished from that of operating companies 

like GM. Later in this testimony, I will argue that this distinction cannot be sustained. 

The forgoing discussion highlights the difficulty of defining both a systemic event 

and a systemically important or TBTF firm, and also the importance of defining 

both with clarity. Great harm could come about if Congress—without establishing 

any standards—simply authorizes a regulatory agency to designate TBTF companies, and authorizes the same or another agency to rescue the companies that are 

so designated. My answer, then, to the Committee’s first question is that—given the 

great uncertainty about (i) what is a systemic event, (ii) how to identify a firm that 

is TBTF, and (iii) what unintended consequences would occur if Congress were not 

clear about these points—it would be neither desirable nor feasible to set up a structure that attempts to prevent systemic harm to the economy by designating systemically important firms and providing for their resolution by a government agency 

rather than through the normal bankruptcy process. 

Nevertheless, it would not be problematic to create a body within the executive 

branch that generally oversees developments in the market and has the responsibility of identifying systemic risk, wherever it might appear to be developing within 

the financial sector. The appropriate body to do this would be the President’s Working Group (PWG), which consists of most of the major Federal financial supervisors 

and thus has a built-in market-wide perspective. The PWG currently functions 

under an executive order, but Congress could give it a formal charter as a government agency with responsibility for spotting systemic risk as well as coordinating 

all financial regulatory activity in the executive branch. 

Breaking up systemically significant or TBTF firms 

There could be constitutional objections to a breakup—based on the takings and 

due process—unless there are clear standards that justify it. I am not a constitutional lawyer, but a fear that a company might create a systemic breakdown if it 

fails does not seem adequate to take the going concern value of a large company 

away from its shareholders. As we know from antitrust law, firms can be broken 

up if they attempt to monopolize and under certain other limited circumstances. But 

in those cases, there are standards for market dominance and for the requisite intent to use it in order to create a monopoly—and both are subject to rigorous evidentiary standards. As I pointed out above, there are no examples that define a systemic risk or why one company might cause it and another might not. Accordingly, 

providing authority for a government agency to break up companies that are 

deemed to be systemically risky could be subject to constitutional challenge. 

In addition, as a matter of policy, breaking up large institutions would seem to 

create many more problems than it would solve. First, there is the question of 

breaking up successful companies. If companies have grown large because they are 

successful competitors, it would be perverse to penalize them for that, especially 

when we aren’t very sure whether they would in fact cause a systemic breakdown 

if they failed. In addition, our economy is made up of large as well as small companies. Large companies generally need large financial institutions to meet their financing needs. This is true whether we are talking about banks, securities firms, 

insurance companies, finance companies, or others. Imagine a large oil company trying to insure itself against property or casualty losses with a batch of little insurance companies. The rates it would have to pay would be much higher, if it could 

get full coverage at all. Or imagine the same oil company trying to pay its employees worldwide without a large U.S. bank with worldwide operations, or the same 

company trying to place hundreds of millions of dollars in commercial paper each 

week through small securities firms without a global reach. 

There are also international competitive factors. If other countries did not break 

up their large financial institutions, our large operating companies would probably 

move their business to the large foreign financial institutions that could meet their 

needs. 

83 

Leaving our large operating companies without an alternative source of funding 

could also be problematic, in the event that a portion of the financial markets becomes unavailable—either in general or for a specific large firm. The market for 

asset-backed securities closed down in the summer of 2007 and hasn’t yet reopened. 

Firms that used to fund themselves through this market were then compelled to 

borrow from banks or to use commercial paper or other debt securities. This is one 

of the reasons that the banks have been reluctant to lend to new customers; they 

have been saving their cash for the inevitable withdrawals by customers that had 

been paying over many years for lines of credit that they could use when they needed emergency funds. The larger firms might not have been able to find sufficient 

financial resources if the largest banks or other financial institutions had been broken up. 

The breakup of large financial firms would create very great risks for our economy, with few very benefits, especially when we really have no idea whether any 

particular firm that might be broken up actually posed a systemic risk or would 

have created a systemic breakdown if it had failed. 

Are there regulatory actions we can take to mitigate or prevent systemic 

risk caused by TBTF companies? 

For the reasons outlined below, it is my view that only the failure of a large commercial bank can create a systemic breakdown, and that nonbank financial firms— 

even large ones—are no more likely than GM to have this effect. For that reason, 

I would not designate any nonbank financial institution (other than a commercial 

bank) as systemically important, nor recommend safety and soundness supervision 

of any financial institutions other than those where market discipline has been impaired because they are backed by the government, explicitly or implicitly. 

The track record of banking regulation is not good. In the last 20 years we have 

had two very serious banking crises, including the current one, when many banks 

failed and adversely affected the real economy. The amazing thing is that—despite 

this record of failure—the first instinct of many people in Washington it is to recommend that safety and soundness regulation be extended to virtually the entire 

financial system through the regulation and supervision of systemically important 

(or TBTF) firms. After the S&L debacle and the failure of almost 1600 commercial 

banks at the end of the 1980s and the beginning of the 1990s, Congress adopted 

the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), a 

tough regulatory statute that many claimed would put an end to banking crises. Yet 

today we are in the midst of a banking crisis that some say could be as bad as that 

of the Great Depression, perhaps even worse. If banks were not backed by the government—through deposit insurance, a lender of last resort, and exclusive access to 

the payment system—their risk-taking would probably be better controlled by market discipline exerted by creditors. But given the government support they receive, 

and its effect in impairing market discipline, regulation and supervision of their 

safety and soundness is the only sensible policy. 

Nevertheless, there are some reasonable steps that could be taken to improve 

bank regulation and to mitigate the possibility that the failure of a large bank 

might in the future have a significant adverse effect on other economic actors. For 

the reasons outlined above, I don’t think that restrictions on size are workable, and 

they are likely to be counterproductive. The same thing is true of restrictions on affiliations and transactions, both of which will impose costs, impair innovation, and 

reduce competition. Since we have no idea whether any particular firm will cause 

a systemic breakdown if it fails, it does not seem reasonable to impose all these burdens on our financial system for very little demonstrable benefit. Restrictions on leverage can be effective, but I see them as an element of capital regulation, as discussed below. 

A good example of the unintended consequences of imposing restriction on affiliations is what has happened because of the restrictions on affiliations between 

banks and commercial firms. As the Committee knows, the Bank Holding Company 

Act provides that a bank cannot be affiliated with any activity that is not ‘‘financial 

in nature.’’ For many years the banking industry has used this to protect themselves against competition by organizations outside banking, most recently competition from Wal-Mart. They and others have argued that the separation of banking 

and commerce (actually, after the Gramm-Leach-Bliley Act was adopted in 1999, the 

principle became the separation of finance and commerce) was necessary to prevent 

the extension of the so-called Federal ‘‘safety net’’ to commercial firms. That idea 

has now backfired on the banks, because by keeping commercial firms out of the 

business of investing in banks, they have made it very difficult for banks to raise 

the capital they need in the current financial crisis. We should not impose restrictions on affiliations unless there is strong evidence that a particular activity is 

84 

harmful. All such restrictions turn out to be restrictions on competition and ultimately hurt consumers, who must pay higher prices and get poorer services. Because Wal-Mart was unable to compete with banks, many Wal-Mart customers pay 

more for banking services than they should, and many of them can’t get banking 

services at all. 

Nevertheless, capital requirements can be used effectively to limit bank risk-taking and growth, and this would be far preferable to other kinds of restrictions. It 

would make sense to raise bank capital requirements substantially. The only reason 

banks are able to keep such low capital ratios is that they have government backing. In addition, capital requirements should be raised as banks grow larger, which 

is in part the result of higher asset values that accompany a growing market. An 

increase of capital requirements with size would also have the salutary effect of 

dampening growth by making it more expensive, and it would provide a strong 

countercyclical brake on the development of asset bubbles. Higher capital requirements as banks grow larger would also induce them to think through whether all 

growth is healthy, and what lines of business are most suitable and profitable. In 

addition, as bank profits grow, capital requirements or reserves should also be increased in order to prepare banks for the inevitable time when growth will stop and 

the decline sets in. Before the current crisis, 10 percent risk-based capital was considered well-capitalized, but it is reasonably apparent now that this level was not 

high enough to withstand a serious downturn. 

In addition, regulation should be used more effectively to enhance market discipline. Bank regulators are culturally reluctant to release information on the banks 

they supervise. This too often leaves market participants guessing about the risks 

the banks are taking—and wrongly assuming that the regulators are able to control 

these risks. To better inform the markets, the regulators, working with bank analysts, should develop a series of metrics or indicators of risk-taking that the banks 

should be required to publish regularly—say, once every month. This would enable 

the markets to make more informed judgments about bank risk-taking and enhance 

the effectiveness of market discipline. Rather than fighting market discipline, bank 

regulators should harness it in this way to supplement their own examination work. 

Finally for larger commercial banks, especially the ones that might create systemic risk if they failed, it would be a good idea to require the issuance of a form 

of tradable subordinated debt that could not by law be bailed out. The holders of 

this debt would have a strong interest in better disclosure by banks and could develop their own indicators of risk-taking. As the market perceived that a bank was 

taking greater risk, the price of these securities would fall and its yield would rise. 

The spread of that yield over Treasuries would provide a continuing strong signal 

to a bank’s supervisor that the market foresees trouble ahead if the risk-taking continues. Using this data, the supervisor could clamp down on activities that might 

result in major losses and instability at a later time. 

Can we improve the current framework for resolving systemically important nonbank financial firms? 

The current framework for resolving all nonbank financial institutions is the 

bankruptcy system. Based on the available evidence, there is no reason to think 

that it is inadequate for performing this task or that these institutions need a government-administered resolution system. Because of the special functions of banks, 

a special system for resolving failed banks is necessary, but as discussed below 

banks are very different from other financial institutions. The creation of a government-run system will increase the likelihood of bailouts of financial institutions and 

prove exceedingly costly to the financial industry or to the taxpayers, who are likely 

to end up paying the costs. 

The underlying reason for the administration’s proposal for a special system of 

resolution for nonbank financial institutions is the notion that the failure of a large 

financial firm can create a systemic breakdown. Thus, although many people look 

at the administration’s resolution plan as a means to liquidate systemically important or TBTF firms in an orderly way, it is more likely to be a mechanism for bailing out these firms so that they will not cause a systemic breakdown. The Fed’s 

bailout of AIG is the paradigm for this kind of bailout, which sought to prevent market disruption by using taxpayer funds to prevent losses to counterparties and creditors. 

As support for its proposal, the administration cites the ‘‘disorderly’’ bailout of 

AIG and the market’s panicked reaction to the failure of Lehman Brothers. On examination, these examples turn out to be misplaced. Academic studies after both 

events show that the market’s reaction to both was far more muted than the administration suggests. Moreover, the absence of any recognizable systemic fallout from 

the Lehman bankruptcy—with the exception of a single money market mutual fund, 

85 

no other firm has reported or shown any serious adverse effects—provides strong 

evidence that in normal market conditions the reaction to Lehman’s failure would 

not have been any different from the reaction to the failure of any large company. 

These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks. 

The special character of banks. Although the phrase ‘‘shadow banking’’ is 

thrown around to imply a strong similarity between commercial banks and other financial institutions such as securities firms, hedge funds, finance companies or insurers, the similarity is illusory in most important respects. Anyone can lend; only 

banks can take deposits. Deposit-taking—not lending—is the essence of banking. By 

offering deposits that can be withdrawn on demand or used to pay others through 

an instruction such as a check, banks and other depository institutions have a special and highly sensitive role in our economy. If a bank should fail, its depositors 

are immediately deprived of the ready funds they expected to have available for 

such things as meeting payroll obligations, buying food, or paying rent. Banks also 

have deposits with one another, and small banks often have substantial deposits in 

larger banks in order to facilitate their participation in the payment system. 

Because of fear that a bank will not be able to pay in full on demand, banks are 

also at risk of ‘‘runs’’—panicky withdrawals of funds by depositors. Runs can be 

frightening experiences for the public and disruptive for the financial system. The 

unique attribute of banks—that their liabilities (deposits) may be withdrawn on demand-is the reason that banks are capable of creating a systemic event if they fail. 

If bank customers cannot have immediate access to their funds, or if a bank cannot 

make its scheduled payments to other banks, the others can also be in trouble, as 

can their customers. That is the basis for a true systemic event. The failure of a 

bank can leave its customers and other banks without the immediate funds they are 

expecting to use in their daily affairs. The failure of a large bank can cause other 

failures to cascade through the economy, theoretically creating a systemic event. I 

say ‘‘theoretically’’ because the failure of a large bank has never in modern times 

caused a systemic event. In every case where a large bank might have failed and 

caused a systemic breakdown, it has been rescued by the FDIC. The most recent 

such case—before the current crisis—was the rescue of Continental Illinois Bank in 

1984. 

The foregoing description of how a large bank’s failure can cause a systemic 

breakdown raises a number of questions about whether and how a systemic breakdown can be caused by the failure of a nonbank financial institution. These financial 

institutions—securities firms, hedge funds, insurance companies, finance companies, 

and others—tend to borrow for a specific term or to borrow on a collateralized basis. 

In this respect, they are just like GM. In common with all other large commercial 

borrowers, nonbank financial institutions also fund themselves with short-term commercial paper. Unless they are extremely good credits, this paper is collateralized. 

If they should fail, their creditors can recoup their losses by selling the collateral. 

Their failures, then, do not cause any immediate cash losses to their lenders or 

counterparties. Losses occur, to be sure, but in the same way that losses will occur 

if GM should file for bankruptcy—those who suffer them do not lose the immediate 

access to cash that they were expecting to use for their current obligations, and thus 

there is rarely any contagion in which the losses of one institution are passed on 

to others in the kind of cascade that can occur when a bank fails. It is for this reason that describing the operations of these nondepository institutions as ‘‘shadow 

banking’’ is so misleading. It ignores entirely the essence of banking—which is not 

simply lending—and how it differs from other kinds of financial activity. 

Because of the unique effects that are produced by bank failures, the Fed and the 

FDIC have devised systems for reducing the chances that banks will not have the 

cash to meet their obligations. The Fed lends to healthy banks (or banks it considers 

healthy) through what is called the discount window—making cash available for 

withdrawals by worried customers—and the FDIC will normally close insolvent 

banks just before the weekend and open them as healthy, functioning new institutions on the following Monday. In both cases, the fears of depositors are allayed and 

runs seldom occur. The policy question facing Congress is whether it makes sense 

to extend FDIC bank resolution processes to other financial institutions. For the 

reasons outlined above, there is virtually no reason to do so for financial institutions 

other than banks. 

Before proceeding further, it is necessary to correct some misunderstandings 

about the effectiveness of the FDIC, which has been presented by the administration and others as a paragon in the matter of resolving banks. The facts suggest 

a different picture, and should cause policymakers to pause before authorizing the 

FDIC or any other agency to take over the resolution of nonbank financial institutions. The FDIC and the other bank regulators function under a FDICIA requireVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00089 Fmt 6633 Sfmt 6621 S:\DOCS\53822.TXT SHERYL
86 

1Kenneth Ayotte and David A. Skeel, Jr., ‘‘Bankruptcy or Bailouts?’’ (March 2, 2009). U of 

Penn, Inst for Law & Econ Research Paper No. 09–11; Northwestern Law & Econ Research 

Paper No. 09–05, pp 9–10. Available at SSRN: http://ssrn.com/abstract=1362639. 

ment for prompt corrective action (PCA) when a bank begins to weaken. The objective of PCA is to give the FDIC and other supervisors the authority to close a bank 

before it actually becomes insolvent, thus saving both the creditors and the FDIC 

insurance fund from losses. It has not worked out that way. Thus far in 2009, there 

have been 32 reported bank failures for which the FDIC has reported its losses. In 

these cases, the losses on assets have ranged from 8 percent to 45 percent, with both 

an average and a weighted average of 28 percent. In 2008, there were 25 bank failures, with losses averaging 25 percent. There may be reasons for these extraordinary losses, including the difficulty of dealing with the primary Federal or state 

regulator, but the consistency of the losses in the face of the PCA requirement casts 

some doubt on the notion that even the best Federal resolution agency—dealing 

with failing insurance companies, securities firms, hedge funds and others—would 

be able to do a more efficient job than a bankruptcy court. 

While the failures of the FDIC as a resolution agency are not well known, the 

weakness of the bankruptcy system as a way of resolving failing financial institutions has been exaggerated. The evidence suggests that the Lehman’s bankruptcy 

filing—as hurried as it was—has resulted in a more orderly resolution of the firm 

than AIG’s rescue by the Fed. As reported by professors Kenneth Ayotte and David 

Skeel, things moved with dispatch after Lehman filed for bankruptcy under Chapter 

11 of the code. Thus, as Ayotte and Skeel note: 

Lehman filed for Chapter 11 on September 15, 2008. Three days later, Lehman arranged a sale of its North American investment banking business 

to Barclays, and the sale was quickly approved by the court after a lengthy 

hearing . . . Its operations in Europe, the Middle East, and Asia were 

bought by Nomura, a large Japanese brokerage firm. By September 29, 

Lehman had agreed to sell its investment management business to two private equity firms.1

Chapter 11 allows bankrupt debtors to remain in possession of their assets and continue operating while their creditors reach agreement on how best to divide up the 

firm’s assets. It also permits firms to return to financial health if their creditors conclude that this is more likely to result in a greater recovery than a liquidation. In 

other words, Chapter 11 provides a kind of bailout mechanism, but one that is 

under the control of the creditors-the parties that have suffered the real losses. Neither the taxpayers nor any other unrelated party is required to put in any funds 

to work out the failed company. 

There are many benefits of a bankruptcy that are not likely to come with a system of resolution by a government agency. These include certainty about the rights 

of the various classes of creditors; a well-understood and time-tested set of procedures; the immediate applicability of well-known stay provisions that prevent the 

disorderly seizure of collateral; equally well-known exemptions from stay provisions 

so that certain creditors holding short-term obligations of the failed company can 

immediately sell their collateral; and well worked out rules concerning when and 

under what circumstances preferential payments to certain creditors by the bankrupt firm have to be returned to the bankrupt estate. 

Still, the examples of Lehman Brothers and AIG have had a significant impact 

on the public mind and a hold on the attitudes of policymakers. It is important to 

understand these cases, and the limited support they provide for setting up a system for resolving large nonbank financial institutions. 

The market reactions after the failures of AIG and Lehman are not examples of systemic risk. Secretary Geithner has defended his proposal for a resolution authority by arguing that, if it had been in place, the rescue of AIG last fall 

would have been more ‘‘orderly’’ and the failure of Lehman Brothers would not have 

occurred. Both statements might be true, but would that have been the correct policy outcome? Recall that the underlying reason for the administration’s plan to designate and specially regulate systemically important firms is that the failure of any 

such company would cause a systemic event—a breakdown in the financial system 

and perhaps the economy as a whole. If this is the test, it is now reasonably clear 

that neither AIG nor Lehman is an example of a large firm creating systemic risk 

or a systemic breakdown. 

In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the market meltdown and the freeze in interbank lending that followed 

the Lehman and AIG events in mid-September 2008 did not begin until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same 

87 

2 John B. Taylor, ‘‘The Financial Crisis and the Policy Responses: An Empirical Analysis of 

What Went Wrong’’ Working Paper 14,631, National Bureau of Economic Research, Cambridge, 

MA, January 2009), 25ff, available at www.nber.org/papers/w14631 (accessed April 8, 

2009).John B. Taylor, Getting Off Track: How Government Actsion and Ingterventions Caused, 

Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, 2009, pp 25–30. 3 Ayotte and Skeel, p 27. 

4 American International Group, 10–Q filing, June 30, 2008, 95–101. 

week, an action that implied that financial conditions were much worse than the 

markets had thought.2 Taylor’s view, then, is that AIG and Lehman were not the 

cause of the meltdown that occurred later that week. Since neither firm was a bank 

or other depository institution, this analysis is highly plausible. Few of their creditors were expecting to be able to withdraw funds on demand to meet payrolls or 

other immediate expenses, and later events and data have cast doubt on whether 

the failure of Lehman or AIG (if it had not been bailed out) would have caused the 

losses that many have claimed. 

In another analysis after the Lehman and AIG events, Ayotte and Skeel concluded that the evidence suggests ‘‘at a minimum, that the widespread belief that 

the Lehman Chapter 11 filing was the singular cause of the collapse in credit that 

followed is greatly overstated.’’3 They also show that that there was very little difference between the market’s reaction to Lehman and to AIG, although the former 

went into bankruptcy and the latter was rescued. 

Advocates of broader regulation frequently state that financial institutions are 

now ‘‘interconnected’’ in a way that they have not been in the past. This idea reflects a misunderstanding of the functions of financial institutions, all of which are 

intermediaries in one form or another between sources of funds and users of funds. 

In other words, they have always been interconnected in order to perform their 

intermediary functions. The right question is whether they are now interconnected 

in a way that makes them more vulnerable to the failure of one or more institutions 

than they have been in the past, and there is no evidence of this. The discussion 

below strongly suggests that there was no need to rescue AIG and that Lehman’s 

failure was problematic only because the market was in an unprecedentedly fragile 

and panicky state in mid-September 2008. 

This distinction is critically important. If the market disruption that followed Lehman’s failure and AIG’s rescue was not caused by these two events, then identifying 

systemically important firms and supervising them in some special way serves no 

purpose. Even if the failure of a systemically important firm could be prevented 

through regulation—a doubtful proposition in light of the current condition of the 

banking industry—that in itself would not prevent the development of a fragile market, or its breakdown in the aftermath of a serious shock. The weakness or failure 

of individual firms is not the source of the problem. In terms of a conventional systemic risk analysis, the chaos that followed was not the result of a cascade of losses 

flowing through the economy as a result of the failure of Lehman or the potential 

failure of AIG. In the discussion that follows, I show first that Lehman did not 

cause, and AIG would not have caused, losses to other firms that might have made 

them systemically important. I then show that both are examples of nonbank financial firms that can be successfully resolved—at no cost to the taxpayers—through 

the bankruptcy process rather than a government agency. 

AIG Should Have Been Sent into Bankruptcy. AIG’s quarterly report on 

Form 10–Q for the quarter ended June 30, 2008—the last quarter before its bailout 

in September—shows that the $1 trillion company had borrowed, or had guaranteed 

subsidiary borrowings, in the amount of approximately $160 billion, of which approximately $45 billion was due in less than 1 year.4 Very little of this $45 billion 

was likely to be immediately due and payable, and thus, unlike a bank’s failure, 

AIG’s failure would not have created an immediate cash loss to any significant 

group of lenders or counterparties. Considering that the international financial markets have been estimated at more than $12 trillion, the $45 billion due within a 

year would not have shaken the system. Although losses would eventually have occurred to all those who had lent money to or were otherwise counterparties of AIG, 

these losses would have occurred over time and been worked out in a normal bankruptcy proceeding, after the sale of its profitable insurance subsidiaries. 

Many of the media stories about AIG have focused on the AIG Financial Products 

subsidiary and the obligations that this group assumed through credit default swaps 

(CDSs). However, it is highly questionable whether there would have been a significant market reaction if AIG had been allowed to default on its CDS obligations in 

September 2008. CDSs—although they are not insurance—operate like insurance; 

they pay off when there is an actual loss on the underlying obligation that is protected by the CDS. It is much the same as when a homeowners’ insurance company 

88 

5 Ayotte and Skeel, Op. Cit., p 25, note 73. 

goes out of business before there has been a fire or other loss to the home. In that 

case, the homeowner must go out and find another insurance company, but he has 

not lost anything except the premium he has paid. If AIG had been allowed to default, there would have been little if any near-term loss to the parties that had 

bought protection; they would simply have been required to go back into the CDS 

market and buy new protection. The premiums for the new protection might have 

been more expensive than what they were paying AIG, but even if that were true, 

many of them had received collateral from AIG that could have been sold in order 

to defray the cost of the new protection. CDS contracts normally require a party like 

AIG that has sold protection to post collateral as assurance to its counterparties 

that it can meet its obligations when they come due. 

This analysis is consistent with the publicly known facts about AIG. In midMarch, the names of some of the counterparties that AIG had protected with CDSs 

became public. The largest of these counterparties was Goldman Sachs. The obligation to Goldman was reported as $12.9 billion; the others named were Merrill Lynch 

($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion), and Wachovia 

($1.5 billion). Recall that the loss of CDS coverage—the obligation in this case—is 

not an actual cash loss or anything like it; it is only the loss of coverage for a debt 

that is held by a protected party. For institutions of this size, with the exception 

of Goldman, the loss of AIG’s CDS protection would not have been problematic, even 

if they had in fact already suffered losses on the underlying obligations that AIG 

was protecting. Moreover, when questioned about what it would have lost if AIG 

had defaulted, Goldman said its losses would have been ‘‘negligible.’’ This is entirely 

plausible. Its spokesman cited both the collateral it had received from AIG under 

the CDS contracts and the fact that it had hedged its AIG risk by buying protection 

against AIG’s default from third parties. 

Also, as noted above, Goldman only suffered the loss of its CDS coverage, not a 

loss on the underlying debt the CDS was supposed to cover. If Goldman, the largest 

counterparty in AIG’s list, would not have suffered substantial losses, then AIG’s 

default on its CDS contracts would have had no serious consequences in the market. 

This strongly suggests that AIG could have been put into bankruptcy with no costs 

to the taxpayers, and if it had not been rescued its failure would not have caused 

any kind of systemic risk. On the other hand, it is highly likely that a systemic regulator would have rescued AIG—just as the Fed did—creating an unnecessary cost 

for U.S. taxpayers and an unnecessary windfall for AIG’s counterparties. 

Lehman’s Failure Did Not Cause a Systemic Event. Despite the contrary 

analyses by Taylor, Skeel, and Ayotte, it is widely believed that Lehman’s failure 

proves that a large company’s default, especially when it is ‘‘interconnected’’ through 

CDSs, can cause a systemic breakdown. If that were true, then it might make sense 

to set up a regulatory structure to prevent a failure by a systemically important 

company. But it is not true. Even if we accept that Lehman’s failure somehow precipitated the market freeze that followed, that says nothing about whether, in normal market conditions, Lehman’s failure would have caused the same market reaction. In fact, analyzed in light of later events, it is likely that Lehman’s bankruptcy 

would have had no substantial adverse effect on the financial condition of its 

counterparties. In other words, the failure would not—in a normal market—have 

caused the kind of cascade of losses that defines a systemic breakdown. 

After Lehman’s collapse, there is only one example of any other organization encountering financial difficulty because of Lehman’s default. That example is the Reserve Fund, a money market mutual fund that held a large amount of Lehman’s 

commercial paper at the time Lehman defaulted. This caused the Reserve Fund to 

‘‘break the buck’’—to fail to maintain its share price at exactly one dollar—and it 

was rescued by the Treasury and Fed. The need to rescue the Reserve Fund was 

itself another artifact of the panicky conditions in the market at the time. That particular fund was an outlier among all funds in terms of its risks and returns.5 The 

fact that there were no other such cases, among money market funds or elsewhere, 

demonstrates that the failure of Lehman in a calmer and more normal market 

would not have produced any of the significant knock-on effects that are the hallmark of a systemic event. It is noteworthy, in this connection, that a large securities 

firm, Drexel Burnham Lambert, failed in 1990 and went into bankruptcy without 

any serious systemic effects. In addition, when Lehman’s CDS obligations were resolved a month after its bankruptcy, they were all resolved by the exchange of only 

$5.2 billion among all the counterparties, a minor sum in the financial markets and 

certainly nothing that in and of itself would have caused a market meltdown. 

So, what relationship did Lehman’s failure actually have to the market crisis that 

followed? The problems that were responsible for the crisis had actually begun more 

89 

6George G. Kaufman and Kenneth Scott, ‘‘What Is Systemic Risk and Do Regulators Retard 

or Contribute to It?’’ The Independent Review 7, no. 3 (Winter 2003). Emphasis added. 

than a year earlier, when investors lost confidence in the quality of securities—particularly mortgage-backed securities (MBS)—that had been rated AAA by rating 

agencies. As a result, the entire market for asset-backed securities of all kinds became nonfunctional, and these assets simply could not be sold at anything but a distress price. With large portfolios of these securities on the balance sheets of most 

of the world’s largest financial institutions, the stability and even the solvency of 

these institutions—banks and others—were in question. 

In this market environment, Bear Stearns was rescued through a Fed-assisted 

sale to JPMorgan Chase in March 2008. The rescue was not necessitated because 

failure would have caused substantial losses to firms ‘‘interconnected’’ with Bear, 

but because the failure of a large financial institution in this fragile market environment would have caused a further loss of confidence—by investors, creditors, and 

counterparties—in the stability of other financial institutions. This phenomenon is 

described in a 2003 article by professors George Kaufman and Kenneth Scott, who 

write frequently on the subject of systemic risk. They point out that when one company fails, investors and counterparties look to see whether the risk exposure of 

their own investments or counterparties is similar: ‘‘The more similar the risk-exposure profile to that of the initial [failed company] economically, politically, or otherwise, the greater is the probability of loss and the more likely are the participants 

to withdraw funds as soon as possible. The response may induce liquidity and even 

more fundamental solvency problems. This pattern may be referred to as a ‘common 

shock’ or ‘reassessment shock’ effect and represents correlation without direct causation.’’6 In March 2008, such an inquiry would have been very worrisome; virtually 

all large financial institutions around the world held, to a greater or lesser extent, 

the same assets that drove Bear toward default. 

Although the rescue of Bear temporarily calmed the markets, it led to a form of 

moral hazard—the belief that in the future governments would rescue all financial 

institutions larger than Bear. Market participants simply did not believe that Lehman, just such a firm, would not be rescued. This expectation was shattered on September 15, 2008, when Lehman was allowed to fail, leading to exactly the kind of 

reappraisal of the financial health and safety of other institutions described by 

Kaufman and Scott. That is why the market froze at that point; market participants 

were no longer sure that the financial institutions they were dealing with would be 

rescued, and thus it was necessary to examine the financial condition of their 

counterparties much more carefully. For a period of time, the world’s major banks 

would not even lend to one another. So what happened after Lehman was not the 

classic case of a large institution’s failure creating losses at others—the kind of systemic event that has stimulated the administration’s effort to regulate systemically 

important firms. It was caused by the weakness and fragility of the financial system 

as a whole that began almost a year earlier, when the quality of MBS and other 

asset-backed securities was called into question and became unmarketable. If Lehman should have been bailed out, it was not because its failure would have caused 

losses to others—the reason for the designation of systemically important or TBTF 

firms—but because the market was in an unprecedented condition of weakness and 

fragility. The correct policy conclusion arising out of the Lehman experience is not 

to impose new regulation on the financial markets, but to adopt policies that will 

prevent the correlation of risks that created a weak and fragile worldwide financial 

market well before Lehman failed. 

Thus, Lehman didn’t cause, and AIG (if it had been allowed to fail) wouldn’t have 

caused, a systemic breakdown. They are not, then, examples of why it is necessary 

to set up a special resolution system, outside the bankruptcy process, to resolve 

them or other large nonbank financial firms. Moreover, and equally important, a 

focus on Lehman and AIG as the supposed sources of systemic risk is leading policymakers away from the real problem, which is the herd and other behavior that 

causes all financial institutions to become weak at the same time. 

The funding question. There is also the question of how a resolution system of 

the kind the administration has proposed would be financed. Funds from some 

source are always required if a financial institution is either resolved or rescued. 

The resolution of banks is paid for by a fund created from the premiums that banks 

pay for deposit insurance; only depositors are protected, and then only up to 

$250,000. Unless the idea is to create an industry—supported fund of some kind for 

liquidations or bailouts, the administration’s proposal will require the availability 

of taxpayer funds for winding up or bailing out firms considered to be systemically 

important. If the funding source is intended to be the financial industry itself, it 

would have to entail a very large levy on the industry. The funds used to bail out 

90 

AIG alone are four times the size of the FDIC fund for banks and S&Ls when that 

fund was at its highest point—about $52 billion in early 2007. If the financial industry were to be taxed in some way to create such a fund, it would put all of these 

firms—including the largest—at a competitive disadvantage vis-a-vis foreign competitors and would, of course, substantially raise consumer prices and interest rates 

for financial services. 

The 24 percent loss rate that the FDIC has suffered on failed banks during the 

past year should provide some idea of what it will cost the taxpayers to wind up 

or (more likely) bail out failed or failing financial institutions that the regulators 

flag as systemically important. The taxpayers would have to be called upon for 

most, if not all, of the funds necessary for this purpose. So, while it might be attractive to imagine the FDIC will resolve financial institutions of all kinds more effectively than the way it resolves failed or failing banks, a government-run resolution 

system opens the door for the use of taxpayer funds to unnecessary bailouts of companies that would not cause systemic breakdowns if they were actually allowed to 

fail. 

Sometimes it is argued that bank holding companies (BHCs) must be made subject to the same resolution system as the banks themselves, but there is no apparent reason why this should be true. The whole theory of separating banks and BHCs 

is to be sure that BHCs could fail without implicating or damaging the bank, and 

this has happened frequently. If a holding company of any kind fails, its subsidiaries can remain healthy, just as the subsidiaries of a holding company can go into 

bankruptcy without the parent becoming insolvent. If a holding company with many 

subsidiaries regulated by different regulators should go into bankruptcy, there is no 

apparent reason why the subsidiaries cannot be sold off if they are healthy and 

functioning, just as Lehman’s broker-dealer and other subsidiaries were promptly 

sold off after Lehman declared bankruptcy. If there is some conflict between regulators, these—like conflicts between creditors—would be resolved by the bankruptcy 

court. 

Moreover, if the creditors, regulators, and stakeholders of a company believe that 

it is still a viable entity, Chapter 11 of the Bankruptcy Code provides that the enterprise can continue functioning as a ‘‘debtor in possession’’ and come out of the proceeding as a slimmed-down and healthy business. Several airlines that are functioning today went through this process, and—ironically—some form of prepackaged 

bankruptcy that will relieve the auto companies of their burdensome obligations is 

one of the options the administration is considering for that industry. (Why bankruptcy is considered workable for the auto companies but not financial companies 

is something of a mystery.) In other words, even if it were likely to be effective and 

efficient—which is doubtful—a special resolution procedure for financial firms is unlikely to achieve more than the bankruptcy laws now permit. 

In addition to increasing the likelihood that systemically important firms will be 

bailed out by the government, the resolution plan offered by the administration will 

also raise doubts about priorities among lenders, counterparties, shareholders, and 

other stakeholders when a financial firm is resolved or rescued under the government’s control. In bankruptcy, the various classes of creditors decide, under the supervision of a court, how to divide the remaining resources of the bankrupt firm, 

and whether the firm’s business and management are sufficiently strong to return 

it to health. In an FDIC resolution, insured depositors have a preference over other 

creditors, but it is not clear who would get bailed out and who would take losses 

under the administration’s plan. One of the dangers is that politically favored 

groups will be given preferences, depending on which party is in power at the time 

a systemically important firm is bailed out. 

Perhaps even more important, the FDIC’s loss rate even under PCA demonstrates 

that the closing down of losing operations is slow and inefficient when managed by 

the government. Under the bankruptcy laws, the creditors have strong incentives 

to close a failing company and stop its losses from growing. As the FDIC experience 

show, government agencies have a tendency to forbear, allowing time for the losses 

in a failing firm to grow even greater. 

Given that bailouts are going to be much more likely than liquidations, especially 

for systemically important firms, a special government resolution or rescue process 

will also undermine market discipline and promote more risk-taking in the financial 

sector. In bailouts, the creditors will be saved in order to prevent a purported systemic breakdown, reducing the risks that creditors believe they will be taking in 

lending to systemically important firms. Over time, the process of saving some firms 

from failure will weaken all firms in the financial sector. Weak managements and 

bad business models should be allowed to fail. That makes room for better managements and better business models to grow. Introducing a formal rescue mechanism 

will only end up preserving bad managements and bad business models that should 

91 

1 Robert E. Litan is Vice President, Research and Policy, The Kauffman Foundation and Senior Fellow, Economic Studies and Global Economy Programs, The Brookings Institution. This 

testimony draws on several of the authors’ recent essays on the financial crisis on the Brookings 

website, www.brookings.edu, the work of Douglas Elliott of Brookings and the papers of the 

Squam Lake Working Group on Financial Regulation http://squamlakeworkinggroup.org/. 2See the papers by Doug Elliott on the Brookings website. 

3 If it is any consolation, between 72 and 80 percent of Federal income taxes are paid by the 

top 10 percent of taxpayers. Average working families will not be paying much for the bailout. 

have been allowed to disappear while stunting or preventing the growth of their better-managed rivals. Finally, as academic work has shown again and again, regulation suppresses innovation and competition and adds to consumer costs. 

Accordingly, there is no need to establish a special government system for resolving nonbank financial institutions, just as there is no need to do so for large operating companies like GM. If such a system were to be created for financial institutions other than banks—for which a special system is necessary—the unintended 

consequences and adverse results for the economy and the financial system would 

far outweigh any benefits. 

PREPARED STATEMENT OF MARTIN NEIL BAILY 

SENIOR FELLOW, ECONOMIC STUDIES PROGRAM, THE BROOKINGS INSTITUTION, 

AND FORMER CHAIRMAN OF THE COUNCIL OF ECONOMIC ADVISERS

UNDER PRESIDENT CLINTON, AND ROBERT E. LITAN 1

MAY 6, 2009 

Thank you Mr. Chairman and members of the Committee for asking us to discuss 

with you the appropriate policy response to what has come to be widely known as 

the ‘‘too big to fail’’ (TBTF) problem. We will first outline some threshold thoughts 

on this question and then answer the questions that you posed in requesting this 

testimony. 

The Key Points 

Too Big to Fail and the Current Financial Crisis 

• The U.S. economy has been in free fall. Hopefully the pace of decline is now 

easing, but the transition to sustained growth will not be possible without a restoration of the financial sector to health. 

• The largest U.S. financial institutions hold most of the financial assets and liabilities of the sector as a whole and, despite encouraging signs, many of them 

remain very fragile. 

• Many banks in the UK, Ireland, Switzerland, Austria, Germany, Spain and 

Greece are troubled and there is no European counterpart to the U.S. Treasury 

to stand behind them. The global financial sector is in a very precarious state. 

• In this situation policymakers must deal with ‘‘too big to fail’’ institutions because we cannot afford to see the disorderly failure of another major financial 

institution, which would exacerbate systemic risk and threaten economic recovery. 

• The stress tests are being completed and some banks will be told to raise or 

take additional capital. There is a lot more to be done after this, however, as 

large volumes of troubled or toxic assets remain on the books and more such 

assets are being created as the recession continues. 

• It is possible that one or two of the very large banks will become irretrievably 

insolvent and must be taken over by the authorities and, if so, they will have 

to deal with that problem even though the cost to taxpayers will be high. But 

pre-emptive nationalization of the large banks is a terrible idea on policy 

grounds and is clouded by thicket of legal problems.2

• Getting the U.S. financial sector up and running again is essential, but will be 

very expensive and is deeply unpopular. If Americans want a growing economy 

next year with an improving labor market, Congress will have to bite the bullet 

and provide more Treasury TARP funds, maybe on a large scale. The costs to 

taxpayers and the country will be lower than nationalizing the banks. 

• Congress recently removed from the President’s budget the funds to expand the 

TARP, a move that can only deepen the recession and delay the recovery.3

92 

4 However it is important that international negotiation be used to keep a level playing field 

globally. 5http://squamlakeworkinggroup.org/. 

6See ‘‘The Origins of the Financial Crisis’’ and ‘‘Fixing Finance’’ available on the Brookings 

website. 

Too Big to Fail: Answering the Four Key Questions (Plus One More) 

• Should regulation prevent financial institutions from becoming ‘‘too big to fail’’? 

We need very large financial institutions given the scale of the global capital 

markets and, of necessity, some of these may be ‘‘too big to fail’’ (TBTF) because 

of systemic risks. For U.S. institutions to operate in global capital markets, they 

will need to be large. Congress should not punish or prevent organic growth 

that may result in an institution having TBTF status. 

• At the same time, however, TBTF institutions can be regulated in a way that 

at least partially offsets the risks they pose to the rest of the financial system 

by virtue of their potential TBTF status. Capital standards for large banks 

should be raised progressively as they increase in size, for example. In addition, 

financial regulators should have the ability to prevent a financial merger on the 

grounds that it would unduly increase systemic risk (this judgment would be 

separate from the traditional competition analysis that is conducted by the Department of Justice’s Antitrust Division). 

• Should Existing Institutions be Broken Up? Organic growth should not be discouraged since it is a vital part of improving efficiency. If, however, the FDIC 

(or another resolution authority) assumes control of a weakened TBTF financial 

institution and later returns it to the private sector, the agency should operate 

under a presumption that it break the institution into pieces that are not considered TBTF. And it should also avoid selling any one of the pieces to an 

acquirer that will create a new TBTF institution. The presumption could be 

overcome, however, if the agency determines that the costs of breakup would 

be large or the immediate need to avoid systemic consequences requires an immediate sale to another large institution. 

• What Requirements Should be Imposed on Too Big to Fail Institutions? TBTF 

or systemically important financial institutions (SIFIs) can and should be specially regulated, ideally by a single systemic risk regulator. This is a challenging task, as we discuss further below, but we believe it is both one that can 

be met and is clearly necessary in light of recent events. 

• Too big to fail institutions have an advantage in that their cost of capital is 

lower than that of small institutions. At a recent Brookings meeting, Alan 

Greenspan estimated informally that TBTF banks can borrow at lower cost 

than other banks, a cost advantage of 50 basis points. This means that some 

degree of additional regulatory costs (in the form of higher capital requirements, 

for example) can be imposed on large financial institutions without rendering 

them uncompetitive.4

• Improved Resolution Procedures for Systemically Important Banks. This is an 

important issue that should be addressed soon. When large financial firms become distressed, it is difficult to restructure them as ongoing institutions and 

governments end up spending large amounts to support the financial sector, 

just as is happening now. The Squam Lake Working group has proposed one 

solution to this problem: that systemically important banks (and other financial 

institutions) be required to issue a long-term debt instrument that converts to 

equity under specific conditions. Institutions would issue these bonds before a 

crisis and, if triggered, the automatic conversion of debt into equity would 

transform an undercapitalized or insolvent institution, at least in principle, into 

a well capitalized one at no cost to taxpayers.5

• Where the losses are so severe that they deplete even the newly converted capital, there should be a bank-like process for orderly resolving the institution by 

placing it in receivership. Treasury Secretary Geithner has outlined a process 

for doing this, which we generally support. There are other important resolution-related issues that must be addressed and we discuss them below. 

• The Origin of the Crisis and the Structure of the Solution. The financial crisis 

was the result of market failure and regulatory failure. Market failure occurred 

because wealth-holders in many cases failed to take the most rudimentary precautions to protect their own interests. Compensation structures were established in companies that rewarded excessive risk taking. Banks bought mortgages knowing that lending standards had become lax.6

93 

• At the same time, there were thousands of regulators who were supposed to be 

watching the store, literally rooms full of regulators policing the large institutions. Warnings were given to regulators of impending crisis but they chose to 

ignore them, believing instead that the market could regulate itself. 

• In the future we must seek a system that takes advantage of market incentives 

and makes use of well-paid highly qualified regulators. Creating such a system 

will take time and commitment, but it is clearly necessary. 

Expanding on the Issues 

As the Committee is well aware, TBTF actually is somewhat of a misnomer, since 

no company is actually ‘‘too big to fail.’’ More accurately, as we have seen in the 

various bailouts during this crisis, even when the government comes to the rescue, 

it does not prevent shareholders from being wiped out or having the value of their 

shares significantly diminished. The beneficiaries of the rescues instead are typically short-term creditors, and in some cases, longer term creditors. The rescues are 

mounted to prevent systemic risk, which can arise in two ways: if creditors at one 

institution suffer loss or have to wait for their money, their losses will cascade 

throughout the financial system and threaten the failure of other firms and/or creditors in similar institutions will ‘‘run’’ and thereby trigger a wider crisis. 

In what follows we refer to financial institutions whose failure poses systemic risk 

as ‘‘systemically important financial institutions’’ or ‘‘SIFIs’’ for short. Clearly, large 

banks can be SIFIs because they are funded largely by deposits that can be withdrawn on demand. But, as has been painfully learned during this crisis, policymakers have feared that certain non-banks—the formerly independent investment 

banks and AIG—can be SIFIs because they, too, are or were funded largely by 

short-term creditors. 

By similar reasoning, other financial institutions—if sufficiently large, leveraged, 

or interconnected with the rest of the financial system—also can be systemically important, especially during a time of general economic stress: 

—Our entire financial system, for example, depends on the ability of the major 

stock and futures exchanges to price financial instruments, and on the major financial clearinghouses to pay those who are owed funds at the end of each day. 

—The harrowing experience with the near failure of LTCM in 1998 demonstrates 

that large, leveraged hedge funds can expose the financial system to real dangers 

if counter-parties are not paid on a timely basis. 

—Large troubled life insurers can also generate systemic risks if policyholders run 

to cash out their life insurance policies, or if the millions of retirees who rely on 

annuities suddenly learn that their contracts may not be honored sharply curtail 

their spending as a result. 

—It is an open question whether the large monoline bond insurers, which have 

been hit hard by losses on subprime securities they have guaranteed, are systemically important. On the one hand, these losses for a time appeared to threaten the 

ability of these insurers to continue underwriting municipal bond issues (their core 

business), which could have had major negative ripple effects throughout the economy. On the other hand, as the recent entry of Berkshire Hathaway into this business has demonstrated, other entrants eventually can take up the slack in the market if one or more of the existing bond insurers were to fail. Nonetheless, because 

the entry process takes time, it is possible that one or more of the existing bond 

insurers could be deemed too big (or important) to fail in a time of broad economic 

distress, such as the present time. 

—One or more large property-casualty insurers could be deemed to be systemically important if they each were hit suddenly by a massive volume of claims—for 

example, following one or a series of catastrophic hurricanes—which, among other 

things, could trigger a large amount of securities sales in a short period of time. 

A large volume of CAT claims could also imperil the solvency of one or more large 

insurers (and/or possibly state backup insurance pools, like the one in Florida) and 

leave millions of policy holders without coverage, an outcome that Federal policymakers may deem unacceptable. 

One question we are certain you have been asked by your constituents and the 

media is why the auto companies have been treated differently, at least so far, from 

large financial firms. To be sure, in each case, it now appears that the Federal Government will end up owning some or, in the case of GM, most of the equity. But 

the creditors of the auto companies are not being protected, unlike those of the large 

financial firms that have been labeled ‘‘too big to fail.’’ Why the difference? 

There is an economic answer to this question which admittedly may be politically 

less than persuasive to some. Essentially by definition, systemically important fiVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00097 Fmt 6633 Sfmt 6621 S:\DOCS\53822.TXT SHERYL
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nancial institutions are funded largely if not primarily by short-term borrowings— 

deposits, repurchase agreements, commercial paper—which if not fully repaid when 

due or ‘‘rolled over’’ will cause not only the firm to fail, but threaten the failure of 

many other firms throughout the economy in one or both of the ways we have already described. In contrast, non-financial firms are typically not funded primarily 

by short-term borrowing, but instead by a combination of longer-term debt and equity. To be sure, their failure can lead to the failure of other firms, such as suppliers, and also trigger a wider loss of confidence among consumers, but most economists believe the damage to the entire economy is not likely to be as substantial 

as it would be if depositors at one or more of the largest banks or the short-term 

counter-parties of a large hedge fund or insurance company are not paid on time. 

We are nonetheless confident that the various financial firm bailouts do not 

please you or your constituents, which presumably is why you’ve convened this 

hearing. We are all highly uncomfortable with having the government bail out some 

or all possibly all of the creditors of large systemically important financial institutions. In particular, there are three reasons for this discomfort. 

First, if creditors of some institutions know that they will be fully protected regardless of how the managers of those firms act, the creditors will have no incentive 

to monitor the firms’ risks and to discourage the taking of excessive risk. Economists call this the ‘‘moral hazard’’ effect, and over time, if left unchecked it will lead 

to too much risk-taking by too many institutions, putting the economy at risk of future bubbles and the potentially huge costs when they pop. 

Second, bailouts of creditors of failed firms are fundamentally inconsistent with 

capitalism, which rewards and thus provides incentives for success, but punishes 

failure. Socializing the risks of failure is not how the game is played, and not only 

introduces too much risk-taking into the economy, but is also rightfully perceived 

as unfair by those firms whose creditors who are not given this protection. 

Third, we are learning that bailouts undermine the public’s trust in government, 

which can make it harder for elected officials to do the public’s business. Thus, for 

example, the unpopularity of the bailouts thus far may slow down the much needed 

cleanup of the financial system, which will slow the recovery. Likewise, if the public 

gets the impression that much of what Washington does is bail out mistakes, voters 

may be much more reluctant to support and fund worthy, cost-effective endeavors 

by government to ensure more universal health care, fix education, and address climate change, among other important objectives. 

For all these reasons, policymakers must take reasonable steps now to prevent 

institutions from becoming TBTF, or if that is the outcome of market forces, then 

to prevent these institutions from taking excessive risks that expose taxpayers to 

paying for their mistakes. These are essentially the options on which you have requested comment, and to which we now turn. 

Desirability and Feasibility of Preventing Institutions from Becoming TBTF 

Clearly, we all want a financial and economic system in which those who take 

risks—whether they are large or small—to bear the full consequences of their actions if they are wrong, just as they are entitled to all of the rewards if they are 

successful. The policy challenge is how best to ensure this result. 

One way to prevent non-banking financial institutions from becoming TBTF is to 

impose limits on their size, measured by assets, indebtedness, counter-party risk exposures, or some combination of these factors. While, as we discuss further below, 

these measures are useful for establishing whether an institution should be presumptively treated as systemically important and thus subject to heightened regulatory scrutiny, it would be quite extraordinary and unprecedented to actually prevent such institutions from growing above a certain size limit. Putting aside the arbitrary nature of any limit, imposing one would establish perverse, and we believe, 

undesirable incentives that would undermine economy-wide growth. 

For one thing, any size limit would punish success, and thus discourage innovation. There are well-managed large financial institutions, such as JP Morgan, TIAACREF, Vanguard and Fidelity, to name a few. If the managers and shareholders of 

each of the institutions had been told in advance that beyond some limit the company could not grow, each of them would have stopped innovating and serving customers’ needs well before reaching the limit. Employee morale also clearly would 

suffer, especially for those employees paid in stock or options, whose value would 

quite growing and indeed fall as companies reached their limit. These outcomes not 

only would ill serve consumers, but would discourage future entrepreneurs from 

reaching for the heights. 

Second, even though this crisis has demonstrated that the failure of large financial institutions can impose substantial costs on the rest of the financial system 

economists do not know with any degree of precision at what size these externalities 

95 

7 Elliot’s discussions of the difficulties of even temporary nationalizations also appear on the 

Brookings website. 

outweigh the benefits of diversification and economies of scale that large institutions 

may achieve (and further, how these size levels likely vary by activity or industry). 

Accordingly, by essentially requiring large, growing companies to split themselves 

up beyond some point, policymakers would be arbitrarily sacrificing these economies. 

Nonetheless, there are steps short of an absolute size limitation that policymakers 

should consider to contain future TBTF problems. 

First, Congress could require regulators to establish a rebuttable presumption 

against financial institution mergers that result in a new institution above a certain 

size. Such a standard would provide stronger incentives, if not a requirement, that 

companies earn their growth organically. For reasons just indicated, we are not certain that economists yet have sufficient evidence to know with any precision at what 

size level such a presumption should be set, but the harms from limiting mergers 

beyond a size threshold would be less than imposing an absolute limit on internal 

growth. 

If Congress takes this approach, we recommend that it continue to require dual 

approval for mergers by both the antitrust authorities and the appropriate financial 

regulator (either the relevant supervisor for the firm, or a new systemic risk regulator, our preference). The reason for this is that while the antitrust enforcement 

agencies (the Department of Justice and the Federal Trade Commission) have welldefined and supportable numerical standards for assessing whether a merger in any 

industry poses an unacceptable risk of harming competition, they have no special 

expertise in making the financial decision with respect to the size at which an institution poses an undue systemic financial risk. This latter decision is more appropriate for the relevant financial regulator to make. 

A second suggestion about which we have even greater confidence is for Congress 

to require the appropriate financial regulator(s) to subject systemically important financial institutions to progressively tougher regulatory standards and scrutiny than 

their smaller counterparts. We provide greater detail below on how this might be 

done. The basic rationale for this is quite straightforward. Larger financial institutions, if they fail or encounter financial trouble, imperil the entire financial system. 

This externality must be offset somehow, and a different regulatory regime—one 

that entails progressively tougher capital and liquidity standards in particular—is 

the best way we know how to accomplish this. 

Third, even for large systemically important financial institutions, it is possible 

to retain at least some market discipline and thus to limit the need for Federal authorities to protect at least some creditors, which is what makes a large and/or highly interconnected financial firm ‘‘too big to fail.’’ The way to do this is to require 

as many SIFIs as possible (large hedge funds may be excepted because their limited 

partnership interests and/or debt are not publicly traded) to fund a certain minimum percentage of their assets by convertible unsecured long-term debt. Because 

the debt would be long-term it would not be susceptible to runs (as is true of shortterm debt, which in a crisis may not be rolled over). Furthermore, if the debt must 

be converted to equity upon some pre-defined event—such as a government takeover 

of the institution (discussed below) or if the capital-to-asset ratio falls below some 

required minimum level—this would automatically provide an additional cushion of 

equity when it is most needed, while effectively requiring the debt holders to take 

a loss, which is essential for market discipline. The details of this arrangement 

should be left to the appropriate regulators (or the systemic risk regulator), but the 

development of the concept should be mandated by the Congress. 

Should SIFIs Be Broken Up? 

Even if financial institutions are not subjected to a size limit, a number of experts 

have urged that regulators begin seizing weak banks (and perhaps weak non-bank 

SIFIs), cleaning them up (by separating them into ‘‘good’’ and ‘‘bad’’ institutions), 

and then breaking up the pieces when returning them to private hands (through 

sale to a single acquirer or public offering). 

We address below the merits of adopting a bank-like resolution process for nonbank SIFIs. For the numerous practical reasons outlined by our Brookings colleague 

Doug Elliott, we also urge caution in having regulators seize full control of financial 

institutions unless it is clear that their capital shortfalls are significant and cannot 

be remedied through privately raised funds.7

However, where regulators lawfully assume control of a troubled important financial institution (bank or non-bank), we are sympathetic with having the FDIC (or 

any other agency charged with resolution) required to make reasonable efforts to 

96 

break up the institution when returning it to private hands (through sale or public 

offering) if it is already deemed to be systemically important or to avoid selling it 

to another institution when the result will be to create a new systemically important 

financial institution, provided the resolution authority also has an ‘‘out’’ if there is 

no other reasonable alternative. 

The rationale for the proposed presumption should be clear: given the costs that 

taxpayers are already bearing for the failure of certain systemically important institutions in this crisis, why, if it is not necessary, allow more TBTF problems to be 

created or aggravated by future financial mergers? Congress should recognize, however, that in limiting the sale of troubled financial institutions, it may make some 

resolutions more expensive than they otherwise be, at least in the short run. Subject 

to the qualification we next set out, this is an acceptable outcome, in our view, since 

measures that avoid making the TBTF problem worse have long-run benefits to taxpayers and to society. 

There must be escape clause, however. The Treasury, the Federal Reserve Board 

and the appropriate regulator may believe that the functions of the failing (or failed) 

institution are so intertwined or inseparable, and/or that its purchase by a single 

entity in a very short period of time—as in the case of Bank of America’s acquisition 

of Merrill Lynch or JP Morgan’s purchase of Bear Stearns—is so essential to the 

health of the overall financial system that disposition of the institution in pieces is 

impractical or substantially more costly (as measured by the amount of government 

financing required) than other alternatives. Such a ‘‘systemic risk exception’’ should 

be very narrowly drawn, and conceivably require the approval of all of the regulatory entities just mentioned. 

We should note, however, that if Congress also creates a bank-like resolution 

process for non-bank SIFIs, the systemic risk situation we describe truly should be 

exceedingly rare. Once regulators have the authority to put a non-bank SIFI into 

receivership and to guarantee against loss such creditors as are necessary to preserve overall financial stability, then regulators should not be forced by the pressure 

of time to sell the entity in one piece. Of course, it still may be the case that the 

activities of the institution are sufficiently inseparable that it would be impractical 

or highly costly for the resolving authority to break up the firm in the disposition 

process. If that is the case, then the regulators should have the ability to sell off 

the institution in one piece. 

One other practical issue must also be addressed. There must be some way for 

the resolving authority to identify the circumstances under which the resolution of 

a troubled institution would create or aggravate the TBTF problem. One way to do 

this is to require an appropriate regulator (a topic we discuss shortly) to designate 

in advance certain financial institutions as being systemically important (and thus 

subject to a tougher regulatory scrutiny). Alternatively, the resolution authority 

could make this determination at the time, in consultation with the Federal Reserve 

and/or the Treasury, or with the designated systemic risk regulator. In either case, 

the resolution authority must still be able to determine if a particular sale might 

create a new systemically important institution. 

Regulating SIFIs 

If SIFIs are not to be broken up (outside of temporary government takeover) or 

subjected to an absolute size constraint, then it is clear that they must be subject 

to more exacting regulatory scrutiny than other institutions. Otherwise, smaller financial institutions will be disadvantaged and the entire financial system and economy will be put at undue risk. That is perhaps one of the clearest lessons from this 

current crisis. 

We recognize, however, that establishing an appropriate regulatory regime for 

SIFIs is a very challenging assignment, and entails many difficult decisions. We review some of them now. Our overall advice is that because of the complexity of the 

task, as well as the constantly changing financial environment in which these institutions compete, that Congress avoid writing the details of the new regime into law. 

Instead, it would be far better, in our view, for Congress to establish the broad outlines of the new system, and then delegate the details to the appropriate regulator(s). 

First, the regulatory objective must be clear: We suggest that the primary 

purpose of any new regulatory regime for systemically important financial institutions should be to significantly reduce the sources of systemic risk or to minimize 

such risk to acceptable levels. The goal should not be to eliminate all systemic risk, 

since it is unrealistic to expect that result, and an effort to do so could severely 

dampen constructive innovation and socially useful activity. 

Second, if SIFIs are to be specially regulated, there must be criteria for 

identifying them. The Group of Thirty has suggested that the size, leverage and 

97 

8Group of Thirty. ‘‘Financial Reform: A Framework for Financial Stability’’ (Washington D.C., 

Jan 2009) . 

degree of interconnection with the rest of the financial system should be the deciding factors, and we agree.8 We also believe that whether an institution is deemed 

systemically important may depend on both general economic circumstances, as well 

as the conditions in a specific sector at the time. Some large institutions may not 

pose systemic risks if they fail if the economy is generally healthy or is experiencing 

only a modest downturn; but the same institution, threatened with failure, could be 

deemed systemically important under a different set of general economic or industry-specific conditions. This is just one reason why we counsel against the use of 

hard and fast numerical standards to determine whether an institution is systemically important. Another reason is that the use of numerical criteria alone could 

be easily gamed (institutions would do their best either to stay just under or over 

any threshold, whichever outcome it believes to be to its advantage). Accordingly, 

the regulator(s) should have some discretion in using these numerical standards, 

taking into account the general condition of the economy and/or the specific sector 

in which the institution competes. The ultimate test should be whether the combination of these factors signifies that the failure of the institution poses a significant 

risk to the stability of the financial system. 

As we discussed at the outset of our testimony, application of this test should result in some banks, insurers, clearinghouses and/or exchanges, and hedge funds as 

being systemically important (certain formerly independent investment banks that 

have since converted to bank holding companies or that are no longer operating as 

independent institutions also would have qualified, and conceivably could do so 

again). We doubt whether venture capital firms would qualify. 

Clearly, to the extent possible, the list of SIFIs should be compiled in advance, 

since otherwise there would no method of specially regulating them (some institutions that may be deemed systemically important only in the context of particular 

economy-wide or sector-specific conditions cannot be identified in advance, or may 

be so identified only when such conditions are present). A natural question then 

arises: should this list be made public? As a practical matter, we do not think one 

could avoid making it public. At a minimum, it would be apparent from the capital 

and liquidity positions reported in the firms’ financial statements that the relevant 

institutions had been deemed by regulators to be systemically important. Meanwhile, the presence of more intensive regulatory oversight, coupled with a mandatory long-term debt requirement, both not applicable to smaller institutions, would 

counter the concern that public announcement of the firms on the list would somehow weaken market discipline or give the institutions access to lower cost funds 

than they might otherwise have. 

Institutions designated as systemically important should have some right to challenge, as well as the right to petition for removal of that status, if the situation warrants. For example, a hedge fund initially highly leveraged should be able to have 

its SIFI designation removed if the fund substantially reduces its size, leverage and 

counter-party risk. 

As this discussion implies, the process of designating or identifying institutions 

as systemically important must be a dynamic one, and will depend on the evolution 

of the financial service industry, the firms within in, and the future course of the 

economy. It is to be expected that some firms will be added to the list, while others 

are dropped, over time. In particular, regulators must be vigilant to include new 

variations of the ostensibly off-balance sheet structured investment vehicles (SIVs), 

which technically may have complied with existing accounting rules regarding consolidation, but which functionally always were the creations and obligations of their 

bank sponsors. Regulators should take a functional approach toward such entities 

in the future for purposes of determining whether an institution is systemically important. If the firm’s affiliates or partners in any way could require rescue by other 

institutions, then that prospect should be considered when assessing the size, leverage, and financial interconnection of the firm. 

Third, the nature of regulation should depend on the activity of the institutions. For financial intermediaries, such as banks and insurance companies, and 

clearinghouses or exchanges, which are considered to be systemically important, the 

main regulatory tools should be higher capital, liquidity and risk management 

standards than those that apply to smaller institutions. It is to be expected that 

these standards will differ by type of institution. Furthermore, the appropriate regulator(s) should consider making these standards progressively higher as the size of 

the SIFI increases, to reflect the likely increasing bailout risk that SIFIs pose to 

the rest of the financial system as they grow. 

98 

9We are aware that the Committee has not asked for views about which regulator should 

have this authority, but if asked, we would suggest either a single new Federal financial solvency regulator, or the Federal Reserve. For further details, see Testimony of Robert E. Litan 

before the Senate Committee on Homeland Security, March 4, 2009. 

Several more details about these standards also deserve mention. Capital standards, for SIFIs and other financial institutions, should be made less pro-cyclical, or 

even counter-cyclical. Another lesson from this crisis is that financial regulation 

should not unduly constrain lending in bad times and fail to curb it in booms. The 

way to learn this lesson, however, is not to leave too much discretion to regulators 

in raising or lowering capital (and possibly liquidity) standards in response to 

changes in economic conditions. If regulators have too much discretion about when 

to adjust capital standards, they may succumb to heavy pressures to relax them in 

bad times, and not to raise them when times are good. To avoid this problem, Congress should require the regulators to set in advance a clear set of standards for 

good times and bad (or, at a minimum, to specify a range for those standards, as 

the Group of Thirty has suggested). 

With respect to their oversight of an institution’s risk management procedures, 

regulators must be more aggressive in the future in testing the reasonableness of 

the assumptions that are built into the risk models used by complex financial institutions. In addition, regulators should consider the structure of the executive compensation systems of SIFIs under their watch, paying particular attention to the degree to which compensation is tied to long-run, rather than short-run, performance 

of the institution. In the normal course of their supervisory activities, regulators 

should use their powers of persuasion, but should also have a ‘‘club in the closet’’— 

the authority to issue cease and desist orders—if necessary. 

For private investment vehicles, primarily or possibly only hedge funds, the appropriate regulatory regime is likely to differ from publicly traded financial intermediaries. Here, we would expect that the appropriate regulator, at a minimum, 

would have the authority to collect on a regular basis information about the size 

of the fund, its leverage, its exposure to specific counter-parties, and its trading 

strategies so that the supervisor can at least be alert to potential systemic risks 

from the simultaneous actions of many funds. We would expect that most of this 

information, with the exception of fund size and perhaps its leverage, would be confidential, to preserve the trade secrets of the funds. We would not expect the regulator to have authority to dictate counter-party exposures or trading strategies. 

However, where the authorities see that particular funds are excessively leveraged, 

or when considered in the aggregate their trading strategies may create excessive 

risks, the appropriate regulator should have the obligation to transmit that information to the banking regulators or the systemic risk regulator, which in turn should 

have the ability to constrain lending to particular funds or a set of funds. 

Fourth, ideally a single regulator should oversee and actively supervise 

all systemically important financial institutions (bank and non-bank). Splitting up this authority among the various functional regulators—such as the three 

bank regulators, the SEC (for securities firms), the CFTC, a merged SEC/CFTC or 

another relevant body (for derivatives clearinghouses), and a new Federal insurance 

regulator—runs a significant risk of regulatory duplication of effort, inconsistent 

rules, and possibly after-the-fact finger-pointing in the event of a future financial 

crisis. Likewise, vesting authority for systemic risk oversight in a committee of regulators—for example, the President’s Working Group on Financial Markets—risks indecision and delay. The various functional regulators should be consulted by the systemic risk regulator. In addition, the systemic risk regulator should have automatic 

and regular access to information collected by the functional regulators. But, in our 

view, systemic risks are best overseen by a single agency.9

If a single systemic risk regulator is designated, a question that must be considered is whether it, or the appropriate functional regulator, should actively supervise 

systemically important institutions. There are merits to either approach. However, 

on balance, we believe that the systemic risk regulator should have primary supervisory authority over SIFIs. There is much day-to-day learning that can come from 

regular supervision that could be useful to the systemic risk regulator in a crisis, 

when there is no room for delay or error. 

In addition to overseeing or at least setting supervisory standards for SIFIs, the 

systemic risk regulator should be required to issue regular (annual or perhaps more 

frequent, or as the occasion arises) reports outlining the nature and severity of any 

systemic risks in the financial system. Such reports would put a spotlight on, among 

other things, rapidly growing areas of finance, since rapid growth in particular asset 

classes tends to be associated (but not always) with future problems. These reports 

99 

10For a guide to how the Canadians have done it, see Pietro Nivola, ‘‘Know Thy Neighbor: 

What Canada Can Tell Us About Financial Regulation,’’ March 2009, at www.brookings.edu. 

should be of use to both other regulators and the Congress in heading off potential 

future problems. 

A legitimate objection to early warnings is that policymakers will ignore them. In 

particular, the case can be made that had warnings about the housing market overheating been issued by the Fed and/or other financial regulators during the past 

decade, few would have paid attention. Moreover, the political forces behind the 

growth of subprime mortgages—the banks, the once independent investment banks, 

mortgage brokers, and everyone else who was making money off subprime originations and securitizations—could well have stopped any counter-measures dead in 

their tracks. 

This recounting of history might or might not be right. But the answer should not 

matter. The world has changed with this crisis. For the foreseeable future, perhaps 

for several decades or as long as those who have lived and suffered through recent 

events are still alive and have an important voice in policymaking, the vivid memories of these events and their consequences will give a future systemic risk regulator 

(and all other regulators) much more authority when warning the Congress and the 

public of future asset bubbles or sources of undue systemic risk. 

Fifth, Congress should assign regulatory responsibilities for overseeing 

derivatives that are currently traded ‘‘over-the-counter’’ rather than on exchanges. As has been much discussed, regulators already are moving to authorize 

the creation of clearinghouses for credit default swaps, which should reduce the systemic risks associated with standardized CDS. But these clearinghouses must still 

be regulated for capital adequacy and liquidity, either by specific functional regulators or by the systemic risk regulator. 

Yet even well-capitalized and supervised central clearinghouses for CDS and possibly other derivatives will not reduce systemic risks posed by customized derivatives whose trades are not easily cleared by a central party (which cannot efficiently 

gather and process as much information about the risks of non-payment as the parties themselves). Congress should enable an appropriate regulator to set minimum 

capital and/or collateral rules for sellers of these contracts. At a minimum, more detailed reporting to the regulator by the participants in these customized markets 

should be required. 

Finally, while there are legitimate concerns about the efficacy of financial regulation, we believe that these should not deter policymakers from 

implementing and then overseeing a special regulatory system for systemically important financial institutions. We recognize, of course, that financial 

regulators did not adequately control the risks that led to the current crisis. But 

that does not mean that we should simply give up on doing something about the 

TBTF problem. 

We should remember that U.S. bank regulators in fact were able to contain risk 

taking for roughly the 15 year period following the last banking crisis of the late 

1980s and early 1990s, and financial regulators are already learning from their mistakes this time around. Furthermore, we take some comfort from the fact that Canadian bank regulators have prevented that country’s banks from running into the 

trouble that our banks have experienced, by applying sensible underwriting and 

capital standards. So, regulation, when properly practiced, can prevent undue risktaking.10

Further, under the regulatory system we recommend, regulators would not be the 

only source of discipline against excessive risk-taking by SIFIs. They would be assisted by holders of long-term uninsured, convertible debt, who would have their 

money at risk and thus incentives to monitor and control risk-taking by the institutions. 

In short, regulators, working hand in hand with market participants under the 

right set of rules, can do better than simply waiting for the next disasters to occur 

and cleaning up after them. The costs of cleaning up after this crisis—which eventually could run into the trillions of dollars—as well as the damage caused by the crisis itself should be stark reminders that we can and must do better to prevent future crises or at least contain their costs if they occur. 

Improving Resolution of Non-Bank SIFIs 

The Committee is surely aware of the many calls for extending the failure resolution procedure for banks to non-banks determined to be systemically important (either before or after the fact). The basic idea, known as ‘‘prompt corrective action’’ 

or ‘‘PCA’’, is to authorize (or direct) a relevant agency (the FDIC in the case of 

banks) to assume control over a weakly capitalized institution before it is insolvent, 

100 

11Lehman was not rescued and thus all its losses have fallen on its shareholders and creditors. We won’t know for some time the full cost of JP Morgan’s rescue of Bear Stearns, which 

was aided by loans from the Federal Reserve, or certainly the much larger final cost of the Fed’s 

takeover of AIG. 

and then either to liquidate it or, after cleaning up its balance sheet (by separating 

out the bad assets), return it to private ownership (through sale to another firm or 

a public offering). Such takeovers are meant to be a last resort, only if prior regulatory restrictions and/or directives to raise private capital, have failed. Many have 

argued that had something like this system been in place for the various non-banks 

that have failed in this crisis—Bear Stearns, Lehman, and AIG—the resolutions 

would have been more orderly and achieved at less cost to taxpayers.11

We agree with this view. By definition, troubled systemically important financial 

institutions cannot be resolved in bankruptcy without threatening the stability of 

the financial system. The bankruptcy process stays payment of unsecured creditors, 

while inducing secured creditors to seize and then possibly sell their collateral. Either or both outcomes could lead to a wider panic, which is why a bank-like restructuring process—which puts the troubled bank into receivership, allowing the FDIC 

to transfer the institution’s liabilities to an acquirer or to a ‘‘bridge bank’’—is necessary for non-bank SIFIs. 

Congress must resolve a number of complex issues, however, in creating an effective resolution process for these non-bank institutions. 

First, the law should provide some procedure for identifying the systemically important institutions that are eligible for this special resolution mechanism in lieu 

of a normal bankruptcy. This can be done either by allowing the appropriate regulator (we would prefer this be a single systemic risk regulator) to designate specific 

institutions in advance as SIFIs and therefore subject to a special resolution process 

if they get into financial trouble, or on ad hoc basis, as the appropriate regulator(s) 

deem appropriate. Secretary Geithner, for example, has proposed that the Secretary 

of Treasury could make this designation, upon the positive recommendation of the 

Federal Reserve Board and the appropriate regulator, in consultation with the 

President. We favor a combination of these approaches: institutions subject to special regulation as SIFIs automatically would be covered by the special non-bank resolution process, while the Treasury Secretary under the procedure outlined by Secretary Geithner would have the ability to use the special resolution process for other 

troubled institutions deemed systemically important given unusual circumstances 

that may be present at a particular time. 

Second, there must be clear and effective criteria for placing a financially weak 

non-bank SIFIs into the special resolution process, ideally before it is insolvent. In 

principle, bank regulators have this authority under FDICIA, but in practice, regulators tend to arrive too late—after banks are well under water (one recent, notable 

example is the failure of IndyMac, which is going to cost the FDIC several billion 

dollars). 

There is really only one way to address this problem, for banks and non-bank 

SIFIs alike, and that is to raise the minimum capital-to-asset threshold that can 

trigger regulatory takeover of a weak bank or non-bank SIFI (if, by some chance, 

there is still some positive equity after an early resolution, it can and should be returned to the shareholders, as is the case for early bank resolutions, at least in principle). Since the appropriate threshold is likely to differ by type of institution, this 

reform is probably best handled by delegating the job to the appropriate regulator: 

the banking regulators for banks and Treasury and/or the FDIC for non-bank SIFIs 

(or the systemic risk regulator, if one is established). The capital-to-asset trigger 

also should be coordinated with any new counter-cyclical capital regulatory regime 

that may be established for banks and other financial institutions. In particular, 

once the new standards are phased in, they should not be so low in recessions as 

to render ineffective any capital-to-asset trigger designed to facilitate sufficiently 

early interventions by regulators to avoid or at least minimize losses to taxpayers. 

Third, the resolution mechanism must have a well-defined procedure for handling 

uninsured creditor claims. Unlike a bank that has insured liabilities, the creditors 

of a non-bank are likely to be uninsured (unless they have bought reliable credit 

default protection, or they have some limited protection through other means: 

through state guaranty funds for insurance policy holders or through SPIC for brokerage accounts). In a normal bankruptcy, creditors are paid in order of seniority 

and whether their borrowings are backed by specific collateral. Market discipline requires that creditors not be paid in full if there are insufficient corporate assets to 

repay them. However, what makes a non-bank systemically important is that the 

failure to protect at least short-term creditors can trigger creditor runs on other, 

similar institutions and/or unacceptable losses throughout the financial system. 

101 

There are several ways to handle this problem. One approach would require all 

SIFIs, bank and non-bank, to file a resolution plan with their regulator, spelling out 

the procedures for ‘‘haircutting’’ specific classes of creditors if the regulator assumes 

control of the institution. Another approach is to have the regulators spell out those 

procedures including minimum haircuts that each class of creditors would be expected to receive if the regulators assume control of the institution. A third idea is 

to address the issue on a case by case basis—for example, by dividing the institution 

into a ‘‘good’’ and ‘‘bad’’ entity, and require shareholders and creditors to bear losses 

associated with the ‘‘bad’’ one. Of course, to be truly effective in preserving market 

discipline, regulators actually must imposes losses under any of these approaches 

on unsecured creditors, which as recent events have demonstrated, can be difficult, 

if not impossible, to do. 

In particular, when overall economic conditions are dire, as they have been 

throughout the current crisis, regulators will feel much pressure to protect one or 

more classes of creditors in full, regardless of what any pre-filed or mandated resolution plan may say (or what the allocation of losses may be as a result of splitting 

the institution in two). Thus, in the banking context, FDICIA enables regulators to 

guarantee all deposits, included unsecured debt, of banks when it is deemed necessary to prevent systemic risk. This ‘‘systemic risk exception’’ to the general rule 

that only insured deposits are covered may be invoked, however, only with the concurrence of 2⁄3 of the members of the Federal Reserve Board, 2⁄3 of the members of 

the FDIC Board, and the Secretary of the Treasury, in consultation with the President. Even then, the Comptroller General must make a report after the fact assessing whether the intervention was appropriate. A similar systemic risk exception 

(with the perhaps the same or a similar approval procedure) should also be established for debt issued by troubled non-bank SIFIs (Secretary Geithner has suggested 

that government assistance be provided when approved by the Treasury and the 

FDIC, in consultation with the Federal Reserve and the appropriate regulatory authority). 

Fourth, the resolution process should be overseen by a specific agency. The Treasury has proposed that the FDIC handle this responsibility, as has the current FDIC 

Chair. Given the FDIC’s expertise with resolving bank failures, expanding its authority to cover suitable non-banks makes sense. 

Fifth, the non-bank resolution process must have a funding mechanism. This is 

relatively easy, as these things go, for banks, which are covered by an explicit deposit insurance system that is funded by all members of the banking industry. Of 

special relevance to the TBTF issue, if the Federal Government guarantees uninsured deposits and other creditors of any banks under the ‘‘systemic risk exception’’, 

all other banks must be assessed for the cost, although the FDIC can borrow from 

the Treasury to finance its initial outlays if its reserves are insufficient (under current law, the FDIC’s borrowing limit is $30 billion, but in light of the current crisis, 

the agency is requesting that this limit be raised to $500 billion). 

It is difficult to structure an assessment structure for the costs of rescuing the 

creditors of non-bank SIFIs, however. For one thing, who should pay? Just the other 

members of the industry in which the failed SIFI is active (such as other hedge 

funds or insurers, as the case may be), all non-bank SIFIs, or even all non-banks? 

Under any of these options, what would be the assessment base, and should the contribution rate differ by industry sector? And should any assessment be collected in 

advance, after the fact, or both? 

Merely asking these questions should make clear how difficult it can be to design 

an acceptable industry-based assessment system. We realize that on grounds of equity, it would be appropriate only to assess other SIFIs, assuming they are specifically identified. But this approach may not raise sufficient funds to cover the costs 

involved. We note that the costs of the AIG rescue alone, for example, are approaching $200 billion. A similar amount has been put aside for the conservatorships of 

Fannie Mae and Freddie Mac. 

Congress could broaden the assessment base to include all non-bank institutions 

(to cover the costs only of providing financial assistance to non-bank SIFIs). This 

may not appear equitable on the surface, but if the institution receiving government 

funds is truly systemically important then even smaller institutions do benefit when 

the government steps in to prevent creditor losses at a SIFI from damaging the rest 

of the financial system. 

Indeed, if an institution is truly systemic, then everyone presumably benefits from 

not having the financial system meltdown, which is why it is advisable in our view 

for Congress to give the FDIC and/or the Treasury an appropriation up to some sizable limit—say $250 billion—that could be tapped, if necessary for future non-bank 

SIFI resolutions. Congress may also want to instruct the FDIC and/or the Treasury 

to use this appropriation only as a resort, and turn to assessments on some class 

102 

1The opinions expressed in this piece are mine alone, but I have benefited immensely from 

past discussions and work with Douglas Diamond, Anil Kashyap, and Jeremy Stein, as well as 

members of the Squam Lake Group (see http://www.cfr.org/project/1404/ 

squamllakelworkinglgrouplonlfinanciallregulation.html). 

of institutions first. We have no objection to such an approach, but for reasons just 

noted, there is no perfect way to do that. In any event, as with bank resolutions 

under the systemic risk exception, the Comptroller General should be required to 

report to Congress on all non-bank resolutions, too: whether government-provided 

financial assistance was appropriate, and whether the resolution was completed at 

least cost. 

However the Congress decides these issues, it should do so promptly, without 

waiting to reach agreement on a more a comprehensive financial reform bill. The 

country clearly would be best served if a new resolution process were in place before 

another large non-banking firm approaches insolvency before this recession is over. 

Concluding Observations 

We would like to close with perhaps the obvious observation that addressing the 

TBTF problem is not simple. Further, as we have noted, it is unreasonable to expect 

any new policy framework to prevent all future bailouts, and future bubbles. Perfection is not possible in this or any other endeavor, and suggestions for policy improvements should not be judged against such a harsh and unrealistic standard. 

The challenge before the Congress instead is to significantly improve the odds 

that future bailouts of large financial institutions will be unnecessary, without at 

the same time materially dampening the innovative spirit that has driven our financial system and our economy. We believe that goal can be accomplished, but it will 

take time. Congress will write new laws, but will have to place considerable faith 

in regulators to carry them out. In turn, regulators will make mistakes, they will 

learn, and they will make mid-course corrections. 

This Committee is certainly well aware that regulation can never fully keep up 

with market developments. Private actors always find ways around rules; economists call this regulatory arbitrage, in which the regulatory ‘‘cats’’ are constantly 

trying to keep the private ‘‘mice: from doing damage to the financial system.’’ This 

crisis has exposed the unwelcome truth that over the past several years, some of 

the private sector mice grew so large and so dangerous that they threatened the 

welfare of our entire financial system. It is now time to beef up the regulatory cats, 

to arm them with the right rules, and to assist them with constructive market discipline so that the game of regulatory arbitrage will be kept in check, while the financial system continues to do what it is supposed to do: channel savings efficiently 

toward constructive social purposes. 

Thank you and we look forward to addressing your questions. 

PREPARED STATEMENT OF RAGHURAM G. RAJAN 

ERIC J. GLEACHER DISTINGUISHED SERVICE PROFESSOR OF FINANCE, 

UNIVERSITY OF CHICAGO, BOOTH SCHOOL OF BUSINESS

MAY 6, 2009 

Too Systemic to fail: Consequences, Causes, and Potential Remedies1

Perhaps the single biggest distortion to the free enterprise system is when a number of private institutions are deemed by political and regulatory authorities as too 

systemic to fail. Resources are trapped in corporate structures that have repeatedly 

proven their incompetence, and further resources are sucked in from the taxpayer 

as these institutions destroy value. Indeed, these institutions can play a game of 

chicken with the authorities by refusing to take adequate precautions against failure, such as raising equity, confident in the knowledge the authorities will come to 

the rescue when needed. 

The consequences are observationally identical to those in a system of crony capitalism. Indeed, it is hard for the authorities to refute allegations of crony capitalism—after all, the difference is only one of intent for the authorities in a free 

enterprise system do not want to bail out systemically important institutions, but 

are nevertheless forced to, while in crony capitalism, they do so willingly. More 

problematic, corrupt officials can hid behind the doctrine of systemic importance to 

bail out favored institutions. Regardless of whether such corruption takes place, the 

collateral damage to public faith in the system of private enterprise is enormous, 

especially as the public senses two sets of rules, one for the systemically important, 

and another for the rest of us. 

103 

2For example, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in many 

ways was meant to ensure regulators took prompt corrective action, by reducing their leeway 

to forbear. However, FDICIA was focused on the problem of relatively small thrifts, not ‘‘toobig-to-fail’’ institutions. 3The academic literature lends support to such a view for banks because it finds few economies of scale for banks beyond a certain size. 

As important as the economic and political damage created in bad times, is the 

damage created in good times because these institutions have an unfair competitive 

advantage. Some institutions may undertake businesses they have no competence 

in, get paid for guarantees they have no ability to honor, or issue enormous amounts 

of debt cheaply only because customers and investors see the taxpayer standing behind them. Other institutions may deliberately create complexities, fragilities, and 

interconnections so as to become hard to fail. In many ways, therefore, I believe the 

central focus of any new regulatory effort should be on how to prevent institutions 

from becoming too systemic to fail. 

Is it only too ‘‘big’’ to fail? 

Note that I have avoided saying ‘‘too big to fail.’’ This is because there are entities 

that are very large but have transparent, simple structures that allow them to be 

failed easily—for example, a firm running a family of regulated mutual funds. By 

contrast, there are relatively small entities—the mortgage insurers or Bear Stearns 

are examples—whose distress caused substantial stress to buildup through the system. This means a number of factors other than size may cause an institution to 

be systemically important including (i) the institution’s centrality to a market (mortgage insurers, exchanges) (ii) the extent to which systemic institutions are exposed 

to the institution (AIG) (iii) the extent to which the institution’s business and liabilities are intertwined, or are in foreign jurisdictions where U.S. bankruptcy stay does 

not apply, so that the act of failing the institution will impose substantial losses on 

its assets, and (iv) the extent to which the institution’s business interacts in complex 

ways with the financial system so that the authorities are uncertain about the systemic consequences of failure and do not want to take the risk of finding out. 

This last point takes us to the role of regulators and politicians in creating an 

environment where institutions are deemed too systemic to fail. For the authorities, 

there is little immediate benefit to failing a systemically important institution. If 

events spin out of control, the downside risks to one’s career, as well as short-term 

risks to the economy, loom far bigger for the authorities than any long term benefit 

of asserting market discipline and preventing moral hazard. Moreover, the public 

is likely to want to assign blame for a recognized failure, while a bailout can largely 

be hidden from public eye. Finally, the budgetary implications of recognizing failure 

can be significant, while the budgetary implications of bailouts can be postponed 

into the future. For all these reasons, it will be the brave or foolhardy regulator who 

tries to fail a systemically important institution, and give the experience of the 

events surrounding the Lehman bankruptcy, I do not see this happening over the 

foreseeable future. 

If the authorities are likely to bail out systemically—or even near-systemically important institutions—the solution to the problem of institutions becoming ‘‘too systemically important to fail’’ has to be found elsewhere than in stiffening the backbone of regulators or limiting their discretion.2 There are three obvious possibilities: 

1) prevent institutions from becoming systemically important; 2) keep them from 

failing by creating additional private sector buffers; 3) when they do become truly 

distressed, make it easier for the authorities to fail them. Let me discuss each of 

these in turn. 

Preventing Institutions From Becoming Systemically Important 

Many current regulatory proposals focus on preventing institutions from becoming 

systemically important. These include preventing institutions from expanding beyond a certain size or limiting the activities of depository institutions (through a 

modern version of the 1933 Glass-Steagall Act). I worry that these proposals may 

be very costly, and may still not achieve their intent. Here is why. 

Clearly, casual empiricism would suggest that some institutions have become too 

big to manage. If in addition they are likely to impose costs on the system because 

they are ‘‘too big to fail,’’ it seems obvious they should be constrained from growing, 

and indeed should be forced to break up.3 Similarly, it seems obvious that the peripheral risky activities of banks should be constrained or even banned if there are 

underlying core safe activities than need to be protected. 

104 

4 Banks like Citibank have found sufficient ways to get into trouble in recent decades even 

when Glass Steagall was in force. 

Economic Concerns 

More careful thought would, however, suggest serious concerns about such proposals. First, consider the economic concerns. Some institutions get large, not 

through opportunistic and unwise acquisitions, but through organic growth based on 

superior efficiency. A crude size limit, applied across the board, would prevent the 

economy from realizing the benefits of the growth of such institutions. Furthermore, 

size can imply greater diversification, which can reduce risk. The optimal size can 

vary across activities and over time. Is a trillion dollar institution permissible if it 

is a mutual fund holding assets? What if it is an insurance company? What if it 

is an insurance company owning a small thrift? Finally, size itself is hard to define. 

Do we mean assets, liabilities, gross derivatives positions, net derivatives positions, 

transactions, or profitability? Each of these could be a reasonable metric, yet vastly 

different entities would hit against the size limit depending on the metric we choose. 

Given all these difficulties, any legislation on size limits will have to give regulators 

substantial discretion. That creates its own problems which I will discuss shortly. 

Similar issues arise with activity limits. What activities would be prohibited? 

Many of the activities that were prohibited to commercial banks under GlassSteagall were peripheral to this crisis. And activities that did get banks into trouble, 

such as holding sub-prime mortgage-backed securities, would have been permissible 

under Glass Steagall.4 Some suggest banning banks from proprietary trading (trading for their own account). But how would regulators distinguish (illegitimate) proprietary trading from legitimate risk-reducing hedging? 

Regulatory Concerns 

Regulating size limits would be a nightmare. Not only would the regulator have 

to be endowed with substantial amounts of discretion because of the complexities 

associated with size regulation, the regulated would constantly attempt to influence 

regulators to rule in their favor. While I have faith in regulators, I would not want 

them to be subject to the temptations of the license-permit Raj of the kind that 

flourished in India. Indeed, even without such temptations, regulators are influenced by the regulated—one of the deficiencies uncovered by this crisis is that banks 

were allowed under Basel II to set their levels of capital based on their own flawed 

models. 

Moreover, the regulated would be strongly tempted to arbitrage draconian regulations. In India, strict labor laws kicked in once firms reached 100 employees in size. 

Not surprisingly, there were a large number of firms with common ownership that 

had 99 employees—every time a firm was to exceed 100 employees, it broke up into 

two firms. Similarly, would size limits lead to firms shifting activity into commonly 

owned and managed, but separately capitalized, entities as soon as they approach 

the limits? Will we get virtual firms that are as tightly knit together as current 

firms, but are less transparent to the regulator? I fear the answer could well be yes. 

Similar problems may arise with banning activities. The common belief is that 

there are a fixed set of risky possibilities so if enough are prohibited to banks, they 

will undertake safe activities only—what one might call the ‘‘lump of risk’’ fallacy. 

The truth is that banks make money only by taking risks and managing them carefully. If enough old risky activities are banned, banks will find new creative ways 

of taking on risk, with the difference that these will likely be hidden from the regulator. And because they are hidden, they are less likely to be managed carefully. 

Political Concerns 

Finally, the presumption is that the political support for heavy regulation will 

continue into the future. Yet, as the business cycle turns, as memories of this crisis 

fade, and as the costs associated with implementing the regulation come to the fore 

without visible benefits, there will be less support for the regulation. Profitable 

banks will lobby hard to weaken the legislation, and they will likely be successful. 

And all this will happen when we face the most danger from too-systemic-to-fail entities. If there is one lesson we take away from this crisis, it should be this—regulation that the regulated perceive as extremely costly is unlikely to be effective, and 

is likely to be most weakened at the point of maximum danger to the system. 

I would suggest that rather than focusing on regulations to limit size or activities, 

we focus on creating private sector buffers and making institutions easier to fail. 

Let us turn to these now. 

105 

5See the comprehensive discussion of capital requirements in the Squam Lake Group’s proposal http://www.cfr.org/publication/19001/reforminglcapitallrequirementsl 

forlfinanciallinstitutions.html. 6This describes work done by the Squam Lake Group, and a more comprehensive treatment 

is available at http://www.cfr.org/publication/19002. 7This is based on a paper I wrote with Anil Kashyap and Jeremy Stein, which is available 

at http://www.kc.frb.org/publicat/sympos/2008/KashyapRajanStein.03.12.09.pdf 

Adding Additional Private Sector Buffers. 

One proposal making the rounds is to require higher levels of capital for systemically important institutions. The problem though is that capital is costlier than 

other forms of financing. In boom times, the market requires very low levels of capital from financial intermediaries, in part because euphoria makes losses seem remote. So when regulated financial intermediaries are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated 

intermediaries, as did banks in setting up SIVs and conduits during the current crisis. If systemically important institutions are required to hold substantially more 

capital, their incentive to undertake this arbitrage is even stronger. Even if regulators are strengthened to detect and prevent this shift in activity, banks can subvert capital requirements by taking on risk the regulators do not see, or do not penalize adequately with capital requirements. 

So while increased capital for systemically important entities can be beneficial, I 

do not believe it is a panacea.5 An additional, and perhaps more effective, buffer 

is to ask systemically important institutions to arrange for capital to be infused 

when the institution or the system is in trouble. Because these ‘‘contingent capital’’ 

arrangements will be contracted in good times when the chances of a downturn 

seem remote, they will be relatively cheap (compared to raising new capital in the 

midst of a recession) and thus easier to enforce. Also, because the infusion is seen 

as an unlikely possibility, firms cannot go out and increase their risks, using the 

future capital as backing. Finally, because the infusions come in bad times when 

capital is really needed, they protect the system and the taxpayer in the right contingencies. 

Put differently, additional capital is like keeping buckets full of water ready to 

douse a potential fire. As the years go by and the fire does not appear, the temptation is to use up the water. By contrast, contingent capital is like installing sprinklers. There is no water to use up, but when the fire threatens, the sprinklers will 

turn on. 

Contingent Debt Conversions 

One version of contingent capital is for banks to issue debt which would automatically convert to equity when two conditions are met; first, the system is in crisis, 

either based on an assessment by regulators or based on objective indicators such 

as aggregate bank losses (this could be cruder, but because it is automatic, it will 

eliminate the pressure that would otherwise come on regulators), and second, the 

bank’s capital ratio falls below a certain value.6 The first condition ensures that 

banks that do badly because of their own errors, and not when the system is in 

trouble, don’t get to avoid the disciplinary effects of debt. The second condition rewards well-capitalized banks by allowing them to avoid the forced conversion (the 

number of shares the debt converts to will be set at a level so as dilute the value 

of old equity substantially), while also giving banks that anticipate losses an incentive to raise new equity well in time. 

Capital Insurance 

Another version of contingent capital is to require that systemically important 

levered financial institutions buy fully collateralized insurance policies (from 

unlevered institutions, foreigners, or the government) that will infuse capital into 

these institutions when the system is in trouble.7

Here is one way it could operate. Megabank would issue capital insurance bonds, 

say to sovereign wealth funds or private equity. It would invest the proceeds in 

Treasury bonds, which would then be placed in a custodial account in State Street 

Bank. Every quarter, Megabank would pay a pre-agreed insurance premium (contracted at the time the capital insurance bond is issued) which, together with the 

interest accumulated on the Treasury bonds held in the custodial account, would be 

paid to the sovereign fund. 

If the aggregate losses of the banking system exceed a certain pre-specified 

amount, Megabank would start getting a payout from the custodial account to bolster its capital. The sovereign wealth fund will now face losses on the principal it 

has invested, but on average, it will have been compensated by the insurance preVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00109 Fmt 6633 Sfmt 6621 S:\DOCS\53822.TXT SHERYL
106 

8Mohamed El Erian of Pimco phrases this as a situation where what the market thinks of 

as constant parameters become variables, resulting in heightened risk aversion. One example 

of this is the failure of Lehman, which resulted in the Reserve Primary money market fund 

‘‘breaking the buck’’. The strategy of money market funds investing in the debt of systemically 

important-but-weak banks in order to obtain higher yields imploded, causing a run on money 

market funds. 

mium.Clearly, both the convertible debt proposal and the capital insurance proposal 

will have to be implemented with care. For instance, it would be silly for any systemically important institution to buy these instruments, and they should be deterred from doing so. At the same time, some obvious objections can be answered 

easily. For instance, some critics worry whether there will be a market for these 

bonds that fall in value when the whole economy is in distress. The answer is there 

are already securities that have these characteristics and are widely traded. Moreover, a bank in Canada has actually issued securities of this sort. 

Making Institutions Easier to Fail. 

Let us now turn to the other possible remedy—making systemically important institutions easier to fail. There are currently a number of problems in failing systemically important institutions. Let me list them and suggest obvious remedies. 

(i) Regulators do not have resolution authority over non-bank financial firms or 

bank holding companies, and ordinary bankruptcy court would take too long— 

the financial business would evaporate while the institution is in bankruptcy 

court. This leaves piece-meal liquidation, with attendant loss in value, as the 

only alternative to a bailout. Regulators need resolution authority of the 

kind the FDIC has for banks. 

(ii) Regulators do not have full information on the holders of a systemically important institution’s liabilities. They have difficulty figuring out whom the 

first round of losses would hit, let alone where the second round (as institutions hit by the first round fail) would fall. While in principle they could allow 

the institution to fail, and ensure the first and second round failures are limited by providing capital where necessary, they do not have the ability to do 

so at present. Furthermore, because the market too does not know where the 

exposures are, the failure of a large institution could lead to panic. More information about exposures needs to be gathered, and the authorities 

need the ability to act on this information (including offering routine warnings 

to levered regulated entities that have high exposure to any institution), as 

well as the ability to disseminate it widely if they have to fail an institution. 

(iii) The foreign operations of institutions are especially problematic since there 

is no common comprehensive resolution framework for all of a multi-national 

bank’s operations. Failing a bank in the United States could lead to a run 

on a branch in a foreign country, or a seizure of local assets by a foreign authority in order to protect liability holders within that country. These actions 

could erode the value of the bank’s international operations substantially, resulting in losses that have to be borne by U.S. taxpayers, and making authorities more reluctant to fail the bank. A comprehensive international 

resolution framework needs to be negotiated with high priority. 

(iv) The operations of some systemically important institutions are linked to their 

liabilities in ways that are calculated to trigger large losses if the bank is 

failed. For instance, if a bank is on one side of swap transactions and it fails, 

the counterparties on the other side need to be paid the transactions costs 

incurred in setting up new substitute swap contracts. Even if the market is 

calm, these seemingly small transactions costs multiplied by a few trillion 

dollars in gross outstanding contracts can amount to a large number, in the 

many billions of dollars. If we add to this the higher transactions costs when 

the market is in turmoil, the costs can be very high. Regulators have to 

work with the industry to reduce the extent to which business losses 

are triggered when the institution’s debt is forced to bear losses. 

These cross-default clauses essentially are poison-pills that make large institutions too costly to fail. 

(v) Finally, the implicit assumption that some of these institutions will not be 

failed causes market participants to treat their liabilities as backed by the full 

faith and credit of the government. These liabilities then become the core of 

strategies that rely indeed on their being fully backed. Any hint that belief 

in the backing is unwarranted can cause these strategies to implode, making 

the authorities averse to changing beliefs.8 Regulators have to convince 

the market that no institution is too systemically important to fail. 

107 

The problem is that none of this can be achieved if the financial institutions are 

working at cross-purposes to the regulator—all will be for naught if even while the 

regulator is working with international authorities to devise a comprehensive resolution scheme, the financial institution is adding on layers of complexity in its international operations. Therefore I end with one last suggestion: Require systemically important financial institutions to develop a plan that would enable 

them to be resolved quickly—eventually over a weekend. 

Such a ‘‘shelf bankruptcy’’ plan would require institutions to track, and document, 

their exposures much more carefully and in a timely manner, probably through 

much better use of technology. The plan will need to be stress tested by regulators 

periodically and supported by enabling legislation—such as one facilitating an orderly transfer of the institution’s swap books to pre-committed partners. And regulators will need to be ready to do their part, including paying off insured depositors 

quickly where necessary. 

Not only will the need to develop a plan give these institutions the incentive to 

work with regulators to reduce unnecessary complexity and improve management, 

it may indeed force management to think the unthinkable during booms, thus helping avoid the costly busts. Most important, it will convey to the market the message 

that the authorities are serious about allowing the systemically important to fail. 

When we emerge from this crisis, this will be the most important message to convey. 

108 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM SHEILA C. BAIR 

Q.1. Mr. Wallison testified that, ‘‘In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the 

market meltdown and the freeze in interbank lending that followed 

the Lehman and AlG events in mid-September 2008 did not begin 

until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that 

financial conditions were much worse than the markets had 

thought. Taylor’s view, then, is that AlG and Lehman were not the 

cause of the meltdown that occurred later that week. Since neither 

firm was a bank or other depository institution, this analysis is 

highly plausible.’’ 

Do you agree or disagree with the above statement? Why, or why 

not? 

A.1. Professor Taylor argues that the data on the LIBOR–OIS 

spread indicate that the market had a stronger reaction to the testimony by Federal Reserve Board Chairman Ben Bernanke and 

Treasury Secretary Henry Paulson of September 23, 2008, on the 

government policy intervention that would become known as the 

TARP program than to the bankruptcy of Lehman Brothers on September 15. Professor Taylor’s interpretation does not acknowledge 

that the events of the period happened so rapidly and in such short 

order that it is difficult to disentangle the effects of specific news 

and market events. Other evidence suggests that reserves held by 

banks jumped dramatically immediately after Lehman entered 

bankruptcy (Federal Reserve Statistical Release H–3), indicating 

that banks preferred the security of a deposit at the Federal Reserve over the risk-and-return profile offered by an interbank loan. 

Following the Lehman Brothers bankruptcy filing, Primary Reserve—a large institutional money market fund—suffered losses on 

unsecured commercial paper it had bought from Lehman. The fund 

‘‘broke the buck’’ on September 16. This ‘‘failure’’ instigated a run 

and subsequent collapse of the commercial paper market. 

The events of the week may have had compound effect on the 

market’s perception of risk. For example, it is unclear whether AIG 

would have deteriorated as fast if Lehman had not entered bankruptcy. Indeed, TARP may not have even been proposed without 

the failure of Lehman. It also took time for markets to understand 

the size of the Lehman bankruptcy losses—which were larger than 

anticipated—and to use this new information to reassess the worthiness of all surviving counterparties. 

In the FDIC’s view, uncertainty about government action and 

interventions has been a source of systemic risk. As outlined in my 

testimony, the FDIC recommends a legal mechanism for the orderly resolution of systemically important institutions that is similar to what exists for FDIC-insured banks. The purpose of the resolution authority should not be to prop up a failed entity, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible. Imposing losses on shareholders and other creditors will restore market 

discipline. A new legal mechanism also will permit continuity in 

key financial operations and reduce uncertainty. Such authority 

109 

can preserve valuable business lines using an industry-paid fund 

when debtor-in-possession financing is unavailable because of market-wide liquidity shocks or strategic behavior by potential lenders 

who also are potential fire sale acquirers of key assets and businesses of the failing institution. Under a new resolution process, 

uninsured creditor claims could be liquefied much more quickly 

than can be done in a normal bankruptcy. 

Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector 

would have been much worse? Some commentators have suggested 

that the stress tests conducted on banks by the Federal Government have replaced Basel II as the nation’s new capital standards. 

Do you believe that is an accurate description? Is that good, bad, 

or indifferent for the health of the U.S.-banking system? 

A.2. Throughout the course of its development, the advanced approaches of Basel II were widely expected to result in lower bank 

capital requirements. The results of U.S. capital impact studies, 

the experiences of large investment banks that increased their financial leverage during 2006 and 2007 under the Securities and 

Exchange Commission’s version of the advanced approaches, and 

recent evidence from the European implementation of Basel II all 

demonstrated that the advanced approaches lowered bank regulatory capital requirements significantly. Throughout the interagency Basel II discussions, the record shows that the FDIC took 

the position that capital levels needed to be strengthened for the 

U.S. Basel II banks. If the advanced approaches of Basel II had 

been fully in place and relied upon in the United States, the FDIC 

believes that large banks would have entered the crisis period with 

significantly less capital, and would therefore have been even more 

vulnerable to the stresses they have experienced. 

Supervisors have long encouraged banks to hold more capital 

than their regulatory minimums, and we view the stress tests as 

being squarely within that tradition. While stress testing is an important part of sound risk management practice, it is not expected 

to replace prudential regulatory minimum capital requirements. In 

many respects, the advanced approaches of Basel II do not constitute transparent regulatory minimum requirements, in that they 

depend for their operation on considerable bank and supervisory 

judgment. The FDIC supported the implementation of the advanced approaches only subject to considerable safeguards, including the retention of the leverage ratio and a regulatory commitment that the banking agencies would conduct a study after 2010 

to identify whether the new approaches have material weaknesses, 

and if so, that the agencies would connect those weaknesses. 

Q.3. If there is an ordered resolution process, whether that’s bankruptcy, a new structured bankruptcy or a new resolution authority—what can we do to generate the political will to use it? 

A.3. For a new resolution process to work efficiently, market expectations must adjust and investors must assume that the government will use the new resolution scheme instead of providing government support. It is not simply a matter of political will, but of 

having the necessary tools ready so that a resolution can be 

credibly implemented. A systemic resolution authority could step 

110 

between a failing firm and the market to ensure that critical functions are maintained while an orderly unwinding takes place. The 

government could guarantee or provide financing for the unwinding 

if private financing is unavailable. Assets could be liquidated in an 

orderly manner rather than having collateral immediately dumped 

on the market. This would avoid the likelihood of a fire sale of assets, which depresses market prices and potentially weakens other 

firms as they face write-downs of their assets at below ‘‘normal’’ 

market prices. 

Q.4. Should we be limiting the size of companies in the future to 

prevent a ‘‘too-big-to-fail’’ situation, or can we create a resolution 

process that only needs the political will to execute it that will 

eliminate the need to be concerned about a company’s size? 

A.4. The FDIC supports the idea of providing incentives to financial firms that would cause them to internalize into their decisionmaking process the potential external costs that are imposed on society when large and complex financial firms become troubled. 

While fewer firms may choose to become large and complex as a 

result, there would be no prohibition on growing or adding complex 

activities. 

Large and complex financial firms should be subject to regulatory 

and economic incentives that require these institutions to hold 

larger capital and liquidity buffers to mirror the heightened risk 

they pose to the financial system. Capital and regulatory requirements could increase as firms become larger so that firms must operate more efficiently if they become large. In addition, restrictions 

on leverage and the imposition of risk-based premiums on institutions and their activities should provide incentives for financial 

firms to limit growth and complexity that raise systemic concerns. 

To address pro-cyclicality, capital standards should provide for 

higher capital buffers that increase during expansions and are 

drawn down during contractions. In addition, large and complex financial firms could be subject to higher Prompt Corrective Action 

limits under U.S. laws. Regulators also should take into account 

off-balance-sheet assets and conduits as if these risks were on-balance-sheet. 

Q.5. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations? 

A.5. In bankruptcy, current law allows market participants to terminate and net out derivatives and sell any pledged collateral to 

pay off the resulting net claim immediately upon a bankruptcy filing. In addition, since the termination right is immediate, and the 

bankruptcy process does not provide for a right of a trustee or debtor to transfer the contracts before termination, the bankruptcy filing leads to a rapid, uncontrolled liquidation of the derivatives positions. During normal market conditions, the ability of counterparties to terminate and net their exposures to bankrupt entities prevents additional losses flowing through the system and serves to 

improve market stability. However, when stability is most needed 

during a crisis, these inflexible termination and netting rights can 

increase contagion. 

Without any option of a bridge bank or similar type of temporary 

continuity option, there is really no practical way to limit the poVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00114 Fmt 6633 Sfmt 6604 S:\DOCS\53822.TXT SHERYL
111 

tential contagion absent a pre-packaged transaction or arrangements by private parties. While this sometimes happens, and did 

to some degree in Lehman’s bankruptcy, it raises significant questions about continuity and comparative fairness for creditors. During periods of market instability—such as during the fall of 2008— 

the exercise of these netting and collateral rights can increase systemic risks. At such times, the resulting fire sale of collateral can 

depress prices, freeze market liquidity as investors pull back, and 

create risks of collapse for many other firms. 

In effect, financial firms are more prone to sudden market runs 

because of the cycle of increasing collateral demands before a firm 

fails and collateral dumping after it fails. Their counterparties 

have every interest to demand more collateral and sell it as quickly 

as possible before market prices decline. This can become a self-fulfilling prophecy—and mimics the depositor runs of the past. 

The failure of Lehman and the instability and bail-out of AIG led 

investors and counterparties to pull back from the market, increase 

collateral requirements on other market participants, and dramatically de-leverage the system. 

In the case of Lehman, the bankruptcy filing triggered the right 

of counterparties to demand an immediate close-out and netting of 

their contracts and to sell their pledged collateral. The immediate 

seizing and liquidation of the firm’s assets left less value for the 

firm’s other creditors. 

In the case of AIG, the counterparties to its financial contracts 

demanded more collateral as AIG’s credit rating dropped. Eventually, AIG realized it would run out of collateral and was forced to 

turn to the government to prevent a default in this market. Had 

AIG entered bankruptcy, the run on its collateral could have translated into a fire sale of assets by its counterparties. 

In the case of a bank failure, by contrast, the FDIC has 24 hours 

after becoming receiver to decide whether to pass the contracts to 

a bridge bank, sell them to another party, or leave them in the receivership. If the contracts are passed to a bridge bank or sold, 

they are not considered to be in default and they remain in force. 

Only if the financial contracts are left in the receivership are they 

subject to immediate close-out and netting. 

Q.6. Chrysler’s experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward— 

senior creditors get paid 100 cents on the dollar and everyone else 

gets in line. That imposes the losses on those who chose to take the 

risk. Indeed, the sanctity of a contract was paramount to our 

Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ‘‘laws impairing the 

obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.’’ 

With that in mind, what changes can be made to bankruptcy to 

ensure an expedited resolution of a company that does not roil the 

financial markets and also keeps government from choosing winners and losers? 

112 

A.6. Bankruptcy is designed to facilitate the smooth restructuring 

or liquidation of a firm. It is an effective insolvency process for 

most companies. However, it was not designed to protect the stability of the financial system. Large complex financial institutions 

play an important role in the financial intermediary function, and 

the uncertainties of the bankruptcy process can create ‘runs’ similar to depositor runs of the past in financial firms that depend for 

their liquidity on market confidence. Putting a bank holding company or other non-bank financial entity through the normal corporate bankruptcy process may create instability as was noted in 

the previous answer. In the resolution scheme for bank holding 

companies and other non-bank financial firms, the FDIC is proposing to establish a clear set of claims priorities just as in the 

bank resolution system. Under the bank resolution system, there 

is no uncertainty and creditors know the priority of their claims. 

In bankruptcy, without a bridge bank or similar type of option, 

there is really no practical way to provide continuity for the holding company’s or its subsidiaries’ operations. Those operations are 

based principally on financial agreements dependent on market 

confidence and require continuity through a bridge bank mechanism to allow the type of quick, flexible action needed. A stay that 

prevents creditors from accessing their funds destroys financial relationships. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of 

a large, complex financial institution includes the risk that it will 

become a systemically important event. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM GARY STERN 

Q.1. Mr. Wallison testified that, ‘‘In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the 

market meltdown and the freeze in interbank lending that followed 

the Lehman and AIG events in mid-September 2008 did not begin 

until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that 

financial conditions were much worse than the markets had 

thought. Taylor’s view, then, is that AIG and Lehman were not the 

cause of the meltdown that occurred later that week. Since neither 

firm was a bank or other depository institution, this analysis is 

highly plausible.’’ 

Do you agree or disagree with the above statement? Why, or why 

not? 

A.1. Members of the Board of Governors of the Federal Reserve 

System have addressed the factors that contributed to the market 

dislocation in mid-September 2008. See, for example, the testimony 

of Chairman Ben S. Bernanke on U.S. financial markets before the 

Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 

on September 23, 2008, and the testimony of Vice Chairman Donald L. Kohn on American International Group before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 

Washington, D.C., on March 5, 2009. Based on my understanding 

of the facts and circumstances around market conditions in midSeptember, I will defer to these descriptions of events. 

113 

Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector 

would have been much worse? 

A.2. To the degree that a fully implemented Basel II would have 

left large financial institutions with less capital, the financial crisis 

could have been more severe. To the degree that large financial institutions would have had improved risk management systems due 

to Basel II, perhaps the crisis would not have been as severe. In 

short, we cannot know with any precision how a fully implemented 

Basel II would have altered bank performance during the recent financial crisis; the effect that a fully implemented Basel II would 

have had on the depth and severity of the financial crisis would 

have depended on competing factors such as the two just noted. In 

any case, and consistent with my remarks during the recent hearing, I believe Basel II should undergo a thorough review to determine if and how policymakers should modify it. 

Q.3. Some commentators have suggested that the stress tests conducted on banks by the Federal Government have replaced Basel 

II as the nation’s new capital standards. Do you believe that is an 

accurate description? Is that good, bad, or indifferent for the health 

of the U.S. banking system? 

A.3. As noted by the Board of Governors of the Federal Reserve 

System in ‘‘The Supervisory Capital Assessment Program: Overview of Results’’ (May 7, 2009), ‘‘the SCAP buffer does not represent a new capital standard and is not expected to be maintained 

on an ongoing basis.’’ I believe that policy is appropriate. 

Q.4. If there is an ordered resolution process, whether that’s bankruptcy, a new structured bankruptcy or a new resolution authority—what can we do to generate the political will to use it? 

A.4. Consistent with my testimony, I believe that financial 

spillovers lead policymakers to provide extraordinary support to 

the creditors of systemically important financial institutions. To 

discourage policymakers from providing such support requires 

them to take action to reduce the threat of these spillovers. I provided examples of these actions in my written testimony. 

Q.5. Should we be limiting the size of companies in the future to 

prevent a ‘‘too-big-to-fail’’ situation, or can we create a resolution 

process that only needs the political will to execute it that will 

eliminate the need to be concerned about a company’s size? 

A.5. As I noted in my written testimony, I do not believe that either reducing the size of financial institutions or creating a new 

resolution framework for nonbank financial institutions will, by 

itself, sufficiently address the ‘‘too-big-to-fail’’ problem. Neither step 

will effectively reduce the spillover problem that leads to the provision of government support for uninsured creditors of systemically 

important financial institutions in the first place. A resolution regime offers a tool to address some spillovers and not others. I detail 

in my written testimony recommendations to address spillovers. 

Q.6. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations? 

114 

A.6. We discussed issues surrounding so-called early termination, 

closeout netting, and other aspects of the treatment of derivative 

contracts in bankruptcy and their relation to the ‘‘too-big-to-fail’’ 

problem in our earlier analysis. (See Gary H. Stern and Ron J. 

Feldman, 2009, Too Big To Fail: The Hazards of Bank Bailouts, 

pp.118 and 119.) These issues deserve careful scrutiny in light of 

the AIG and Lehman situations to ensure that current policy and 

law adequately reflect the ‘‘lessons learned’’ from those two cases. 

Q.7. Chrysler’s experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward— 

senior creditors get paid 100 cents on the dollar and everyone else 

gets in line. That imposes the losses on those who chose to take the 

risk. 

Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers 

Number 44 to the American people that, ‘‘laws impairing the obligation of contracts are contrary to the first principles of the social 

compact, and to every principle of sound legislation.’’ 

With that in mind, what changes can be made to bankruptcy to 

ensure an expedited resolution of a company that does not roil the 

financial markets and also keeps government from choosing winners and losers? 

A.7. I see merit in creating a resolution regime for all systemically 

important financial firms that has similarities to the one currently 

used by the FDIC to resolve banks. As noted in my written testimony, ‘‘such regimes would facilitate imposition of losses on equity 

holders, allow for the abrogation of certain contracts, and provide 

a framework for operating an insolvent firm. These steps address 

some spillovers and increase market discipline.’’ However, as noted 

previously, these advantages do not address the full range of potential spillovers and thus may not sufficiently facilitate policymakers’ 

decision to impose losses on creditors of systemically important 

firms. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM PETER J. WALLISON 

Q.1. If there is an ordered resolution process, whether that’s bankruptcy, a new structured bankruptcy or a new resolution authority—what can we do to generate the political will to use it? 

A.1. The problem with a new resolution authority is that there will 

be too much political will to use it. My concern is that regulators 

will use the system to bail out failing financial companies when 

these companies should be allowed to go into bankruptcy. The result will be that the taxpayers will end up paying for something 

that—in bankruptcy—would be paid for by the company’s creditors. 

Q.2. Should we be limiting the size of companies in the future to 

prevent a ‘‘too-big-to-fail’’ situation, or can we create a resolution 

process that only needs the political will to execute it that will 

eliminate the need to be concerned about a company’s size? 

115 

A.2. There is no reason to be concerned about the size of any company other than a commercial bank, and even then it would not be 

good policy to try to limit the size of a bank because we are afraid 

that its failure will cause a systemic problem. Companies and 

banks get large because they are good competitors and serve the 

public well. We shouldn’t penalize them for that. In addition, our 

big international operating companies need big international banks 

to serve their needs. If we cut back the size of banks or insurance 

companies or securities firms because of fear about systemic risk, 

we would be adding costs for our companies for no good reason. Finally, I don’t think that any financial company other than a large 

commercial bank can—even in theory—create a systemic problem. 

Banks alone have liabilities that can be withdrawn on demand and 

are used to make payment by businesses and individuals. If a bank 

fails, these funds might not be available, and that could cause a 

systemic problem. But other financial companies are more like 

large commercial operating companies. They borrow money for a 

term. If they fail, there are losses, but not the immediate loss of 

the funds necessary to meet daily obligations. For example, if GM 

goes into bankruptcy, it will cause a lot of disruption, but no one 

who is an investor in GM is expecting to use his investment to 

meet his payroll or pay his mortgage. That’s also true of insurance 

companies, securities firms, hedge funds and others. If they fail 

they may cause losses to their investors, but over time, not the cascade of losses through the economy that is the signature of a systemic breakdown. We should not be concerned about losses to creditors and investors. It’s the wariness about losses that creates market discipline-which is the best way to control risk-taking. 

Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations? 

A.3. Most financial contracts are exempt from the automatic stay 

that occurs when a bankruptcy petition is filed. This allows the 

counterparties of a bankrupt company to sell the collateral they are 

holding and make themselves whole, or close to it. This prevents 

losses from cascading through the economy when they occur. They 

are stopped by the ability of counterparties to sell the collateral 

they hold and reimburse themselves. As a result, we have only one 

example of a Lehman counterparty encountering a serious and immediate financial problem as a result of Lehman’s failure. That 

was the Reserve Fund, which was holding an excessive amount of 

Lehman’s short term commercial paper. Other than that, Lehman’s 

failure is an example of what I said above about nonbank financial 

institutions. They do not cause the kind of cascading losses that 

could occur when a bank fails. We do not therefore need a special 

resolution function for these nonbank firms. 

AIG should have been allowed to go into bankruptcy. I don’t see 

any reason why AIG’s failure would have caused the kind of systemic breakdown that was feared. Again, the ability of counterparties to sell their collateral would have reduced any possible losses. 

Much a ttention has been focues on credit default swaps, but we 

now know that Goldman Sachs, which was the largest AIG swap 

counterparty, would not have suffered any losses if AIG had been 

allowed by the Fed to go into bankruptcy. The reason that GoldVerDate Nov 24 2008 11:07 Jan 19, 2010 Jkt 000000 PO 00000 Frm 00119 Fmt 6633 Sfmt 6604 S:\DOCS\53822.TXT SHERYL
116 

man would not have suffered losses is that they had collateral coverage on their swap agreements, and if AIG had failed they would 

have been able to sell the collateral and make themselves whole. 

So the treatment of financial contracts in bankruptcy is a strong 

reason to allow bankruptcy to operate rather than substituting a 

government agency. 

Q.4.a. Chrysler’s experience with the Federal Government and 

bankruptcy may prove a useful learning experience as to why 

bankruptcy despite some issues may still best protect the rights of 

various investors. A normal bankruptcy filing is straight 

forwardsenior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose 

to take the risk. 

A.4.a. Exactly right. 

Q.4.b. Indeed, the sanctity of a contract was paramount to our 

Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ‘‘laws impairing the 

obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.’’ 

A.4.b. Again, exactly right. 

Q.4.c. With that in mind, what changes can be made to bankruptcy 

to ensure an expedited resolution of a company that does not roil 

the financial markets and also keeps government from choosing 

winners and losers? 

A.4.c. I am not enough of a bankruptcy specialist to make a recommendation. However, the Lehman bankruptcy seems to be going 

smoothly without any significant reforms. In the 2 weeks following 

its filing Lehman sold off its brokerage, investment banking and investment management businesses to 4 different buyers, and the 

process is continuing. Based on the Lehman case, it does not appear to me that any major changes are necessary. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM MARTIN NEIL BAILY 

Q.1. If there is an ordered resolution process, whether that’s bankruptcy, a new structured bankruptcy or a new resolution authority—what can we do to generate the political will to use it? 

A.1. Presumably the key thought behind this question is what can 

be done to ensure that some class of creditors, in addition to shareholders, can be forced to incur at least some loss in the event a 

large systemically important financial institution were to subject to 

some resolution procedure? One way is to ensure that all such institutions are required to back at least of their assets by uninsured 

long-term subordinated (unsecured) debt, a security not subject to 

a ‘‘run’’ since its holders cannot ask for their money back until the 

debt matures. Precisely for this reason, regulatory authorities can 

safely permit the holders of such instruments to suffer some loss 

without a threat of wider financial contagion. In addition, Congress 

can and should exercise vigilant oversight over the activities of any 

authority that may be given the power to resolve such troubled institutions. 

117 

Q.2. Should we be limiting the size of companies in the future to 

prevent a ‘‘too-big-to-fail’’ situation, or can we create a resolution 

process that only needs the political will to execute it that will 

eliminate the need to be concerned about a company’s size? 

A.2. There is no principled basis, in our view, for imposing arbitrary size limits by institution. However, regulation can and should 

be designed to ensure that as institutions grow in size and begin 

to expose the financial system to danger should those institutions 

fail, the institutions internalize this ‘‘externality.’’ This can be accomplished by imposing progressively higher capital and liquidity 

requirements as financial institutions grow beyond a certain size, 

as well as more intensive supervision of their risk management 

practices. In addition, resolution authorities should be instructed to 

make an effort to break up troubled systemically important financial institutions, unless the costs of such breakups are projected to 

outweigh the benefits (in terms of reducing future exposure to systemic risk). 

Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations? 

A.3. We do not claim expertise in this area, and leave it to others 

to comment. 

Q.4. Chrysler’s experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward— 

senior creditors get paid 100 cents on the dollar and everyone else 

gets in line. That imposes the losses on those who chose to take the 

risk. 

Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers 

Number 44 to the American people that, ‘‘laws impairing the obligation of contracts are contrary to the first principles of the social 

compact, and to every principle of sound legislation.’’ 

With that in mind, what changes can be made to bankruptcy to 

ensure an expedited resolution of a company that does not roil the 

financial markets and also keeps government from choosing winners and losers? 

A.4. We agree that the sanctity of contracts is of paramount importance in our constitution and our economy. Bankruptcy law is not 

an area of our expertise. In the area of financial institutions in particular, however, we reiterate that one way to retain at least some 

market discipline without threatening the financial system is to require large systemically important financial institutions to issue at 

least some long-term subordinated (unsecured) debt.