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S. HRG. 112–679 

IS SIMPLER BETTER? LIMITING FEDERAL SUPPORT 

FOR FINANCIAL INSTITUTIONS 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS AND CONSUMER 

PROTECTION 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

SECOND SESSION 

ON 

EXPLORING POLICIES TO FURTHER LIMIT FEDERAL SUPPORT FOR 

LARGE, COMPLEX FINANCIAL INSTITUTIONS 

MAY 9, 2012 

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

( 

Available at: http://www.fdsys.gov/ 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

LAURA SWANSON, Policy Director 

JEFFREY SIEGEL, Senior Counsel 

DAWN RATLIFF, Chief Clerk 

RIKER VERMILYE, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

SHERROD BROWN, Ohio, Chairman 

BOB CORKER, Tennessee, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JERRY MORAN, Kansas 

MIKE CRAPO, Idaho 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

GRAHAM STEELE, Subcommittee Staff Director 

MICHAEL BRIGHT, Republican Subcommittee Staff Director 

(II)
C O N T E N T S 

WEDNESDAY, MAY 9, 2012 

Page 

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

Opening statements, comments, or prepared statements of: 

Senator Corker .................................................................................................. 1 

Senator Merkley ............................................................................................... 2 

WITNESSES 

Paul A. Volcker, Chair, President’s Economic Recovery Advisory Board, and 

former Chairman, Board of Governors of the Federal Reserve System .......... 2 

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

Thomas M. Hoenig, Vice Chairperson and Member of the Board of Directors, 

Federal Deposit Insurance Corporation ............................................................. 14 

Prepared statement .......................................................................................... 40 

Randall S. Kroszner, Professor of Economics, University of Chicago, Booth 

School of Business ................................................................................................ 15 

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

Tom C. Frost, Chairman Emeritus, Frost National Bank ................................... 25 

Prepared statement .......................................................................................... 61 

Marc W. Jarsulic, Chief Economist, Better Markets ............................................ 26 

Prepared statement .......................................................................................... 62 

James E. Roselle, Executive Vice President and Associate General Counsel, 

Northern Trust Corporation ................................................................................ 28 

Prepared statement .......................................................................................... 89 

Anthony J. Carfang, Partner and Director, Treasury Strategies, Inc., on behalf of the U.S. Chamber of Commerce .............................................................. 30 

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

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Thomas M. Hoenig speech presented to the European Banking and Financial 

Forum in Prague, 1999 ........................................................................................ 130 

Prepared statement of Wallace C. Turbeville, Senior Fellow, Demos ................. 139 

Federal Reserve Bank of Dallas 2011 Annual Report .......................................... 163 

(III)

(1) 

IS SIMPLER BETTER? LIMITING FEDERAL 

SUPPORT FOR FINANCIAL INSTITUTIONS 

WEDNESDAY, MAY 9, 2012 

U.S. SENATE, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

AND CONSUMER PROTECTION, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Committee convened at 2:03 p.m. in room 538, Dirksen Senate Office Building, Hon. Sherrod Brown, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF SENATOR SHERROD BROWN 

Senator BROWN. The Subcommittee on Financial Institutions and 

Consumer Protection will come to order. 

I thank Senator Corker for, always, his cooperation. Senator 

Merkley, thank you for joining us. Mr. Volcker, nice to see you. 

We have three panels today. Opening statements, I always give 

moderately short ones. It will be even shorter today, and Senator 

Corker always gives thoughtful and even shorter statements, so we 

will begin briefly with that. 

I want to thank everybody involved for helping pull together this 

important hearing. Getting such excellent and qualified individuals 

to discuss such an important but, admittedly, broad set of topics 

was not easy, so I appreciate the cooperation of all of you who are 

major players in your own right throughout our financial system. 

As I said, I will keep my message brief. I would simply say it is 

vital we take the necessary steps sooner rather than later to end 

Government policies that support and encourage large, complex institutions. That is why today I am introducing my legislation, the 

SAFE Banking Act. It was known formerly as the Brown-Kaufman 

bill and amendment. The ideas we will explore today have traction 

on both sides of the aisle. For instance, we know that the full Committee’s Ranking Member, Senator Shelby, voted both against the 

Gramm-Leach-Bliley Act and in favor of Brown-Kaufman when it 

was an amendment to the Dodd-Frank bill. And thanks again to 

the witnesses. 

Senator Corker, your comments. 

STATEMENT OF SENATOR BOB CORKER 

Senator CORKER. Thank you, Mr. Chairman, and Dr. Volcker, 

thank you for being here. I enjoyed talking to you prior to and I 

enjoyed reading your testimony yesterday evening as it came in. 
2 

I think we all agree that we need a safe banking system and we 

want one that also meets the needs of a 21st century economy, and 

that is the balance, I think, that we are all looking for. 

I want to thank you, in particular, in your testimony for pointing 

to the fact that Congress still has not dealt with the GSEs, and I 

know as a man who was under extreme stress during the early 

1980s and made a lot of tough decisions that have caused you to 

be highly honored by people all across this country, you must look 

at amazement on a U.S. Congress that fails to deal with an evident 

huge problem in our country but has lacked the courage to deal 

with that. So I appreciate you pointing that out. 

I was thinking as we read a lot of materials getting ready for 

this hearing, and I certainly appreciate all the witnesses that have 

come, you know, the most dangerous thing that a bank does is 

make a loan. At the end of the day, without sound underwriting, 

all the things that we do here do not make a lot of sense. 

But I sure thank you for your testimony. I look forward to hearing it orally and then the questions, and we are honored to have 

you here. 

Senator BROWN. Thank you. Thank you, Senator Corker. 

Senator Merkley. 

STATEMENT OF SENATOR JEFF MERKLEY 

Senator MERKLEY. Thank you, Mr. Chair. 

Just very briefly, welcome. It is so good to have you, Mr. Volcker, 

and for your leadership in helping establish the concept that there 

needs to be a firewall between ordinary banking activities and 

hedge fund-style investment activities by banks in order to create 

a safer and sounder banking system. I certainly look forward to 

your comments. 

Thank you. 

Senator BROWN. Thank you, Senator Merkley. 

Our first panelist, and I do not normally do cliches, but he is a 

man who needs no introduction. I appreciate so much Chairman 

Volcker joining us. He has dedicated his life to ensuring, as Senator Corker said, the American financial system is safe and sound, 

first as President of the Federal Reserve Bank of New York and as 

the Chair of the Board of Governors of the Federal Reserve System. 

Through your efforts, Dr. Volcker, to reform our financial system, 

though they may have frustrated some bankers on Wall Street and 

some lobbyists in Washington, there is no doubt our country is a 

better place because of your hard work. 

Thank you for your decades of service. You have the floor. 

STATEMENT OF PAUL A. VOLCKER, CHAIR, PRESIDENT’S ECONOMIC RECOVERY ADVISORY BOARD, AND FORMER CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE 

SYSTEM 

Mr. VOLCKER. Thank you, Mr. Chairman, and I want to thank 

you for holding this hearing. We are kind of in midstream on banking reform and banking regulation and I think this is a good time 

to review where we are and where we are going, so it is a useful 

service. 
3 

I know in writing to the panelists, you raised a series of questions. I will not attempt to answer them all, but you are certainly 

right in the underlying premise that banking has changed a lot in 

the past 20 years. It has changed very broadly from a, I guess what 

I used to think of as a profession that concentrated on relationships 

with its customers in very important ways. It has moved generally 

toward a much more transaction-oriented concentration. That is 

particularly true of the bigger banks. And it has certainly in the 

process become a lot more complex, a lot more opaque, very complicated. 

For a while, it was thought that with all the wisdom and engineering and expertise brought to the table, banking would be, if not 

failsafe, safer. That turned out to be an illusion when we had the 

great breakdown. And, obviously, reform is necessary, and I think 

that reform properly has to go into structural aspects of banking 

as well as raising capital requirements, better supervision. All that 

kind of thing is important, but I do think we need some structural 

changes and they revolve very fundamentally around this issue of 

too-big-to-fail and the moral hazard that was involved and is involved if the Government is bailing out failing financial institutions 

and particularly banks, big banks. 

And that is kind of the central issue that runs through a lot of 

the structural changes which are incorporated basically in the 

Dodd-Frank. I do not think there has been any legislation in other 

countries as comprehensive as the Dodd-Frank bill. They all have 

the same problem. All the regulators and governments are worried 

about the same thing because this has been a worldwide breakdown of finance. And the United States, I do think that I can fairly 

say that it has been in the lead on actual legislative changes. 

It deals, one way or another, in almost all the factors bearing on 

relevant structural changes. First of all, it deals directly to reduce 

the risks involved. Senator Brown, you are absolutely correct that 

making loans can be the most risky thing in banks. It becomes 

even riskier when they lose the capacity to deal with the relationship one-on-one with adequate credit controls. It should not necessarily be all that risky, but if you are making subprime mortgages and farming them off to other people, it is indeed an exceedingly risky proposition. 

Just take that where it is. Banks must make loans, it is essential 

to the economy, but look at other activities they have gotten into 

in recent years. Dodd-Frank deals with the problem of derivatives. 

They have just been exploding all over the place, continue to explode after the crisis, maybe at smaller volume, but everything is 

relative. I am told there is $700 trillion of derivatives outstanding 

in the world today—$700 trillion. And you wonder whether they 

are all directed toward some explicit protection against some explicit risk that can be dealt with by derivatives or whether they 

have not been themselves a kind of trading operation. 

Dodd-Frank does call upon its simplification in that area, tries 

to put as much of it as possible through clearinghouses and organized settlement arrangements, which are fiercely contested by the 

banks, but if that can be done for the great mass of derivatives, 

that will be a help. 
4 

Other institutional factors concerning what banks can do or not 

do, of course, is the restraint on proprietary trading, the restraint 

on ownership of hedge funds and equity funds, the kind of thing 

that somehow has my name attached to it. I would only say in that 

connection that is sometimes talked about as purely a risk factor. 

It is a risk factor, there is no question. This is speculative trading. 

But its influence goes far beyond the particular risks involved in 

particular transactions. It is a cultural issue. 

Hedge funds, equity funds, and propriety trading itself are necessarily involved in big banks’ conflicts of interest, almost continuously. And traders get to be richly rewarded. That affects the compensation practices and the culture of the bank throughout, leading 

to, in my view, unnecessarily dangerous behavior. 

The other part of Dodd-Frank I just mentioned, because in a way 

it is the heart of it, Dodd-Frank says no failing financial institution 

is going to be rescued. It will be liquidated, merged, sold, but the 

stockholders will be gone, creditors will be at risk, the management 

will be gone, and that is different, obviously, from what happened 

in 2008, 2009, in the midst of the crisis that raised all the questions about too-big-to-fail. 

There is a lot of skepticism in the market, as you are aware, as 

to whatever the law says, when push comes to shove, the Government will act, presumably against the law, to continue rescuing 

them with Government money. I think that skepticism is overdone, 

but it has got to be dealt with. And in the case of these big banks, 

the management of the bank after its failure, by any resolution authority gets very complicated internationally. 

And I just want to say that while I am obviously on the sidelines 

here, I have been impressed by the amount of effort going on, particularly between the FDIC and the U.K. authorities on this issue, 

where there is a meeting of minds as to the general approach. The 

legal systems may be different, but there is a meeting of the minds 

as near as I can see in the Euro zone generally. But getting that 

down in a very complicated way so that the authorities can work 

together when you have an incipient failure is very important and 

I do think considerable progress is being made in that area. 

So I will just stop there, touching on some of the points that I 

think are critical. 

Senator BROWN. Thank you, Chairman Volcker, very much. 

Senator Johanns, welcome to the Subcommittee. 

I will take 5 minutes in questions, turn it to the Ranking Member, and then we will go from there. 

You have often talked today and many other times about the 

moral hazard issue, the pattern of Government support for the 

largest institutions breeds greater risk taking. In December at that 

Committee table, Sheila Bair—who had resigned by then, was 

former FDIC Chair Sheila Bair—told the Subcommittee, quote, ‘‘It 

is important for the Government to be sending all the right signals 

that we do not view it as good in and of itself to keep these institutions alive just because they are big.’’ 

Your comments a minute ago that the skepticism might be 

overdone about the view of the Government stepping in, legally or 

not, what should regulators do to send messages to the markets 

that these institutions will not be propped up, especially when 
5 

these institutions do have an advantage in the money markets, the 

capital markets? 

Mr. VOLCKER. Well, the first point I want to make is when you 

are talking about the biggest commercial banking institutions, you 

have a degree of regulation. You have the proposals on proprietary 

trading, hedge funds, equity funds, and derivatives, and better capital standards to minimize the chance that those biggest institutions are really going to get in trouble to the point that they need 

to be rescued. But if they do need to be, they are on the brink of 

failure or actually failing, the law provides authority, I understand 

in this case the FDIC that has experience in this area, will act as 

conservator or liquidator of that institution, will have sufficient authority to keep the institution running in essential ways in the 

short run so that there is a continuity in the marketplace and you 

do not incite a spreading, contagious kind of panic or connections 

because the FDIC will have the authority—sufficient authority—to 

keep it operating in the short run in areas that are essential. 

I think that is possible. It is done now with smaller institutions. 

But as I said before, to make that effective, I think, for some of 

these biggest institutions that have very substantial operations 

overseas, those operations tend to be centered in the U.K. So I 

think you do want to get consistency between the U.K. and U.S. 

authorities. 

And you also have the provision in the law for so-called living 

wills, where the banks should organize themselves in a way that 

makes it easier to break them up than is the case now. And that 

will be a continuing supervisory challenge, to make sure the banks 

are properly creating these so-called living wills. 

Senator BROWN. Thank you. Bloomberg released a study recently 

that the banking sector is becoming larger, more concentrated, they 

said having grown seven times faster than GDP since the beginning of the financial crisis. Its growth has been concentrated, as 

you know, in the largest banks. The top 10 banks in the United 

States grew from 68 percent of all bank assets in 2006 to 77 percent of all U.S. bank assets in 2010. 

Based upon these numbers and no sort of end in sight to this 

that I can see, do you—are the regulators doing enough? How concerned should we be about this continuing—if, in fact, it is a continuing level of—this continuing increase in concentration? 

Mr. VOLCKER. Well, I think there has, obviously, been a great increase in concentration. Most of it took place before 2006, whatever 

the figures you—— 

Senator BROWN. Right. Right. 

Mr. VOLCKER. It took place in the 1990s and the early part of 

this century. It was aided and abetted by the end of Glass-Steagall. 

But before that, it seems like yesterday I was in the Federal Reserve—it wasn’t yesterday, it was a good many yesterdays ago—but 

at that time, banks could not branch outside their home States, by 

and large. And the United States had one of the most decentralized 

banking systems. And it has suddenly gone from a very decentralized system into a rather concentrated system, which I think is unfortunate. In the midst of the crisis, it got worse because the big 

commercial banks were joined with big investment banks. 
6 

Now, how to deal with that, you may have people on this panel 

that are much more aggressive than I. I do not know how to break 

up these banks very easily. But some of the things we are talking 

about, reduced trading, for instance, will reduce the overall size of 

the bank reasonably. Some of the restraints on derivatives will reduce their off balance sheet liabilities significantly. So these modest 

steps, there is a provision in the law they cannot grow beyond certain limits by merger or acquisition. 

So there are some limits here, but as you say—you asked me 

whether I prefer a banking system that had less concentration. I 

would, but I think we can live, more or less, with what we have. 

Senator BROWN. Thank you, Mr. Chairman. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman and Dr. Volcker. 

Thanks again for being here. 

I have read some of the comments that you have made specifically about the Volcker Rule, and I know we had a chance to talk 

in advance of this—— 

Mr. VOLCKER. I am glad somebody has read those comments. 

Senator CORKER. Yes, sir. I read them all the time. 

[Laughter.] 

Senator CORKER. There has been a—what has happened here, I 

think there has been consensus around the fact that prop trading 

is out the door, and I think that is one of the major contributions 

that you have made to this debate. What is happening as the regulators wrestle with this, and some of the regulators have differing 

agendas than others, there really have been attempts by some to 

really do away with market making itself. I think you have had 

some comments about that and I wonder if in front of this Committee you might differentiate between the two. It is my sense that 

you had no intentions to do away with the legitimate market making ,but prop trading was really the focus of what you were trying 

to do. 

Mr. VOLCKER. That is correct. I am not involved, obviously, in 

writing the rules, and I am sure it got very complex, and it may 

be an effort to try to identify particular transactions in a way that 

is difficult unless you are sitting on the trading desk, but I think 

can be identifiable. 

My view all along has been two things. One, I think it is important that the management of the banks, and I include not only 

chief executive officers but the directors of these banks, do understand what the law says, and the law says no proprietary trading. 

Now, all banks, unless they are totally irresponsible, and I do not 

think these big banks are totally irresponsible, will have strong 

controls on their trading desks in their own interest. They do not 

want rogue traders sitting around jeopardizing billions of dollars of 

their capital, so they will have, I am sure, rather detailed controls 

on their traders, and what is important is those controls take account of the fact that no longer should there be proprietary trading 

and a special proprietary desk, which I think they do understand. 

And no longer should the traders on the market making desk be 

taking proprietary risks under the disguise of market making. 

I think that can be identified as a problem by adequate so-called 

metrics afterwards. You look at the size of the trading relative to 
7 

the size of their position and you look at the volatility and you look 

at measures like value at risk and whether they are suitably narrow for a trading operation or very broad, which suggests a proprietary trading operation. If you see those telltale signs, there is no 

question the regulator ought to get in there, the supervisor ought 

to go in there and raise questions with the board of directors 

whether the bank is sufficiently charged in what the law says. 

Senator CORKER. Some of the—we have looked at some of the 

rules, and by the way, I have always understood that what you intended was to keep banks from being involved in prop trading, but 

that legitimate market making was something you thought they 

should continue to do. Some of the rules that are being created, 

though, there is one rule that we just read yesterday where the 

regulators were saying if you engage in market making and you 

make any profit on it, then it is really prop trading. Now, I do not 

know many institutions that are involved in businesses where they 

can only lose money. You would consider that, I assume, to be an 

overreach or not what was intended. 

Mr. VOLCKER. It is nonsense, frankly. 

Senator CORKER. Nonsense. I am glad—— 

Mr. VOLCKER. You can make money on market making. You can 

certainly make money on responding to customer requests. And 

until recently——you know, prop trading in banks is a recent phenomenon. Banks did not do that historically. And somehow, they 

did not go out of existence. 

Senator CORKER. So keeping—— 

Mr. VOLCKER. Proprietary trading is not a necessary ingredient 

of bank profits. It is a very volatile ingredient of bank profits. You 

know, I have read—I think it is appropriate—that all the money 

that was made on trading in this century by banks up until 2007 

disappeared in 2008, which gives you a sense that this is not a 

risk-free business. 

Senator CORKER. So an institution that would hold a very small 

amount of inventory, a very small amount, that was legitimately 

held for their customers’ use, you think that is a legitimate thing 

for banks to be involved in, and I appreciate you saying that. I 

wish that you could sit down with the Federal Reserve and some 

of these other institutions and cause them to very simply lay out 

what it was that you intended when you began this process, because I think they are making it overly complicated and I think a 

lot of institutions are in a place right now where they have no idea 

as the ticker is going where they are going to end up. 

Mr. VOLCKER. Well, I do not want to get involved in the detailed 

regulatory process. I had enough of that in my lifetime. But the 

general principle that you describe, I believe, is consistent with my 

position. You emphasize a small position. I always wonder, when 

they tell me it is just like running a corner dress shop or Christmas sales, whether the market is so predictable as Christmas sales 

and do you really need a big inventory. 

You said small inventory. I sometimes wonder, if they want to 

be prepared for market making and customer trading, why do they 

not have a short position, because the customer may want to sell. 

So they ought to have a balanced position, it seems to me, and the 

position is very unbalanced. It raises a question. 
8 

Senator CORKER. Yes. Well, listen. Thank you so much. I wish 

I had more time to talk to you, and hopefully, we will do that in 

person in either my office or your office soon. Thanks a lot. 

Mr. VOLCKER. Thank you. 

Senator BROWN. Thank you, Senator Corker. 

Senator Merkley. 

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

Volcker. 

I thought I would ask about a couple of issues that have been 

raised in the context of the Volcker Rule. One argument that has 

been made is that it will result in decreased liquidity in the trading 

world and that will be a very bad thing. Is that an issue? Is that 

a problem? 

Mr. VOLCKER. Well, I do not think it is a problem. Put it the 

other way around. It would be, I was going to say, a little extreme, 

but I do not think it is really extreme. The markets seemed to become very liquid before the crisis. There were a lot of complaints 

from the banking system itself that the markets were too liquid 

and it was hard to make money in very liquid markets. Now, I am 

not worried about being hard to make money, but it led to some 

behavior that I think is not very constructive. 

You would not have had all these subprime mortgages tied up in 

CMOs and CDOs if they were not so easily traded. These are longterm obligations. If you are buying one of those obligations, you 

should be prepared to keep it for a while. That would be the normal investor’s reaction, normal banking reaction. If you think you 

can trade it tomorrow at no loss, then it becomes a trading proposition and a speculative proposition. And if the markets are too liquid, it can give rise to behavior that is not very useful in terms of 

the basic fitness of banking or finance markets generally. 

Now, I am not alone in this thinking at all, obviously. There is 

a big movement in Europe to tax transactions to make the market 

less liquid. The fullest analysis I know of this is by the chief 

English regulator who examined this pro and con very carefully 

and came to a conclusion that, yes, beyond a certain point, liquid 

markets—highly liquid markets are not in the public interest. I 

could give you another analyses, but it is a matter—obviously, you 

want to be able to buy and sell reasonably. That does not mean you 

will have to be able to buy and sell a long-term security 10 minutes 

after you bought it at no risk. 

Senator MERKLEY. Well, thank you. Another issue that has been 

raised is that the Volcker Rule creates a handicap for American financial institutions vis-a-vis European financial institutions. Any 

insights on that issue? 

Mr. VOLCKER. Well, when I sat at this table many times when 

I was Chairman of the Federal Reserve, the complaint that I would 

hear all the time was American banks are at a disadvantage to foreign banks because they are too small and we want to be big like 

Japanese banks. That was the favorite example that was taken. We 

want to be big like Japanese banks because we are at a disadvantage and we have to carry more capital than Japanese banks. 

I would rather have smaller banks and stronger banks, and we 

see what happened in Japan with their big banks. It was not all 

a great treat. 
9 

So my answer is very simple. If we want to make some rules that 

are consistent with banks doing their basic job, I would not worry 

that foreign banks can do some things that we think do not contribute to a safe and sound banking system. 

And I—you know, the English authorities, the U.K. authorities, 

are always told by their banks, you cannot do this, you cannot do 

that because we will be at a disadvantage to American banks. You 

are told all the time, you cannot do this or that because you are 

going to be disadvantaged with the English banks. Well, the fact 

is, the approaches are not that different and capital requirements 

should not be that different. And there is a lot of effort to make 

sure the capital requirements are not that different. 

Now, in this trading operation, the British looked at what we are 

doing and at one point they expressed sympathy, and now they are 

at the same point with a different law. They say no investment 

banking, no trading, no proprietary trading, no hedge funds, no equity funds in a bank, in a commercial bank. You can have it in the 

same holding company, but it has got to be in a separate part of 

the holding company and we are going to make a great wall between one side of the holding company and the other side of the 

holding company. 

I do not know whether that is any easier. The banks, obviously, 

do not like that. I do not know what they like least. But they are 

after the same problem and they have a somewhat different approach. You could argue their approach is much more rigorous than 

what we have. So, the banks can choose whether they like that poison or our poison, but there is not—I do not think either of them 

are poison, frankly, but we found it difficult in the Federal Reserve 

and it became even more difficult in the midst of the crisis to maintain a distinction between parts of the holding company, because 

when you are in crisis, everybody leaps over those boundaries and 

the authorities say, OK, we have had a crisis. Go ahead and leap. 

I would like to think of this ring fencing. That is the favorite 

British term. You are going to ring fence the—I do not know if the 

commercial bank is going to ring fence both of them. My experience 

with ring fences is the gophers go underneath and the deer jump 

over—— 

[Laughter.] 

Mr. VOLCKER.——and you have got a lot of lawyers to help them. 

But the point I am making is they are somewhat different approaches to the same problem, and you could argue all day as to 

which is better or which is worse from the standpoint, more restrictive from the standpoint of the banks. 

Senator MERKLEY. Well, both are focused on the same issue of 

insured deposits and access to discount windows being separated 

from the hedge fund-style investing. 

I am out of time. Thank you very much for your commentary and 

your leadership. Thank you. 

Mr. VOLCKER. Well, the British proposal, fiercely contested by 

the banks, is to separate it by putting the hedge funds away from 

the banks. Never should there be any contact between them. We 

say you can have limited—it turned out to have limited ability to 

sponsor hedge funds and equity funds. The original proposal was 

not to have any sponsorship. So it is limited, but it is pretty much 
10 

under control. And I think the banks—my impression is, during the 

process, pretty much giving up their hedge funds, equity funds. 

Senator MERKLEY. Thank you. 

Senator BROWN. Thank you, Senator Merkley. 

Senator Johanns. 

Senator JOHANNS. Mr. Chairman, good to see you again. 

Mr. VOLCKER. Thank you. 

Senator JOHANNS. One of the last times you appeared before the 

Banking Committee, the full Committee, was prior to the passage 

of Dodd-Frank and it was at a point in time where the Volcker 

Rule was just kind of unveiled, if you will, the concept, at least. I 

remember during that hearing, and I do not have the exactly language in front of me, but we were kind of debating back and forth, 

all of us, what is this going to involve? What is going to be covered 

by the Volcker Rule? What is proprietary trading, et cetera? And I 

remember you, maybe somewhat exasperated with me at the time, 

said, you know, if you do not do something, this will haunt you. 

And then the second thing you said—— 

[Laughter.] 

Senator JOHANNS.——which is fine. The second thing you said 

was that, even though it is hard to define, we will know it when 

we see it. And again, those are not your exact words, but very 

clearly, that was the impression I had. 

Mr. VOLCKER. I recall both of those. 

Senator JOHANNS. Yes. Now, we have the 300-page rule—go 

ahead. Did I misstate that? 

Mr. VOLCKER. You have got a 35-page rule accomplished in 300 

pages of explanation, questions, comments—— 

Senator JOHANNS. Yes. I was getting to the fact that I think 

there are 1,300 questions, and it just kind of goes on and on and 

on. 

Really, on both sides of the aisle, there has been concern about 

its complexity. You have expressed concern about its complexity. As 

I have talked to those kind of at the ground floor level who have 

got to administer this thing, they are kind of saying, gee, how do 

we administer this? How do we take whatever is here and put this 

in a real life situation and administer it? 

And here is what I am concerned about. My concern is, number 

one, it is going to be very difficult for the people in the field to say, 

you have violated the rule or you have not violated the rule. 

Number two, it seems to me that the very goal here was to try 

to deal with these very large institutions that were doing irresponsible things, but at the end of the day were making this so complicated that I think we are forcing more consolidation, not less. 

And I would like your opinion on those two points. Are we making this so complicated that the big are going to get bigger and the 

small are just going to sell out? 

Mr. VOLCKER. This is a matter that, with some exceptions, broadly, these prohibitions apply to six, seven, eight institutions. The 

typical regional banks, certainly the particular community bank, is 

not doing proprietary trading. If they doing it, it is a very rare kind 

of transaction. 

So you are talking about a very concentrated number of banks, 

very sophisticated. They have trading desks. They do have, as I 
11 

said before, their own interests, I am sure, strict controls over their 

trading desks, maybe not as strict as they should be sometimes, 

but they have them, because once in a while, even with those controls, they found out some rogue trader fell into a ditch and cost 

the bank $9 million, billion dollars or something, which has happened on a number of occasions either here or abroad. 

I think you do not have to trace every transaction in real time. 

I do not think that is the purpose of regulation, at least not the 

way I would write it. The regulation should describe generally a 

characteristic of proprietary trading. Then it should have some 

very sophisticated, but I do not think all that complex, measures 

of the bank activity. 

Now, all these banks will have daily reports on their trading activity anyway. If they do not, they ought to be put in jail for having 

unsafe and unsound banking practices. These trading desks are all 

controlled, daily. You know, in general, what the characteristics are 

of proprietary trading. You can look at those reports weekly, 

monthly, whatever you want to look at them, as set down by the 

Federal Reserve or whoever is doing it. If you see characteristics 

of those trading patterns that suggest proprietary trading, then you 

go look at it. 

In the last extreme, go to the trading desk and see what they are 

doing. If they say it is a customer trade, who is the customer? Why 

were you buying all these securities? You were not making a market when you are in the market buying the same security all morning. You are not in the market if there is no customer on the other 

side, or you are not market making for a customer. You do not 

have to look at it in that detail unless you were very suspicious, 

and I assume that, in good faith, with the management understanding what is at stake, that their reputation is at stake with the 

regulator, they will take due care. 

Senator JOHANNS. I am out of time. Thank you, Mr. Chairman. 

Senator BROWN. Thank you, Senator—— 

Mr. VOLCKER. I have had traders, people who ran trading desks 

in the past, tell me—in effect, they said, do not believe all this 

stuff. I ran a trading desk. It was the policy of the institution not 

to do proprietary trading. We were an active trader, but we did not 

do proprietary trading and our daily reports showed it. 

Senator BROWN. Thank you. 

With the fact there are two other panels after you in mind, I 

have one question I want to ask. Certainly, the other Members of 

the Subcommittee can ask a question or two in addition, if you 

want, maybe not a whole second round. But Senator Merkley asked 

the question that you answered in terms of British banks tell their 

regulators that the Americans will have the advantage, and the 

American banks tell their regulators the British banks will have an 

advantage. In light of that, we know that the Swiss and the U.K. 

financial sector was significantly larger, their concentration, and 

banks in both nations were bailed out with billions of dollars from 

their governments and from others, including us, too. Both have 

taken dramatic action. 

I would just like your brief comment on, or your comments generally on what you think about Switzerland’s considering 19 percent capital requirements. U.K. has established firewalls, as you 
12 

said, between banks’ risky activities and traditional banking. Give 

me your thoughts on those two approaches. 

Mr. VOLCKER. Well, I will make one point. Those countries, their 

banks are no bigger than our banks, but the countries are smaller 

so they are more concentrated, much more concentrated than we 

are. So they feel even more vulnerable than we feel, I think, to 

these problems. 

Switzerland was obviously very concerned because they have two 

big banks. Both were in trouble. One was in severe trouble. They 

took strong measures, including exceptionally high capital standards and other measures, and my understanding is, and you can 

find out more directly, my understanding is that the biggest of 

those banks has practically given up proprietary trading. Whatever 

the law said, I am sure that they were under pressure from the 

central bank. And they have moved away from some of these activities to nonrisky activities, to investment—basically, toward investment banking, traditional banking on the one side, investment 

management on the other side. And they have been de-risked substantially. 

There has been some reaction along the same lines at some of 

the British banks. The British are still open as to how they apply 

the proposed regulation. It may be not insignificant. I was invited, 

and I will go, to have a little session with the European Parliament, with the British regulators and the commission. I say the 

British regulators. Mr. Vickers, who made the proposal about the 

British banking system. So we are going to have a better feel for 

how coordinated we are next month. I think the obvious purpose 

of the invitation was to try to get a maximum amount of coordination. 

Senator BROWN. Thank you. 

Senator Corker, any comment? 

Senator CORKER. In your written testimony, you alluded to the 

Government-Sponsored Enterprises, in particular, Fannie and 

Freddie. As you know, it has been 4 years and 95 percent of the 

mortgages originated today are dependent upon them. How important is it, in your opinion, that we move away from that reliance, 

and should they exist in their current forms? 

Mr. VOLCKER. Well, it is important if you think the free market 

financial system is important. Here we are sitting here with half 

of the capital market under the control of the two institutions, both 

of which at this point are Government owned. It is kind of ridiculous when you look at it. 

Senator CORKER. I assume you think having a free market system is—— 

Mr. VOLCKER. Well, I think not only you, but I think some other 

people are, too. So right now, unfortunately, the residential mortgage market is dependent on two de facto governmental institutions, Fannie Mae and Freddie Mac. So how do we wean away from 

that? It is going to take years, frankly. But, please, let us not make 

the same mistake of having these quasi-governmental institutions, 

half private, half public—they are public when they get in trouble 

and they are private when they are making money. 

Senator CORKER. That is right. 
13 

Mr. VOLCKER. And that is a recipe for a not very disciplined, effective mortgage market, in my opinion. And that is a big issue of 

how we reconstruct the mortgage market. And, literally, it will 

take years. 

Senator CORKER. Thank you very much. 

Senator BROWN. Senator Merkley. 

Senator MERKLEY. Thank you, Mr. Volcker. The group of regulatory agencies working on the Volcker regulations, those 30 pages 

that you referred to, have indicated that they might not be prepared to implement them in July, the 2-year time period after the 

passage of Dodd-Frank. Should they hold their deadline solid and 

get those rules implemented in July? 

Mr. VOLCKER. Well, I am not clear, frankly, on just what their 

attitude is. I have seen a couple of statements that confused me a 

little bit, and my understanding of the basic situation is they are 

aiming to get the final rule out by July, whatever the date is. They 

recognize it will take some time to adapt. They recognize that over 

a 2-year period, you may find particular things in the regulation 

you want to change. But the law also says after July whatever it 

is, no proprietary trading. So, I do not know, somebody told me, 

some law firm said if they do not carve out, they can do proprietary 

trading. That is a very strange reading of the law, but I—it is a 

very—I do not know. I will not get into the legal profession at this 

point. It does seem to me a rather strange, contrived reading. I do 

not even see how it is contrived, but there we are. 

Senator MERKLEY. Thank you. 

Senator BROWN. Senator Johanns. 

Senator JOHANNS. It just occurs to me with the passage of DoddFrank, it incorporates the Volcker Rule and a whole host of other 

things—it is a very lengthy, complex piece of legislation—that at 

the end of the day, we still have a very small number of financial 

institutions that control an enormous amount of the capital of the 

United States and we just have not impacted that very much. Do 

you disagree with my assessment of that? 

Mr. VOLCKER. No. No. We do have a much more concentrated financial system than we used to have. I do think that skepticism 

about dealing with institutions outside of the banking organization 

itself, the protected sector of the market, I think the idea that they 

can and will fail is totally credible to me. When you talk about the 

biggest banking institutions, they get a lot of Government support 

in the ordinary course of business. I think they should be regulated 

to the point, including what we are talking about in derivatives 

and proprietary trading, that the risk of those institutions failing 

will be very remote. But they, you know, you say they have gotten 

quite concentrated. I agree with you. 

Senator JOHANNS. Yes. Thank you, Mr. Volcker. 

Senator BROWN. Thank you very much for your testimony—— 

Mr. VOLCKER. Thank you. 

Senator BROWN.——and for your service for so many years. 

Mr. VOLCKER. I do appreciate you took this initiative. Thank you. 

Senator BROWN. Thank you. 

The Chair will call up Tom Hoenig and Randall Kroszner, if you 

would join us. 

[Pause.] 
14 

Senator BROWN. Tom Hoenig—perhaps there is no stronger advocate for America’s community banks than Thomas Hoenig. Dr. 

Hoenig is a Member of the Board of Directors of the Federal Deposit Insurance Corporation. For two decades, he has served as 

President and Chief Executive Officer of the Federal Reserve Bank 

of Kansas City. He spent 18 years as a bank supervisor at the Kansas City Fed. 

Randall Kroszner is the Norman R. Bobins Professor of Economics at the Booth School of Business at the University of Chicago. 

Dr. Kroszner served as Governor of the Federal Reserve System 

from 2006 until early 2009. During his time as a member of the 

Federal Reserve Board, he chaired the Committee on Supervision 

and Regulation of Banking Institutions and the Committee on Consumer and Community Affairs. 

Dr. Hoenig, you first. Thank you again for joining us. 

STATEMENT OF THOMAS M. HOENIG, VICE CHAIRPERSON AND 

MEMBER OF THE BOARD OF DIRECTORS, FEDERAL DEPOSIT 

INSURANCE CORPORATION 

Mr. HOENIG. Well, thank you very much, Chairman Brown and 

Ranking Member Corker and Senator Johanns. Thank you for the 

opportunity to testify on issues relating to improving the safety and 

soundness of the Nation’s banking system. 

Having joined the Board of the FDIC less than a month ago, it 

is a privilege to serve and to be part of a board that can draw from 

the depth of collective experiences and diverse backgrounds that I 

think will inform our discussions and our decisions going forward. 

This Subcommittee has asked me to discuss a paper titled, ‘‘Restructuring the Banking System to Improve Safety and Soundness’’ 

that I prepared with my colleague Chuck Morris in May of 2011 

when I was President of the Federal Reserve Bank of Kansas City. 

I welcome this opportunity to explain the recommendations in that 

paper. 

One note—while I am a Board member of the FDIC, on this, I 

speak for myself today. 

First, banking organizations should be allowed to conduct the following activities: commercial banking, underwriting securities and 

advisory services, and asset and wealth management services. Most 

of these latter services are primarily fee-based and do not disproportionately place a firm’s capital at risk. They are similar to 

the trust services that have long been part of banking itself. 

But in contrast, dealing and market making, brokerage, and proprietary trading extend the safety net’s coverage and yet do not 

have much in common with core banking services. Under the safety 

net and the incentives that follow from it—risks are created that 

are difficult for management and the markets to assess, to monitor, 

and to control. 

Thus, under the proposal, banking organizations would not be allowed to do trading, either proprietary or for customers, or make 

markets which requires the ability to do trading. Allowing customer trading makes it easy to game the system by concealing proprietary trading as part of the customer trading. Also, prime brokerage services require the ability to trade and essentially allow 
15 

companies to finance their activities with highly unstable, uninsured deposits. 

This combination of factors, as we have recently witnessed, leads 

to unstable markets, financial crises, and Government bailouts. 

Furthermore, these actions alone would provide limited benefits if 

the newly restricted activities migrate to the shadow banks without 

that sector also being reformed. We need to change the incentives 

within the shadow banking system through reforms of money market funds and the repo market. 

The first change to the shadow banking system addresses potential disruptions coming from money market funding of shadow 

banks to fund long-term assets. Money market mutual funds and 

other investments that are allowed to maintain a fixed net asset 

value of a dollar should be required to have a floating net asset 

value. Shadow banks’ reliance on this source of short-term funding 

would be greatly reduced by requiring share values to float with 

their market values. 

The second recommendation is to change the bankruptcy law to 

eliminate the automatic stay exemption for mortgage-related repurchase agreement collateral. This exemption allowed all of the complicated and often risky mortgage securities to be used as repo collateral just when the securities were growing rapidly and just prior 

to the busting of the housing price bubble. One of the sources of 

instability during the crisis was the repo runs, particularly on repo 

borrowers using subprime mortgage related assets as collateral. Essentially, these borrowers funded long-term assets of relatively low 

quality with very short-term liabilities. 

The proposal would not eliminate risk in the financial system. It 

would shift it away from the incentives of the safety net. This plan 

would return U.S. banks to a position of financial clarity and 

strength from which the country enjoyed decades of its greatest 

global economic advantage. It would improve the stability of the financial system by clarifying for management and regulators where 

risks reside; improving the pricing of risk; and, thus, enhancing the 

allocation of resources within our economic system. It would promote a more competitive financial system as it levels the playing 

field for all financial institutions in the United States. 

Finally, it will raise the bar of accountability for actions taken, 

and to an important degree give further credibility to the supervisory authorities’ commitment to place these firms into bankruptcy or FDIC receivership when they fail, thus reducing the likelihood of future bailouts. 

I am pleased to provide you these comments and I am happy to 

take your questions. Thank you. 

Senator BROWN. Thank you, Dr. Hoenig. 

Dr. Kroszner, thank you for joining us. 

STATEMENT OF RANDALL S. KROSZNER, PROFESSOR OF ECONOMICS, UNIVERSITY OF CHICAGO, BOOTH SCHOOL OF 

BUSINESS 

Mr. KROSZNER. Thank you very much. I am delighted to be here, 

Chairman Brown, Ranking Member Corker, Senator Johanns. 

My general approach to these very important issues that you 

have convened this hearing on is to try to clearly state objectives 
16 

what regulation and regulatory reform are about and then try to 

weigh the costs and benefits of alternatives in order to decide 

which regulations and which reforms are most effective in trying 

to address those objectives. My priorities and objectives, I think, 

are very much shared by the Committee and in the discussion that 

we heard earlier, enhance the stability of the financial system and 

its resilience to shocks since its shocks are going to be inevitable. 

In other words, we can talk about it as trying to make the markets 

more robust to those shocks, and I go into much more detail in the 

contribution to the book that I have with Bob Shiller on reforming 

U.S. financial markets, on trying to make markets more robust. 

Second, obviously, we have to mitigate taxpayer exposure and 

moral hazard incentives, as was discussed in the previous panel, 

and I certainly applaud and share the objectives of the recent regulatory reforms, but I perhaps want to raise some questions about 

whether some of the proposed means are the most effective means 

possible to try to achieve those ends. Would they be the ones that 

would be the highest in a cost-benefit test? 

I think it is extremely important to identify the fragilities in the 

system and address those as directly as possible rather than rely 

too much on any one regulatory instrument or one regulatory intervention because I think that opens up the greatest possibilities for 

unintended consequences. I think some of the greatest fragilities in 

the system are leverage, liquidity, and interconnectedness. Our 

focus today seems to be primarily on interconnectedness issues, too 

big or, as I would like to characterize it, too interconnected to fail. 

Chairman Volcker in his testimony also characterized things that 

way. 

And so what we need to do is think about exactly where are 

those fragilities in the markets and address them directly. One of 

those fragilities which Dodd-Frank takes steps toward is trying to 

clarify contracts and contract enforcement, something that is very 

important in thinking about resolution of the large, complex financial institutions. New authority is given to the Treasury and the 

FDIC, but that authority has not really been clarified yet by the 

regulators. I think that is of the utmost importance. One of the 

challenges that we saw during the crisis was the uncertainty about 

contract enforcement, uncertainty about what is mine and what is 

thine in customers’ accounts, and that is a recipe for an implosion 

of the business model and for just uncertainty where people in general pull back. So I urge greater clarity on that. 

Second, as has already been discussed, over-the-counter derivatives markets, trying to migrate those to cleared platforms, providing more information to market participants, more information 

to supervisors, and better incentives to avoid risk concentrations, 

as we saw in AIG. 

Third, I wanted to think about activity restrictions. And interestingly, Chairman Volcker in his testimony says that his first principle is that risk of failure of large interconnected firms must be 

reduced, whether by reducing their size, curtailing their interconnectedness, or limiting their activities. So it is interesting that 

he sees those as alternatives, and I think in thinking about it from 

a cost-benefit perspective, that is the appropriate way to think 
17 

about it. What is the best way to try to limit those kinds of risks 

to both the taxpayer and to the system overall? 

I am not 100 percent convinced that trying to draw the lines on 

what is and is not different types of trading activities will be the 

most effective way of getting there. As was discussed in earlier 

questioning, there is a lot of uncertainty about where the line 

should be drawn, and I think the greater clarity, the better. I was 

very heartened that former Chairman Volcker said that he did not 

want to exclude market making. I think it is very important not 

to exclude that very important function that provides liquidity and 

robustness to the markets in general. We would not want to have 

the unintended consequence of producing rules that actually make 

markets less robust rather than more robust. But I think it is very 

difficult to draw those lines clearly and crisply and ensure that we 

do not have unintended consequences of pushing activities off balance sheet or into the shadows, and so I think it is incumbent upon 

the supervisors and regulators to have much greater clarity when 

it comes to those issues. 

Also, something that has been mentioned is the culture of institutions and the culture of risk taking if these activities are there. 

I think it is important to remember that there were many institutions that were much more narrowly focused, primarily on mortgage lending, institutions like Washington Mutual, Countrywide, 

Indy Mac, that were not engaged in proprietary trading, not engaged in these other activities that may involve risks. But we are 

reminded that even their core activity of mortgage lending was extremely risky and brought these institutions down. So it is not 

clear to me that simply removing these activities will be things to 

change the culture or make institutions more stable. In some cases, 

as we have seen, very focused institutions actually could be quite 

unstable. 

Thank you very much. 

Senator BROWN. Thank you, Dr. Kroszner. 

Dr. Hoenig, let me begin with you. I want to follow up on the 

concentration question that we discussed with Chairman Volcker. 

You and I have talked in the past about the importance of manufacturing. Your region was obviously a major manufacturing center 

and other things. The last 35 years, the share of GDP of manufacturing and financial services basically flipped. Thirty years ago, 

manufacturing was 25 percent plus of GDP and financial services 

about 10. Those numbers have more or less reversed in more modern days. 

To what do you attribute this growth of finance versus manufacturing in the real economy? Has this benefited our country? Give 

me thoughts on sort of how it happened and how Federal policy 

may have contributed to it. 

Mr. HOENIG. Well, relative to the manufacturing side, there are 

a whole host of considerations in terms of international competitiveness and all these sorts of things. But in terms of the growth 

of the financial industry, I think it is clear that if you provide a 

subsidy to an industry, as we have the financial industry in terms 

of these largest institutions, that is, when we passed the GrammLeach-Bliley Act, we allowed these high-risk activities, broker-dealer activities, into the safety net, which is a subsidy. 
18 

We allowed them to, number one, leverage up and to become 

larger than they otherwise would have because they could take on, 

number one, greater risk with less capital required. Therefore, they 

could balloon their balance sheets, and they did. And I think those 

are the kinds of things that contributed to their very rapid growth 

and very strong drive toward mergers, consolidation—and the effect was concentration in the industry. 

It is partly the subsidy that is provided through the protection 

of the safety net that contributed to their advantage. You did not 

have the same, and, I think, wisely so, subsidies going into necessarily these other industries, although subsidies is a big issue in 

the United States, I realize, for other industries, as well. But I 

think for the financial industry, it was a big factor allowing them 

to grow and take on greater risk. 

Senator BROWN. Thank you. Before I move on, Dr. Hoenig, I 

would like to submit for the hearing record a speech that Dr. 

Hoenig gave in Prague in 1999. You talked about the wave of 

mega-mergers and the problem of too-big-to-fail. Your prescience, 

unfortunately, was pretty accurate there, and without objection, I 

would like to submit that for the record, the speech. 

Senator BROWN. Three years ago or so, Dr. Hoenig, you said that 

when Gramm-Leach-Bliley passed in 1999—this was now 10 years 

later, you said this in 2009—the five biggest banks held 38 percent 

of the assets in the financial industry. That, by then, had grown 

to 52 percent. I would like to ask you both, each of you, a threepart question. I will start with Dr. Hoenig. 

Tell me what this growth and consolidation has meant in three 

ways. One, for the management seeking to understand the companies they are running, so this huge growth, what it means to people actually in charge of running these institutions. Second, to the 

authorities monitoring these risks, how the regulators have been 

able to both understand and regulate these much larger entities. 

And, third, what it has meant to the community banks that are 

competing with these ever-growing mega-banks. 

Dr. Hoenig, I will start with you on the three-part question, then 

Dr. Kroszner. 

Mr. HOENIG. If I can, Senator, I would go back to my confirmation hearing when it was pointed out that if a bank is well capitalized, well managed, and well supervised, it will not fail. And if you 

think about the decade following Gramm-Leach-Bliley, allowing 

these institutions, these broker-dealer activities and institutions to 

be brought into the safety net, it encouraged through the safety 

net, enormous increases in leverage and debt. We saw the capital 

levels of our financial institutions decline, or the leverage increase, 

and so we had weaker capital, very thin capital levels when the crisis emerged in 2007 and 2008. 

Second, we allowed the scope, if you will, of management to, I 

think, go beyond its capacity. It was not just these very important 

activities of lending and payment system intermediation that were 

there. Now you had all these new high-risk-oriented broker-dealer 

activities. So the scope of management had to be able to cross over 

and manage these activities. That was an enormous additional 

level of responsibility that clearly was beyond management’s ability 
19 

to monitor and to control the risk. Had they been able to, we would 

not have had the crisis. So it was outside their bounds. 

And I think in terms of bank supervision, if it is beyond the management and directors’ ability to control this risk and monitor this 

risk, I think it is a lot to ask the supervisors to fill the gap when 

you are pushing this risk off balance sheet and other ways of doing 

it. It is a lot to ask the supervisor. 

So what is the effect on the community bank? It is important because when you give one sector an advantage of this very significant too-big-to-fail safety net. Then, where are you going to put 

your funds as a major or as a medium-sized company or corporation? You are going to put it with the institution that will not be 

allowed to fail, and that is a nice advantage if you want to grow 

and become more, I would say, dominant in the industry. 

And the other thing about it is—in that sense, it is unfair because it does make consolidation even more important to the largest institutions—maintains too-big-to-fail—and that is a disadvantage to the regional banks and, I think, to the community banks, 

as well. That is how I have judged it over the last decade watching 

this emerge. 

Senator BROWN. Dr. Kroszner. 

Mr. KROSZNER. I will try to be brief. On the management issue, 

going back to the examples I had given of institutions that were 

very focused on a narrow set of activities, mortgage lending, that 

did not necessarily make them better managed or less risky, and 

there are some very large complex institutions that seem to have 

done well in the crisis internationally, both in the United States 

and outside of the United States, banks that have been more universal banks. 

We can find examples on either side. So I am not saying that it 

is consistent that diverse banks are always better managed and focused banks are always worse managed. That is certainly not the 

case. But I think it is very hard to generalize. I really think it depends upon the structure of the institution itself and the supervisory process over it. 

Senator BROWN. So these banks are not necessarily—sorry to interrupt, but—— 

Mr. KROSZNER. Sure. 

Senator BROWN. These banks, as I think Dr. Hoenig implied, if 

not said directly, in your mind are not by nature of their size too 

big to manage, if I could—— 

Mr. KROSZNER. Not necessarily, because we could see that there 

were some smaller institutions that were more focused that I think 

were very poorly managed and badly managed. So there are certainly some institutions that were not very well managed that were 

very large, so I do not want to say that in all cases they have gotten it right. In most—I should not say most, but in many cases 

they got it right. 

Senator BROWN. In essence, they are not too big to manage. 

Mr. KROSZNER. Not in principle too big to manage, that is right. 

But they certainly could be. Just the small institutions could be 

very poorly managed. Focused institutions like the ones that we 

are focused on, the mortgage market, many examples where they 

were, unfortunately, very poorly managed. 
20 

That brings us to the next step about the authorities and the regulators, and this gets back to one of the issues that I had mentioned in my oral remarks about pushing things off into the shadows. So in principle, if you can make things very transparent, very 

simple, they are easier for the regulators to monitor. The challenge 

is that even if we try to do that for one set of organizations, that 

does not mean that the risks disappear. 

As Tom Hoenig made very clear in, I think, his very interesting 

proposal, he wanted to focus on not just the banking system, but 

also the shadow banking system, because when you put restrictions 

on one piece, there is a natural tendency for some of those activities to occur elsewhere. We sometimes would joke about the whacka-mole problem, that you push down the mole that pops up from 

this game in one spot, but it pops up somewhere else. The risk does 

not disappear even if you get it out of one particular set of institutions because of the interconnections. Those activities typically are 

done either off balance sheet or very close to the bank as other 

funders are funded by the banks. 

So it is not clear to me that we actually can make the system 

easier for the regulators if one set of institutions may have fewer 

activities but a lot of those other activities do not actually disappear but are taking place in the shadows. 

The issue of the community banks. I very much share Tom 

Hoenig’s view that we should not be having subsidies to one type 

of institution versus another institution. To use the public fisc to 

try to unbalance the competitive landscape is inappropriate, inconsistent with free markets, unfair, and not good policy. So we certainly want to try to rein in any particular subsidies that are being 

given to one type of institution versus the other to maintain the 

robustness of the 6,000 community banks that continue to exist in 

the United States today. 

Senator BROWN. And do you agree—I was not clear on how far 

your agreement with Dr. Hoenig was in terms of the advantages 

that large banks get over small banks in terms of the way the system has been built, that the less expensive the financial market, 

the advantages they get that way, in borrowing and other things. 

Mr. KROSZNER. Well, I think the community banks are largely in 

different markets than the largest five or six institutions, or three 

or four institutions, that are really focused internationally on very 

large lending. So there is a lot of separation in the activities that 

they undertake. There are concerns on both sides that there are 

some subsidies on the smaller bank side from some of the safety 

net as well as on the larger bank side, and I think a careful costbenefit analysis should be done to identify where those subsidies 

may be and, as much as possible, eliminate them, because I think 

both it is unfair and not good policy. 

Senator BROWN. And do you agree that there are different consequences if a small bank fails versus a larger bank fails? 

Mr. KROSZNER. There may well be different consequences. The 

key is whether you have correlation of the risk. So if it is just an 

isolated institution, just that there is a problem with that one institution, that is one issue. But if you have 1,000 institutions that are 

all doing the same business, exposed to the same risks, and if one 

goes down, that is effectively the same as a thousand of them going 
21 

down, then it may not make that much of a difference whether we 

have a few larger institutions or a thousand that may go down simultaneously. 

Senator BROWN. Thank you. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and thank both of 

you for being here, and Dr. Hoenig, thank you for the time we 

spent yesterday. I appreciate it and am looking forward to the 

Hoenig Rule someday. 

[Laughter.] 

Senator CORKER. But, look, you had made some comments earlier 

on. We had gone back, talking about Dodd-Frank itself, and I want 

to get to the model that you propose to have. It is really GlassSteagall on steroids in many ways. But you talked about DoddFrank and the fact that it actually made our banking system, our 

financial system, less safe, and I am just—and you went on to say, 

‘‘I do not see a system that is more safe. I see it as less safe. What 

about it has made it more safe?’’ When you say that, what is it in 

particular that you are referring to, if you can generalize? 

Mr. HOENIG. OK. What I am saying is if we have the elements 

of the resolution, which I think is extremely important, we also 

have the view that this new legislation will eliminate future crises 

that we have out there. And I think—I said I am skeptical, and I 

think skeptical is healthy in the sense that 30 years of asserting 

that we have no institution too-big-to-fail and then bailing them 

out is something that we need to be aware of. But, the real advantage is it makes us more resolute to make sure that we do take 

them into either bankruptcy or receivership going forward, and I 

think that is extremely important. 

Now, Dodd-Frank does give us the mechanism to do that. It is 

whether we have the will going forward. Now we have even larger 

institutions accumulating greater risk and concentration, so the 

‘‘will’’ part will be even more difficult come forward. 

What the proposal I put forward says is, let us take these highrisk activities and let us move them out into the market and let 

the market be the judge there, and the part that was meant to be 

protected by the safety net—the payment system, the settlement 

system, the intermediation process—let us allow that to continue 

to be protected, but we take these others where the subsidy has allowed the leverage to move up and take that away. Then DoddFrank becomes even more, I think, powerful in the sense of resolving institutions that, in fact, fail with the next crisis. And I think 

that is where we have an opportunity to strengthen our hand going 

forward. 

And I want to comment on the fact that if, as some people say, 

if you take this away, we will not be as competitive. But in the 

1980s and 1990s before the repeal of Glass-Steagall, the United 

States had the most vibrant banking and capital markets in the 

world. People came to us to get the financing, every bit as much 

as anywhere else in the world. When I say move them out, I do 

not mean let us eliminate market making. I do not mean, let us 

eliminate trading. I am saying, let us put it into the market where 

it can meet the market test, where it can be competitive and where 

the greatest innovation will come from. By putting them together 
22 

and putting that subsidy around it, I think you inhibit our ability 

to compete in the world today in a vigorous and in a capitalistic 

sort of way, and that is my whole point for this proposal. 

Senator CORKER. I know we had a lot of discussion around the 

Federal Reserve Rule 23(a), and I know we are going to talk about 

that some more later—— 

Mr. HOENIG. Right. 

Senator CORKER.——because there is a firewall that is being created there from the standpoint of money flowing back and forth 

and I look forward to future conversations there. 

But your approach is—what you are saying is you do not think 

Congress should even consider arbitrarily limiting the size of an institution. You think that separating one type of activity from the 

basic activities that banks did originally, you think separating 

those two is probably the best route to take, and over time, because 

of that separation, the size issue will resolve itself, is that correct? 

Mr. HOENIG. Yes. I am saying that if you try and resolve it by 

arbitrarily putting a size limit on, what is your principle for that? 

Is it antitrust? What is it? When you say, let us move these out, 

if you take these high-risk activities and move them out and make 

them subject to the market where they can fail, I think that becomes its own, if you will, control system. 

In commercial banking, now, we are going to have large institutions. We always have. But at least it allows the regional bank and 

the community bank to compete on a more equal footing. And this 

country has always had a range of very large institutions to very 

small in the financial side and it has paralleled our industrial 

side—large industrial to small. And we have been able to have a 

broad cross-section of each. 

We are now moving this into fewer and fewer institutions where 

everything has to take place and I think that disadvantages the 

vibrance of the United States, our entrepreneurial spirits that come 

from local financing, and I think it compromises that because it focuses everything on fewer and fewer banks over time, and that is 

what we want to avoid. I think we will always have large institutions, but when you level the playing field, I think you also allow 

for continuation of having small to medium to regional institutions 

competing and providing credit in the market. I think that not separating out the subsidy to the largest institutions handicaps the 

rest of the industry and, I think, handicaps, if you will, Main 

Street America. 

Senator CORKER. Well, listen, thank you, and again, I really enjoyed the time and look forward to furthering our conversations. I 

know the last two witnesses have referred to the resolution piece, 

and while it did not end up perfectly, that is certainly an area that 

I know myself and Senator Warner spent a lot of time on, and 

hopefully, officials will have the courage to put a bank out of its 

misery if it fails. I know the tools certainly have been given there. 

And I think there are some more evolutions that need to occur. I 

mean, some of the bankruptcy components that we were not able 

to get into the bill should be there. 

Dr. Kroszner, you spoke about—in your testimony, you made 

comments about cost-benefit analysis. I am hearing out there in 

sort of the world of people dealing with regulators that there really 
23 

are not appropriate cost-benefit analyses being done on these rules 

and there are many people who are predicting a plethora of lawsuits down the road as these rules actually come into play because 

the regulators are not adhering to Congressional mandates of ensuring that there are cost-benefit analyses. I am wondering if you 

are hearing the same thing. 

Mr. KROSZNER. Well, I think it is extremely important to focus 

on cost-benefit analysis. I mean, if you—and it has bipartisan support. I was actually recently reviewing the Executive Orders from 

President Reagan and from President Obama on exactly this issue 

and it is really quite surprising how similar they look. So I think 

there is agreement across the aisle that to make good policy, you 

have to think about the cost and the benefits. 

Obviously, there have been a number of lawsuits that some regulators have lost recently because they have not properly done economic analysis. I think it is very important to do that. I think that 

should be the focus of both thinking about what the objectives are, 

thinking about what the relevant alternatives are, and then doing 

as best a job as possible. It is never going to be perfect because you 

are trying to predict the future. You do not have the future data. 

But you can draw on historical analogies, international analogies, 

and different economic theories to try to get a feeling for what 

would make the most sense to try to address the objective you 

have. 

And I think that is very important, because one of the disciplines 

that cost-benefit analysis does, it asks you, what are you trying to 

achieve? Sometimes people just have various objectives that are not 

well specified, not well focused. But it forces the policy process to 

address that. And so the more that they do, the better it will be. 

Senator CORKER. Let me ask you this. What is driving many of 

the regulators that are promulgating these rules? What is driving 

them, especially around Dodd-Frank, not to be doing what they 

have been mandated to do as it relates to cost-benefit analysis? 

And, Dr. Hoenig, if you want to weigh in on that, because I do 

think these rules are going to be on their way for years. We have 

done anything but create predictability—— 

Mr. KROSZNER. Yes. 

Senator CORKER.——at a time when people talk about predictability. As a matter of fact, you would have to wonder what 

Congress’s intent was with all of Dodd-Frank when it was put in 

place from that standpoint. But what do you think is driving regulators to ignore this cost-benefit analysis and set themselves up for 

major setbacks down the road? 

Mr. KROSZNER. Well, I am hoping that they are not. I am not 

privy to the internal processes, so I do not want to say anything 

specific about any particular process. But I think a lot of regulations—a lot of regulatory processes, more than 100, I believe, were 

set in train by Dodd-Frank with a relatively tight time table. And 

so that perhaps may have put some constraints on the ability to 

take as much time to gather the data and do the analysis that is 

necessary. 

This is one of the issues, I think, that has come up with the 

many questions that were in the Volcker Rule proposal. A lot of 

them involved requests for data, which I think is exactly the right 
24 

thing for the regulators to do. And if it need be that it takes a little 

bit more time to do the analysis, to be able to draw the lines appropriately to really try to minimize unintended consequences and increase the robustness of the system, I would be very sympathetic 

to allowing more time for that. 

Mr. HOENIG. I would offer this. I am only getting involved in it 

in the last month, but I would share this observation, that there 

are two complaints that I see coming forward, that they are not 

moving fast enough and that they are moving—— 

Mr. KROSZNER. Too fast. 

Mr. HOENIG.——too fast. 

[Laughter.] 

Mr. HOENIG. I do think that they are being very careful, because 

I think most of the regulatory authorities understand the law of 

unintended consequences, have seen it and are worried about it, 

and, therefore, are trying to be very deliberate. And I know from 

experience that cost-benefit analysis is very time consuming and 

very slow and I think that is one of the reasons that, for some, this 

has been going slower than people would like. 

So I think there is a sincere effort to get this right, but it is a 

big piece of legislation. There are a lot of moving parts in it. And 

it is probably going to be hard to satisfy everyone when we get 

through with this. 

Senator CORKER. Thank you both very much. 

Senator BROWN. Thank you both for joining us. Dr. Hoenig, 

thank you and thanks for your service. And Dr. Kroszner, thank 

you very much for joining us. 

Mr. KROSZNER. Thank you. 

[Pause.] 

Senator BROWN. The third and final panel—thank you for joining 

us. Thank you very much for your patience and for waiting through 

two panels. They were interesting. I know we all learned—at least, 

I think, Senator Corker and I learned some things. 

Tom Frost is a lifelong banker, the fourth generation of his family to oversee the Frost Bank, which was founded in 1868 in San 

Antonio, Texas. He is the Chief Executive of the Board of Frost National, with 78 financial centers across Texas. 

Marc Jarsulic is no stranger to this Committee. He worked as an 

economist on the JEC, the Joint Economic Committee, and was a 

senior staffer for the Senate Committee on Banking under Chairman Dodd during the crafting of Dodd-Frank. Mr. Jarsulic currently serves as Chief Economist at Better Markets, an organization that promotes the public interest in the capital and commodities markets. 

James Roselle is the Executive Vice President and Associate 

General Counsel of Northern Trust Corporation, a global financial 

services firm based in Chicago. He is focused on regulatory changes 

resulting from Dodd-Frank and briefs his firm’s Board of Directors 

on these issues. 

And Mr. Anthony Carfang is the Director of Treasury Strategies. 

Mr. Carfang has helped some of the world’s largest banks and securities firms to position their services in the marketplace. He has 

advocated for the interests of his clients with regard to regulatory 

issues and liquidity management. 
25 

Thanks to all four of you. Mr. Frost, would you begin. 

STATEMENT OF TOM C. FROST, CHAIRMAN EMERITUS, FROST 

NATIONAL BANK 

Mr. FROST. Well, thank you for inviting me. It is a real honor for 

you to have me here, and I especially note that except for my compatriot from Northern Trust, we are the only people who are actually practicing in the industry that you are listening to. And I 

would hope that you would, in the future, hear more from us who 

are in the business than just listen to educators and regulators, 

many of whom I agree with, but I think to hear practitioners— 

banking has been in my DNA, as you said, for now 5 years [sic]. 

I am from San Antonio, Texas, and I served for 57 years, 26 of 

them as Chief Executive Officer of a commercial bank established 

by my Great-Grandfather. The institution grew and prospered 

through money panics, wars, and depressions, now with $20 billion 

in assets and now 115 offices, all of them in Texas. The Frost Bank 

did not take Government funds from the issuance of preferred 

stock in 1933 and was one of the first banks to refuse TARP money 

in 2008. 

I personally survived the very difficult times of Texas in the 

1980s where many lessons were learned and the Frost Bank was 

the only one of the top 10 commercial banks in Texas to survive 

through a period when a significant number of banks failed and 

most of the savings and loans were closed. 

I will start out with my first days as a young college graduate 

and a fresh employee of the institution I have just described, and 

I want to say as an aside, one of the things I am going to be talking about here is a difference in cultures, and I want you to focus 

on that. We have all talked about where people came from, how big 

they are, what kind of people, where we have not talked about the 

culture in which they lived and worked. 

My Great Uncle Joe, who was then CEO—this is 1950 when I 

got out of college—I was a young, inexperienced banker. I had been 

there in the summers. He told me that the very first goal we had 

was to be able to return the deposits received from the customers— 

the first goal we had. Our obligation was to take care of the community’s liquid assets and to manage them in a safe and sound 

fashion for the use—loans—of the community to grow. 

Uncle Joe told me in 1950 that we were not big enough to be 

saved by the Government, that we would need to always maintain 

strong liquidity, safe and sound assets, and adequate capital. I was 

impressed by the fact that the need to make money was not high 

on this list but does occur if sound banking practices are observed. 

Uncle Joe was not a fan of the FDIC. He told me it took his 

money to subsidize his inefficient competition. I personally support 

the FDIC as a protector for the depositor, but want to suggest that 

this safety net apply only to banks which receive FDIC-insured deposits. I am convinced that offering the safety net to other financial 

institutions which provide services not deemed appropriate for deposit loan commercial banking institutions is not sound public policy. 

The deposit facilities of financial institutions which provide primarily investment, hedging, and speculative services should have 
26 

no taxpayer safety net. These institutions should be governed by 

market forces with investors understanding what can be earned 

and what can be lost. This would involve the need to separate two 

cultures, the one which Uncle Joe articulated and our family has 

followed for 144 years, by establishing long-term customer relationships and building our community and preserving its liquid assets. 

Other financial institutions can provide the other services that are 

not authorized to insured deposit banks at a potential good profit, 

but without a taxpayer risk through a Federal safety net. 

I would suggest that the two types of institutions have separate 

ownership, separate management, and separate regulation. My 

conviction comes after seeing both systems, which were separated 

but now have been joined to create a situation which in 2008 

brought bout the near catastrophe of collapse of the world financial 

systems. Following the path that we are on currently will not only 

provide opportunity for the same occurrence to be—consequences to 

be repeated, but also mean the end of a banking system consisting 

of many providers. 

It seems we are rapidly approaching a system which will be an 

oligopoly of a few major institutions whose management will not 

only have the same concerns and dedications as emphasized by 

Uncle Joe. So if both cultures are separated, the clients of both will 

prosper, but without the inordinate risk of a potential massive cost 

to the taxpayer. 

I thank you for giving me the opportunity to express my opinion, 

which has been developed over a half a century’s experience and 

has led me to the conviction that the insured deposit banking system we had was effective, worked well, and did not require any significant Federal support until 2008 when other activities of large 

institutions involved in so-called investment activities nearly destroyed the financial system and imposed enormous costs on taxpayers to the present day. 

Gentlemen, what we are talking about is a conflict of cultures, 

and I would like to ask you to even stop and talk about doing something differently than what is proposed to you in Dodd-Frank and 

talking about the separation of the cultures, the absence of a Federal safety net for one, different regulation, different ownership, 

and the market activity organized—supported by one, and to take 

a look at a different way to do things, because if we keep things 

doing the same way over and over and expecting different results, 

I think, facetiously, that is called insanity, and I think we are on 

the level of going to do the same thing over and over and over 

again with what we are proposing. 

Thank you. 

Senator BROWN. Thank you, Mr. Frost. We appreciate your comments. 

Mr. Jarsulic, welcome again back to the Committee. 

STATEMENT OF MARC W. JARSULIC, CHIEF ECONOMIST, 

BETTER MARKETS 

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

Corker. Thank you for the invitation to Better Markets to testify 

today. 
27 

Let me start with the observation that the very largest bankholding companies, which for convenience we can think of as the 

10 largest, are now distinctly different from the rest of the banking 

industry. They are more highly leveraged than other banks. They 

are far more likely to operate large and complex broker-dealers. 

And they are more likely to be directly dependent on unstable 

sources of short-term financing. Each of these characteristics made 

the large bank-holding companies vulnerable during the financial 

crisis and each of these characteristics needs to be addressed by effective implementation of relevant sections of the Dodd-Frank Act. 

During the crisis, high leverage, that is, a high ratio of assetsto-equity, increased the likelihood that the large bank-holding companies would become insolvent if asset prices declined significantly. 

During the period 1990 to 2000, the 10 large bank-holding companies had a leverage ratio of about 20-to-1, which in itself is fairly 

high. By the end of 2000, the leverage ratio had risen to 34, and 

this put the large bank-holding companies at approximately the 

same level of the five largest stand-alone investment banks, who 

had a leverage ratio of 36. 

Thus, in 2007, large bank-holding companies, like the large investment banks, could see their equity wiped out by a 3-percent decline in asset values. Their funding sources and assets were not 

identical to the investment banks, but on the important dimension 

of leverage, they were in the same ballpark. 

Proprietary trading made them less safe because the speculative 

positions can quickly produce large unexpected losses which may 

not be backed up by sufficient capital. I think the trading losses at 

Citigroup are a case in point. As part of its trading operations, 

Citigroup was one of the largest issuers and traders of CDOs in the 

world, many of them backed by subprime mortgage-backed securities. But Citigroup was unwilling to sell the so-called super senior 

tranches of these CDOs at market clearing prices, so between 2003 

and 2007, they accumulated $43 billion worth of these securities 

which they held in conduits and in the trading book. But in 2007, 

when the subprime mortgage market tanked, Citigroup had to 

start writing things down, and by the end of 2008, they lost $39 

billion on these CDO-related positions. So very early in the crisis, 

proprietary trading did significant damage to a big bank-holding 

company. 

A final area of instability comes from the dependence of the large 

bank-holding companies on short-term very unstable financing. 

This makes the banks less safe because creditor runs can force 

asset sales and realization of losses. And during the crisis, there 

were runs on both repo borrowing and asset-backed commercial 

paper. The trading operations of the large bank-holding companies 

and investment banks are often highly dependent on repo funding, 

which is collateralized short-term borrowing, often for periods as 

short as a day. It is estimated that in 2007, the five largest investment banks funded as much as 42 percent of their assets on repo 

funding. That is, they were borrowing every day to support their 

book, and I do not think there is a good reason to believe that bank 

traders were operating differently. 

Second, the banks commonly use conduits, which issue shortterm commercial paper backed by a pool of assets, because it allows 
28 

them to increase their leverage at a relatively low cost. But again, 

there was a run on asset-backed commercial paper during the crisis 

and ultimately the Federal Reserve had to step in to rescue this 

market. 

Given the scale of the large bank-holding companies, these 

vulnerabilities also threaten the financial stability of the system as 

a whole. No large bank-holding company failed, but I think if you 

look back to the scale and scope of the rescue effort at Citigroup, 

we can see that it was a very close thing. 

So to prevent the recurrence of near catastrophes in the future, 

regulators need to use the tools created by Dodd-Frank to eliminate 

the threats to financial stability that are caused by large bankholding companies. In particular, we need, one, effective leverage 

limits for the largest bank-holding companies. Section 165 of the 

Dodd-Frank Act gives the Federal Reserve the option to impose 

much higher capital requirements on the banks. The Fed is imposing Basel III requirements, and these, for reasons we could talk 

about, seem relatively inadequate. 

Second, effective implementation of the Volcker Rule would do a 

lot to reduce the risk created by bank trading operations, and I 

think that there are two parts to this. One is a well defined definition of market banking so that it cannot be gamed and cannot become a source of risk. But of equal importance are significant leverage limits on trading operations because they are based on a funding model which is highly leveraged and highly unstable. 

And finally, there needs to be an effective regulation of shadow 

banking activity, in particular, aspects of the shadow banking industry that cause potential creditor runs on these big bank-holding 

companies, for example, the behavior of the conduit market. 

Taking these steps, I think, will go a long way to containing the 

risk posed by the size and complexity of the largest bank-holding 

companies. Thank you. 

Senator BROWN. Thank you. 

Mr. Roselle, thank you for joining us. 

STATEMENT OF JAMES E. ROSELLE, EXECUTIVE VICE PRESIDENT AND ASSOCIATE GENERAL COUNSEL, NORTHERN 

TRUST CORPORATION 

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

Corker. I appreciate the opportunity to testify before you today on 

behalf of Northern Trust. 

Northern Trust supports the very positive efforts of Congress and 

this Committee to put in place reforms that reduce risk to the financial system, and many of those are included in the Dodd-Frank 

Act. Those are all very good reforms. However, it is essential that 

efforts to reduce risk are carefully calibrated so they do not inadvertently restrict or harm core banking activities that serve the 

needs of customers in the United States and around the world, that 

provide employment for our citizens, and that promote the economy. 

I would like to focus my testimony on specific provisions contained in the Volcker Rule to show why it is so important to consider the full impact of regulatory reforms in order to avoid unin-
29 

tended negative consequences for individual banks and for the 

economy more generally. 

Northern Trust does not engage in the types of activities the 

Volcker Rule intended to prohibit. In fact, we heard from Chairman 

Volcker earlier that he thought the proprietary trading rules would 

only impact maybe six to eight institutions. I wish that were true. 

Specifically, Northern Trust does not engage in high-risk proprietary trading and investment activities. Because of the traditional 

nature of our core banking business, we anticipated the Volcker 

Rule would have little or no impact on our business. The rules as 

currently proposed, however, will adversely impact traditionally 

low-risk business activity that investors rely on for investment 

management purposes. If not corrected in the rulemaking process, 

a core banking business of Northern Trust and other banking companies will be adversely impacted, which may ultimately impair 

the competitiveness of U.S. banks in a business where we are the 

acknowledged global leaders. 

Today, I want to summarize three parts of the proposed rule to 

implement Volcker that go beyond what the law requires and that 

may significantly impact Northern Trust and our clients. First, the 

proposed rule unnecessarily includes a broad range of funds that 

banking entities will be restricted from sponsoring or investing in. 

The definition of a covered fund would capture nearly all foreign 

funds, as well as many other entities that do not have traditional 

hedge fund or private equity fund characteristics. This definition is 

important, because if a bank is deemed to be a sponsor or an advisor to a covered fund, then the proposed rule—then under the proposed rule, the bank is prohibited from providing any credit whatsoever to the fund under the super 23(a) provisions. 

Ordinary custodial and administrative services provided to our 

clients must include the provision of intra-day or short-term extensions of credit to facilitate securities settlement, dividend payments, and similar custody-related transactions. These payment 

flows are expected in order for transaction settlements to operate 

smoothly and they have been encouraged by global financial supervisors. Nevertheless, these low-risk extensions of credit appear to 

be considered as prohibited covered transactions under the proposed rule. 

Second, the proposed inclusion of foreign exchange swap and forward transactions within the proprietary trading prohibitions will 

result in damage to a traditional and low-risk activity with no offsetting benefit to the U.S. financial system. As a significant global 

custodian and asset manager, Northern Trust carries on an active 

foreign exchange trading operation that is directly related to our 

core client services. In essence, these currency transactions are 

simple cash management transactions used by our clients to efficiently manage cross-currency needs. The agencies should exclude 

these transactions from the trading restrictions for the same reason 

that the Treasury Secretary proposed to exclude them from Title 

VII of Dodd-Frank. 

Third, the compliance requirements in the proposed rule are unduly burdensome and will unnecessarily increase compliance costs 

for banks with little or no offsetting benefit. The proposed rule essentially requires the bank to prove that each transaction does not 
30 

fall within the prohibited category and requires banks to produce 

a large number of compliance metrics which will result in considerable systems expenditures and ongoing costs of compliance. We believe the agencies could carry out the intent of Congress more effectively and with less cost to the banking system with a simpler rule 

that is supplemented by a few key metrics and active supervision 

of bank trading risks and practices. 

We urge this Committee to encourage the agencies to adopt final 

regulations that carry out Congressional intent to prohibit highrisk trading and investment activities but not to adversely impact 

those traditional business activities that played no role in causing 

the financial crisis. Preserving our business models will ensure 

that U.S. banks can operate effectively and competitively while protecting against negative impacts on the broader economy and U.S. 

employment. 

Thank you, Chairman Brown, Ranking Member Corker, for allowing me to present Northern Trust’s views on this critically important topic. 

Senator BROWN. Thank you, Mr. Roselle. 

Mr. Carfang, welcome. Thank you for joining us. 

STATEMENT OF ANTHONY J. CARFANG, PARTNER AND DIRECTOR, TREASURY STRATEGIES, INC., ON BEHALF OF THE U.S. 

CHAMBER OF COMMERCE 

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

Corker. I am delighted to be here today on behalf of the U.S. 

Chamber of Commerce, the three million members, each of whom 

are customers of banks. So we are representing the customer side 

this afternoon, as well. 

My name is Tony Carfang and I am partner with Treasury Strategies. We are a leading consulting firm in the area of Treasury and 

cash management. We help corporate treasurers day in and day 

out manage their risk, raise their capital, fund their accounts, and 

meet their payrolls. We also work with the financial institutions, 

large and small, in fact, around the globe, who provide services to 

businesses to make productive use of their capital. 

I would like to leave you with four messages today. Number one 

is that the U.S. economy is the most capital efficient in the world. 

None comes close, and I will share with you some statistics in a 

second. But I want to say that this is a delicate balance and we 

need to make sure as we move to the next generation of financial 

services we do not destroy the capital efficiency that we have 

worked two centuries to achieve. 

Number two is that the U.S. financial system is a very delicate 

mosaic of banks, money market funds, securities firms, institutions 

large and small serving corporations large and small who have 

needs that in some cases are regional, in some cases are global, 

some are industry specific, and what we have is actually a very 

beautiful mosaic of all of this coming together, and we need to understand how this all works before we begin changing it. 

The third point I would like to make today is that risk is like 

energy in that it can neither be created nor destroyed. It can only 

be transferred. So please do not be lulled into thinking that if you 

eliminate a risk in a particular institution that that risk goes 
31 

away. It goes somewhere else and we need to understand where it 

goes. So, for example, if a bank is unable to help a client hedge 

commodities, let us say, and there is a farmer out there somewhere 

whose profit, whose crop is at risk, so we have taken the risk out 

of the bank and put it back on the farm. We need to be careful 

about that. Similarly, a manufacturer who cannot hedge foreign exchange may choose not to export and may actually shrink the size 

of the company. There is an interconnectedness here that we need 

to be very careful to preserve. 

The fourth point I would like to make is that we are in the midst 

of an uncontrolled experiment. Now, we are not arguing against 

regulation at all, but what is happening is that there are a number 

of regulations being promulgated around the world right now that 

are directed at financial institutions, things like Basel III, things 

like derivative regulation, new talk of another round of money market fund regulations. All of these are untested and they are all designed, oriented toward financial institutions, but, frankly, they all 

land on the desk of the corporate treasurer. The financial institutions are the intermediaries. It is the consumer, it is the business 

person, it is the corporate treasurer that is dealing with all of these 

simultaneously. 

Senator, you raised the question of cost-benefit analysis earlier, 

and frankly, not only do each of these need to have a much more 

thorough cost-benefit analysis, but they need to be analyzed in the 

context of their interrelationship and what it means to simultaneously change a liquidity requirement, add a capital requirement, 

eliminate a trading business, and throw in a little bit of risk management or whatever you want. We have an experiment that is 

moving out of control. 

I would like to go back to the point of capital efficiency because 

that is a hallmark of American business. U.S. companies are sitting 

on a record amount of corporate cash, and I am sure you see those 

headlines, $2.2 trillion at the end of the last quarter. That represents 14 percent of U.S. GDP. A similar ratio in Europe is 21 

percent. That is, European corporations hold cash on their balance 

sheets equal to 21 percent of the total GDP of the Euro zone. You 

might say we are 50 percent more efficient. Should we lose this 

capital efficiency and companies move to this 21 percent range as 

a result of some regulations that are not totally thought through, 

that $2.2 trillion on Americans’ balance sheets at 14 percent, 21 

percent, that translates to $3.3 trillion. 

We are, in effect, taking $1.1 trillion out of the U.S. economy, 

putting it in cash on balance sheets and effectively sidelining it. So 

we have the potential here of destroying capital efficiency that has 

a magnitude that is greater than the entire stimulus program, $1.1 

trillion. That is more than QE II. That is more than the entire 

TARP program. So I think we are playing with fire here and we 

need to be very, very careful, hence the point on an appropriate 

cost-benefit analysis not only on one regulation but across the 

board. 

We want to make sure that America’s businesses can continue to 

have access to the capital markets and raise capital as efficiently 

as possible so that they can grow their businesses, so that they can 

create jobs, so that they can manage their risk. 
32 

And I would say to you the real threshold question and what we 

are putting at risk here is when a business’s treasurer calls a bank 

to raise capital or to manage risk, is there going to be a U.S. banker there to answer the call? 

Thank you very much. 

Senator BROWN. Thank you, Mr. Carfang. 

I am a little confused. I was going to go in a different place, but 

I want to follow up with your last statement there. 

Mr. CARFANG. Sure. 

Senator BROWN. The $2.2 trillion, the 14 percent of GDP that 

sits as cash reserves, these are not just banks. These are—you are 

talking about all American companies? You are talking about 

Alcoa, any large manufacturers that sit on large cash reserves? 

Mr. CARFANG. I am talking about all of America’s nonfinancial 

corporations. This is published each quarter—— 

Senator BROWN. Yes. I guess—that seems—I know of that. I 

think we hear that often—— 

Mr. CARFANG. Yes. 

Senator BROWN.——and I guess I do not think that it is a regulatory issue as much as it is these companies do not see, for reasons of uncertainty or reasons of lack of demand, do not see it as 

good economics for their companies, good policies for their companies to invest back in job creation, invest in capital equipment. 

That is my understanding. 

Mr. CARFANG. Well, and they also need that for working capital 

and precautionary needs, as you just pointed out. And my point is 

that the comparable number in Europe is 50 percent higher—— 

Senator BROWN. Right. I got that, the 14 versus 21. I guess when 

I talk to—and my State, Ohio, has a large number of major manufacturers. They tell me, 5 years ago, that a company might have 

had $100 million in cash reserves, now has $400 million. That is 

not a question of they need more in order to potentially protect 

themselves as much as it is they do not see the demand in the marketplace for them to reinvest in the company, or they use those dollars to buy other companies or stockpayer—stocks, whatever. OK. 

Let me go somewhere else with this, and thank you for that insight, Mr. Carfang. 

Mr. Frost, you had mentioned, I thought, importantly so, that 

you and Mr. Roselle are the only people that are working actually 

in banks on any of three panels of the seven of you here today. Let 

me ask you a question based on that. You are $20 billion in assets, 

48th largest bank in the United States. That is one-one-hundredfifteenth the size of the largest bank in the United States. The 

former executive of a trillion-dollar bank told the Financial Crisis 

Inquiry Commission that it is impossible for executives to understand the balance sheet of an institution of that size—that size, 

115 times your size—on a daily basis. 

I asked Mr. Kroszner and Mr. Hoenig about that. Do you think 

those institutions, those five, six, seven, those institutions that are 

a $1.5, $2 trillion in assets, are they too big to manage? We had 

that question on the last panel. In your mind, from your experience 

of 60 years at the bank and your family’s experience, are these too 

big to manage? 
33 

Mr. FROST. I think, because of the cultures, they are impossible 

to both be managed by the same manager. Now, you have read, 

maybe, about Built to Last and Good to Best [sic], the books, and 

those books say that the most effective corporations in all of America that were built to last did not have profit as a major objective 

of the company, and the ones that went from good to best reduced 

the level of profit making. So you have got a culture with the large 

investment financial firms that deal only with transactions, where 

the transactions work out to a direct impact on the pocket of the 

person who is dealing with the customer. That is what investment 

banking does, and they do it beautifully. 

When you talk about Uncle Joe and talking to me, profit was 

down at the bottom of the list, and our present mission statement 

is we will grow and prosper by building long-term relationships 

based on good service and high ethical standards and safe and 

sound assets. But I want to tell you, the reason our mission statement is that way has nothing to do with profit. It tells everybody 

what to do when they come to work every day. Build relationships. 

We build them with each other to have the ability to take care of 

customers. We build the customers to take care of us. 

So I do not think when you have the transactional businesses 

that we are—Mr. Volcker talked all about them, the man from the 

Federal Reserve of Kansas City later on talked about it. When you 

have a manager that is basically thinking about his own pocketbook and what he is going to gain by the dollars and cents that are 

coming down and not thinking of the customer, you have a different culture than the one that I have grown up in, the Kempers 

in St. Louis—I mean, in Missouri, there are two of them in Kansas 

City, run beautiful banks, there is a man in Oklahoma who runs 

the Bank of Oklahoma, same way. When you are working to take 

care of the relationships with your customers for what will be of 

value and benefit to them and taking care of them and great value 

to the whole economy, the whole community, and profit comes if 

you do that well without starting out and saying, I am making a 

deal today because it is going to bring $500,000 into my pocket at 

the end of this year by the bonus I am going to get. 

So my answer is you cannot have the two cultures in one entity. 

They have got to be in separate entities. And I am, in all due deference to the U.S. Chamber of Commerce, we had big financial institutions, Goldman Sachs and others, that were doing very well 

taking care of big companies internationally and we had big banks 

that we could take care of and compete with very satisfactorily, 

even though we are in different markets with the smaller entities, 

and that system worked. 

So in answer to your question, I think if we have the cultures 

that do not understand, that operate differently, I think you cannot 

possibly succeed, and that is what 2008 brought us. Two-thousandeight brought us the disaster of the culture that had profit at the 

top of what they wanted to do. They did not care who ended up 

with those mortgage bonds. They only cared about the interest to 

them. And every single step felt that way in those mortgage things, 

right down to the last poor dumb guy that bought them without 

doing anything but looking at the ratings, and what we had was 
34 

a disaster because everybody down the line was just making some 

money off of it and had no vigorish in the game. 

So, to me, your answer—my answer is, you cannot put the two 

together. That is what we have demonstrated by getting away from 

Glass-Steagall. You cannot put them together. You will have a disaster. You will keep doing the same thing over again, and that is 

the definition—and expecting a different result, and that is the definition of insanity. 

Senator BROWN. Thank you, Mr. Frost. A 144 years of success is 

hard to argue with. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and I thank all of 

you for your testimony. 

If I understand you, Mr. Frost, what you are, I think, advocating, 

generally speaking—I know it is a very general statement—but basically, Dodd-Frank did everything but address the core issue from 

your perspective. It went around the world trying to address all 

these little things that at the end of the day you think best could 

be resolved by sacking Dodd-Frank and just going back to GlassSteagall, or maybe what Mr. Hoenig was referring to, GlassSteagall on steroids. Is that a generalization of what you are saying? 

Mr. FROST. Well, yes, both of them are, but Dodd-Frank, of 

course, had a big package of things that, I think, were a big mistake and ought to have been dealt with separately, and I am only 

talking about one of them and the one of them is the separation 

of the two financial systems, the one with the safety net which 

worked and we had—we solved in this country every single commercial bank failure, including all the large banks in Texas. And 

I do not care what Governor Perry said running for President. 

Texas has had a few things that were not exactly perfect—not very 

many, but the banks were one. And what we have done is we had 

a system that worked and not a single penny of taxpayer money 

went to solve one of those banks. The taxpayer money went to take 

care of those savings and loans that you allowed to go in and do 

things that—you, the Congress, allowed to go in and take interest 

in entities to which they were lending. 

So what I am saying is we had a system that worked. It can continue to work regardless of the size of the two if you separate the 

cultures. Let one have a safety net and have a regulation that does 

not allow it to do certain things and the other has no Government 

safety net, but has different regulation that makes them lose 

money and not ruin the system. 

Right now, the Dodd-Frank is just a real mish-mash of things to 

do, including protect consumers, protect mortgages, manage big 

banks, and let me tell you, we have all been hearing today about 

how to handle the big banks, and the unintended consequences 

which many people here mention is what is happening to us in the 

smaller banks. We are getting killed by this thing because you are 

not paying attention, Mr. Chamber of Commerce, to the mosaic and 

the change in the mosaic. It ain’t the mosaic that we saw before 

we took away Glass-Steagall. It is a different mosaic. 

We have got 52 percent of the banking assets inside about four 

or five banks, and if we make separate businesses of them, about 
35 

one-half the assets of those two large banks are at the at risk part 

of investment banking and only one-half are in deposit insured 

things, and why do you have the taxpayer insuring deposits to give 

to somebody to go out and use it for something else. That does not 

make any sense at all. We made a big mistake in putting these two 

things together. I supported it. I have made a few mistakes in my 

life and that is one of them I will admit, and I will make some 

more, I am sure. 

But we are on the wrong path. That is my message to you all. 

And we are on the wrong path because the cultures are different 

and you are trying to regulate them together with a thing that no 

human being can either manage or regulate, in my opinion. 

Senator CORKER. Mr. Roselle, you run a really boring operation 

yourself and it does a different—is involved in different kinds of activities than was just described, and you are the other true practitioner that is here, although the others obviously have a lot of wisdom. How would you respond to what Mr. Frost just said? 

Mr. ROSELLE. That is a challenge, Senator. Let me say this. I 

think we are not going down the wrong path. I believe that DoddFrank has a lot of very positive aspects to it. I think improvement 

of capital ratios, capital planning, resolution planning, liquidation 

authority, improvements in governance and risk management, 

those are all very positive aspects of the Dodd-Frank Act and I 

think the financial system is much better off for many of those. 

There are a lot of details in the Act that do create issues for us, 

and—— 

Senator CORKER. What about—and I—— 

Mr. ROSELLE. Sure. 

Senator CORKER.——and you did a great job in your testimony 

of laying out some of those, but from the standpoint of Mr. Frost’s 

real solution to this, I mean, I just wonder if your point of view— 

if you share his point of view regarding the total separation and 

really returning to Glass-Steagall. 

Mr. ROSELLE. I do not share that point of view. I—— 

Senator CORKER. I thought you might not. That is why I asked 

the question. 

[Laughter.] 

Mr. ROSELLE. But even though we are not in a lot of those businesses, Senator, I think it is a mistake to try to put in place a separation that is based on a decision made at a point in time that 

becomes immutable. Things change. Financial markets change. Client needs change. And I think we as institutions and as the financial system need to be in a position to meet those changes. 

I will give you an example. Northern Trust used to be primarily 

almost exclusively in the wealth management area. We serviced 

private clients, and out of that we found a lot of those clients needed us to keep custody of their assets. We started doing that. We 

started doing that around the world as they invested globally. That 

emerged, or that evolved into the need for foreign exchange transactions to support those clients. Securities lending came out of custody. Things evolve, and I think it is a mistake to try to have an 

artificial separation. 

Absolutely, we should have tight controls and good oversight, and 

that is why I referred to a lot of the good parts of Dodd-Frank that 
36 

I think do that. But I think to have an artificial separation that 

says, this one set of activities are going to be here and another are 

going to be over there does not make sense, and frankly, I do not 

know that it really does anything to reduce risk. It drives those activities, perhaps, into a less regulated environment that may create 

much higher risk as we go down the road. So I would be very careful about any kind of separation like that. 

Mr. FROST. May I make one comment on that? 

Senator BROWN. Very brief, Mr. Frost. 

Mr. FROST. All right. I want to make clear that I did not say that 

there would be total separation. There would be overlaps of things 

that those banks can do. We did that with Glass-Steagall. So I 

think a lot of the things he is talking about could be done by the 

commercial banks and they could be done by the investment banks 

and there could be overlaps. 

One of the very significant things we all did years ago was the 

banks did—underwrote and handled the markets on Government 

bonds and tax supported municipals and so did the investment 

bankers. So I am not talking about where you would take a total 

separation of everything. I am talking about only those things that 

we have had to pay for and the taxpayer should not have to pay 

for and should be done by markets instead of by an underwriting 

that we now have on deposits and using the Federal underwriting. 

That is why people go to the big banks. They have got the Federal 

underwriting of money, that if they want, they can take it and put 

it in these other things. 

I am saying too much. I know that it is a thing that we all feel 

very strongly about and you do, too, and thank you for listening to 

me. 

Senator BROWN. Thank you all. Mr. Frost, thank you, and Mr. 

Roselle, thank you, and Mr. Carfang, thank you very much. 

Before calling the hearing to a close, I would like to make one 

comment about a program that is especially important to community banks that are forced to compete with Government, in my 

mind, subsidized mega-banks. The FDIC’s Transaction Account 

Guarantee, or TAG program, expires at the end of the year. It has 

been a valuable tool for America’s community banks and it has not 

cost taxpayers a dime. I believe we must extend this program. I 

look forward to working with both the Chairman and the Ranking 

Member of the full Committee and with Senator Corker to extend 

the TAG program so community banks can continue to compete. 

Thank you all for joining us. Some Members of the Subcommittee 

may have questions for any of the four of you or the three on the 

first two panels. We may send you questions, and they will be submitted within a few days and we would like your answer within a 

week if they do that. 

So thank you very much for being with us. The hearing is adjourned. 

[Whereupon, at 4:04 p.m., the hearing was adjourned.] 

[Prepared statements and additional material supplied for the 

record follow:] 
37 

1 Alan Greenspan, 1996. 

PREPARED STATEMENT OF PAUL A. VOLCKER 

CHAIR, PRESIDENT’S ECONOMIC RECOVERY ADVISORY BOARD, AND

FORMER CHAIRMAN, BOARD OF GOVENORS OF THE FEDERAL RESERVE SYSTEM

MAY 9, 2012 

‘‘Too Big To Fail’’—the Key Issue in Structural Reform 

The greatest structural challenge facing the financial system is how to deal with 

the wide-spread impression—many would say conviction—that important institutions are deemed ‘‘too large or too interconnected’’ to fail. During the crisis, creditors—and to some extent stockholders—were in fact saved by injection of official 

capital and liquidity in the aggregate of trillions of dollars, reinforcing the prevailing attitudes. 

Few will argue that the support was unwarranted given the severity of the crisis, 

and the danger of financial collapse in response to contagious fears, with the implication of intolerable pressures on the real economy. But there are real consequences, 

behavioral consequences of the rescue effort. The expectation that taxpayers will 

help absorb potential losses can only reassure creditors that risks will be minimized 

and help induce risk-taking on the assumption that losses will be socialized, with 

the potential gains all private. Understandably the body politic feels aggrieved and 

wants serious reforms. 

The issue is not new. The circumstance in which occasional official rescues can 

be justified has long been debated.1 What cannot be in question is that the prevailing attitudes and uncertainties demand an answer. And that answer must entail 

three elements: 

First, the risk of failure of ‘‘large, interconnected firms’’ must be reduced, whether 

by reducing their size, curtailing their interconnections, or limiting their activities. 

Second, ways and means must be found to manage a prompt and orderly financial 

resolution process for firms that fail (or are on the brink of failure), minimizing the 

potential impact on markets and the economy without massive official support. 

Third, key elements in the approach toward failures need to be broadly consistent 

among major financial centers in which the failing institutions have critical operations. 

Plainly, all that will require structural change embodied in legislation. Various 

approaches are possible. Each is difficult intellectually, operationally, and politically, but progress in these areas is the key to effective and lasting financial reform. 

I think it is fair to say that in passing the Dodd-Frank legislation, the United 

States has taken an important step in the needed directions. Some elements of the 

new law remain controversial, and the effectiveness of some of the most important 

elements are still subject to administrative rule writing. Most importantly, a truly 

convincing approach to deal with the moral hazard posed by official rescue is critically dependent on complementary action by other countries. 

In terms of the first element I listed to deal with ‘‘too-big-to-fail’’—minimizing the 

size and ‘‘interconnectedness’’ of financial institutions—the U.S. approach sets out 

limited but important steps. The size of the major financial institutions (except for 

‘‘organic’’ growth) will be constrained by a 10 percent cap on their share of bank 

deposits and liabilities. That cap is slightly higher than the existing size of the largest institutions, and is justified as much to limit further concentration as by its role 

as prudential measures. 

The newly enacted prohibitions on proprietary trading and strong limits on sponsorship of hedge and equity funds should be much more significant. The impact on 

the sheer size of the largest U.S. commercial banking organizations and the activities of foreign banks in the United States may be limited. They are, however, an 

important step to deal with risk, conflicts of interest, potentially compensation practices and, more broadly, the culture of banking institutions. 

The justification for official support and protection of commercial banks is to assure maintenance of a flow of credit to businesses and individuals and to provide 

a stable, efficient payment system and safe depository. Those are both matters entailed in continuing customer relations and necessarily imply an element of fiduciary responsibility. Imposing on those essential banking functions a system of highly rewarded—very highly rewarded—impersonal trading dismissive of client relationships presents cultural conflicts that are hard—I think really impossible—to 

successfully reconcile within a single institution. In any event, it is surely inappropriate that those activities be carried out by institutions benefiting from taxpayer 

support, current or potential. 
38 

Similar considerations bear upon the importance of requiring that trading in derivatives ordinarily be cleared and settled through strong clearing houses. The purpose is to encourage simplicity and standardization in an area that has been rapidly 

growing, fragmented, unnecessarily complex and opaque and, as events have shown, 

risk prone. 

There is, of course, an important legitimate role for derivatives and for trading. 

The question is whether those activities have been extended well beyond their economic utility, risking rather than promoting economic growth and efficient allocation of capital. 

There is one very large part of American capital markets calling for massive 

structural change that so far has not been touched by legislation. The mortgage 

market in the United States is dominated by a few Government agencies or quasigovernmental organizations. The financial breakdown was in fact triggered by extremely lax, Government-tolerated underwriting standards, an important ingredient 

in the housing bubble. The need for reform is self-evident and the direction of 

change is clear. 

We simply should not countenance a residential mortgage market, the largest part 

of our capital market, dominated by so-called Government-Sponsored Enterprises. 

Collectively, Fannie Mae, Freddie Mac and the Home Loan Banks had securities 

and guarantees outstanding that exceed the amount of marketable U.S. Treasury 

securities. The interest rates on GSE securities have been close to those on Government obligations. 

That was possible because it was broadly assumed, quite accurately as it has 

turned out, that in case of difficulty those agencies would be supported by the 

Treasury to whatever extent necessary to maintain their operations. That support 

was triggered in 2008, confirming the moral hazard implicit in the high degree of 

confidence that Government-Sponsored Enterprises would not be allowed to fail. 

The residential mortgage market today remains almost completely dependent on 

Government support. It will be a matter of years before a healthy, privately supported market can be developed. But it is important that planning proceed now on 

the assumption that Government-Sponsored Enterprises will no longer be a part of 

the structure of the market. 

It is evident that there is not yet full international agreement on elements of the 

basic structural framework for banking and other financial operations. Some jurisdictions seem content with what is termed ‘‘universal banks’’, whatever the conflicts, 

risks and cultural issues involved. In the United States, there are restrictions on 

the activities of commercial banking organizations, particularly with respect to trading and links with commercial firms. 

Financial institutions not undertaking on commercial banking activities will be 

able to continue a full range of trading and investment banking activities, even 

when affiliated with commercial firms. When deemed ‘‘systemically significant’’, they 

will be subject to capital requirements and greater surveillance than in the past. 

However, there should be no presumption of official support—access to the Federal 

Reserve, to deposit insurance, or otherwise. Presumably, failure will be more likely 

than in the case of regulated commercial banking organizations protected by the official safety net. Therefore, it is important that the new resolution process be available and promptly brought into play. 

In the U.K., another approach has been supported by the current government: a 

‘‘pure’’ deposit taking and lending bank would be separated from an investment 

bank within the holding company. A ‘‘ring fence’’ would strictly limit contact between the two businesses. 

As an operational matter, some interaction between the retail and investment 

banks is contemplated in the interest of minimizing costs and facilitating full customer service. American experiences with ‘‘fire walls’’ and prohibitions on transactions between a bank and its affiliates have not been entirely reassuring in practice. Ironically, the philosophy of U.S. regulators has been to satisfy itself that a financial holding company and its nonbank affiliates should be a ‘‘source of strength’’ 

to the commercial bank. That principle has not been highly effective in practice, and 

does not appear to be a part of the U.K. approach. 

More broadly, a comprehensive approach internationally is seen to be developing 

in which systemic oversight is coupled with resolution authority for both banks and 

nonbanks. A dividing line between those activities worthy of government support 

and those that are not is common to both the U.S. and U.K. approaches. 

The Volcker Rule is a part of this formula, and should not be considered in isolation against the total task at hand. Coupled with increased capital requirements, 

the Dodd-Frank legislation, if fully enforced, is a solid step toward reigning in ‘‘toobig-to-fail’’. 
39 

The regulators are still hard at work completing the important rulemaking, and 

will soon turn their attention to constructing the supervisory manuals and other 

tools of enforcement. After the transition period when the legislation and new capital requirements are a functioning part of our financial and supervisory system, not 

only should risk be reduced but important cultural issues will begin to be addressed. 

Unfinished business remains. Money Market Mutual funds are another example 

of moral hazard, and seem to me more amenable to structural change. By grace of 

an accounting convention, shareholders in those funds are permitted to meet requests for withdrawals upon demand at a fixed dollar price so long as the market 

valuation of fund assets remains within a specified limit around the one dollar ‘‘par’’ 

(in the vernacular ‘‘the buck’’). Started decades ago essentially as regulatory arbitrage, money market mutual funds today have trillions of dollars heavily invested 

in short-term commercial paper, bank deposits, and notably recently, European 

banks. 

Free of capital constraints, official reserve requirements, and deposit insurance 

charges, these MMMFs are truly hidden in the shadows of banking markets. The 

result is to divert what amounts to demand deposits from the regulated banking 

system. While generally conservatively managed, the funds are demonstrably vulnerable in troubled times to disturbing runs, highlighted in the wake of the Lehman 

bankruptcy after one large fund had to suspend payments. The sudden impact on 

the availability of business credit in the midst of the broader financial crisis compelled the Treasury and Federal Reserve to provide hundreds of billions of dollars 

by resorting to highly unorthodox emergency funds to maintain the functioning of 

markets. 

The time has clearly come to harness money market funds in a manner that recognizes both their structural importance in diverting funds from regulated banks 

and their destabilizing potential. If indeed they wish to continue to provide on so 

large a scale a service that mimics commercial bank demand deposits, then strong 

capital requirements, official insurance protection, and stronger official surveillance 

of investment practices is called for. Simpler and more appropriately, they should 

be treated as an ordinary mutual funds, with redemption value reflecting day by 

day market price fluctuations. 

I call your attention to another piece of unfinished business. It should be simpler 

because it has already been passed into law: specifically a member of the Federal 

Reserve Board should be designated as Vice Chairman for Supervision. Supervision 

of the banking and financial system should have a strong and visible place on the 

agenda at the Federal Reserve. It should have a proper focus in Congressional oversight. That the position remains unfilled, 2 years after its authorization and in the 

midst of financial uncertainty, is a mystery to me. 

THE ‘‘VOLCKER RULE’’, SOVEREIGN DEBT, AND INTERNATIONAL COOPERATION

February 8, 2012 

By Paul A. Volcker 

I confess total surprise about the vehement complaints by some European and 

other foreign officials about the restrictions on proprietary trading by American 

banks embedded in the Dodd-Frank Act—now dubbed the ‘‘Volcker’’ Rule. 

It made me think—think all the way back to my years in the U.S. Treasury and 

Federal Reserve, years when the Glass-Steagall Act was in full force. The practical 

effect was to ban all securities trading by American banks—not just ‘‘proprietary’’ 

trading, but also ‘‘market making’’ and ‘‘underwriting’’ (except when involving U.S. 

Government and certain municipal securities). I do not recall, and I am morally certain it never happened, receiving a single complaint that that American law was 

discriminatory, that it damaged other sovereign debt markets, or that it limited the 

ability of foreign governments to access capital markets. 

There is a certain irony in what I read. In Europe, there are plans to introduce 

a financial transaction tax, justified in part by officials because it puts ‘‘sand in the 

wheels’’ of overly liquid, speculation prone securities markets. For reasons analogous to the Volcker Rule, the U.K. is planning to ‘‘ring fence’’ trading and investment banking from retail banking, attempting to create airtight subsidiaries of larger organisations. The commercial banks responsible for what is deemed essential 

services to the economy will be insulated from all trading and only then be protected 

by the official safety net of access to the central bank, deposit insurance, and perhaps assistance in emergencies. 

That approach, as a matter of regulatory philosophy and policy, resembles the 

seemingly less draconian U.S. restrictions on proprietary trading. 
40 

Co-authored by Charles S. Morris Vice President and Economist, Federal Reserve Bank of 

Kansas City in May 2011. 

This document does not represent the views of the Board of Governors of the Federal Reserve 

or the Federal Reserve System. Michal Kowalik, an Economist in the Banking Research Department at the Bank, contributed substantially to the proposal. The authors would like to thank 

Viral Acharya, Matt Richardson, Larry White, Richard Sylla, Thomas Philippon, Lasse Pedersen, Jacob Goldfield, and Nada Mora for helpful comments and suggestions. 

The simple fact is that Dodd/Frank specifically permits both ‘‘market making’’ in 

response to customer needs and ‘‘underwriting’’. No doubt American banks will, 

upon request, be happy to provide those services to the U.K. and other governments. 

They can continue to purchase foreign sovereign debt for their investment portfolios—should I say a la MF Global? What would be prohibited would be ‘‘proprietary’’ trading, usually labeled as ‘‘speculative’’. How many times in the past have 

we heard complaints by European governments about speculative trading in their 

securities, particularly when markets are under pressure? 

Is there really a case that proprietary trading is of benefit to the stability of commercial banks, to their risk profile, and to their compensation practices and desirably fiduciary culture? I think not, and we need to look no further than Canada for 

a system in which its large banks have been much less committed to proprietary 

trading than a few American giants. In any event, there are and should be thousands of hedge funds and nonbank institutions ready, willing and able to undertake 

proprietary trading in unrestricted securities in large volumes. The point is those 

traders should not have access to the taxpayer support implicit in the safety net of 

commercial banks. 

In addressing liquidity, can it really be of concern that some of the largest banks 

in Europe, in Japan, in China, and indeed in Canada cannot maintain effective markets in their own sovereign debt? U.S.-chartered commercial banks could remain 

participants ‘‘making markets’’ for their customers wherever they are. 

Let’s get serious. 

National regulatory (and at least as important, accounting and auditing) authorities should, to the extent practical, seek common understanding and common approaches. In the past, I participated in that process, helping to initiate the effort 

to achieve common capital standards for banks. I am today encouraged by efforts 

underway by the United States, the United Kingdom, and other authorities to reach 

the needed degree of consensus with respect to resolution authority—in plain 

English how to practically end the ‘‘too-big-to-fail’’ syndrome. That’s really complex. 

The major banks are international, and managing their orderly merger or liquidation will necessarily involve cooperation among jurisdictions. That is a key challenge, arguably the key challenge for banking reform. It needs to be dealt with. 

Meanwhile, let us not be swayed by the smoke screen of lobbyists dedicated to 

protecting the interests of some highly compensated traders and their risk-prone 

banks. 

The American regulators are now considering what adjustments should be made 

in their preliminary rules with respect to market-making and proprietary trading, 

while hopefully reducing the inevitable complications imposed by the very complexity of modern finance. I regret that the effect, if not the intent, of much of the 

lobbying has been to add complications rather than to clarify the principles involved. 

As with any new regulation, there will be, with experience, opportunities to deal 

with unnecessary frictions or unintended consequences. But I certainly take comfort 

with the stated confidence of the authorities that the rule adopted will be both 

workable and effective. 

PREPARED STATEMENT OF THOMAS M. HOENIG * 

VICE CHAIRPERSON AND MEMBER OF THE BOARD OF DIRECTORS

FEDERAL DEPOSIT INSURANCE CORPORATION

MAY 9, 2012 

Restructuring the Banking System to Improve Safety and Soundness 

Over the past 30 years, the U.S. banking system has changed dramatically from 

the stylized view of banking that arose from the banking panics of the early 1930s. 

The structure of the banking industry that emerged from the 1930s separated investment banking and other financial services from ‘‘traditional’’ commercial banking—making loans and taking deposits to provide payment, liquidity, and credit 

intermediation services. Because these core banking services are a critical part of 

the economic infrastructure and banks are susceptible to disruptions from depositor 
41 

runs, the structure also included a public safety net to protect depositors and their 

banks. 

The current financial structure is vastly different. Leading up to the financial crisis, the financial system had become dominated by a handful of large, complex financial organizations and it is even more so since the crisis. These companies combine traditional banking activities with a variety of nonbank activities. Banks benefit from additional activities, for example, if they increase the diversification of 

their assets and revenue streams. However, additional activities can also increase 

banks’ riskiness and create complexity that makes it more difficult for the market, 

bank management, and regulators to assess, monitor, and/or contain risk taking 

that endangers the public safety net and financial stability. Thus, the social costs 

of additional activities and the associated complexity can greatly exceed the private 

benefits to an individual bank. 

This paper offers a proposal to reduce the costs and risks to the public safety net 

and financial system and reintroduce accountability by restricting bank activities. 

The designation of allowable activities is based on the principle that banks should 

not engage in activities beyond their core services of loans and deposits if those activities disproportionately increase the complexity of banks such that it impedes the 

ability of the market, bank management, and regulators to assess, monitor, and/or 

control bank risk taking. Such activities are not essential for conducting the socially 

valuable core banking activities and lead to unnecessary risk to the safety net and 

financial system. 

Specifically, in addition to their traditional business of providing payment and settlement services, granting loans, and offering deposits, banks also would be allowed 

to underwrite securities, offer merger and acquisition advice, and provide trust and 

wealth and asset management services. They would not be allowed to conduct 

broker-dealer activities, make markets in derivatives or securities, trade securities 

or derivatives for either their own account or customers, or sponsor hedge or private 

equity funds. 

The benefits of prohibiting banks from engaging in high-risk activities outside of 

their core business, however, would be limited if those activities continue to threaten stability by mostly migrating to the ‘‘shadow’’ banking system. Shadow banks are 

financial companies not subject to prudential supervision and regulation that use 

short-term or near-demandable debt to fund longer-term assets. In other words, 

shadow banks essentially perform the same critical, core functions as traditional 

banks, but without an explicit safety net or prudential regulation. As a result, the 

shadow banking system is susceptible to disruptions that threaten financial and economic stability and lead to additional implicit Government guarantees and the associated moral hazard to take greater risks. 

To mitigate the potential systemic effects and moral hazard of shadow banks or 

other financial companies, this paper makes two additional recommendations. First, 

money market mutual and other investment funds that are allowed to maintain a 

fixed net asset value of $1 should be required to have floating net asset values. Second, bankruptcy law for repurchase agreement collateral should be rolled back to 

the pre-2005 rules, which would eliminate mortgage-related assets from being exempt from the automatic stay in bankruptcy when the borrower defaults on its repurchase obligation. 

Evolution of current financial structure 

• The 1930s financial structure that lasted largely until the end of the century 

was shaped by three major legislative and regulatory changes: the GlassSteagall Act, creation of Federal deposit insurance, and Federal Reserve’s Regulation Q. 

• The Glass-Steagall Act refers to four provisions of the Banking Act of 1933 

that separated commercial and investment banking. Deposit (i.e., commercial) 

banks were prohibited from conducting securities activities (underwriting and 

dealing) or affiliating with companies that conducted securities activities. The 

rationale was that banks are crucial for a well-functioning economy because 

they settle payments, provide deposits that are available at par value on demand, and are the primary source of credit for vast majority of businesses 

and individuals. These functions are a critical part of the economy’s financial 

infrastructure. 

• Banks are provided access to a public safety net because of their importance 

and susceptibility to runs from using demand deposits to fund longer-term, 

illiquid loans. Prior to the 1930s, the Federal Reserve’s discount window pro-
42 

1 Also, only members of the Federal Reserve could borrow from the discount window until the 

Monetary Control and Depository Institutions Deregulation Act of 1980. 

vided a limited safety net for solvent banks.1 The public safety net was significantly enhanced in 1933 by passage of the Federal Deposit Insurance Act 

and the associated provision of limited deposit insurance because it protected 

depositors of banks that failed. 

• Access to a safety net, however, increases the incentive for banks to take 

greater risks. Given the importance of a stable banking system, the necessity 

of a public safety net to provide the stability, and an incentive to take greater 

risk, a mechanism is needed to prevent banks from taking excessive risks and 

endangering the safety net. The market cannot be solely relied upon to prevent the risk taking because some deposits are insured and banks are inherently opaque. As a result, prudential supervision and regulation must be used 

to prevent excessive risk taking. 

• One of the key regulations of the Banking Act of 1933 was the prohibition 

of paying interest on demand deposits and the authority to impose ceilings 

on savings deposit rates, which was implemented through the Federal Reserve’s Regulation Q. The rationale for Regulation Q was to prevent competition for deposits from causing instability in the banking system. 

• The combined effect of the Glass-Steagall Act, bank access to a Government 

safety net, prudential supervision and regulation, and deposit rate ceilings 

was a fairly stable, profitable banking industry with a positive franchise 

value for many years. The franchise value was protected to the extent banks 

were protected from outside competition and competition among themselves. 

• Over time, banks faced increasing competition on both the liability and asset 

sides of the balance sheet. The increase in competition was spurred by advancements in portfolio theory, investment and money management techniques, and 

information technology combined with greater volatility of the economic environment. 

• On the liability side, banks had to compete with money market mutual funds 

(MMMFs) and savings association NOW accounts that paid interest on close 

substitutes for bank demand deposits. They also faced greater competition for 

household savings from mutual funds, pension funds, and insurance companies. 

• MMMFs started in 1971 as a competitive alternative to bank deposits because 

they paid a market interest rate and were allowed to maintain a net asset 

value (NAV) of $1 a share as long as they met certain accounting (net asset 

value has to be greater than 99.5 cents) and investment (quality and maturity) requirements. They allow investors to withdraw funds on demand and 

have limited check-writing privileges. MMMF shares are held by individuals, 

institutional investors, and corporate and noncorporate businesses as an alternative to bank deposits for cash management and payments purposes. 

MMMFs started out investing in highly rated financial and nonfinancial company commercial paper (CP) and short-term Treasury securities, and then 

over the years expanded to other money market instruments (MMIs), such as 

asset-backed commercial paper (ABCP), and short-term repurchase agreements (repo). 

• It is important to note that although an MMMF investor technically owns equity shares of the fund (i.e., there is zero leverage), the investor is more like 

a depositor because the expectation is that funds can be withdrawn at a par 

value of $1 a share (i.e., there is no equity and leverage is infinite). As a result, MMMF investors act more like depositors and will run whenever they 

are concerned about a fund’s safety so they can redeem their shares for $1 

before the fund ‘‘breaks the buck’’ and reduces the value of the shares. 

• NOW accounts were developed by savings and loans in the early 1980s as a 

competitive alternative to demand deposits that paid interest. NOW accounts 

essentially were just like demand deposits—funds were available upon demand and had unlimited checkwriting privileges—but they could pay interest 

because the depository institution reserved the right to require notice before 

allowing funds to be withdrawn or transferred by check. 

• On the asset side, banks faced competition in making loans from investment 

banks (junk bonds, securitization and nonfinancial commercial paper), mortgage 

brokers, and specialty lenders such as unaffiliated finance companies (primarily 

consumer lending), captive lenders (auto financing, retailers), and factors (trade 

receivable lending). 
43 

2The description of the shadow banking system and the process described below is largely 

from ‘‘Shadow Banking’’ by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, 

Staff Report no. 458, Federal Reserve Bank of New York, July 2010. 3The one exception is the step that actually securitizes loans into MBS/ABS. 

4There are also direct investors in these money market instruments, such as securities lend- ers. 

• Banks have long faced competition in making loans from unaffiliated and captive finance companies and factors. Commercial paper became a competitive 

alternative to bank operating loans for large, highly rated nonfinancial companies in the late 1960s and early 1970s. 

• Competition for bank loans increased substantially beginning in the 1980s 

with the growth of junk bonds and an ability to originate and distribute loans 

through the development of mortgage-backed securities (MBS), followed by 

other types of asset-backed securities (ABS), which are typically backed by 

consumer loans (credit cards, auto, student). 

• The combination of alternatives to bank deposits and loans created an alternative system for providing complete end-to-end banking—from gathering funds 

to making loans—which collectively comprises the so-called shadow banking 

system.2

• In contrast to a typical bank that conducts the entire process of borrowing 

funds from savers, making loans to ultimate borrowers, and holding the loans 

to maturity, credit intermediation through the shadow banking system is a 

vertical process that takes place through a series of entities—collectively 

called shadow banks—similar to a supply chain manufacturing process. 

• Funding for each of the entities takes place in wholesale markets. Money 

market instruments—specifically CP, ABCP, and short-term repos—are a 

major source of funds at virtually each step in the process.3 The major investors in the MMIs are MMMFs and other short-term investment funds that 

have a fixed NAV of $1.4 At some steps of the process, major funding sources 

also include medium-term notes and ABS that are purchased by long-term investors, such as mutual funds, pension funds, and insurance companies. 

• A typical example of the shadow banking intermediation process is as follows: 

1. A loan is made by either a nonbank financial company or a bank. The 

nonbank companies finance the initial loans with CP or medium-term 

notes (MTN). 

2. The loan is sold to a bank or broker-dealer conduit, which is an intermediate entity that temporarily warehouses the individual loans until it 

has enough to package together as an MBS or ABS. The conduits are funded with ABCP. 

3. The loan warehouse sells the package of loans to a securitization sponsor 

that sets up a trust to hold the loans, which is financed by selling MBS/ 

ABS backed by the loans. This is the only step in the process not financed 

by MMIs. 

4. The ABS are purchased by a variety of entities that are funded by a variety of sources. 

a. Entities that tend to fund ABS with longer-term sources of funds include 

mutual funds, pension funds, and insurance companies. 

b. BHCs may purchase ABS and hold them on bank balance sheets funded 

by deposits. However, prior to the financial crisis, they generally held 

them in off-balance-sheet entities, such as structured investment vehicles (SIVs) or other conduits, that were funded by CP or ABCP. The CP 

or ABCP, in turn, was typically funded by MMMFs and other MMI 

funds with $1 NAVs. 

c. Investment banks and FHCs purchased ABS for a variety of reasons. 

They may have been held by a securities subsidiary as a proprietary 

trading asset, in inventory for filling customer trades, or warehoused for 

creating collateralized debt obligations (CDOs). The ABS were typically 

funded with repo and sometimes ABCP, which again were funded by 

MMMFs and other MMI funds with $1 NAVs. 

• Increased competition for banks from the shadow banking organizations combined with regulatory capital requirements (stemming from the first Basel Accord) that were higher than for their competitors led to reduced profits and declining franchise values. As a result, banking organizations looked for alternative activities, revenue streams, and business models, which included the 
44 

5One of the Glass-Steagall Act provisions was Section 20 of the Banking Act of 1933. Section 

20 prohibited Federal Reserve member banks from affiliating with organizations that ‘‘engaged 

principally in the issue, floatation, underwriting, public sale, or distribution of stocks, bonds, debentures, notes, or other securities.’’ For many years, the administrative limit for not being 

‘‘principally engaged’’ was that underwriting and dealing accounted for 5 percent or less of a 

subsidiary’s gross revenue. As banks became larger, underwriting and dealing became cost effective even with the 5 percent revenue limit. Overtime, banking organizations began petitioning 

for larger limits, which the Federal Reserve agreed to based on assessments of the risks and 

benefits to the economy, with the limit eventually rising to 25 percent in 1997. 6Prior to the 2004 SEC ruling, the SEC determined the haircuts used to calculate the leverage ratios of broker-dealers. The 2004 ruling allowed the broker-dealers to use their internal 

risk management models to compute these haircuts. The ruling followed a similar change to the 

Basel I Accord from 1996, under which commercial banks could compute their capital requirements for trading positions using their own models. 

originate-to-distribute shadow banking business model. Whereas the traditional 

banking model of making loans and holding them to maturity earned profits 

from loan-deposit rate spreads, the shadow banking model earned profits from 

fees and trading gains. 

• Some banks responded to the increased competition by focusing first on being 

able to engage in investment banking and securities activities and later more 

broadly on broker-dealer and shadow banking activities. 

• Banks were able to whittle away at the Glass-Steagall Act restriction on investment banking activities in the 1990s by creating Section 20 securities 

subsidiaries and through Federal Reserve Board approvals of higher thresholds for being ‘‘principally engaged’’ in securities activities.5

• To fully participate, however, banks needed the Glass-Steagall Act prohibition 

on affiliation with securities companies to be repealed, which was achieved 

with the passage of the Gramm-Leach-Bliley Act (GLBA) in 1999. The GLBA 

allowed the formation of financial holding companies (FHCs), which were 

BHCs engaged in certain nonbanking activities, such as securities underwriting, broker-dealer activities, and insurance underwriting, not permitted 

for BHCs. 

• Significant changes in the investment banking industry also occurred to take 

full advantage of the opportunities of the shadow banking industry. With the 

growth of bond markets and the development of MBS securities in the 1980s, 

investment banks moved from partnership structures to public corporate structures. The corporate structures essentially allowed the investment banks to engage in riskier activities that put the firm’s capital at risk, such as proprietary 

trading, leveraged lending, and hedge fund sponsorship, that the partners were 

not willing to do when their own money was at risk. In addition, the risks were 

exacerbated by relying on debt financing, i.e., leverage, much of which was 

short-term repo. In fact, it became much easier to use debt after 2004 when the 

SEC allowed broker-dealers to use their internal risk management models to 

compute the haircuts for calculating their net capital.6

Implications for financial structure, risk, and stability 

• The sharp line between commercial and investment banks is significantly 

blurred as each has engaged in shadow banking activities. 

• The larger banking organizations engage in activities traditionally limited to 

investment banks, which exposes them to investment bank risks. Traditional 

banks that take in deposits and make and hold loans to maturity have to 

manage credit and interest rate risk. As FHCs have expanded activities to 

earning fees from trading and ABS underwriting, their risk exposures expanded to include market risk from trading and the risk from having to roll 

over uninsured wholesale money market funding risks. 

• Similarly, the larger investment banks now engage in activities traditionally 

limited to commercial banks, which exposes them to commercial bank risks. 

By switching from a partnership to public corporate structure, taking on leverage, and making direct investments and loans that were held on the balance sheet, investment banks expanded their risk exposures beyond market 

risk to credit and funding risk. 

• With the largest financial companies—both banking and investment banking organizations—being the key players in shadow banking activities, both types of 

organizations play a special role in the economy that once was limited to commercial banks. Through shadow banking activities, both types of organizations 

ultimately provide the same credit intermediation function of traditional 

banks—lending long term using funds available to creditors upon demand. 
45 

7 In a September 2010 working paper ‘‘Securitization Without Risk Transfer,’’ Viral Acharya, 

Philipp Schnabl, and Gustavo Suarez provide evidence consistent with regulatory arbitrage 

being a reason for the use of ABCP programs by banks. They also document changes in regulatory rules that enabled banks to perform this type of regulatory arbitrage. In July 2004, the 

OCC, Federal Reserve, FDIC, and OTS exempted assets in ABCP programs from the calculation 

of risk-weighted assets. As a result, assets moved from banks’ balance sheets to ABCP programs 

did not have to be considered when calculating risk-weighted assets for capital requirements. 

Moreover, under the Basel I and Basel II Accords, assets placed in ABCP programs carried 

lower capital charges than the same assets carried on balance sheets. 

• The expansion of activities by commercial and investment banks has led to a 

less stable financial system because it is dependent on wholesale, money market 

funding without an explicit safety net of insurance and access to central bank 

lender-of-last-resort facilities. 

• Just like banks were subject to depositor runs that created liquidity crises before deposit insurance was available, virtually every step of the shadow banking process is dependent on uninsured investments in MMMFs and other 

MMI funds with NAVs of $1. 

• Investors in these money market funds have full access to their money as 

long as the underlying NAV is $1 or more, so once concerns arise about the 

quality of the underlying assets, i.e., that the underlying NAV will drop below $1, investors have an incentive to withdraw their funds before others. A loss 

in funding at any step of the process will cause the system to break down 

just like a loss in funding at a traditional commercial bank. 

• The heavy involvement of large banking organizations (in the form of FHCs) 

and investment banks in shadow banking activities exposes them to similar 

risks that previously had been eliminated by deposit insurance in retail banking. 

• Bank subsidiaries are still protected from insured depositor runs, but the 

holding companies and banks are now exposed to money market fund runs. 

• The bank subsidiaries are exposed to the money market runs because the 

banks often provide credit lines on the ABCP that fund ABS held by affiliated 

holding company subsidiaries, such as off-balance-sheet conduits and SIVs. 

The ABCP often needs a credit line or guarantee so that it has the AAA rating needed to make it an eligible investment for MMMFs. So if MMMFs decide not to roll over their ABCP investments in an SIV and the underlying 

ABS had fallen below par value, the SIV would sell the ABS to the bank 

guarantor at par, which means the bank takes the loss and has to fund the 

ABS on balance sheet. In other words, the credit and funding risk to the bank 

from guaranteeing the off-balance-sheet funding of ABS with ABCP is the 

same as if it held the underlying ABS on its own balance sheet. 

• To make matters worse, even though the risks to the bank of holding assets 

on balance sheet or guaranteeing them off balance sheet are the same, FHCs 

had an incentive to move the assets off balance sheet because it can fund 

those assets with much less capital.7 Specifically, the risk-based capital requirements of FHCs had a much higher risk weight for holding the loans or 

ABS on balance sheet than for guaranteeing the ABCP funding of an off-balance-sheet entity. As a result of this arbitrage of regulatory capital requirements, FHCs are much riskier because they can fund the credit risk with 

much higher leverage. 

• FHCs also are exposed to runs by money market investors even if the MMIs 

are not fully guaranteed because of reputational risk. Although subsidiary 

conduits and SIVs that hold ABS are technically bankruptcy remote, FHCs 

either purchase assets and bring them on balance sheet or provide capital to 

avoid the negative reputational effects of defaulting on the securities funding 

the subsidiaries. 

• Finally, the broker-dealer subsidiaries of investment banks and FHCs also 

are exposed to MMI runs. As already noted, broker-dealers use repo and 

ABCP to fund ABS held as part of their proprietary trading business, as inventory for filling customer trades, or for creating CDOs. 

• Overall, the largest financial companies conduct a variety of traditional and 

nontraditional banking activities, many of which have increased the complexity 

of their operations and portfolios. These companies benefit from additional activities, for example, if they increase the diversification of their assets and revenue streams. However, these benefits are outweighed by the significant complications it poses for the market, bank management, and regulators to assess, 
46 

monitor, and/or contain risk taking that endangers the public safety net and financial stability. Specifically, as explained below, combining banking and nonbanking activities makes it more difficult to supervise and regulate banks, to 

price deposit insurance, and for bank management to manage risks. It also reduces market discipline by making banks less transparent. 

• Some activities make it more difficult to supervise banks. 

• The goal of prudential supervision is to control bank risk taking so that they 

are safe and sound and do not endanger the safety net. This is done by monitoring a bank’s financial condition, lending, operational, risk management, 

and other practices and enforcing regulatory rules. Due to the periodic nature 

of bank supervision, supervisors are able to get only a snapshot of bank processes, risk exposure, and capital positions at a given point in time. These 

snapshots are useful only as long as they are able to predict the bank’s processes, risk exposure, and capital positions between the supervisory examinations. The flexibility to adjust risk profiles between exams depends to some 

extent on the activities banks engage in and the nature of the risks. 

• Many of the nontraditional activities that the large, complex banking organizations engage in are difficult to supervise effectively because they are very 

risky in the short term and can be used to quickly change a bank’s risk profile. For example, trading and market-making are high frequency activities 

that can take place between exams with little evidence that they ever occurred. As a result, a snapshot of positions of these activities on one day has 

no predicative value for the positions, for example, a week later. Monitoring 

these activities on a high-frequency basis would be very costly for banks and 

supervisors. Moreover, it requires substantial transparency that banks are 

likely to strongly oppose. Thus, while examiners may err in their judgment 

on the riskiness of any activity, they do not have the tools to monitor the 

riskiness of many traditional nonbanking activities. 

• Banks with a variety of activities require much more complex regulations. 

• The history of the Basel capital requirements provides a good example of the 

difficulty in effectively regulating complex financial companies. The increased 

variety and complexity of bank activities required much more complex capital 

standards, which the financial crisis showed were not very effective. Complex 

capital requirements are very difficult to monitor and understand for banks, 

supervisors, and the market. 

• One problem is that the various capital requirements under Basel are essentially relative prices, which generally will be incorrect when they are administratively set. As a result, the regulatory capital requirements did not adequately align bank risks with capital levels. In particular, it created opportunities for regulatory arbitrage that was a major contributor to the risk taking 

of the large, complex banking companies and the financial crisis. For example, the capital charge for an MBS based on a pool of subprime loans was 

lower than that for a portfolio of mortgages held on the balance sheet. Capital 

charges were also lower for an MBS held in off-balance-sheet conduits than 

on the balance sheet. 

• The difficulty in determining appropriate requirements is even more difficult 

when banks face a variety of risks, such as credit, market, and interest risk. 

Understanding and formally modeling these risks and their relationships is 

very difficult, especially after a systemic shock or during a financial crisis. In 

addition, the variety of assets held by the complex banks meant regulators 

had to rely on bank internal models, which provided banks opportunities to 

game the capital regulations. The incentive to game regulations is a problem 

particularly for banks suffering large losses because it buys them more time 

to find a way out of their problems. 

• Complexity of activities makes it difficult to price deposits insurance: Deposit 

insurance would not create moral hazard if the premiums were priced appropriately to reflect a bank’s risk. However, pricing deposit premiums correctly is 

difficult for the same reasons that it is difficult to determine capital requirements. 

• To the extent it is possible, resolving large, complex banks is much more difficult and costly. 

• Complex financial institutions are hard to resolve in a quick and orderly manner. Lehman Brothers is a good example of the difficulty in resolving a complex company. The number of transactions and complexity of interconnections 

made it very difficult to determine the company’s value over a weekend, 
47 

8Donald Morgan provides evidence on the increased opacity of banks from combining lending 

and trading activities in ‘‘Rating Banks: Risk and Uncertainty in an Opaque Industry,’’ American Economic Review, September 2002. 9 All aspects of managing a large, complex financial company is difficult, but given the context 

of this paper, the focus is on risk management. 

which made it difficult to find a buyer. And Lehman Brothers was a relatively 

simple company as compared to a bank like Citigroup, which has more than 

2,000 majority-owned subsidiaries that include a ‘‘Lehman Brothers’’ equivalent. It would be much harder to wind down or find the number of separate 

buyers necessary to transfer Citigroup’s operations to third parties. 

• In addition to the difficulty in resolving complex banks, the fallout from the 

Lehman Brothers failure shows that complex institutions are more likely to 

be bailed out in the future. The probability of an implicit Government guarantee from a bailout creates additional moral hazard. Moreover, if the market 

and banks expect bailouts, banks have an increased incentive to become more 

complex, and it will be supported by a lack of market discipline. 

• Banks with a variety of activities are less transparent. Relative to nonfinancial 

companies, it is difficult for investors to evaluate the condition of banks and 

their riskiness because their balance sheet assets and activities are opaque and 

easily changed.8 Traditional banking is opaque because only the bank knows 

the risk and quality of its loans. Banks that engage in nontraditional activities 

such as trading, hedge funds, private equity, and market making are even less 

transparent because the success of these strategies depend on the confidentiality of the positions and speed with which the banks are able to change their 

exposures. Given the lack of transparency, regulators must play a larger role 

relative to the market in monitoring and disciplining banks. However, as already discussed, regulators are also at a disadvantage when dealing with banks 

engaging in complex activities. 

• Complexity makes risk management much more difficult.9

• Risk management is particularly difficult when there are many different operation and activities divisions in a bank. Examples include understanding all 

of the different business lines and their interactions, having appropriate management information systems, and appropriately allocating and pricing capital across activities. 

• The risk management of a complex institution will also vary with the background of the senior leadership. For example, the risk tolerance is likely to 

be lower if the senior leadership of a large, complex bank has a commercial 

banking background than a trading background. 

• To the extent that a bank’s senior management has difficulty understanding 

and managing its risks, it is even more difficult for supervisors to scrutinize 

and monitor its risks. 

• In summary, the financial system has become less stable over the past 30 years 

as banks and other financial companies have expanded into more complicated 

activities that are not supported by a public safety net or subject to prudential 

supervision. The root of the problem is that large, complex financial companies 

are funding long-term, illiquid assets with liabilities available upon demand. In 

addition, after the crisis, the concentration of the industry and complexity of activities at the largest banks have increased. The industry is dominated by a 

handful of companies that combined are as large as half of annual U.S. economic output, of which the failure of any could cause financial instability. Finally, because these companies are so large and complex, they and other institutions that could be deemed systemically important receive an implicit Government guarantee on their debt—and sometimes on their equity—they have an 

incentive to take extra risk, which further increases systemic risk (the too-bigto-fail problem). 

Proposal to Reduce Costs and Risks to the Safely Net and Financial System 

This proposal to reduce costs and risks to the safety net and financial system has 

two parts. The first part proposes to restrict bank activities to the core activities 

of making loans and taking deposits and to other activities that do not significantly 

impede the market, bank management, and regulators in assessing, monitoring, 

and/or controlling bank risk taking. However, prohibiting banks from engaging in 

activities that do not meet these criteria and that threaten financial stability would 

provide limited benefits if those activities migrate to shadow banks. The second part 

proposes changes to the shadow banking system by making recommendations to re-
48 

10This categorization of financial activities is from Matthew Richardson, Roy Smith, and Ingo 

Walter in Chapter 7 of Regulating Wall Street: The Dodd-Frank Act and the New Architecture 

of Global Finance, edited by Viral V. Acharya, Thomas F. Cooley, Matthew Richardson, Ingo 

Walter, New York University Stem School of Business, John Wiley & Sons, Inc., 2010. 11 Banking organizations would be allowed to purchase and sell derivatives to hedge their assets and liabilities. 

form money market funds and the repo market. Following the proposal, alternative 

proposals are discussed and critiqued. 

Restricting activities of banking organizations 

• The financial activities of commercial, investment, and shadow banks can be 

categorized in the following six groups:10

• Commercial banking—deposit taking and lending to individuals and businesses. 

• Investment banking—underwriting securities (stocks and bonds) and advisory 

services. 

• Asset and wealth management services—managing assets for individuals and 

institutions. 

• Intermediation as dealers and market makers—securities, repo, over-thecounter (OTC) derivatives. 

• Brokerage services—retail, professional investors, and hedge funds (prime 

brokerage). 

• Proprietary trading—trading for own account, internal hedge funds, private 

equity funds, and holding unhedged securities and derivatives. 

• Based on the criterion that permissible activities should not significantly impede the market, bank management, and regulators in assessing, monitoring, 

and/or controlling bank risk taking, banking organizations should be able to 

conduct the following activities: commercial banking, investment banking as defined above, and asset and wealth management services. Investment banking 

and asset and wealth management services are mostly fee-based services that 

do not put much of a firm’s capital at risk. In addition, asset and wealth management services are similar to the trust services that have always been allowable for banks. 

• In contrast, the other three categories of activities—dealing and market making, brokerage, and proprietary trading—do not have much in common with 

core banking services and create risks that are difficult to assess, monitor, and/ 

or control. Banking organizations would not be allowed to do any trading, either 

proprietary or for customers, or make markets because it requires the ability 

to do trading.’’11 In addition, allowing customer but not proprietary trading 

would be conducive to ‘‘concealing’’ proprietary trading as part of the inventory 

necessary to conduct customer trading. Prime brokerage services not only require the ability to conduct trading activities, but also essentially allow companies to finance their activities with highly unstable uninsured ‘‘deposits.’’ 

• Prohibiting these activities would make banks more transparent and would 

enable better market discipline, supervision, regulation, and resolution. 

• Because these activities involve taking positions that can be continuously adjusted and manipulated, they are inherently opaque and difficult for supervisors to monitor and regulate and for investors to understand. 

• Moreover, regulatory arbitrage between balance-sheet and off-balance-sheet 

activities and between banking and trading books is difficult to prevent with 

regulation. 

• The proposed activity restrictions also will improve the management of banks 

by focusing their activities solely on the traditional banking business with exposure only to risks inherent in these activities. 

• There is an inherent difference in the underlying factors that make commercial banking and securities firms successful. Banking is based on a long-term 

customer relationship where the interests of the bank and customer are the 

same. Both the bank and loan customers benefit if borrowers do well and are 

able to pay off their loans. In contrast, trading is an adversarial zero-sum 

game—the trader’s gains are the customer’s losses. Thus, restricting these activities removes a conflict of interest between a bank and its customers, which 

could produce a more stable, less risky company. 

• The inherent riskiness of securities trading, dealing, and market-making attracts, and in fact requires, people who are predisposed to taking short-term 
49 

12 Anat R. Admati, Peter M. DeMarzo, Martin R. Heliwig, and Paul Pfleiderer provide an excellent discussion of the reasons for substantially increasing bank capital requirements in ‘‘Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity 

is Not Expensive,’’ August 2010, Rock Center for Corporate Governance at Stanford University 

Working Paper No. 86, Stanford Graduate School of Business Research Paper No. 2065. Martin 

Hellwig provides arguments for abandoning risk-sensitive capital requirements in ‘‘Capital Regulation after the Crisis: Business as Usual?’’ Reprints of Max Planck Institute for Research on 

Collective Goods 2010/31. 13 Robert DeYoung comments in the Federal Reserve Bank of Minneapolis Region (2010) that 

it is not really possible to provide empirical evidence for or against existence of economies of 

scale in large and complex financial institutions because there are too few of them for a meaningful statistical analysis to be conducted. 14 A survey of empirical studies on economies of scale is provided by Matthew Richardson, Roy 

Smith, and Ingo Walter in Chapter 7 of Regulating Wall Street: The Dodd-Frank Act and the 

New Architecture of Global Finance, edited by Viral V. Acharya, Thomas F. Cooley, Matthew 

Richardson, Ingo Walter, New York University Stern School of Business, John Wiley & Sons, 

Inc., 2010. 

risks rather than lenders with a long-term perspective. The combination of securities with commercial banking activities in a single organization provides 

opportunities for the senior management and boards of directors to be increasingly influenced by individuals with a short-term perspective. As a result, the increased propensity of these corporate leaders to take risk leads to 

more of a short-term-returns culture throughout the organization. 

• Historically, bank investments were restricted to loans and investments in investment-grade securities. As demonstrated in the financial crisis, the complexity of many asset-backed securities made it very difficult to determine their 

credit quality. As a result, banking organizations should be prohibited from 

holding ‘‘complicated’’ securities, such as multilayer structured securities (e.g., 

CDOs) because it is difficult to determine and monitor their credit quality. 

• Off-balance-sheet holdings and exposures should be supervised and regulated as 

if they were on-balance-sheet because, as was also demonstrated in the crisis, 

they ultimately put a bank’s capital at risk. 

• Restricting banks to the activities mentioned above will allow capital regulation 

to be simplified and improved. As noted in the previous section, the complexity 

of Basel capital regulation is necessary but still ineffective because there is no 

ability to satisfactorily model the wide range of complexity and risk characteristics of current allowable activities. Capital regulation will be simpler and more 

effective because there is less need for complicated risk-based requirements if 

the balance sheet is largely limited to loans and investment grade securities, 

i.e., a relatively high simple leverage ratio would be effective.12

• Critics of restricting bank activities argue it would reduce the economies of 

scale and scope that are critical for the largest banks to be successful in global 

markets and that large corporations want one-stop shopping for their financial 

services. These arguments, however, are not persuasive. 

• First, there is no strong evidence of economies of scale. There are many conceptual and empirical problems with studies of economies of scale.13 Nevertheless, older studies from the 1990s show that there are no economies of 

scale when banks are larger than about $250 million in assets, although the 

threshold is likely to be higher in today’s economy because of inflation and 

advancements in information technology. In fact, a more recent study from 

the mid-2000s suggests there are economies of scale for the largest banking 

organizations, but the results are highly questionable because there are so 

few banks at the sizes in question and the study uses data prior to the problems that banks had during the financial crisis. 

• Second, there is even less evidence of economies of scope.14 In fact, there is 

evidence that multiple functions of large, complex banks actually increase 

systemic risk and anecdotal evidence that if bank activities are restricted as 

suggested here, a nonbank financial industry would emerge and thrive. 

• Third, large corporations would still be able to do one-stop shopping for commercial and traditional investment banking services, although they would 

have to go to securities dealers to purchase swaps and other derivatives for 

hedging purposes. 

• Finally, even if there are economies of scale or scope, it does not necessarily 

mean that banks should be allowed to continue to conduct all of their current 

activities. Whether they should depends on comparing the marginal benefits 

from the reduced private costs of operation to the social costs associated with 
50 

15Some of the new rules for MMMFs are: 30 percent of assets must be liquid within 1 week, 

no more than 3 percent of assets can be invested in second-tier securities, the maximum weighted-average maturity of a fund’s portfolio is 60 days, and MMMFs have to report their holdings 

every month. 

financial crises. Given the large costs of the 2007–9 crisis, the efficiencies and 

cost benefits of size and scope would need to be extremely large. 

• Critics of restricting activities also question how we would go about divesting 

the prohibited activities. The divestitures that were required by the GlassSteagall Act and the breakup of AT&T in the 1980s suggest that divestitures 

can be conducted in an orderly manner in a relatively short period of time. 

• Critics of restricting activities also are concerned that it would cause two major 

problems for U.S. banks because they would face a competitive disadvantage 

relative to universal banks, mostly from Europe, that are allowed to conduct the 

full range of activities. 

• One problem is it would drive U.S. banks to move to other countries. However, it seems highly improbable that any other country would be willing or 

able to expand its safety net to new large and complex banking organizations. 

• Second, the competitive disadvantage of U.S. banks would lower their franchise values, which would provide an incentive to take even greater risks to 

raise lost revenues and maintain ROEs. However, the virtue of restricting activities is that it is easier for the supervisors and the market to detect and 

punish excessive risk taking. 

Reforming the shadow banking system 

• Restricting the activities of banking organizations alone, however, does not completely address the stability of the financial system. In fact, it could worsen the 

risk of financial instability by pushing even more activities from the regulated 

banking sector to large, interconnected securities firms, which would expand the 

sector that was an integral part of the financial crisis. 

• As previously discussed, the source of this instability is the use of short-term 

funding for longer-term investment in the shadow banking market, i.e., the maturity and liquidity transformation conducted by a lightly regulated/unregulated 

sector of the financial system. We believe this source of systemic risk can be 

significantly reduced by making two changes to the money market. 

• The first recommendation addresses potential disruptions coming from money 

market funding of shadow banks—money market mutual and other investment 

funds that are allowed to maintain a fixed net asset value of $1 should be required to have floating net asset values. 

• The primary MMIs today are MMMFs and repo (ABCP has largely disappeared as a funding instrument for financial companies since the financial 

crisis). Individuals, institutional investors, and nonfinancial companies are 

the primary holders of MMMF and other MMI funds with a $1 NAV, which 

in turn are major investors in repo along with other financial companies. 

• Some have suggested that MMMFs should be backed by Government guarantees. We see no reason why the safety net should be extended and the taxpayer put at risk when other solutions are feasible. In addition, providing 

Government guarantees would require prudential supervision to prevent excessive risk taking, but it would not be effective because of the ability of 

funds to rapidly shift their risk profiles. 

• The runs during the crisis on MMMFs occurred because of concerns about the 

quality of their investments and because of the promise to maintain a $1 

NAV. MMMF investment rules have been strengthened by increasing the 

minimum average quality and decreasing the maximum average maturity of 

their investments.15 However, because of the difficulty in calibrating these requirements, it is not clear that the vulnerability of MMMFs to runs in a systemic event would be significantly reduced as long as the $1 NAV is maintained. We believe reliance on this source of short-term funding and the 

threat of disruptive runs would be greatly reduced by eliminating the fixed 

$1 NAV and requiring MMMFs to have floating NAVs. 

• Critics of eliminating a $1 NAV for MMMFs argue that this limits cash management options for large corporations. However, MMMFs were first introduced 

to evade interest rate ceilings on deposits, and the only remaining Regulation 

Q deposit rate ceiling—the prohibition of paying interest on business transactions deposits—was eliminated by the Dodd-Frank Act. Some may be con-
51 

cerned that their deposits will be largely uninsured, but they were uninsured 

when invested in MMMFs. 

• The second recommendation addresses potential disruptions stemming from the 

repo financing of shadow banks—the bankruptcy law for repurchase agreement 

collateral should be rolled back to the pre-2005 rules. This change would eliminate mortgage-related assets from being exempt from the automatic stay in 

bankruptcy when a borrower defaults on its repurchase obligation. 

• One reason for the runs on repo during the crisis was because of the prevalence of repo borrowers using subprime mortgage-related assets as collateral. 

Essentially, these borrowers funded long-term assets of relatively low quality 

with very short-term liabilities. The price volatility of subprime MBS rose 

sharply when subprime defaults started reducing MBS income flows. As a result, haircuts on subprime repo rose sharply or the repo was not rolled over. 

• The eligibility of mortgage-related assets as collateral exempt from the automatic stay in bankruptcy in case of default by the borrower is relatively recent. The automatic stay exemption allows the lender to liquidate the collateral upon default as opposed to having to wait for the bankruptcy court to 

determine payouts to secured creditors. 

• Prior to 2005, collateral in repo transactions eligible for the automatic stay 

was limited to U.S. Government and agency securities, bank certificates of deposits, and bankers’ acceptances. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the definition of repurchase agreements to include mortgage loans, mortgage-related securities, and interest 

from mortgage loans and mortgage-related securities. This meant that repo 

collateralized by MBS, CMOs, CMBS, and CDOs backed by mortgage-related 

assets were exempt from the automatic stay. 

• We believe the threat of runs by repo lenders would be significantly reduced 

by rolling back the bankruptcy law for repurchase agreement collateral to the 

pre-2005 rules. 

• Overall, these two changes to the rules for money market funds and repo would 

increase the stability of the shadow banking system because term lending would 

be less dependent on ‘‘demandable’’ funding and more reliant on term funding. 

Term wholesale funding would continue to be provided by institutional investors 

such as mutual funds, pension funds, and life insurance companies. While this 

might increase the cost of funds and, therefore, the cost of mortgages and other 

consumer loans, it would be less risky and more reflective of the true costs. 

Alternative proposals 

• A variety of alternative policy reforms, which are not necessarily mutually exclusive, have been proposed to improve the stability of the financial system. 

These proposals address the structure of banking organizations (size limitations), bank regulation and supervision (stronger resolution authority, stronger 

capital regulation, systemic risk fees, improved supervision) and institutional 

changes (Government guarantees for repo similar to deposit insurance). 

• Size limit 

• Banking organizations have been prohibited from merging if the new company would hold more than 10 percent of national deposits since 1994, and 

the Dodd-Frank Act prohibits mergers of financial companies if the new company would hold more than 10 percent of financial industry liabilities. These 

provisions do not limit organic growth. 

• We are not in favor of a strict size limit because it is not clear what the size 

limit should be or how it should change over time. 

• Resolution authority (would only address the too-big-to-fail problem and not systemic risk more generally)—the Dodd-Frank Act includes a provision for resolving systemically important companies. 

• We believe resolution authority is necessary but it may not be sufficient for 

very large, complex financial institutions. The resolution authority is too political because the Treasury secretary makes the final decision to close a failing company as opposed to independent supervisory authorities. 

• But even if it were up to the supervisory authorities, it is not clear they 

would use it when faced with the failure of a systemically important company. Liquidating a large and complex financial company will always impose 

costs and disruptions even under ideal circumstances, but is more likely to 

cause systemic problems. Given the tradeoff between costs and economic disruption that are large, highly visible, and immediate versus benefits that may 
52 

16The New York University Stern School of Business V-Lab project proposes a method to assess the systemic relevance of financial institutions. 

take years to be recognized, the more likely scenario is that regulators will 

choose to bail out the company. This decision is even more skewed to avoiding 

the short-run costs because of pressures on regulators from politicians and 

the big banks. 

• Improve capital regulation—this is the approach taken by the Basel Committee 

in developing the Basel III capital requirements. The Dodd-Frank Act also has 

provisions to improve capital regulation. 

• Basel III attempts to correct the problems with Basel II and is an improvement. It increases the minimum capital requirement (capital to risk-weighted 

assets), introduces a leverage ratio and capital conservation buffer, tightens 

restrictions on what counts as capital so that common equity is the predominant source of capital, improves the treatment of off-balance-sheet exposures 

and funding, and includes a proposal for counter-cyclical capital requirements. 

• Some countries require an even higher minimum capital requirement than 

the recommended 7 percent (Tier 1 common equity base plus capital conservation buffer) in Basel III. For example, Switzerland is requiring a 10 percent 

Tier 1 equity risk-based ratio and a 19 percent total capital risk-based ratio. 

The preliminary report of the U.K.’s Independent Commission on Banking, 

the Vickers report, also recommends a 10 percent Tier 1 common equity riskbased capital requirement for British banks. 

• Nevertheless, we do not believe Basel III capital rules will be effective largely 

because of the complexity of the largest financial companies and the variety 

of their activities. The complexity and variety of activities requires complex, 

risk-based capital rules, which were reflected in the 1996 revision to Basel 

I and the 2004 Basel II requirements. However, the requirements depend on 

regulators setting relative prices in the form of risk weights for the various 

asset classes, or for the firms to set their own requirements based on internal 

model risk calculations. Basel III is an extension of these previous standards, 

and the underlying problems causing instability remain. In addition, the leverage ratio is based on Tier 1 capital instead of common equity and is only 

3 percent. Stronger minimum leverage ratios have been recommended by 

economists and some regulators. 

• The Dodd-Frank Act requires regulators to set more stringent capital requirements for BHCs and FHCs with more than $50 billion in assets and nonbank 

financial companies determined to be systemically important than for other 

banking organizations. The capital requirements, however, are based off the 

Basel III requirements. 

• Systemic risk fee 

• These proposals are based on the traditional economic policy of taxing 

externalities. Market data on financial companies and historical data on financial crises are used to assess the expected cost of financial crises and the 

individual contributions of financial institutions to these costs. Based on these 

estimates, a fee is charged so that financial institutions internalize the systemic impact of their decisions.16 Presumably, the fee would also account for 

the increased systemic risk of being too-big-to-fail. By charging the appropriate fee, companies would reduce or even divest activities that are no longer 

profitable. 

• Charging a fee clearly is an appropriate policy option, but we believe it would 

be very hard to implement in practice for the same reasons as implementing 

the risk-based capital requirements along the lines of Basel II. It is extremely 

hard in practice to calibrate the risk-weights and fees in such a way that the 

banks are not able to arbitrage them away. In addition, because it is impossible to always charge the right fee on a continuous basis, some firms will 

still end up taking too much risk. While the likelihood of a crisis would be 

reduced, the cost of a crisis may still be too large. 

• Improve supervision 

• The Dodd-Frank Act made the Federal Reserve the consolidated supervisor 

for BHCs and FHCs with more than $50 billion in assets and nonbank financial companies determined to be systemically important. The Act also requires 

the Federal Reserve to establish more stringent prudential standards for 

these organizations than for other banking organizations. 
53 

17The Senior Supervisors Group provides a number of reasons for poor risk management practices in complex financial institutions in the March 2008 report ‘‘Observations on Risk Management Practices during the Recent Market Turbulence.’’ 18Gary Gorton and Andrew Metrick propose a system of insurance for money market mutual 

funds combined with strict regulation of securities used as collateral in repo transactions in 

‘‘Regulating the Shadow Banking System.’’ 

• We do not believe enhanced supervision will be effective without restricting 

the activities of the largest financial companies. First, there is evidence that 

the largest financial companies did not fully understand the extent of their 

risk exposures for a variety of reasons.17 If the organization does not fully understand the risks, it is infeasible for the regulatory authority to understand 

the risks and effectively supervise the organization. 

• Second, many of the activities that pose the greatest risks to the organization 

and to the broader financial system and economy are not conducive to prudential supervision because of the short-term nature of the risks. As noted 

earlier, activities that have high short-term risks cannot be effectively monitored because supervision and regulation occurs periodically at potentially irregular intervals. 

• Essentially, the overall regulatory system for the largest financial companies 

broke down by not keeping up with the evolution of the financial system. 

Commercial and investment banking organizations began engaging in activities that the market, bank management, and regulators cannot assess, monitor, and/or control very well. As a result, expanding supervision to the same 

activities that cannot be supervised well will not fix the problem. 

• Guaranteeing repo—a variety of proposals have been made, many of which include provisions to limit Government liability, such as limiting collateral to very 

safe securities and charging a fee.18

• The idea behind this approach is that repo is a primary source of funds for 

much of the shadow banking system, but also provides value to large financial 

and nonfinancial companies that have a demand for repo because they want 

a risk-free asset for cash management purposes and bank deposits are only 

insured up to $250,000. 

• We see no reason why the Government and taxpayer should step in and insure positions taken by sophisticated investors with abilities to analyze the 

risk of securities that back their loans. Therefore, there is no rationale for the 

Government to provide guarantees even in exchange for heavier regulation 

and supervision of repo markets. 
54 

Stability, growth and regulatory reform 

R ... "", .. u. S. KII. R '''''J<-- 'If c.--b (h:I ,~ .,o.i:..,." _ s.:.-o(Bwso ... 

An fIIlOImous ~n lias gons tiki I1flnlChg and finWlCiaI rrIfIJlatay refomJ ft:ilrNrlrriJ 1M recent f/mlrdal 

Clisls. The pi1pBrlsan Blletnpl 10 dtlset/09 some key open qut!:Stbnsabolllt1e relarton among SJ;Jbllty, 

glowth. 8f!d regi.JalOry reform and 111«1 raise some COI"C8ms abOll (Wefflfflfl!8s1s aJ S()ffI6 i1stnmenls 

andurtierem,nasi5 on others h theongcing refamprocfJ6S. 

PutlI; detf. tfJJf)4Uf'J pol:)' If/d ~f>IfIdJIlt.JboIl)I 

8anqugdo f"f8I..::lt · Flnln:iaI Slabllj;yRwioW ' No. 18 ' A.priI2012 
55 

All ~lIon»O\" dR>(\ h.u lIone UIOO b.:Intln~ 

and f1.lIancl:a.l '~gul"\(ltJ fIllOnU lo"' lIl ~ 

th~ ",cenl fl'\arlCI ... 1 (,ISiS I could 001 begin 

,0 OO'I'er ~ MlIaH flacuon or 1M kfy 1IS\1I!IC", of,lIe 

OIlI!C"lnR worldwide debIIle hlMtoo, 1 wUl try to 

dnlCt'lbe some key open qU~\I(>Il5~IXIU\ the rel'l!1OO 

~n'lO la 6UbliJl)'. \ll"O""th. and ",s;uIOltOry reR>rm :Iud 

then I3I.'<e some concerns .bout overemphMl.> on 

some lMwmeml3nd IInd 'em l~l asu o:m OIheu III 

the oJ1lll>lrlll reb'm plOOlSi'i (The ntl. dll"« .leQiOfIS 

m:!w heavll,y on Krosz.nu ftnthCOlru n.Q). 

11 DoES GREATER FlrIANCIAl DEPTH 

AND DEVELOPMENT INCREASE 

OR REOUCE VOlAnUn? 

AJ With any ,lme or rdon n, II I$Cf\JC1.;II to d~~r1r 

uu ~L'te lhe gom or obJcGtlve& or banting lilli' 

Ona"ellli re,#ulatOl}' ",fuml, ludll\lI bOth public 

nd 1)f1";l\C /l)n11.. of cu]~tlotl . I believe m~\ 

th~ ~al of b~nk l$ :and Ananclal develo ptlll'lflt 

.nrt ",gulanon ' llouid be \0 WPpo(l mld enh:UlU 

U$\alll~bl e economIc lltow,h, WIlSl$le ll1 " 'Itll 

Wl\SUmu~oll that maintains the \Q~1;lI of 

the ma.te.!. A bQ1:el)o)dyo(f'e~ardl~6Ilth)1 

~ &epand d~"doped finano;l.tll ~ya«!m lnd'lVln~ 

(Ore .. behUid economIC ,Ievcloprnent and growlh 

(sec, e4l., .he.st"nm~ryln LC'ltne/IJ"hcomulII ,hal 

I d(';lw on h"~l C~unuy eVldenoe SU\llI«1S 

Iha ..... lch "Y ... ems Un bo p.nl<:t~.r1y hdpl'ul foe 

'hOI<! at Ihe lowu end o/'.h ~ trmnlc dbuibu.l!)n. 

The pt\m;>ry mechanISm Ibt lh. !'OWlye growlh 

Ilnpacu appelu to be .tllough moreuUlR Ihe 

rn ency of Ihe .ulo;:..,UOR of c.tPII:II to Ille h~e&1 

r...um projeCts ""d .I;IYIOl! Ihe less .muont <IoCA>!ss t:l 

Clpltallha, Ihey ...-QuId no! lIave Ill) les:sdevelOpCd 

sy .... om 

11\15 h'le of ~ lIQWeve" i"ner.1l.lY does nOt 

~ddreu ; fUnd ~mental Inue. M~lt lher.! be ~ 

,rMe~(fW1,h voIaull1Y'/ (Seoe K~ ' and Str:tll'lll, 

:ron .) Tllal I$, to (oIl",ln l hl&he~ ~lQWlh ''''lum· 

IhIOU$h I1f1ll",,,.}l de.-tloplilem, 10 ~,cre a cos. In 

temlS 0/' IIf1!.IU 'ust· III Ihe sYlllem? Followlllg Ihe 

cruIS, tillS IS. a1t1e:ll lMue 10 Invell\lIJte R)r .hl5 

rt.lSOU, I ""'Iud..:! '.lIM2illabl. go"",.h" rather llIJn 

simply "~l'IJ"'lh' lIS ~n o r die ~oal or ,ell-ula",,,· 

n:ftotm , ThIS lSMI e r.lLSu. a lin diet 1nd mu h mort 

Y>tX11lII' '1lleitlOn, Irlhere I' IYch a Ir.>d ~, Ulen 

hOW WOUld ~ dCtef'l~1 1e diC O!"~IUI';StU ot Ihe 

fI":UlclJl~ b. JII eootlon\y? 

Th~ "," ally . areuer 11n~n lAI de pth a nd 

d!:valo pmull GOll ld ellher Ine.use or de el'o!.u<:I 

,,~bt!IIY. On ,he one h.nd, 'it Illl'\le r "',Id lIlOIe 

;je\'tloped fln.1f\l;l.ll..,OIIOf tould In'PIt''e full; ~"f\8 

~lId dl" ~fl lIk lUon and Ihen:by n!:duc.: vol~.III\y 

01, Ihe OIlIu, ~ L'U"~llnd mOte developed Alune,", 

se<::WT GO\Ild 3110\0' gruo:er OOf\Ce'lIr.luon. of Tl$t 

~nd £,!!ncr.lle IfII000000nni!c\IOn.'I, Ihen!by "",emMUy 

n~WIlQ dlOl enwe S)'WOm nlll')ftl !i':Ijli.1e 0IIlI1 vulnen\ll ~ 

10 fillocb, Policy II\.lken nQ~Qe(] In Ananct.1 

(tpl1l~IOIY team n~tJ \0 c:<)!uldoe. Illc-'O oPpoQllS 

Ib ~ 111 the filt,m cl.ll J)'I'lwm 

Unfilt'U'Mtely, Illt\e ,-e.eardt eJ:!$t. IC! he lp ~\I!d e 

IX'tK;y nl:,l~(l lI. In urller wOlk wnlt Luc LaeVtll 

and Dmn rl~ KII,,~ bltl on b.:mklna aUd (2007). 

for 'I)lJnlple, we ndl~ tlr add,t&se(] thIS by 

lootIng al whether flnns lllal ~](o d more on 

SOUfC'es of .,tlern.' AMnoe weI,., lUI horde' dunng 

b.IIl'.:IIliI'Iln:tneL11 ~ 1IWI1l111\S Ih., !dl«! n\Of$ 

011 !mem.:llly~neD'..:! C33h \lows""" only dld wll 

1l,1d this gener~Uy aclOSS coumnel, we /lJulld d~u 

d," affect ... "" ~IOSI p<"<"lounced 111 ooumt\e. wldl 

Ill~ deepest 8T\.lnelal5yRellls, (See abo Kros;lnet 

2007,) Th~ e,'\dence thus IIlnl.$ a, Ihe po!SlbllllY 

or. 1f,ld~ff, '11M deepet 61l.:1nCIIl .}'S1~1l1 m",hl 

CI'l!:Ite mot e OOluklCUOt'lS b/!~n llie rea! and "Ill 

1l'~'n cl:I l ~Ct:lfI ,hal OO\ild nme ,he 6mlS thlll fI!ly 

OlOR he""tyoll die 8MOClai symul nae vulnfflhlll11" banking clisls Our ~naLyoIo, '10......,,,r. d~11\Qt 

llloW liS 10 olddress III det:lU til/! w~ll:lfl!qUMt on 01 

... lIo,hel tIlC.1e 1Ir'lleS of finns or Ihe eeonon~' as a 

.... hoIe .... as beul!roff!n ~iC long nln, 

The <1."0 hom br.lnchlllg dele~ulauon ' crOb 

US 1i1~ U, howeve " ' ''gge'I' ,hal the,. 11 no 

lroUe<.olT 001 Ihal ()eept'lIln£ 01 lll. A,,,,nclal I«lOr 

10 a .... In·wlll. · The evidenc e .ru~e.", .n.. ,t:l.e 

~lOwlh rales te ncllO InerNfiC ~].)Wllta br.lnQu!1$ 

doJlt$u ~llOI1 Ex;Inunhlll ,he <lmlner oentu,y dUfUIIl 

.... /Ildl . t:lIU, rel'l)\)\'ed b~m l1llhal !t ~ r'e .... me<l 

b;lnb fulm br;mchlf\& ~efOa; ~"eJ, or~I1, Rime. 

~.Id Suahan (lOU ) and KJo.znet and Su:ilian 

(tonheomulJ!:l fI,1d diM me;lSluu c r ... a.e eOO\lOOlIC 

ooI,IUII;,Y fi:U ill d ie b.l.nkltlllsystcm ~lIegr.tled acros.s 

$t:l.~ '''' . .. 'n,. Y1ll"Iabillo.y c.f ... ,. ernploymeut 

~IO\'I' th a nd Ihe ~Ih f~.sute pro..l\lo." , Rlr 

enmple. deen:&etl afl er tlllel1lt:lle br.mclUI\JI. was j)eltUllted !metestl11gly, !XlIII ~",w,h sl\oo:ks and 

Alblicc«lC; 1I'IO'II18o'Y{df¥_rnlnl:>dJst;lll1ly' 

BaflQW oe 'FilIIIoi • ~ltl Slidity No. ,e · AoIrI2Q11 
56 

IfCnd powth t:I't~ ~c I~ illIte II("fl»l;S!.1((!5 

at !II t. ~IP\k O{ OXIQ)mon.ll lt,)' rAl he O\' lol r~lp v{ 

b.nks In IhcuWleJ I~ ' 

The rd~uoMlup bolWe<!n tho. fin.nclOll ""<AO. ~nd 

"'~'UUcy. illu" .. ~n open IIn."1I0n tha, 'noN. ... OIk 

on tho! 111/:I0I0; ,~ ec ,,\ S""ncl.ll .:n.1I IUY ho:lp \0 shed 

1~1I upOn 

21 How to Juoc.E THE COSTS AN) BENERTS 

~ ftWfCIII,l..IHN(1.'AD:;IH? 

AldloOt'£ll ! believe that 611.,,)(:1>1 1!lIlO • .,"'01l$ ~Ro 

CIIICio"i In ~ d;rmnuc, &roWllll;eoonCIlt1Y, lO8On1e ~ 

theOd ,",1<PY:IIlallS rrny Ix J:onlll .. £~ The 'l!I>O<Y 

t'Joc o{ cr .. ,H, ... l:1oh .... n.,.. (CDS). ". =rnple. IS 

th:I. tbo:y 0'" btill"""JUlO'i~I"1lJ tha, pcmlll """ke!. 

p.1I ~" w hoedriIe del:tull M oil(! I:I'-'e .supefVlOOfS 

one n1oeU1C \0 'ne;asu", nwke' ~""f!\lOrlS 0 1"";0 ftnp'$ 

or a oo.·utt~ " rISk In """ ,Ime. The 'OOd' IlIGt 

o{cos. 110 ..... ""~ IS ,II" .IJ()' Qn pel nm .""",MunQ 

rISk OOncc".r. ,\i}1IS ( "\I-. Ale) ,ha, Cln 1I""",,,,,e 

r~k In' tI"C() QQ llQ~ ' . nd J),<'I'e,nIC riP. wht n 

' Mdt <l<l n.t'.lCl ~ <lfe uaded o~ r·tll .-<o "n, (1".nd ,1(;0 

""UIl,1lly e1e~red (fOe ~"et .nd$hUle1; 2011). 

TIle!Xl&t>IIl twO-tlud I"IIIUlMoflnliO'r.l,lOJI rn~,he 

IIU""IOO o{how .""1'<..-110. (or m3ri;er I'1UloClpOm) 

e.mn determi ne In o-d'";II>CC "'. n~;LWQa~ ,,·nh ~ 

new 1,l$lnilnen' 01 ~ 1\~rkeIStru l\lludl.lt wookl 

be ~ II> rtduGt <I".., ru.b. ObVlco.'-'I)·. WI UI 

• ne'" In.lI.men" It IS difficult _ Ifnotlmposslble _ 

to IInderl.lke the empUical I. mnl! ,0 ~'" ,h~ 

IWO Ct<:es "'al .... e11 an In"","",100 nl.1Y , .. V .. The 

C(lft or W1PI'~ all tYJlM o(tlnanCII~1 Innov;t.ll()tl 

due.o 1,,,,,(lIa.,,, <ilIA, OW"e""~ seems tOO {lre.lt 

Oevelop'II£' ' ... ",ewo.t lb. er,tJ.~ung "'" ~ 

.nd ~Qefit< or "'QQ"3110!! U Mother cn ~ '50ue 

mt.ted b1 'he R<:Cnt "1Sj,, II()W ,,;, de> dll$, hOWeve,. 

""""uu. fultd.monw <hallonze 

P.Yen 'n _ whele "'e di;) hove re ~,rvel,y ~ 

d.", ....... " IS po.Wble <I ... llt ~ In'lOvotlo n 'I$0Il11 

.::an dl"~ !lie hlStonc.al r:ottel~uoll' d mu_ 

liotlts,.MY m.oy be endo!l<noOIJs w ,lit tnnO\l;ltlC>t\, 

tSec Kroozncr. 201& ) Rlt· ,,.,., of die Ziltll """'''f)'. 1Xe..,"II~dte 1Mf_( l113fte, lrIlbe]JnledSt:ites 

P<Mc""III."""'_.ypo.l:)''''''IhI~lt .. .. 

w~ . rel311Yd y ft:t~m"n' ~ lI-~tIlphle~U)', .0 

g~,..,.,.phl ~ dlVenlSc.:>11On (i/"n IlIOUg.<.iIC )O) 11o 

WIlIJ red pOll t15t In.e rM;1le bank""- u well 3$ 

~CO£:faplIl CJlIy d", .... fI.d poolJof m~~kad 

set unuu(M8S) helj\e<l1O pftl'<lOO a """on.1 sou..:c 

nfftn.:tnclll£. In ptlOOplr. tnntsonlli.l,b. ndrver&l{y 

~wJJ /lI)'n 1« .tI! MlLI'tn~ m t OOn"""lrn,lOI1' und 

mcbvldu3.1 borne (J\\lleDOOUid ~~p a nlllonal mth<lr 

th:ut loc:tllSed "",.kill ft>t 6"" ta~.11e\r lllO" ~ 

"TIk: .. itlll.,.~u l. how.!~I. ch.11\!1'!d.1te tusoorlc:t l 

o:>m! l~tl on. and rllb by helpbtg to m c • .,.,..,", til" 

Ul~'IOf1 , l-.enee <l<lm:l,,"'I, 0l" 1101ISl1I£ m:ttkC\, 

' Cltl56 th. «IWIQ)'. 'tlt1lS, the bc ~at$of~1'I1IQ! 

;"YclSl&ClIU01' "";Ilted I,""CISeIj· ~ Im""menl.SSUal 

as MIlS ro&e to plOVkIIl ~"" dl"""lficatIOlL AS th~ 

"""m,,1e ~ f!,~ o_1be t:"tcaot:r 6tUlldal 

I"""",," on IS a ,,;utl "'~'ly yt:ll"ll tMk bu, on~ thot 

deservu HIU;{h ten (;fI 

31 C OULD HIGH CAPITAL REQUIROIEN1S 

PROYIOE A FALSE SENSE OF SECUIltTY? 

'!l .. ClUIii _.lied Ih~lbotI\ t.II~ q~:u\otY ",Id quttJl1Y 

l'Ife;t p,,:l! helu byl;lrutk,,~ >tid O"'"lI\.:a."Il !nsutUU,,1I.S 

.... t le de:ltly In'ldeq~3, e to deal WI", &l1OCk, 10 Ihe 

~}':Iletn I wam 10 ~1,e uA.,nbl$lIOusIy ",al [ bel"",. 

llut U1Iposblg 11\31>. , ""plClI toIlUI",nte" " i:-l!oow1l111 

!he ,,,~"!II ~ ~, ,..;pOIWl. y~rn, ho~""~ 

II ~""l r:tUI ~ e:t 1~t.1l ft<lUIR.netIU IS 1101 a O-lte<lU ~nd 

111&0' ''' c.:a.!eS~.,U) t:) bt! Idled "PO"~" ... I>so."u.e 

"" direc tly <1d.1re&$1rt; fi":l$;lIIUes II! ,llc t;ySltAl 

H'a!t c:tpmt "","lre m. "'i. I WOlf}". &;In proVIde 

.. Cal oc 6o<1lS\' of ~CUflIY 1(> ~u[~\01'$ an..! \0 lile 

pubho abOu. lilt .. /eIY ~ 6O~ltd" e" of tlt e nnoneul sy,,"'" and Iud '0 com[.'l" y In 

m •• Ii\I~ reueffe@l.\IOf!,· fefbnn (SeUI9o '\ICI:et; 

2012) A hl.\!h c:lplt:il '«lunemen~ 1\), InlUnOl!. " 

not ~ ."botll"'. ii»" devdoplna ood. tty ,_Iutlon 

proo;tdUltl-; both dome~colly and c~e . 

or n" unp(QVI~ markct In{I;&SINel",e, ,oeh 8$ 

«nlrnl-deat"lrt;" onr-th""'-'OUll"'. d. ,w:ruva (.see 

K ..... n toeT ",Id SblUet ?Dl 1) t belle-..... Nt It ,"bes>. II> 

:rdd~" p • .:.blen," "lid ""IneIltbUII1Ca directly ""he. 

th!ut 'niI''''<tly 'n onkr to ,,,/11100 ,h .. hbhOOod of 

uDin'tndf(! <l<lnsoequenc.oe&. 

~_ di ~ FlnancIllS~tl liI)' fIeII ... · No, 10 · ,IQrI lOU 
57 

R,,!!SIII, tOO he~V1ly on 3~' one inmum ru, ~~II 

U I::l ptui requt,enlol! nu, may nO. be 3 !"Odent 

~P\lf«Idl Rlr rt.tuiaas and supervuGr:I _ much ;lS 

W!! would no. 10';1111 banb to put 100 IMIlY oftllur 

~ hI one bukel' Very hrgll (.:trloi requiremems 

I::lU genenue lncerltlvel 10 tht ownc,,· (If .he 

ft't.ln ~'\I h'll>lUUUl'n 10 tly \0 ~ue on ,UOf1:l N k !t. 

(I'Ue' ID re<H:ll "'tum (Ill equuJ' iIOolh (~e Levine 

fo nhoomlnR). Mm-e II ·" v, dr. b~h r tire 

~lllrem n' , tile more Irlcemlve !here b ID Rnd "-:t,},, lOllItd it. Thew. lnctutl''eJean d ID ~ " ' Utlbet or 

unlme nd. d ooulilquen oos. 

A velY hl~r caPIt:iJ requ lremeUt, fur tL'ml'l ~ Giln Iud to more ff-b3l u' ee l ac uvu,)' Hid riSk 

oeJlpOlluru by a regulJ.ed ItlStlm.lons Ibm UII\Y be 

h~ rde t' for It.'petvlwn a nd Ihe jlubho \0 dClcel. 

Sew!Id, It Q n plI3h :>cUVllle$oifll1lD the ',h:odows,' 

UI nurk<o'$ ~nd tl'uoon~ .ha. are 1t0l duecd )' 

...,subled bill Ih.;il ,nay be d ,,"!S Inte, Ol) n'~ 10 

the ItJlIIl ~ IAAltltlklns., 1'.8_. oo tTOWel>, l\Io;,l en , 

3nd ooun""tp.1tu .... TIuld. I. C:m ch.nne.! dfons In 

fin.:tn ~'\Il1I nov:lU u to l't.~l e IllStrunl<lnls dl1lt m ay 

~ p;!fUCUia ' (;;IpI!i1I requtrtmems but ,\(It nJdu c.e 

tUb 10 an IndlvtlluJllnStUullon or 1:1 the &ySt.e1ll as 

~ whole. II isqune ,Ufflct ~, Ib, d. e Ba.!eI COmnlluec 

u wt ll J& nJdOn.'Il ~uL1lOts !Oaet tlte rm: jlI'1(!lft~ 

·,\gllt" In ~ <\ynanuo ,k~t. 11IU$, I:Ilher Ih~n 

Wru.etVlfl$ Impervl&Ory reso ~ and prOVIding 

I/Iu~ , clIshlOns agJ,nso. ~boc , very h1S!h cajlIt.11 

nqulremolnlS c:ould pu adoJtlCaLly ~ql"f'! g,e,lIer 

YIgUanC(l b)" WJl'lrv lSOt$. atner-ll e more fr3$ll e 

InletcOnnecuou, ;\00 d, by l1o, e nU.,Uy redu ce 

Ihe OYCr.lU 6'lk lY and IKIUOOllf.W or.1I<! sy6""m. 

I "ill (1m". 3n "naloJO' WIth tl>!! M'lgtIlD\ 1.11 .. , 'he 

nlOn! heavUy you n!1y OIr anyonr: ,nstlll"""",. tite 

mo re Ineo"uvt tllef'! b \0 e>';lde It :In" Ihe rewer 

re5OUI(t5 may be :tIloaued \0 oth er ttlStn" nt ~ 

rd l\ln ~ (en oiftme) RlIlowltlg tht la ~ ~ 

o( ~ In \\\l,,1 Wor I. \h ~ Fren.:11 de1».ed Ill<l mOSt 

efJectl'''' wa:,. \0 pll:", nt I relteOll oflh.ll tr:Iae d)", 

a~ ... les de o.UUd llIu !"d th t f'tana! sltould 111_ 

In new \)"llG o(<I(.nol"ed IIlWlle vehi cle" ~l tfJO"o1-'e ( 

",d ,ho .1;11111113 (1~ ~ $t:lndlnll a.lIlY 10 r 

• Gem"'" rnva.sw,,, ~"d allow :I r:lpId . nd no lbl e 

, ... "" • .u Ifon~ <IId ;><:cut. .A.nd,t ,,"bg!"o, o:ou """ ..-:l 

Iha, resoorces would be mOle dr~e ve )" u£ed 10 

hulld a heavUy klruiitd b.1ntolr to liele. ~nd $\oW a 

Getman U.va.5IOIt If an ltIv.uton we re to begin. he 

aJVUe4. th IS dete ~ wou ld gtve wllicWln, time fOr 

Fr.wce t<l mobrllse . ltd ".U Ul1 lftervet. Iltef'eby 

~hu.~ 31 ge "'1111ting nn and UlV e61 mellt 

III ~ 1le;lfl ~ 0( raptd reJp(llue.' M~lnol or OOUfSe 

WOIl U>e~IlIU, t!e ",. and Y"moe buUI wbJt tJlue 'o ~ 

klk>WU ~ ~l ~ Ma~oot LI"" ~I on.g ~ e:LW!nr oo,(\e, 

10 the I YXlt. 

In t3 po ~. the Gt:rnt.11lS n a""':llly it1c d to \lnd 

Yi around the rttrutkatloll .nd tn v!'.S~ her.9tly 

In In novati ve llrIIIouli hlobUe v~ hl n {P.lnu r 

DI\1S ton~} and altpower (Ltttl.w:lne). "l1le Genn:r1lS 

nll <1e~ hghmm! N lcllnke (Bliluateg) th fO ual'llI ~ 

Ardenn"" brest. Ihe "'t:I~1 p(IIn. or d.e M'I!Inot 

LI.le, CI.-e n d, e denK tleM <>f Ihe 1bre51 aud dletr 

1Q,Uilr:a'IOI13. however, the FrenclI mtllt:lfy dld ur;.o; 

believe ,h' l :I quick Inn~ ,hl"Ou!llt Ih ~ Amelltlef 

"'» le. '00'·'011&130·, Ihey we~ WTOfl$ Jlld 800Il 

the I>i.lgUlOt LIn e """, Sillroltndcd, ... d Y,anae rd l 

loGen.I1IItY tWO nth a/l. r d.e l"lml UlvastOll. 

In resu< L' to lY~fO nn. lI lo lm pon.1m to lI yto 3.~the 

f:\b!l <Se,1Se or 1Il00llty and aGeMIYe rell.:e nee OIl .one 

lnStmmeUl Cit plt:tl 'M1TIIl1S' r.1Il be l~fu) but they 

can ~150 e= ~ 51~ 'M ntlV e5 \0 ft,1d Innov:mvc 

w."\)"S iQaY:lde thcm As the CIWS demoru.tr.lted, wNl 

'1Il.I' have b ten .\lee" as a l\.t:aplt3H~ l'ISUWtJOO 

Gin h.we th,", 'IOnlllCidon' erOOe a lrenlol!ly quICkly 

tt, .umullllOOS .mrte! o;:ondl dOI\l. ' Prompt o::>rrecllve 

:lencm ' , d lwon Cilr1oll:oytT5 J!x7;c the regub""7 

n"mmtom 10 proYlde lUffiete lll time /br ren.t(II.1 

;Kuon, Wllhe I;Iptd decline ofW<lSltlt\ll,on Mutual·i 

t::1 pl!i1l ..,Uott. fur lnst;lnoe. de QIOIUt,:a"". tb'l ~l C 

carl.." '~uft;::' Ll n' may no. IIr ... , S"Jl'i'n-ISo" 

JUfH Clem ltine lOaCt In 3ddllton, a:llVlil(&" \h.:lt ""toe 

IhOtl$.h t to be . elatIVely low rUt. suo:JI as hOWl '1S 

(as eVidellCtd by low B.1 1 I r1Sk we~ u). col~d 

oK\Wlly be dlt piacuo(gJtJteSt yuloot1lbill.y. m~ h 

ILU die AnI nllll ' 

The leuc.n lOr supervlln($. 3tld Qul lOl i " r1l)\ '0 

nob· on ~ry h@! ~PIla. 1 as ~ l ubiStm,," t1:ord ~l1na 

Wldl fragUltloill a"d '"IJJ net1lb~I1I ~5 dm1\Lghou, ~, . 

"Y" n' Th~ "nm •• nd."j com.o:q" ""<U of .komr;r "" 

7Iw,..,_o(""_ ... " .. _ ...... ,, __ I<oof.....;.,.. ............ . ..... _..J_ .. _ ... _,...~ .. "' .. (-""..v....,._rf) ~ · ... ___ .,.-.-_ .......... /0-_ ............. -.1._'''' __ 1''''100. __ . .............. f&oI ....... ~ .. __ • ......-. ___ .~..4..,._, 190 

A/.Ilft)OOoIit. WOII>Q/Y(Df¥_Itln:lllltlb#n 

BafIQIM ~ fi"lIfA · F'MrCial Stilbilly RwiM • /oio •• e' Apr, am 
58 

have \he j)OI<il1\l;1l lO «>.1"«. cuMr ~I.lll ~'UI~I\Ce, 

n1bUI.y f<h~ s1 .... m C:iplcol ""IuII. moms 0I101I1.l 

b e ImdefltOOd U 3 oomille mem 10 fvu ry 

Vli!L1nr.e and ,lOt a SOUIU oomrt~ ey [;lin 

o;)Ilc;enlro <h" ~ muchemplo.lShlo Ibe $UI)eIVlSOt')' 

cornmunltY h\'!$ be en PUI o n <;:I plt:ll lhal o ltle, 

,etOr!lu, $\IchascfOl.S ooroer ~lu'IO Il.'lnd O"iu~ 

arc deu"" uv ... onlO ct:n'I:I11y oIMId pbtfonna. 

h3ve no. boen fl!OelYlfI£ <hll priofl\y tlle.y d<: .. ~ 

41 WIl.L "' '''CROPRUOEl'mAL 

APPROACHES BE EFFEC1IVE? 

Supe rvISOr.; nd cemrnJ b.1nk.!. ro \lll<llhe w(lIld 

n " belnl:.)IIked 10 do more. and belllll en mOl"e 

.... ulhom y. to ~ In 'nJ,lol;ropnad m~I' polley, 

[n P=I "I~'. n\rnJ b;lnk3 ~Il: belll~ N ed 0) ac. 

001 ollly In theIr "",lklOOallOle as 'O,e U W\lUI>MrS" 

3' ,he n.,mes ()f a On~n t:l[ aUI~ h~v l beaun 10 

bum bIll ~I so 10 a ct a. macroprudemla l ' amoke 

detroor.;' \)e re lh O.me.s 3p (l1i ~ bl lo ""n~ 

dt'.l1Ol$ Oil ~ 2010b and 2&11 . ami )(fINne, 

and Strn!t.ln. lOll ) 

'rhe "O,e exUl\I:UlShel" tole Is Ibe tJiI5$IC OIle tll.l, 

cemral banb Iuve pL'lyro . Ienden: Onil$! ,no(\ 

nd IIqul(luy Cl\'al(J($llll1mu of fin3tl1;Llls'Il:M and 

.umlllL Once the ilames or Ih~ auIS' .ppe.,~ ,he 

cen,,;o1 blIok a n theo dlltlJe ,Item .... ,It liquidItY t:) 

pre¥ent the fi re SJ1 re~dlllj from ont hlStI ~U n Of 

malke, 10 anoth.,. III order ", ""old a oW! n ..... ldt 

00II ~1lOn, R)' nlO'llrlgbtyood 1~,ud.:> n..s~ Ill ~ 

rei\ll.lllClns, IhlS "macroptlldeml.ll appro;ach' ,nay 

I~ ... d 10 leu I'Illl'llalOry ;If\.>1I!'"oIQo!. 

The ' 51110" del eclOr' or llIa p\lld en Uil ' role 

n'pllJ '~ II"" the t;elllfalllall}: I ... a !Ut'dol",e n.ll 

~1U!b1!11Y 10 et "",ty to pre Vt'lIlh ~ under nolO 

~Ulb~ InlO nOlJDt$ Bems l\fI).l \l ~ In IIlDllltoflDg 

looIYId.al mW,UllOOS Dnt1 m~ro:moeaed maru u 

i:Jt ' I@ll$ o( (W~1 and ~1tJI wh~' macropn.(le ~1 

policy oIlOuld us upon. In 5<lme C3Sef, II make 

In,,,lve effecuYe C' W It :1I1<><;."lon b ... f':J.1!I 11IJI; the 

~ or fIIndl~ In 'lont/! seaon: J<!lauve \0 <),MI& 

The nl.'Knlprudtn1lol1 role cemutly does not O)ntlln 

WIllI ,he IllOft tl3(hOOn~l ·fi re c tlng"lshllr' .... Ie. bu. 

PtIJl~_ /IICWI«M)lPOky.~ flrIIJQI WlIiIIf 

II /l!qu IIU a Illud. U \lollided ~, Of 3udlOUlief ll!1.1 

UVltl .., 1m tI." ",n 9f1hlt eell""'- b.:mk_ 

TIKI ma IO\.'I1Id ntl.ll appmach. how e~ lw" lo:ol3l 

tlIree cbalJtllgu I'1rs.. wh~\ mettles of Iht:lnc l.ll 

lII.lbtlllYOf SJS\emte nsk ... U! t~"I", rQpltlde"'l/Il 

os1 'o ""'\1l& the fiMnc:t.l1 Md cu rreocy rt ~ 

'" tho! ~ . nd lQOOs, atademlQl aM ~rcl>em 

J, ~ [me ntallo.",! MlmeW)' Pt."II;o"d Wodd Batik 

tned oo oo vtlOV 'early wanUlIll' ·SY9;em.no olnU(:IJl;'IIII 

wh ere a C!\$IS mll!h. OOC"t. 'ntuexercuc h.-.s))ll:lved 

dl/llCUII, a ll,llhere a re Ill) nlly ~ cadY 

wJrnlll$IodJoeaO)n; to w ~ud'\l;>rlt! ~ to CI eally 

en"u$h 10 amid the rI!!1, ClIWi: 

[n addlllOn • .:an ,ln~n lal co m!ca proVide 

~ r.l1~ht fOt ..... rd .nd IheoleuuUy glounde(l 

benchnl.lrk to 115_ If tub al e beU\g Inlprope rly 

r=~ 01 pnoed1 Rl:u:.\l:.bll! P«lP1e O)uld di5.lg;ret 

aoo..'~M""pn.,C :l.$&JmptlOnsaOOut Of .ruM Ul ru.k 

3velSlClU. IIlSCoum rlIlU, • .. ~O 11!.Ics," and Otl l~' etaors 

'" _ . Jlna1l$. Rei\'1l1OtS (hus \I!:IS ~ a1UCJl;m 

ofbeUIJl~tblU1llY .I[\,'''~n'pung w substitUt e the .. 

J udgJneni r those Of In"u wm whO .;t{e lluUlo.i! 

OI 1r own Illlml!)' 011 ,he line, Snell ar.se~u>e nlS ;\Ie 

p.1r11cula.ly dlfficul, In w Jlad lntIO'I'iIIIY~ 2n: ~ 

whc.-e dal:'l h\.Sti)l'li:1 are $hon. 

I'lnally. WIll a nlr.l1 b3nk's Ind Jl ndffi~e be 

c hall en ged If " na~lIu In maCTO pn.de ,,"al 

jlOltcymakul$l" In .he MU of hOuSlnQ \\I Ih e 

United SI,:l.e., many plO{!r:.nlS olMld ~ ho me 

OWneclllp, byl()W~\kIW'fI fQYmenll< <<' 5UbsI.iuIQS 

stC\1rI ..... uon The IUII-~ ccou .of th<:se otlbsldlM 

h~'~ b«ollle clear as 1_ 3. Flmnle Mao! Jnd 

I'redobe M3C nlOuOl Yet nclthcrthe 2010 I)(:dd·Pn.tIk 

A<:I ,\Of a ny biSc Clu m a(t. have been ~lk n to 

~d/Il leSe 1S&Ie5 Ua centrol ba.ll; 3gaUI becomes 

QOIl(;< rne(l about "frothu,,:S&" 11\ holL'lll$. r<>! IOCSI(l 

rrono;e k»O..o.v:l1ue r.1II ~. ~"'"' seeulltj4;lIlOU. Or t:lLW C~ PIt.ll ml{:ll' run IOI!) polltIC.I) be;lClwlnCb. 

nl" ""elected body of the \Xmnl b.,,,}: co.~d be 

ac.; iIM<t o(Ne,ruhng 3n cleaed t:o:dy.llUl Rllnl y 

could PilI the cemllli ban); !Il Ihe poUIl c:t1 croM 

ha.rs '00 le ld to que .. .~ ,.,.,,,, Ill< ~"" .... nl$ ;o1Yl 

ru~.\(b k>r ~, ea , poUt\e31 overstgllt [(r(C,jVe 

IIl.:1CtoplIIde"tl.1! polICIeS ,hu.s nu.)' UIV'o)I\'fl rub r 

OU3! han~ inde\lelldence .1. 1 good lI(We m3n ~ .. 

~ driI FntIQ , F;..-"" Slitili!\l~ " No. 'G' AplI iO'1 " 
59 

51 Wu RESTRCTIONS OM 84MK ACTIVmeS, 

SUCH 4S THE VOLCKER RULE, 

IMPRO.'E STABILITY? 

h) res(>;)nse '" the fl"an.a.1I CIISIi of tile e.:uly 10lOt., 

the 1J1l1~d $\.lIU ~opwd a ~uo ) be: lw~e,) 

InvUlme ol b.:ultlng u>d G(I,nmerclal b~n tln~ 

wllh the C1a~le.:I\!.~l1 N:I_ Tlu~ Act Jltohiblto!d 

a commercul b.tllk or CIOfl1l1,ercJ.:ll bank holdlni 

eomp:my ftQm ha'1~ ~II)' ail!ll.1t e~ e'13'Iaed In ~ 

¥:If'Je1\Y of C,tlV Ules ~ U !oeQJnues under","un;. 

'The 1m Crnm,ll.!.e:Idl.1ll1\lly Ao. rel.12d p.)llSof the 

Cl=.Ste~l1.o.ct 10 1l_ oo,lk holdlll£ oompantes 

10 have ..,parntely Inwrporn led ~nd ~pI", ""d 

$ublidL!U\e$ enl~ In InYelunem d Itlerchant 

b.lnklll£aalVlUo'o5, twO ~\olll$h ~OOI11merel.ll \).:1111;. 

ttSo1ta lUI proI~fro1l1 doII~M (h,tctlyor through 

ItlOl<o'" !otLl»I.1la.y Dulln~ tile LIst d=de, :O ft"·l~~ 

US banluh.:lYllbeooolle lilll:nlflc.l>l1 ~ ~ershl,~, 

~"']lle. marl< .. m.lk.Il\ll \Uld 5e(:ur1ues u,rle......nU'lil 

,hf U~h IMII' 1I1l'Ulmem b.llltllll/ su~dIo1n~ 

In .... spons, ,0 ' he mOil ,eU ", CIISIS, ,he 

Dod.:l·~· 3nk ACI ",cluded a ,btm of aCtiVIties 

n!Mn(l.IOn caned the Volcker Rule The VQlcter Rule 

St',( 11y HIllI" COmme r( 131 bank a~tl"l\ eS In 

p..:.pne~1f)' It3dlflg, ",waUl otqlllty, wu\ hcdQt j\,nds 

The p,.o hlbulOnS on p. 1¥:I,e eqUIty aoo he\lil_ fU!Ids 

h;r;e ,101 CTe.:l le.J much OOlllloyel$)' because Ihese 

aQl¥1ul$(tf. rel~'lVtlly e.:>l<Y lQ de8nll aud Il:jd n'" 

bttOme an .mport:lnt pul o f oommerCl>I ban k 

O",,<1tlO"s. p[OPl1tt.,Y 'r:ldllli, however, 1Il'"O !v ~s 

much g:r1:>IU dt:1J~ liU«l de8ne ~nd ,mpl m~m 

The rerent nonce ofpropo6o!d ,ulell'L-'ttllfl from Ihe 

US n!gulalQl}' a~O!IC:!eS r:m tnOllllhan twO hundr«! 

pa,ges mil ;sked fbr c:onunellls 011 :J.8J quet<uons! 

DeJltnd~~ up.;!Il wlult Ihe fletul~,(Jr.;.(~ 10 define 

:as ' propt1oeClry' (th£ DOO:J.Fr.lIIk ~\l(Jn Jlm"Idm 

little ooncrete ~1I1d.1. Cealld, he nce, thlltona, lISt 01 

que.stJ(ms), ,he Voleke, Rule 11M ,he "",e"'l:IllO 

rWu<t m ller lhan Increase rUk~, the t>ants l1I,he 

,na,kelS. Fus" <llluml hedging RCIIVLUU o(b~nb 

eooldbe CulUUm. Sttond, Iht 10k Ihal bmb JlI;jJ a. martel m~ In tey global matkets, ruclt ... 

u.:..e ~ a<>W"''''.n. k<:On ....... cowld 1>0 ........ ced OJ 

e LlmllUu,d. 'Ille brunumded ~1.IMlCe !XlIII.;! be: 

t(o l'e(\u~ llQulc!ny ~"d lno:re.ue bIJ"Alo; Jpte'ilb. 

A ",unllt'r of lntern;",on."Il ... gubtor.!, ,n ;l(\JIUon \0 

m.: bIInb, hlve rnl5ed th e IXIOI:a1l that the Rule m~y 

1II>t:e unportJ.l)t nl:ltket& ~llq ld an;I ~$Ublt. 

In O<IJllIon, II lsdiffiwlt !O find l}"Ste,natlCtYl<leoce 

frol" ~lt!"Ne1l! CrUIs Iha\ II)V(ltvemem U) l'Opn ~1Q' 

Ir:ldlnll mC u~d ,he tl$k ilf &lLlu,'t' In th .. 

D'U,ed S~ll"" the m""" b..nb 1M, coIlapi$OO did "" 

rnmartly btC~I~ Of hL#l1 Up06Uf'e 10 mOlljpiu, '1'), dlUI lQ propnelOlf)' It:ldl''lI. 1l1le,mtlonally, 

'u\llvc:rwJ·b;tnbd~1 OOtttfe worse 111.11' thell ,00'" 

'lr:1rtl,lonlll' breuuen~nd In many casGbenefi,te4 

L't9m dIe dlYenlfiC.JUon o(lncome sources h~, nre 

~l.W(: lleo.t w,,1t enllaie'nelll In • WIde ,.rlelY 0 1 

~e vltle.s ~nerlnd MellCt,lOll) 

AS we h3'" CSfJllrlu-.:.:d from o:.:trller eptsOdos of "e{I~!a, Of)' ~,bl\r:IS! e, reMIiCtlO<lS lha, apply to ont 

sel of Lns<lluII II~ may JUSI mO' "jl IlSks 10 Q\h 1 

IflStltutlolU Of ,,,,,.ketA.,,d ''':!.y, '" o.he&UU!! un,e, 

1iI"·Use In,er·Hnlr.a.tef and markel opaqucnc». 

Depe ndll\a 1111011 ,,113, (OnSlltU'er 'ptOprL~I:"")" 

uadlna, pushUI$ rot .•• klng 3c"VlttesJUSI ootlllile 

of ~M commerel:ll bankl' ''' ~_m could It~Ye the 

WIUltended t:OfI5e(jlIell,cofn1.llu~ die emit\:! 'YMem 

more, ralher than l~u, 11~1e. Makln$ marketll 

,t);),e, no, Ius, mbu$< I! cnocC.l fbf the M:lbHIW 

of the fina,n.:ul sy5tem ~nd 'm ..... be an llllpo.Qn, 

£iQottaten !1\ ..... 11\ In the deb3Ulo ... r3( 'IYll,)' 

",stn~1l0n$ on ball .... (sec ".onne., !OlL)c and 

"1'OWle' ~,ld SI .... l'lan, 2(111 ) 

61 CotlCLUDltlG REIU.cIICS 

'nle .... L'll1Oll onlOl\ll Molbd llY, growdl, • noll I\'gIIlauon 

II! Q\lI:lL:llibr ~ letlxm prop:le;lls~l\(\ t>tlo'fltl'l'" 

1 It ..... ! ke,ched ~ {rAn",,,'Ork ft>. 1II1nklng aboul 

Iht.le l.\oIue$a nd ,oumm on a few spec,ilc I"t'6)rms. 

PQiUey·mJtel3!ohOIlld clearly a rtlClJlJlc ao.als and 

l"'do!~f8, "YOId OI'em!llmoe on my one re;gul.:"Ot)' 

IIlS1rl'men\ .ndbe S<J1UlllVe ,0 p:i\enttll uI1Ime,lded 

con~ fneu or retolatOry ~Rlrrn" ldenu~'nt 

ft:illbtle.!l and then :lddlesli"lII th!!m "" directly," 

pO<\<IIbl a ""'~Id m an .m.c.._ ... 'O' 00 a,tl\.nca the 

~Slll~ of Ihe iimncral system 

" AI*dlll!t l!IGI'ltll(VrdCf""'m_I$/~ 

8It1lQ!.lQ 0» fj;n:o. "-lIW"I:lal St:bliI'fR;Miw· ~ , II' Afl!lao'2 
60 

REFERENCES 

CQod ~'rt (C,) (2010) 

'TIlt h'~~ rolt of n,~1 !);an):,,; IllS Allnual 

Rellean:h ConferenOl!. June. 

liroJ~r (It. S.) ( 1000) 

'TI\(I e volutio n of unlvc 1 b:lnkllljl a nd h i 

«:platlon III IW'II:ntle!b cen,ury Ame n",,', PII. 7O-IIQ 

In Anthony S:l undt m 300 b~ WaIte., M.I.. Unl'leB:lI 

&lnklng: rln,ncU] Sr ... em De&1$Il Rt«lmlde~ 

lrwtn. 

linmner (R. S.) (?007) 

'Ana!yslni and :lSSUS11ljI banktng Crises.' 511eedl 

~. Feder,l Rtlerve Dant M S.1n Fra nc IS co. 

Confen:nceon the ,ul<ln Flt~,naal CrISIS ",",VISIt«!, 

SePtember!>. 

Ii"m.ocr (It. S.) (lOIO) (al 

"llle p;lIaooIof fin.:mcUltnOOYOltton.' WO"'"w lbpa', 

Jlebnta1)' 

liroUllt.T (It. s.) (lOtll) (h) 

·Wh .. .!bould central b:lnb do? A comme nt on 

Goodhan..' PJS A,b}tI.'II RL!eJn:h Conr ~nce. June. 

lironn.:r (It. S.) (lOIO) (e) 

·lmeKoruu:aedllt.ls. fI:l$:IlllY. and \he fI«II1C1:tl crwr'". 

F,m.n ~'l CfUIS hll]n,ry OommWlon. FdJrugj)', 

li ro~.mt.T (R, S.) 

·\\)IJulllY. IMCNauon, ""Plt.ll, and mactol'nldentll\l 

PJlIcy: A comment on JIlISS l..evtne.' i'edernll"'!.! 5erYe 

&lnt o r K.1n u& CIIY, Jact ooll Ho le Sym~lum 

Pl'Oowlln», Ibnhoomtn.g. 

linmncr (It. S.) (!OJl) 

' ChUengei of m,ero prode nual polley: In 

Clu.,siens (S.). Iivanofr (D.), K;r.ufn.an (0 ) .nd 

Kodrn (I .. ). edl., M,crol'rudenuat regul"ory 

polt clu, the new .000d 10 On~n cl ~l SI-,btlty?, 

H actenAct, NJ World St;fcn,i/fc P~lIIilh~rs, 

JIV 3~.a6 

Kn» •. ncr(II..S,). I ...... .., n ( t ,);!.n<i KJl na<:bld ( O,) 

(2001) 

'Danklni crtlles, fm,ncl31 D.ce , ~nd 

Growth: !"un.al of Fin"n" .. 1 EGl/lIomia, April, 

84(1). pp. 187.228. 

Pldo d9tr. mc:n«IrY~i;y.t1lll' 1nI ...... fld&, 

liroUl~r (R. 5.) and cJlck (w.) (2011 ) 

'11le ' <lfP)n5t-ofthe 1'00"",,1 Reserve to the re~n\ 

bJutn'i and RUJutl>l~. In J e;on I'!!.m~Feny, 

Adam ()S~ . 3nd I'ab,I,,1Q s..c¢:Omaunl. ~d~, 

An OoMn Ap;1I17 CQrnp.trlr-,; ThI,...,,!>nuc Rt,JIOfUt 

0) !be nlllnCIal CrISIS, BrulStl&: llruri'!l ~lloljju, e 

and PeltfIDnln"L'uoon b" In"""",Lotul [cononHQ. 

liroUlloCr (It. So) ;1,. 1 R."\J;I n (R. C.) OO ) 

'11 the GIa5l.SIt~1 Aa JUKLiIul? A .study of II" 

USupenerlCfowlth un lve.1S;I] bJnklJlabtfure 1033', 

AI!tOiron EcoIlGfIlU: Raw'. J'P. 81C1J2. Sepoe.me. 

liruozncr (It. So) a nd SII1J1e. (R. J.) (lOll ) 

Rtji:>nr.:ng US fil1GIIGio/ maruI.s: "flI\:rlOt1.llH:[o,t O/llt 

/I(!,WtlI Dodd-flmtl;. Clmbrttlge. MA. MIT Press 

Ii",S1 loCr (It. So) ~ •• I Stn han (P. E.) nOll) 

'FlnanClal IIlgubtory re form. cMl ~ ahead: 

A",mam EcoIwmic Rn'iOl', i'flpas "nd~, 

M~', 101(3)' pp. 242.-46. 

liron.ne r ( Il. 5.) .. nd 5 ,ra l).lll (t~ E.) 

'Rell"b,ton and de.ttiulJtlOn o r tha US banILlni 

Indus"y, G1Iuse&, Q)~ueIlCllS, and [rnpllt.JlIoas RH" 

!he 1Il' lIrlI,' RlnhoonU~ til NJncy !IDle, e.:1, Snldit::s in 

RQu1lri»r. CIl~· NB[R~nd UnlVm'(,lo· ofOtkA., 

L" 'lnCl ( R,) 

'~~ulJUIlJ! linane !>1 mar~'1 ~nd tnslhUllon£ to 

pronlOteJtrIIWth, ' l'eder:tl JWeooe D.lnk o{K;ms.}sClly, 

J.>ckson Iiole SympJi!lum Prooeedl.lgt" IOnhoomlllJ! 

.olI""kl l1 ~ (11.) "ml S,r~b " ( I'. Il.) (1011) 

'Fln ~ncl~ 1 In.e,llrmlo n. u~jng. and eOOllomle 

vvla,Ults.' IIWkin,q RIp:T, IIoston Coll~ Novenlber 

llol\$lll (11. j. IUnlC ( .... ). ~,11I Str .. II:1Jl (p. q (]OI).II 

'1!.11\k Intoegr:ltton "",d.lol.ltebIlSlOOll cycle..' Qwmtr(!l 

!QlImllIo( EGoMlnia, 11 9. pp. 1S5~ 

IWnllln)tlt (M.) ",,11 RUI'I' (M.) (2010) 

M~lOI !.Ine I~o. lIoul es on the rrend, Fn>ntle~ 

O;dbr<l. O>P"IY PubllllhlnliTIoc ke r ( I',) ("!OJ 2) 

'&lnks "'wt «:dam, 'htir VfOptr role: FIM>I«(III 

Timts, JanuryJO. 

Ba/IQuo <» FrafI<:Q' F1f111"lail Slo1ttiIV Row\Qw • ~ 1 e'~. :<112 
61 

PREPARED STATEMENT OF TOM C. FROST 

CHAIRMAN EMERITUS, FROST NATIONAL BANK

MAY 9, 2012 

My name is Tom Frost. I am from San Antonio, Texas and served for 57 years, 

26 of these as Chief Executive Officer of a commercial bank established by my greatgrandfather. The institution grew and prospered through money panics, wars and 

depressions. Now with $20.3 billion in assets at year end 2011 and 115 offices all 

in Texas, the Frost Bank did not take Government funds from the issuance of preferred stock in 1933 and was one of the first banks to refuse TARP money in 2008. 

I personally survived the very difficult times in Texas of the 1980s where many lessons were learned. The Frost Bank was the only one of the top 10 commercial banks 

in Texas to survive through a period when a significant number of the banks failed 

and most of the savings and loans were closed. 

But, I will start out with my first days as a young college graduate and a fresh 

employee of the institution I have just described. My great Uncle Joe, then CEO, 

told me that the very first goal we had was to be able to return the deposits received 

from customers. Our obligation was to take care of the community’s liquid assets 

and to manage them in a safe and sound fashion for the use (loans) of the community to grow. Uncle Joe told me in 1950 that we were not big enough to be saved 

by the Government. That we would need to always maintain strong liquidity, safe 

and sound assets, and adequate capital. I was impressed by the fact that the need 

to make money was not high on this list, but did occur if sound banking principles 

were observed. Uncle Joe was not a fan of the FDIC saying that it took his money 

to subsidize his inefficient competition. I, personally, support the FDIC as a protection for the depositor, but want to suggest that this safety net apply only to banks 

which receive FDIC insured deposits. I am convinced that offering this safety net 

to other financial institutions which provide services not deemed appropriate for deposit/loan commercial banking institutions, is not sound public policy. The deposit 

facilities of financial institutions which provide primarily investment, hedging and 

speculative services should have no taxpayer safety net. These institutions should 

be governed by market forces with investors understanding what can be earned and 

what can be lost. 

This would involve the need to separate two cultures. The one which Uncle Joe 

articulated our family has followed for 144 years by establishing long-term customer 

relationships, building our community and preserving its liquid assets. Other financial institutions can provide the other services that are not authorized to insured 

deposit banks at a potential good profit, but without a taxpayer risk through a Federal safety net. 

I would suggest that the two types of institutions have separate ownership, separate management, separate regulation. My conviction comes after seeing both systems which were separate, but now have been joined, to create a situation which 

in 2008 brought about the near catastrophe of collapse of the world financial systems. Following the path that we are on currently will not only provide opportunity 

for the same consequences to be repeated, but also mean the end of a banking system consisting of many providers. It seems we are rapidly approaching a system 

which will be an oligopoly of a few major institutions whose management will not 

have the same concerns and dedication as evidenced by my Uncle Joe. If both cultures are separated, the clients of both will prosper, but without the inordinate risk 

of a potential massive cost to the taxpayers. 

I thank you for giving me the opportunity to express my opinion which has developed through over half a century experience and has led me to the conviction that 

the insured deposit banking system we had was effective, worked well, and did not 

require any significant direct Federal support until 2008 when the other activities 

of large institutions involved in so called investment activities nearly destroyed the 

financial system and imposed enormous costs on taxpayers to the present day. 
62 

Marc Jarsulic 

Chief Economist 

Better Markets, Inc. 

Testimony on "Is Simpler Better? Limiting Federal Support for Financial 

Institutions." 

Senate Committee on Banking Housing and Urban Affairs 

Subcommittee on Financial Institutions and Consumer Protection 

May 9, 2012 

Good afternoon Mr. Chairman Brown, Ranking Member Corker and members of the 

committee. Thank you for the invitation to Better Markets to testify today. 

Better Markets is a nonprofit, nonpartisan organization that promotes the public 

interest in the domestic and global capital and commodity markets. I won't take the time 

or space here to list everything it does, but would refer you to our website at 

www.bettermarkets.com. 

My name is Marc Jarsulic and I am the Chief Economist at Better Markets. Prior to 

that, I was a senior staffer in the Senate. Prior to working in the Senate, I was an attorney 

concentrating on antitrust and securities law, and an academic economist. 

INTRODUCTION 

The very largest bank holding companies are now distinctly different from the rest 

of the banking industry. They are more highly leveraged than other banks, are far more 

likely to operate large and complex broker dealers, and are more likely to be directly 

dependent on unstable short term financing. 

1 
63 

Each of these characteristics made the large bank holding companies vulnerable 

during the financial crisis: 

High leverage made them less safe because the ability of a bank to survive a 

significant decline in the value of its assets depends on the market value of its 

equity. Other market participants will continue to deal with a bank only if, 

after the loss, it is perceived to have sufficient remaining equity to remain 

solvent in the event of another shock. So the bank's leverage - together with 

the market value and liquidity of its assets - is a key determinant of its ability 

to function during times of financial stress. 

Proprietary trading made them less safe because speculative positions can 

quickly produce large losses. Trading losses at Citigroup are a case in pOint. 

Dependence on unstable short term financing made them less safe because 

creditor runs (which materialized in both the repo and asset-backed 

commercial paper markets) can force the sale of assets and the realization of 

losses. 

Given the scale of the large bank holding companies, these vulnerabilities also 

threatened the stability of the financial system as a whole. The failure of Lehman produced 

a huge financial shock and panic. The failure of one of the largest bank holding companies 

would have been even more serious. 

The federal government managed, through massive intervention, to prevent any of 

the largest bank holding companies from failing. In the case of Citigroup, for example, that 

2 
64 

rescue included the Troubled Asset Relief Program ("TARP") capital injections, direct asset 

guarantees, support for its broker dealer through the Term Asset Securities Lending 

Facility and the Primary Dealer Credit Facility, and purchase of its commercial paper 

through the Commercial Paper Funding Facility. 

To prevent the need for such rescues in the future, regulators need to use the tools 

created by the Dodd-Frank Act to eliminate the threats to financial stability created by the 

large bank holding companies. In particular there should be: 

Effective leverage limits for the largest banks 

Effective implementation of the Volcker Rule 

Effective regulation of shadow banking activity 

Taking these steps will go a long way toward containing the risks posed by the size 

and complexity of the largest bank holding companies. 

1. What makes large bank holding companies distinctive? 

In addition to their size, large bank holding companies ("LBHCs") - which for 

convenience we can think of as the 10 largest are distinguished from the rest of the 

banking industry in at least three ways. 

First, they are very highly leveraged. As can be seen from Figure 1 (below), which 

uses the ratio of tangible assets to tangible common equity as the measure ofleverage, the 

10 largest bank holding companies had a collective leverage ratio of 21.2 during the 1990-

3 
65 

2000 period. The remaining BHCs had a collective leverage ratio of 15.6 during that same 

period. It is also apparent that in the run-up to the financial crisis leverage ratios of the 

LBHCs increased dramatically. At the beginning of the crisis in 2007 the leverage ofthe 

LBHCs was nearly equal to that of the five largest stand-alone investment banks, and at the 

end of 2008 the LBHC leverage had risen to 47.5. 

Second, several of them are heavily engaged in trillions of dollars of complex 

proprietary trading in equity, debt and derivatives. For example, five LBHCs - Bank of 

America, Citigroup, Goldman Sachs, J.P. Morgan, and Morgan Stanley - are so-called "G14 

institutions": the 14 firms that do most of the trading in OTC derivatives world-wide.1 

Third, several of them have been and apparently remain dependent on short term, 

unstable financing. They sponsor and guarantee securitization conduits - which are part of 

the "shadow banking system." These conduits allow sponsors to finance significant 

volumes of assets using short term asset-backed commercial paper ("ABCP").2 In 2007, for 

example, Citigroup, Bank of America and JPMorgan were among the top 10 bank sponsors 

of conduits. The ratio of sponsored ABCP to their total Tier 1 capital was 102%, 50.2%, and 

52.7 % respectively.3 

Several of them also rely heavily on very short term repo financing to operate their 

broker dealers. Outstanding repo finance by primary dealers - which today include Bank 

of America, Citigroup, Goldman Sachs, JPMorgan Chase, and Morgan Stanley - reached a 

The G-14 includes Bank of America-Merrill Lynch, Barclays Capital, BNP Paribas, Citi, Credit Suisse, 

Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley, The Royal Bank of Scotland Group, 

Societe Generale, UBS, and Wells Fargo. See http://wwwft.com/intl/cms/s/Q/595ZeZeZ-1e3e-lleQbab6-00144feab49a html#axzzlulCH2PLP 

Z. Poznar et at (2010). Shadow Banking. Federal Reserve Bank of New York, Staff Report No. 458, july. 

See V. Acharya et at (2010). Securitization without risk transfer, Table 1, available at 

httP·/lssmcom/abstract-1364525. 

4 
66 

peak of$4.6 trillion in early 2008, and remains significant at approximately $2.7 trillion in 

February 2012.4 

Both the ABCP and repo markets experienced massive runs during the financial 

crisis. 

2. Why large bank holding companies were vulnerable during the financial crisis 

The distinguishing characteristics of LHBCs - high leverage, heavy involvement in 

complex trading, and reliance on short term and shadow banking finance - helped make 

them vulnerable to shocks in the financial crisis. By virtue oftheir size, these 

vulnerabilities made the LBHCs potential threats to overall financial stability. This forced 

the federal governmentto commit massive resources to rescue them. 

Leyera&e 

High leverage ratios make individual banks less safe. The ability of an individual 

bank to survive a significant decline in the value of its assets will depend on the market 

value of its equity at the moment of the loss. Other market participants will continue to 

deal with the bank only if, after the loss, it is perceived to have sufficient remaining equity 

to remain solvent in the event of another shock. So the bank's leverage - together with the 

market value and liquidity of its assets - is a key determinant of its ability to function 

during times of financial stress. 

Data from the Federal Reserve Bank of New York, available at 

http://wwwnewyorkfedorg/markets!statrel.htm! 

5 
67 

Higher leverage ratios also make the financial system as a whole less stable. The 

ability of the banking system as a whole to absorb losses through acquisition of the weak 

by the healthy - will be a function of the overall leverage of the banking system.s Since the 

LBHCs hold a majority of banking assets, and a large share of the assets of all financial 

intermediaries, equity declines at one or more such bank will have a large effect on the 

overall equity of the banking system. 

Moreover, revelation of insufficient equity at even one large bank can produce a 

Lehman moment when generalized panic sets in. Even if the failed bank is resolved in an 

efficient manner under the Orderly Liquidation Authority of the Dodd-Frank Wall Street 

Reform and Consumer Protection Act ("Dodd-Frank Act"), contagion to other large banks is 

then likely. 

Concerns about equity positions of large banks led the entire federal government to 

provide extraordinary aid to banks during the financial crisis. The Troubled Asset Relief 

Program, a small part of the overall emergency federal assistance, provided massive 

injections of equity capital. Banks were able to avoid equity losses because the government 

helped them borrow and avoid write-downs from asset sales in distressed markets -

through the Term Auction Facility, and the Temporary Liquidity Guarantee Program, the 

Term Securities Lending Facility, the Primary Dealer Credit Facility, and the Commercial 

Paper Funding Facility. 

For a discussion of the relationship between leverage, entity stability and overall financial stability see 

Archaya et a!. (20l0). Measuring Systemic Risk, available at http://ssrncom/abstract=1573171; 

Browlee and Engle (20ll). Volatility, Correlation and Tails for Systemic Risk Management, available at 

vlab.stern.nyu.edu. 

6 
68 

It is important to recognize that risk-based capital requirements and market 

discipline did not restrain bank leverage during the run-up to the crisis. In fact, leverage at 

LBHCs was essentially the same as that of the 5 largest stand-alone investment banks by 

the end of 2007, and continued to rise for a substantial period thereafter. (See Figure 1, 

below) There can be no doubt that the high leverage of the large bank holding companies 

made them vulnerable to the losses they experienced after the house price bubble burst. 

The damage inflicted on Citigroup by its broker dealer subsidiary vividly illustrates 

the threat that proprietary trading poses to even the largest banks. During the run-up to 

the crisis, Citigroup traders were among the largest creators and sellers of collateralized 

debt obligations ("COOs"). The COO business required traders to acquire a pool of assets, 

"structure" a new set of securities based on that pool, and then sell some or all of these 

newly structured securities to third parties. Creating and pricing the new securities 

required some expertise, but at its heart the COO business was a convoluted proprietary 

trade in which the traders acquired assets, held them as inventory, and planned to resell 

them later at a higher price.6 

These COO securities differed in their credit ratings, the rate of interest paid to 

investors, and in their payment priority in the event of default. The quantity and 

The securities comprising the CDO asset pools were varied •• including RMBS, high grade bonds, and 

tranches from other CDOs. However, many of the underlying securities were constructed from sub prime 

residential mortgages. The Office of the Controller of the Currency estimates that 70 percent of the assets 

underlying Citigroup CDO's issued between 2003 and early 2006 were sub prime' related. See U.S. Office 

of the Comptroller of the Currency (200B). Memo from John Lyons, Examiner·in·Charge. Citibank, N.A., 

Subject: Subprime CDO Valuation and Oversight Review - Conclusion Memorandum. July 17, S. Available 

at 

httn:llfcic.law.stant'ord.edu/resourcelindex/Search,yideos:Q/Search.Documents:1/Search.endmonth:02 

ISearch.endyear:20 121Search footnotes: 10,42 

7 
69 

:haracteristics of each class of security were chosen by the Citigroup traders to maximize 

their profits. They found it profitable to create a class of "Super Senior" securities which 

were nominally highly-rated and which paid relatively low interest rates. Citi traders 

found that investors were unwilling to buy the Super Seniors. But instead of offering the 

securities at a lower price and higher interest rate - which would have required lowering 

the rates paid on the other COO securities and reduced their price - the Citigroup traders 

continued to create Super Seniors and to hold them. They would only have created and 

held unsalable Super Senior securities to maximize their overall returns.7 

To boost the return from holding the Super Senior positions, Citigroup relied on 

leverage. During 2003 and early 2006, Citigroup financed $25 billion in Super Senior 

securities through conduits. These special purpose vehicles ("SPVs") issued asset-backed 

commercial paper, for which Citi provided "liquidity guarantees." The guarantees meant 

that Citi would buy the commercial paper issued by the conduit ifno one else would.B 

Liquidity guarantees meant that third party purchasers of the commercial paper faced 

default risk only if Citigroup itself failed to honor its guarantee, regardless of the market 

value of the Super Senior securities. 

Citigroup ceased to issue liquidity guarantees in early 2006. However, between 

early 2006 and August 2007 another $18 billion in Super Senior securities were added 

The Controller of the Currency recognized this motive for the Citigroup trading strategy in its January, 

2008 review of Citigroup's COO-related losses notjng that "The bank built up [Super Senior] positions 

because they are hard to sell in the primary issuance market at the nominal spreads available for [Super 

Senior] once deals were completed (lO-20bps) and the bank was unwilling to give up some of the 

inception profits. " See Ibid. 

The amount ofleverage on the Citi conduits is not clear from available data. If the SPVs were entirely 

financed by commercial paper, the leverage was infinite. 

8 
70 

directly to Citigroup's trading book positions. Because the securities were held in the 

trading account, little or no capital was required to back them.9 

In late 2007 it became clear that the Super Senior securities were worth far less 

than their face value. To avoid having to make good on its liquidity guarantees, Citigroup 

bought $25 billion of commercial paper that had been issued by the Super Senior conduits, 

and placed those Super Senior securities on the books of the Citigroup commercial bank. 

Beginning in November 2007, Citigroup was forced to recognize huge losses on the 

Super Senior securities and other positions.to In a remarkably understated 2007 annual 

inspection report on Citigroup, the Federal Reserve Bank of New York observed that 

"[m]anagement did not properly identify and assess its subprime risk in the COO trading 

books, leading to significant losses. Serious deficiencies in risk management and controls 

were identified in the management of Super Senior COO positions and other subprimerelated traded credit products." 11 By the end of 2008 Citigroup had written off $38.8 

billion related to these positions and to ABS and COO securities it held in anticipation of 

constructing additional CDOS.12 

Financial Crisis Inquiry Commission (2011). Final Report of the Financial Crisis Inquiry Commission, U.S. 

Government Printing Office, 196-197. 

10 Citigroup, Inc. (2007). Press release, November 4 (announcing losses of approximately $8 billion to $10 

billion), available at http://www.sec.goY(Archives(edgar (data(831001(000110465907079495(a07-

28417 1ex99d1.htm 

11 Federal Reserve Bank of New York (2008). Summary of Supervisory Activity and Findings for Citigroup, 

January1, 2007 - December 31, 2007, 5, available at 

http:((fck law.stanford.edu (resource (index (Search. keywords: fcic085390(Search Yjdeos:Q/Search.Documents·1/Search Interviews:O/Search endmonth'02lSearch endyea 

.cl.O..U 12 See Citigroup, Inc., Form 10K for the period ending December 31,2007,48; Form 10K for the period 

ending December 31, 200B, 68. 

9 
71 

These losses reduced Citigroup's capital, helped to bring the company to the brink of 

failure, and made a federal rescue necessary. The amount of federal help required to 

prevent Citigroup from failing was stupendous, including capital injections, debt 

guarantees, and asset guarantees.13 

Citigroup was also the heaviest user of the Term Securities Lending Facility 

("TSLF"), and a very heavy user of the Primary Dealer Credit Facility ("PDCF"), two 

emergency lending facilities set up to halt a destabilizing collapse of broker dealers 

generally. Reliance on these facilities indicated that a broker dealer was having difficulty 

funding its positions in repo markets. So the fact that Citigroup went to the PDCF 279 

times for overnight loans averaging $7.2 billion each, and used the TSLF to execute 43 

swaps of "investment grade" collateral averaging $3.7 billion each, are clear signs that its 

broker dealer was in a very difficult shape. (see Appendix, below). 

The debacle at Citigroup is merely illustrative of the harm that bank proprietary 

trading produced and threatened to produce. The heaviest users of TSLF and PDCF funds 

includes several other bank-based broker dealers, among them Bank of America, Deutsche 

Bank, Credit Suisse and Barclays. (see Appendix, below). Although they did not create 

wreckage on the scale of Citigroup, they were clearly on the brink of doing so. 

13 See Special Inspector General for the Troubled Asset Relief Program (2011). Extraordinary Financial 

Assistance Proyjded to Cjtigroup, Inc. January 13. 

10 
72 

Unstable short term financing 

LBHCs as conduit guarantors and sponsors 

Asset conduits are special purpose vehicles, created by commercial and investment 

banks, and other financial firms securitized lending. In general they issue ABCP and other 

short-term liabilities that are used to fund the purchase of less liquid assets oflonger 

maturity. Some conduits had liquidity or credit guarantees provided by commercial banks, 

while others such as the structured investment vehicles ("SIVs") had no formal guarantees 

from their creators. 

Among all conduits rated by Moody's as of January 1, 2007, the mean asset size was 

$4.1 billion. In this sample, around 73 percent of conduits by assets were sponsored by 

commercial banks.14 However, these conduits held over $1.2 trillion in assets, which meant 

that they were collectively a very significant part of the financial system.15 

As noted earlier, LBHCs were important guarantors of conduit ABCP. Bank of 

America, Citigroup and JPMorgan Chase guaranteed ABCP the value of which exceeded 

50% of their total Tier 1 capital. 

When it became clear in mid-2007 that the house price bubble had burst and that 

subprime mortgage assets would sustain significant losses, the market for ABCP began to 

contract rapidly. Outstanding financial ABCP began to plummet from its peak value of $1.2 

14 Ibid, Table 2. 

lS It should be noted that the Moody's sample omits collateralized debt obligations and may be otherwise 

incomplete. 

11 
73 

trillion in August 2007, By December it had collapsed by approximately a third to $833 

billion,16 

This run on conduits had significant effects on the financial system, Banks that had 

provided liquidity and credit guarantees had to make good on them and took losses, Other 

banks, such as Citibank, absorbed losses on SIVs they had sponsored, even though they 

were not legally compelled to do SO,17 Given a lack of publicly available data, the extent of 

conduit-related losses is difficult to calculate, However, the run created the possibility that 

conduit management or guarantors would be forced into a fire sale of assets, The resulting 

effect on prices would have spread losses to other financial actors, leading to downward 

price spiral. 

This threat explains the efforts of then-Treasury Secretary Paulson to organize an 

SIV rescue through a private-sector "Master Liquidity Enhancement Conduit" in late 2007, 

This effort failed, In the end, the Federal Reserve was compelled to support the ABCP 

market to prevent a downward asset price spiral. It created the AMLF, CPFF, and Money 

Market Investor Funding Facility ("MMIF") to do so, which at peak operating levels added 

more than $340 billion to the Federal Reserve balance sheet,IS 

Although the asset-backed commercial paper market is now much smaller than it 

was in 2007, it is still important to the financial system, At the end of April 2012 

16 v, Ach31ya et a!., op. cit., 3. 

17 See http://www.marketwatch.com/stOl:y/citigroup-to-take-49-bln-of-siv-assets-onto-balance-sheet. 

18 See http://wwwfederalreservegoy/releases/h41/Z009010Z/. 

12 
74 

outstanding ABCP amounted to $327 billion, comprising more than a third of all 

outstanding commercial paper.19 

LBHC dependence on repo finance 

Broker dealer use of rep a financing 

Repo borrowing is an important source of funding for broker dealers, including 

those inside the LBHCs. The 19 U.S. primary dealers, which is a subset of all repo market 

borrowers, reported repo financing of $4.6 trillion in fixed income securities on March 4, 

200a. It has been estimated that in mid-200a, the (then) five largest broker 

dealer/investment banks collectively financed 42 percent of their assets through repo 

borrowing.2o While primary dealer repo borrowing is now approximately $2.7 trillion, it is 

still a huge source of finance for these firms. 

Repo allows a borrower to become highly leveraged. In a repo transaction the asset 

serves as collateral for the loan. So the borrower needs to provide equity funding for the 

asset only to the extent that the lender insists that the value of the collateral exceed the 

value of the loan. These repo "haircuts" can be very low. Haircuts for private label MBS 

and corporate bonds were estimated to be 3-4 percent in 2007 in the tri-party repo 

market.21 In the bilateral dealer bank market, haircuts on unpriced and subprime MBS and 

corporate bonds are estimated to have been zero in the first half of 2007.22 

19 See http://www.federalreserve.gov/releases/cpJ. 

20 M. King (2008). Are the brokers broken? Citibank Global Markets Ltd. 

21 A. Krishnamurthy. et al. (2011). Sizing Up Repo, 27. 

22 G. Gorton and A. Metrick, Securitized Banking and the Run on Repo, 12. Table II, Panel D, available at 

http://ssmcom/abstract-1440752 

13 
75 

When haircuts are low - as they were for highly-rated subprime MBS and many 

other types of securities in early 200? - it is possible to obtain very high leverage (at 

relatively low short-term interest rates) to support a trading position in assets with long 

maturities. The high leverage of the large broker dealers is explained in significant part by 

their use of repo borrowing as a source of debt finance. 

Positions that are financed using very short-term borrowing create the potential for 

a rapid run by the lenders. Repo funding is cheap because any individual lender can change 

the rate and collateral requirements of a loan very quickly, or simply decide not to roll it 

over, when a borrower or an asset class becomes less desirable to them. But when things 

go wrong and lenders as a group decide against a borrower or the collateral he holds, that 

borrower can see his repo funding vanish in short order. A significant increase in haircuts, 

for example, means that the borrower must have adequate equity to cover the lost 

financing, or sell off the position. 

If the borrower has used repo to create significant leverage, a run on repo can spell 

disaster. If the assets he has supported are illiquid or have declined in value, he can be 

forced to recognize losses and perhaps become insolvent. And of course there may be 

spillover effects to other firms and to repo financing in general. These dynamics were very 

important during the financial crisis. 

Runs an repa financing during the crisis 

Once it became clear that there would be large losses on subprime and other nonAgency MBS in mid-200?, repo runs soon followed. There is evidence that non-Agency ABS 

and MBS securities - which were used as collateral in the tri-party repo market by several 

14 
76 

large broker dealers prior to the crisis - ceased to be acceptable repo collateral as the 

financial crisis intensified. This hit particular LBHC dealers especially hard. 

According to Krishnamurthy et a1. 23 : 

While the repo contraction on non-Agency MBSI ABS appears small for the 

shadow banking system, we find evidence that it played a more significant 

role for some dealer banks. For Merrill Lynch, Goldman Sachs, Morgan 

Stanley and Citigroup, nearly 50% of the [tri-party] repo transactions with 

[money market funds] prior to the crisis were backed by non-Agency 

MBSI ABS and corporate debt, and almost all of this repo from [money 

market funds] disappears in the crisis. 

In the bilateral repo market - where secured loans are made between large financial 

institutions with no intermediary - there is evidence of a huge increase in haircuts for a 

wide range of non-Treasury assets after the middle of 2007. By one estimate the average 

haircut rose from zero in the beginning of 2007 to 45 percent by the beginning of 2009. 24 

Many bilateral repo borrowers are hedge funds and other firms seeking cash from the 

prime brokerage operations of broker dealers. However, dealers also fund themselves 

through this market.25 So the rise in haircuts had an impact on leveraged dealer positions. 

The liquidity crises and dramatic failures of Bears Stearns and Lehman Brothers 

were in significant measure caused by the disappearance of repo financing on which they 

23 A. Krishnamurthy et aI., op. cit., 4. 

24 G. Gorton and A. Metrick, op. cit, 20-21. 

Z5 T. Adrian et al. (2012), Repo and Securities Lending, Federal Reserve Bank of New York, Staff Report No. 

529, December, 4-5. 

15 
77 

were heavily dependent. In the run-up to their respective failures, various tri-party repo 

counterparties cut their exposures, required larger haircuts and higher interest rates, and 

ultimately ceased dealing with them.26 The bilateral repo market also turned against Bear 

Stearns and contributed to its demise. According to the Financial Crisis Inquiry 

Commission report, repo lenders to two Bear Stearns internal hedge funds increased 

collateral haircuts or refused to roll over their loans before the funds filed for bankruptcy 

on July 31, 2007.27 

The Federal Reserve was forced to support broker dealers to stem the run on repo financing 

The Federal Reserve was so alarmed by the crisis in the repo market that it 

established two separate rescue facilities. The Primary Dealer Credit Facility (PDCF) 

provided overnight repo financing to primary dealers for tri-party eligible collateral. The 

Term Securities Lending Facility (TSLF) provided 2a-day swaps oftri-party-eligible 

collateral for Treasury securities. The Treasury securities then could be used as collateral 

for repo borrowing. 

Both these facilities were widely used by very large broker dealers, including those 

housed in major banks. Summary data on broker dealer borrowing from the PDCF and 

TSLF- which show large scale borrowing by several important broker dealers are 

presented in Tables 1 and 2 in the Appendix. Borrowing from the TSLF was highly 

26 Financial Crisis Inquiry Commission (2011).Final Rell0rt of the National Commission on the Causes of the 

Financial and Economic Crisis in the United States Government Printing Office, 280-91, 324-31; D, Duffie 

(2010), The failure mechanics of dealer banks, Bank for International Settlements, Working Paper No, 

301, March, 16; A. Copeland et al (2010), The tri-party repo market before the 2010 reforms, Federal 

Reserve Bank of New York, Staff Report No. 477, November, 55-63. 

27 Financial Crisis Inquiry Commission (2011), Final Report of the National Commission on the Causes of 

the Financial and Economic Crisis in the United States Government Printing Office, 280-91. 

16 
78 

correlated with broker dealer financial weakness - as measured by leverage and 

cumulative stock price declines.28 

3. Policy implications 

The financial crisis was arrested through massive intervention by the federal 

government. The demonstrated willingness of the government to take such actions 

continues to reassure financial markets. However, many of the underlying structural 

problems that led to the crisis remain unresolved. The leverage of LBHCs is not yet 

constrained. Effective limitations on bank trading, much of which takes place in LBHCs, 

have yet to be put into place. Steps have not been taken to prevent runs on short term 

finance from putting the LBHCs in jeopardy once again. 

The Dodd-Frank Act gave regulators the tools to achieve many of these necessary 

changes. Properly utilized, many of the existing threats to financial stability can be 

significantly limited. 

Effective leverac:e limits for the larc:est banks 

The Federal Reserve should use its authority under Section 165(b)(1)(A)(i) ofthe 

Dodd-Frank Act to impose significant new leverage requirements on the largest banks. 

These leverage ratios should rise with bank asset size, since the combination of size and 

high leverage increases the risk to financial stability. 

29 V. Archaya et al. (2011). Dealer Financial Conditions and the Term Securities Lending Facility: Was 

Bagehot Right After All, December 29, 5. 

17 
79 

Required leverage ratio should be calculated using tangible common equity and 

tangible assets. During the financial crisis, market participants focused the market value of 

the equity of financial firms under stress. Ofthe available accounting measures of firm 

equity, tangible common equity comes closest to the values that market participants take 

seriously. 

As can be seen in Figure 1, the leverage ratios for smaller banks are consistently and 

significantly lower than those ofthe large bank holding companies. A natural hypothesis is 

that this reflects the differential treatment that lenders give to big banks that have an 

implicit guarantee from the federal government because they are "too big to fail." Some 

have suggested that leverage limits for the big banks should be set at the level that market 

forces have determined is appropriate for banks without implicit government guarantees. 

That would imply a leverage limit of about 16. 

However, there is good reason to believe that the leverage ratio of smaller banks 

would be inadequate for large banks. While smaller banks may not have the same "too big 

to fail" guarantee, they are still inside the federal safety net. They have access to discount 

window, and they have sticky sources of funds because their depositors are federally 

insured. This exempts them from substantial market discipline. 

Moreover, to the extent that leverage ratios at smaller banks do reflect the effects of 

market discipline, that discipline will never take externalities into account. That is,large 

equity losses at several smaller banks can have an important impact on overall financial 

stability. The failures ofWaMu, Wachovia, and IndyMac certainly contributed to overall 

financial distress during the financial crisis. But market forces do not take account of such 

18 
80 

externalities when funding the borrowing of individual banks, precisely because they are 

externalities. 

In fact, recent research by the Centre for Economic Policy Research indicates that an 

upper bound for the leverage ratio should be much lower - approximately 5. 29 This 

research indicates that this significantly reduced leverage ratio will deliver significant net 

economic benefits: 

We conclude that even proportionally large increases in bank capital are like 

to result in a small long-run impact of the borrowing costs faced by bank 

customers .... ln light of the estimates of costs and benefits we conclude that 

the amount of equity funding that is likely to be desirable for banks to use is 

very much larger than banks have had in recent years and higher than the 

minimum agreed Basel III framework." 30 

The Federal Reserve has proposed adopting the Basel III capital requirements as 

part of its implementation of Section 165 of the Dodd-Frank Act. This will allow the large 

bank holding companies to maintain very high leverage ratios. 31 To reduce threats to 

financial stability, permissible leverage should be significantly lower. 

29 D. Miles eta!' (2011). Optimal Bank Capital, Centre for Economic Policy Research Discussion Paper 8333, 

38, available at www.cepr.org/pubs/dps/DP8333.asp. 

30 D. Miles et al., op. cit, 3. 

31 Basel III calls for a phased- in capital to risk-weighted-assets ratio of 10.5 percent, of which 7 percent is 

common equity. Large so-called G-SlB's are to have a maximum 3.5 percent additional capital surcharge. 

50 if a G-5lB were assessed the full additional 3.5 percent surcharge, the common equity frisk-weighted 

asset ratio would be 10.5 percent Since risk-weighted assets are on average sigoificantly less actual 

assets - by one estimate approximately 40 percent less - the ratio could be less than 6.3 percent, giving a 

leverage ratio of nearly 16 relative to common equity. 

19 
81 

Effective implementation oBbe Volcker Rule 

LBHC trading created significant losses and threats to financial stability during the 

financial crisis. Section 619 of the Dodd-Frank Act (the "Volcker Rule") requires that those 

risks be eliminated, through the elimination of proprietary trading, and necessary 

restrictions on permitted trading. 

Rules on market making, which remains permissible under the statute, must 

eliminate incentives to disguise proprietary trading as market making. The risks posed by 

trading in Treasury securities and certain other assets, which also remains permissible 

under the statute, need to be reduced by effective leverage requirements.32 

Limit firm revenue and trader compensation to observable bid-ask spread 

To eliminate trader incentives to take large, high-risk positions in hopes oflarge 

bonuses, revenue for permitted market making activity must be strictly limited to an 

observable and meaningful bid-ask spread or fees and commissions. 

An observable and meaningful bid-ask spread will exist only where traders 

continuously offer to buy or sell a well-defined asset and actively do so, allowing the 

32 Better Markets has flied three comment letters in connection with the proposed Voleker Rule: See Better 

Markets Comment Letter, November 5, 2010 on Study Regarding Implementation of the Prohibitions on 

Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds ("Better 

Markets 11/5/10 Comment Letter") available at 

http://www.hettermarkets.com/sites/default/files /FSO C -%20Comment"m 2 0 Letter·%20Volcker%2 0 11-

5.:1JWldt Better Markets Comment Letter, February 13, 2012 on Prohibition on Proprietary Trading and 

Certain Relationships with Hedge Funds and Private Equity Funds ("Better Markets 2/13/12 Comment 

Letter") available at http://wwwbettermarketscom/sites/default/files/SEC'%20CL-

%20Volcker%20Rule-%202-13-12 pdf: and Better Markets Comment Letter, April 16, 2012 on 

Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, 

Hedge Funds and Covered Funds ("Better Markets 4/16/12 Comment Letter") available at 

http://www.bettermarkets.com/sites/default/files/CL%20CFTC%20FINAL%20Volcker%20Rule%204-

~. 

20 
82 

calculation of the spread from contemporaneous, executed purchases and sales with nondealer customers. The existence of such a bid-ask spread shows that market making 

services - the provision of immediacy to customers who desire to buy or sell- are actually 

being provided. 

This limitation will have the effect of eliminating trader incentives to hold unhedged 

asset inventories. Because by definition significant income from the price appreciation of 

positions will be a signal that the traders are not engaged in market making, they will have 

a strong incentive to carefully hedge the inventories that they do hold to meet client 

demand. 

In addition, requiring observable and meaningful bid-ask spreads will prevent 

banks from using the market making exemption to take positions in assets that are: 

• traded so infrequently that bid-ask spreads cannot be calculated from 

contemporaneous purchases and sales; or 

• so-called Level 3 assets that are "marked to model", such as "structured" 

securities or complex bespoke derivatives. 

During the crisis, trader inventories of these assets proved to be worth far less that 

their reported values indicated. Firms such as Citigroup and Merrill Lynch were forced to 

write down their positions and recognize losses that severely weakened them. 33 

Eliminating the accumulation of positions in these highly risky assets in the banks will in 

33 The effects of impossible to value COO securities on Citigroup are discussed in the Better Markets 

2/13/12 Comment Letter, op. cit. 

21 
83 

itself make them more stable. Moreover, it will meet the requirement of Section 619(d)(2) 

of the Dodd-Frank Act, which prohibits trading activity that exposes a banking entity to 

high risk assets and high risk trading strategies, or threatens financial stability. 

In addition, by eliminating impossible-to-value assets from trader balance sheets, 

market participants will be better able to assess the risk of transacting with bank dealers. 

This should increase market discipline of the market makers. Moreover, regulators will 

have a more accurate idea of the solvency of the traders they oversee. 

Finally, an obvious but nonetheless important benefit of limiting permissible market 

making income is that it provides an easily monitored, market generated metric that will 

give bank traders clear guidance on what they may do. This will clearly satisfy any demand 

for bright lines or safe harbors for trading activity. 

Establish leverage limits for permitted trading 

Although the Volcker Rule specifically permits a few enumerated non-proprietary 

trading activities, such as market making, from the prohibition on proprietary trading, even 

those few permitted activities are qualified. In particular, subsection 619(d)(2)(A) 

removes the permitted status of any activity that 

(ii) would result, directly or indirectly, in a material exposure by the banking 

entity to high-risk assets or high-risk trading strategies (as such terms shall be 

defined by rule as provided in subsection (b) (2); 

(iii) would pose a threat to the safety and soundness of the banking entity; or 

22 
84 

(iv) would pose a threat to the financial stability ofthe United States." 

Events of the financial crisis have demonstrated that the financial model still used 

by bank broker dealers is highly unstable and poses significant threats to bank safety and 

soundness, and to overall financial stability. Broker dealers historically have been highly 

leveraged, willing to depend on repo and other short term borrowing to fund longer 

maturity and less liquid assets, and subject to fatal lender runs in times of stress. These 

weaknesses required the Federal Reserve to create the TSLF and PDCF in order to bail out 

the broker dealers during the crisis. 

Because of the demonstrated threat posed by the broker dealer funding model, any 

rule implementing the Volcker Rule needs to address its weakness directly. By doing so the 

rule would decrease the likelihood that otherwise undeterred proprietary trading would 

create significant threats to a bank or to overall financial stability. Unfortunately the 

proposed rule does not do so. Instead, in merely restates Section 619(2)(A) in slightly 

altered form. 

What the rule ought to do is place meaningful leverage and liquidity requirements 

on bank broker dealers. The lower the permitted leverage, the smaller the impact of an 

asset price decline on the equity of anyone trader. The higher the liquidity requirements, 

the less likely that an asset price decline would result in a forced asset sale. 

It must be recognized that unless leverage and liquidity requirements are very 

tough, the threats created by bank trading operations will persist. Runs by bank depositors 

are not deterred by fractional capital requirements alone, because depOSitors know that 

they can take losses if the bank's assets lose sufficient value. Depositor runs are prevented 

23 
85 

by deposit insurance, which assures depositors that they will not lose by continuing to fund 

the bank. But there is at the moment nothing analogous to deposit insurance for repo 

lenders. So it is entirely predictable that in a period of market turmoil repo lenders will 

reduce the acceptable leverage ratio for assets they fund from fifty to two, or exit the repo 

market altogether, at a moment's notice, just as they did during the financial crisis. 

Therefore, to meet the requirements of 619(d)(2)(A) the proposed rule must mandate low 

leverage and high liquidity for bank broker dealers. 

Effective replation of shadow bankine system. 

The Financial Stability Oversight Council has adopted rules to implement Section 

113 of the Dodd-Frank Act, which provides authority forilesignating systemically 

significant nonbank financial firms for supervision by the Federal Reserve.34 That is, 

Section 113 gives the federal government the power to bring the shadow banking system 

into the light of regulation. The runs on repo and on asset-backed commercial paper 

during the crisis demonstrate that asset conduits and the repo market need to be 

designated and supervised to prevent a repetition of these events in the future. 35 

,. See Comment Letter filed by Better Markets December 19, 2011 on Authority to Require Supervision and 

Regulations of Certain Nonbank Financial Companies available at 

http' /Iwww.bettermarkets corn Isjtes/default/files/CL%20FSOC%20SIFls%ZQ1Z-19-11 pdf 

3S Federal Reserve Governor Daniel Tarullo has publicly acknowledged that the tri-party repo marketwhere some but certainly not all repo lending takes place - needs oversight. See 

http:l(www.federalreserye.goy/newseyents/speech/tarulloZ01Z0SQ2a.htm. 

24 
86 

50 

45 

40 

35 

30 

25 

20 

15 

10 

Appendix 

Figure 1 

Leverage Ratios: Bank Holding Companies, 

5 La est Investment Banks 

-10 largest 

+---~r---------------------------------------.-~~--------~~-- SHCs 

- - 5 largest 16s 

............. ---'''''----.-.-.-.-----,.". ... '''-.-:::c--------... --------... --t--------.!..IhL--___ .L_ ...... SHCs except 

- _ - \ •••••• \ !01.rgest 

................ -.. ...... ........... 

Note: The leverage measure for investment banks 

in 2008 and 2009 is reduced to Goldman Sachs, Morgan 

+-~~~I~~.-----------------------~~~~~~~~~~~~~~~or 

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 

25 
87 

Table 1 

Borrowing from PDCF 

Source: http://www.federalreserve.gov/newseventslreform_pdcf.htm. Dealers ranked by total amount borrowed. 

26 
88 

Table 2 

Borrowing rrom TSLF 

41 

20 31 

21 1,700 43 

15 2,445 36 

5 2,298 33 

1,224 25 

1,631 17 

1,276 13 

820 14 

14 

10 

II 569 

61 5 294 

Bear, Stearns & Co .• Inc. 35 69 

Dresdner Kleinwort Securities LLC 33 65 

Notes: The tables reports the average amount borrowed and the number of borrowings by dealer for the 33 Schedule J and 58 Schedule 2 

operations. Borrowing<; through the TSLF Options Program are excluded. Dealers that never borrowed from the program are excluded. Dealers 

are ordered in the table based on the weighted average quantity borrowed across the Schedule 1 and Schedule 2 operations, with weights based on 

the number ofSchedulc I and Schedule 2 operations (i.e., 33 and 5&) 

Source: Archaya et al (2011), dealers ranked by total borrowing. 

27 
89 

1Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68,846 (Nov. 7, 2011). 2Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 

13 of the Bank Holding Company Act of 1956, as amended). 3See Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies before the S. Comm. On Banking, Housing & Urban Affairs, 111th Cong. 2 (February 2, 

2010)(testimony of the Honorable Paul Volcker, Chairman, President’s Economic Recovery Advisory Board). 4Section 13(f) of the Bank Holding Company Act, as amended. 

5See attached comment letter from Vanguard dated February 13, 2012, on prohibitions and 

restrictions on proprietary trading and certain interests in, and relationships with, hedge funds 

and private equity funds. http://1.usa.gov/IrG535. 

PREPARED STATEMENT OF JAMES E. ROSELLE 

EXECUTIVE VICE PRESIDENT AND ASSOCIATE GENERAL COUNSEL

NORTHERN TRUST CORPORATION

MAY 9, 2012 

Good afternoon Chairman Brown, Ranking Member Corker, and Members of the 

Committee: 

My name is James Roselle; I am the Associate General Counsel for Northern 

Trust Corporation, a global financial services firm that provides investment management services, asset and fund administration, and fiduciary and banking solutions to corporations, institutions, and individuals worldwide. As of March 31, 2012, 

Northern Trust has over $4.6 trillion in assets under custody and $700 billion in 

assets under management. I appreciate the opportunity to testify before you today 

on behalf of Northern Trust. 

Northern Trust supports the very positive efforts of Congress and this Committee 

to put in place reforms that reduce systemic risk to the financial system and prohibit high-risk activities that contributed to the financial crisis. As regulators and 

market participants continue work on implementing and complying with the new financial reform law (‘‘Dodd-Frank Act’’), I would like to focus my testimony on specific provisions contained in the Proposed Rule 1 issued pursuant to the so-called 

‘‘Volcker Rule.’’2

The restrictions and prohibitions set forth in the Volcker Rule were intended to 

limit banking organization exposure to high risk proprietary trading and investment 

activities. As a global custody bank and asset manager, Northern Trust does not engage in the types of activities that the Volcker Rule intended to prohibit. Specifically, Northern Trust does not engage in high-risk proprietary trading and investment activities. Because of the traditional nature of our core banking business, we 

anticipated that the Volcker Rule would have little or no impact on our business. 

Before the Dodd-Frank Act was passed, former Federal Reserve Board Chairman 

Volcker stated that ‘‘[c]ustody and safekeeping arrangements for securities and 

valuables’’ are among the core banking functions that must remain permissible 

under the Volcker Rule.3

The rules as currently proposed, however, will adversely impact traditionally lowrisk business activity that investors rely upon for investment management purposes. 

This impact is contrary to the stated intention of Congress; it will not promote the 

safety and soundness of the U.S. financial system and may in fact increase systemic 

risk. If not corrected in the rulemaking process, a core banking business of Northern 

Trust and other U.S. banking companies will be adversely impacted, which may ultimately impair the competitiveness of U.S. banks in a business where we are the 

acknowledged global leaders. 

Today I will discuss three parts of the Proposed Rule to implement the Volcker 

Rule that may significantly affect Northern Trust and our clients. Our key concerns 

are: (1) the overly broad definition of ‘‘covered fund’’ and the impact that so-called 

‘‘Super 23A’’4 prohibitions will have on custody-related transactions with many clients; (2) the proposed inclusion of foreign exchange swaps and forwards in the proprietary trading restrictions; and (3) the unnecessary and onerous proposed compliance requirements. 

First, the Proposed Rule unnecessarily includes a broad range of funds that banking entities will be restricted from sponsoring or investing in. The definition of ‘‘covered fund’’ would capture nearly all foreign funds (including those that are similar 

to U.S. regulated mutual funds that are exempt from the Volcker Rule), all funds 

that trade futures, swaps or other commodity interests to any extent (including U.S. 

mutual funds) 5, as well as many other entities that do not have traditional hedge 

fund or private equity fund characteristics. This definition is important because, if 

a bank is deemed to be a ‘‘sponsor’’ or ‘‘adviser’’ to a ‘‘covered fund,’’ then under the 
90 

6 12 U.S.C. Section 371c. 

7See comment letter from BNY Mellon, Northern Trust, and State Street dated February 13, 

2012, on proposed rulemaking implementing the Volcker Rule-Hedge Funds and Private Equity 

Funds. http://1.usa.gov/Jjgh9b. 8See attached comment letter from Northern Trust dated February 13, 2012, on proposed 

rulemaking implementing the Volcker Rule—Proprietary Trading. http://1.usa.gov/IJVcsd. 9 ‘‘Determination of Foreign Exchange Swaps and Foreign Exchange Forwards under the Commodity Exchange Act’’ issued by the Department of the Treasury on April 29, 2011. 

Proposed Rule the bank is prohibited under the Super 23A requirements from providing any credit whatsoever to the fund. 

Custody banks such as Northern Trust are among the leading global providers of 

asset management and custody services to the many foreign funds that do not share 

the characteristics of hedge funds or private equity funds but nevertheless fall within the proposed definition of ‘‘covered fund.’’ Moreover, our custody services often include ancillary services that may cause us to be deemed a ‘‘sponsor’’ for a client’s 

fund under the Proposed Rule. If large numbers of sponsored or advised foreign 

funds become subject to the Volcker Rule, the custody banks will be prohibited from 

providing traditional operational extensions of credit and will need to satisfy onerous compliance requirements that in some cases may conflict with laws in certain 

non-U.S. jurisdictions. 

Such a sweeping approach is inconsistent with Congressional intent as well as the 

findings and recommendations of the Financial Stability Oversight Committee 

(‘‘FSOC’’) in its study on the Volcker Rule. The legislative history of the Volcker 

Rule indicates that Congress intended and expected the Agencies to use their rulemaking authority to implement the Volcker Rule in a way that focuses its prohibitions and restrictions on traditional hedge funds and private equity funds. The Proposed Rule expands the universe far beyond the intended scope of the law. 

To compound the problem, the Proposed Rule adopts an extremely rigid interpretation of the Super 23A restriction that will put at risk traditional payment and settlement services that custody banks provide for their clients. Ordinary custodial and 

administrative services provided to our clients of necessity must include the provision of intra-day or short-term extensions of credit to facilitate securities settlement, 

dividend payments and similar custody-related transactions. These payment flows 

are expected in order for transaction settlements to operate smoothly and they have 

been encouraged by global financial supervisors. Northern Trust and other banks 

have a robust risk framework to deal with these types of payments, and our risk 

framework and exposure limits are regularly examined by bank supervisors. Nevertheless, even these low-risk extensions of credit appear to be considered as prohibited ‘‘covered transactions’’ under the Proposed Rule. It is unfortunate that the Proposed Rule has not followed the framework of Section 23A of the Federal Reserve 

Act 6 and Regulation W, which contain provisions that permit these low-risk operational exposures subject to well-established risk management standards. 

These custody-related transactions simply do not give rise to the type of risk that 

the Volcker Rule was intended to address. Prohibiting them will encourage covered 

fund clients to make alternative arrangements for custodial and administrative 

services with non-U.S. banks, which will damage the competitive position of Northern Trust and other U.S. banks. Moreover, prohibiting these transactions could result in market disruption and elevated levels of risk in global payment and settlement systems, with no corresponding systemic or firm-specific risk reduction.7

Northern Trust believes the agencies have ample authority to craft a rule that does 

not have these unintended and adverse consequences for a traditional core banking 

activity. 

Second, the proposed inclusion of foreign exchange swap and forward transactions 

within the proprietary trading prohibitions will result in damage to a traditional 

and low-risk activity, with no offsetting benefit to the U.S. financial system.8 As a 

significant global custodian and asset manager, Northern Trust carries on an active 

foreign exchange trading operation that is directly related to our core client services. 

Foreign exchange transactions typically are generated as a result of the routine purchase or sale of securities, or the receipt or payment of income, dividends or redemptions, by or for our clients. In essence, these currency transactions are simple cash 

management transactions used by our clients to efficiently manage cross currency 

needs. 

Secretary Geithner cited the key differences between foreign exchange transactions and other types of derivatives in his proposed determination to exclude foreign exchange swaps and forwards from the clearing and settlement requirements 

of Title VII of the Dodd-Frank Act.9 The proposed determination correctly concluded 

that foreign exchange swaps and forwards ‘‘already reflect many of Dodd-Frank’s ob-
91 

10With respect to the proprietary trading portions of the Volcker Rule, Northern Trust concurs with the attached comment letter submitted by SIFMA’s Asset Management Group dated 

February 13, 2012, on restrictions on proprietary trading and certain interests in and relationship with hedge funds and private equity funds. http://1.usa.gov/IB2ldf. 

jectives for reform including high levels of transparency, effective risk management, 

and financial stability.’’ Foreign exchange swaps and forwards have fixed payment 

obligations, are physically settled, and are predominately short-term instruments; 

therefore the risk profile is different from other derivatives. This is a traditional 

banking activity that is clearly not required by statute to be included in the Volcker 

Rule’s proprietary trading ban and, for the reasons stated above, should be excluded 

from the Rule’s trading restrictions.10

Third, the compliance requirements of the Proposed Rule are unduly burdensome 

and will unnecessarily increase compliance costs for banks with little or no offsetting benefit. The Proposed Rule essentially requires the bank to prove that each 

transaction does not fall within the prohibited category. At Northern Trust, a very 

high percentage of trading assets reported on our Call Report are foreign exchange 

transactions that, for the reasons given above, should be excluded from the trading 

restrictions. We have very small mark-to-market exposures in ‘‘plain vanilla’’ derivatives and securities. Yet, under the Proposed Rule, we would be required to produce 

a large number of compliance metrics, many of which are poorly designed to reveal 

evidence of prohibited proprietary trading, resulting in considerable systems expenditures and ongoing costs of compliance. We believe these costs have not adequately been considered by the Agencies in issuing the Proposed Rule. We believe 

the Agencies could carry out the intent of Congress more effectively and with less 

cost to the banking system with a simpler rule that is supplemented by active supervision of bank trading risks and practices. 

Northern Trust has submitted comments on the Proposed Rule to implement the 

Volcker Rule restrictions, and we have had meetings with the Agencies to discuss 

our concerns. I am confident that the Agencies will seriously consider the comments 

received, and that the final rule, or a re-proposal of the Proposed Rule, will deal 

more effectively with the intended purpose of the Volcker Rule and avoid adverse 

unintended consequences. 

We believe that our conservative and highly focused business model is one that 

contributes to financial stability and long-term benefits for our clients, shareholders 

and employees. As the rulemaking phase continues, we urge this Committee to encourage the Agencies to adopt final regulations that do not adversely impact those 

traditional business activities that played no role in causing the financial crisis. 

These activities provide market participants with efficient and safe investment management services. Preserving such business models will ensure that U.S. banks can 

operate competitively while protecting against negative impacts on the broader 

economy and U.S. employment. 

Thank you Chairman Brown, Ranking Member Corker, and Members of the Committee, for allowing me to present Northern Trust’s views on this critically important topic. 

PREPARED STATEMENT OF ANTHONY J. CARFANG 

PARTNER AND DIRECTOR, TREASURY STRATEGIES, INC. 

ON BEHALF OF THE U.S. CHAMBER OF COMMERCE

MAY 9, 2012 

The U.S. Chamber of Commerce is the world’s largest business federation, 

representing the interests of more than 3 million businesses of all sizes, 

sectors, and regions, as well as State and local chambers and industry associations. 

More than 96 percent of the Chamber’s members are small businesses with 

100 or fewer employees, 70 percent of which have 10 or fewer employees. 

Yet, virtually all of the nation’s largest companies are also active members. 

We are particularly cognizant of the problems of smaller businesses, as well 

as issues facing the business community at large. 

Besides representing a cross-section of the American business community 

in terms of number of employees, the Chamber represents a wide management spectrum by type of business and location. Each major classification 

of American business—manufacturing, retailing, services, construction, 

wholesaling, and finance—is represented. Also, the Chamber has substantial membership in all 50 States. 
92 

The Chamber’s international reach is substantial as well. It believes that 

global interdependence provides an opportunity, not a threat. In addition to 

the U.S. Chamber of Commerce’s 115 American Chambers of Commerce 

abroad, an increasing number of members are engaged in the export and 

import of both goods and services and have ongoing investment activities. 

The Chamber favors strengthened international competitiveness and opposes artificial U.S. and foreign barriers to international business. 

Positions on national issues are developed by a cross-section of Chamber 

members serving on committees, subcommittees, and task forces. More than 

1,000 business people participate in this process. 

Good afternoon Chairman Brown, Ranking Member Corker, and Members of the 

Subcommittee. Thank you for the opportunity to testify, on behalf of the U.S. Chamber of Commerce, at today’s hearing: ‘‘Is Simpler Better? Limiting Federal Support 

for Financial Institutions’’. This is a timely hearing and is a unique opportunity to 

discuss the capital markets that fuel business expansion and the concurrent economic growth and job creation that occurs as a result. 

I am Anthony J. Carfang, a founding partner of Treasury Strategies, Inc. Treasury Strategies is one of the world’s leading consultancies in the area of treasury 

management, payments and liquidity. Our clients include the CFOs and treasurers 

of large and medium sized corporations as well as State and local governments, hospitals and universities. We also consult with the major global and regional banks 

that provide treasury and transaction services to these corporations. In thirty years 

of practice, we have consulted with businesses and financial institutions of every 

size and complexity on a global basis. 

Last year, the Chamber of Commerce issued a report, Sources of Capital and Economic Growth: Interconnected and Diverse Markets Driving U.S. Competition, a copy 

of which is attached as part of this testimony for today’s hearing. The purpose of 

the report was to demonstrate the wide variety and diversity of capital needed to 

fuel business expansion and job growth. This diverse quilt includes debt markets, 

equity markets, bank loans, trade finance, angel investing, venture capital, credit 

cards, home equity loans and the list goes on and on. 

It has been my experience that all of these capital raising methods are needed 

as options for businesses because flexibility will allow them to meet their needs depending on the maturity of the firm, business cycle, regulatory pressures and 

counterparty positions. Global financial systems are needed for large corporations, 

but also small businesses that engage in international trade. Community banks assist small businesses, while credit cards help fuel the entrepreneurial spirit that 

continually reinvigorates the economy. 

So while the premise of the hearing is that our financial systems need to be 

plainer and simpler, the fact is that we need a mosaic of interconnected products 

of varying size and complexity to meet the capital needs of a 21st century economy. 

Constraining our financial systems to look plainer and simpler would be as beneficial as reestablishing the horse and buggy as the foundation of our transportation 

systems. There is no guarantee that plainer and simpler translates to safer. The opposite, because of lack of diversification, might well be true. Furthermore, the loss 

of productivity, speed and communication would cause our economy to shrink and 

businesses to disappear. 

Consideration of financial systems and products cannot be divorced from the way 

that the markets work and the purposes they serve. Viewed from this practical perspective, financial institutions and systems are a conduit—a means of transferring 

capital from investors to the businesses that need it. A well-regulated conduit will 

efficiently and reliably provide businesses with the resources needed to grow and 

thrive. Inappropriately restricting that conduit is analogous to blocked blood vessels 

that deprive the heart of needed oxygen, causing a heart attack and coronary disease. Many aspects of our financial system are in fact already being circumscribed by 

legislators and regulators today. Just consider the rapid succession of far-reaching 

regulations that have flowed from the Dodd-Frank Act and other responses to the 

2008 financial crisis—the Volcker Rule, new derivatives regulations, potential 

money market regulations, Basel III capital standards, systemic risk mandates, to 

name a few, all have one thing in common—they will impact the ability of businesses to raise capital and the ability and willingness of investors to provide it. 

If we judge these regulatory initiatives in light of my earlier-stated premise that 

businesses need access to a mosaic of financial products and systems to raise capital 

number of questions must be considered: How do these initiatives impact that mosaic? How would placing artificial caps on these systems or institutions impact cap-
93 

ital-raising for companies and the return that investors expect to receive? How 

would restricting diversification reduce risk? Ultimately, how could U.S. businesses 

compete and hire workers in a global marketplace, if their ability to raise capital 

is impaired? 

Economic Consequences 

Up to now, businesses operating in the United States have been the most capital 

efficient and productive in the world. Thanks to our financial institutions and existing banking frameworks, businesses and the U.S. economy benefit greatly from: 

• The broadest, deepest and most resilient capital markets, 

• The best risk management products and tools, 

• The most robust and liquid markets, 

• The most technologically advanced cash management services, and 

• The most efficient and transparent payment systems. 

As a result, U.S. businesses are extremely efficient. Consider the following Treasury 

Strategies analysis: companies doing business in the United States operate with approximately $2.2 trillion of cash reserves. That represents only 14 percent of U.S. 

gross domestic product. In contrast, corporate cash in the Eurozone is 21 percent 

of Eurozone GDP. In the UK, the ratio is even higher at 50 percent. 

The availability of highly liquid capital pools allows Treasurers to keep less cash 

on hand and use a just-in-time financing system that allows companies to pay their 

bills and raise the capital needed to expand and create jobs. 

Using this analysis to look at just two items posed by today’s hearing—placing 

caps on the size of financial institutions or the imposition of the Volcker Rule as 

currently drafted—shows that America’s capital efficiency will decline. This will result in corporations having to maintain larger cash buffers. Were cash reserves to 

rise to the Eurozone level of 21 percent of GDP, that new level would be in excess 

of $3 trillion. 

Stated differently, CFOs and Treasurers would need to set aside and idle an additional $1 trillion of cash that could otherwise be used for expansion and hiring. $1 

trillion dollars of idle cash is a staggering number. By way of comparison: 

• It is greater than the entire TARP program. 

• It is more than the Stimulus program. 

• It is even greater than the Federal Reserve’s quantitative easing program, QE 

II. 

This would seriously slow the economy to the detriment of businesses, workers and 

consumers. To raise this extra $1 trillion cash buffer, companies may have to 

downsize and lay off workers, reduce inventories, postpone expansion and defer capital investment. Obviously, the economic consequences would be huge. 

Why would treasurers have to idle so much more cash? 

Artificial caps and the Volcker Rule, as currently proposed, will create a subjective regulatory scrutiny of trades, making a company’s ability to raise capital more 

expensive and time consuming. They will increase administrative expenses for 

banks which will translate into a higher cost of capital for businesses. Real-time financing will no longer be possible for many companies. This will raise costs for most 

companies and make foreign capital markets more attractive for some companies, 

while shutting other companies out of debt markets entirely. 

This is also not happening in a vacuum. 

Corporate treasurers must also contend with looming money market fund regulations that may imperil 40 percent of the commercial paper market, Basel III capital 

and liquidity requirements and expected derivatives regulations. 

As I said earlier all of these efforts simultaneously converge on the desk of the 

corporate treasurer, adversely impacting business’s ability to raise capital and mitigate risk. It is unclear how well these proposals have been vetted and the extent 

to which their cumulative impacts have been considered and analyzed. Never before 

have so many unproven, high stakes regulations been imposed simultaneously. This 

is a dangerous experiment. 

In January, Federal Reserve Governor Tarullo testified before the House Financial Services Committee that the regulators did not know or understand what normal market making or underwriting practices are. Market making and underwriting 

are used by nonfinancial firms to raise money. Yet the regulators admit that they 

don’t understand the activity or products they are attempting to regulate—three 

months after the three hundred page Volcker Rule regulation has been proposed. 
94 

Similarly, no economic analysis has been performed regarding the potential impacts on our economy and job growth that may flow from capping the size of financial institutions. For instance, where will community banks go for liquidity? 

There is a very close relationship between large banks and community banks that 

could be jeopardized by ill-considered, arbitrary regulations. Large banks are a 

major source of liquidity for community banks and their business and consumer customers. 

For example, large banks lend to community banks via the fed funds market so 

that community banks will have funds to invest locally. Often, large banks will participate in loans originated by community banks, allowing that bank to better serve 

the community. Typically, community banks will access services of larger banks in 

order to meet occasional customer needs such as international wire transfers, foreign currency orders or letters of credit. Breaks in this chain can have direct adverse consequences for Main Street businesses and the smaller financial firms that 

service them. If community banks lose access to liquidity, by extension, Main Street 

businesses lose access to capital. 

Similarly, if a company must go to multiple institutions to raise capital for a deal, 

rather than one institution, market efficiency and capital formation are impaired. 

Economies of scale must be considered for the ease and efficiency of the overall economy. 

The nature of financial risk 

I would like to add a statement about managing financial risk. A common understanding among our clients is that, like energy, risk can neither be created nor destroyed but only transferred. So when you consider ways to reduce banking system 

risk, do not be tricked into thinking that risk disappears. It simply moves elsewhere. Our system relies on the presence of actors who view the potential rewards 

of accepting this risk as sufficient to prompt them to do so. If they should come to 

view the costs and risks as outweighing any potential reward, the flow of capital 

will come to a standstill. 

To truly minimize the probability of future financial crises, we must understand 

how this risk moves and where it will show up next. Risk is managed most efficiently when it is transparent, properly understood and the market responds with 

robust, efficient and liquid hedging solutions. 

A corporate CFO whose company imports a raw material from the Far East, for 

example, must manage currency risk, commodity price risk, interest rate risk and 

operational shipping risks. By simply precluding a bank from helping a company to 

hedge these risks, the Volcker Rule or size limitations does not make those risks 

go away. 

CFOs and Treasurers will undoubtedly conclude that some risk management techniques and some heretofore efficient transactions will no longer be available, or, if 

they are available, they will no longer be cost effective. They will decide to ‘‘go 

naked’’ and retain more risk internally. The upshot of this is that they will hold 

even more precautionary cash on their balance sheets as a buffer. This will take 

money out of the real economy, stall economic growth, stunt the creation of new 

jobs, and destroy existing jobs. 

The corporate treasury is the financial nerve center of a business, which must 

make countless decisions on a daily basis to identify and manage the complexities 

of the company’s cash-flow in global as well as local markets. To assist them in this 

critical and ongoing task, some companies require a bank that can deliver global 

economies of scale. Other companies require a broad array of services that only a 

full service bank can provide. Still others require specific knowledge of local markets 

that regional and community banks best provide. Most companies required all of the 

above at some point in their life cycle. The Volcker Rule and size caps would virtually eliminate U.S. banks from offering both the scale services, scope services and 

localized specialties that today’s U.S. businesses need. 

Many companies have recently engaged Treasury Strategies to assist in upgrading 

their treasury technology. Their intent is to get a real time view of their cash, and 

implement automated tools to easily move that cash around the globe. In this 

frictionless environment, cash can easily move to the most favorable jurisdictions. 

Thus, regulations that limit a financial institution’s ability to provide a full range 

of services erode the dominance of the U.S. banks. Many companies have already 

established regional treasury centers for functions traditionally housed in the 

United States. All of this leads to capital flowing out of the United States and competitiveness declining. 

Let me also state that Treasury Strategies and our clients fully support well 

thought out efforts to improve economic efficiency and to reduce the likelihood of 

another systemic failure. The U.S. Chamber’s position is the same and it has advo-
95 

cated for stronger capital rules, rather than a unilateral ban on proprietary trading, 

as a pro-growth means of stabilizing the financial system and avoiding systemic failure. 

However, we are in danger of developing an overly complex hodgepodge of 

unproven regulations that will be extraordinarily vague and create regulatory risk 

and legal uncertainty. In short we may deprive the American economy of one extraordinary advantage—the efficiency associated with predictability and legal certainty in the rules governing our financial systems. 

We could deprive our economy of competitive advantages at the same time that 

it must become more globally competitive to grow our economy and put America 

back to work. 

Conclusion 

I appreciate the opportunity to appear before you today on behalf of the U.S. 

Chamber of Commerce. 

Financial regulatory reform is an unfinished project that must take into account 

the needs of treasurers and businesses to meet the demands needed to grow and 

operate in an increasingly competitive and global environment. Proposals to impose 

artificial and arbitrary caps on the financial industry, or the Volcker Rule (as currently proposed), or additional money market regulation will not reduce systemic 

risk. Instead they will only shift that risk. They will force the nonfinancial companies that are the engines of our economy to retrench, enhance their cash positions 

and face a much tougher time raising the capital needed to operate, grow and create 

jobs. 

This is about a grand tradeoff: are we willing to jeopardize America’s capital raising and job creating engine in exchange for a vague, unproven hope of reducing financial risk? As stated earlier, risks can only be shifted, not eliminated. We believe 

that these regulations will make U.S. capital markets less robust, U.S. business less 

competitive and ultimately harm all Americans by slowing America’s economic activity. 

In thinking through these difficult problems, I would respectfully suggest that policymakers ask this question before proposing new laws or approving new regulations governing America’s financial system: 

When a business’ treasurer calls a U.S. bank or financial firm to raise the cash 

needed to meet the pay bills or fund expansion, will someone be there to answer 

that phone call? 

If not, the business will suffer, as will the economy and job creation. 

I am delighted to discuss these issues further and answer any questions you may 

have. 
96 

~') CENTER FOR CAPITAL MARKETS 

\} ... UI'I ""~~ OMPETITIVENESS 

SOURCES OF CAPITAL 0 

ECONOMIC GROWTH: 

Interconnected and Diverse Markets Driving U.S. Competitiveness 

Spring 2011 
97 

,. CENTER FOR CAPITAL MARKETS 

~~ OMPETITIVENESS 

Since its inception, the U.S. Chamber's Center for Capital Markets Competitiveness (CCMC) has led a 

bipartisan effort to modernize and strengthen the outmoded regulatory systems that have governed our 

capital markets. Ensuring an effective and robust capital formation system is essential to every business 

from the smallest start-up to the largest enterprise. 

Copyright © 2011 by the United States Chamber of Commerce. All rights reserved. No part of this pUblication may be reproduced or transmitted In any formprint, electronic, or otherwise-without the express written permission of the publisher, 
98 

Contents 

eXcCU fiVe SUMMAflY ................................................................................................................................ 2 

INTRODLICTION .................................................................................................................................... 4 

II. THE ROLE or THE FINANCIAL SYSTEM IN PROMOTING ECONOMIC GflOWTH ............................. 6 

The Conceptual Link Between the Financial System and Economic Growth ................... , .......... ,. 6 

The Services the Financial System Provides and How They Help Economic Growth . ........... , ..... 8 

III. AN OVEflVIEW OF HOW THE U.S. FINANCIAL SYSTEM WORKS .......................... . .................... 11 

Oebt Versus Equity and Use by Consumers and Businesses ....................................................... 13 

Individua.I/Consumer Financing ............................................... , ........................ , ................. , ............. 14 

Business Financing: Equity ....... , ............................................ " ...................... , .. , ......... ., .................... 15 

Internal Equity FinanCing ........................................................................... , ................................. 15 

Extemal Equity Financing ................ ,', ...... , ...................................................... , ........... , ......•..... ".16 

Intermediated Equity Capital ...................... , ................................................................................ 17 

Business Rnancing: Debt ................................................................................................................. 21 

Nonmarket, Intermediated, and Direct Debt ...................................... , .... , .................................... 21 

Public Debt """"."".""" .. "." .... """." .. """,,,,,,,,,.,,,, .. ,, ... ,,.,,,,,,,,,,.,,,,. ."."."""""""" 23 

IV. "[HE INTERCONNLCTEDNESS OF THE FINANCIAL SYSTEM .. """ .. "."""""."" .. " .... " .. """"."." .. ". 25 

CONCLUSION "."."""."" .. """." .. """ ..... "" ........... """".""""""".".".""".""."."""." .. ""."."""" .. ".30 

www.centerforcapitalmarkets.com 
99 

Executive Summary 

This paper provides a broad overview of 

the U,S. financial system. It describes the variety 

of financing sources available to both individual 

consumers and businesses, and the considerations 

that lead a consumer or a business to choose a 

specific financing source. It then discusses how 

this variety of financing sources provides beneffts 

to the economy. Five main conclusions emerge 

from this analysis. 

sources include family and friends, credit cards, 

home equity loans, and other types of bank loans. 

Consumer credit provided through these diverse 

sources is a large segment of allr economy. The 

major provlders of consumer credit-commercial 

banks, finance companies, credit unions, the federal 

government, sayings institutions, and nonfinancial 

businesses-provided over $2.4 trillion of consumer 

credit as of year-end 2010. The efficient availability 

of this credit is critical in an economy so dependent 

First, a robust, efficient, and diverse on domestic consumption. It is important to note 

financial system facilitates economic growth. that for many smaller businesses, especially startResearch has shown that the level of financial deve!- ups, these consumer credit products are often the 

opment is a strong predictor of economic growth. only available sources of new or even working cap/-

This research is based on a study of a large number tal. Entrepreneurs often rely on access to personal 

of countries. Even with the unprecedented economic credit, including credit cards and home equity !oans, 

crisis, the growth in the U.S. financial services indus- to launch their new businesses. 

try has been accompanied by a robust growth in our 

economy, as measured by growth in gross domestic Third, as businesses grow they can 

product (GOP). The financial system facilitates eco- access both debt and equity financing, and the 

nomic growth by providing four basic services: 

facilitating trade; 

facilitating risk management for various !ndividuals and businesses; 

mobilizing resources; and 

obtaining information, evaluatIng businesses 

and individuals based on this infonnation, 

and allocating capital. 

it is through the provision of these services that the 

financial system ensures that investment capital is 

channeled most efficiently from the providers of capital to the users of capital, so that both the economy 

and employment grow. 

mix of these two, called the "-capital structure" 

decision, is an important choice every business 

makes. Three broad categories of financing sources 

are available to businesses for either debt or equity 

capital. One source of capital involves raising funds 

without using any intermediaries like banks or going 

to the public capital market. Included in this category are family and friends, employee ownership, 

retained earnings generated by the operating profits of the business, customers and suppliers, and 

angel investors. A second category is intermediated 

finance that does not involve going to the capital 

market. Included in this are loans from intermediaries !ike banks and insurance companies, funding by 

Second, in terms of their financing private~equjty firms and venture capitalists, small 

choices, individuals are largely limited to debt business investment companies that provide Smallfinancing for raising capital. For individuals, these Business-Administration-sponsored financing, and 

Sources of Capital and Economic Growth 
100 

factoring companies that provide financing against financing would decline as well. Hence, assessing the 

receivables. While all these financing sources are risks associated with regulatory changes in the finanimportant, venture capital has played an especialfy cial system is a notoriously difficuft task. This often 

vital role in helping launch new businesses: venture leads to unintended consequences when changes are 

capital financing accounts for 21 % of GOP. Many introduced in some part of the financial system. Dis .. 

famous companies like Apple were financed in their turbing examples ofthis can be found in the impact of 

infancy by venture capital. For more mature business, bank loans are an essential source of finance. 

In 2009, U.S. banks made more than $7 trillion in 

loans. The third category of financing available to 

businesses is direct capital market access, whereby 

the firm uses an investment bank and sells debt 

or eqUity claims directly to capital-market investors. These include commercia! paper, initial public 

offerings (IPOs), bond sales, and secondary equity 

offerings. 

Fourth, a rich diversity of financing 

sources is provided by the U.S. financial system. 

This diversity helps U.S. consumers and businesses 

the Sarbanes-Oxley Act and the litigation environment 

faced by U.S. companies. These changes have contributed to a slowdown of the rate at which new public 

companies are formed and an increase in the rate at 

which existing public companies are !eaving the market, leading to a substantial decline in the number of 

publicly listed U.s. companies. 

A well-developed financial 

system goes hand-in-hand 

with robust economic growth 

and increased employment. 

to better manage their risks and lowers their cost of Awel!-developedfinancial system goes handcapital. Diversity enables consumers and businesses in-hand with robust economic growth and increased 

to effectively match thelr financing needs to the employment. The better the financial system funcfinancing sources, with each financing source pro- tions, the more new companies are launched, the 

viding a different set of services. Since the needs of larger the number of publicly listed companies, the 

those seeking financing differ, it is beneficial to have better the overall management of risk, the greater the 

specialized financiers catering to different needs. The availability of consumer credit, and the higher aggreresutt is better risk management and higher invest- gate investment. 

ment in the economy, leading to an increase in GOP 

and employment. 

Fifth, the U.S. financial systern is highly interconnected. What happens to one financing source 

typically affects a host of other financing sources as 

well as those seeking financing. These spillover effects 

cause any change in the part of the system to be 

propagated through the entire system, often in ways 

that are difficult to predict. For example, if our public equity markets were to diminish in the fLrture-say 

due to excessively onerous regulation-it is very likely 

that the supply of private equity and venture capital 

www.centerforcapitalmarkets.com 
101 

I. Introduction 

In the early 19805, the financial services liquidity-imbalance, an easy-money monetary policy. 

industry accounted for about 10% of total corpo- a political desire for widespread home ownership, 

rate profits in the United States. In 2007, it was 40%. and various developments in the financial sector. 

Some have used statistics like this to argue that finan- All of these factors need attention if we are to have 

cial services are becoming excessively important at a well-regulated, transparent, efficient, and robust 

the expense of other parts of the economy, such as financlal system consisting of a diversity of financmanufacturing and services that produce obviously ing sources. Thus, financial reform must go hand 

tangible economic value. However, nothing could be in hand with a strong financial services sector. The 

further from the truth. Given the economic crisis we recently passed Dodd-Frank Wall Street Reform and 

have witnessed over the past three years, it is easy to Consumer Protection Act tackles a variety offtnancial 

forget that growth in financial services over the past reform issues, but many of the specific regulations 

two decades was also accompanied by some of the have yet to be written, so time will tell about how 

most spectacular economic growth we have ever wit- effectively the Act will deal with the causes of the 

nessed. In the 1980s, U.S. gross domestic product crisis. Nonetheless, an important point to remember 

(GOP), the most commonly used measure of the size is that the data show a strong correlation between 

of the economy, stood at under $3 trillion. In 2007, 

when the share of total corporate profits accounted 

for by financial services was four times as large as 

in the 1980s, it was around $14 trillion. Today the 

U.S. financial services industry employs mora than 

5.17 million people, about 6% of total private non~ 

farm employment, and this number is projected to 

grow to 12% by 2018. The wealth generated by the 

financial services industry contributed nearly 6% 

($828 billion) to U.S. GOP in 2009.' 

In the wake of the recent financial crisis, some 

have argued that the economic growth we witnessed 

was merely an unsustainable bubble, and that when 

the bubble burst, the economy came crashing down. 

While the causes of this crisis are not the topic of 

this paper, it is worth noting that the crisis was a 

economic growth and strength of financial services. 

Financial markets and the 

financial service firms that 

operate in those markets help 

individuals and businesses raise 

capital of various sorts, as they 

channel money from savers to 

those with investment ideas. 

It was not a coincidence that the U.S. economy grew so rapidly during a time that financial 

services grew in importance. Financial markets and 

the financial service firms that operate in those markets help individuals and businesses raise capital of 

consequence of a variety of factors in the United various sorts, as they channel money from savers to 

States: an excess supply of liquidity due to a global those with investment ideas. The more well developed 

1 u.s. Finencial Services Industry: Contributing to a Mare Competitive U.S. Economy. SIFMA. http://www-ita.doc.gov/td/flnancei 

pub!icationslU.S.%20Financial%20Servlces%201ndustry.pdf. 

(Jufy2010). 

the financial system, the better lubricated this channel, and the lower the transactions costs and other 

impediments to investment and economic growth. 

Sources of Capital and Economic Growth 
102 

Indeed, one of the roadblocks to economic of financing sources avallable to them, and the 

growth in the former eastern-block Communist coun- financial instruments/contracts that are used to raise 

tries in Europe, such as Romania, has been the lack capital. Section IV discusses how different parts of 

of developed financial systems. The fact that the U.S the financial system are connected and the role of 

financia! system is well developed and innovative has the large diversity of financing sources in making the 

been a big boon to individuals and businesses1 as financial system deep and vibrant, and facilitating 

they have been able to access a variety of financing economic growth. 

sources to raise relatively low-cost capital to grow. 

Even within the United States, the number one reason 

When small businesses 

do succeed and create 

employment and growth, an 

important factor in their success 

is access to the financing 

needed to support growth. 

for the failure of small businesses is lack of access 

to funding. Put differently, when small businesses 

do succeed and create employment and growth, 

an important factor in their success is access to the 

financing needed to support growth. The strength of 

the financial system has also been a significant factor in the creation of prominent new firms that have 

been launched in the past 25 years and have gone on 

to become global powerhouses. Starbucks, Yahoo, 

Google, and eBay are but a few examples. No other 

country in the world can match this, in large part 

because no other country in the world has such a 

deep and vibrant financial system. 

What is the U.S. financial system composed 

of and how does it work? What makes it so deep and 

vibrant? These are the main questions addressed in 

this research paper. Section II discusses the role of 

the financial system in promoting economic growth. 

Section III provides an overview of the financial system and addresses the question of how the financial 

system functions. The focus is on the types of businesses that are involved in raising capital, the types 

www.centerforcapitalmarkets.com 
103 

II. The Role of the Financial System in 

Promoting Economic Growth 

There is a rich body of research on the role of hand, is patient and would not mind giving her money 

the financial system in promoting economic growth, to someone now in exchange for a larger payment in 

much of it from comparisons of different countries. the future. However, she does not know Peter well and 

For example, in a study of 56 developing countries, is concerned that he might be a crook who will simply 

the leve! of financial development in 1960 was a abscond with her money if she lends it to him. 

strong predictor of economic growth over the next 

30 years. after controillng for a variety of economic 

and political factors.'! This and other studies provide 

ample evidence that rSlbust financial development is 

followed by healthy economic growth. This section 

will discuss this research to develop an understanding of what the facts say and why they say what they 

say, But first, it is useful to understand the basic ecoWithout a financial system in this community, 

Peter will be limited to planting whatever apple trees 

he can using his own seeds and labor, but without any 

fertilizer or farm equipment. Suppose he can plant a 

few trees and harvest 500 apples a year. That then 

defines his economic output. 

nornics behind how the financial system promotes Now suppose the community's financial syseconomic growth, tem includes a bank and a financial market where 

financial securities are traded. Now Peter Gan go to 

The Conceptual link Between the the bank and request a loan that would be repaid from 

future sales of apples. The bank will conduct a credit 

analysis and determine whether Peter is a good credit Financial System and Economic 

Growth risk. The bank will also monitor Peter to make sure 

A simple example illustrates this !ink. Sup- that he is not a cfook who absconds with the bank 

pose we have a community in which fOUf people own loan. With the assurances provided, Mary will be willproductive resources: Mary, Peter, Paul, and Sally. ing to deposit her money in the bank. This is better 

Mary has saved some money that she keeps in a for her than keeping the money idle in a safe in her 

safe in her house. Peter owns an orchard and some house and earning zero interest, With the bank loan, 

apple seeds that he can plant to grow trees and har- Peter wi!! buy some fertilizer from Paul and some farm 

vest apples. Paul has a farm on which he naturally equipment from Sally on a cash-an-purchase baSis. 

produces fertilizer. Sally owns some farm equipment He can now plant more trees to produce more apples, 

that can be used for tilling the land and digging holes so heends up with 10,000 apples rather than 500. The 

for planting trees. economic output of this economy has gone up due to 

the financial market. A further increase in economic 

Neither Paul nOf Sally is willing to sell any output may arise from the fact that Paul and Sally 

goods or services fOf the promise of a future return. may use the money Peter pays them to produce more 

They will sell only if they get paid now. But Peter has fertiliZer and farm equipment. This output may have 

no money to pay anyone now, Mary, on the other uses in other parts of the economy, leading to further 

increases in economic output, and so on {see fjgure 1}. 

2 See Levine (199S). 

Sources of Capital and Economic Growth 
104 

This simple example illustrates three important ways in which the financial system contributes to 

economic growth: 

it increases trade and the flow of goods and services; 

it increases the rate of physical capital accumulation; and 

it increases the efficiency of combining capital and labor in production. 

Figure 1: How the Financial System Promotes Growth 

of labor In production and thereby produces more apples. 

www.centerforcapitalmarkets.com 

ProdUCBsmore 

farm equipment 
105 

The Services the Financial System 

Provides and How They Help 

Economic Growth 

There are four basic services provided by 

financial systems that help spur economic growth~ 

(ses figure 2). 

to move money from one party to the other and often 

across national boundaries. Without these systems, 

companies would be greatly impeded in their ability to do business with each other, and economic 

growth would suffer. 

The Financial System Facilitates Risk 

Management: Financial systems help individuals 

The Financial System Facilitates Trade: and businesses improve their management of variIn primitive economies, trade was based on barter, cos sorts of risks. This is important for economic 

something that Peter and Paul CQuid not do in our growth because increased risk reduces investment. 

example because Peter had no apples in his inven- In our example, Peter faces some risk when he buys 

tory to trade. The invention of money minimized the fertilizer and farm equipment to increase his apple 

Figure 2: The Basic Services Provided by a Financial System 

FINANCIAL S¥STEM 

need for barter trade, thereby increasing commercial crop. If it does not rain as much as Peter expects, he 

transactions and trade. In modern economies, it is not may have a lean harvest and be unable to fully repay 

enough to have money to facilitate transactions-this his bank loan. This may cause him to lose his farm 

money needs to be moved around. Financial systems, to the bank. Or there may be enough rain, but new 

with the appropriate hubs and spokes for recording apple orchards may spring up in neighboring comand clearing multilateral financial transactions, help munities and the market may be flooded with apples, 

pushing the price of apples well below normal. These 

3 See Levine (1996). risks may cause Peter to cut baCk on how much 

Sources of Capital and Economic Growth 
106 

he invests in buying fertilizer and farm equipment. 

A financial system prices risk and provides mecha~ 

nisms for pooling, amellorating, and trading risk. It 

provides producers like Peter a way to manage risks. 

For example, Peter could use the financial system to 

purchase insurance against a low harvest or could 

hedge apple price risk In the futures market. The 

financial system also gives investors like Mary better 

risk management opportunities. For example, Mary 

may be concerned about liquidity risk jf she lends 

directly to Peter. Once the money is loaned, Mary 

may be unable to get any of it back until the apples 

are harvested and sold. But what if a medical emerw 

gency arises and Mary needs the money before then? 

With a financial system, Mary would simply withdraw her deposit from the bank when she needs it. 

Thus, a financial system, by facilitating improved risk 

management for both borrowers and savers, spurs 

long-run investments that fuel economic growth 

A financial system, by 

facilitating improved risk 

management for both 

borrowers and savers, spurs 

long-run investments that fuel 

economic growth. 

The Financial System Mobilizes Resources: As our 

example shows, without a financial system, Mary's 

savings would have stayed locked up in her safe. It 

took a financial system to mobilize those resources 

and get them to Peter, who could put them to pro-

"We have entirely lost the idea that 

any undertaking likely to pay, and seen to be 

likely, can perish for want of money; yet no 

idea was more familiar to our ancestors, or is 

more common in most counties. A citizen of 

Long in Queen Elizabeth's time. "would have 

thought that it was no use inventing railways 

(if he could have understood what a railway 

meant), for you would not have been able to 

collect the capital with which to make them. 

At this moment, in colonies and in all rude 

countries, there is no large sum of transferable money, there is not fund from which you 

can borrow, and out of which you can make 

immense works." 

What Bagehot was referring to was the abil~ 

lty of the financial system to mobilize resources that 

would permit the development of better technologies 

that lead to economic growth. 

The Financial System Obtains and 

Processes Information and Allocates Capi~ 

tal: Individual savers, like Mary, may not have the 

resources or expertise to evaluate firms, projects, 

and managers before deciding whether to invest in 

them. Financial intermediaries, like banks and invest* 

ment banks, have a cost and expertise advantage in 

collecting and processing such information, and then 

helping the capital-allocation process based on that 

information.s This, in turn, encourages investors to 

supply capital to these intermediaries, which channel 

the capital to businesses that make investments that 

fuel economic growth. 

For example, imagine that someone comes ductlve use. Almost 150 years ago, the famous 

economist Walter Bagehot described how the finan- to you and asks for a loan to finance a new restaurant. 

cia! system helps to mobilizes resources and spur While you have the money to lend, you are not sure 

this is a good investment for you. But if your friend 

goes to a bank for the loan, the bank Can gather the economic growth:4 

4 See Bagehct (187:3), reprinted 1962, as noted by Levine (1996). 5 See Greenbaum and Thakor (ZOO?), 

www.centerforcapitalmarkets.com 
107 

necessary information about potential future income In summary, the financial system provides 

and the assets purchased with the loan that can four key services-facilitates trade, facilitates risk 

be used as collateral, conduct the necessary credit management, mobilizes resources, and acquires and 

analysis with this information, and decide whether to processes information that helps in the allocation of 

lend and how to structure the loan. Such expertise capital. These key services help to increase the flow 

is part of the bank's business skill set, Knowing that of goods and services, increase the rate of physical 

the bank will do this, you may be willing to deposit capita! accumulation, and increase the efficiency of 

your money so that the bank can, in turn, use it to combining capital and labor in production. The result 

is more economic growth. 

In a different context, venture capitalists are 

also information-processing experts. When a venture 

capital firm !ike Sequoia Capital evaluates a startup firm, it uses its expertise in assessing the firm's 

growth potential and odds of success on the basis of 

the firm's business plan. It then uses this assessment 

to decide whether to provide financing. Promising 

new ventures that survive this screening are able to 

obtain more financing than they might receive from 

family and friends. 

Figure 3: The U.S. Financial System: Individuals/Consumers 

USERS OF CAPITAL iNTERMEDIARIES 

Banks 

INVESTORS AND 

SOURCES OF CAPITAL 

Family and Friends 

_ Credit Cards 

- rg:,,~ Equity 

_ ~~~~sand Other 

Nonbank Loans 

~o Sources of Capital and Economic Growth 
108 

III. An Overview of How the U.S. 

Financial System Works The U.S. financial system is a complex mosaic of institutions, markets, investors (businesses and 

individuals), savers, and financial contracts, all of whlch are interconnected. Before we can understand the 

role played by each part of the financial system, it is necessary to understand some key distinctions between 

the contracts by which financial capital is raised and the differences between individuals/consumers and 

bUsinesses with respect to how these financing contracts are used. 

4: The U.S. Financial 

USERS OF CAPITAL INTERMEDIARIES INVESTORS AND 

SOURCES OF CAPITAL 

Family and Friends 

Employee Ownership 

Retained Earnings 

+--------- Angellnvestors 

Private and Public 

Placements of Equity 

Customers and Suppliers 

Corporate Parents 

..... Debt and Equity 

Investors 

Pension Funds, 

..... Endowments, Insurance 

Companies, Individuals 

and Families 

Private and Government 

Investors Provising 

..... Small-Business 

Administration (SBA)-

Sponsored Financing 

..... Institutional and 

Individual Investors 

www.centerforcapitalmarkets.com 
109 

Figure 5: The U.S. Financial System: Businesses Raising Debt Financing 

USERS OF CAPITAL INTERMEDIARIES INVESTORS AND 

SOURCES OF CAPiTAL 

Depositors (Individuals 

and Businesses) and 

Those Who Buy Bank 

Equity 

Policyholders, 

individuals, and 

Businesses 

Factoring Companies' 

Investors 

- Taxpayers 

Suppliers 

Capital Mark~t Investors Providing Commercial 

Paper and Public Bond Financing 

Sources of Capital and Economic Growth 
110 

Debt Versus Equity and Use by 

Consumers and Businesses 

Although a highly developed financial system like the United States has a plethora of financial 

contracts, the contracts by which individuals and 

businesses raise capita! can be divided into two main 

groups: equity and debt. 

With an equity contract, a business wishing 

to raise capital would sell an ownership stake in the 

shareholders can be paid. In our example, if Peter 

finances with a bank loan, he must first use ail of the 

profit from selling apples to repay the bank, even 

before he pays taxes. Only after he repays the bank 

and pays his taxes can he keep what is left over 

for himself as the owner of his business. 

Consumers finance primarily 

with debt contracts, 

business to investors, who would provide the exter- Consumers finance primarily with debt con~ 

nal financing the business needs. In the example tracts. Bank loans, home mortgages, and credit card 

discussed earlier, Peter might go to Mary and offer borrowing are all forms of debt contracts. There is 

her a 30% ownership share in his apple business in a good reason why equity is not used in consumer 

order to raise the money to buy fertiltzer and farm financing. A loan taken by a consumer is essentially a 

equipment, rather than taking a bank loan. How financial claim by the lender on the borrower's future 

much money Mary would make on her investment labor income. It is relatively easy for the borrower to 

would depend entirety on the profitability of the busi~ simply withhold the supply of this labor income-for 

ness. If Mary invested $100,000 for a 30% ownership example, by quitting work-and make the lender'S 

share and Peter made a profit of $15,000 in the first claim worthless. A debt contract, with a requireyear after paying off all his operating expenses, Mary ment to repay by a certain date and penalties for not 

would be entitled to receive 30% of that, which is repaying, provides better incentives for the borrower 

$4,500. If Peter's business made a profit of $50,000, to repay. 

Mary would get $15,000 in the first year alone, and 

if the business made no profit in the first year, Mary Businesses finance with both debt and 

would get nothing in the first year. Each year, Mary equity. In fact, the mix of debt and equity financing 

would receiVe 30% of the profits, assuming all profit is an important decision for any business. Equity 

is distributed as dividends. Moreover, Mary's investment has no stated maturity. That means Peter never 

has to return her original investment of $100,000 to 

her as a lump sum. The only way for Mary to recover 

that original investment is to sell her ownership stake 

to someone else. 

With a debt contract-for example, a bank 

loan-the lender is promised a repayment of the 

original loan amount plus some interest. A debt claim 

has both a stated maturity and priority over equity. 

"Stated maturity" means that the lender must be 

fully repaid by a certain date. "Priority over equity" 

means that debt holders must be fully repaid before 

Businesses finance with 

both debt and equity, In fact, 

the mix of debt and equity 

financing is an important 

decision for any business, 

financing is viable for businesses because the financial system provides corporate governance to keep 

managerial actions roughly aligned with the interests 

of the financiers of the business. Further, businesses 

have powerful incentives to keep producing profits, 

www.centerforcapitalmarkets.com 
111 

so they are unlikely to withhold the supply of produc~ 

tive inputs like labor. 

Individual/Consumer Financing 

Consumers can tap a variety of sources for 

financing, most of which is in the form of debt (see 

figure 3). 

Of course, once you take the loan, you will be faced 

with additional monthly payments on the loan. 

Before the subprime financial crisis, home 

equity loans were a significant source of finance for 

many consumers. The average U.S. homeowner 

extracted 25-30 cents for every dollar increase in 

home equity during 2002-2006, and home-equity~ 

Friends and family provide a potentially based borrowing was equal to 2.8% of GOP every 

year from 2002 to 2006.$ significant source of capital. Often these loans have 

vague1y defined maturity with specific purposes, for 

example, a student loan that will be repaid sometime 

after graduation or a car loan. Many people rely on 

this form of financing in emergencies or for purposes 

for which bank loans are difficult to get. 

Credit card financing is unsecured debt, 

which means there is no specific collateral back~ 

jng the loan. Since it is largely used as a means of 

transaction financing, the issuer expects to be repaid 

Bank and other loans represent a significant 

portion of the financing available to individuals. These 

loans include borrowing from commercial banks, 

finance companies (e.g., car loans), credit unions, the 

federal government, and so on. The amount of this 

borrowing is huge. As of year-end 2010, consumer 

credit outstanding was $2.41 trillion, having grown at 

an annual rate of 2.5% in the fourth quarter of 2010 

(see table 1). 

from the borrower's income within a relatively short Nonbank loans are provided by a wide array 

time. Interest rates and late-payment fees tend to of lenders. Perhaps the biggest nonbank financial 

be high to encourage prompt payment. The viabil- intermediary is the U.S. government. From Fannie 

ity of credit card financing rests on a well-developed Mae and Freddie Mac to Sally Mae (the Student Loan 

financial system with a high level of trust and a deep Marketing Association), the amount of credit provifinancial market in which banks can raise financ- sian that involves the U.S. government dwarfs that lng by securitizing their credit card receivables and by any bank. 

selling the claims to investors. The volume of credit 

card finance, and hence the enormous paymenttransactions convenience afforded to consumers, 

both decline exponentially as one moves from welldeveloped financial systems (like the United States) 

to less-developed financial systems. 

Various other lenders also exist on the 

«periphery" of the financial services industry and 

serve as "bankers" to the poor and the eXCluded. 

Pawnbrokers are one such group of lenders. Pawnbroking is a form of asset-backed (secured) fending. 

The !ender makes a loan that typically is small, 

Home equity loans are a convenient way for say $50-$100, for a few weeks or months, and is 

consumers to borrow against the price appreCiation secured with merchandise {e.g., jewelry, electronics) 

in their homes. For example, say you need $75,000. 

Your home is worth $300,000 and you owe the that has a resale value roughly twice the debt. Interbank $200,000. Then your home equity is $100,000 est rates tend to be high, roughly 25-30% per month 

($300,000 minus $200,000), and you can borrow in some states. Default rates range between 10% 

the $75,000 you need against the home equity. 6 See Mian and Sufi (201 O}. 

Sources of Capital and Economic Growth 
112 

Source: Federal Reserve Statistical Release, February 7, 2011. 

and 30%. In 2004, there were 15,000 pawnbrokers remain with the borrower while the loan is outstand* 

In the United States. 7 lng and repossess it only upon default. 

Payda.y lenders represent another source Attention will be turned next to business 

of nonbank credit. They provide unsecured, short- financing. While for purposes of discussion, it is usetenn loans to customers. The loan arises in one of fu1 to create a clean separation between consumer 

two ways. The first is a "traditional" payday loan, in and business financing, in practice this dividing line 

which the borrower writes a post-dated (or undated) is often fuzzy. In particular, many individuals will use 

personal check to the lender, and the lender makes their access to consumer financing to raise the money 

a loan equal to the check amount minus a finance they need to invest in their businesses, For example, 

charge. The lender usually deposits the check and someone may charge a business purchase to a pergets paid the day the borrower receives his pay. The sonal credit card or use a home equity loan to make 

second invofves the lender directly debiting the bor- the investment needed to expand the business. 

rower's bank checking account on a future date for 

the amount of the loan plus the finance charge. The 

typical loan has a two-week maturity. Payday !ending 

is legal and regulated in many states, but is illegal or 

infeasible given the Jaw in some states. 

Title lenders are similar to payday lenders, 

the difference being that title lenders make secured 

loans rather than unsecured loans. That is, the title 

holder (lender) holds collateral against the loan. Car 

Business Financing: Equity 

Businesses can raise equity financing from a 

richly diverse set of sources (see figure 4). 

Internal Equity Financing 

Family and friends represent an important 

financing source for start-up businesses. The typical family or friend Investor is someone who has 

title loans are quite common, and in this case the been successful in his own business and wishes to 

lender holds the title to the borrower's car until the invest both to help a family member or friend and/or 

loan is repaid. Title lending is an extension of pawn- because someone had made a similar investment in 

broking. A key difference is that While a pawnbroker his business when it was a start-up. For example, a 

keeps possession of the collateral during the term of health care private equity firm was launched about 

the loan, the title lender may permit the collateral to 10 years ago in St. Louis, MO, with financing provided 

7 See Greenbaum and Thakor (2007), 

entirely by family and friends because the founders 

discovered that no Wall Street firm was willing to 

www.centerforcapitalmarkets.com 
113 

provide start-up financing to a group of individuals growth prospects and some synergies with their 

who had operating experience in the industry but no own businesses, and operate in an industry that the 

private~equity experience, Similarly, Facebook was individuals have successfully worked in or are bu!l~ 

launched from a Harvard dorm room and eventually ish about. Angel financing is quite often tapped by 

expanded with family and friends financing. Typically. early-stage companies that have yet to establish 

family and friends will invest up to $100,000 each. a track record of revenues or earnings that would 

enable them to obtain institutional financing from 

Employee ownership is another way in venture capital firms or banks. In our apple-orchard 

which firms can raise equity financing. Employee example, if Peter cannot get a bank loan to buy ferM 

stock ownership plans {ESOPs} give employees the tilizer and farm equipment, he might seek out angel 

opportunity to become shareholders in the company. 

As shareholders, employees can experience increased 

pride and security, and may become more productive. 

Employees can participate via stock purchases, by 

re'Ceiving a portion of their compensation as stock 

rather than cash, and sometimes by providing per~ 

sonal assets to the business. There are more than 

11,500 ESOPs in place in the United States, covering 10 million employees (10% of the private-sector 

workforce). The total assets owned by U.S. ESOPs 

were estimated at $901 billion at end of 2007.S 

Retained earnings represent a vital source 

of internal equity financing for bUsinesses. When a 

firm makes a profit at the end of a year after settling 

all its expenses, paying creditors, and paying taxes, it 

will typically payout a portion of the profits as a dividend to its shareholders. The amount remaining after 

the dividend payment is called retained eam;ngs, and 

it augments the firm's equity. Retained earnings may 

be viewed as a "sacrifice" made by the shareholders 

in the sense that they forgo some dividends in order 

to build up the firm's equity. Companies generally 

retain 30% to 80% of their after·tax profit every year. 

investors (typically investors who, unlike Mary, know 

him and something about his business) to provide 

the financing in exchange for an (equity) ownership 

stake in the business. 

Angel financing is quite 

often tapped by early-stage 

companies that have yet to 

establish a track record of 

revenues or earnings that 

would enable them to obtain 

institutional financing from 

venture capital firms or banks. 

Angel financing is often quite expensive. 

Capital from angel investors can cost the entrepre~ 

neur anywhere from 10% to 50% of the ownership 

in the business. In addition, many angel investors 

charge a monthly management fee. 

Businesses can sometimes raise equity 

financing from customersl suppliers, and sales 

representatives. These parties may be motivated to External Equity FinanCing 

Angel financing involves raising equity provide financing because they believe that the busicapital from individual investors, known as "angels." ness has growth potential that may not be realized 

These individuals look for companies that have high without the financial support provided by the equity 

input, and also that the equity position may become 

8 The ESC/=' AsSOCiation Industry Statistics, http://www.esopas- a profitable investment down the road. For example, 

sociation,org/mediafmedia_statlstlcs.asp (March 2011). 

Sources of Capital and Economic Growth 
114 

IBM once invested enough in Intel to own 20% of 

Intel's equity. It made this investment to financially 

boost Intel, a key supplier whose microprocessors 

were used in all IBM persona! computers. 

Corporate parents represent another significant financing source for some institutions. A 

holding company may provide its subsidiary with 

PE firms specialize in buying 

firms, some of which may be 

publicly owned, and holding 

them as part of a portfolio of 

privately-owned firms. 

capital rather than incurring the cost of raising exter~ professionals serve as general partners, and invesnal capital. For example, when ABN-Amro, the Dutch tors serve as passive limited partners and provide 

banking giant, acquired laSalle Bank in Chicago in the capital. The PE firm usually collects a manage1979, it infused $300 million of capital into Its newly ment fee of 2% or less plus 20% of the capita! gain 

acquired subsidiary. 

Intermediated Equity Capital 

Thus far we have discussed non intermefrom the investment. Many PE firms deliver attractive 

returns to their investors, net of these charges. 

The largest PE firm in the world is Kohlberg 

Kravis Roberts & Co. (KKR), which had more than 

diated sources of equity capital, in which the user $230 billion in completed and pending acquisiobtains capital directly from the investors (who rep- tions during 2005-2010. Other big PE firms include 

resent the sources of capital). Other forms of equity 

capital involve financial intermediaries that help to the Blackstone Group LP, Carlyle Group, Cerberus, 

Clayton DubHler and Rice, Goldman Sachs Capita! link the sources and users of capital. Partners, Bain Capital, TPG Capital, and Permira. 

The first of these is private equity. The term While these are the largest PE firms, they represent 

a mere fraction of the total number of PE firms in 

private equity (PE) is used to refer to a finn whose the business. There are more than 2,500 PE firms 

equity is not publicly traded on a stock exchange or 

capital that is not quoted on a public exchange. PE worldwide, and they raise many billions of dollars in 

firms specialize in buying finns, some of which may capital every year, In 2006, PE firms bought 654 U.S. 

be publicly owned, and holding them as part of a companies for $375 billion, and U.S,-based PE firms 

raised $215.4 billion in investor commitments.9 

portfolio of privately~owned firms. After they improve 

the management of these firms, the PE firms either 

sell them to other firms or take them public through a PE firms use a variety of strategies to acquire 

sale of stock in the market. For example, the Black~ firms: leveraged buyouts {LBO), growth capital, disstone Group's PE unit recently acquired theme park tressed investments, meZZanine capital, and venture 

operator Busch Entertainment Corp. (previously capital. In a typical LBO deal, the PE finn acquires 

owned by the Anheuser-Busch Corp.) and renamed majority control of an existing or mature firm and 

it SeaWorJd Parks & Entertainment. Blackstone also finances the acquisition with a relatively high amount 

acquired frozen-foods maker Birds Eye Foods in a of debt. The assets of the acquired firm serve as collateral for the debt used by the PE firms to acquire it. PE transaction. 

PE finns are typically organized as limited 

partnerships to hold investments in which investment 

9 Robert J, SamuelsOI'1, The Private Equity 800m, Washington Post, 

http.:/lwww.washingtonpost.comlwp-dynlcontentrarticle/2007l03114/ 

AR2007031402177.htm! (March 17, 2007). 

www.centerforcapitalmarkets.com 
115 

Over time, the cash flows generated by the acquired the successful launch of so many new companies in 

firm help to payoff the debt used for the acquisition. the United States. Numerous famous firms, such as 

Apple, Google, and Microsoft, were launched with 

Venture capital will be discussed shortly as the help of VC financing. 

a distinct source of equity capital because there are 

also specialized venture capitalists that do not do 

private equity deals. Growth capital refers to equity 

investments, quite frequently minority investments, 

made by PE firms in mature companies that are 

seeking capital to expand or restructure operations 

or fund Some other major investment. By obtaining 

this capital from a PE firm, the firm that acquires 

the capital avoids the dilution in the capital market 

that would occur if it were to issue equity. There 

is ownership dilution with a PE firm as well, but 

the minority ownership of the PE firm represents a 

{monolithic} block ownership as opposed to a more 

diffused dilution in the capita! market. 

Distressed investments are investments 

(either debt or equity) that PE firms undertake in 

financially distressed companies. Occasionally. PE 

firms will take more senior positions than equity in 

either distressed or healthy firms. These may be subordinated debt or preferred stock (which has seniority 

over common equity but is junior to debt). The objecVC-backed companies account for 21 % of 

U.S. GOP and thus playa vita! role in job creation 

in our knowledge economy. Two million new businesses are created every year in the United States, 

of which about 600 to 800 get VC funding. 10 

VC financing is provided by both government-sponsored and private entities. In fact, an initial 

step in the development of this industry was the passage of the Small Business Investment Act of 1958, 

which allowed the SBA to license private "Small Business Investment Companies" (SBICs) to help flll the 

gap between the availability of VC and the needs of 

small businesses in start-up and growth situations. 

The structure of the program is unique in that SBICs 

are privately owned and managed investment funds, 

licensed and regulated by SBA, that use their own 

capita! plus funds borrowed at favorable rates with 

an SBA guarantee to make equity and debt invest~ 

ments in qualifying small businesses. 

tive in taking such positions would be to reduce the There is also a substantial institutional VC 

PE firm's risk exposure. industry in the United States. These privately owned 

financial intermediaries typically invest in high-growth 

Mezzanine capital refers to a subordinated companies that are capable of reaching sales of at 

debt or preferred equity claim on the firm's assets least $25 million in five years. According to recent 

that is senior to the firm's common equity, but junior estimates based on surveys from the National Vento other claims. Such capital has a lower return but ture Capital Association, U.S. venture capital firms 

less risk for the PE firm providing the financing. invest between $5 billion and $10 billion per year. 

Since 1970, VC firms have reportedly invested in 

Venture capital (Ve) is an enormously more than 27,000 start-ups to the tune of $456 bilimportant source of finance for start-up companies. lion. Some of the major VC firms include Sequoia 

The fact that the United States has the most well- Capital, Benchmark Capital, Mitsubishi UFJ Capital, 

developed VC market in the world-with Silicon and Kleiner, Perkins, Caufield & Byers. 

Valley setting the "gold standard" for a VC community-has often been singled out as a key reason for 10 Venture Impact The economic Importance of Venture Backed 

Companies to the U.S. Economy, (Nationa! Venture Capital Associa~ 

tion) (2009). 

18 Sources of Capital and Economic Growth 
116 

VC firms raise their own financing from inves- even public firms take advantage of private pfacetors (sources of capital). These include pension funds ment, because it helps to raise equity capital without 

(42% of funds), insurance companies (25% of funds), additional information disclosure of the kind required 

endowments (21% offunds), individuals and families for a public offering. This can be beneficial for firms 

(10% of funds), and others (2% of funds). VC firms that wish to protect the confidentiality of product 

typically stay invested in their portfolio companies for information or technology. 

five to eight years before selling them off. 

Facebook is a good example of how prlvate 

Investment banks also act as intermediaries placement of equity can help a firm raise financthat help businesses raise capital from a variety of lng for growth. A relatively new company that is at 

sources. An investment bank is a financial instltution the vanguard of the social-network phenomenon, 

that assists individuals, corporations, and govero- Facebook's initial equity funding came from privatements in raising capital by underwriting and/or acting equity placements with Peter Theil (co-founder of 

as the client's agent in the issuance of securities. An PayPal), Acce! Partners, and Greylock Partners. The 

investment bank may also help companies involved in first round of private-equity investment in Facebook 

mergers and acquisitions by providing a host of ser- came In September 2004 when Peter Thiel invested 

vices, such as market making, trading of derivatives, $500,000 (valuing the company at $5 million). Since 

bonds, equity, foreign exchange, and commodities. then, PE firms have continued to invest in Facebook. In early 2011, a fund organized by Goldman 

Unlike commercial banks, investment banks Sachs invested more than $1 billion in Facebook. 

do not finance themselves with deposits, although General Atlantic recently agreed to purchase 0.1 % 

most major Wall Street investment banks have of Facebook from its employees at a price that valbecome parts of Bank Holding Companies since ues Facebook at $65 billion. 

the subprime financial crisis. Investment banks 

may have VC subsidiaries that provide VC financing In terms of public offerings of equity, lnvestto businesses. ment banks help to take private firms public through 

initial public offerings (IPOs) of stock. An IPO 

Investment banks also help businesses with involves the sale of common stock to the public for 

private placements of equity, whereby new equity the first time. Through the IPO, part of the ownership 

capita! can be raised without having to issue equity of the company transfers from the entrepreneur{s) 

on the public stock exchanges. A firm that wishes who launched the company to capital-market inves~ 

to raise equity hires an investment bank to locate tors. In exchange, the firm is able to raise hard cash 

institutional and individual investors who wish to as it sells its shares to investors. The firm will typiinvest in the company. These investors purchase the cally hire an investment bank to help with the IPO. 

equity being offered for sa!e in privately arranged Among the many services the investment bank protransactions. For a private firm, the benefit of this is vides are the pricing of the IPO, the I'road shows" 

obvious-because it is not publicly listed, a private during which the company is publicized to poten.tia! 

placement allows it to raise equity capital beyond investors prior to the IPO, and the actual underwhat is available from retained earnings. The addi- writing of the equity issue. The investment bank 

tional capital can help to finance expansion, business receives a percentage of the proceeds of the !PO as 

growth, and additional employment. But sometimes compensation for its services. 

www.centerforcapitalmarkets.com 
117 

A number of large IPOs have been in the 

news. AT&T Wireless did a $10.6 billion IPOin 2000, 

and in 2010 General Motors re-emerged from post 

bankruptcy privatization with a $23.1 billion IPO. We 

all remember Google's IPO in 2004, which turned 

its 1,000 employees (who were shareholders) into 

instant millionaires, and its founders, Sergey Brin and 

Larry Page, into billionaires. Moreover, with its publicly traded stock from the fPO serving as currency, 

Google was able to acquire video-sharing service 

YouTube in 2006 for $1.6 billion. 

Apart from a short rebound of 

a couple of years before the 

subprime crisis, IPO volume has 

been declining since 2004, 

equity capital after they have already gone public. 

Companies rely on these secondary equity offer~ 

ings (SEOs) when they need equity capital beyond 

what is provided by retained earnings. For example, 

Figure &. The Decline in Publicly Listed U.S. Companies 

9000 

4000 

3000 

2000 

1000 

0~~1~W~'~~19~~~~19~95~~lW~7-L~1~9W~~~~,-L~w~m~~~2~~~~XQ~7~~'OCO~ 

Source: Letter by James Angel, dated January 14, 2011, to the Securities and EXchange Commission. 

Apart from a short rebound of a couple of in 2009 many U.S. banks made secondary equity 

years before the sub prime crisis, IPO volume has offerings to raise equity capital to satisfy regula~ 

been declining since 2004. There was also a decline tory capital requirements, because their equity was 

prior to 2004, in part due to the more stringent and depleted during the crisis. 

costly corporate governance stipulation contained in 

the Sarbanes-Oxley Act. IPOs are one of many indi- IPOs and SEOs allow publicly traded compa~ 

cators of the competitiveness of U.S. capital markets. nies to raise capital, grow, and increase employment. 

The number of publicly traded companies and the 

In addition to IPOs, investment banks also amount of capital that they raise are both good indihelp publicly traded companies raise additional cators of the health of the economy and the prospects 

'1{\ LV Sources of Capital and Economic Growth 
118 

for future employment. From this standpoint, recent the cash-on-hand that is needed to pay suppliers, 

developments in U.S. capital markets cause con- support inventories, and pay other daily bills. Intercern. The number of domestic U.S. companies listed mediate-term and long-term debt-financing take 

on our exch~nges has been declining for the past 15 the form of bank-term loans, These are the stanyears or so. At the end of 1997, about 8,000 domes- dard commercia! loans with fixed interest rates, set 

tid companies were listed on the New York Slock maturity dates, and monthly or quarterly repayment 

Exchange (NYSE), American Exchange (AMEX), and schedules. 

NASDAQ. This number had dropped to fewer than 

5,000 by the end of 2009, and there are now fewer Intermediate-term loans usually have a 

than 4,000 companies in the Wilshire 5000 index of maturity of three years or less. They are generally 

U.S. public companies {see figure 6).11 This decline, repaid in monthly installments (in some cases with 

combined with the sputtering volume of U,S. IPOs, balloon payments) from the cash flows generated by 

suggests that we are creating new public companies the sale of goods and services and the collection of 

at a slower rate than before and that existing public cash. In our apple orchard example, Peter would pay 

companies are vanishing at a higher rate than new off an intermediate-term loan by selling apples and 

public companies are being created. Although many collecting cash from his customers. 

factors are contributing to this decline, the litigation 

environment and regulatory and compliance burdens A longwterm loan typically has a maturity of 

faced by U.S. companies, as well as the passage of between three and ten years. These loans are secured 

Sarbanes-Oxley Act, are significant issues. (collateralized) by some assets in the business. Operating cash flows are still relied on for making either 

Business Financing: Debt monthly or quarterly repayments, 

Nonmarket, Intermediated, and Direct Debt In 2009, U.S. banks made more than $7 tril~ 

Businesses raise large amounts of financing lion of commercia! and industrial, real estate, and 

from debt from a variety of sources. Commercial consumer loans, as well as other loans and leases. 

banks are traditionally an important source of debt {see figure 7}. This is a very important source of debt 

financing. For example, Avolon, an aircraft leasing financing for businesses. 

group, announced in January 2011 that it had raised 

$2.5 billion in debt since May 2010, the latest coming in the form of $465 million debt raised from a 

consortium of three leading U.S. banks: Wells Fargo 

Securities, Citl, and Morgan Stanley. Businesses use 

banks to obtain short~term, intermediate·term, and 

long-term debt financing. 

Short~term bank financing (typically with 

loan maturities under one year) is used by busiw 

nesses to finance work;ng capital needs, that is, 

11 LaUer by James Angel, to the Securities and EXchango Commission (SEC) http://www.sec,gov/comments/s7·02·10/s70210. 

shtml {January 14, 2011}. 

In addition to making loans, banks also make 

loan commitments to businesses. In a bank loan 

commitment, a bank promises to lend the borrower 

up to a predetermined amount at a contractually 

determined interest rate in the future. Typically, commitments are provided for specific uses, such as 

meeting working capital financing needs or financing an acquisition. As of March 2001, outstanding 

(unused) bank loan commitments to U,S. corporations stood at $1.6 trillion, so this is a large source 

of financing. 

www.centerforcapitalmarkets.com 
119 

Insurance companies are interested in making long-maturity 

loans because they need to balance the risk of their long-maturity 

liabilities, like life insurance policies. 

Institutional tenders, such as commercial- long-term investments in manufacturing plants (such 

finance companies like GE Capital and insurance as Ford or Caterpillar), networks (such as AT&T), and 

companies, have been a major sourCe of long-term so on. These investments produce cash flows aver 

debt financing for U.S. businesses. Institutional lend- a long time horizon. The risks in these investments 

ers make loans that may be more than 10 years in are best managed by financing them with relattvely 

maturity and thus fill a need at the longer end of the long-maturity liabilities, such as loans from insurance 

debt maturity spectrum (term loans are typically less companies. Absent such loans, the management of 

than 10 years in maturity), Insurance companies are risks inherent in long-term investments would not be 

interested in making long~maturity loans because as efficient. 

they need to balance the risk of their long~maturity 

!labilities,like life insurance policies. By making such The factoring Qf accounts receivables is 

long-term loans available to companies, insurance another source of debt financing that is available 

companies help their borrowers improve their risk to businesses, Every business that sells to custommanagement. For example, many companies make ers on credit-the customer purchases the good or 

Figure .,., U.s. Aggregate Lending: Commercial Banks (Seasonally Adjusted) 

0._. 

II CQn1rtum:la! and Industrial ..consumer 

Sources of Capital and Economic Growth 
120 

service but pays at a later date-generates "accounts Public Debt 

receivables" when it makes sales. In our apple orchard Thus far we have discussed nonmarket, interexample, Peter might sell $1,000 of his apples to the mediated, and direct (non Intermediated) forms of 

school in his town but the school may not pay Peter debt. Companies that have publicly traded debt can 

until three weeks later. Peter would then record $1 ,000 also directly access the capital market for borrowing 

as a sale on his income statement and $1,000 as an 

account receivable on the asset side of his balance 

sheet. The problem with accounts receivables is that 

even though a sale has been recorded, there is no cash 

coming in at that time. Sometimes, a company wlll 

"factor" its receivables. Speciallzed factoring companies will provide cash to the manufacturer against that 

manufacturer's accounts receivables, with a reserve 

payment set aside, that is, the factoring companies 

purchase the receivables. After the manufacturer's 

customers have paid, the factor pays the manufacturer the balance minus an amount representing the 

factor's discount and interest on the funds originally 

paid to the manufacturer. 

by issuing pubfic debt with the help of investment 

banks. Two main forms of public debt are available 

to U.S. firms: commercial paper and long-term debt. 

Companies that have publicly 

traded debt can also directly 

access the capital market 

for borrowing by issuing 

public debt with the help of 

investment banks. 

Commercial paper is usually short-maturlty 

(less than one year) unsecured debt financing that 

Accounts payable is a similar source of is available only to the highest-credit-quality firms. 

financing provided by the firm's suppliers, Most firms It is typically used for financing accounts receivable 

do not pay their suppliers as soon as they receive the and inventory. This is a huge market, with almost $1 

goods. It is fairly common practice for firms to pay trillion in outstanding commercial paper predicted 

their suppliers within 30 days of receipt of the goods for 2011. At the end of 2009, there were more than 

(e.g., Dell has followed this practice), but some com- 1,700 commercial paper issuers in the United States. 

panies take eVen longer. For example, AB-Iobev, the Commercial paper is available in a variety of den omibeer company, has a 90-day payment policy for its nations and usually ranges in maturity from 2 to 270 

suppliers. Whenever a company purchases some- days. It is relatively low~cost (currently, commerthing but does not pay for it right away, it records the cial paper rates are less than 0.5% per annum) and 

purchase as an expense on its income statement and hence attractive to companies that can access the 

the amount yet to be paid as a liability, called accounts commercial paper market. For these companies, it is 

payable, on its balance sheet. This liabllrty is essen- often an alternative to a short-term bank loan. Howtially a form of short-term debt. ever, it is also risky because its availability and cost 

are highly dependent on volatile market perceptions 

The U.S. Small Business Administration of the firm. For example, in March 2002, Bm Gross, 

(SBA) provldes another source of debt financing. The manager of PIMCO Total Return, the world's largest 

SBA offers long-term financing for purchasing fixed bond fund, said that Genera! Electric (GE) was excesassets. Typically these loans require a personal guar- sively reliant on commercial paper and that his fund 

antee from any investor with a stake in the bUsiness would not buy any GE commercial paper "for the 

exceeding 5%. foreseeable future." GE's stock price fell 3.5% after 

www.centerforcapitaimarkets.com 
121 

the announcement,'2 More recently, when the credit In both cases, commercial paper as well as 

market experienced stress during the subprime cri~ long-term debt, investment banks help firms with the 

Sis, the commercial paper market was one of the first process of issuing debt to capital market investors. 

to dry up. 

Commercia! paper is usually a very safe 

investment because the issuer's financial condition 

can be reliably predicted over a short time horizon 

and because only companies with relatively high credit 

ratings issue commercial paper. The typical denomination for a commercial paper issue is $1 00,000 or more, 

which makes direct investment in commercial paper 

difficult for retail investors. To deal with this, money 

market mutual funds have emerged that invest in commercial paper, allowing investors to invest indirectly by 

purchasing shares in the mutual fund. 

Long-term debt involves bond issues with 

maturities exceeding one year. WhHe commercial 

paper is typically used to satisfy short-term liquidity 

needs of the firm (e.g., financing inventories), long# 

term debt is used to finance the purchase of fixed 

assets like machines or acquisitions of other companies. Companies rely on long-term bond financing 

for a variety of uses and typically pay higher interest rates than on commercia! paper. For example, 

McKesson, the biggest U.S. drug distributor, issued 

$1.7 billion of 5-year, 10~year and 30~year bonds, as 

reported in its February 23, 2011, filing with the SEC. 

Tracking the upward-sloping yield curve, the interest 

rates were 3.25% on the 5-year bonds, 4.75% on the 

10-year bonds, and 6% on the 3D-year bonds.13 As 

of 2007, the amount of U,S. corporate bonds out~ 

standing exceeded $5 trillion. 

12 CNNMoney. ~GE Drops on Gross Comments", http://money. 

cnn,com/2002/03/21/News/companies/ge/indaxiindex.htm 

(March 21.2002), 

1-3 McKesson Corp. Form 8-k, EdgarOnlinc, http://yahoo.brand. 

edgar-onHne.com/displayfllinglnfoaspx?FitingIO",7757B32-4769-

12827 &type=sect&dcn",OOOb95012:3-11-019414. 

Sources of Capital and Economic Growth 
122 

IV. The Interconnectedness of the 

Financial System 

Two important messages emerge from the 

description of the financial system. One is that there 

is a great diversity of financing sources available to 

individuals and businesses seeking financing. And 

the other is that the different components of the 

financial system are interconnected. 

Why do we need such a diverse set offinanc~ 

jng sources? The simple reason is that the greater 

the diversity, the more effectively the financial system 

can meet the needs of individuals and bUsinesses. 

Why do we need such a 

diverse set of financing 

sources? The simple reason is 

that the greater the diversity, 

the more effectively the financial 

system can meet the needs of 

individuals and businesses. 

For example, suppose that the only mortgages avai!- The reason that firms such as Microsoft and Merck, 

able were 30~year fixed rate mortgages. These might which have intellectual property to protect, tend to 

meet the needs of individuals who wish to lock in an use relatively low amounts of debt is that an increase 

interest rate for a long period of time. But what about in debt financing brings with it a higher likelihood that 

the person who believes interest rates might fal! in the the firm wi!! be unable to meet its repayment obliga~ 

future or whose financial condition is likely to improve tion or violate certain debt covenants, For example, 

over time so he would be able to afford higher inter- as we saw in the subprime crisis, homeowners who 

est rates in the future? Such a person would prefer defaulted on their mortgages were those who had 

a variable or adjustable rate mortgage, in which the higher loan~to-value ratios than others, because 

interest rate fluctuates with market rates, or one that higher indebtedness meant larger monthly mort~ 

that has a lower initial rate and a higher subsequent gage payments and hence a lower ability to make 

rate. A greater variety of mortgages accommodates the payments when faced with a decline in income. 

a greater variety of individual preferences and needs. The same is true for companies. When there is a covenant violation or default on a repayment obligation, 

Like individuals, businesses have a diverse the firm may be forced to either sel! assets {some 

set of needs. Some face a great deal of uncertainty which may have valuable intellectual property} or 

in their core business model and prefer to finance declare bankruptcy (in which case ownership of the 

largely with equity in order to limit the bankruptcy intellectual property might transfer to the creditors), 

risk associated with debt. Other firms invest heavlIy in R&D and have substantial intellectual property Even within the spectrum of a specific form of 

that they wish to protect. Such firms wilt also tend to financing like equity or debt, diversity plays an imporfinance primarily with equity to minimize bankruptcy tant role. Consider equity first. Some firms prefer to 

risk. Microsoft is one example. Other examples are finance primarily through retained earnings because 

drug companies such as Merck that invest heavily in it is important for them to avoid the ownership diluR&D. These firms tend to have low debtlequity ratios tion associated with issuing equity. Yet others, 

in their financing mix. especially those firms that are growing rapidly, will 

www.centeliorcapitalmarkets.com 
123 

find that relying solely on internally generated equity These employees understand that if they work hard 

is not enough to support their growth. Such firms and provide the best customer service, Starbucks' 

will wish to use external equity financing. And in this stock price will go up. Such employee stock owner~ 

respect, the more -diverse the sources of external ship is valued more by employees when they can sell 

equity finance, the better. For example, a firm may be their stock in a liquid public market than when it is 

seeking equity to help finance its growth in a market privately held, 

in which it is selling a product for which it has developed a proprietary technology. Such a firm may not Diversity of financing sources is also 

wish to issue equity in the public market because it important for businesses seeking debt financing. 

would have to disclose sensitive information about Sometimes firms have short-term borrowing needs. 

its technology, due to the information disclosure They would tend to satisfy these needs through 

requirements of the securities exchange. While the accounts payable financing, accounts receivable facinformation is disclosed primarily for investors, it is taring, or bank loan commitments. larger firms with 

also necessarily revealed to competitors at the same impeccable credit ratings may choose to augment 

time. To avoid this, the firm may wish to use a private these short-term financing sources with commercial 

placement of equity to raise external equity capital. paper financing. The availability 01 diverse short-term 

If the private placement option were not available, financing sources permits firms to match quite prethe firm might prefer to forgo issuing equity and cisely their specific needs to the financing source. 

expanding in order to protect the confidentiality The result is that more short-term financing needs 

of its proprietary technology. It is easy to think of are met than would be possible with fewer financing 

examples, Facebook raised private equity at a time sources. Consequently, firms invest more. 

when it would have found it difficult to raise pub~ 

lic equity. Similarly, Intel raised private equity from At other times, firms have longer-term debt 

IBM, a customer, rather than issuing public equity. financing needs. A firm may be investing in a new facAlthough IBM has divested most of its holdings in tory that has an anticipated economic life of 20 years. 

Intel, at one time it owned 20% of the company. Forsuch along-term investment, It will seek a long-term 

loan. If only short-term debt financing were available, 

By contrast, other firms might be more inter- the firm might pass up the investment opportunity. 

ested in a public sale of equity-either through an 

IPO or an SEO-because publicly traded equity Firms sometimes finance acquisitions with 

provides greater liquidity and typically has a lower debt. For example, InBev's purchase of Anheuser 

cost of capital associated with it than private equity. Busch, the largest U,S. beer manufacturer, was 

Moreover, public equity also helps with employee financed predominantly with debt. In such cases, the 

motivation and retention. For example, having pub- firm may wish to match the maturity structure of its 

licly traded equity allows companies like Microsoft debt with the pattern of cash flows it anticipates genand Starbucks to compensate their employees with erating after the acquisition. This, too, typically calls 

shares of stock. When Microsoft's stock price was for long-term debt financing. 

rising rapidly in the 1990s, this was very attractive to 

its employees and it allowed Microsoft to attract and A diverse set of financing sources also 

retain high-quality talent. Starbucks takes stock own- enables firms to strike the appropriate balance 

ership right down to the employees in its retail stores, between the cost of debt financing and liquidity 

20 Sources of Capital and Economic Growth 
124 

A diverse set of financing 

sources also enables firms to 

strike the appropriate balance 

between the cost of debt 

financing and liquidity risk. 

risk. Since long-term debt financing is usually more 

expensive than short-term debt financing. pure cost 

considerations would push the firm in the direction 

of short-term debt like commercial paper or a shortterm bank loan. But short-maturity debt also exposes 

the firm to liquidity risk because it may not be able to 

roll over its short-term debt. A recent example of this 

is Bear Stearns, the investment bank. It was financing 

itself with debt of one-month maturity that was rolled 

over every 30 days. When concerns about its hedgefund losses became sufficiently grave, this 30-day 

debt flnancing evaporated, and the bank was on the 

they wlil eventually exit by taking these firms public 

and selling off their ownership shares. If our public 

equity markets were to diminish in the future, perhaps because of excessively onerous regulation, it 

is vety likely that the supply of PE and VC financing would decline as well. Without the attractive 

"exit option" provided by the public equity market, 

PE and VC firms would view their investments as 

lacking the potential to be "liquefied" in the future 

via an IPO, and would therefore scale back on their 

investments. Clearly, some capital market regulation 

is necessaty to ensure transparency and integrity, 

and this improves the efficiency and attractiveness 

of the market. But when it becomes excessive, it Can 

drive firms away. Thus, more onerous capital market 

regulation might reduce investment in small and mid~ 

sized companies and lower aggregate employment 

Similarly, good public equity and debt markets aJlow banks to raise debt and equity capital to 

brink of insolvency before its government-assisted support their own growth. This, in turn, enables banks 

takeover by JPMorgan Chase. Firms are constantly to extend loans that support the financing needs and 

ttying to balance the cost of borrowing against liquid- growth plans of individuals and businesses. If burity risk, and a diverse set of financing sources helps densome new regulatory requirements made bank 

them to achieve the right balance. capita! more expensive, bank lending would decline. 

The consequence would be lower GOP growth and 

A greater diversity of financing sources employment. 

helps individuals and bUsinesses to: 

Indeed, given the interdependence between 

improve their management of risk and achieve banks, markets, and among the different compoa better balance between the cost of financing nents of the market, if one financing source Were to 

and risk: and disappear, it would have potentially devastating conincrease investments, and thus employment sequences for other parts of the financial system.14 

in the economy. This can be seen most vividly in emerging markets. 

When Romania converted from a centrally planned, 

It is useful to note that the different parts of Communist-run economy to a free-market economy, 

the financial system are intimately interconnected. the housing market was underdeveloped. it was 

For example, venture capita! and private equity are difficult to jump-start this market even in the new 

available in part because we have such deep and free-market economy because banks were reluctant 

relatively efficient capital markets. PE and VC firms to lend to consumers to buy houses. This reluctance 

make their investments with the expectation that 

14 See Song and Thakor(2010). 

www.centerforcapitalmarkets.com 
125 

arose from the inability of banks to securitize home in about defaults on home mortgages, and many of 

mortgages because the securitization market did not the securities being used as collateral in repos were 

exist in Romania the 1990s.15 Thus, the absence of mortgage-backed securities. Thus, what happened 

the securitization market stunted the growth of the in home mortgages affected short-term credit avai!-

home mortgage market. ability to financial firms, which then spilled over into a 

general decline in the credit available to businesses 

Even within the United States, we have seen and individuals. 

numerous examples of this. Many U.S. corporations, 

especially non-depository financial companies, rely 

on the repo market for their short-term funding needs. 

The repo market, whose precrisis size is estimated at 

between $10 trillion and $20 trillion, involves a firm 

taking a short-term loan (typically overnight loans) 

from another firm under a repurchase agreement in 

which eligible securities are used as collateral. So, 

I might have $100 worth of marketable securities 

against which I might borrow $100 from you for, say, 

a day. When I repay the loan, I get my securities back 

(I "repurchase" them). If I default, you keep the securities. Repos have 'thaircuts" associated with them. If 

I can borrow $100 against $100 worth of securities, 

the haircut on the repo is O. If I can borrow only $90 

against $100 worth of securities, the haircut is 10%, 

and so on. It is estimated that between early 2008 and 

early 2009, the haircut on repos went from 0 to 45%,10 

If one takes the simple average of these two numbers 

as the average haircut during this period, then one 

can estimate that about $2.25 trillion in short-term 

borrowing capacity vanished fairly quickly from the 

market as companies were now able to borrow that 

much !ess using the same collatera! as before. This 

led to a significant decline in lending to individuals 

and businesses, as a major part of our financial sys~ 

tem found itself to be liquidity constrained. 

This example lIiustrates both interconnectImagine what would happen to U.S. credit 

card lending if the market for credit card securitization were to disappear. Millions of consumers would 

find themselves without access to credit cards. Simi~ 

larly, imagine what would happen to entrepreneurs 

if venture capital were to disappear. Scores of new 

businesses would fail to be launched. 

When the components of 

the financial system are so 

interconnected, even small 

initial changes in one part of 

the system can reverberate 

through the entire system 

and manifest as big 

eventual changes. 

The "theory of unintended consequences" 

says that rt is difficult to predict how the financial 

system will react if one of its components is tinkered 

with via regulatory changes. When the components 

of the financial system are So interconnected, even 

small initial changes in one part of the system can 

reverberate through the entire system and manifest 

as big eventual changes. For example, when the 

edness and the danger in making changes in one Federa! Reserve injected substantial liquidity into 

part of the financial system. One reason that repo the economy from 1995 th!'Dugh 2005, it was hard to 

haircuts went up is that bad news began to trickle imagine that this would contribute to a housing price 

15 See Meyendorff and Thaker (2002). 

16 See Gorton and Metrick (2010). 

bubble and crisis. Such unintended consequences 

are also encountered in other parts of the economy. 

Sources of Capital and Economic Growth 
126 

For example, not many would have predicted that the legal liability on credit rating agencies for "rating mls-

"cash for clunkers" stimulus initiative would have the 

unintended consequence of hurting automobile parts 

suppliers and putting many of them out of business. 

Interconnectedness magnifies the errors embedded 

in regulatory missteps and increases the uncertainty 

generated by them. 

The effects of this interconnectedness can 

spill over into different types of financing. For example, suppose that banks find their equity capital has 

been depleted because of credit and trading losses 

such as those that we witnessed during the recent 

crisis. At the same time, it might be more difficult 

to access public equity markets for more capital 

because the market is stressed and investors are 

averse to purchasing additional equity in banks. A 

consequence of this would be a decline in bank lending. similar to the 7.5% decline in U.S. bank lending 

witnessed in 2009.17 Another consequence would be 

a decline in neW lines of credit (or loan commitments) 

extended by banks. Because companies use lines of 

credit from banks extensively to back up commercial paper issues, U.S. corporations would suffer a 

"double whammy" in the sense that they would not 

only have diminished access to bank loans, but also 

lesser access to the public debt market. In this way, 

adverse developments for banks in the market for 

bank equity capital can spill over into the debt market 

for other firms. Aggregate investment, employment, 

and GOP suffer as a result. 

This interconnectedness is one of the main 

reasons why regulatory intervention in one part of the 

financial system so often generates unpredictable 

and undesirable consequences in some other part 

of the financial system. Consider what happened 

when the Dodd-Frank Act effectively expanded the 

17 Statement of Martin J. Gruenberg, Vice Chalrmi:ln FDIC, on 

Condition of Small Business i:lnd Commercial Real Estate lending In 

Local Markets, FDIC, http://wwwJdic.gov/newslnews./speechesiolhersispfeb2610.html (Fobruary 26,2010). 

representation." The three major U.S. credit rating 

agencies responded by asking debt issuers to not 

use their ratings. However, by SEC regulation, these 

debt issues needed ratings, so the market for these 

issues essentially froze for a few months. Scores of 

debt issuers were denied access to much needed 

funds. Such are the workings of the theory of unintended consequences. 

This interconnectedness 

is one of the main reasons 

why regulatory intervention 

in one part of the financial 

system so often generates 

unpredictable and 

undesirable consequences 

in some other part of the 

financial system, 

www.centerforcapitalmarkets.com 
127 

V. Conclusion 

This paper has surveyed the U.S. financial aCcess includes going directly to the capital market 

system from the standpoint of the various types to raise money, such as through a commercial paper 

of financing sources available to individuals and or public debt issue. 

businesses and the different types of financing 

arrangements (contracts) by which capital is raised. Fourth, a rich variety of debt and equity 

The main messages emerging from this discussion financing sources is available in the United 

are as follows. States. This diversity is crucia! for helping our economy to keep its competftive edge because it enables 

First, the financial system helps economic businesses to improve their management of risk and 

growth. This is achieved through the provision of lower their cost of capital, so that both investment 

four basic services: facilitating trade; facilitating risk and employment increase. 

management for various individuals and businesses; 

mobilizing resources; and processing information Finally, the U.S. financial system is highly 

about individuals and businesses and allocating interconnected. This interconnectedness means 

resources. that any changes in one part of the financial SYSM 

tem-either through a shock like a crisis or through 

Secondf individuals (consumers) are regulatory intervention-can reverberate throughout 

largely limited to debt financing for raising capital. the entire system, often in unpredictable ways. As a 

Nonetheless, consumers can use a farge number result, well-intentioned initiatives may produce more 

of sources to raise this financing, including banks, harm than good. 

finance companies, and the federal government. 

This paper has not addressed some quesThird, businesses regularly access both tions. What does the future hold for fmancial 

debt and equity capital, and the appropriate services? What effect will the Dodd-Frank Act have 

mix of debt and equity, called the "capital struc~ on the financial services industry? Will the industry 

ture" decision, is a key strategic choice for any experience an increase or decrease in the diversity of 

company_ Businesses have three basic sources of financing sources in the future? How will the regu!acapital: private, intermediated sources, and public tory structure evolve? These are interesting questions 

markets. These three categories exist for both debt to ponder, and the answers will not only influence how 

and equity capital. In private non-intermediated we deal with global challenges but also determine the 

sources, the firm raises financing outside the public magnitude of future economic growth because of the 

capital market without using a financial intermediary close relationship between financial system developlike a bank, Included in this are sources like friends ment and economic growth~ discussed in this paper. 

and family, cash generated from the firm's operating The world's population is growing and is likely to hit 

profits, customers, and suppliers. Private interme~ 9 billion in this century. This growth will put substan~ 

diated Sources include bank loans, borrowing from tialty greater stress on the natura! resources needed 

finance companies and insurance companies, and to support this population-food, water, and energy. 

loans from the parent company. Public market Innovations of all sorts will be needed to optimize the 

:10 Sources of Capital and Economic Growth 
128 

use of limited resources and harness new resources, 

These innovations will need to be financed. A vibrant 

and robust financial system in the United States wi!! 

play a critical role in supporting these innovations 

and helping them to become commercial successes. 

The Microsofts, Googles, Genentechs, and Facebooks of tomorrow will rise from the commitment to 

innovation that wlil be fueled by the financial services 

sector in the United States and elsewhere. Financial 

markets in emerging countries like India, China, and 

Brazil will continue to grow and challenge the preeminence of U.S. financial markets. Already, two~thirds 

of the world's equity market capitalization is outside 

the United States. Global competition among financial markets is sure to intensify even further. Thus, 

business will go to the most transparent and we!!~ 

regUlated markets, and will flow away from markets 

that are more onerously regulated and involve higher 

costs of capItaL As long as economically sensible 

regulation supports the transparency and health 

of the U.S. financial system, the economic growth 

that will follow the wave of future innovation will be 

accompanied by growth in the depth and size of the 

U.S. financial services industry and the economic 

value provided by it. 

www.centerforcapitalmarkets.com 
129 

References 

8agehot, Walter (1873), Lombard Street. R.D. Irwin. Homewood, Illinois: 1962. 

Gorton) Gary. and Andrew Metrick, "Securitized Banking and the RUn on Repo", Yale ICF Working Paper 

No. 09-14, November 2010. 

Levine, Ross, "Foreign Banks, Financial Development, and Economic Growth", in International Rnancial 

Markets: Harmonization versus Competition, ed., Claude E. Barfield, Washington, D.C.; The AEI Press, 

1996. 

Greenbaum, Stuart I. and Anjan V. Thakor, Contemporary Financial Intermediation, Elsevier, 2007. 

Mian, Atif and Amir Sufi, "Household Leverage and the Recession of 2001 and 2009," fMF Economic 

Review 58-1, August 2010, pp. 74-117. 

Meyendorff, Anna and Anjan V. Thakor, Designing Financial Systems in Transman Economies: Strategies for 

Reform in Central and Eastern Europe, MIT Press, 2002. 

Song, Fenghua, and Anjan V. Thakor, "Financial System Architecture and the Co-Evolution of Banks 

and Markets," The Economic Journal 120-547, September 2010, pp. 1021-12. 

Sources of Capital and Economic Growth 
130 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Thomas M. Hoenig 

President 

Federal Reserve Bank of Kansas City 

Presented to 

The European Banking and Financial Forum 

Prague 

March 25, 1999 

In the past few years, the pace of consolidation in the banking industry has accelerated, and 

combinations between banks and other financial service providers have become increaSingly prevalent. 

In some countries, consolidation has resulted from the need to eliminate weak or problem institutions. 

More generally, however, the unprecedented wave of merger activity in financial services is being driven 

by powerful changes in telecommunications and information technology and by the removal of legal and 

regulatory barriers to national and international linkages. An important recent development is a change 

in the scale of financial industry mergers. Indeed, the size of these business combinations has increased 

to the point that, both in the United States and Europe, "megamergers" are reshaping the structure of 

the financial services industry. 

Financial mega mergers raise a number of important public policy issues. Some of these issues are very 

familiar and apply equally to mega mergers and to more traditional mergers between financial service 

providers. For example, regulatory approval of mega mergers may depend on antitrust implications and 

industry concentration. 

However, the rise of banking and financial industry conglomerates brings into sharper focus a longstanding concern not addressed in existing merger guidelines. In a world dominated by mega financial 

institutions, governments could be reluctant to dose those that become troubled for fear of systemic 

effects on the financial system. To the extent these institutions become "too big to fail," and where 

uninsured depositors and other creditors are protected by implicit government guarantees, the 

consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial 

system. 

In my remarks, today, I will focus on the challenges posed by financial industry mega mergers and 

examine some possible policy options currently under study. My discussion will begin by briefly 

reviewing consolidation trends and the rise of mega mergers. I will then highlight some of the policy 

issues raised by megamergers and discuss some of the policy alternatives under review. 

Not surprisingly, there are no easy answers to the challenges accompanying the advent of megamergers. 

I am decidedly less optimistic than some about whether we will, in the end, be able to rely sufficiently 

on market discipline to correct for potential distortions stemming from government guarantees. I 

------------------------------- Pagel 
131 

suspect we will inevitably find ourselves having to deal with an institution that is too big to fail and, over 

time, relying more heavily on regulation and prudential supervision to oversee activities. Part of our 

challenge is to outline how we might in the future deal with "too big to fail" as we attempt to balance 

the economic benefits of consolidation against the potential costs to the financial system. 

The Rise of Megamergers 

In the United States and other industrialized countries, consolidation in financial services is occurring 

along three dimensions: within the banking industry, between banks and other financial service 

providers, and across national borders. To date, much of the consolidation has happened within the 

banking industry. In the United States we have seen the number of banking organizations fall from 

around 12,000 in the early 1980s to about 7,000 organizations today, a decrease of over 40 percent. In 

European countries, where the number of banks is much smaller than in the United States, a similar 

trend nevertheless is apparent. 

There are also growing linkages between banks and other financial service providers. In the United 

States and Canada, there has been a trend toward consolidation of commercial banking and investment 

banking operations. In Europe, where the universal banking model is more prevalent, the trend has 

been to combine banking and insurance activities. 

While much of the consolidation, thus far, has occurred within domestic financial markets, there are 

signs of increased cross-border activity as well. In the United States, Canadian, Japanese, and European 

banks have acquired a variety of institutions. In Europe, important mergers have occurred between 

financial institutions in Belgium and the Netherlands, and more cross-border activity is expected with 

the launch of the Euro. 

At the same time that mergers are reducing the number of financial institutions, the size of these 

combinations is increasing dramatically as compared both to previous mergers in the industry and to 

nonfinancial mergers. For example, in the United States we have seen such combinations as 

NationsBank/Bank of America and Citibank/Travelers. In Canada, two proposed mergers invoMng four 

of the top five Canadian banks were recently denied by the government. In Europe, we have seen 

megamergers in Switzerland, France, Austria, Belgium, Spain, and the Netherlands. And, Deutsche 

Bank's pending acquisition of Bankers Trust would create a dominant global banking organization. 

The trend toward consolidation in the financial services industry can be traced to several factors. In the 

United States, one impetus was the need to eliminate weak or problem institutions during the thrift and 

banking crises of the late 1980s and 1990s. Some EUropean countries experienced similar problems with 

institutions weakened by exposure to real estate lending. 

A more important factor behind the wave of merger activity, however, is technological change in 

telecommunications and information processing, which has dramatically lowered the cost of providing 

many financial services. In this environment, mergers may allow financial institutions to achieve greater 

economies of scale made possible by the new technologies. These same forces have also increased 

-----------------------------~e2 
132 

pressures for consolidation by lowering costs of entry, increasing competition within the financial 

services industry, and causing less efficient firms to merge. 

Merger activity has also been stimulated by a reduction in legal barriers to consolidation both nationally 

and internationally. In the United States, for example, consolidation within the banking industry 

accelerated with the removal of barriers to interstate banking. Many countries have also relaxed existing 

barriers to combinations of banks with other financial service proViders. finally, barriers to consolidation 

across countries have also been lowered as many countries have opened up their domestic financial 

markets by liberalizing foreign ownership of domestic financial institutions. 

Policy Issues Raised by Megamergers 

Rapid banking consolidation and the recent creation of very large financial institutions are beginning to 

raise a number of important public policy issues. for example, how can we be certain that these 

mega mergers are in the public interest, and are our traditional regulatory tools adequate for addressing 

policy concerns that might arise with such mergers? 

Traditional policy issues 

Within the United States, the Justice Department and banking agencies must consider a variety of public 

policy issues before approving bank mergers and acquisitions. The federal Reserve Board, for instance, 

must approve acquisitions and mergers of bank holding companies, and each proposal must satisfy 

several specific factors. These include the competitive effects of the transaction, the financial and 

managerial resources and prospects of the resulting organization, and the effect on the communities to 

be served. 

In judging competitive effects, the Board primarily focuses on competition within local banking markets 

or individual metropolitan areas, where the effects are likely to be the most direct and observable. 

Competition is judged by the structure of each market - most notably the number of banks within the 

market, the amount of banking concentration both before and after the merger, and the level of 

competition from nonbank sources. One other potential constraint on large mergers is the Riegle-Neal 

Interstate Banking Act, which sets a 10 percent nationwide deposit concentration limit on organizations 

making interstate acquisitions and a 30 percent statewide limit (unless a state chooses a different limit). 

So far, few of the megamergers within the United States have posed significant competitive issues under 

our antitrust guidelines or concentration limits. Most of the large mergers have been interstate 

acquisitions in which an organization expands into new markets, leaving local market concentration 

unchanged. Also, for large in-market mergers, the markets have often been of low or moderate 

concentration with numerous competitors. In other cases,large organizations have been able to divest 

of a portion of their offICes to meet the competitive gUidelines. Although at some point mega mergers 

will likely raise antitrust concerns, our current competitive standards still leave substantial room for 

further consolidation in the United States. 

---------------- Page3 
133 

The other factors used to judge mergers also would appear to have only a limited restraining influence 

on mega mergers. In a{jdressing financial and managerial consi{jerations and future prospects - the 

safety and soundness criteria for mergers - large organizations commonly claim improved earnings 

growth as they enter new, attractive markets. They also emphasize prospects for better diversification 

of risk as they expand geographically and begin serving a wider range of customers. In addition, the 

organizations most active in merging and expanding are likely to be those with the most attractive stock 

and whose prospects the financial markets therefore view most favorably. To satisfy convenience and 

needs considerations and public benefits, organizations that continue to be active in the merger 

business will necessarily have established a record of serving their communities. 

Consequently, many financial industry megamergers do not appear to raise serious antitrust issues 

under traditiomil u.s. merger gUidelines. In addition, large combinations between banks and other 

financial service providers -- which appear to be our next big merger wave - would likely receive 

approval under the traditional merger guidelines, since the merging firms focus on a somewhat different 

range of services., Also, while antitrust and safety and soundness criteria differ across countries, the 

recent merger trends in Europe and other areas seem to indicate that considerable scope exists for 

larger financial institutions within the context of current regulatory parameters. 

New policy concerns 

Although the new banking and financial conglomerates may pass our traditional statutory and 

regulatory gUidelines, I believe that such combinations require that we refocus our attention on a longstanding, vexing concern. To the extent that these institutions become "too big to fail" and are 

perceived as protected by implicit guarantees, the consequences can be quite serious. Moreover, under 

these circumstances our current mix of market and regulatory discipline may tend to shift further away 

from market discipline and increasingly toward regulatory discipline resulting, perhaps, in a less efficient 

industry. 

What is "too big to fail" - What do we mean when we say a financial institution is "too big to fail 

(lBTF)?" This term might best be applied to institutions so large that their activities make up a 

Significant portion of a country's payments system, credit-granting process, or other key financial roles. 

As a result, any substantial disruption in the institution's operations would likely have a serious effect on 

a country's financial markets, either preventing the markets from operating properly or raising 

questions about their integrity. The outgrowth of lBTF is that countries extend protection to large 

institutions and their customers not granted to others. This protection, moreover, can take a variety of 

forms. Even when regulators sell a large failing bank, remove its management, and let stockholders take 

the full loss, lBTF would still exist if uninsured depositors are protected or other groups of creditors or 

customers receive favored treatment. 

The concept of "too big to faU" came to prominence in the United States during the banking problems of 

the 1980s and early 19905. Regulatory steps were taken to protect uninsured depositors and, in some 

cases, other types of cre{jitors in large bank failures including Continental Illinois, several major banks in 

------------------------------- Page4 
134 

Texas, and the Bank of New England. A number of concerns were used to rationalize this policy. In 

particular, there was some fear that a more general panic might extend to similar types of banks. In this 

event, any deposit losses might severely harm smaller banks with correspondent accounts, other 

business customers, workers due to receive payroll checks, and a broad range of public and private 

organizations. Consequently, there could be significant effects on the local and regional economy. 

following these events, The Federal Deposit Insurance Corporation Improvement Act was passed to 

limit future bailouts of uninsured depositors. The act attempts to restrict the use of TBTf policies by 

prohibiting the fDICfrom taking steps to protect uninsured depositors if that would increase insurance 

losses. However, the act contains an exception. TBTf could be adopted if a bank failure would have 

·serious adverse effects on economic conditions or financial stability." Although the law's standards for 

making this exception are quite restrictive, I must also point out that its effect is to give statutory 

recognition to the concept of TBTf. 

While U.S. banking authorities are fully committed to the 1991 restrictions, how the market views the 

possibility of TBTF, is still critically important. If uninsured depOSitors and other market participants 

believe they will be protected and therefore fail to exert the desired discipline, then the risk-return 

tradeoff within the largest institutions, over time, will tend to become unbalanced. Furthermore, it may 

be more difficult to discipline uninsured depositors in today's world where banking involves instant 

communications and where solvency and resolution decisions on ever larger, more complex institutions 

cannot be made at a moment's notice. I might also add that recent history throughout the world 

suggests that TBTf may be the policy of choice in crisis situations, particularly when mega institutions 

playa large role in a country's economy and financial markets. 

Consequences of "too big to fail" - What are the some of the consequences of TBTf? One obvious result 

is the creation of competitive inequalities. To the extent that very large banks are perceived to receive 

governmental protection not available to other banks, they will have an advantage in attracting 

depositors, other customers, and investors. This advantage could threaten the viability of smaller banks 

and distort the allocation of credit. 

A second danger of TBTF is the creation of additional moral hazard problems beyond those resulting 

from the existing deposit insurance systems. If uninsured depositors and creditors of large institutions 

are protected from loss, the safety net is likely to be extended to a broader range of financial activities. 

Market discipline will be curtailed and prevented from working through to an appropriate solution, and 

institutions will have greater risk-taking incentives. Consequently, to preserve financial stability, 

regulation and prudential supervision may have to be extended to a larger part of the financial system. 

A third danger of TBTF is ineffiCiency. Making large banks a protected class of institutions will lead to a 

less efficient financial system in a variety of ways. Creditors and investors will not have the appropriate 

signals for directing their funds to the most efficient institutions. In addition, bank management will not 

face the full force of marketplace discipline and so may be under less pressure or delayed pressure to 

operate efficiently. And as large institutions take on an expanding range of activities, these inefficiencies 

and distortions will be extended to an increaSing portion of the financial system and overall economy. 

--------------------------------Page5 
135 

Are these inefficiencies a serious problem or just a conjecture? I think if we look at the countries that 

experienced serious banking problems and were protective of their major banks, we are made aware of 

the inefficiencies and how quickly they can spill over into the general economy. 

Dealing with Megamergers: The Policy Options 

If mega mergers increase the possibility financial institutions may indeed be too big to fail, what is the 

appropriate policy response? It seems to me there are two approaches. We could attempt to prevent 

the formation of mega institutions that might raise concerns, using either existing or modified merger 

guidelines. Alternatively, we could allow megamergers to occur but alter the supervisory and regulatory 

framework to attempt to mitigate the distortions caused by TBTF. 

As I noted earlier, existing merger guidelines are unable to deal with the TBTf problem because they 

center on the competitive effects of mergers in local markets. Since many megamergers will involve 

market or service extensions, we would not generally expect to find serious competitive effects in local 

markets. Put somewhat differently, the effects of megamergers and related concerns of TBTF will 

surface long before anticompetitive effects show up on our radar screen. 

Nor do I feel it is feasible to modify merger guidelines to reflect TBTF concerns. In general, I fail to see 

how we can establish a size threshold for institutions beyond which TBTF considerations dominate. We 

clearly want to permit mergers that enhance effICiency within the financial system. Mergers we want to 

prevent are those with no dear efficiency gains and that are viable, in part, because of the subsidy 

resulting from the institution becoming too big to fail. As a practical matter, it would be extremely 

difficult for regulators to make these kinds of judgments and to develop effective merger guidelines that 

incorporate TBTF considerations. 

Consequently, I believe we should not focus on limiting megamergers but, rather, on minimizing the 

distortions arising from TBTF. One strategy currently receiving attention relies on steps to reinforce 

market discipline. The appeal of this approach is that, if market discipline can be increased, excess risktaking can be controlled and efficiency increased. Proposals to enhance market discipline generally rely 

on increasing the incentive and ability of the market to monitor financial institutions. Incentives to 

monitor can be enhanced through such mechanisms as the required use of subordinated debt or private 

insurance. The ability of the market to monitor performance can be improved through greater 

disclosure of information. 

While I certainly favor moving in this direction, I question whether enhanced market discipline can 

adequately deal with TBTF. The key issue is credibility. Proposals that rely on increased incentives to 

monitor risk-taking simply won't be effective unless market participants are convinced they will not be 

protected in times of financial stress and unless they have the power to quickly alter management 

practices. Generally speaking, credibility will depend not only on current policy but also on past 

practices. Unfortunately, as we know from experience, in times of crisis credibility comes at a high price. 

-------------------------------- P~e6 
136 

As a result, I believe, reluctantly, that much of the burden of dealing with megamergers and the effects 

of TBTF will inevitably fall to more traditional forms of regulation and prudential supervision. Here we 

have two distinct challenges. First, as megamergers create linkages between banks and other financial 

service providers, how do we prevent the extension of TBTF beyond the banking system? Second, where 

market discipline is to a degree muted, how do we control the risk-taking activities of those institutions 

that are too big to fail? 

With regard to the first challenge, the critical issue is how to contain TBTF, even if we cannot totally 

eliminate it. If we cannot limit TBTF, we risk extending the safety net as megamergers evolve to combine 

traditional banking with other financial and nonfinancial activities. At issue is whether we can develop 

an organizational structure for financial service providers that serves to contain the effects of troubled 

institutions perceived to be TBTF. 

One form this debate has taken in the United States is how to insulate banks and the payments system 

as affiliated entities take on a broader range of activities and risks. The essence of the argument focuses 

on the trade-off between operational flexibility and containment of the fall out from a problem 

institution. Although this issue has not been as prominent in Europe because of the dominant role of 

universal banks in providing financial services, it is likely to become more relevant as banks face 

increased competition from capital markets. In my view, this is an issue of fundamental importance, and 

how the debate is resolved will impact how the world handles TBTF in future crises. 

Regardless of how this debate comes out, we still face the challenge of managing the risk-taking 

incentives of institutions that are TBTF. If we cannot rely entirely on enhanced market discipline, much 

of the burden will fall on regulation and supervisory oversight. As mega mergers produce larger and 

more complex institutions, regulators will have to respond to these changes. There are several efforts 

under way including the Group of 30 activities and attempts to revise the Basle risk-based capital 

standards to incorporate more accurate measures of risk exposure. And, in the United States, we have 

taken steps to change the emphasis of bank examinations toward a better understanding of an 

institution's prinCipal risk exposures and an assessment of its risk management controls and procedures. 

Realistically, however, there are limitations to the effectiveness of regulation and supervision in 

accomplishing these tasks, particularly in large and complex organizations. Relying on regulation and 

supervision to control risk-taking requires a delicate balance between providing effective oversight 

without becoming intrusive and imposing excessive costs on the institution. 

In the end, I doubt that we can yet be confident in our ability to either completely isolate the effects of 

the failure of a large institution or to provide a regulatory and supervisory mechanism that can eliminate 

TBTF as a possibility over the business cycle. With the advent of financial mega mergers, TBTF is likely to 

become even more prominent as an issue, particularly in times of financial stress. Thus, while I strongly 

support our efforts to improve both market and regulatory oversight of global institutions, I believe we 

must also spend more energy preparing now, in a public policy context, to deal with these institutions 

and TBTF when the crisis inevitably occurs. 

--------------------------------Page7 
137 

Summary and Conclusions 

let me dose with a brief summary and some final observations. The recent consolidation trend in 

banking and financial services is clearly changing the financial landscape in many countries. While the 

creation of larger institutions holds out the prospect of gains in the efficient delivery of financial 

services, it also raises important public policy issues. In addition to traditional antitrust and related 

issues, financial megamergers refocus a difficult and troubling concern. To the extent that these 

institutions become "too big to fail," the loss of effective market discipline creates an environment 

where the risk-return trade-off may become unbalanced and where inefficiency can creep into the 

system. 

Unfortunately, there are no simple solutions to this problem. Attempts to enhance market discipline, 

while important, are unlikely to be fully successful; meaning that more of the burden will move toward 

regulation and prudential supervision. But, unless we can find a way of limiting the extension of 

government guarantees, we risk the inevitable extension of regulation into an ever-widening part of the 

financial system. We would be wise, therefore, to recognize that TBTF will be an important public policy 

issue going forward and as we work to allow the benefits of consolidation, we also work to avoid 

sacrificing competitive fairness, efficiency and, most certainly, financial stability. 

------------------------------~e8 
138 

Demos 

IDEAS & ACTION 

Testimony of 

Wallace C. Turbeville, Senior Fellow, Demos 

The Committee on Baking, Housing and Urban Affairs of the United States Senate 

Subcommittee on Financial Institutions and Consumer Affairs 

Hearing on "Is Simpler Better? Limiting Federal Support for Financial 

Institutions" 

May 9, 2012 

Chainnan Brown, Ranking Member Corker and Members of the Subcommittees, thank you for 

the opportunity to provide testimony on the centrally important issue of universal banking. 

After seven years as a lawyer specializing in public and private securities offerings, I was an 

investment banker at Goldman Sachs for more than a tWelve years and then managed a small 

advisory finn. I also served as CEO of a finn providing counterparty credit management services 

in the derivatives markets. For the last two years, I have focused my efforts on financial system 

refonns, participating in dozens of fonnal comments and various roundtable discussions at the 

request of regulatory agencies. I am a Senior Fellow at Demos, a multi-issue national 

organization, combining research, policy development and advocacy to influence public debate 

and catalyze change. 

For me, today's hearing evokes memories of a time 33 years ago when, as a young attorney, I 

was commissioned to write testimony to be delivered to a committee of Congress on behalf of 

the Securities Industry Association, one of the predecessors of SIFMA, that represented the 

interests of investment banks. The goal of the testimony was to resist the repeal of GlassSteagall, and so to protect investment banks from competition fueled by the massive cheap 

capital of the commercial banks. 

Circumstances are different today, but some fundamental principles remain the same. Universal 

banking is no longer an abstract concept in the US financial services sector, but has become a 

dominant way of doing business. In light of the catastrophic and ongoing consequences of the 

2008 financial crisis, it is appropriate to reflect on the path chosen in the last decade of the 20th 

century, culminating in the repeal of the Glass Steagall Act. 

CONNECT WHH DfMOS AT: WWW.DEMOS:ORG 

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lauren5trayer 

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f2U} 389-1413 
139 

Today's hearing examines the results of the dramatic deregulation ofthe financial sector that 

allowed banks to expand their businesses far beyond the limits established in the wake of the last 

major financial and economic crisis, the Great Depression. In the 1930's, wise policy-makers 

came to understand the danger of allowing financial institutions that are entrusted with customer 

deposits to also participate in the business of volatile trading markets and complex and inherently 

risky financial instruments. No doubt, the Subcommittee will hear that these concepts are out of 

step with today's global marketplace, dominated by elaborate technology and cutting-edge 

quantitative analysis. This argument is totally inadequate for the purposes of today's enquiry. 

Clearly, the systemic risks that threatened the irretrievable collapse of global financial systems in 

2008 must be addressed. The problems arising from too-big-to-fail institutions, interconnected 

by shadowy and complex exposures to risks, are clearly related to the universal bank model. 

But today's hearing goes even further. Universal banking also leads to oligopolistic markets that 

are inefficient in performance of their fundamental social purpose, the intermediation between 

sources and productive uses of capital. There is a vast difference between efficient extraction of 

profits from the capital and commodities markets, which is a hallmark of universal banking, and 

providing for the efficient capitalization of businesses and governments. The two must be 

rigorously distinguished. 

The questions raised at today' s hearing are profound. Regulatory responses to the specific 

causes ofthe financial crisis are high priorities. But this effort is not complete unless the 

underlying conditions that gave rise to the crisis are addressed as well. The universal banking 

model that was the culmination of deregulation severely distorts the provision of financial 

services. This has created massive inefficiencies at the same time that technology and 

quantitative advances are deployed to benefit the dominant market participants. 

The details of the next potential financial crisis are unknowable. But it is certain that the 

distortions created by the great deregulation experiment will produce another calamity if the 

oligopoly of universal banks is not addressed. 

Universal Banking in Perspective 

It might be useful to place the concept of universal banking into the context of the fundamental 

social purpose ofthe financial markets. Aside from insurance and risk transfer and payment 

systems, the essential service of the financial sector is efficient intermediation.! Sources of 

capital (savings, pension funds and similar funds that need to be "put to work") must be matched 

up with users of capital to finance productive activities and households that require credit. The 

matching systems must be efficient in terms of fundamental capital cost and the cost of 

intermediation. The price paid for matching, i.e., intermediation, must be reliable and rationally 

related to the service provided. 

Thomas Philippon, "The Size of the US Finance Industry: A Puzzle," November 2011. 

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Universal banking commingles two fonns ofintennediation, the traditional commercial banking 

intennediation between customer deposits and lending; and the intennediation between 

investment capital and investment opportunities provided by various traded financial markets. 

(It also involves insurance and payment transfers, subjects that are important, but not directly 

related to the issues discussed in this testimony.) The question is whether the universal banking 

model is intolerably risky and/or expensive. 

Major developments in the financial markets prior to the repeal of Glass Steagall blurred the 

distinctions between investment banking and commercial banking, particularly the advent of 

money market mutual funds. As a result, the commercial banking function became more and 

more identified with an important distinguishing characteristic, FDIC insurance. The insurance 

was designed to provide a firewall against depositor runs on banks. Money market funds, which 

were the investment banks' way to compete against commercial banks for deposits, have no such 

protection against runs, as illustrated by the Fed intervention to support money market funds in 

2008. 

The debate in the years prior to repeal ofthe Glass Steagall Act is particularly instructive. The 

investment banks were vehemently opposed to repeal in those years, and they were uniquely 

positioned to evaluate the issues associated with universal banking. Their opposition centered on 

two points. First, they expressed concern that the commingling of commercial banking with 

investment banking would give rise to systemic risks. 2 Additionally, they predicted that 

universal banking would create predatory market power.3 Eventually, the investment banks 

came to realize the inevitability ofthe repeal and discovered ways to accrue market power of 

their own. They relented in 1999, paving the way for repeal. The result was the oligopoly that 

exists today. Thus, the investment banks' warnings have proven to be accurate and the handful 

that survive are now part of the problem that they warned against. 

Responses to Questions 

Below are my responses to the specific questions raised that have been raised in connection with 

the hearing. 

1. To what extent, and in what ways, have large, diversified banks - sometimes referred to 

as "universal banks" - changed the business of banking? 

Banking in the United States has become extraordinarily concentrated and oligopolistic. Waves 

of change have swept over financial services throughout the era of deregulation, primarily 

resulting in an economy skewed toward extraction of value by financial institutions. 

Senate Banking Committee, Comprehensive Reform in the Financial Services Industry, Part II, June 11, 13, 

IS-20, 19S5, S. Hrg. 99-120, pt. 2, testimony of Shapiro, Robert F., board chairman, Securities Industry Association 

(SIA). 

l 

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Concentration 

As universal banking approached, investment banking began a period of dramatic consolidation. 

Lehman Brothers did not achieve too-big-to-fail status Uudged in retrospect) through internal 

growth. Its DNA included firms such as Kuhn Loeb, Shearson, Hammill & Co. and EF Hutton. It 

was even owned by American Express for a time. As repeal of Glass Steagall approached, the 

commercial banks got into the consolidation frenzy, as Citicorp acquired Salomon and Smith 

Barney and Credit Suisse acquired First Boston and Donaldson, Lufkin and Jenrette. Finally, 

during the crisis, Bear Stearns was scooped up by JP Morgan Chase (which earlier had acquired 

Hambrecht & Quist) and Bank of America absorbed Merrill Lynch, both with the direct 

involvement ofthe government. Morgan Stanley and Goldman Sachs converted to banks to 

steady themselves in the turmoil. 

During these 30 years, commercial banking consolidated as well. Consider the banks that were 

absorbed into JP Morgan: Chase Manhattan, Chemical, Manufacturers Hannover, First Chicago, 

National Bank of Detroit and BankOne. The consolidation was widespread, resulting in a system 

of mega-banks. 

A recent research piece by the Dallas Fed provides a window on this process.4 The study 

observes that in 1970 the top 5 banks in terms of assets held 17% of aggregate bank assets. By 

2010, the top 5 banks held 52% of aggregate assets, as shown in the following chart extracted 

from the report. 

Federal Reserve Bank of Dallas, 2011 Annual Report, Choosing the Road to Prosperity, available at 

http://www.dallasfed.org/fed/annuallindex.cfm. 

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The most dramatic part of the report and the covering letter by Dallas Fed President Richard W. 

Fisher is that they call for a "downsizing" of these megabanks. Their primary argument is that 

financial institutions remain "too-big-to-fail," risking another painful and damaging bailout if a 

large financial crisis is threatened. In their view, the continuing cloud of too-big-to-fail hanging 

over the economy is simply intolerable and costly. 

However, this report also contains some intriguing observations that go beyond the systemic risk 

of over concentration in the banking system. Chief researcher Harvey Rosenblum states that: 

When competition declines, incentives often turn 

perverse and self-interest turns malevolent. 

This goes beyond worries about to-big-to-fail. It is not a concern with the intolerability of the 

risk of liquidation of a large bank. Rosenblum identifies distortions in a market that is dominated 

by an oligopoly of banks. This passage points out the damage that can be done to the economy 

even if these banks do not fail. The systemic risk of to-big-to-fail exists because of 

concentration. But, the pernicious oligopolistic marketplace that Rosenblum describes an 

ongoing problem that burdens the economy and intensifies the risks of a financial crisis 

occurring. 

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It must be noted that the literal transformation to a system dominated by universal banks was not 

completed until the onset of the financial crisis itself. Bear Steams and Merrill Lynch were 

absorbed, Lehman evaporated as an entity and Goldman Sachs and Morgan Stanley converted to 

banks. However, the remaining investment banks had grown very large and engaged in ever 

more risky behavior as they sought to compete with the universal banks. The advent of universal 

banking played an enormous role in the evolution of financial services to the conditions that 

existed in 2007 and 2008. The extraordinary concentration of institutions that resulted from the 

crisis was the final chapter in a long story. 

Growth of Financial Sector 

The other dramatic development is that financial sector share of the economy has increased to 

unprecedented levels growing from 2.3% to 7.7% of the GDP in the last 60 years,S while the 

manufacturing and services sectors have become relatively smaller. This was not because of 

increased demand for financial services, which only grew by 4% in the last decade6 It is clear 

that this cannot be explained as the value of exporting financial services by US institutions.7 The 

explanation lies in the domestic economy. 

Perhaps most telling is the financial sector share of profits in the entire economy. The chart 

below, prepared by Yardeni Research, tracks 60 years of data on financial sector profits, 

illustrating that profit share has ranged from 8 to 34%.8 More recent data indicate that the profit 

share has once again exceeded 33%. 

Thomas Philippon, "The Equilibrium Size ofthe Financial Sector," New York University, August 2007. 

Thomas Philippon, "The Evolution of the Us Financial Industry from J 860 to 2007: Theory and Evidence," 

November 2008, available at http://pages.stem.nyu.edul-tphilipp/papen;/finsiz.pdf. 

7 III 

Yardeni Research, Inc., "Products, Productivity, Prosperity," March 7, 2012. 

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CHART 6: FINANCIAL SECTOR SHARE OF PROATS 

united States: Financial Sector PrOfits as a shate of total Corporate Profits 

35 

Source: Yardeni Research, Inc. 

The relative growth ofthe financial sector is not necessarily a problem if the services provided 

by the sector provide commensurate value to the overall economy. Otherwise, the reallocation of 

value drains resources that could be put to uses that would increase the productivity of the 

economy and the public's wealth. It might benefit the owners of financial firms (and bonus 

recipients), but to the extent that it only transfers wealth, it does not benefit the broad economy. 

As discussed below, wealth transfer has been the predominant result. 

A groundbreaking study by Thomas Philippon of New York University's Stern School of 

Management reaches dramatic conclusions.9 Professor Philippon uses the neoclassical growth 

model (which focuses primarily on productivity, capital accumulation and technological 

advances) to examine fmancial intermediation in the United States over a l40-year period. He 

constructs an index that measures the unit cost of financial intermediation. His work indicates 

that the finance industry has become less efficient in providing intermediation services over time. 

He summarizes his findings as follows: 

Thomas Philipp on, "Has the U.S. Finance Industry Become Less Efficient?" November 2011. (Hereinafter 

cited as "Philippon 1112011"). 

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[TJhe finance cost index has been trending upward, especially 

since the 1970s. This is counter-intuitive. If anything, the 

technological development of the past 40 years (IT in particular) 

should have disproportionately increased efficiency in the finance 

industry. How is it possible for today's finance industry not to be 

significantly more efficient than the finance industry of John 

Pierpont Morgan? I conclude from [the historic trends] that there is 

a puzzle ... 

Finance has obviously benefited from the IT revolution and this 

has certainly lowered the cost of retail finance. Yet, even 

accounting for all the financial assets created in the US, the cost of 

intermediation appears to have increased. So why is the nonfinancial sector transferring so much income to the financial 

sector? Mechanically, the reason is an enormous increase in 

trading. 

The study indicates that the cost of intermediation between the suppliers of capital and the 

productive consumers of capital has increased notwithstanding IT advances, sophisticated 

quantitative analysis, massively larger trading volume and diversity in financial and derivatives 

markets. Under the Efficient Market Hypothesis (famously espoused by Alan Greenspan), the 

professor correctly concludes that this is absolutely counter-intuitive. But from the perspective 

of an observer of trading behavior and market evolution, his results make perfect sense. 

Technology and volumes can decrease individual transaction costs. Simultaneously, the entire 

intermediation system can be burdened by oligopolistic market activity that diverts value from 

the system. That these conditions coexist is actually the most likely outcome when one 

combines oligopolistic universal banking, high tech and advanced quantitative analysis and a 

preoccupation of money managers with transaction costs rather than fundamental value. 

Decline of Corporate Lending 

In 1978, the financial sector contracted $13 of credit for every $100 contracted by the private 

economy; by 2007, the financial sector share was $51.!O This excludes the credit associated with 

the $30 trillion derivatives market that is a complex and volatile form of leverage. The capital 

and derivatives markets had largely displaced corporate borrowing. 

Aside from insurance and risk transfer and payment systems, the essential service of the financial 

sector is efficient intermediation.lJ Sources of capital (savings, pension funds and similar funds 

that need to be "put to work") must be matched up with users of capital to finance productive 

activities. The matching systems must be efficient in terms of fundamental capital cost and the 

10 

11 Simon Johnson and James Kwak, "Thirteen Bankers," Pantheon Books, 20 I 0 at page 59. 

Thomas Philippon, "The Size oflhe US Finance Industry: A Puzzle," November 2011. 

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146 

cost ofintennediation. The price paid for matching, i.e., intennediation, must be reliable and 

rationally related to the service provided. 

Intennediation can be effectively provided by traditional commercial banking or by market based 

trading. 12 Commercial banks loan from capital and funds held as individual and corporate 

customer deposits. In this business, the mismatches between sources of capital and its uses are 

covered by the capital reserves ofthe banks. These mismatches include credit differentials in the 

fonn ofloan defaults and mismatches oflong-tenn (such as 20-year, fixed rate mortgages) vs. 

short tenn (demand deposits). As an outgrowth ofthe two financial crises of the 20th century, this 

business model was reinforced by creation of the Federal Reserve System (in response to the 

1907 Panic) and FDIC insurance (in response to the Great Depression). 

Alternatively, intennediation can be provided by the traded markets. Capital suppliers invest in 

securities (often pooling resources for investment in mutual funds), capital consumers issue 

securities to procure funding and both contract for derivatives. Financial institutions provide the 

trading capital needed to make sure that "supply and demand," represented by capital suppliers 

and consumers is in equilibrium in tenns oftiming. Derivatives, in theory, mitigate the risk of 

mismatches ofloan interest rates and currency differentials. 

For advocates of the Efficient Market Hypothesis, the capital market is the preferred venue for 

intennediation. It is the perfect environment for the use of infonnation technology and 

sophisticated algorithmic trading strategies that should (in their view) squeeze out even the most 

miniscule pricing inefficiency. The evolution ofthe financial system during the period of 

deregulation has reflected this premise, with banks declining in importance to intennediation and 

capital markets increasing. The bank share of all financial assets fell from 50% in the 1950's to 

below 25% in the 1990's13 The pace ofthis shift increased with the growth of money market 

funds, pension funds and mutual funds (providing direct investment that displaced bank lending) 

and securitization of consumer debt over the last 30 years. I' 

Conventional views of the markets, represented by the Efficient Market Hypothesis, would 

predict that the price received by providers of capital and the price received by consumers of 

capital must have narrowed proportionately with the greater ability to deploy vast sums of cash 

to exploit tiny market anomalies identified in "real time," using technology infonned by 

sophisticated analytics. In other words, the cost of intennediation paid by the economy as a 

whole should have plummeted as ever more powerful efficiencies were introduced. The research 

of Professor Philipp on, described above, indicates that the results were precisely the opposite. 

The most powerful reason behind the decline in corporate lending may well be the profit margins 

ofthe banks. A bank has finite capacity to take on the credit of any corporate entity. It can use 

12 Ross Levine, "Bank-Based or Market Based Financial Systems: Which is Better?" William Davidson 

Institute Working Paper 442, February 2002. 

1J Hyman Minsky, "Stabilizing an Unstable Economy," McGraw-Hill, 2008, introduction at page xxii. 

i4 Johnson and Kwak, at page 84. 

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this capacity to make a loan. Alternatively it can use the capacity to enter into a derivative or 

other exotic financial arrangement. As recounted by a bank insider in a recent interview, the 

profitability of a derivative transaction per unit of credit capacity is ten times the profitability of 

using the capacity for a loan. 15 This is precisely in line with my personal conversations with 

corporate lending professionals at large banks. Under these conditions, it is unsurprising that 

corporate lending has declined. 

Financialization 

The corollary to the decline in corporate lending was explosion of financialization fueled by 

universal banking. Professor Simon Johnson describes financialization as "the transformation of 

one dollar of lending to the real economy into many dollars of financial transactions.,,16 This 

represents the financialization of typical bank assets through asset-backed securitizations. 

However, equity securities (Exchange Traded Funds) and commodities (Commodity Index 

Funds and Commodity ETFs) are also financialization vehicles for assets that are not 

traditionally held by commercial banks. 

The damage inflicted by asset-backed securitizations in the residential housing markets has been 

well documented. The large banks were able to seize a dominant position in the household 

lending businesses and mismanaged the process terribly. 

ETFs and Commodity Index Funds have also had a destabilizing effect because of structural 

inefficiencies. Both are structures designed to create synthetic ownership of assets. The 

investors actually own instruments that are valued based in indices of market baskets of assets. 

Equity ETFs have been shown to influence the prices of stocks that are constituents of the 

particular index. 17 And Commodity Index Funds have been shown to influence commodity price 

curves, creating commodity price disruption by creating the impression of rising prices. ls 

Financialization has been driven by the changing role of commercial banking in a system 

dominated by universal banks. It is inherently an inefficient system because structural elements 

have unintended consequences. Mortgage Backed Securities, including synthetic MBS, were 

clearly the proximate cause ofthe financial crisis of 2008. But it is now understood that the 

opaque asset value associated with financialization of every sort can be seen as an inefficiency 

that is extraordinarily costly to the economy. In stressed conditions, it can also result in a 

shutdown of financial flows in part or all ofthe financial system. In the drive to make banking 

more and more universal, this is a path that is treacherous indeed. 

15 Frontline Broadcast, "Money, Power and Wall Street." Chapter 2, available at 

http://www.pbs.org/wgbhlpages/frontline/money-power-wall-streel/. 

16 Johnson and Kwak at page 59. 

17 Jeffrey Wurgler, "'On the Economic Consequences of Jndex-Linked Investing/' NYU Stem School of 

Business, July 2010, available at htlp:llpapers.ssm.com/so13/papers.cfm?abslract id= 1667188.1. 

IS David Frenk and Wallace Turbeville, "Commodity Index Traders and the Boom/Bust Cycle in 

Commodilies," October 2011, available at http://papcrs.ssrn.com/so13/papcrs.cfm?abstract id=1945570. 

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2. What are the benefits or dangers associated with the "universal bank" model that 

combines traditional banking and trading? In particular, what does this mean for 

consumers, industry competition and financial stability? 

Financial Stability 

Clearly, concentration in the banking sector creates great danger of systemically significant 

failures. 19 Banks become too-big-to-fail and government is left with the Hobson's Choice of a 

bailout in a crisis?O The existence of this phenomenon has been recognized since at least 1984, 

when insolvency of Continental Illinois precipitated a bailout and the Comptroller of the 

Currency identified 11 banks as too-big-to-fail.21 The moral hazard implications are enormous. 

However, it is more than just size. The Federal safety net that supports depository institutions is 

an important element. The FDIC occupies a pivotal role in resolving a failed institution that 

benefits from its insurance. To minimize loss, it must actively manage the disposition of the 

failed bank's component parts. The government is directly involved with the entire process. In 

the universal bank model, the trading operations are extraordinarily complex and susceptible to 

liquidity crises of their own, as margin calls are made and access to securities financing such as 

repurchase agreements is foreclosed. It should be noted that Lehman Brothers had 2,854 

subsidiaries around the globe. In this process, the government's involvement is inescapable. 

As a result, the universal banking model is a poor vehicle for the allocation of capital. The safety 

net and the too-big-to-fail condition mean that consequences of failure are mitigated and capital 

is plentiful and cheap. Business lines that might not make sense in a more limited, smaller and 

diverse business regime are completely rational to managers in a universal bank. Especially in 

complex and volatile trading activities, this can amplify the risks taken by the bank, to the 

ultimate detriment of the taxpayers and the economy as a whole. 

Consumers 

But the damage is more pervasive, regardless of the occurrence of an actual bank failure. As the 

Securities Industry Association foresaw in the 1980s and 1990s (described above), universal 

banking embeds opportunities for oligopolistic and predatory business practices. Services can be 

tied together. Customers can become so reliant on access to the universal banks that competition 

is stifled. And abundant cheap capital can be deployed to create trading advantages. 

Advances in technology and quantitative analysis have made this problem much worse. 

Transactions can be made more complex. In such circumstances, value is obscured and the 

market power ofthe universal bank can be optimized. Recent research has pointed out that the 

value of many derivatives products that are successfully sold to customers are beyond the ability 

" Federal Reserve Bank of Dallas, "Choosing the road to Prosperity: Why We Must End Too-big-to-fail 

Now" available at http://www.dallasfed.org/fedlannual/index.cfm 

20 Gary H. Stern and Ron J. Feldman, "Too-Big-to-Fail: The Hazards of Bank Bailouts," Washington: 

Brookings Institution Press, 2009. 

21 Johnson and Kwak at page 134. 

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ofthe most sophisticated banks to comprehend, much less the customers.22 A separate question 

is why the customers buy transactions that they cannot understand. Perhaps the persuasive 

abilities of universal bankers are enhanced by the reliance of the customer on access to the bank. 

The transfer of deposit assets to the trading business rather than lending has another subtle, but 

important, effect. The relationship of the banks to customers is far more transactional. A 

business interacts with its banks in a completely new way. The opportunity for conflicts of 

interest is enormous, and both sides recognize it. The long-term relationship of a business with 

its banks can be dynamic and stabilizing. Its decline as a way of doing business is a net loss. 

Benefits 

The benefits of economies of scale in the universal banking model are undeniable. It should be 

remembered, however, that even the most predatory monopoly can provide economies of scale. 

The Philipp on study described above suggests that the balancing of costs and benefits does not 

favor universal banking. This system has proven efficient in maximizing profit for the banks. 

But it has actually made the process of raising capital for productive uses and consumer needs 

more costly. 

It is often asserted that greater trading market liquidity is a benefit inherent in universal banking. 

In particular, overt proprietary trading and proprietary trading that is housed in businesses 

denoted as market making or similar activities is the liquidity that is referred to. 

This assertion, even when made in "expert" studies, is superficial and perhaps worse. Market 

liquidity is generally defined as the degree to which a security or derivative can be bought, sold or 

entered into without affecting its market price. Liquidity must not be confused with volume. 

Some trading volume can provide liquidity incidentally to its actual purpose. But that liquidity is 

not reliable, especially in stressed market conditions when liquidity serves its most useful 

purpose. For example, a recent study ofthe "flash crash" shows that computer-driven 

algorithmic trading activity can amplify the price effect of a given market event.23 Market 

participants misperceive the volume generated by the algorithmic traders as stabilizing liquidity. 

However, the algorithmic systems are rigged to exit the market and dump inventories at the 

worst possible time, in terms of stability. The perceived stabilizing liquidity is an illusion. In 

fact, this volume becomes an immense consumer of liquidity. 

Nonetheless, universal banks claim that limitations on their activities will burden the economy 

with premia on capital investment. The forecasting ofliquidity in the absence ofuniversal 

banking and measurement of its consequences in terms of liquidity premia and bid/ask spreads is 

analytically difficult. Many factors intervene. For instance, liquidity is related to credit spreads 

(the interest rate impact of the credit quality of the issuer of debt) in complicated ways. 

Conditions in the financial markets can affect the appetite for higher yielding, lower credit 

22 Arora, S., Barak, B., Brunnenneier, M., Ge, R., "Computational Complexity and Infonnation Asymmetry 

in Financial Products," October 19,2009, available at http://scholar.princetoll.edu/markus/publications/tenn/39. 

23 A. Kirilenko, A. Kyle, M. Samadi and T. Tuzun, "The Flash Crash: The Impact of High Frequency Trading 

on an Electronic Market," May 2011 available at http://papcrs.ssm.com/so13/papers.cfm?abstraeUd=1686004. 

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quality debt. When there is great confidence in the economy and interest rates are generally low, 

investor appetite for the yields generated by relatively lower credit quality will be higher. As a 

result, liquidity is relatively higher for this category of debt. In contrast, when the economic 

outlook is weak and financial markets are more concerned about failures, relative liquidity is 

lower for this debt. This represents a "flight to quality." 

Oliver Wyman Approach to Liguidity. The recently published Oliver Wyman study is a good 

example of the claimed benefits. It relies on a prior study entitled "Corporate bond liquidity 

before and after the onset of the subprime crisis.,,24 The purpose of this prior study was to 

examine the particular effects of the crisis on liquidity premia. One thing is for certain: 

extrapolation of liquidity premia based on data from the most stressed economic and financial 

conditions in modem times to forecast general liquidity costs is a bad idea. The forces affecting 

liquidity costs under such specifically stressed conditions distort liquidity cost relationships in 

the extreme. 

As a result of using the study ofliquidity during the crisis to estimate the premium for lower 

liquidity, other flaws in the Oliver Wyman study are amplified. For instance, assumptions for the 

amount ofreduced liquidity (i.e., no replacement for bank liquidity from other sources was 

assumed) were comEounded by application of cost factor derived from distorted, extraordinarily 

stressed conditions. 5 The Oliver Wyman Study obtains the result it seeks because it has 

assumed the result as the starting point, that is to say that liquidity will evaporate rather than 

migrate. 

In addition, the overall approach misses a critically important point. Higher liquidity premia have 

a self-correcting effect in normal conditions. Liquidity premia are related to bid/ask spreads. 

When liquidity is low, the ,spreads will be high because liquidity providers will require greater 

compensation for the service they provide. (I will buy your bond, but only if my expected 

compensation is relatively high, since there is greater risk of re-selling it because oflow 

liquidity.) As bid/ask spreads increase because oflower liquidity, more capital will be attracted 

to the market to take advantage ofthe profit potential. This, in tum, moderates bid/ask spreads 

and liquidity premia until equilibrium is achieved. 

It is remarkable that the financial services industry puts forth arguments that simply ignore the 

laws of supply and demand as they apply to capital. 

Volume vs. Liquidity. Much of the analysis and comment is based on confusion between 

volume and liquidity. Trading activity that provides liquidity, in particular market making, 

provides real value to the economy. Other activity generates volume, but the value is less clear, 

to say the least. In fact, this activity may impose a net drag on the economy. Recent academic 

J. Dick-Nielson, p, Feldhutter and D. Lando," Corporate bond liquidity before and after the onset of the 

sub prime crisis." May 2011, available at http://papers.ssrn.com/so13/papers.cfm?abstract id= 1364635. 

15 To calculate the cost of power liquidity, the Oliver Wyman Study used values c;lculated by Dick-Neilson, 

Feldhutter and Lando. Oliver Wyman describes how they selected the particular cost percentages for their study: 

"DFL construct two independent 'panels' of bond liquidity data - one for the Q3 2005-Q2 2007 period, one for the 

Q3 2007-Q2 2009 period - using TRACE data. The most recently available panel is used in our analysis; the earlier 

period shows smaller, but still significant effects." 

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studies indicate that 

dealer activity is overwhelmingly weighted toward trading that does not provide 

liquidity; 

activity that represents the greatest volume increases the costs of accessing liquidity; and 

the layers of intermediation that have arisen from trading practices other than market 

making, while efficiently executed to generate profits for traders, involve costs to the rest 

ofthe economy that result in an inefficient financial system for the economy as a whole. 

As a result, the assertion that universal banking benefits the economy is extremely questionable, 

and the better analysis is that the real economy suffers costs. These studies are reviewed below. 

A study by professors at MIT's Sloan School of Management examines this issue in the context 

of modem market behavior.26 The Wang Study focuses on a phenomenon illustrated most 

graphically by the Flash Crash. While trading volumes may be extremely high, most dealer 

trading does not appear to be providing market making. It does not work to provide liquidity to 

investors so as to provide stable and efficient pricing. Key points of observation are times of 

market stress. 

Not only is the social function of liquidity provision most 

important to other market participants during these periods, it is 

also these periods (when prices have likely diverged from 

fundamentals) during which expected profits from providing 

liquidity should theoretically be the highest. Therefore, if market 

makers are providing liquidity by accommodating order 

imbalances, we should observe greater dealer trade activity during 

periods of higher volatility and kurtosis.27 

The Wang Study finds that such greater activity does not occur at these times. Further, the study 

finds substantial evidence that trading activity is largely based on information and designed to 

profit from short-term price movements. "We have shown that dealers do not provide liquidity 

to the market; instead, they trade on information.,,28 

In contrast with the Oliver Wyman Study, a better analysis of the universal banking model is that 

the effects on liquidity largely center on the availability of subsidized capital deployed to chase 

transactions that would not make sense but for the subsidy. Capital raised by short-term leverage 

(which is so dangerous to the markets) may also recede as lenders can no longer depend on a toobig-to-fail bailout. It can also be anticipated that high frequency, algorithmic trading activity 

will moderate as more demanding and socially useful rationales for capital deployment are 

imposed. 

26 J. Chae and A. Wang, "Who Makes Markets? Do Dealers Provide or Take Liquidity?," August 2003 (the 

Wang Study") available at http://papers.ssrn.com/soI3/papers.cfm?abstract id",1364635. 

27 Wang Study, pages [7-[8. 

28 Wang Study, page 30. 

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But more importantly, the liquidity argument centers on transaction costs. When the market is 

functioning normally, volume can have beneficial effects on transaction costs (often expressed as 

bid/ask spreads). But this does not translate directly into an efficient intermediation system. If a 

significant portion of the market volume actually distorts the perceived value of the securities 

and derivatives being traded, the transactions may be inexpensive to transact but also 

fundamentally mispriced. Elimination of the perverse incentives induced by the universal 

banking system will result in a more rational and disciplined set of market participants. This 

should curb the volume that is injurious to the economy and improve the efficiency of the overall 

market function. 

Liquidity may be affected if universal banking were not the norm, though the Oliver Wyman 

Study provides little guidance on how. But the best analysis is that the effects will be, on the 

whole, healthy for the economy and the public. The recent study by Thomas Philippon of New 

York University's Stem School of Business described above undertakes a quantitative analysis 

of the economy-wide cost of financial intermediation over the last century through the device of 

a "finance cost index."z9 The Philippon Study concludes that, historically, the cost of 

intermediation has been remarkably stable. However, the further conclusion is particularly 

relevant to the liquidity discussion: the financial cost index has been trending upward for 40 

years, a period when technological and quantitative advances must have reduced financial 

costs.30 

At least a part of the answer to this puzzle may well be the inefficient deployment of bank capital 

to layers of uneconomic intermediation as banks seek higher returns from the spreads between 

cheap capital costs and exotic securities and derivatives. This is completely consistent with the 

answer suggested by Professor Philippon. 

Finance has obviously benefited from the IT revolution and this 

has certainly lowered the cost of retail finance. Yet, even 

accounting for all the financial assets created in the US, the cost of 

intermediation appears to have increased. So why is the nonfinancial sector transferring so much income to the financial 

sector? Mechanically, the reason is an enormous increase in 

trading] I 

The layers of socially unproductive intermediation are best illustrated by the algorithmic trading 

that contributes heavily to today's market volume. In fact, it is clear that the dominance of 

algorithmically driven trading using techniques associated with high frequency trading does not 

provide liquidity. Rather, it consumes liquidity with adverse consequences. A recent study of 

these issues draws conclusions that are summarized as follows: 

We analyze the impact of high frequency trading in financial 

29 Thomas Philippon, "Has the U.S. Finance Industry Become Less Efficient," November 2011 C"Philippon 

Study"), available at CSSRN·idI972808[l J).pdf. 

JO Phillipon Study, pages 16·17. 

3J Phillippon Study, page 22. 

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markets based on a model with three types of traders: liquidity 

traders (LTs) , professional traders (PTs), and high frequency 

traders (HFfs). Our four main findings are: i) The price impact of 

liquidity trades is higher in the presence of the HFfs and is 

increasing with the size of the trade. In particular, we show that 

HFfs reduce (increase) the prices that LTs receive when selling 

(buying) their equity holdings. ii) Although PTs lose revenue in 

every trade intermediated by HFfs, they are compensated with a 

higher liquidity discount in the market price. iii) HF trading 

increases the microstructure noise of prices. iv) The volume of 

trades increases as the HFfs intermediate trades between the LTs 

and PTs. This additional volume is a consequence of trades which 

are carefully tailored for surplus extraction and are neither driven 

by fundamentals nor is it noise trading. In equilibrium, HF trading 

and PTs coexist as competition drives down the profits for new 

HFfs while the presence of HFfs does not drive out traditional 

PTS.32 

Thus, algorithmic and high frequency trading actually extracts value by intermediating between 

liquidity providers (market makers) and liquidity traders (large scale investors) and extracts 

value so as to widen spreads. This volume does not provide liquidity that is beneficial to the 

overall intermediation process; it exploits the process at a cost to the investors. 

The consequences to the shape of the American economy are potentially dramatic. Professor 

Philippon eloquently poses this issue as follows: "the finance industry that sustained the 

expansion of railroads, steel and chemical industries, and the electricity and automobile 

revolutions was more efficient than the current finance industry.,,33 

Industry Competition 

It is difficult to imagine a financial services industry that is less competitive than that which 

prevails today. As described above, concentration has increased dramatically in the last 35 

years. The advent of universal banking in the United States is a primary cause. 

A reversal of this condition would undoubtedly reorder the industry. Capital and talented 

personnel would migrate from the dominant universal banks into existing and new institutions. 

It is likely that investment banks would reemerge. Without the need to compete with the 

subsidized and plentiful capital of the universal banks, the investment banks would probably be 

leaner and more risk averse than they were in the years leading up to the crisis. Importantly, 

conflicts of interest that are embedded in the existing system would decline. 

Indeed, the buy-side has recognized the harm to their bottom line posed by the universal banks 

trading against them. In its 2009 report on financial reform, the Council ofInstitutional 

A. Cartea and J. Penal va, "Where is the Value in High Frequency Trading?," December 2011, available at 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id= 1712765. 

lJ Philippon Study, page 2. 

32 

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Investors ("CII") prominently highlighted the need to address proprietary trading, noting that 

"Proprietary trading creates potentially hazardous exposures and conflicts of interest, especially 

at institutions that operate with explicit or implicit government guarantees. Ultimately, banks 

should focus on their primary purposes, taking deposits and making loans.,,34 As one member of 

the CII Investors' Working Group panel explained it, proprietary trading has significantly 

harmed the institutional investors: 

Proprietary trading by banks has become by degrees over recent 

years an egregious conflict of interest with their clients. Most if not 

all banks that prop trade now gather information from their 

institutional clients and exploit it. In complete contrast, 30 years ago, 

Goldman Sachs, for example, would never, ever have traded against 

its clients. How quaint that scrupulousness now seems. Indeed, from, 

say, 1935 to 1980, any banker who suggested such behavior would 

have been fired as both unprincipled and a threat to the partners' 

money.35 

Furthermore, the bipartisan Levin-Coburn Report by the Senate Permanent Subcommittee on 

Investigations offers a detailed description of some of the conflicts of interest that directly cost 

investors billions of dollars.36 

Summary 

Balancing benefits and dangers is critically important to the economy as a whole. If capital is 

misallocated away from productive uses and value is extracted by the universal banking system, 

the ability of businesses to generate productive employment is damaged. Income inequality 

grows as the value of non-financial employment shrinks and the profit share of the financial 

sector increases (along with bonuses). And the effectiveness of monetary policy is diminished as 

the system of intermediation capital sources to productive uses is compromised. 

In reality, the issues of systemic risk and the efficient functioning of the financial system are one 

in the same. In the US economy, inefficiencies are exploited relentlessly and incent risk-taking 

in the process. Asset and debt bubbles, together with the inevitable bust cycles, are an obvious 

result. The velocity of these forces is breathtaking in markets operating with high technology 

and fast evolving financial innovation. Universal banking, in the context of the US economy, is 

inherently risky and costly. 

J4 cn Investors' Working Group, "U.S. Financial Regulatory Reform: The Investor's Perspective," July 2009, 

page 3, available at 

http://www.cii.orglUserFiles/file/resource%20center/investment%20issues/lnvestors'%20Working%20Grollp%20Re 

p,0rt%20(July%202009).pdt) 

5 Jeremy Grantham, "Lesson Not Learned: On Redesigning Our Current Financial System," GMO Q. 

LETTER SPECIAL TOPIC, 2 (Oct. 2009), available at h!!J!;/lwww.scribd.com/doc/2l682547/Jcrcmy-Grantham. 

J6 United States Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and 

Governmental Affairs, Majority and Minority Staff Report, "Wall StTcet and the Financial Crisis: Anatomy ofa 

Financial Collapse," April 201 I. 

18 
155 

3. Do traditional banks need to be large or engage in trading/investment banking 

activities in order to serve clients and customers, including large multinational 

corporations ? 

4. Can the needs 0/ customers be served by smaller banks, or banks that solely provide 

particular services? 

Large, oligopolistic companies always raise the issue of economies of scale when arguing against 

the efficiencies of competition. This position is particularly difficult to understand in the context 

of universal banks that are too-big-to-fail. 

It is understandable that large clients and customers might perceive benefits from dealing with 

universal banks. Much of the service provided to these entities involves renting the balance 

sheet of the universal banks. If a large customer seeks to move a big securities position, its bank 

will take it off the customer's hands and distribute the position over time so as not to affect the 

price by flooding the market. The cost of capital to hold the position is transferred from the 

customer to the bank. If the capital of the bank benefits from the Federal safety net and too-bigto-fail status, the customer benefits proportionately. 

The problem, of course, is that the benefit exists because the American taxpayer ultimately bears 

risks of the universal bank's failure. No one sees the cost until a financial crisis ensues and a 

very large bill is presented to the public. 

Implicit in the question is that only large universal banks will serve the trading/investment 

banking needs of the multinational corporations. Such an assertion would have sounded 

ludicrous to the bankers in Goldman Sachs' London office in 1995 that competed so successfully 

with European universal banks (and I should know, having been assigned there at that time). In 

reality, customers would be served better by a financial sector made up of an array of smaller, 

institutions that are well capitalized in relation to their business activity. In this model, conflicts 

of interest would be fewer and costs more transparent. The incremental costs to users of services 

from a leaner system would be those associated with too-big-to-fail. This is a good trade indeed. 

5. Does the government offer support or subsidies/or large banks? l/so how? 

The response to question 1 details the support provided in the form oftoo-big-to-fail realities and 

the Federal safety net of FDIC insurance and access to the Fed window. 

There are indirect supports as well. Large banks depend on an enormous number of businesses 

to trade continuously. The too-big-to-fail guarantee that was made explicit in 2008 is not useful 

unless it extends to the large bank ecosystem. Thus, the $700 billion direct bank bailout known 

as the Troubled Asset Relief Program, or "TARP," was only the tip ofthe iceberg. The Federal 

Reserve acted decisively, barely pausing to build consensus or consult with political leaders. It 

allowed banks to borrow freely at low rates, a conventional tool of the central bank, and provided 

19 
156 

interest on amounts deposited by the banks on reserves, generating a risk-free arbitrage profit. 

And, on the heels ofthe Lehman Brothers collapse, it was discovered that AIG, the world's 

largest insurance company, was bankrupt as a result of spiraling losses on exotic financial 

instruments. This threatened to drag the banking system down alongside AIG. The Fed loaned it 

$85 billion to cover amounts owed to the largest banks, a mere down payment into the financial 

black hole that AIG was fast becoming. The money passed directly through to the creditor banks, 

taking pressure off ofthe financial system but adding to the amount of the "bailout." 

But the bailout was even broader. Over thirty years of deregulation, the financial system had 

rapidly evolved away from the structures put in place during the Great Depression, and the new 

system could not withstand the stresses of2008. Pushing the bounds of its legal authority, the 

Fed took actions targeted at critical elements of the new system that dwarfed T ARP in scope, but 

of which that the public was largely unaware.37 

Losses at money market funds threatened a depositor run on the $3.4 trillion of assets 

held by these entities.38 Over the years, money market funds had largely replaced 

conventional bank savings deposits, but these funds did not enjoy the stabilizing benefits 

of FDIC deposit insurance, the New Deal program assuring against depositor runs. The 

Fed immediately put a lending facility in place that effectively guaranteed money market 

deposits and warded off a catastrophic run that would have dragged down the banks. 

One of the most popular investment sources for money market funds is the commercial 

paper market into which companies and structured financing vehicles sponsored by banks 

issue short term IOU's. In 2008, there was $1.8 trillion of commercial paper outstanding, 

approximately 70% of which had terms of3 days or less. 39 When the commercial paper 

market started to fail, the Fed stepped in to purchase the IOUs and guarantee investors 

that the commercial paper would be rolled over or paid off as it matured. 

Banks had more and more used "repurchase agreements" to finance their holdings of 

securities and derivatives. They would borrow money against the securities and 

derivatives, agreeing to repay the loans and retrieve the collateral on a daily basis. The 

"repo" market, as it was known, had mushroomed to $4.5 trillion and almost all of it had 

J7 Board of Governors of the Federal Reserve System, Office of Inspector General, "The Federal Reserve's 

Section 13(3) Lending Facilities to Support Overall Market Liquidity: Function, Status, and Risk Management," 

November 2010. 38 Diana Henriques, "Treasury to Guaranty Money Market Funds," New York Times, September 19,2008, 

available at http://www.nytimes.comI2008/09120IbusinessI20moneys.html. 

39 Richard Anderson and Charles Gascon, "The Commercial Paper Market, the Fed, and the 2007-2009 

Financial Crisis," Federal Reserve Bank of St. Louis Review, November/December 2009, 91(6), pp. 589-612, 

available at http://research.stlouisfed.org/publications/review /09/11/ Anderson.pdf. 

20 
157 

to be rolled over every single day.40 As banks grew to believe that other banks might 

implode at any moment, and as the securities and derivatives used as collateral fell in 

value, repurchase agreement lending started to dry up. Banks started selling offthe 

securities and other collateral that could no longer be financed, creating a "fire sale" 

effect. This drove down the collateral value of the securities and derivatives, threatening 

a death spiral of epic proportions. The Fed stepped in to guarantee the repo market, 

slowing the spiral. 

Foreign banks needed access to US dollars to avoid default on ongoing dollar 

denominated liabilities. They could not rely on borrowing dollars in the crippled US 

commercial paper market. So the only source was the market for swapping dollars in 

exchange for other currencies with US Banks, a $4 trillion per day market.4l Banks in 

other countries came to doubt the reliability of US banks - no one knew whether US bank 

were solvent. A worldwide collapse might ensue if the foreign banks defaulted for want 

of dollars. The Fed offered unlimited access to foreign central banks to swap dollars for 

foreign currency so that the central banks could in turn loan dollars to local banks, 

avoiding their default. Most accurately measured, the daily peak of Fed swaps exceeded 

$850 billion. 

Actions by the US administration, Congress and the Fed held off a general collapse, but the 

consequences of these events persist to this day. Andrew Haldane, Bank of England Executive 

Director for Financial Stability, has estimated the ultimate cost to the worldwide economy to be 

between $60 and $200 trillion.42 By comparison, worldwide GDP for the 12 months ending May 

2011 was $65 trillion.4] To state the obvious, even if Haldane's figure is off by a bit, the 

consequences have been grave. 

As a result, the subsidy provided by the too-big-to-fail reality extends far beyond a direct bailout 

to the banks. It covers the ecosystem that supports their continued existence. 

6. Is government "safety net" support appropriate, either for institutions of a certain size 

or for institutions that engage in certain activities? 

4<J Andrew Metrick, Haircuts, Federal Reserve Bank ofSt. Louis Review, NovcmbcrlDeccmber 2010; 

Primary Dealers' Outstanding Reps (July 6, 1994 to 2009) (Source: FRB of NY) 

http://www.zerohedge.com/sitcs/default/files/images/Repo%20l.jpg; SIFMA US Primary Dealer Financing 

http://www.sifma.org/research/statistics.aspx 

41 Bank for International Settlements, "Triennial Central Bank Survey, Report on Global Foreign Exchange 

Market Activity in 2010," December 2010, available at http://www.bis.org/publ/rpfxfJOt.pdf. 

42 Paul Hannon, "Economic Hit from Crisis: A very Big Number," Wall Street Journal, March 30, 2010; text 

of speech available at www.banko[england.co.uklpublicationslspeechesl...Ispeech433.pd[ 

43 "In Search of Growth," The Economist, May 25. 2011, available at 

http://www.cconomist.comlhlogs/ dailychart/20 II 105/worid _gdp. 

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158 

Bank runs of various sorts continue to be a threat to the financial system. In one manifestation, 

depositors instigate a run on the system by withdrawing deposited funds (recall Jimmy Stewart 

holding off the townspeople in It's a Wonderfol Life). This happened to money market funds in 

2008. In another version, banks cut off short term funding provided to other banks. This 

occurred in the bank-centered repurchase agreement, commercial paper and currency swap 

markets in the recent crisis, as banks decided that no one holding toxic assets could be trusted. If 

the "bank run" cannot be contained, commercial activity comes to a halt, as in the Great 

Depression.44 Mitigating the risk of such an event has obvious value, and as Andrew Haldane's 

estimate illustrates, the value is indisputably enormous. 

The safety net must target the financial panics that can lead to runs. Depositor runs are 

addressed by deposit insurance. Interbank liquidity runs are addressed by access to the Fed 

window. 

But the safety net makes sense only under certain conditions. Foremost, is that the safety net 

should only be used to benefit low risk, stable return institutions. Commercial banks, not 

universal banks, fit this description. The commingling of deposit insurance and financial market 

intermediation is inherently a source of systemic risk and moral hazard. 

Furthermore, the safety net only makes sense if other sources of bank runs, transmitted through 

interconnectedness, are addressed by either regulatory intervention or similar safety nets. 

Regulation is far preferable. The potential for money market depositor runs must be dealt with. 

Fed Chairman Bernake has recently reiterated this point and pledged to take action.45 Similarly 

the inherent instability of the repurchase agreement market must be addressed. Some prospects 

for this exist, but the prudential regulators need to be extremely meticulous in the measurement 

ofthe short-term volatility of this market and the required liquid capital needed to mitigate its 

effects. Similarly, the stability ofthe $4 trillion a day foreign exchange market must be 

addressed. An answer to this seems far away. The intervention by the Fed to facilitate 

transactions, which continues to this day, is not a solution. 

Finally, systemically important financial institutions must be designated and brought under 

prudential supervision, as envisioned in the Dodd-Frank Act. It is unrealistic to believe that 

dealing with banks subject to the safety net will avoid the contagion of major failure by 

systemically important non-banks. The Dodd-Frank regulation of systemically important nonbanks must be finalized. 

7. Would you favor limiting the size - for example, leverage or nondeposit liabilities - of 

financial institutions? 

44 Bemanke, Ben S., "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great 

Depression," American Economic Review, 73 (June 1983), pp. 257-76. 

4' International Business Times, "Bemake Calls for More Shadow Banking Curbs," April 10, 2012, available 

at http://www.ibtimes.com/articles/326117/20 12041 O/federal-reserve-bemanke-speech-shadow-bankingregulation.htm. 

22 
159 

Leverage is a critically important issue. The assets held by the financial sector exploded in the 30 

years prior to 2008, and it was in large part financed with debt. In 1978, commercial banks held 

an aggregate of$\.2 trillion in assets, or 53% of the US GDP. By the end of2007, this figure had 

grown to $1 \.8 trillion representing 84% ofGDP. Similarly, investment banks grew from $33 

billion (1.4% ofGDP) to $3.1 trillion (22% ofGDP).46 Compare this with the $4.7 trillion 

repurchase agreement market in which securities are financed by selling them with an obligation 

to repurchase, primarily in overnight transactions (described above). This practice - in 

substance, a form of secured lending - exposes the financial system to tremendous risk. Declines 

in the value of securities impair the value of the collateral securing the loans. Banks can be 

forced to sell the securities to extinguish the repo debt, and this causes securities to decline 

further setting off a dangerous spira\. 

Regulations limiting debt to equity rations are important. Prudent rations are in the range of 10 -

15 to I, a far cry from the levels of 2007 and 2008. However, limitations on leverage must 

effectively measure and limit the use of short term financing, such as repos and securities 

lending. These limitations must not be limited to the trading books of banks. They must take 

into consideration the potential moving of assets to the loan books as well. 

Other non-deposit liabilities must also be addressed. Off balance sheet financing of assets was a 

major component in the demise of Bear Steams. Banks must be foreclosed from entanglement in 

hedge funds and asset-backed financings. 

But derivatives pose a risk even larger. These positions must be seen for the leveraged 

transactions that they are. This $30 trillion per year market embeds huge uncapped credit 

exposures to price movements in a vast array of securities, commodities and other assets. 

Transactions through clearinghouses, a goal of the Dodd-Frank Act and international policymakers, are managed transparently under rules overseen by regulators. However, the bilateral 

over-the-counter market will simply not be eliminated by the Dodd-Frank Act, with its 

exclusions for end users and other derivatives users. 

Finally, the corporate practices of the banks create leverage that goes unseen. The banks operate 

multiple subsidiaries throughout the world. As an example, Lehman Brothers had 2,854 

subsidiary companies. A common practice is to manage risk on a consolidated basis and sweep 

cash into the parent institution, often as frequently as overnight. It is umealistic to assume that 

the exposures of subsidiaries, and in particular complex and difficult to measure undertakings, do 

not constitute leverage of the parent bank. 

8. Would you favor limiting activities of individual banks, such as restricting the amount 

of investment banking or trading activities they may engage in? 

There are three conceptual ways to limit the risks of investment banking businesses conducted by 

universal banks. Some or all of these investment banking activities can be prohibited, with 

priority given to those that involve the greatest risk. Safe forms of capital may be required as 

46 Johnson and Kwak at page 59. 

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reserves against loss and as a means of curbing excessive risk taking. And regulations may 

require the activities to be ring-fenced in subsidiaries that can fail without damage to the bank. 

Of these, the approach in the US has focused on activity restrictions and capital requirements, 

recognizing that the conceptual justification of ring fencing may well prove to be illusory in 

practice. 

The need for activity restrictions is inescapable. Capital requirements are useful, especially if 

intelligently applied in proportion to the risks that are reserved against. However, capital 

requirements are based on the measurement of risk. Faulty risk measurement was a major factor 

in the financial crisis. Forecasting risk is always influenced by historic experience, even if the 

statistical measurements relied on prior to 2008 are expanded. It is difficult to anticipate the 

unprecedented. 

Moreover, risks are measured using forecasting models. This is a reasonable and centrally 

important practice. But models are created by people and are therefore subject to their biases. 

Prudency dictates that there are activities that simply must be prohibited to banks. This does not 

mean that a given activity cannot exist in the marketplace. It means that the activity must be 

limited to financial institutions that are not commercial banks. 

Section 619 of the Dodd-Frank Act (often referred to as the Volcker Rule) is intended to prohibit 

activities, in particular proprietary trading and excessive involvement with hedge funds. Certain 

proprietary activities are permitted, most notably market making. The response from industry has 

been loud and strong, as should be expected. For example, it is asserted that taking a position, 

with respect to which there is no market for the bank to exit the trade, is actually market making 

if the counterparty is a client. Taking on such a risk is not primarily motivated as customer 

service; it is primarily a proprietary bet. One hopes that the regulatory agencies do not suffer 

from amnesia: positions that cannot be liquidated at a known price precisely describes the toxic 

assets that rendered bank balance sheets indiscernible, triggering the runs that caused the crisis. 

The Proposed Rules to implement Section 619 are said to be long and complicated, but this is an 

almost absurd exaggeration based on a double-spaced version and including the lengthy 

discussion of the issues issued with the Proposed Rule. The Proposed Rule itself runs only about 

13 pages in the Federal Register, with 12 pages of appendices, hardly a threat to any record for 

length of regulation. The reason behind any complexity is not the desire of regulators to burden 

the banks with rules. Section 619 of the Dodd-Frank Act surgically excises only those elements 

of trading that pose the greatest risks, allowing banks to continue activities such as market 

making, underwriting and restrained participation in hedge funds and private equity funds. The 

intent was to limit bank activities as little as possible. 

However, the banks themselves had allowed the proprietary trading fever to infect the c1ientoriented businesses that the Volcker Rule seeks to exclude from the prohibition. For instance, 

desks engaged in client-oriented market making could never hope to generate revenues to match 

their colleagues on desks explicitly dedicated to prop trading. As a result, market-making desks 

24 
161 

migrated into prop trading by seeking client business that justified the accumulation of huge 

positions that they called "inventory" (semantics that are best described as Orwellian). There is 

no better illustration than the recent Oliver Wyman study that describes inventory levels at 4.6 

times average daily volume for less liquid products.47 The conclusion is inescapable: this is not 

making a market under any conventional meaning of the concept; it is proprietary trading using a 

more benign name. 

As a result, to preserve certain activities that are less risky, client oriented businesses, the 

regulators were compelled to define and describe them using legitimate, non-Orwellian rules and 

monitoring regimes. 

Moreover, many of the complexities of the Volcker Rule stem from endless entreaties of 

financial institutions, which met with the regulatory agencies some 350 times. Having prevailed 

with the insertion of numerous exceptions and penuissions, it is ironic that banks now complain 

about the complexity that is an inescapable consequence. 

The only reasonable response to the criticisms leveled to date regarding the Proposed Rule under 

Section 619 is to eliminate the exceptions from the proprietary trading prohibition for less risky 

fonus of trading. That way, the banks will not have to be monitored for non-compliance, 

behaviors that they have exhibited in the past. 

*** 

Thank you for the opportunity to present my views. 

47 Oliver Wyman Study, page 9. 

25 
162 

As a notion, we face a distinct choice, We can perpetuate too big to fail, with its inequities and dangers, or we 

can end it Eliminating TBTF won't be easy, but the vitality 

of Ollr capitalist system and the long-term prosperity ii 

produces hang in the balance, 
163 

Choosing the Road to Prosperity 

More than three years after a crippling financial crisis, the American economy 

still struggles, Growth sputters, Job creation lags. Unemployment remains high. 

Housing prices languish. Stock markets gyrate. Headlines bring reports of a 

shrinking middle class and news about governments stumbling toward bankruptcy, at 

home and abroad, 

Ordinary Americans have every right to feel anxious, uncertain and angry, They have 

every right to wonder what happened to an economy that once delivered steady progress. 

They have every right to question wherher poficymakers know the way back to normalcy. 

American workers and taxpayers want a broad·based recovery that restores confi~ 

dence. Equally important. they seek assurance that the -causes of the financial crisis have 

been dealt with, so a similar breakdown won't impede the flow of economic activity. 

The road back to prosperity wHl require reform of the financial sector. In par~ 

tkular, a new roadmap must find ways around the potential hazards posed by the 

financial institutions that the government not all that long ago deemed "too big to 

fail" -or TBTF, for short. 

In 2010, Congress enacted a sweeping. new regulatory framework that attempts 

to address TBTF. While commendable in some ways, the new law may not prevent the 

biggest financial institutions from taking excessive risk or growing ever bigger, 

TBTF institutions were at the center of the financial crisis and the sluggish recovery that followed, If allowed to remain unchecked, these entities will continue posing 

a dear and present danger to the U.S, economy, 

As a nation, we face a distinct choice. We can perpetuate TBTF, with its inequities 

and dangers, or we can end it, Eliminating TBTF won't be easy, but the vitality of our 

capitalist system and the long-term prosperity it produces hang in the balance. 
164 

Flows, Frailties and Foibles 

The financial crisis arose from failures 

of the banking, regulatory and political 

systems. However, focusing on faceless 

institUtions glosses over the fundamen~ 

tal fact that human beings, with all their 

flaws, frailties and foibles, were behind the 

tumultuous events that few saw coming 

and that quickly spiraled out of control. 

C:;"-'!'EIo.~"'\, Good times breed complacency-not 

right away, of course, but over time as 

memories of past setbacks fade. In 1983, 

the U.S. entered a 2S-year span disrupted 

by only two brief, shallow downturns, ac· 

counting for just 5 percent of that period 

(Exhibh '/), The economy performed 

unusually well, with strong growth, low 

unemployment and stable prices. 

This period of unusual stability and 

prosperity has been dubbed the Great 

Moderation, a respite from the usual tumult 

of a vibrant capitalist economy. Before the 

Federal Reserve's founding in 1913, recession 

held the economy in its grip 48 percent of 

the time. In the nearly 100 years since the 

Fed's creation, the economy has been in 

recession about 21 percent of the time. 

When competition declines, incentives otten turn perverse, and self-interest can turn malevolent That's what 

happened in the years before the financial crisis. 

When calamities don't occur, it's hu~ 

man nature to stop worrying. The world 

seems less risky, 

Moral hazard reinforces complacency. 

Mora! hazard describes the dangerthat 

protection against losses encourages riskier 

behavior, Government rescues of troubled 

financial institutions encourage banks and 

their creditors to take greater risks, know~ 

ing they'l! reap the rewards if things turn 

out wen, but will be shielded from losses if 

things sour. 

In the run~up to the crisis of 2008, the 

public sector grew complatent and relaxed 

the financial system's constraints, explicitly 

in taw and implicitly in enforcement. Ad· 

ditionally, government felt secure enough 

in prosperity to pursue social engineering 

goals-most notably, expanding home 

ownership among low~income families. 

At the same time, the private sector 

also became complacent, down playing 

the risks of borrowing and lending, For 

example, the traditional guideline of20 

percent down payment for the purchase 

of a home kept slipping toward zero, es~ 

pecially among lightly regulated mortgage 

companies. More money went to those 

with less ability to repay,l 

Greed 

You need not be a reader of Adam 

Smith to know the power of5elf~inter~ 

est-the humah desire for material gain. 

Capitalism couldn't operate wlthoutlt, 

Most of the time, competition and the rule 

of law provide market discipline that keeps 

self~interest in check and steers it toward 

the sodal good of producing more of what 

consumers want at lower prices. 

When competition declines, incen~ 

tlves often turn perverse, and seff~lnterest 

can turn malevolent. That's what happened 

in the years before the financial crisis, New 

technologies and business practices reduced 

lenders' "skin in the game"-for example, 

consider how lenders, instead of retaining 

the mortgages they made, adopted the 

new orlgjnate-to~istribute model, allowing 

them to pocket huge fees for making loans, 

packaging them into securities and selling 

them to investors. Credit default swaps fed 

the mania for easy money by opening a 

casino of sorts, where investors placed bets 

on-and a few financial institutions sold 

protection on-companies' creditworthiness. 

Greed led innovative legal minds to 

push the boundaries of financial integrity 
165 

with off"ba!ance~sheet entities and other accounting expedients. Practices that weren't 

necessarily illegal W€re certainly mislead~ 

lng-at least that's the conclusion of many 

postcrisis investigations.1 

~tl1plicily 

We admire success. When everybody's 

making money, we're eager to go along for 

the ride-even in the face of a suspicion 

that something may be amiss. Before the 

financial crisis, for example, investors relied 

heavifyon the credit-rating companies that 

gave a green light to new, highly complex 

financial products: that hadn't been tested 

under duress, The agencies bestowed their 

top rating to securities backed by high-risk 

assets-most notably mortgages with small 

down payments and Hnle documentation 

of the borrowers' income and E"mployment, 

Billions of dollars of these securities were 

later downgraded to "junk" status. 

Complicity extended to the public 

sectof."'e Fed kept interest rates too low 

for too long. contributing to the speculative binge in housing and pushing investors 

toward higher yields in riskier markets. Congress pushed Fannie Maeand Freddie Mac, 

the de facto government-backed mortgage 

Exhibit 1 

Reduced Time Spent Recossion 

SOURCE'NatiooW B~reauoIEeonam;cR~sean:h 
166 

Concentration amplified the speed and breadth of the 

subsequent damage to the banking sector and the 

economy as a whole, 

Exhibit 2 

U's, Banking Conc(mtrotion Increased Dromotlccllly 

NOTE:A~1swerecalculiltoousill9tooregu~ryilighholdefortOllholderf(jfabankarl\l summing assets forali the 

l>ln~ wilh the same top holder to 11m an ~tlmate oj ofgaoll;atioo"lftl'lll ban~ assets 

giants, to become the largest buyers of 

these specious mortgage products. 

Hindsight leaves u:s wondering what ft~ 

nandal gurus and poHcymakers could have 

been thinking. ButcompHdty presupposes 

a wiUful b!indness~we see what we Want to 

see or what life's experiences condition us to 

see, Why spoil the partywheh the economy 

is growing and more people are employed? 

Imagine the political storms and publlc 

ridicule that would sweep over anyone who 

tried! 

Exuberance 

Easy money leads to a giddy selfdelusion-it's human nature. A contagious 

divorce from reality lies behind many of his -

tory's great speculative episodes, such as the 

Dutch tulip mania of 1637 and thf,' South 

Sea bubble of 1720. Closer to home in time 

and space, exuberance fueled the Texas oil 

boom of the early 19805. In the lirst decade 

of this century, it fed the musion that housing prices could rise forever. 

In the run-up to the financial crisis, 

the certainty of rising housing prices 

convinced some homebuyers that highrisk mortga-ges, with little or no equity, 

weren't that risky. It induced consumers 
167 

to borrow on rising home prices to pay for 

new Cars, their children's education or a 

long~hoped·forvacation, Prudence would 

have meant sitting out the dance; buying 

use of off~balance#sheet financing} Equity's legal boilerplate. 

share of aSsets dwindled as banks borrowed These large, complex nnanciat instituto the hilt to chase the easy pronts in new-, tions aggressively pursued profitS in the 

complex and risky financial instruments. overheated markets for subprime mort~ 

into the exuberance gave people what they Their balance sheets deteriorated-too little gages and related securities. They pushed 

the limits of regulatory ambiguity and fax 

enforcement, They carried greater risk and 

overestimated their ability to manage it. 

wanted-at least for a while. 

All booms end up busts. Then comes 

the sad refrain of regret: How could we 

have been so foolish? 

~ofi~ 

In the financial crisis, the human traits of 

complacency, greed complicity and exuber~ 

ance were intertwined with concentration, 

the result of businesses' natura! desire to 

grow into a bigger, more important and 

dominant force in their industries. Concen~ 

tration amplined the speed and breadth 

of the subsequent damage to the banking 

sector and the economy as a whole. 

The biggest US, banks have gotten a 

lot bigger, Since the early 1970s, the share 

of banking industry assets controlled by 

the five largest US. institutions has more 

than tripled to 52 percent from 17 percent 

(Exhibit 2), 

Mammoth institutions were built on a 

foundation of leverage, sometimes mislead~ 

ing regulators and investors through the 

capital, too much debt, too much risk 

The troubles weren't always apparent, 

Financial institutions kept marking assets 

on their books at acquisition cost and 

sometimes higher values jftheir proprietary 

models could support such valuations. 

These accounting expedients allOVw'€d them 

to claim they were healthy-until they 

weren't. Write·downs were later revised by 

several orders of magnitude to acknowledge 

mounting problems. 

With size came complexity. Many big 

banks stretched their operations to include 

proprietary trading and hedge fund investments. They spread their reach into dozens 

of countries as financial markets globalized, 

Complexity magnifies the opportunities 

for obfuscation. Top management may not 

have known all of what was going on-par~ 

ticularly the exposure to risk Regulators 

didn't have the time, manpower and other 

resources to oversee the biggest banks' vast 

operations and ferret out the problems that 

might be buried in financial foomotes or 

In some cases, top management groped 

around in the dark because accounting and 

monitoring systems didn't keep pace with 

the expanding enterprises. 

Blowing a Gasket 

tn normal times, Rows of money and 

credit keep the economy humming. A 

healthy financial system facilitates payments 

and transactions by businesses and consumers, It allocates capital to competing investments, It values assets, It prices risk For the 

most part, we take the financial system's 

routine workings for granted-until the machinery blows a gasket. Then we scramble to 

fix it.. so the economy can return to the fast 

lane, 

In 2007, the nation's biggest in# 

vestment and commercia! banks were 

among the first to take huge write-off's on 

mortgage-backed securities (EKhihit 3), 
168 

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169 

The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did 

essentially fail, surviving only with extraordinary government 

assistance, 

Box 1 

Oeg,e"" of foUu,,,: Ikmkrupfcles, Buyouls Clnd 1I;:1l1outs 

F

or capitalist economies to thrive, weak companies must 

go out of business. The reasons for faUure vary from 

outdated products, excess Industry capacity, mismanagement and simple bad luck. The demise of existIng firms 

helps the economy by freeing up resources for new enterprises, 

leaving healthier sUNivors in place, Joseph SChumpeter coined 

the- term 'creative destruction" to descrioo this failure and 

rene-wof process-o major driver of progress in Q fre&€nterprise 

economy, Schumpeter and his discipleS view this process as 

beneficia! despite the accompanying loss of jobs, asset values 

and equity. 

The U.S. economy offers Cl TOnge of options for this precess Of failure and rebirth: 

BankruptCies 

'Enterpris€!s beyond saving wind up in Chapter 7 bank-

(Uptcy, ~ith operations ended and assets sold off. Firms with 

o viable business but too much debt or other contractual 

obligation'S usually file tor Chapter 11 bankruptcy, continuing 

to operate under court protection from creditors, Soth forms 

of bankruptcy result in a hit to stakeholders: shareholders, 

employees, top managers Gnd creditors ore wiped out or 

allowed to survive at a significant haircut Bankruptcy means 

liquidation Of reduction; whether the bankrupt fifm dies completely or scales down and survives with the same or similar 

name, the end game is reaUocation of resources, 

.Buyow's 

A company facing potential bankruptcy may instead 

be sold,The acquisition usually produces similar stakeholder 

reduction results as a Chapter 11 bankruptcy, but without the 

obliteration of eqUity ownership and creditor fd!iout, 

Bailouts 

The government steps In to prevent bankruptcy by providing 

loons or new capital. The government becomes the mosf 

senior secured creditor and begins downsizing losses, mall'--

ogement, the corporate balance sheet and risk appetite. As 

the company restructures, the govemment, often very slowly, 

WGons the company off fife support. 

8anks om $PQCiai 

The FDIC handles most bank failures through 0- resolution 

similar to a pnvate-sector buyoutThe FDIC is funded primarily 

by tees garnered from the bclnking industry. The foiled institution's shareholders, employees. management and unsecured 

creditors still generally suffer significant losses, while insured 

depositors are protected, 

In the wake of the financial crisis, Dodd-Frank added a 

new option: the Orderly liquidation Authority (OLA), In theory, 

OLA wi!! follow the spirit of a Chapter 7 bankruptcy-llquidatlcn of the failed firm's assets-but in an 'orderly' manner. 

"Orderly" moy involve some FDIC/government financing to 

maximize firm value prior to the sale, thus blending some of 

the degrees, of failure already discuss,ed, 

Buyouts, bankruptcies and FDIC resolutions have a long 

history of providing a reasonably predictable process that 

imposes no costs to taxpayers. Bcmkrupicles and buyouts support creatiVe destruction using private sector funding. By controst. bailouts and OLA aTe specifically aimed at dealing with 

too-big-to-fail instlfutions and are ltkely to inVOlve some form of 

taxpayer assistance sinCe this degree of taUure comes after 

private sector solutions are deemed unavailoble. Bailouts 

provide delayed support of the creative destruction process • 

using sometimes politically influenced taxpayer funds instead 

of the free-enferpriso route of reduction, rebirth and reallocation. 

In essence, dealing with TBTF findncia! institutions necessitates qUQsi-nationolization of a private company, a process 

antithetical to a cQPitaltst system. 

But rt'Iakc- no mistake abey! it; A ballouf is <1 failufS; just 

with a different JabElt, 
170 

As housing markets deteriorated, policymakers became alarmed, seeing the number of big. globally interconnected banks 

among the wounded. The loss of even 

one of them~ they feared, would create a 

domino effect that would lead to a collapse of the payment system and severely 

damage an economy already battered by 

the housing bust. 

Capital markets did in fact seize up 

when lehman Brothers, the fourth-largest 

investment bank, declared bankruptcy in 

September 2008. To prevent a complete 

collapse of the financial system and to 

unfreeze the flow of finance, the expedient fix was hundreds of billions of dollars 

in federal government loans to keep these 

institutions and the finandalsystem afloat. 

In short, the situation in 2008 

removed any doubt that several of the 

largest u.s. banks were too big to fail.~ At 

that time, no agency compiled, let alone 

published, a list ofTBTF institutions. Nor 

did any bank advertise itself to be TBTF. 

In fact, TBTf did not exist explicitly, in 

law or policy~and the term itself disguised the fact that commercial banks 

holding roughly one-third of the assets 

in the banking system did essentially Jail, 

surviving only with extraordinary government assistance (FJ>:'hihit 4).5 Most of the 

largest financial institutions did not fall in 

the strictest sense. However, bankruptdes, 

buyouts and bailouts facilitated by the 

government nonetheless constitute failure 

(Box 1), The US, financial institutions that 

Exhibit 4 

failed outright between 2008 and 2011 

numbered more than 4DO-the most since 

the 1980s. 

The housing bust and recession 

disabled the financial system, stranding 

many institutions on the roadway, creating 

unprecedented traffic jams. Struggling 

Tolal Assets of Failed and Assisted Institutions Reached 

Extraordinary levels 

SOURCE: rudera1 Oep.:lSltlnsufance Corp 
171 

Psychological side effects ofTBTF can't be measured, 

but they're too important to ignore because they affect 

economic behavior, 

"91 

ilCOtKKlly 

expands 

banks could not lend, slowing economic 

activity. Massive !ayoff5 followed, pinching 

household and business spending. which 

depressed stock prices and home values, 

furtherredudng lending. These troubles 

brought more layoffs, further reduc~ 

ingspending. Overall economic activity 

bogged down. 

The chain reaction that started in December 2007 became the longest recession 

in the post-World War II era, lasting a total 

of 18 months to June 2009, Real oUtput 

from peak to trough dropped 5.1 percent. 

Job losses reached nearly 9 million. Unem~ 

p!oyment peaked at 10 percent in October 

2009. 

The economy began seeing a slight 

easing of congestion in midT2009, With the 

roadway beginning to dear of obstacles, 

households and businesses sensed an op~ 

portunity to speed up, New jobs, higher 

spending, rising asset prices and increased 

lending all reinforce each other, building 

up strength as the economy proceeds on a 

growth path (fJl.hI/;it Sf. 

EqUipmBflt,~ sortware 

r.12,nflt"!}'££liC'l.!~~i"e 

In an internal combustion engine, 

small explosions in the cylinders' combus~ ~ltd oilier bllSiooss 

irweslmellblnctBase 
172 

tion chambers propel a vehicle; likewise, 

the monetary policy engine operates 

through cylinders that transmit the impact 

of Fed actions to decisions made by busi~ 

nesses, lenders, borrowers and consumers 

([xhibit 6),6 

When it wants to get the economy 

moving faster, the Fed redua!s its policy 

interest rate-the federal funds rate, what 

banks charge one. another for overnight 

loans. Banks usually respond by mak~ 

ing more credit available at lower rates, 

adding a spark to the bank loan cylinder 

that drives borrowing by consumers and 

companies. Subsequent buying and hiring 

boost the economy, 

Interest rates in money and capi~ 

tal markets generally fall along with the 

federal funds rate, The reduced cost of 

financing taking place in the securities 

market cylinder enables many large busi~ 

nesses to finance expansion through sales 

of stock, bonds and other instruments. 

Increased activity occurs in the asset prices 

and wealth cylinder stemming from the 

propensity of falling interest rates to push 

up the value of assets-bonds, equities, 

homes and other real estate. Rising asset 

values bolster businesses' balance sheets 

and consumers' wealth, leading to greater 

capacity to borrow and spend. 

Declining interest rates stimulate ac~ 

tivity in the exchange rate cylinder; making 

investing in U.S. assets less attractive rela~ 

tive to other countries, putting downward 

pressure on the dollar. The exchange rate 

adjustments make U.S. exports cheaper, 

stimulating employment and economic 

activity in export industries. However, what 

other countries do is important; if they 

also lower interest rates, then the effect on 

exchange rates and exports will be muted. 

From the first moments of the 

financial crisis, the Fed has worked 

diligently-often quite imaginatively-to 

While reducing the interest burden for 

borrowers, monetary policy in recent years 

has had a punishing impact on savers, 

particularly those dependent on shrinking 

interest payments. 

In the United States, economic 

growth resumed in mid-2009-but it has 

been tenuous and fragile through its first 

two-plus years. Annual growth has aver~ 

aged about 2.5 percent, one of the weakest 

rebounds of any post~WWU recovery, Stock 

prices quickly bounced back from their 

recessionary lows but seem suspended 

in trendless volatility, Home prices have 

languished. 

At the same time, job gains have been 

repair damage to the banking and financial disappointing, averaging 120,000 a month 

sectors, fight the recession, dear away from january 2010 to December 2011, 

impediments and jump-start the economy. less than half what they were in the midThe Fed has kept the federal funds to late 1990s when the !abor force was 

rate dose to zero since December 2008. To considerably smaller. Through 2011, only a 

deal with the zero lower bound on the federal funds rate, the Fed has injected billions 

of dollars into the economy by purchasing 

long-maturity assets on a massive scale, 

creating an unprecedented bulge in its 

balance sheet That has helped push down 

borrowing costs at all maturities to their 

fowest levels in more than a half century, 

third of the jobs lost in the recession have 

been regained. 

Whats Different Now? 

The sluggish recovery has confounded 

monetary policy. Much more modest Fed 

actions have produced much stronger 

results in the past. So, what's different now? 
173 

Exhibit 6 

A vehicle's engine with one cylinder misfiring may get you 

where you want to go; it jus! takes longer, The same goes lor 

the machinery of monetary policy, largely because of the 

interdependence 01 all the moving parIs, 

The Four Cylinders of the Monetary Policy Engine 

Part of the answer lies in eltcesses that 

haven't been wrung out of the economyfalling housing prices have been a lingering 

drag. Jump-starting the housing market 

would surely spur growth, but TSTF banks 

remain at the epicenter of the foreclosure 

mess and the backlog of toxic assets standing in the way of a housing revival. Mortgage credit standards remain relatively 

tight? 

Loan demand lags because of uncertainty about the economic outlook and 

diminished faith in American capitalism. 

Even though banks have begun easing 

lending standards, potential borrowers be~ 

lieye the tight credit standards of2008-10 

remain in place, 

Another part of the answer centers 

on the monetary policy engine, It stH! isn't 

hitting on aU cylinder.;, impairing the Fed's 

ability to stimulate the real economy's 

growth of output and employment. As a 

result, historically low federal funds rates 

haven't delivered a large expansion of overall 

credit. With bank lending weak, financial 

markets couldn't play their usual role in 

recovery-revving up lending by nonbanks 

to the household and business sectors, 

A vehicle's engine with one cylinder 
174 

misfiring may get you where you want to 

go; it just takes longer. The same goes for 

the machinery of monetary policy, largely 

because of the interdependence of aU the 

moving parts. When one is malfunction· 

ing. it degrades the rest. A scarcity of bank 

financial system. Bank capital is an issue of downside because most Americans came 

regulatory policy, not monetary policy. But away from the financial crisis believing that 

monetary policy cannot be effective when economic policy favors the big and wel!¥ 

a major portion of the banking system is connected. They saw a topsy-turvy world 

undercapitalized. that rev¥arded many of the largest financial 

The machinery of monetary policy institutions, banks and non banks alike, that 

credit, for example, inhibits firms' capacity hasn't worked weI! in the current recovery. 

to increase output for exports, undermining The primary reason: TBTf financial instituthe power within the exchange rate cylinder. tions. Many of the biggest banks- have sput· 

lost risky bets and drove the economy into 

aditch,ll 

These events left a residue of distrust 

for the government. the banking system, 

the Fed and capitallsm itself (Box 2). These 

psychological side effects of TBTF can't be 

measured, but they're too important to 

ignore because they affect economic be~ 

havlor. People disillusioned wjth capitalism 

aren't as eager to engage in productive actit,lities, They're likely to approach economic 

decisions with suspicion and cynicism, 

shying away from the risk taking that drives 

entrepreneurial capitalism. The ebbing of 

faith has added friction to an economy trying to regain cruising speed, 

Similarly, the contributrons to recovery tered, their balance sheets still clogged with 

from securities markets and asset prices 

and wealth have been weaker than expected. A prime reason is that burned int,lestors 

demand higher-than¥normal compensation 

for investing in private-sector projects. They 

remain uncertain about whether the fi· 

nancial system has been fixed and whether 

an economic recovery is sustainable. They 

worry about additronal financial shockssuch as the euro zone crisis. 

Sludge on the Crankshaft 

toxic assets accumulated in the boom years, 

In contrast, the nation's smaller banks 

are in somewhat better shape by some measures. Before the financial crisis, most didn't 

make big bets on mortgage-backed securi· 

ties, derivatives and other highly risky assets 

whose value imploded. Those that did were 

dosed by the Federal Deposit Insurance 

Corp. (FDIC), a government agency. 

Coming out of the crisis, the surviving 

small banks had healthier balance sheets, 

However, smaller banks comprise onty oneA fine-tuned financial system requires sixth of the banking system's capacity and 

well-capitalized banks, with the resources can't provide the financial clout needed for Shifting into Gear 

to cover losses from bad loans and invest· a strong economic rebound. looking back at the financial crisis, rep 

ments.ln essence, bank capital is a key The rationale for providing public cession and the tepid recovery that followed 

lubricant in the economic engine (see funds to TBTF banks was preserving the points to two Challenges facing the US. 

6), Insufficient capita! creates a financial system and staving off an even economy in 2012 and beyond. The short 

grinding friction that weakens the entire worse recession. The episode had its term demands a focus on repairing the 
175 

The verdict on Dodd-Frank will depend on what the final rules 

look like, So far, the new law hasn't helped revive the economy 

and may have inadvertenlly undermined growth, 

Box 2 

T!l1'F: A Pe'YerMo" oj Capttalism 

A

n unfortunate side effect of the government's massive aid to TBTf 

bonks has been an erosion of faith in American capltollsm. Ordinary 

workers and consumel'$ who mlght usually thank capitalism for their 

higher living standards have seen a peNerse side of the system, where 

they see that normaf rules of markets don't apply to the rIch, powerful and 

we!konnecled, 

Here oro some ways TBTF has vloloted basic tenets of a capifoUst system; 

without sin}' 

powerful. 

CapifCiism requires busineSS$! (trod in-dMduols. b'& held Qcc'Ounktble 

for the eOt1$eqlu:mee-s of their actlt.}l\$, Accounfablfrty is 0 key ingredient 

for maintaining public faith [n the economic system. The perceptlon-and 

the reality-is. that virtually nobody has boon punished or held account~ 

able for their roles in the financial crisis. 

The idecr that som.e- institutions. am rau inexorably 1;(00&$ the> fO{Jndolion.s Df 'Our mar/{ef·bQ5<'l>d sy$1em of capitolism. 
176 

financial system's machinery,so the impacts about the future. tions, tacking on additional requirements 

of monetary policy can be transmitted to A prolonged legislative process preced· for the big banks that pose systemic risk, 

the economy quickly and with greater force. eel the protracted implementation period, hold the riskiest assets and venture into the 

To secure the long term, the country must with bureaucratlt procedure trumping more exotic realms of the financial land~ 

find a way to ensure that taxpayers won't be decisiveness. Neither banks nor financial scape.9 Mandating larger capital cushions 

on the hook for another massive bailout. markets know what the new rules will be, tied to size, complexity and business lines 

Both challenges require dealing with and the lack of clarity is delaying repair of will give TBTF institutions more "skin in 

the threat posed by TBTF financial institu· the bank-lending and financial market parts the game" and restore some badly needed 

tions; otherwise, it will be difficult to restore of the monetary policy engine. 

confidence in the financial system and the The law's sheer length, breadth and 

capitalist economy that depends on ie. complexity create an obstade to transparThe government's prindpal response to ency, which may deepen Main Street's 

the financial crisis has been the Dodd-Frank distrust of Washington and Wall Street. 

Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law on 

July 21, 2010. Irs a sprawling. complex piece 

of legislation, addressing issues as diverse as 

banks' debit card fees and systemic risk to 

the financial sys.tem. Since Dodd-Frank be~ 

came law, at least a dozen agencies, induding the Fed, have been working to translate 

its provisions into reguladons to govern the 

financial system. They're unlikely to finish 

until 2013 at the earliest. 

The verdict on Dodd-Frank will 

depend on what the final rules look like. 

So far, the new law hasn't helped revive the 

economy and may have inadvertently undermined growth by adding to uncertainty 

especially as big institutions use their law~ 

yers and lobbyists to pratect their turf. At 

the same time, small banks worry about a 

massive increase in compliance burdens. 

Polkymakers can make their most immediate impact by requiring banks to hold 

additional capital. providing added protection against bad loans and investments. In 

the years leading up to the financial crisis, 

TBTF banks squeezed equity to a minimum. 

They ran into trouble because they used 

piles of debt to expand risky investmentsin the end finding that excessive leverage is 

lethal 

The new regulations should establish 

basic capital levels for an finandal lnstitu· 

market discipline. Overall, the revised regu~ 

latory scheme should provide incentives to 

cut risk. Some banks may eyen rethink their 

mania for growing bigger. 

Higher capita! requirements across 

the board could burden smaller banks and 

probab!yfurther crimp lending. These institutions didn't ignite the financial crisis. They 

didn't get much of a helping hand from 

Uncle Sam. They tend to stick to traditional 

banking practices. They shouldn't face the 

same regulatory burdens as the big banks 

that follow risky business models. 

TBTF banks' sheer size and their 

presumed guarantee of government help 

in time of crisis have provided a Significant 

edge-perhaps a percentage point or 

more-in the cost of raising funds. lO Making these institutions hold added capita! 

will level the playing fi-eld for all banks, 

large and small. 
177 

Higher capital requirements across the board oould burden smaller banks and probably further crimp lending, 

These institutions shouldn't face the same regulatory burdens as the big banks that follow risky business models, 

Facing higher capita! requirements, 

the biggest banks will need to raise additional equity through stock offerings or in* 

creased retained earnings through reduced 

dividends. Attracting new investment will 

be comparatively less burdensome for the 

healthiest institutions, difficult for many 

and daunting for the weaker banks. 

Dodd-Frank !eaves the details for 

rebuilding capital to several supervisory 

agencies. The specifics are stm being worked 

out; it appears banks will have until 2016 or 

2017 to meet the higher thresholds. 

Given the urgent need for restoring 

the vitality of the banking industry, this may 

seem a long wait. However, capital rebuild~ 

ing will likely take place faster as the stronger 

banks recognize the advantages of being 

first movers. Recently, many of the largest 

banks have made effortS to raise capital and 

have met or surpassed supervisory expecta~ 

tions for capital adequacy under stress 

rests.l1 

Banks that quickly dean up their 

balance sheets wilt have a better chance 

of raising new funds-so they can then be 

in shape to attract even more new capital. 

Past evidence shows that financial markets 

favor institutions that offer the best pros~ 

peets for returns with acceptable risk.u 

Laggards wi!! be worse off. finding it 

even more difficult to attract new investors. Ultimately, these institutions wi!! 

further weaken and may need to be broken 

up, their viable parts sold off to competi. 

tors. With the industry already too conce!'ltrated, it's important to redistribute these 

banking assets in a way that enhances 

overall competition, 

Ensuring that banks have adequate 

capital is essential to effective monetary 

policy, It comes back to the bank capital 

linkage, which recognizes that banks must 

have healthy capita! ratios to expand 

lending and absorb losses that normally 

occur, Repairing the damaged mechanism 

through which monetary polky impacts 

the economy will be the key to accelerating 

positive feedbacks. 

To some extent,. the Fed's zero interest 

rate polky, adopted ih December 2008 at 

the height of the financial crisis, assisted 

the banking industry's capital rebuilding 

process, It reduced banks' costs of funds 

and enhanced profitability. ButshorHerm 

interest rates cannot cro~ the zero lower 

bound, limiting any additional impact from 

this capital-building mechanism. It eQuId 
178 

be argued that zero interest rates are taxing 

savers to pay for the recapitalization of the 

TBTF banks whose dire problems brought 

about the calamity that created the original need for the zero interest rate policy, 

Unfortunately, the sluggish recovery is 

a cost of the long delay in establishing the 

new standards for bank capital. Given the 

urgent need to restore economic growth 

and a healthy job market, the guiding principles for bank capital regulation should 

be: codify and clarify, qUickly. There is no 

statutory mandate to write hundreds of 

pages of regulations and hundreds more 

pages of commentary and interpretation. 

Millions of jobs hang in the balance. 

A Potential Roadblock 

Dodd-Frank says explicitly that 

American taxpayers won't again ride to the 

rescue of troubled financia! institutions. It 

proposes to minimize the possibility of an 

Armageddon by revampihg the regulatory 

architecture. 

As part of its strategy to end TBTF, 

Dodd-Frank expanded the powers of the 

Fed, FDIC and most other existing regula~ 

tars. New watchdogs will be put on alert. 

A 10~member Financial Stability Oversight 

Council (FSOq, aided by a new Office 

of Financial Research, has been charged 

with monitoring systemic risk. It will try to 

identify and resolve problems at big banks 

and other financial institutions before they 

threaten the financial system. In an €ffort 

to increase transparency, much of the new 

information will be made public.. Opaque 

business practices thwart market discipline. 

Can Dodd-Frank do what was 

unthinkable back in 2ooS-identify and 

liquidate systemically important financial 

institutions in an orderly manner that 

minimizes risk to the financial system and 

economy? 

The current remedy for insolvent 

institutions works well for smaller banks, 

protecting customers' money while 

the FDIC arranges sales or mergers that 

transfer assets and deposits to healthy 

competitors. During the financial crisis, 

however, the FD!C didn't have the staff, 

financial resources and time to wind down 

the activities of even one truly mammoth 

bank. Thus, many TBTF institutions stayed 

in business through government support,13 

Dodd-Frank envisions new procedures for troubled big banks and financial 

institutions, directed by the FS0C watchdog and funded by fees charged to the 

biggest financial institutions. 

The goal is an alternative to the TBTF 

rescues of the past three decades. In prac~ 

tice, these rescues have penalized equity 

holders while protecting bond holders and, 

to a lesser extent, bank managers. Disciplining the management of big banks, justas 

happens at smaller banks, would reassure a 

public angry with those whose reckless decisions necessitated government assistance. 

Will the new resolution procedures 

be adequate in a major financial crisiS? 

Big banks often follow parallel business 

sttategies and hold similar assetS. In hard 

times, odds are that several bigfinancial 

institutions will get into trouble at the 

same time.14 Liquid assets are a lot less 

liquid if these institutions try to sell them 

at the same time. A nightmare scenario of 

several big banks requiring attention might 

still overwhelm even the most faNeachlng 

regulatory scheme. In all likelihood, TBTF 

could again become TMTF-too many to 

fail, as happened in 2ooS. 

A second important issue is credjbil~ 

ity. Going into the financial crisis, markets 

assumed there was government backing 

for Fannie Mae and Freddie Mac bonds 
179 

A financial system composed of more banks-numerous 

enough to ensure competition but none of them big enough 

to put the overall economy in jeopardy-will give the United 

States a better chance of navigating through future financial 

potholes, restoring our nation's faith in market copltalism, 

despite a lack of explicit guarantees. When 

push came to shove, Washington rode to 

the rescue. Similarly, no specific mandate 

existed for the extraordinary governmental 

assistance provided to Bear Stearns, AIG, 

Citigroup and Bank of America in the midst 

ofthe financial crlsiS.15 lehman Brothers 

didn't get government help, but many of 

the big institutions exposed to lehman 

did.16 

Words on paper only go so far. What 

matters more is whether bankers and their 

tutions.ln the fUNre, the ultimate decision 

won't rest with the Fed but with the Trea· 

sury secretary and, therefore, the president. 

The shift puts an increasingly political 

cast on whether to rescue a systemically 

important financial institution. (It may be 

hard for many Americans to imagine political leaders sticking to their antHBTF guns, 

especially if they face a too-many-to-fail 

situation again.) 

If the new law lacks credibility, the 

risky behaviors of the past win likely recur, 

creditOrs actually believe Dodd-Frank puts and the problems of excessive risk and 

the government out of the financial bailout debt could lead to another financial crisis, 

business. If $0, both groups will practice Government authorities would then face 

more prudent behaVior. 

Dodd-Frank has begun imposing 

the same edge-of-the-precipice choice they 

did in 200B-aid the troubled banking 

some market discipline and eroding the big behemoths to buoy the financial system or 

banks' cost-of-funds advantage, Creditrating agencies have lowered the scores 

for some larger banks, recognizlng that the 

law reduces government bailout protections that existed just a few years ago and 

risk grave consequences for the economy. 

The pretense of toughness on raTF 

sounds the right note for the aftermath of 

the financial crisis. But it doesn't give the 

watchdog FSOC and the Treasury secretary 

[hat Washington's fiscal problems limit its the foresightand the backbone to end 

ability to help beleaguered financial institu- TBTF by closing and liquidating a large 

tions in a financial emergency. financial institution in a manner consistent 

While decrying TBTF, Dodd-Frank with Chapter 7 of the U.s. Bankruptcy Code 

lays out conditions for sidestepping the Box 'I), The credibility of Dodd-Frank's 

law's proscriptions on aiding financial lnsti- disavowal ofTBTF will remain in question 
180 

unti! a big financial institution actually fails mate solution for TBTF-breaking up the out of existence. They arise from human 

and the wreckage is quickly removed so the nation's biggest banks into smaller units.17 weaknesses-the complacency that comes 

economy doesn't slow to a halt. Nothing It won't be easy for several reasons. First, from sustained good times, the greed and 

would do more to change the risky behav~ 

jar of the industry and its creditors. 

For all its bluster, Dodd-Frank leaves 

TBTF entrenched, The overall strategy 

for dealing with problems in the financial 

industry involves counting on regulators to 

reduce and manage the risk. But huge insti~ 

tutions still dominate the industry-just as 

they did in 200K In fact, the financial crisis 

increased concentration because some 

TBTF institutions acquired the assets of 

other troubled TBTF institutions, 

The TBTF survivors of the financial 

crisis look a lot like they did in 2008, They 

maintain corporate cultures based on the 

shorNerm incentives of fees and bonuses 

derived from increased oligopoly power, 

They remain difficult to control because 

they have the lawyers and the money to re~ 

sist the pressures of federal regulation. Just 

as important, their significant presence in 

dozens of states confers enormous political 

clout in their quest to refocus banking stat~ 

utes and regulatory enforcement to their 

advantage. 

The Dallas Fed has advocated the ultlthe prospect raises a range of thorny issues irresponsibility that run riot without marabout how to go about slimming down the ket discipline, the exuberance that overbig banks. Second the level of concentra- rules common sense, the complicity that 

tion considered safe will be difficult to results from going along with the crowd. 

determine, Is it rolling things back to 1990? 

Or 197m Third. the political economy of 

TBTF suggests that the big financial institUtions will dig in to contest any breakups, 

Taking apart the big banks isn't cost~ 

less. But it is the least costly alternative, and 

it trumps the status quo,18 

A financial system composed of 

more banks, numerous enough to ensure 

competition in funding businesses and 

households but none of them big enough 

to put the overall economy in jeopardy, 

wi!! give the United States a better chance 

of navigating through future financial 

potholes and precipices, As this more 

level playing field emerges, it will begin to 

restore our nation's faith in the system of 

market capitalism, 

Taking the Right Route 

Periodic stresses that roil the financial 

system can't be wished away or legislated 

We should be vigilant for these failings, but 

we're unlikely to change them. They're a 

natural part of our human DNA. 

By contrast, concentration in the 

financial sector is anything but natural. 

Banks have grown larger in recent years because of artificial advantages, particularly 

the widespread belief that government will 

rescue the creditors of the biggest financial 

institutions. Human weakness will cause 

occasional market disruptions, Big banks 

backed by government turn these manageable episodes into catastrophes, 

Greater stability in the financial sector 

begins when TBTF ends and the assumption of government rescue is driven from 

the marketplace. Dodd-Frank hopes to 

accomplish this by foreswearing TBTF, 

tightening supervision and compiling more 

information on institutions whose failure 

could upend the economy. 

These well-intentioned initiatives may 
181 

be laudable, but the new law leaves the 

big banks largely intact, TBTF institutions 

remain a potential danger to the financial 

system, We canet be sure that some future 

government won't choose the expediency 

of bailouts oVer the risk of severe recession 

or worse. The only viable solution to TBTF 

lies in reducing concentration in the bank~ 

ing system, thus increasing competition 

and transparency. 

The road to prosperity requires re~ 

capitalizing the financial system as quickly 

as possible. The safer the individual banks, 

the safer the financial system. The ultimate 

destination-an economy rela6vely free 

from financial crises-won't be reached 

until we have the fortitude to break up the 

giant banks. 

Harvey Rosenblum is the Dallas Fed's 

executive vice president and director of 

research, Special mention and thanks go 

to Richard AIm for his journalistic assis~ 

tance, to David Luttreff jor research and 

documentation and to Samantha Coplen 

and Darcy Melton/or their artistry in the 

exhibits. 

The road to prosperity requires recapitalizing the financial system as quickly as possible, Achieving an economy relatively 

free from financial crises requires us to have the fortitude to 

break up the giant bonks, 

Noles 

1 "Toming the Credit Cycle by limtling High-Risk 

lending: by Jeffery W, Gunther, Federal Reserve 

Bank of Dallas Economic Letter. vol. 4, no, 4, 2009, 

~ See speech by U.S< Attomey General Eric 

Holder, Columbia Universrty Law SchooL New 

Yoo:. City, Feb, 23, 2012. in Which he noted that 

'much of the conduct thot led to the financial 

crisis was unethical and irresponsible .. but this 

behovior-whi!a morally reprehensible-may 

not necessarily have been cnmino!.' www. 

justice.gov lisa! opal ag /speeches/20l2/agspeech-120223Nml 

3 A structured investment vehicle (SIV) is an 'offbaiance-sheat'legal entity thot issues securities 

collafera!1zed by loons or other receiyabfes from 

a separate but relafed entity while investing in 

assets of longer maturity, Several ot the largest 

bonks used SIVs to issue commercial paper to 

fund investments in high-yielding securitized 

assets. Wher'l these risky assets began to default, 

the banks reluctant1y took them back onto their 

balance sheets and suffered large writa.-dawns, 

·In conjunction with the 1984 rescue of Continental Bank. the Comptroller of the Currency, 

the supervisor of nationally chartered bonks, 

acknowledged the TBTF status of the largest 

banks. see "U,S, \Von'! Let 11 Biggest Bonks in Nation Foil.' byTim Carrington. 'MJII Street Journal, 

Sep1.20, 1964. 

$ In 2008 and 2009, the Federal Deposif Insurance Corp, (FDIC) facilitated the failure of 165 

institutlons with $542 billion in assets. The largest 

bcmk failure in hiStory occurred when Washington Mutual shuttered its dOOIs in late september 

2008, its $307 billion in assets accounting for 

the lion's share of/he $372 billion total of tailed 

instHulions' assets thot year. Although staggering, 

the omount of capilOl drained from the banking 

system due 10 failures during the crisis pedes fn 

comporison with the $3.2 tril!lon in assets ossociafed with instillilions receiVing extraordinary 

assistance from the FDIC during this penod. mast 

01 it involving just two entities, Crtigroup and 

Bonk of America. 

6 'Regulatory and Monetary Policies Meet 'Too 

Big to Fail," by Harvey Rosenblum, Jes$iCo:l K, 

Renier and Richard A!m. Federal Reserve Bank of 

Dollas Economic Letter, vo1. 5, no, 3, 20lO 

1 According to the July 2011 Federal Reserve 

Senior Loan Officer Opinion Survey. a majority 

of large bonks have edsed standards for consumer loans and for commercial on<;l industrial 

loans, However, credtl standards on residential 

and commercial reOl eslOte lending remain 

tight oYer the period since 2005. 

'Taxpayers' money 'NOsn't 'givenH to the banks, 

It was loaned, and most loans have been 

repaid with interest Neverfheless, the perc:ephon remains that boiloul dollars were gifts. And 

perception drives public sentiment 

, At this lime (March 2012). it appeQrslhat bank 

capitol regulations under Dodd-Frank will follow 

the Basel !II framework, with copital surcharges 

of at leasf 1 percentage point imposed on 

globa! systomlcolly important financial Institutions (G-SIFls).ln addition, a mare reollslic 

definition of capitol is likely to be put in place fo 

avoid a repeat of the situotion in 2008-09, when 

f\vo of the largest banks were never rated less 

than "odequately capitalized' of the height of 

the crisis, while at the some time they together 

received hundreds of billions in capitol infusions 

and loon guarantees and never made it onto 

the FDIC's Problem Bank Ust. 
182 

lD Soo "How Much Did Banks Pay to Become 

Too-Big-tofoif and fa B€!came Systemically 

Important?: by Elijah Brewer !II and Julapa 

JogtionL Federal Reserve Bonk of Philadelphia, 

Working Paper no, 11--37. 2011. and the literature 

cited therein, 

11 The Federal Reserve's Comprehensive Capital 

Analysis and Review (CCAR) evaluates the capito! Planning processes and copilol adequacy 

of the lorgest bank holding companies. This exerciss includes 0 supervisory stress test to evaluate 

whether firms would have sufficient capitol in 

times of severe economic and finanCial stress. 

In the CCAR !'EMul!s released on MarCh 13,2012, 

15 of the 19 bank holding cornp:mies were 

es~ma1ed to maintain capitol ratios above 

regulatory minimumleveis under the hypothetical stress scenario, even after considering the 

proposed capital actions, such as dividend 

increases or share buyback.s. For more information, see www,federalreserve.gov/newsevents/ 

press/bcreg/20120313a.htm 

121n the early 199Qs, financial markets raworded 

banks for increasing their capital-to-osset ratios. 

Banks that held more capitol hod higher retums 

an equity (ROE) primarily because of reduced 

interest rams paid for uninsured liabilities. 

See "Banking in Ihe 21st Century: by Alan 

Greenspan. remarks 01 the 27th Annual Conference on Bank structure and competition. Federal 

Reserve Bank of Chicago, May 2, 1991, especialty 

pp. 9-10.1n addition, bonks were f9V{arded wilh 

higher equity prices for dividend retention and 

issuance of new stock, two methods of raising 

capitol that bankers generally cblm will reduce 

stock prlces. See 'Bank Copllol Ratios, Asset 

Growth and the Slack Morket: by Richard Cantor and Ronald Johnson, Foderal Reserve Bonk 

of New York FRBNY Quarterly Review. Autumn 

1992. pp. 10-24 (emphasis added) 

II For OtHer large nonbank financial firms (for 

example, lahman Brothel1;,AIG and Bear 

steams) and for bank holding companies, there 

was na resolution authority at oll.The chOice 

came down to buyouts. bankruptdes or bailouts 

(see Bo;.: 1). WITh no priva1e-sedor buyers willing 

to step up. and wUh bankruptcy generally a 

long and uncertain process, government intervention in tha fOrm of bailouts become the least 

disruptive alferna1ive, of least in the short run. 

14The FDIC estimates that it could have 

performed an orderly liquidation of lehman, if 

it had Dodd-Frank powers six months befOre 

Lehman declared Chapter 11 bankruptcy in 

September 2008, and would have paid creditors 

97 percent of what they were owed. But this assumes that other giontfinancio! Institutions did 

not require simuttnneous and similar attention. 

15 On Melreh 24, 2008, the Federal Reserve Bonk 

of New York announced that it would provide 

Sept, 15, 2008, the world's largest underwriter of 

mortgage bonds, lehman Brothers, llIed for Ihe 

world's largest bankruptcy with listed liabilities of 

$613 bi\l1on.lhe fallowing day, one of the world's 

largest insurance organizations and counterparties for credit defaul! swaps, AIG. received 

Federal Reserve support: an $B5 tiUion secured 

credft facility amid credit rating downgrades 

and financial market panic. On Nov, 23, 2008, 

the Treasury, federal Reserve and the FDIC 

entered into on agreement with Citigroup to 

provide a package of guarantees. liquidity GCcess and nonrecourse capital to proiect against 

losses on on asset pool of approxfmalely $306 

billion of loons and securitles.On Jan. 16, 2009, 

a similar government !oon-loss agreement was 

offered fa Batik of America, bock.stopping on asset pool of $118 billion, a large majority of which 

was assumed as a resutt of BofAs acquisition of 

broker-dealer MElrrililynch, 

I' More than three years have passed since 

the lehman bankruptcy, A vigorous debate 

persists regarding (1) whether the fed could 

have found a way to boil out Lehman and 

(2) whether thiS might have avoided a global 

financial and economic collapse. Using doto 

from \ate 2008 and early 2OQ9 shown in Exhibit 

3. the inescapable onS';V8:r to ba1h questions is 

tt would not have mattered.Two days 10ter,AlG 

was essentially nationalized, and within a matter 

of a few months. the already imbedded but unrecogniZed and undisclosed losses at CltIgroup 

and Bonk oi America necessitated a combined 

Fed and FD!C Qssislonce package that quasinationalized these institutions. The extent of 

these losses was disavowed by managements 

up until assistance pockages were announced 

17"Toming the To0--8ig-to-foils:WiIi Dodd-Fronk 

Be the Ticketor Is lap.J3ond SurgeI)' Required?: 

speech by Richard fiSher, president and chief 

executive officer of the Federal ReseNe Bonk of 

Dollas, Columbia University's Politics and Busi· 

ness Club, New York City, Nov. 15. 2011; 'Financial 

Reform or Financial Dementia? <" by Richard 

Fisher. Southwest Graduate School of Banking 

53rd Annual Keynote Address, Dallas, June 3, 

2010; 'Paradise last: AddreSSing 'Too Big to Foil," 

speech by Richard Rsher, Cato Institute's 27th 

Annual Monetary Conference, Washington, D.C" 

Nov. 19,2009. 

II Evidence of economies of scale (that is, reduced average costs associated wilh increased 

sidies enjoyed by the largest banks. especially 

after the government intervenfions and bailouts 

of 2008 and 2009, See 'Scale Economies Are a 

Distraction: by Robert DeYoung. Federal Reserve 

Bank of Minneapolis The Region, Sepfember 

2010, pp. 14-16. as well os Brewer and JogtianL 

note 10. However. Dodd-Frank seeks to reduce 

these WTF s\Jbsidies,