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S. HRG. 112–270 

DEBT FINANCING IN THE DOMESTIC FINANCIAL 

SECTOR 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS AND CONSUMER 

PROTECTION 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

CAPITAL REQUIREMENTS AND DEBT FINANCING IN THE DOMESTIC 

FINANCIAL SECTOR 

AUGUST 3, 2011 

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

( 

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

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

LEVON BAGRAMIAN, Hearing Clerk 

JANA STEENHOLDT, 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, AUGUST 3, 2011 

Page 

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

WITNESSES 

Joseph E. Stiglitz, Ph.D., Professor of Finance and Economics, Columbia 

Business School, Columbia University ............................................................... 4 

Prepared statement .......................................................................................... 27 

Response to written question of: 

Senator Shelby ........................................................................................... 47 

Edward J. Kane, Ph.D., Professor of Finance, Boston College ............................ 6 

Prepared statement .......................................................................................... 31 

Response to written question of: 

Senator Shelby ........................................................................................... 47 

Eugene A. Ludwig, Chief Executive Officer, Promontory Financial Group ........ 9 

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

Response to written question of: 

Senator Shelby ........................................................................................... 49 

Paul Pfleiderer, Ph.D., C.O.G. Miller Distinguished Professor of Finance, 

Graduate School of Business, Stanford University ........................................... 12 

Prepared statement .......................................................................................... 38 

Response to written question of: 

Senator Shelby ........................................................................................... 49 

(III)

(1) 

DEBT FINANCING IN THE DOMESTIC 

FINANCIAL SECTOR 

WEDNESDAY, AUGUST 3, 2011 

U.S. SENATE, SUBCOMMITTEE ON FINANCIAL INSTITUTIONS, AND CONSUMER PROTECTION, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Subcommittee met at 2:04 p.m., in room SD–538, Dirksen 

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

OPENING STATEMENT OF SENATOR SHERROD BROWN 

Senator BROWN. Thank you for joining us. The Subcommittee on 

Financial Institutions and Consumer Protection of the Senate 

Banking Committee will come to order. 

Thank you very much for joining us today, the four witnesses 

and those in the audience and staff. Thank you. I know that when 

you schedule a hearing, when you schedule it ahead of time, you 

do not always really know, but when there is one that happens 

after people start leaving town, there is no telling what will happen. So I am just honored the four of you still showed up and that 

staff on both sides showed up and have been helpful in the planning of this hearing. 

I will do an opening statement, then have each of you do the 

same, and the questions and answers may be a little more free 

flowing than they might at another hearing. I am going to probably 

ask you to respond to each other’s assertions and statements and 

observations. All four of you are highly respected in these fields 

and have thought a lot about this and reflected a lot about this, 

and so it should be an interesting discussion for an hour or so. 

The recent debate that we just concluded—and mercifully is concluded, or at least round one is—obviously was fixated on the national debt, but it was more than just the national debt that we 

should be worried about. Too many people in Washington seem to 

have forgotten about the debt that helped put us in this deep recession and cost our country and almost everyone in it so much, and 

that is the debt of the financial sector. 

CBO estimates the entire cost of rescuing our failing banking 

system—the bailouts, decreased tax revenues, new spending programs in response to the trouble economy, and interest payments— 

will cost our Nation some $8.6 trillion, meaning 8 thousand billion 

dollars. That is more than 57 percent of our GDP. We cannot allow 

collective amnesia to obscure the role that excessive financial serv-
2 

ice debt played in causing the deepest recession since the Great Depression, and that really is the purpose of this hearing. 

In nearly the last century and a half, U.S. banks’ capital ratios 

declined from about 25 percent—and all of you have written and 

thought about this a lot—to around 5 percent of total assets. In the 

last two decades, the 10 largest banks nearly doubled their leverage—that is, they have halved assets, if you will, that they have 

available to pay off that debt. 

At the time of the financial crisis in 2007–08, four of our five 

largest investment banks were leveraged 30, 35, and in one case 

40 to 1. That means when their assets declined by even the smallest amount, they were unable to cover to pay their debts. They 

were essentially insolvent, as we know. This overreliance on borrowing from other businesses makes the financial system so interconnected, so interdependent that the failure of one firm can bring 

down the entire sector, if not the entire economy. The implicit assumption that the Government will backstop their losses gives companies an incentive to engage in what economists George Akerlof 

and Paul Romer have called ‘‘looting.’’ Companies can risk bankruptcy at the expense of the rest of society instead of bearing the 

losses themselves. 

According to Kansas City Fed President Thomas Hoenig, the 20 

biggest banks are more highly leveraged than their community 

bank competitors—if I can use that word ‘‘competitors’’ in that 

case. The largest banks are able to borrow more cheaply than they 

otherwise would because it is assumed that the Government will 

step in to prevent them from failing. 

As a result, the largest banks make bigger profits than those do 

not enjoy Government subsidies of one form or another. They are 

least able to weather an economic downturn because of that significant leverage. And not surprisingly, the largest banks are often 

bigger than before. Prior to 2006, the 10 largest banks held 68 percent of total bank assets. By the end of 2010, they had 77 percent 

of total banking assets. 

Simply put, were there another economic calamity, bailing these 

banks out again would impose an even higher cost on taxpayers. 

This is not capitalism in any sense of the word. The easiest way 

to prevent the need for future bailouts is simple: requiring banks 

to hold increased capital reserves. Capital buffers simply require 

banks to fund themselves using their own money instead of other 

people’s money. 

Last Tuesday, the Ranking Member of the full Committee, Senator Shelby, said one of the lessons of the financial crisis should 

be the importance of maintaining strong capital requirements, especially for large global banks. I could not agree more. The least 

we can do is ask the financial sector to have a prudent amount of 

its own money to cover its own losses. We require as much of our 

community banks, much less a SIFI, much less a threat to our system, and the same rules should apply to everyone. That is why we 

are having this hearing today and testifying are some of the Nation’s greatest economic minds that have great insight into all of 

this. 

Let me introduce each of the four of you, and then we will call 

on all four of you and work our way across. 
3 

Joseph Stiglitz, born in Gary, Indiana, in 1943, has taught at 

Princeton, Stanford, MIT, and was Drummond Professor and Fellow at All Souls College in Oxford. He is now a university professor 

at Columbia and co-chair of Columbia’s Committee on Global 

Thought. He is the co-founder and executive director of the Initiative for Policy Dialogue there. He was awarded the Nobel Prize in 

Economics 10 years ago for his analyses of markets with asymmetric information. He was lead author of the 1995 report on the 

Intergovernmental Panel on Climate Change, which shared the 

2007 Nobel Peace Prize. Stiglitz was a member of the Council of 

Economic Advisers in the early Clinton years and served as chair 

from 1995 to 1997. He then became chief economist and senior vice 

president at the World Bank from 1997 to 2000. Dr. Stiglitz, thank 

you for joining us. 

Edward Kane is a professor of finance at Boston College. For 20 

years he held the Everett Reese Chair of Banking and Monetary 

Economics of Ohio State University and had the bad judgment to 

leave. 

[Laughter.] 

Senator BROWN. Currently he consults for the World Bank and 

is a senior fellow in the Federal Deposit Insurance Corporation’s 

Center for Financial Research. Previously, Dr. Kane has consulted 

for numerous agencies, including IMF, components of the Federal 

Reserve System, and three foreign central banks. He has consulted 

for the Congressional Budget Office, the Joint Economic Committee, and the Office of Technology Assessment when we had one 

in the U.S. Congress. 

Eugene Ludwig is founder and chief executive officer of Promontory Financial Group, the leading consulting firm for financial 

companies worldwide. Prior to founding Promontory, Mr. Ludwig 

was vice chair and senior control officer of Bankers Trust Deutsche 

Bank. Earlier he served for 5 years as Comptroller of the Currency. 

As Comptroller, Mr. Ludwig headed the Office of the Comptroller 

of the Currency, the Federal agency responsible for supervising the 

preponderance of bank assets in the U.S. Prior to being Comptroller, he was a partner in the law firm of Covington & Burling 

in Washington, specializing in banking law. 

And last, Paul Pfleiderer received a B.A., a Master of Philosophy, 

and Ph.D. degrees from Yale, all in the field of economics. He has 

been teaching at Stanford for some 30 years. His research, much 

of which is jointly pursued with Anat Admati, another professor of 

finance at the GSB, is generally concerned with issues that arise 

when agents acting in financial markets are differentially informed. His current research concerns corporate governance. In addition to his academic research, Professor Pfleiderer has consulted 

for various companies and banks. He has been involved in developing risk models and optimization software for use by portfolio 

managers. 

Dr. Stiglitz, if you would begin. 
4 

STATEMENT OF JOSEPH E. STIGLITZ, PH.D., PROFESSOR OF FINANCE AND ECONOMICS, COLUMBIA BUSINESS SCHOOL, COLUMBIA UNIVERSITY 

Mr. STIGLITZ. Well, thank you for this opportunity to address the 

question of the financial structure of the banking industry, which 

I believe is central to the future stability and prosperity of the 

American and global economy. And let me thank you, Senator 

Brown, for holding these hearings. 

Two fundamental analytic insights, buttressed by some empirical 

observations, should inform our thinking about the appropriate 

regulation of banks, including capital requirements and risk taking. The first is that when information is imperfect and risk markets incomplete—that is, always—there is no presumption that unfettered markets will result in efficient outcomes. The reason is 

that actions give rise to externalities, consequences that are not 

borne by those undertaking them. There is a systematic misalignment of private and social returns. 

This result is of central importance in banking and finance because the very rationale for the sector arises out of risk management and the acquisition and utilization of information necessary 

for the efficient allocation of capital. The externalities consequent 

to the excessive risk taking of the banks are manifest: It is not just 

the costs of the bailouts and the millions of Americans who have 

lost their homes, but the literally trillions of dollars of lost output, 

the gap between the economy’s actual and potential output, the 

predictable and predicted fallout of the crisis. The resulting suffering—including that of the 25 million Americans who would like 

a full-time job and can’t get one—is incalculable. The budgetary 

problems facing the country too are in no small measure a result 

of the inevitable decline in revenues and increase in expenditures 

that follow. It is well known that recoveries from financial crises 

are slow and painful. 

This crisis not only demonstrated the importance of the 

externalities to which failures in financial markets give rise, but 

also the importance of what economists call agency problems— 

those, like bank officials, who are supposed to take actions on behalf of others, who have a fiduciary responsibility, often have incentives that lead them to take actions that benefit themselves at 

the expense of those they are supposed to serve. 

The second fundamental insight is that increased leverage in 

general does not create value, but simply shifts risk. As leverage 

increases, increased risk is placed on the equity base. This is the 

central insight of the Modigliani-Miller theorem. In the 1960s and 

1970s, I showed that that result was far more general than 

Modigliani-Miller had thought, but that there were limitations too, 

most of which cautioned against excessive leverage: If there were 

real costs to bankruptcy (as there are), then increased leverage increased the likelihood of these dissipative costs. 

In the financial sector, the social costs of increased leverage are 

even greater because of the societal costs associated with the 

externalities that I described earlier. The misalignment of incentives is even more in the case of too-big-to-fail banks—banks that 

are so large that the potential consequences of allowing them to go 

bankrupt poses an unacceptable risk. 
5 

The key empirical observation is that markets are often not rational in assessing risk; this is true even of the so-called experts, 

but even more so of those who are financially unsophisticated. Alan 

Greenspan testified to this before Congress when he expressed his 

surprise that the financial markets had not managed risk as well 

as he had expected. But while he was correct in the conclusion that 

financial markets had done a miserable job of managing risk, I was 

surprised at his surprise. After all, anyone looking at the incentive 

structures confronting key decisionmakers should have realized 

that they had incentives for excessive risk taking and short-sighted 

behavior. 

But beyond that, Greenspan made another error: If I mismanage 

risk, if I am irrational in my risk analyses, I and my family suffer, 

but there are unlikely to be societal consequences. But if a bank 

and especially a very large bank mismanages risk, the macroeconomy can be seriously affected. There are externalities. It is 

these externalities that provide the motivation for Government programs. It is these externalities that explain why self-regulation 

simply will not work. It is deeply troubling when the country’s 

major financial regulators do not understand the rationale for regulation. 

Rational markets would realize that increasing leverage shifted 

risk and would demand compensating differentials. As we see 

banks striving to increase their leverage, there may be uncertainty 

about what is driving this. Is it because in doing so, they increase 

the implicit subsidy from the Government? Is it because they do 

not understand the fundamentals of risk? Is it because they understand the fundamentals of risk, but realize that their bondholders 

and shareholders do not, so that they can extract more money for 

themselves? But about this there is no uncertainty. Excessive leverage has large societal costs. Banks, and especially the big 

banks, need to be restrained. 

Indeed, the analysis above suggests that there are few or no societal costs to doing so and considerable benefits. It is not as if leverage somehow manufactures resources out of thin air. Lending is 

risky. The risk has to be borne somehow. It is borne by equity holders of lending institutions—to the extent it is not shifted to Government, FDIC, bondholders, or depositors. It is better to have it better distributed, among a large equity base, given the high social 

costs of financial disruption. 

Recent empirical research has provided considerable support for 

the views expressed here. Even if there were some increases in 

lending costs as a result of increased equity requirements, those 

costs have to be offset against the benefits. 

There are very large societal costs from bank failures, as I said 

before, and these can be substantially reduced by higher equity requirements. 

Some have argued that even if it makes sense in the long run 

to increase capital requirements, doing so in the short run can be 

costly, especially at a time such as this when the economy is fragile 

and the banking system already weak. At most, this is an argument for a paced increase in capital requirements and one which 

would not allow any dividends or share buybacks or extravagant 

bonus pools until the desired capital ratios are reached. But one 
6 

should at the same time be aware of the large risks, especially 

under the current circumstances, of delay. It is precisely because 

the economy is fragile, banks have inadequate capital, and the 

banking sector in the aftermath of the crisis is more concentrated 

than before that the risk of a financial catastrophe of the kind that 

we experienced in 2008 is so great today. The downside risks of not 

doing something are especially grave now. 

I have focused my remarks this afternoon on increasing banks’ 

equity capital. There are a number of other factors affecting the 

risk to the economy posed by the banking and financial sector. I 

have noted the risk of too-big-to-fail banks. We should not allow 

any bank to grow to a size that it poses a systemic risk to the economy. Yet in the aftermath of the crisis, as you pointed out, the 

banking sector has become more concentrated, and the risk posed 

by too-big-to-fail banks has, if anything, increased. We saw too in 

the crisis that the risks posed by non-transparent transactions, 

such as over-the-counter CDSs and off-balance-sheet activities. One 

of the reasons that the financial system froze was that everyone 

knew that there was no way that they could know the true financial position of most of the banks. While the Dodd-Frank bill improved matters, it went nowhere far enough. The problems continue, and as long as they continue, our economy is at risk. 

We may never fully protect the economy against the risk of another crisis such as the one we have been through. But this much 

should be clear: Our economic and financial system is badly distorted. Resources were misallocated before the crisis. No Government has ever wasted resources—outside of war—on the scale that 

has resulted from the failures of America’s financial system. We 

may have begun the work of making our financial system once 

again become the servant of the society which it is supposed to 

serve, but there is a long way to go. Lending, especially to smalland medium-sized enterprises, is constrained. Activities that pose 

unnecessary risks to our entire economy continue. 

We cannot rely on the self-restraint or self-regulation of financial 

markets. We learned that lesson in the aftermath of the Great Depression, and the decades following World War II, with this strong 

regulatory system, were among the most prosperous this country 

has experienced. The question is: Will we relearn that lesson in the 

aftermath of the Great Recession of 2008? 

Senator BROWN. Thank you, Dr. Stiglitz. 

Dr. Kane, thank you for joining us. 

STATEMENT OF EDWARD J. KANE, PH.D., PROFESSOR OF 

FINANCE, BOSTON COLLEGE 

Mr. KANE. Thank you, Mr. Chairman. It is an honor and privilege to share with you my concerns about the distributional effects—— 

Senator BROWN. Is your microphone on? 

Mr. KANE. Shall I start again? 

Senator BROWN. Go ahead. 

Mr. KANE. [Continuing] The distributional effects of making taxpayers back up Treasury and Federal Reserve bailouts of insolvent 

and ungrateful financial institutions. 
7 

During the housing bubble, our representative democracy better 

served the interests of foreign and domestic financial institutions 

than the interests of society as a whole, as Joe Stiglitz has been 

saying. But why were taxpayer interests poorly represented? It is 

because of regulatory capture. 

The financial industry sewed huge loopholes into the capital requirements and regulatory definitions of risk that—then and now— 

are supposed to keep financial instability in check. The Dodd-Frank 

Act left many critical issues open. It did not try to define ‘‘systemic 

risk’’ or to confront the ongoing foreclosure mess and Fannie and 

Freddie disasters. And implementation of its strategy for dealing 

with regulation-induced innovation and for disciplining lead institutions is left to regulators. The Keating 5 episode tells us how 

hard it can be for regulators to write rules that truly crack down 

on politically influential firms. Sadly, the same gaps and issues 

exist in reform efforts unfolding in Basel and in the European 

Union. 

The issue before us is to put reform on a more promising path. 

To me, this means Governments must do three things: redefine the 

supervisory missions of regulatory agencies, rework bureaucratic 

incentives in these agencies, and refocus reporting responsibilities 

for regulators and for protected institutions on the value of taxpayers’ safety net support. Unless these duties are embraced explicitly and enforced in an operational and accountable way, it is 

unreasonable to believe that authorities will adequately measure 

and contain systemic risk during future booms and busts, let alone 

in the bust we are still living through today. 

A first step would be to strengthen training and recruitment procedures for top regulators. As you know, most top regulators leave 

behind them, under current appointment procedures, a trail of political debts they have to surface. If it were up to me, I would establish the equivalent of an academy for financial regulators and 

train cadets from around the world. Among other things, students 

would be drilled in the duties they owe the citizenry and in how 

to overcome the unhealthy political pressures elite institutions 

exert when and as they become undercapitalized. 

The public recognizes that the Fed and Treasury rescue programs placed heavy and less than fully acknowledged burdens on 

the citizenry. Evaluating Fed and TARP rescue programs against 

the unrealistic standard of doing nothing at all, high officials tell 

us that their bailout programs were necessary to save us from an 

economic depression and actually made money for the taxpayer. 

Both claims are false, but in different ways. 

Bailing out firms indiscriminately—and the lack of discrimination is the point—hampered rather than promoted economic recovery. It evoked reckless gambles for resurrection among rescued 

firms and created uncertainty about what set of citizens would finally bear the extravagant costs of these programs. Both effects 

continue to disrupt the flow of credit and real investment that is 

necessary to trigger and sustain economic recovery. 

The claim that the Fed and TARP programs actually ‘‘made 

money’’ for the taxpayer is half-true. The true part of the proposition is that, thanks to the vastly subsidized terms of these programs, most institutions were eventually able to repay the formal 
8 

obligations they incurred. But the other half of the story is that 

these rescue programs forced taxpayers to provide undercompensated equity funds to deeply troubled institutions, and that the 

largest, as you said, and most influential of these firms were allowed to make themselves bigger and even harder to fail. 

Government credit support transferred to taxpayers the bill for 

past and fresh losses at protected firms. Authorities chose this path 

without weighing the full range of out-of-pocket and implicit costs 

of indiscriminate rescues against the costs of alternative programs 

such as prepackaged bankruptcy or temporary nationalization and 

without documenting differences in the way each deal would distribute benefits and costs across the population of this country. 

Going forward, the crucial problem is how to relate capital requirements to systemic risk. We do want to raise capital requirements, but we have to relate them to more securely systemic risk. 

Acting in concert, market and regulatory discipline force a firm 

to carry a capital position that outsiders regard as large enough to 

support the risks it takes. Taxpayers become involved in capitalizing major firms because creditors regard the conjectural value of 

the off-balance-sheet capital that Government guarantees supply as 

a put option—a ‘‘taxpayer put’’—that serves as a partial substitute 

for on-balance-sheet capital supplied by the firm’s shareholders. So 

Citicorp was not undercapitalized. It was just capitalized too heavily with its taxpayer put. 

So the root problem is that supervisory conceptions of capital and 

systemic risk fail to make Government officials and protected firms 

accountable for the roles they play in generating adverse movements in either variable. Policymakers’ knee-jerk support of creative forms of risk taking among the client firms they supervise 

and officials’ proclivity for absorbing losses in crisis situations 

make sure that tough decisions favor industry interests over those 

of the taxpayer. 

Systemic risk can be likened to a disease that has two symptoms. 

The Dodd-Frank Act and the Basel III framework use higher capital requirements to treat only the first of these symptoms: the extent to which institutions expose themselves in directly and readily 

observable ways to credit risks that in extremis might fly across a 

chain of connected counterparties. But to be effective, the medicine 

of capital requirements must be adapted to take fuller account of 

a firm’s funding patterns and to treat a second and more subtle 

symptom. This second symptom is the ease with which actual or 

potential living-dead institutions can use financial accounting 

tricks and innovative instruments to hide risk exposures and to accumulate fresh losses until their insolvency becomes so immense 

that they can drive regulators into a panic and extort life support 

from them. 

So in good times and in bad, the existence of this ‘‘taxpayer put’’ 

allows elite private institutions to issue the equivalent of Government debt and makes ordinary citizens uncompensated equity investors in such firms. 

My recommendations for regulatory reform are rooted in the 

straightforward ethical contention that protected institutions and 

regulatory officials owe fiduciary duties to taxpayers. The existence 

of a safety net makes taxpayers silent equity partners in major fi-
9 

nancial firms. Not only are they silent partners, they are uncompensated or poorly compensated partners. So as de facto investors, 

taxpayers deserve to be informed at regular intervals about the 

value of their side of the taxpayer put. Consistent with U.S. securities laws, managers of important financial firms should measure 

and report under penalties for deception and negligence the value 

of taxpayers’ stake in their firm on the same quarterly frequency 

that they report to stockholders, and Government officials should 

examine, challenge, aggregate, and publicize this information. 

My two-piece conception of systemic risk clarifies that it is embodied in a coercive option-like equity investment by taxpayers in 

the firms the safety net protects. The value of taxpayers’ position 

varies with the risk that an institution might sustain losses that 

exceed its ownership capital—a guaranty that is often called ‘‘tail 

risk’’ by economists—and with the percentage of this tail risk that 

the Government is likely to absorb. It is one of these bets that 

heads, the institution wins, and tails, the taxpayer loses. 

Defining systemic risk as taxpayers’ side of an unfavorably structured claim also provides a metric for tracking systemic risk over 

time. That is the advantage of this definition. Requiring authorities 

to calculate and disclose fluctuations in the aggregate value of the 

taxpayer puts would make regulatory authorities operationally accountable for the quality of their supervisory performance in booms 

and recessions alike. Most existing measurement strategies incorporate the pioneering perspective of Robert Merton. Studies using 

this approach show that regulators could have tracked the growing 

correlation of institutional risk exposures as an early warning system for the current crisis. Expanding the format for collecting information from covered institutions to include estimates of the potential variability of their returns over different horizons should 

improve the precision of systemic risk estimates and officials’ accountability for regulatory and supervisory performance. 

Under current rules, accounting standards for recognizing emerging losses make evidence of an institution’s insolvency dangerously 

slow to surface. Efficient safety net management requires a more 

sophisticated informational framework than current methods of 

bank accounting and examination provide. To protect taxpayers 

and to enhance financial stability, examinations and bank accounting reports should not focus narrowly on measures of tangible capital. They should also develop and report explicit estimates of the 

intangible value of an institution’s claim on taxpayer resources. To 

hold financial institutions and regulators accountable for carrying 

out these tasks conscientiously, regulators and financiers must be 

made to accept a system of ethical constraints that would make 

them share this information with the public. 

Thank you, Mr. Chairman. 

Senator BROWN. Thank you, Dr. Kane. 

Mr. Ludwig, welcome. Thank you for joining us. 

STATEMENT OF THE EUGENE A. LUDWIG, CHIEF EXECUTIVE 

OFFICER, PROMONTORY FINANCIAL GROUP 

Mr. LUDWIG. Thank you very much, Mr. Chairman, for having 

me here today. I would like to commend you, Chairman Brown, 
10 

Ranking Committee Member Senator Corker, and the other Members of the Committee for holding this hearing. 

Chairman Brown and Ranking Member Corker and the rest of 

the Members of the Committee can take pride in having worked 

hard to address the challenges posed by the financial crisis. You 

have brought important congressional focus on the issues of financial stability, safety and soundness, and the regulatory framework. 

You have passed landmark legislation in this area and continue to 

engage in serious oversight. 

We must never lose sight of the tremendous toll that the financial crisis has taken on our country. Millions of Americans are reeling from lost jobs, lost homes, and lost life savings. This loss has 

hit our low- and moderate-income citizens the hardest. It is a terrible tragedy for many families across America. 

As we continue to recover from the financial crisis, our challenge 

now is to successfully implement the very powerful post-crisis reforms enacted through Dodd-Frank, the Basel Committee and the 

Financial Stability Board. Implemented correctly, these new rules 

will add markedly to financial stability. However, if they are implemented without a sense of their cumulative impact on financial institutions and the system and without a sense of balance and proportion, these rules will put a drag on the financial system, our 

economy, and on job growth. Furthermore, if the implementation of 

these rules is excessive, we could actually see a decrease in safety 

and soundness. 

Now, I would like to take a moment to discuss capital requirements—an issue that I know is of great interest to this Subcommittee. Clearly, capital is critical to a safe and sound financial 

system. The Dodd-Frank Act, Basel III, and the Financial Stability 

Board reforms recognize the importance of capital, and they have 

acted forcefully. Through their reforms we now have very tough 

capital requirements and capital levels that significantly exceed 

previous requirements. 

Under Basel III, banks will have to hold 10.5 percent total capital and 7 percent common equity. On top of that, U.S. regulators 

may add an additional countercyclical capital buffer of up to 2.5 

percent. Furthermore, most of the financial institutions typically 

carry a buffer above the required minimums. 

At a minimum, this is over a 300-percent increase in required 

common equity before additional buffers and revised risk weights 

are factored into the equation—three times, 300 percent, a very significant addition. This is an important change because common equity is the highest quality capital, although it is the most expensive 

for banks to raise. 

Now, it is also important to note that prior to the crisis several 

of our largest non-bank institutions were subject to a much less 

rigorous capital regime. Post-crisis, due in part to major investment banks converting to or being purchased by commercial banks, 

and in part to the ability of the FSOC to designate non-bank financial institutions as systemically important, a number of institutions 

will see an even more marked increase in their capital requirements. So we are seeing a real uptick in the amount of capital in 

the system. 
11 

But while capital is an important tool in the supervisory toolkit, 

it is only one tool. I believe we have achieved important reforms 

involving capital and, therefore, I would not at this time advise any 

further increases in capital requirements beyond the Dodd-Frank 

and tough Basel standards. 

What I would like to stress is that critically important to safety 

and soundness is balance, balance, balance. 

So how do you achieve the right balance and ensure that our regulators and regulations are both serious and meaningful but not so 

elaborate that they needlessly weigh down the economy? Unfortunately, there is no quick fix. But I can provide seven suggestions. 

First, constant and thoughtful congressional oversight. I think 

this Committee, as I mentioned, is to be commended for this hearing. Congressional oversight is enormously important for the regulatory mechanism to function correctly. Bringing regulators up 

here, calling them to task, asking the right questions, as you are 

doing today, is just critical. 

Number two, support of the work of the Office of Financial Research and its critical role in monitoring systemic risk and promoting financial stability. The OFR, one of the creations of DoddFrank, is, I think, one of the greatest steps forward in this piece 

of legislation. It creates a body of economists who think and worry 

independently about the next financial bubble, and it helps financial regulators to target their resources in the right direction. That 

is just getting started. Ensuring that the OFR is moving forward 

is critical. 

Number three, ensure that our regulators continue to be top professionals who are balanced in their views and devoted to a safe 

and sound banking system that supports prudent innovation and 

economic growth. I certainly agree with Professor Kane that education in the regulatory field, for which there are too few opportunities, is critically important. Today you can get a degree in almost 

everything in America, but there is simply no degree program in 

regulation and supervision, which I think is terrible. 

Number four, avoid waste and excess at all costs. In fact, many 

of our rules and procedures can be applied very well with much 

less waste than is currently the case. This is critical because it is 

not a matter of not having tough regulation, but it is having effective regulation that is targeted, and waste actually decreases safety 

and soundness because it mis-targets resources. 

Number five, periodically review regulatory rules to ensure that 

they are both effective and cause the least burden possible. Regulations tend to grow up around financial institutions like barnacles 

on a ship, and in order to keep the ship sailing forward, one simply 

has to clear the barnacles off from time to time. 

Number six, impose international capital and liquidity rules for 

global banks on a level playing field basis. Global standards must 

not simply put U.S. financial firms at a disadvantage. I think this 

is a very big issue. We have tough regulators, we have tough regulations. The new Dodd-Frank rules are demanding. But we need to 

impose these globally in a level playing field basis. 

Number seven, properly regulate the shadow banking system, 

which currently owns one-quarter of the United States financial 

sector. This is significant because if you look at the institutions 
12 

that failed and triggered the crisis, it was not the commercial 

banking sector. The shadow banking sector, which is still loosely 

regulated, is a genuine danger. 

With that said, I look forward to answering your questions. Mr. 

Chairman, thank you very much for having me today. 

Senator BROWN. Thank you, Mr. Ludwig, very much. 

Professor Pfleiderer. 

STATEMENT OF PAUL PFLEIDERER, PH.D., C.O.G. MILLER DISTINGUISHED PROFESSOR OF FINANCE, GRADUATE SCHOOL 

OF BUSINESS, STANFORD UNIVERSITY 

Mr. PFLEIDERER. Thank you, Chairman Brown, for allowing me 

to be here today in what I think is a very important issue that is 

being discussed here. 

I want to start with a very simple proposition that I think is 

completely uncontroversial, and that is the notion that the Government should not in any way encourage firms to take actions that 

have large social costs and produce little or no social benefit. 

And just to make this particularly salient, imagine a uranium 

processing firm that wanted to locate one of its plants in a crowded 

residential area. Obviously, we would have zoning regulations and 

other regulations that would prohibit that. But what if the Government had a tax policy that encouraged the uranium processing 

plant to locate in a crowded area and in and above that actually 

provided health benefits in terms of insurance protection for health 

claims against the uranium processing plant only if it locates in the 

crowded residential area? That would be a perverse policy, clearly. 

We, fortunately, do not have a perverse policy for uranium processing plants, but we do have a perverse policy when it comes to 

our banking sector, and the reason for that is our Government subsidizes debt and makes equity expensive, and it does that in two 

main ways. First of all, there is a tax subsidy—debt provides a tax 

shield—that is available to all corporations, but particularly available to banks. 

But the other subsidy is the one that is absolutely critical here, 

and that is there is a too-big-to-fail subsidy, a number of implicit 

and explicit guarantees that are given in the Government’s safety 

net that basically subsidize firms when they issue debt and make 

equity expensive. 

Now, this creates huge distortions, and if it affected only a few 

small banks it would not be a problem, but it affects our entire financial system, especially the too-big-to-fail banks, and makes the 

system extraordinarily fragile, and the evidence of what that can 

create is just a few years ago in our crisis, and we are actually seeing more of it play out in Europe as we sit here today. Highly 

levered banks with too little equity create huge externalities that 

are negative in the sense that they create the possibility of a crisis. 

So there is a huge social cost to this and the question is, is there 

any social benefit, and the answer is, no, there is absolutely no social benefit. 

Now, a lot of people claim that equity is expensive, but that is 

based upon a lot of fallacies and mistaken notions. The first notion 

is that banks hold equity. Banks do not hold equity. Banks hold assets. Equity has to do with the right-hand side of the balance sheet 
13 

and in particular the promises banks make to those that are providing their funds, and the promises come in two sorts of forms. 

One is promises that are contractual obligations that are made to 

debt providers, and then equity holders have no contractual promises made by the banks. They just get whatever is left. So the problem, of course, is if you make too many promises to debt holders, 

debt funders of the bank, you get into a situation such as what we 

had in 2008, where the system is teetering on the brink of insolvency, and, in fact, is insolvent. 

So with little equity, we have losses that are essentially socialized. With more equity, we have losses that are privatized. In a 

capitalistic system, we want the latter, not the former. 

So one of the important things in this debate is to distinguish 

private from social costs. Let us go back to the uranium processing 

firm. Imagine that the uranium processing firm is located close to 

a highly populated residential area and the Government says that 

it must be moved. Now, the owners of that plant could claim it is 

costly, but they would say it is costly because we are going to lose 

tax benefits and we are going to lose the insurance you are providing if we were in a highly populated area. We are going to move 

that if we move the uranium processing plant. That is clearly a private cost. You are just simply taking away subsidies. 

Well, the analogy is perfect with the banks here. If we force the 

banks to move toward higher capital to safety, we are taking away 

subsidies that they had that were encouraging them to do bad 

things. That is not costly from a social cost point of view. 

Now, there are a number of other fallacies that are brought up 

in this debate. One of them is that banks require a specific return 

on equity and that this equity return that is required is fixed, 

somehow independent of how the bank is financed. And Professor 

Stiglitz, following up on work done by Franco Modigliani and 

Merton Miller, has showed that this is a basic fallacy. So that is 

an argument that is based not on science. It is based pretty much 

on wishful thinking about how the market might be fooled when 

you change risk exposures. 

Another thing that we see in the marketplace is that a lot of 

compensation is based upon ROE. Well, you can simply go through 

a very simple experiment, just a little back-of-the-envelope calculation. Let us imagine we had two managers, a very good manager 

and a very bad manager, and the good manager has 10 percent equity, not a lot, but 10 percent, and manages the bank’s assets very 

well and has a 3-percent return on assets before interest. Then at 

a 2-percent interest rate paid to its funders, that is a 12 percent 

ROE. 

Now let us talk about a bad manager who has a much less safe 

bank with only 3 percent equity and manages the assets rather 

poorly, earning only 2.5 percent return on assets before interest. 

Well, that results in almost a 19 percent ROE. In other words, if 

you are a bad manager, you can make yourself look good and actually better than a good manager by just having higher leverage, 

which may very well be, in part, some of the incentives for the high 

leverage that we see out there. 

One of the questions that is often asked is where will all this equity come from? Well, that is an easy question to answer. First of 
14 

all, it does not require new resources. It does not require new saving. It just requires that the banks change the promises that they 

have been making. In fact, it can come very easily. It can be built 

up rather rapidly by just preventing banks from paying dividends 

or other payouts to shareholders. They will not do that voluntarily 

because it takes away the subsidy, but they should be required to 

do that in the interest of the social good. 

There is also a statement that is made that we should have a 

level playing field. I agree with that up to a point. I certainly do 

not agree with that, if we were leveling our playing fields by making our banks risky at taxpayers’ expense. That is no way to run 

our financial system. 

So ultimately, my analysis is really quite simple here. What we 

need to do is get the Government less involved in the financial sector, and to get it less involved, that means we have to require that 

the private sector put up more equity and bear the risks that the 

taxpayers are now bearing that distorts the system and leads to financial crisis. 

Thank you, and I look forward to questions. 

Senator BROWN. Thank you, Dr. Pfleiderer. I will start with you. 

I want to sort of take perhaps to another step your uranium 

processing plant metaphor, analogy. In an article you wrote, ‘‘Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital 

Regulation: Why Bank Equity is Not Expensive,’’ you point out that 

non-financial companies typically hold more capital than is require 

of banks. That is according to a research paper by the New York 

Fed. You pointed out the typical non-financial firm has equity that 

exceeds 50 percent of its assets while the median capital ratio of 

commercial banks is about 8.5 percent. 

Two questions. Why do we allow financial companies to hold so 

much less of their own money, and is that a sort of a long-term— 

are we sort of subsidizing, encouraging finance over other sectors, 

perhaps manufacturing, in the economy? And let me parenthetically add, before you answer, my State is the third-largest manufacturing State in the country behind only States much larger, 

Texas and California, in terms of what we produce. In our country, 

only 30 years ago, we were about 25 percent of GDP was manufacturing and financial services was 10 or 11. That has more or less 

flipped in the last 30 years. Is that part of the reason that we allow 

financial companies to hold so much less of their own money, in essence, than we do other sectors of the economy? 

Mr. PFLEIDERER. So I think this comes about through several 

methods. First of all, neither I nor my co-authors or, I think, anyone else at this table is arguing that banks should have 100 percent equity. Certainly, some of the debt that banks use to fund, in 

particular deposits, and most particularly deposits, has social 

value. It is used in the payment system. So we are not arguing for 

100 percent equity, but there is a lot of debt that the banks use 

that is just used basically to get additional funding that exploits 

the Government subsidies that I mentioned. 

So I think one of the things that has happened, especially probably after 1970 or so, is this notion of too-big-to-fail has created 

subsidies to the banks in the sense that there is a backstop that 

the investing public realizes is there that basically encourages 
15 

debt. And the problem feeds on itself because a lot of companies 

out there would love to have the Government insure their debt, as 

well, because that would allow them to issue more debt and get a 

bigger tax advantage because of the tax advantage of debt. The 

only sector that can do that is the financial sector because they do 

have this implicit subsidy and that is what has caused them to 

lever up. 

And what I think is pretty easy to document is that that has created incentives for the financial sector to grow far bigger than what 

is probably socially justified, and the increase in the size has basically been to exploit this subsidy. 

Senator BROWN. Dr. Stiglitz, the implicit subsidies he talked 

about, what are the effects of those distortions and the implications 

for our economy? 

Mr. STIGLITZ. Well, they are very severe. First, the point is, following up on what Paul said, that because of the implicit subsidy, 

particularly the too-big-to-fail banks can get access to capital at a 

lower cost. So you can see it in their cost of funding. So they get 

capital at lower cost than one of your manufacturing firms in Ohio, 

and that leads them to expand. 

The second point is that because the too-big-to-fail banks have 

lower costs than community banks, and the too-big-to-fail banks 

often do not focus on lending to SMEs and the community banks, 

we get a distorted economy. So the parts of the financial sector that 

are involved in small and medium-sized enterprise lending are relatively starved of funds relative to the big banks that are engaged 

in more speculative activities. 

The net result of this is that our economy gets distorted in several ways. We have been focusing on the size, but it is also the case 

that the kinds of activities that they engage in is distorted so that, 

for instance, if you have a Government guarantee, you are more 

willing to undertake greater risk taking. So rather than lending on 

the basis of solid information to small and medium-sized enterprises, you start going into non-transparent CDSs and engaging in 

speculation, knowing that if you gamble big and you win, you walk 

off with the profits. If you gamble big and lose, the taxpayer picks 

up the losses. 

So both ex ante, before crisis, the economy is distorted. But then, 

of course, once the crisis happens, the economy bears an enormous 

price, and this is what has been said by several people this afternoon. This is not capitalism. You mentioned, I think, in your own 

remarks that when you have socializing losses while you are 

privatizing gains, you get a distorted market economy. So this is 

really undermining the functioning of a market economy, and that 

is why economists of both the left and the right agree that this is 

a very serious distortion in our economy. 

Senator BROWN. Dr. Kane, his comments about advantaging or 

disadvantaging various banks, large banks, small banks, you said 

that we have sewed huge loopholes into capital requirements. Talk 

through, if you would, how the fact that large banks are more highly leveraged than regional banks or community banks, how this advantages big banks. What other—and Dr. Stiglitz talked about how 

they can borrow money, obviously, at less cost than other entities, 

I assume. He was talking about manufacturing, but also smaller 
16 

banks. Talk to me about the advantages that the larger banks 

enjoy as a result of that, if you would. 

Mr. KANE. Sure. Dr. Stiglitz emphasized that there was an implicit subsidy to risk taking in the financial sector. The larger institutions can hire better accountants and better lawyers and better 

lobbyists to see that the way in which risk is assessed in the capital requirement system favors them. We have seen a number of institutions around the world fail even though they met the Basel requirements for capital-to-risk-weighted assets. That is because the 

Basel risk weights were wrong. In fact, a lot of the riskiest assets 

were not even being counted in the system. That is no accident. 

The industry is always here before Congress and other legislative 

bodies and before regulatory agencies exaggerating how devastating it would be if innovative assets were treated in a more 

transparent way. 

Most loopholes come from non-transparency, and in practice, 

from a fixed-weight system that, once it is set in place, can be 

gamed. It is a little bit like blackjack, where you have a fixed strategy on the part of a dealer and a variable strategy on the part of 

the player. If the player plays optimally, he will kill the house in 

the long run. 

Mr. STIGLITZ. Can I make—— 

Senator BROWN. Sure. 

Mr. STIGLITZ.——one more example of the nature of the difficulty, and going back to the CDSs, and one of the issues that was 

debated before the Dodd-Frank bill was passed, and that was the 

issue of whether depository institutions that had a Government 

guarantee, FDIC-insured institutions, should be allowed to write 

CDSs. In other words, the extent to which they should be allowed 

to engage in non-transparent over-the-counter gambles. It is not 

clear—they will call them insurance policies. If they are insurance, 

they ought to be regulated by insurance. But if they are gambles, 

it is really peculiar that the Government is insuring people’s gambling. 

But whether they are insurance or gambling, they are not a lending activity. So what are they doing inside a Government-insured 

depository institution? But once you have it inside the depository 

institution with the Government backing them, they have an incentive to engage in this kind of trading, and that is why in the 

months after the crisis it was so clear. Most of the profits they 

were making were associated with trading, not with lending. The 

American people were told the reason for the TARP bailout was to 

get lending started, but that never happened. But they used that 

basis and access to the Fed window at zero interest rate—close to 

zero interest rate—to undertake a high leverage and to undertake 

very highly risky trading activities which they generated high returns, but with the Government backstopping them. 

Mr. KANE. Could I make a point about those high returns, that 

one of the questions that come up about the safety net, if you go 

back in time, was that nobody seemed to lose money on these gambles. They were actually making money. But we see now in the crisis that this money was actually extracted from the taxpayer in advance. It was not profitable at all. It did not help anyone. In fact, 

it hurt. 
17 

Senator BROWN. Thank you. Mr. Ludwig, I want to read a sentence written by Anat Admati, a finance professor at Dr. 

Pfleiderer’s Stanford. She said, ‘‘There is no credible way to get rid 

of bailouts except with capital.’’ Do you agree with that? 

Mr. LUDWIG. I think that capital is tremendously important, as 

Professor Admati said. No regulator would look at that as an unimportant tool. But I would say a couple of things about capital. 

First, the high leverage, which has been rightly criticized by my 

fellow panelists, the excesses of 40:1 to which you referred, Mr. 

Chairman, was largely outside the commercial banking system. I 

think it is excessive. It should not exist. Fortunately, you and the 

rest of the Congress has put a lot of that to rest in terms of the 

banking system with very, very strong capital requirements. 

The second thing I would say is that capital is only one tool. It 

is almost impossible to have so much capital that you can prevent 

failures of financial institutions. Financial institutions, particularly 

commercial banks, typically fail not because of a lack of capital. 

They fail because of liquidity inadequacies. It is the nature of the 

fractional banking system. Fortunately, there, too, both DoddFrank and Basel have been focusing attention over the last yearplus on the liquidity ratios that banks maintain. That is yet another tool in the toolbox. There are multiple tools, and what we 

lacked in the last decade was the utilization of those tools with sufficient vigor. Again, fortunately because of the new law as well as 

the increased energy at the financial regulators, those tools are 

being used vigorously now. 

I think our issue going forward is striking a balance so that we 

have a stable financial system, which we must have. We must have 

a financial system that can support the economy of the United 

States, and I think right now, the dangers we face are losing that 

balance and becoming overzealous in the way we implement DoddFrank in a way that actually will retard growth. 

Senator BROWN. Let me follow up on that, with balance. You had 

said earlier in your testimony, you said, we now have very tough 

capital standards because of Dodd-Frank, because of Basel III. You 

might want to ask your seatmates to comment on that. 

But first, tell me what you think the Fed should do with SIFIs 

in terms of—I assume you are saying the capital requirements of 

Basel III are about right now. Give me your thoughts on what the 

Fed should—what they should impose on SIFIs, the largest banks, 

the financial companies. Should they go beyond Basel III? If so, 

give me your thoughts on a range. 

Mr. LUDWIG. Well, you know, Basel III gives the national regulator a two-and-a-half percent capital cushion on top—— 

Senator BROWN. And you agree with that? 

Mr. LUDWIG. I think that makes sense. However, I would not go 

beyond that. Why? Because the capital increases have been so significant. We are in new territory now, and capital increases do 

have an impact on lending and on the ability of these institutions 

to support the economy. We have multiple other tools, and before 

we take additional steps, we ought to see what the cumulative impact is of the implementation of those tools so that we can again 

have a tough regulatory environment and a stable financial system, 

but also one that can support the economy of the United States. 
18 

Senator BROWN. Thank you. The push-back that I hear around— 

in Ohio and here—against higher capital requirements, significantly higher, higher than Basel III, higher than some bankers 

have said, and as high as some of you have recommended on the 

panel, were two things. One is the comparative competitive disadvantage with European banks, and second, that it would cause 

banks not to lend if we required higher capital standards, especially higher equity standards. Would the other three panelists 

comment on your thoughts about that push-back, that higher capital standards would mean U.S. banks are at a competitive disadvantage and would mean U.S. banks would not lend to the degree that we would like them to optimally. Do you want to start, 

Mr. Pfleiderer. 

Mr. PFLEIDERER. So I want to actually, with your permission, 

just address an issue that came up here. Liquidity is potentially a 

problem. It has always been a problem in the banking system. But 

liquidity in our modern system is only a problem when there is 

really a problem with insolvency. So if a bank has a liquidity problem but it is very solvent, in other words, has a lot of equity, then 

there is no problem at all with going to the Fed and pledging assets, taking a big haircut on them and getting liquidity. It does not 

put the taxpayer at risk. 

The real issue and the issue that we had in the last crisis was 

not just a liquidity issue. It was really an issue that related to insolvency, understanding that potentially a counterparty may be 

below water. 

So the issue in terms of, first of all, competitiveness with European banks and also with cutting back on lending, first of all, we 

do not want to be competitive if it requires that we put our whole 

economy in jeopardy. If banks require a subsidy, and it is not clear 

that they do, but if banks require a subsidy, by all means, we 

should give it in a way that does not require high leverage. So we 

could have high capital requirements and that does take away 

some subsidies that the banks are now getting. If for some reason 

we decide that banks need to be subsidized because they are doing 

something that is underproduced, we need to give those subsidies 

in a way that does not create a fragile banking system. 

And just to tell us where we are right now with respect to these 

capital requirements, one thing that I was going to mention in my 

opening remarks and did not is that just a few weeks ago, Moody’s 

announced that the support rating that it was giving to, say, Bank 

of America, was five notches above what it would give without Government support. So this indicates that, looking forward, to the extent the rating agency is factoring things in correctly, the Government support is moving the Bank of America debt from what would 

be minimum investment grade up to very high quality. 

So one way to answer the question of how much capital do we 

need, well, one barometer, one monitor for that would be if we have 

enough capital so that players in the economy, including the rating 

agencies, do not see Government support in there. In other words, 

we are not subsidizing banks. 

Senator BROWN. Does it bother you, Dr. Pfleiderer that Joe 

Nocera, in an article he wrote a couple of months ago, said that European banks have fought fiercely against capital requirements. 
19 

Does that bother you as an observer of what this means for American banks and our competitiveness and our behavior, if you will? 

Mr. PFLEIDERER. It bothers me to the extent that we live in a 

global economy and, unfortunately, we cannot insulate ourselves 

from mistakes that are made in Europe. So we have an integrated 

economy and if the Europeans run their banks such that they are 

very fragile, there is no doubt that problems created there can spill 

over into our economy. So I—— 

Senator BROWN. And they are surely more fragile than ours. 

Mr. PFLEIDERER. They certainly are. So I think that the goal 

here is to—— 

Senator BROWN. Let me interrupt—— 

Mr. PFLEIDERER.——not race to the bottom, but race to the top. 

We need to get global standards that are much higher. But what 

we should not do is sink to the low standards of the Europeans so 

that we put ourselves in jeopardy as well as the Europeans. Rather, we should figure out a way, if we need to, to subsidize our 

banks that does not require high leverage. And again, that is a 

proposition that I do not think has been demonstrated, that banks 

need subsidies. But if they do, we should do it in a way that does 

not create fragility in our own economy. 

Senator BROWN. Comments, Dr. Kane and then Dr. Stiglitz, and 

then Mr. Ludwig. 

Mr. KANE. The mistakes being made in Europe have come back 

to affect the credibility of the sovereign support that European 

banks enjoy. If you take Ireland, the banks there were allowed to 

run up more debts under Government guarantees than the Government of Ireland could ever pay off by collecting taxes from taxpayers. Somebody is going to have to absorb the differences. Europe is going to learn that subsidizing risk taking by their banks 

is eventually going to ruin their economies for a while. Because 

governments have been subsidizing banks in the past does not 

mean they will take away business in the future. I think one of the 

lessons of this crisis is that depositors and other creditors are going 

to look through the banks to the condition of the sovereigns and 

look for regulation that they can trust. 

Senator BROWN. And the lesson, the primary lesson, is higher 

capital requirements? 

Mr. KANE. Well, I think the primary lesson is you have to focus 

on the difference between average versus marginal requirements. 

We are talking about high average requirements and banks are 

fighting them. But even banks ought to want to be sure that, at 

the margin, governments are not subsidizing foolish risk taking. 

That is the issue that needs to be addressed around the world. We 

can have lots of differences in the systems adapted to the countries 

and the cultures of those countries, but we want to make sure that, 

at the margin, we have found ways to discourage firms from finding ways to hide risks, or hiding or disguising a shortage of capital. 

Senator BROWN. Dr. Stiglitz. 

Mr. STIGLITZ. Yes. First, I want to address the second question 

you raised about would banks not lend. I think I want to go back 

to my first remark, which is that a change in the debt equity— 

change in the financial structure of banks does not really increase 

their costs except to the extent that there is a hidden subsidy 
20 

through the bank bailout, so that to the extent that we can put 

aside the subsidy, the fact is that there would not be higher cost 

and, therefore, there would be no reason there would be less lending. 

Now, this is where the point—— 

Senator BROWN. Do you agree with that, Mr. Ludwig, there 

would not be higher costs for the bank? And then I will get back 

to the rest of your answer, Dr. Stiglitz. 

Mr. LUDWIG. I think the issue here, as a practical matter, Mr. 

Chairman, is that raising equity capital is so costly, particularly at 

this time. And banks have already done so much to increase their 

capital positions. So instead of raising additional capital, they may 

consider simply shrinking their balance sheets in order to accommodate higher capital charges. 

Senator BROWN. Will it make them more reluctant to issue dividends? 

Mr. LUDWIG. As you know, dividends actually have been restrained by the Federal regulators—— 

Senator BROWN. Right, but recently, they were, in fact, distributed, and there was some thought from Simon Johnson and some 

others that the banks, because of equity issues and their saying 

that they could not attract enough equity, that they ought to hold 

on to their profits for a period of time for equity reasons. Is that 

sort of the line of thinking? 

Mr. LUDWIG. It is a matter of balance, Mr. Chairman. If they 

cannot issue reasonable dividends, it makes it harder to attract 

capital. And it also undercuts the confidence the public has in the 

institutions themselves. If they are not in a position to pay a reasonable dividend—one is not talking about anything excessive 

here—then I think the public loses confidence in the institution. So 

I think it is a matter of balance and proportion. 

Senator BROWN. Dr. Stiglitz. 

Mr. STIGLITZ. I actually would argue just the opposite, that if 

they have more capital, there will be more confidence in the public, 

and that, as I said in my testimony, that, in fact, there is a problem of transition. How serious it is, it is hard to ascertain. But if 

there is that problem with transition, we should impose this requirement that they not pay out dividends, not pay out excessive 

bonus pools, and that would allow them to recapitalize the banks 

and put it on a safer basis so that we would not have the taxpayer 

underwriting them. 

The important point I wanted to emphasize, though, is the fact 

that, as Paul emphasized, equity is not costly, that actually, when 

you have a higher leverage, what you are effectively doing is increasing the risk of equity. It is not like there is a fixed price. So 

that is the fundamental flaw in those who emphasize the high cost 

of equity, that when you go to high leverage, you are actually driving up, in effect, the cost of equity, or you are just shifting risk. 

I want to come to just a couple of other points related to the 

question you posed. One of them is the issue of—this is related— 

the discussion about—this debate about liquidity risk versus solvency risk. The point here is that when there is a lower equity 

base, there is a higher probability of a bankruptcy, of a problem, 

and, therefore, a higher likelihood that nobody will give money to 
21 

the banks. That is what causes a liquidity crisis. If everybody knew 

the banks were solvent, there would be no liquidity problem. It is 

because they get afraid that the bank is solvent that there is a liquidity crisis. So these two issues are intertwined and the risk of 

a liquidity crisis which shrinks lending and undermines the economy is related very much to inadequate capital. 

Now, on the issue of the competitive disadvantage, I want to 

agree with what was said. We have to prevent a race to the bottom, 

and that is what has been going on. But I guess there are two 

other points I would also raise. First, the framework for regulation 

inside the United States should be national treatment, so that if 

we have companies, financial institutions coming into the United 

States, we regulate them as national institutions. They ought to be, 

I think, incorporated if they become significant and have a subsidiary, not a branch. 

This basic principle means that the United States is a large market. Banks will want to operate in the United States and we can 

set the regulations that protect the American economy. That is our 

first responsibility, protecting the American economy, protecting 

our jobs, protecting the stability of our society. 

The issue about can our banks compete abroad—well, first, I am 

not really that worried about that, but if it were the case, this is 

a small—you know, in terms of our national economy, how many 

jobs are created in America by the banks operating in Europe, or 

in Latin America? Relatively few. This is not a major industry for 

the rest of our society. 

So in my view, we should be focusing on the United States and 

protecting the United States and not on creating some jobs in Europe in which, yes, there are little profits that go into American 

banking firms, but this is a really minor issue for our economy. 

The final point is that if—to look at the other extreme, we should 

not have the set of regulations in the United States dictated by the 

worst banking regulator in the world. We do not want Iceland and 

Ireland to dictate the terms of American banking regulation. So, 

yes, the banks are always going to say there is some country that 

has been bought by the banks and is going to have low regulation 

and can do things that we cannot do. But what we need to do is 

to be focusing on what is good for the American economy. 

Mr. LUDWIG. Joe, if I might say so, I could not agree with you 

more, but there are three points to note. Number one, we do not 

need to fight the old war. The fact is that, thanks to Congress and 

the Basel Committee, in a sense, we have already won the war. We 

have much higher capital standards. 

Number two, I could not agree with you more: We do not want 

to have a race to the bottom. We do not want to change what we 

have by way of regulation and supervision. What we want to do is 

use our clout to ensure that the regulation and supervision abroad, 

particularly with respect to capital standards which are set internationally, are applied fairly. The reason is anomalies and blowups abroad affect our economy. So the issue in terms of competitiveness is to raise the standards of regulation and supervision outside the United States to meet our higher standards. 

Number three, I would take issue with what a number of panelists have said. Irrespective of the amount of capital, if people get 
22 

panicked enough, they withdraw funds. And the reason is, in part, 

because the genius of banking is two-fold. One is the maturity 

transformation ability of banks. That is, they take in short-term 

funds, people’s deposit accounts, checking accounts, and they lend 

it for longer periods of time, because if you are going to build a 

plant and equipment, it may be 5 years’ payback. And as I said, 

the genius of the banking system is that maturity transformation. 

That means that the bank is always going to be short if everybody runs to the window, and we have seen this in the 1930s movies of the Great Depression. You never have enough in the till. It 

is a matter of confidence, so that capital is certainly important, but 

all the capital in the world will not in and of itself stop banking 

runs. Banking runs get stopped by the public having enough confidence that the regulatory mechanism is doing its job, and that the 

institutions are functioning correctly. That is precisely the framework that has been put in place by Dodd-Frank and the heightened 

regulatory vigor. 

Senator BROWN. Mr. Ludwig, if you were to—if, some say, higher 

capital requirements will dampen, will reduce the amount of lending, why not have—and this is a bit rhetoric, but a bit not—why 

not have no capital requirements? Would that mean more lending? 

Would that mean our economy would get back on its feet and people can get capital? 

Mr. LUDWIG. No, Mr. Chairman. The art of banking and the art 

of finance are matters of balance and proportion, and no capital 

would have some of the unfortunate externalities that Dr. Stiglitz 

and others have referred to. People would say, ‘‘Oh, my God, they 

have got no money in the till at all.’’ I think that is going way too 

far. 

But the practical problem for today is having raised capital so 

significantly—as I mentioned, a 300-percent increase in common 

equity—you get to a point at which even if it is only a transition 

period, and we are in a very delicate economic period right now, 

that banks faced with additional capital requirements are going to 

start shrinking their balance sheets. After all, lending takes up a 

lot of that balance sheet and a lot of the capital need, and lending 

is a risky business. So it is easier for the institutions in terms of 

these commercial loans, which get 100 percent capital weight, to 

shrink their balance sheet. 

Senator BROWN. Dr. Kane. 

Mr. KANE. I want to say several things. 

First, we do not really have much higher capital requirements 

now. These are all to come in the future, and we have a lot of lobbying against their actually being installed. We actually have a 

capital-short banking system today, the taxpayer. 

Senator BROWN. The numbers Mr. Ludwig is talking about are 

the future, not today? 

Mr. KANE. Not today. 

Mr. LUDWIG. Well, that is right on paper, but what happens is 

that the markets, anticipating those requirements, actually impose 

pressure on the institutions to raise capital in the short term. So 

the institutions have, in fact, been raising capital in advance of the 

requirements and have been pressed by the regulators, correctly, to 

push those capital standards up now. 
23 

Senator BROWN. Dr. Kane. 

Mr. KANE. They are being pushed that way, but as you know, 

weak banks were trying to get permission to pay dividends, as you 

mentioned, Senator, and had to be restrained. 

Congress is seeing a lot of lobbying pressure against the implementation of cutting-edge Dodd-Frank reforms. I do not think we 

have to worry about the U.S. banking system ever being overregulated. I think that the lobbyists will see to it that the system is 

underregulated at the margin. And the main point about runs is 

not that when we have a crisis, we can never have enough capital. 

The larger point is that capital deters runs. Where did we have the 

runs in this last crisis? At money market mutual funds and in various off-balance-sheet vehicles, such as structured investment vehicles. Structured investment vehicles were allowed to be pulled back 

onto bank balance sheets. That is when the banking system began 

to look terribly, terribly weak. 

And, finally, on maturity transformation, you know, the S&L industry shows us that you have to regulate maturity transformation. The S&Ls that were making 30-year loans with passbook money became insolvent very quickly when interest rates 

went up. And interest rates are going to go up again in this country, and when they do we have to be very concerned about institutions that are borrowing, say, overnight and lending for even 4 or 

5 months, never mind 5 years. 

Senator BROWN. Thank you. 

I am going to conclude. I want to ask Mr. Ludwig one more question, but I am going to conclude—and I will give you a moment to 

think about it—with each of you to give me the one or two significant improvements you would suggest to Dodd-Frank. I will finish 

with that, so give me one or two thoughts of improving Dodd-Frank 

in your mind. 

Mr. Ludwig, Richard Cordray, the former Attorney General of 

Ohio, came to see me this week. I have known him for many years. 

He is the new—I will not say the new Director of the Consumer 

Financial Protection Bureau because this confirmation is probably 

in some doubt. You recently wrote an article for American Banker 

about competitive advantages of the shadow banking system, the 

shadow banking sector—system, if you will. You said, ‘‘If the newly 

minted Consumer Financial Protection Bureau does not have a 

Senate-approved leader by the first anniversary of Dodd-Frank’’— 

last week, July 21st—‘‘an unintended consequence kicks in. The 

CFPB will be free to examine and take action against banks with 

more than $10 billion of assets, but not against their non-bank 

competitors.’’ 

Are you saying traditional banks are hurt by efforts to block the 

appointment of the Director? 

Mr. LUDWIG. Yes, they are, actually. I am, as you know, Mr. 

Chairman, a huge supporter of consumer protections and services 

to low- and moderate-income people. I think it is very important 

that we have a functioning agency, and in that regard the odd 

anomaly of not confirming Mr. Cordray, is that there will be imposition on the banking sector of consumer rules—not a bad thing— 

but there will not be an imposition of those rules on the non-bank 
24 

financial sector, the shadow banking system—not a good thing. So 

I think we ought to get about moving forward here. 

Senator BROWN. OK. Thank you. 

In conclusion, I would let each of you start. Dr. Stiglitz, since you 

began, what one or two improvements would you make to DoddFrank? 

Mr. STIGLITZ. Well, it is hard to limit it to just two. 

Senator BROWN. But you are going to have to. 

Mr. STIGLITZ. If I can, I will go a little beyond that. 

Senator BROWN. And, certainly, any of you can submit in writing 

anything about today’s hearing. You have 7 days afterwards, including Dr. Stiglitz’s 28 recommendations for changing DoddFrank. 

Mr. STIGLITZ. OK. Well, the first is the point that I think most 

of us have raised, the concern about too-big-to-fail banks. Something should have been done about that, something on the BrownKaufman amendment should have been included. 

Senator BROWN. I would vote for that. 

Mr. STIGLITZ. The second one is much higher capital requirements along the lines that we have been, most of us have been 

talking about. And I do not think Basel III goes anywhere near far 

enough. 

The third is the CDSs exemplifying the continuing excessive risk 

taking. The point I made before that they continue to be engaged 

in by FDIC-insured institutions makes absolutely no sense. The 

fact that a large fraction of them continue to be over-the-counter 

and non-transparent, and the increasing concern that the exchanges themselves, there were not adequate capital requirements 

imposed on the exchanges, so that there is a risk that if the exchange goes down, again, we have systemic risk. 

There should have been joint and several liability of all of those 

trading in the exchange for the losses so that the taxpayer does not 

have to pick them up, and the IMF has put forward actually some 

recommendations along those lines. 

The final point is the anticompetitive practices of the banking 

sector in the control of the means of payment, the credit cards, the 

debit fees, are an outrage and are a major source of revenue which 

distorts our economy and hurts ordinary retail merchants throughout our country—small businesses, again, grocery stores that— 

there are some cases where 50 percent of their profits go on the 

sales of groceries are given to the banks when they are paid for by 

credit card. And that seems disproportionate to the services provided. 

Senator BROWN. Thank you, Dr. Stiglitz. 

Dr. Kane? 

Mr. KANE. Well, I can reduce my advice to two themes, though 

many of Joe’s ‘‘points’’ would go under my ‘‘themes.’’ 

Mr. Ludwig made the point that the Office of Financial Research 

is potentially one of the great innovations of Dodd-Frank. Missing 

today is a Director for this Office of Financial Research, and, of 

course, its governance has been placed under a very complicated 

17-member committee. So I think that Congress really has to address the need to measure and publicize the cost taxpayers incur 

in supporting national and international safety nets. This will be 
25 

the job of the Office of Financial Research, but it needs to be assigned to them in an independent way. Second, to help authorities 

to contain systemic risk skillfully and conscientiously in the long 

run, governments need to change the way regulators are trained, 

recruited, and incentivized. I believe that a national or international academy for financial regulators could help in both tasks. 

Senator BROWN. Thank you. Terrific idea. 

Mr. Ludwig. 

Mr. LUDWIG. Three things. 

One, I lament the fact that we do not have a single prudential 

supervisor. Dr. Stiglitz and I advocated for that early on in the 

Clinton administration. The countries that have done better—Australia, Canada, and Japan—during the crisis had a single, pureplay, focused, and professional prudential supervisor. I think that 

would advance the cause of the financial stability in this country 

markedly. 

I agree with Dr. Kane that education for financial supervisors is 

critical, and we do not have it adequately in this country. As I said, 

no college or university offers a degree in regulation and supervision. 

The third is not a new change to the law, but I think it is absolutely essential that we implement Dodd-Frank with prudence and 

care. Excess here will actually not advance the benefits of safety 

and soundness. There are only so many hours in a day, and we 

want our financial institutions and regulators targeted on those 

things that matter most, not on those things that are extraneous. 

Furthermore, excess here will put a drag on the economy, which 

we can ill afford at this time. 

Senator BROWN. Thank you. 

Dr. Pfleiderer. 

Mr. PFLEIDERER. I am afraid since I am going last, I probably do 

not have much to add here, so I will just in some ways just reinforce what has been said here. 

I have made the analogy—it may not be the best analogy—that 

we are basically trying to regulate cars that are speeding down the 

road at 100 miles an hour that are only 5 feet apart. And, of 

course, that requires very careful regulation to make sure that the 

cars do not hit each other when the obvious solution is just to have 

the cars have a greater buffer between them and follow each other 

at much greater lengths. And that is capital. I do not think we 

have enough. I think that Basel III is not enough. I think that capital does not solve everything here, clearly, but it solves a lot by 

just putting in much more privatization of losses rather than the 

socialization of losses we have now. So I want to reinforce that idea 

that we need more capital. 

I have not thought very much about having a single regulator, 

but having heard this idea, it makes a lot of sense to me, and I 

think that that probably moves in the direction of taking care of 

a lot of the fragmentation that we have now. 

And I think that getting the Office of Financial Research up— 

the problem is that the next crisis may not happen in the way— 

almost certainly will not happen in the way the last one did, and 

we need to constantly be vigilant, and being ahead of the ball rather than behind it is going to be useful. And I think that the OFR 
26 

can help us that way. So getting that up and running is certainly 

important. 

Senator BROWN. Good. Thank you. Thank you all for the spirited 

discussion and for your public service. It was very helpful today. 

Thanks especially to Laura and the majority committee and the 

minority committee staff, and to Jeremy and to Eve and to Graham 

in my office, I appreciate all of this. 

Thank you. We are adjourned. 

[Whereupon, at 3:28 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions supplied for the record follow:] 
27 

1 University Professor, Columbia University; recipient of the 2001 Nobel Memorial Prize in Economics; former Chair, President Clinton’s Council of Economic Advisers, Former Chair, Commission of Experts on Reforms of the International Monetary and Financial System, appointed 

by the President of the General Assembly of the United Nations, 2009, President of the International Economic Association. All views are personal. 2See B. Greenwald and J.E. Stiglitz, ‘‘Externalities in Economies with Imperfect Information 

and Incomplete Markets,’’ Quarterly Journal of Economics, Vol. 101, No. 2 (May), pp. 229–264, 

1986. For an excellent discussion of these externalities at the macroeconomic level, see A. 

Korinek, ‘‘Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses,’’ working paper, University of Maryland, 2011. 3See, e.g., C. Reinhardt, and K. Rogoff, 2009, This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press or J.E. Stiglitz, ‘‘Rethinking Macroeconomics: What Failed 

and How to Repair It,’’ Journal of the European Economic Association, 2011. 4There is by now a large literature explaining and documenting this observation. See, e.g., 

J.E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy, New York: 

W.W. Norton, 2010. Indeed, well before the crisis, it was noted that managerial incentive structures (‘‘incentive pay’’) had perverse effects, not only in encouraging excessive risk taking and 

shortsighted behavior—which is particularly costly when it occurs in the financial sector—but 

also in encouraging dishonest accounting, so manifest not only in this crisis, but in the scandals 

that marked the beginning years of this decade, epitomized by the Enron bankruptcy, the largest bankruptcy up to that point. See, e.g., J.E. Stiglitz, 2003, The Roaring Nineties, New York: 

W.W. Norton. 5F. Modigliani and M. Miller, 1958, ‘‘The Cost of Capital, Corporation Finance and the Theory 

of Investment,’’ American Economic Review, 48, 1958, pp. 261–267. From early on, it was recognized that theorem was relevant to financial firms as well as non-financial firms. See M. Miller, 

1995, ‘‘Do the MM propositions apply to banks?’’, Journal of Banking and Finance, 19(3), pp. 

483–489. 

PREPARED STATEMENT OF JOSEPH E. STIGLITZ, PH.D.1

PROFESSOR OF FINANCE AND ECONOMICS, COLUMBIA BUSINESS SCHOOL, COLUMBIA

UNIVERSITY

AUGUST 3, 2011 

Thank you for this opportunity to address the question of the financial structure 

of the banking industry, which I believe is central to the future stability and prosperity of the American and global economy. 

Two fundamental analytic insights, buttressed by some empirical observations 

should inform our thinking about the appropriate regulation of banks, including 

capital requirements and risk taking. The first is that when information is imperfect 

and risk markets incomplete—that is, always—there is no presumption that unfettered markets will result in efficient outcomes. The reason is that actions give rise 

to externalities, consequences that are not borne by those undertaking them.2 There 

is a misalignment of private and social returns. 

This result is of central importance in banking and finance, because the very rationale for the sector arises out of risk management and the acquisition and utilization of information necessary for the efficient allocation of capital. The externalities 

consequent to the excessive risk taking of the banks are manifest: it is not just the 

costs of the bailouts and the millions of Americans who have lost their homes, but 

the literally trillions of dollars of lost output, the gap between the economy’s actual 

and potential output, the predictable and predicted fallout of the crisis. The resulting suffering—including that of the 25 million Americans who would like a full-time 

job and can’t get one—is incalculable. The budgetary problems facing the country 

too are in no small measure a result of the inevitable decline in revenues and increase in expenditures that follow. It is well-known that recoveries from financial 

crises are slow and painful.3

This crisis not only demonstrated the importance of the externalities to which failures in financial markets give rise, but also the importance of what economists call 

agency problems—those, like bank officials, who are supposed to take actions on behalf of others, who have a fiduciary responsibility, often have incentives that lead 

them to take actions that benefit themselves at the expense of those that they are 

supposed to serve. The so-called incentive systems in place in the financial sector 

may have served the bank managers well, but they did not serve well shareholders 

or bondholders, let alone the rest of society.4

The second fundamental insight is that increased leverage in general does not create value, but simply shifts risk—as leverage increases, increased risk is placed on 

the equity base. This is the central insight of the Modigliani-Miller theorem.5 In the 

1960s and 1970s, I showed that that result was far more general than ModiglianiMiller had thought—but that there were limitations too, most of which cautioned 
28 

6See, in particular, J.E. Stiglitz, 1969, ‘‘A Re-Examination of the Modigliani-Miller Theorem,’’ 

American Economic Review, 59(5), December, pp. 784–793 and J.E. Stiglitz, 1974, ‘‘On the Irrelevance of Corporate Financial Policy,’’ American Economic Review, 64(6), December, pp. 851– 

866. In particular, I showed that the kind of arbitrage that Modigliani and Miller had invoked 

in their analysis was not necessary to establish the result. I established that there did not have 

to exist a set of risk classes as they had assumed; and that the conclusions held in a very generally specified general equilibrium model. What was required was that the level of debt was 

not so high that there was a risk of bankruptcy. For a discussion of some of the other restrictions that have to be satisfied for the result to be true, see the footnotes below. 7The problem would arise even if all the costs were borne by a self-financed deposit insurance 

scheme, and if there were no macroeconomic externalities. 8See for example D. Baker and T. McArthur, 2009, ‘‘The Value of the ‘Too Big to Fail’ Bank 

Subsidy,’’ Center for Economic Policy and Research Issue Brief, September, available at http:// 

www.cepr.net/documents/publications/too-big-to-fail-2009-09.pdf (accessed on August 1, 2011). 9See, e.g., A.G. Haldane, 2009, ‘‘Rethinking the Financial Network,’’ address to the Financial 

Students Association, Amsterdam, April, available at http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf (accessed August 2, 2011); A.G. Haldane and R.M. May, 

2010, ‘‘Systemic risk in banking ecosystems,’’ University of Oxford mimeo; J.E. Stiglitz, ‘‘Contagion, Liberalization, and the Optimal Structure of Globalization,’’ Journal of Globalization and 

Development, 1(2), Article 2, 45 pages; and J.E. Stigltiz, 2010, ‘‘Risk and Global Economic Architecture: Why Full Financial Integration May be Undesirable,’’ American Economic Review, 

100(2), May, pp. 388–392. 10There is a large literature documenting both systematic and non-systematic but persistent 

anomalies in capital markets. See, for instance, R.J. Shiller, 2000, Irrational Exuberance, Princeton: Princeton University Press; or G. Akerlof and R. Shiller, 2010, How Human Psychology 

Drives the Economy, and Why It Matters for Global Capitalism, Princeton, New Jersey: Princeton University Press. See also J.E. Stiglitz, 1982, ‘‘Information and Capital Markets,’’ in William 

F. Sharpe, Cathryn M. Cootner, eds.: Financial Markets: Essays in Honor of Paul Cootner, Englewood Cliffs, NJ: Prentice-Hall, Inc; and the broader discussion of irrationality in capital and 

financial markets in J.E. Stiglitz, forthcoming, The Selected Works of Joseph Stiglitz, Volume 

II, Oxford University Press. For more on the lack of rationality in much economic decisionmaking, see for instance R. Thaler, 1994, The Winner’s Curse: Paradoxes and Anomalies of Economic Life, Princeton, NJ: Princeton University Press. 11 In Congressional testimony on October 23, 2008, Greenspan described being ‘‘in a state of 

shocked disbelief’’ that the lending institutions’ self-interest had not protected shareholders’ equity. Testimony available at http://democrats.oversight.house.gov/images/stories/documents/ 

20081023100438.pdf (accessed August 1, 2011). 

against excessive leverage: if there were real costs to bankruptcy (as there are), then 

increased leverage increased the likelihood of these dissipative costs.6

In the financial sector, the social costs of increased leverage are even greater, because of the societal costs associated with the externalities that I described earlier.7

The misalignment of incentives is even more in the case of too-big-to fail banks— 

banks that are so large that the potential consequences of allowing them to go bankrupt poses an unacceptable risk. Their failure poses a systemic risk. They can reap 

returns from risk taking, with the losses borne by the Government. But too-big-tofail banks present another major distortion: because those providing them with capital know that they are too-big-to-fail, that there is at least a higher probability of 

their being rescued (evidenced so clearly in the recent crisis), they can get access 

to finance at lower costs,8 and thus they can grow relative to competitors, not because of their relative competence, but because of the implicit subsidy. As they 

grow, the likelihood of a rescue increases, and their profitability is enhanced not 

just because of the increase in the implicit subsidy but because of growing market 

power, providing further distortions to the market. Moreover, banks know that if 

they become too-big-to-fail (or too intertwined to fail, or too correlated to fail) they 

will have an enhanced likelihood of being rescued; they thus have strong incentives 

to become too-big-to-fail, too intertwined to fail, and too correlated to fail—as we 

saw in the recent crisis. Systemic risk is real, and markets by themselves work to 

increase it, not to mitigate it. The notion that risk would be spread efficiently, 

through diversification, was either pure propaganda, or based on models that 

showed insufficient understanding of market incentives, of the nature of contagion, 

and/or of the consequences to systemic stability posed by the non-convexities to 

which contagion and bankruptcy give rise.9

The key empirical observation is that markets are often not rational in assessing 

risk; this is true even of the so-called experts, but even more so of those who are 

financially unsophisticated.10 Alan Greenspan testified to this before Congress, 

when he expressed his surprise that the financial markets had not managed risk 

as well as he had expected.11 But, while he was correct in the conclusion that financial markets had done a miserable job of managing risk—one of their central societal functions—I was surprised at his surprise. After all, anyone looking at the incentive structures confronting key decisionmakers should have realized that they 

had incentives for excessive risk taking and short sighted behavior. (That they had 
29 

12See for example ‘‘Understanding Household Debt Obligations,’’ Remarks by Chairman Alan 

Greenspan at the Credit Union National Association 2004 Governmental Affairs Conference, 

available at http://www.federalreserve.gov/boarddocs/speeches/2004/20040223/ (accessed August 1, 2011). 13There are a few other reasons that have been mentioned for banks’ seeming preference for 

excessive leverage. One is that the tax system, by allowing tax deductibility of interest, increases the private return on increased leverage. But if so, this is not an argument for allowing 

greater leverage, but for correcting a tax distortion. (A full analysis of the tax consequences has 

to integrate an analysis of the corporate and individual income tax system. The results are more 

complex and ambiguous, once the preferential treatment of capital gains is taken into account. 

See J.E. Stiglitz, 1973, ‘‘Taxation, Corporate Financial Policy and the Cost of Capital,’’ Journal 

of Public Economics, 2, pp. 1–34.) Another criticism of the Modigliani-Miller analysis (which I 

raised in my original evaluations of their work) is that financial structure may convey information. (See, e.g., H. Leland and D. Pyle, 1977, ‘‘Informational Asymmetries, Financial Structure, 

and Financial Intermediation,’’ 32(2), pp. 371–387; N. Maljuf and S. Myers, 1984, ‘‘Corporate 

Financing and Investment Decisions When Firms Have Information That Investors Do Not 

Have,’’ Journal of Financial Economics, 13, pp. 187–221; B. Greenwald, J.E. Stiglitz, and A. 

Weiss, 1984, ‘‘Informational Imperfections in the Capital Markets and Macro-economic Fluctuations.’’ American Economic Review, 74 (1), pp. 194–199; and J.E. Stiglitz, 1982, Op. cit. But as 

A.R. Admati, et al., point out, if banks are required by regulation to raise capital when their 

capital ratio falls below a certain level, then there is in fact no adverse signal (A.R. Admati, 

P.M. DeMarzo, M.F. Hellwig and P. Pfleiderer, 2010, ‘‘Fallacies, Irrelevant Facts, and Myths in 

the Discussion of Capital Regulation: Why Bank Equity is Not Expensive,’’ Stanford University 

Working Paper No. 86). To the contrary, the only firms in such a situation that would not raise 

new equity would be those that believed that their future prospects were bleak: raising new equity would thus provide a positive signal. While it may be the case that the cost of raising equity 

funds may be high in recessions, this is an argument for macroprudential regulations, which 

adjust capital requirements to the state of the business cycle, or the adoption of related provisioning requirements. A still weaker argument for high leverage is based on the ‘‘back to the 

walls theory of corporate finance’’—high leverage force gives management less leeway to behave 

badly. (See, e.g., M.C. Jensen, 1986, ‘‘Agency Costs of Free Cash Flow, Corporate Finance, and 

Takeovers,’’ American Economic Review, 76(2), pages 323–29.) No evidence of this effect was observed in the run up to the crisis. On the contrary, the convexities in payoffs generated by bankruptcy encourage excessive risk taking, of particular concern in the financial sector. These nonconvexities, in turn, have important consequences for systemic stability, which the standard literature ignored. See below. 

such perverse incentive structures is testimony to the importance of the agency 

problems to which I referred earlier.) 

But beyond that, Greenspan made another error—if I mismanage risk, if I am irrational in my risk analyses, I and my family suffer, but there are unlikely to be 

societal consequences. But if a bank and especially a very large bank mismanages 

risk, the macroeconomy can be seriously affected. There are externalities. It is these 

externalities that provide the motivation for Government programs (like FDIC insurance and regulation). It is these externalities that explain why self-regulation 

simply won’t work. It is deeply troubling when the country’s major financial regulators do not understand the rationale for regulation. 

Rational markets would realize that increasing leverage shifted risk, and would 

demand compensating differentials. (Rational market participants in well-functioning markets would have realized too that a shift to variable rate mortgages from 

fixed rate mortgages would, on average, not save on financing costs, but would expose ordinary citizens to increased risk. But not even Greenspan seemed to understand this, as he seemed to advise ordinary citizens on the virtues of variable rate 

mortgages.12) 

As we see banks striving to increase their leverage, there may be uncertainty 

about what is driving this: is it because in doing so, they increase the implicit subsidy from the Government? Is it because they do not understand the fundamentals 

of risk? Is it because they understand the fundamentals of risk, but realize that 

their bondholders and shareholders do not, so that they can extract more money for 

themselves? But about this there is no uncertainty: excessive leverage has large societal costs. Banks, and especially the big banks, need to be restrained.13

Indeed, the analysis above suggests that there are few or no societal costs to doing 

so, and considerable benefits. It is not as if leverage somehow manufacturers resources out of thin air. Lending is risky. The risk has to be borne somehow. It is 

borne by equity holders of lending institutions—to the extent it isn’t shifted to Government, FDIC, or bondholders, or depositors. It is better to have it better distributed, among a large equity base, given the high social costs of financial disruption. 

Advocates of low equity requirements for banks need to argue that this is the best 

way by which the risks of lending should be distributed within the economy—and 

I have seen not even an attempt to do so. 

Recent empirical research has provided considerable support for the views expressed here. Miles, et al., of the Bank of England find no relationship between 
30 

14D. Miles, J. Yang and G. Marcheggiano, 2011, ‘‘Optimal bank capital’’, Bank of England Discussion Paper No. 31, April. In their analysis, they typically ignore the increased cost of borrowing funds that results from increased leverage, thus overestimating the benefits of leverage. 

They also find no relationship for the UK between Bank leverage and economic growth. Similarly, K. Kashyap, J. Stein, and S. Hanson argue that the effect on lending rates of a substantial 

increase in equity requirements would be very small (‘‘An Analysis of the Impact of ‘Substantially Heightened’ Capital Requirements on Large Financial Institutions,’’ Working Paper, 2010). 15They look at shocks over a sample of 31 countries over 200 years. We suspect that Miles, 

et al., estimate of the small benefit from increased equity in fact considerably overestimates the 

net social benefit, taking into account the costs of bankruptcy and financial distress. 16 Indeed, if the argument that changing bank capital structure increased the cost of capital 

to banks were correct, it would imply that the return to those providing funds to the financial 

system would have increased, and thus arguably that savings might have increased. In fact, we 

have contended that the systemic cost of capital (return to capital) would be essentially unchanged, and thus, whether the economy is open or closed, whether it is operating at full employment or less than full employment, there is little reason to believe that aggregate savings 

or investment would be affected. 

bank leverage and the spread on business loan rates over T-bill rates, and after a 

careful (but conservative) analysis of the consequences of increasing bank-equity requirements, concludes that very substantial increases would have very little effect 

on lending rates.14

But even if there were some increases in lending costs as a result of increased 

equity requirements, those costs have to be offset against the benefits: (a) To the 

extent that the increased costs are a result of increased taxes paid by banks, then 

in principle, the Government could, for instance, have broader based reductions in, 

say, taxes on investment-enhancing growth and efficiency. (b) There are very large 

societal costs from bank failures, and these can be substantially reduced by higher 

equity requirements. Based on a conservative estimate of the increased cost of borrowing and plausible magnitudes for the shocks facing an economy, Miles, et al., 

conclude that substantial increases in the equity requirements are warranted.15

There are two responses to this perspective. The first is that increasing equity requirements will increase the cost of borrowing and lead to less investment. But (in 

a closed economy) aggregate investment is limited by aggregate savings, and there 

is no reason to believe that the latter will be adversely affected.16 But most critically, we have argued that in the case of well-functioning markets, there is no basis 

to this belief. If, of course, markets irrationally do not take into account the additional risk imposed on equity (in the short run), then with increased leverage, funds 

might be able to be provided at lower than their true social costs. But it would be 

a big mistake (as we should have learned) to allow banks to do this. As we have 

learned, society will eventually pay the price for this market distortion—and that 

price can be very, very high. 

The second is that the existing banks (perhaps especially the large banks) have 

an absolute advantage in judging credit worthiness. Restricting leverage in effect restricts their ability to leverage their core competencies to ensure the efficient allocation of resources in society. The crisis has shown that the predicate of this hypothesis is simply false: the large banks’ performance was hardly stellar, and some of 

their (admittedly low) returns were undoubtedly related to the implicit subsidy provided by the Government. But again, more fundamentally, putting aside concerns 

about too-big-to-fail and anti-competitive practices, if the existing banks can demonstrate to the market their greater competency, including at managing risk, they 

will have no difficulty raising capital at the appropriate risk adjusted rate; indeed, 

if they are better at risk management, then their cost of funds will be lower than 

that of their competitors. 

Some have argued that even if it makes sense in the long run to increase capital 

requirements, doing so in the short run can be costly, especially at a time such as 

this when the economy is fragile and the banking system already weak. At most, 

this is an argument for a paced increase in capital requirements, and one which 

would not allow any dividends or share buybacks or extravagant bonus pools until 

the desired capital ratios are reached, unless the bank is raising on the market a 

more than offsetting amount of capital. But one should, at the same time, be aware 

of the large risks, especially under the current circumstances, of delay: it is precisely 

because the economy is fragile, banks have inadequate capital, and the banking sector in the aftermath of the crisis is more concentrated than before that the risk of 

a financial catastrophe of the kind that we experienced in 2008 is so great today. 

The downside risks of not doing something are especially grave now. It may be desirable, or even necessary, for the Government to provide funds for another round 

of equity injections (hopefully done in a far better way than under TARP), if the 

private sector cannot raise the necessary funds. But with literally hundreds of billions of cash available in the private sector, it should tell us something about the 
31 

riskiness of the banks (and perhaps their lack of transparency) if the private sector 

is not willing to make these investments. 

I have focused my remarks this afternoon on increasing banks’ equity capital. 

There are a number of other factors affecting the risk to the economy posed by the 

banking and financial sector. I have noted the risk of too-big-to fail banks. We 

should not allow any bank to grow to a size that it poses a systemic risk to the economy. Yet in the aftermath of the crisis, the banking sector has become more concentrated, and the risk posed by too-big-to fail banks has, if anything, increased. We 

saw in the crisis the risks posed by non-transparent transactions, such as over-thecounter CDS’s, and off-balance sheet activities. One of the reasons that the financial 

system froze was that everyone knew that there was no way that they could know 

the true financial position of most of the banks. While the Dodd-Frank Bill improved matters, it went nowhere far enough: the problems continue, and as long as 

they continue, our economy is at risk. The gravity of the situation is illustrated by 

what has been happening in Europe, where the European Central Bank has warned 

against the risk to Europe’s financial system posed by a Greek default. In principle, 

the direct exposure of the banks outside of Greece should be limited, well within 

the capacity of adequately capitalized banks to withstand. But it is clear that the 

risks can be amplified as a result of the high levels of interconnectivity and through 

CDS’s. The facts of the matter are that no one seems to know with any degree of 

precision to what extent individual banks on either side of the Atlantic are at risk; 

and to protect the banks from the excesses of their own risk taking, the ECB had 

demanded that European taxpayers bear the full costs of any restructuring. The 

ECB’s vehement opposition to what is essential to all capitalist economies—the restructuring of debt of failed or insolvent entities—is evidence of the continuing fragility of the Western banking system. (The appropriate response of the ECB should 

not have been to oppose the restructuring, but rather to insist on an appropriate 

banking and financial sector regulatory framework.) 

We may never fully protect the economy against the risk of another crisis such 

as the one that we have been through. But this much should be clear: our economic 

and financial system is badly distorted. Resources were misallocated before the crisis. No Government has ever wasted resources (outside of war) on the scale that has 

resulted from the failures of America’s financial system. We may have begun the 

work of making our financial system once again become the servant of the society 

which it is supposed to serve, but there is a long way to go. Lending, especially to 

small and medium sized enterprises is constrained. Activities that pose unnecessary 

risks to our entire economy continue. 

We cannot rely on the self-restraint or self-regulation of financial markets. We 

learned that lesson in the aftermath of the Great Depression, and the decades following World War II, with this strong regulatory system, were among the most 

prosperous this country has experienced. The question is, will we relearn that lesson 

in the aftermath of the Great Recession of 2008? 

PREPARED STATEMENT OF EDWARD J. KANE, PH.D. 

PROFESSOR OF FINANCE, BOSTON COLLEGE

AUGUST 3, 2011 

Ours is a representative democracy that espouses the principle that all men and 

women are equal under the law. This ought to mean that, in difficult times, Government officials responsible for managing the Nation’s financial safety net would treat 

the interests of all citizens more or less equally. But this was demonstrably not the 

case during the run-up of the housing bubble, nor beginning in 2007 in Government 

efforts to tame the widespread financial crisis that the bursting bubble brought 

about. Throughout both periods, the interests of domestic and foreign financial institutions were much better represented than the interests of society as a whole. 

Taxpayer interests were poorly represented because, over the years, the financial 

industry has infiltrated the bureaucratic system that is supposed to regulate its 

risk-taking and sewed huge loopholes into the capital requirements that then and 

now are supposed to keep financial instability in check. Unfortunately, the industry’s capture of the regulatory system is politically well-defended. This can be demonstrated in two complementary ways: (1) by enumerating the problems that last 

year’s Dodd-Frank Act did not even try to address (such as how to define systemic 

risk operationally or how to resolve the Fannie and Freddie mess) and (2) by examining the loose ends left in the Act’s efforts to deal with regulation-induced innovation and with institutions that have made themselves too large, too complex, and 

too well-connected politically to be closed and unwound. Living wills, enhanced reso-
32 

lution authority, claw-backs of undeserved executive compensation, and a newly 

minted Office of Financial Research are all good ideas. But the Keating 5 episode 

tells us how hard it can be for regulators to discipline politically influential firms. 

Sadly, the very same criticisms can be levied against the reform efforts unfolding 

in Basel and in the European Union as well. 

What can we do to put reform on a more promising path? Governments must rework bureaucratic incentives to refocus reporting responsibilities for regulators and 

institutions on the value of safety-net support. Until regulatory duties are embraced 

explicitly and enforced in operational and accountable ways, it is unreasonable to 

hope that authorities can or will adequately measure and contain systemic risk during future booms and busts. 

A first step would be to strengthen training and recruitment procedures for top 

regulators. If it were up to me, I would establish the equivalent of a nonmilitary 

academy for financial regulators and train cadets from around the world. The curriculum would teach cadets how to calculate and aggregate the costs of safety-net 

support in individual institutions and countries. Among other things, students 

would be drilled in the duties they owe the citizenry and in how to overcome the 

political pressures elite institutions exert when and as they become increasingly 

undercapitalized. 

Fed and Treasury Rescue Programs Placed Great Burdens on the Citizenry 

GAO data (Government Accountability Office, July 2011) show that, using funds 

that belong ultimately to ordinary citizens, the Fed bought massive amounts of debt 

on greatly subsidized terms from important foreign and domestic banking and securities firms between December 2007 and July 2010. Starting in the last quarter of 

2008, the Treasury’s Troubled Asset Relief Program (TARP) piled additional bailout 

obligations onto these same citizens. 

Evaluating Fed and TARP rescue programs against the convenient standard of 

doing nothing at all, high officials tell us that both bailout programs were necessary 

to save us from worldwide depression and made money for the taxpayer. Both 

claims are false, but in different ways. 

A financial crisis may be described as a struggle by financial firms whose asset 

values have collapsed to offload the bulk of their resulting losses onto creditors, customers, and taxpayers. In the early months of the crisis, Fed and Treasury officials 

assisted economically insolvent zombie institutions (such as Bear Stearns and AIG) 

to develop new risks and to transfer losses onto the Government’s balance sheet. 

Authorities did this by mischaracterizing the causes of these institutions’ distress 

as a shortage of market liquidity and helping insolvent firms to expand and rollover 

their otherwise unattractive debt. Far from assisting zombie institutions to address 

their insolvency, unwisely targeted and inadequately monitored Government credit 

support encouraged troubled firms not only to hold, but even to redouble the kinds 

of gambles that pushed them into insolvency in the first place. 

Bailing out firms indiscriminately has hampered, rather than promoted economic 

recovery. It evoked reckless gambles for resurrection among protected firms and created uncertainty about who would finally bear the extravagant costs of these programs. Both effects disrupted the flow of credit and real investment necessary to 

trigger and sustain economic recovery. 

The claim that the Fed and TARP programs actually ‘‘made money’’ for the taxpayer is half-true. The true part of the proposition is that, thanks to the vastly subsidized terms these programs offered, most institutions were eventually able to 

repay the obligations they incurred. But the neglected parts of the story are that 

these rescue programs forced taxpayers to provide under-compensated equity funds 

to deeply troubled institutions, and that the largest and most influential of these 

firms were allowed to become even bigger. The Government’s deals compare unfavorably with the deal Warren Buffet negotiated in rescuing Goldman-Sachs. His 

deal carried a running yield of 10 percent and included warrants that gave him a 

substantial claim on Goldman’s future profits. Lifelines provided to an underwater 

firm are not truly loans; they are unbalanced equity investments whose substantial 

downside deserves to carry at least a 15 percent to 20 percent return. 

Government credit support transferred or ‘‘put’’ to taxpayers the bill for past and 

interim losses rung up by protected financial firms. Authorities chose this path 

without weighing the full range of out-of-pocket and implicit costs of their rescue 

programs against the costs and benefits of alternative programs such as prepackaged bankruptcy or temporary nationalization and without documenting differences in the way each deal would distribute benefits and costs across the populace. 
33 

The Crucial Problem is: How to Define and Measure Systemic Risk? 

Acting in concert, market and regulatory discipline force a financial firm to carry 

an equity position that outsiders regard as large enough to support the risks it 

takes. Taxpayers become involved in capitalizing major firms because creditors regard the conjectural value of the off-balance-sheet capital that Government guarantees supply through the taxpayer put as at least a partial substitute for on-balancesheet capital supplied by the firm’s shareholders. 

The nature, frequency and extent of modern financial crises support the hypothesis that changes in risk-taking and concealment technologies available to aggressive financial institutions have repeatedly outstripped social controls on the job performance of the parties that society asks to control the safety and soundness of 

interlocking financial systems. The root problem is that supervisory conceptions of 

capital and systemic risk fail to make Government officials accountable for the role 

they play in generating either variable. Policymakers’ knee-jerk support of client 

firms’ creative forms of risk-taking and officials’ proclivity for absorbing losses in 

crisis situations encourage opportunistic firms to foster and exploit incentive conflicts within the supervisory sector and to make sure that tough decisions favor industry interests over those of the taxpayer. 

Systemic risk can be likened to a disease that has two symptoms. The DoddFrank Act and the Basel III framework seek to use higher capital requirements to 

treat only the first of these symptoms: the extent to which institutions expose themselves in directly observable ways to credit risks that might transmit exposures to 

default across a chain of leveraged and short-funded financial counterparties. But 

to be effective, the medicine of capital requirements must be adapted to take fuller 

account of a firm’s particular funding patterns and to treat a second and more-subtle symptom. This second symptom is the ease with which actual or potential zombie 

institutions can use financial accounting tricks and innovative instruments to hide 

risk exposures and accumulate losses until their insolvency becomes so immense 

that they can panic regulators and command life support from them. 

It is this second symptom that gives large and politically powerful institutions the 

ability to shift responsibility for potentially disastrous losses to taxpayers. In good 

times and in bad, the existence of this ‘‘taxpayer put’’ allows these elite institutions 

to issue the equivalent of Government debt and makes ordinary citizens uncompensated equity investors in such firms. Offering taxpayer support to zombie firms impedes macroeconomic recovery by making crippled institutions look stronger than 

they are and turns a blind eye to the ways in which their underlying weakness disposes such firms to seek out long-shot investments instead of fostering flows of 

healthy business and consumer credit. 

My recommendations for regulatory reform are rooted in the straightforward ethical contention that protected institutions and safety-net managers owe fiduciary 

duties to taxpayers. The existence of a safety net makes taxpayers silent equity 

partners in major financial firms. As de facto investors, taxpayers deserve to be informed at regular intervals about how their side of the taxpayer put is doing. Consistent with U.S. securities laws, Kane (2011) calls for managers of important financial firms to measure and report under penalties for fraud the value of taxpayers’ 

stake in their firm on the same quarterly basis that they report to stockholders and 

for Government officials to examine, challenge, aggregate, and publicize this information. 

My two-piece conception of systemic risk casts it as an option-like equity investment by taxpayers in the firms the safety net protects. The value of taxpayers’ position varies inversely both with the risk that an institution might sustain losses that 

exceed its ownership capital (i.e., the size of a firm’s tail risk) and the percentage 

of this tail risk that the Government may be expected to absorb. If tail risks turn 

out favorably, the institution reaps most of the gains. But when things go disastrously sour, the management ‘‘puts’’ the losses to taxpayers. 

Defining systemic risk as taxpayers’ side of an unfavorably structured claim also 

provides a metric for tracking systemic risk over time. Requiring authorities to calculate and disclose fluctuations in the aggregate value of the taxpayer puts enjoyed 

by large institutions would make regulatory authorities operationally accountable 

for the quality of their supervisory performance in booms and recessions alike. Although considerable disagreement exists about the best way to construct a measure 

of systemic risk, everyone agrees that it arises as a mixture of leverage and the volatility of financial-institution returns. Most existing measurement strategies incorporate the pioneering perspective of Nobel Prize Winner Robert Merton. For example, Carbo, Kane, and Rodriguez (2011) use Merton-type contingent-claim models 

with a 1-year horizon to undertake cross-country comparisons of the quality of banking supervision before and during the crisis. Hovakimian, Kane, and Laeven (2011) 

use such a model to evaluate U.S. financial supervision during 1974–2009 and to 
34 

show that regulators could have used the growing correlation of institution risk exposures as an early warning system for the current crisis. Expanding the format for 

collecting information from covered institutions to include estimates of the loss exposure (i.e., the ‘‘volatility’’) of their positions over different horizons in individual 

countries could improve both the precision of systemic-risk estimates and officials’ 

accountability for regulatory and supervisory performance. 

Traditional Reporting and Incentive Frameworks are Inadequate 

Accounting standards for recognizing emerging losses make evidence of an institution’s insolvency dangerously slow to surface. During the housing and securitization 

bubbles that preceded the 2007–2008 financial meltdown, top managers and top regulators of U.S. and EU financial institutions claim that there was no way they could 

see the buildup of crisis pressures. Moreover, as the crisis unfolded, these same officials were reluctant to prepare and publicize timely estimates of the financial and 

distributional costs of bailing out firms that benefited from open-bank assistance. 

By engaging in regulation-induced innovation, nurturing clout, and exerting lobbying pressure, a country’s systematically important financial institutions (SIFIs) 

have kept their tail risks from being adequately disciplined. The importance of political, bureaucratic, and career interests in regulatory decisionmaking allows such 

firms to screen regulatory appointments and to distort regulatory policies ex ante 

and to reshape their enforcement ex post. 

In a world of derivative transactions, top regulators need special training to understand—and considerable mental toughness to discipline—the incremental taxpayer exposures to risk that innovative instruments and portfolio strategies entail. 

Efficient safety-net management requires a more sophisticated informational framework than current methods of bank accounting and examination provide. To protect 

taxpayers and to enhance financial stability, examinations and bank accounting reports should not focus so narrowly on measures of tangible capital. They should also 

develop and report explicit estimates of the intangible value of an institution’s claim 

on taxpayer resources. To keep up with the regulated, regulators must develop 

adaptive statistical strategies that can extract from an ever-wider array of market 

data the evolving size of the public risks that they should be sworn to protect. Finally, to hold themselves accountable for carrying out these tasks conscientiously, 

regulators must accept a system of ethical constraints that requires them to share 

this information with the public. 

Summarizing, regulators need to measure and publicize the implicit and explicit 

costs taxpayers incur in supporting national and international safety nets. To help 

them to do this skillfully and conscientiously, we need to change the way they are 

trained, recruited, and incentivized. I believe that a National or International Academy for Financial Regulators could assist in these tasks. 

References 

Carbo, Santiago, Edward Kane, and Francisco Rodriguez, 2011. ‘‘Safety Net Benefits 

Conferred on Difficult-to-Fail-and-Unwind Banks in the U.S. Before and During 

the Great Recession,’’ Working Paper, Milan: Paolo Banfi Centre (July 12). 

Hovakimian, Armen, Edward Kane, and Luc Laeven, 2011. ‘‘Progress Report on the 

Hovakimian-Kane-Laeven Research Project for the Institute for New Economic 

Thinking’’ (July 1). 

Kane, Edward J., 2011. ‘‘Missing Elements in Financial Reform: A Kubler-Ross Interpretation of the Inadequacy of the Dodd-Frank Act,’’ Journal of Banking and 

Finance (forthcoming). 

U.S. Government Accountability Office, July 2011. Federal Reserve System: Opportunities Exist to strengthen Policies and Processes for Managing Emergency Assistance. Washington. (GAO–11–696). 

PREPARED STATEMENT OF EUGENE A. LUDWIG 

CHIEF EXECUTIVE OFFICER, PROMONTORY FINANCIAL GROUP

AUGUST 3, 2011 

I would like to commend Chairman Brown, the Ranking Committee Member, Senator Corker, and the other Members of this Committee for holding this hearing on 

Debt Financing in the Domestic Financial Sector. Chairman Brown and Ranking 

Member Corker, you and the rest of the Committee Members can take pride in having worked hard to address the challenges posed by the financial crisis. You have 

brought important Congressional focus to the issues of financial stability, safety and 
35 

soundness, and regulatory framework of financial institutions. You have passed 

landmark legislation in this area and continue to engage in serious oversight. 

One of the greatest challenges facing not just the financial and regulatory communities but our economy as a whole is the successful implementation of the very powerful post-crisis reforms enacted by the Congress and the international reforms currently being proposed by the Basel Committee on Banking Supervision and the Financial Stability Board. Properly implemented in a balanced and thoughtful way 

these reforms should enhance financial stability in the United States. 

If this balance is lost however, the potential exists—particularly given the potentially great cumulative impact of these rules—that the financial system will be actually less stable and less able to fulfill its key function in supporting the economy 

of the United States, putting a deleterious drag on capital formation and meaningful 

job opportunities for our people. 

We must never lose sight of the fact that the financial crisis has taken a tremendous toll on our country. Millions of Americans are reeling from the loss of their 

jobs, their homes, and their life savings. We need the banking system to serve them 

again and to fulfill its critical role of supporting economic growth. Therefore, we 

must ensure that the hundreds of rules required by the Dodd-Frank Act are implemented with great care and in a coordinated fashion. The sum total of these reforms 

must contribute to the country’s economic recovery and future stability. 

In implementing the Dodd-Frank Act, it is important to emphasize that the Act 

is sufficiently comprehensive that each rulemaking should be evaluated with the 

recognition that the cumulative impact of the entirety of the Dodd-Frank Act reforms will have an immense, and not entirely predictable, impact. It is critical to 

take a thoughtful approach to the implementation of all of these reforms—domestic 

and international—with an eye toward maintaining the balance of the financial system and allowing the economy to recover and provide Americans with much needed 

jobs and opportunity. 

The modern financial system is a complex mechanism that can be a potent force 

for development and opportunity. It is hard to imagine how a developed economy 

can thrive without a robust financial system. But, as we have seen, modern finance—like every other human endeavor—has flaws. Both the Dodd-Frank Act and 

the rules proposed by the Basel Committee and the Financial Stability Board seek 

to rectify those flaws and provide the medicine needed for a stronger and safer financial system that can support the critical growth ultimately needed for America’s 

recovery. This is truly an omnibus effort; the kind of change that occurs rarely more 

than once in a generation. However, like any strong medicine, if applied incorrectly 

or excessively, the Dodd-Frank Act, and the Basel Committee and Financial Stability Board reforms can produce more harm than good. 

I have been a regulator, banker, and bank adviser for over 30 years. In these 

roles, I have developed, implemented, and evaluated complex financial system rules 

and controls. There are tremendous practical challenges in creating and maintaining 

control systems that function at a level that modern finance demands and that Congress, the regulatory community, and the public have a right to expect. Targeting 

resources to create controls that matter and refraining from imposing excess or 

overkill in reforms are key to successful implementation. Therefore, in this regard, 

I like to say that more is not better, better is better. 

Capital Increases 

The capital rules are a good case in point. Through the work of the Basel Committee, the Financial Stability Board, Congress, and U.S. regulators, we now have 

very tough capital requirements and capital levels that significantly exceed previous 

requirements. 

The major source of higher minimum capital requirements is the work of the 

Basel Committee, in which the U.S. banking regulators play a lead role. Under current Basel capital rules, banks have to hold 8 percent total capital and 4 percent 

Tier 1 capital—only half of which must be common equity. Under Basel III, which 

was issued in December 2010 and will be implemented beginning in 2013, banks 

will have to hold 10.5 percent total capital and 7 percent common equity. On top 

of that, U.S. regulators may add on an additional ‘‘countercyclical capital buffer’’ of 

up to two and a half percent, which, as currently contemplated, must be composed 

of common equity. Furthermore, most financial institutions, out of concern that 

there will be adverse consequences if they breach—even for a short period of time— 

any of their regulatory minimum ratios, typically carry their own buffers in excess 

of those required. 

It is hard to quantify just how much additional capital is being added to the requirements, both because of these complex definitional elements and the fact that 

U.S. implementation of Basel III and capital standards required by Title 1 of the 
36 

Dodd-Frank Act has not yet taken place. However, it is notable that under Basel 

III, banks have to hold a minimum of 7 percent common equity, as opposed to a 

minimum of 2 percent common equity under Basel II (because half of the 4 percent 

Tier 1 minimum could be held as noncumulative preferred stock and certain hybrid 

instruments). This is over a threefold increase in required common equity, before 

even factoring in additional buffers and revised risk weights described below. 

This is an important change, because common equity is the highest quality of capital in terms of loss-absorbing ability, albeit also the most expensive for banks to 

raise. Furthermore, prior to the crisis several of our largest non-bank institutions, 

notably investment banks, were subject to a much less rigorous capital regime. Now, 

given changes occasioned by the financial crisis, as well as the ability of the Financial Stability Oversight Council (FSOC) to designate non-bank financial institutions 

as ‘‘systemically important’’, a number of institutions will see even more marked increases in the capital they are required to hold. 

It should also be noted that after the financial crisis the Basel Committee revised 

certain risk weights on assets that had been instrumental in the financial disruption. For example, re-securitizations and trading assets now will have substantially 

higher risk weights beginning in 2012. The Basel Committee estimates that banks 

will hold four times the amount of capital on trading activities than under the current framework. 

Finally, under a recent Basel Committee proposal, large complex banking companies—so-called global SIFIs—will have to hold yet another capital buffer of one to 

two and a half percent. 

The Importance of Balance 

At the end of the day, capital is an important tool in the supervisory toolbox, but 

it is only one tool; therefore, I would not, at this time, advise any further increases 

in capital requirements beyond the tough new Basel rules. The Dodd-Frank Act provides capital requirements as a regulatory mechanism with other powerful tools to 

enhance safety and soundness of the financial system. While focusing on capital is 

appropriate, to do so to the exclusion of other important mechanisms for ensuring 

bank safety and soundness is risky. We take the chance of capital’s becoming the 

Maginot Line of financial institution safety and soundness. Capital is a necessary 

condition for good safety and soundness, but it is not sufficient in and of itself. 

In this regard, it is worth noting that bank failures in the recent crisis were typically not the result of banks running out of capital, but rather the result of liquidity 

weaknesses. The Dodd-Frank Act requires heightened liquidity standards for bank 

holding companies of $50 billion or more in assets. The Basel Committee is in the 

final stages of issuing stringent new liquidity rules. Furthermore, the Dodd-Frank 

Act provides regulators with an armory filled with other supervisory tools. Some of 

these tools are new, like the work of the Office of Financial Research (OFR), and 

resolution plans. Other tools are not new, but they are greatly enhanced, like stress 

testing and an increased emphasis on governance and risk management. 

Taken as a whole, these tools, along with the significant powers already held by 

bank regulators, should be, at this point, adequate to greatly enhance financial stability. Taken to the extreme, any one or a group of these tools can prove harmful. 

In this regard, it is important to recognize that the CAMELS supervisory rating 

system is one of the valuable ways to rate a banking organization’s safety and 

soundness. The ‘‘E’’ in CAMELS stands for earnings. The E is there because regulators know that it is not possible for a banking organization to be truly safe if it 

does not earn steady and safe returns on a risk adjusted basis. Solid earnings allow 

banking organizations to make loans to firms that want to expand, develop new 

products and equipment, and take sensible risks so they can grow, providing jobs 

and prosperity. But, make no mistake; lending money to even the most sound businesses borrowers is a risky business even with the best borrowers, best collateral, 

and best ideas. 

Without solid earnings, a banking organization cannot as easily attract capital, 

nor can it accumulate as much capital through retained earnings. In this regard, 

it is also worth emphasizing that nothing flows to the bottom line faster than expense, which quickly accumulates with increased capital and controls. While it is 

essential to have strong capital and strong controls, policymakers and regulators 

must remember that banks simply have to be able to bear the expense of the capital 

and controls that are needed. Excess capital and controls risk needlessly weighing 

down a banking organization. 

Some would say that we can solve all the weaknesses in the financial system by 

adding capital, capital, and more capital. My view is different. Yes, capital is needed, and much capital is being added. But we need to be careful about excess. What 

is critically important to safety and soundness is balance, balance, and balance. 
37 

So how do you achieve the right balance? How do we ensure that our regulators 

and regulations are both serious and meaningful, but not so elaborate that they 

weigh down banks to the point of dysfunction? Unfortunately, there is no quick fix, 

but I can provide some suggestions. 

A well functioning set of regulations and a sound regulatory mechanism starts 

with what you are doing at this hearing today: constant and thoughtful Congressional oversight. The next step is ensuring that our regulators continue to be top 

professionals who are devoted to a safe and sound banking system, one that supports prudent innovation and economic growth. Third, both from the standpoint of 

Congressional oversight and as a former regulator, we must avoid waste and excess 

in implementing our rules and procedures. Fourth, I would insist that our regulators periodically review their rules to insure that they are both effective and cause 

the least burden possible. 

For example, our current system of multiple regulators is an area where the burden can be lessened. I have long advocated for one prudential safety and soundness 

regulator, not several. However, since that is the system under which U.S. banking 

institutions currently operate, we must encourage our fine regulatory agencies to divide the work in order to minimize duplication or triplication. 

Finally, I want to note two other points that bear on sound implementation of the 

Dodd-Frank Act and international rules. First, it is essential that in implementing 

international capital and liquidity rules for global banks, we insist on a level playing field. Setting a requirement for the amount of risk-based capital we want banks 

to have globally will not be effective without uniform implementation. How we define the numerator—the capital itself, and the denominator—risk weighted assets, 

is critical. Equally important, we have to ensure that standards are applied fairly 

around the globe if we are to have global standards that do not simply put U.S. financial firms at a disadvantage. 

This is not an easy issue. Today’s Basel capital rules allow banks around the 

world to calculate, within certain parameters and approaches, the risk weights that 

apply to their portfolio of assets. While supervisors have a key role in overseeing 

and approving the models that the banks use for this purpose, there is an emerging 

view that some banks’ models may be less rigorous than others. 

From my experience as a former supervisor and banker, I can assure you that the 

U.S. supervisors have taken this task quite seriously and, accordingly, U.S. banks’ 

models are quite rigorous. In fact, one of the primary reasons that U.S. banks are 

still in the transition stages of implementing Basel II is because of the high standards to which U.S. supervisors hold them. If some non-U.S. banks are allowed to 

use inadequate modeling to determine their capital risk weights, then U.S. banks 

may be at a significant competitive disadvantage. Moreover, the international banking system is only as strong as its weakest link. The Basel Committee is beginning 

to tackle this issue, which is a critical task before the higher Basel III and G–SIB 

(Global Systemically Important Bank) capital requirements become effective. Congress and U.S. regulators should be watchful here too. 

Nonbanks 

Another area where more work needs to be done is outside of the banking system. 

Less-regulated non-bank financial players own one-quarter of U.S. financial sector 

assets. When our capital markets recover and many of the Dodd-Frank Act restrictions become effective, non-bank players are likely to become an even greater force. 

These entities—the so-called shadow banking system—can put on 20:1; 30:1 or even 

50:1 leverage—effectively capital requirements as low as 2 percent. As long as this 

severe imbalance continues, it is a serious threat to the financial system. The FSOC 

has the authority to level this playing field in a variety of ways, including designating activities and non-bank institutions that present systemic risks to the financial system. 

Here again, balance is key. We do want innovative, particularly smaller players 

to have room to grow; we do want to encourage free markets. However, where anomalies become large either in terms of size or imbalance, the better players are 

pushed further out on the risk curve than is desirable and the weaker players become ever more likely to fail and cause disruption. 

Macroprudential Supervision 

One area where implementation of the Dodd-Frank Act is particularly important 

is with respect to the OFR, which was created to monitor, on behalf of the FSOC, 

present and emerging systemic risks in the financial system. OFR is one of the most 

important positive and creative developments resulting from the Dodd-Frank Act. 

Functioning correctly, the OFR should give regulators, the financial system and 
38 

1What follows is largely based on a paper that I co-authored with Anat Admati, Peter 

DeMarzo and Martin Hellwig entitled ‘‘Fallacies, Irrelevant Facts, and Myths in the Discussion 

of Capital Regulation: Why Bank Equity is Not Expensive.’’ That paper and related materials 

can be found at: www.gsb.stanford.edu/news/research/Admati.etal.html. 

Congress better headlights as to where the financial system is headed and any potholes along the road. 

However, for the OFR to function effectively, it must have a Congressionally confirmed director and sufficient staff so it can conduct systemic risk analysis and 

present independent views to both the FSOC and to Congress. 

Further, and enormously important, the OFR should work hard not to create 

undue additional burdens for the financial system. It needs to faithfully execute its 

mandate to use existing data wherever possible, coordinate its data gathering activities, and standardize data collection so the same information is not reported multiple times in multiple formats. 

Conclusion 

Finally, I would like to say a word about the banking system and getting our 

economy moving again. While the fundamental problem with credit right now is a 

sluggish overall economy, at the margin, the elements exist today for a credit crunch 

much like the time I entered office in 1993. In 1993, supervisors and bankers were 

recovering from a period of boom and bust. The supervisory pendulum had swung 

to excess caution in some areas of the country. 

Today, the combination of a plethora of new rules to implement in addition to supervisory caution—of course a natural reaction to a difficult period—threatens to 

dampen economic growth. It is essential for all parties to work toward balance. Regulation and supervision can be both effective and tough, but balanced, allowing for 

safe lending and capital formation. We must all continue to work to strike this balance. 

PREPARED STATEMENT OF PAUL PFLEIDERER, PH.D. 

C.O.G. MILLER DISTINGUISHED PROFESSOR OF FINANCE, GRADUATE SCHOOL OF

BUSINESS, STANFORD UNIVERSITY1

AUGUST 3, 2011 

Government policy should not encourage firms to take actions that have large social costs and create little or no social benefit. This simple proposition is supported 

by both common sense and elementary economic reasoning. For a transparent case, 

consider a firm that wants to locate a uranium processing plant in the center of a 

densely populated residential area. Zoning laws and other regulations will prevent 

the firm from doing this and for good reason: there is no social benefit to locating 

a plant handling radioactive materials in a densely populated area, and there are 

significant social costs, including health risks and declining property values. It 

would be pure folly for the Government to give this company a tax break only if 

it locates its uranium processing plant in a very populated area. It would be even 

greater folly for the Government to provide this tax break and in addition agree to 

pay any health claims brought against the firm, but only if plant is located in a residential area. 

Government Policy Perversely Distorts Banks’ Funding and Creates Unnecessary Risk 

While we don’t have policies that perversely affect the location of uranium processing plants, we do have policies that perversely distort the funding choices made 

by banks and other financial institutions. These policies make it cheap for banks 

to fund themselves with debt and expensive to fund with equity. 

First, our tax system favors debt financing over equity financing. This is because 

interest payments are treated as a deductable expense in the computation of corporate tax, but payments to shareholders are not treated in this way. Debt provides 

a ‘‘tax shield’’ and, holding everything else equal, a company that uses more debt 

financing has a lower tax bill than a company funded with less debt. 

Second, as is well known, banks, especially ‘‘too-big-to-fail’’ banks, benefit from 

implicit guarantees that the Government provides for the banks’ debt. By lowering 

the risk of holding debt, these implicit guarantees lower the interest rate banks 

must pay to their creditors and constitute a significant subsidy to the banks based 

on their using debt rather than equity. It is difficult to measure precisely the magnitude of this subsidy, but there are many reasons to believe that it is quite large. 

First, rating agencies explicitly account for the Government support by giving two 
39 

2See Dean Baker and Travis McArthur, ‘‘The Value of the ‘Too Big to Fail’ Big Bank Subsidy,’’ 

CEPR Issue Brief, September, 2009. 3See Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburg, ‘‘Too-Systematic-To-Fail: 

What Option Markets Imply about Sector-Wide Government Guarantees,’’ NBER Working Paper 

Series, June, 2011. 

ratings for banks: a standalone rating and a support rating. The latter accounts for 

the implicit Government guarantee, and the difference between the two ratings 

gives some indication of the importance of Government support. Moody’s recently 

gave five notches of ‘‘uplift’’ to Bank of America due to Government support, four 

notches to Citibank, and three to Wells Fargo. In the case of Bank of America, this 

means that Government support lifts the bank’s credit rating on senior debt from 

Baa2 to Aa3, changing the category for its bonds from ‘‘minimum investment grade’’ 

to ‘‘very high quality.’’ A study 2 conducted after the crisis looked at the differences 

between funding costs of smaller and larger banks and used these differences to estimate that the value of the ‘‘too-big-to-fail’’ subsidy for the 18 largest U.S. banks. 

The estimates put the aggregate value of the Government subsidy between $6 billion and $34 billion per year, which accounts for somewhere between 9 percent and 

48 percent of bank profits. Using a completely different approach, three researchers 

in a recent paper 3 examined the pricing of put options on financial firms and used 

these market prices to infer the market’s assessment of the value of the subsidy to 

bank shareholders. They find that the subsidy substantially reduces the cost of capital for systemically important banks, and in their calibration the bailout guarantee 

accounts for at least half of the market value of the banks’ stock. In addition to the 

‘‘too-big-to-fail’’ subsidies that the Government delivers through implicit guarantees 

and bailouts, bank funding can also be subsidized by the Government through explicit guarantees such as deposit insurance. Banks pay premiums to the FDIC for 

this insurance, but if these premiums are too low, the insurance is underpriced and 

the banks benefit. 

Both the tax system and the Government safety net subsidize the banks’ use of 

debt. These subsidies make debt cheap relative to equity. The distortions this creates are not innocuous. Encouraging banks to fund themselves almost exclusively 

with debt makes them much more fragile than they need to be. If this just affected 

a few small banks in isolation, it would not be a significant problem. Unfortunately 

it affects the whole banking sector and particularly the ‘‘too-big-to-fail’’ banks. When 

highly interconnected banks and other financial institutions are funded with small 

slivers of equity, there is little margin for error and modest shocks to asset values 

can put the entire system on the verge of insolvency. Slightly larger shocks make 

the system insolvent. As was demonstrated in 2008, when a highly leveraged financial system becomes distressed, the results can spill over into the rest of the economy with devastating consequences. A mere 3 years after the crisis we are seeing 

in Europe further evidence of the vulnerability of economies to a fragile, highly leveraged banking system. There are clearly huge social costs to having thinly capitalized banks. This might be tolerated if there were offsetting social benefits. There 

are not. 

We are told that ‘‘capital is expensive’’ for banks and if we raise equity capital 

requirements by even modest amounts, awful things will happen. These claims and 

dire warnings are based on a number of fallacies and confusions. 

Banks Do Not ‘‘Hold’’ Capital and Capital is Not Idle Funds 

One pervasive confusion stems from the completely misleading notion that banks 

‘‘hold’’ capital. This terminology gives rise to fundamental misunderstandings of 

what capital is and the role it plays. To explain the importance of capital and why 

banks do not ‘‘hold’’ capital requires that we look at a bank’s balance sheet. Figure 

1 presents a simplified version of a bank balance sheet. 
40 

4Throughout this discussion the capital ratio will be taken to mean the ratio of equity to total 

assets. In practice bank capital is measured in a number of different ways. Reported measures 

are generally based on ‘‘book’’ values of assets, which can be quite different from actual market 

values. In addition, reported capital ratios are often calculated in terms of ‘‘risk-weighted’’ assets. Since many types of assets receive risk-weights less than 100 percent, this and the use 

of book values can make capital ratios look high even when a bank is very thinly capitalized. 

On the left-hand side of the balance sheet are the bank’s assets. Among these assets are its cash reserves, its trading account assets and the loans the bank has 

made. On the right-hand side of the balance sheet are the liabilities the bank has 

incurred in raising funds. These liabilities include deposits and various forms of 

debt the bank has issued. Also on the right-hand side is shareholders’ equity. 

Capital is basically shareholders’ equity. This means that the amount of capital 

a bank has is determined by how the right-hand side of the balance sheet is constructed. In Figure 1 the value of the bank’s equity capital is 5 percent of the total 

asset value, i.e., 100/2,000 = 5 percent. It should be noted that before the crisis 

many major banks had capital that was as little as 2 percent or 3 percent of asset 

value.4

The right-hand side of the balance sheet can be understood in terms of the promises the bank has made to the providers of the bank’s funding. When a bank funds 

with debt, it makes an explicit, contractual promise to pay the creditors specified 

amounts. When a bank funds with equity, it makes no explicit promise to pay a 

given amount; the shareholders providing the equity funding are simply entitled to 

what is left (if anything) after the creditors (depositors and bond holders) have been 

paid. 

Financial crises and the need for Government bailouts occur when banks suffer 

losses on their assets and become insolvent or close to insolvent. Insolvency quite 

simply means that the bank is unable to meet the contractually specified promises 

it has made to its creditors because its assets are worth less than its liabilities. 

Imagine the bank whose balance sheet is given in Figure 1 suffers a loss of 25 on 

its trading assets and a loss of 125 on its loan portfolio. Its balance sheet becomes: 

The bank is now ‘‘underwater,’’ and this is reflected in the fact that shareholders’ 

equity is negative. Bank shareholders, like all shareholders, have limited liability. 

This means that they cannot be forced to kick in the 50 required to make up the 

shortfall between the value of the bank’s assets and the contractual promises made 

to the depositors and other debt holders. If this were a non-financial company rather 

than a ‘‘too-big-to-fail’’ bank, bankruptcy would occur, the shareholders would be 

‘‘wiped out,’’ and creditors would be forced to take some losses. In the case of a systemically important, ‘‘too-big-to-fail’’ bank, the Government will be under tremendous pressure to keep a bank from failing and will provide support to keep the bank 

afloat. The result will be something like what is depicted in Figure 3: 
41 

By various means the Government can ‘‘inject money’’ into the bank. For example, 

it can buy bank assets at inflated prices, provide additional guarantees that increase the value of some of the bank’s assets, or provide funding at below market 

rates. However value is injected, the only way that the Government can truly make 

an insolvent bank solvent is to increase the value of the bank’s assets on the lefthand side of the balance sheet by more than the value of any claims (e.g., preferred 

shares) it gets from the bank on the right-hand side. In the example shown in Figure 3, the Government increases the value of the bank’s assets by 75 and only takes 

a claim worth 20. The difference is 55. Of this 55, 50 goes to filling in the amount 

the bank was underwater (the shortfall between the bank’s assets and its liabilities) 

and the remaining 5 is a benefit to the shareholders. 

Now let’s start the story again, except in this case we will assume that the bank 

is much better capitalized. Instead of having only 5 percent equity capital to total 

assets, the bank has a much more prudent ratio of 15 percent equity to total assets. 

This is shown in Figure 4. 

On the left we have the balance sheet of the original, poorly capitalized bank. On 

the right we have our much better capitalized bank. First note that the two banks 

are holding exactly the same assets. The better capitalized bank is not being forced 

to ‘‘hold’’ something that its poorly capitalized twin is not holding. Claims such as 

the one made by Steve Bartlett (Financial Services Roundtable, September 17, 2010) 

that ‘‘every dollar of capital is one less dollar working in the economy’’ are simply 

false. Our better-capitalized bank has the same assets and the same number of dollars working in the economy as the poorly capitalized bank. 

The difference between the balance sheets in Figure 4 relates to the contractual 

promises the two banks have made. The better-capitalized bank has only taken on 

600 in non-deposit debt, not 800, and has funded itself with more equity. This 

means that it has much more equity to absorb losses. Assume now that both banks 

suffer the losses discussed above: a loss of 25 in trading assets and a loss of 125 

in the value the loan portfolio. Figure 5 shows the balance sheets after the losses: 

With 15 percent initial capital our prudent bank remains strongly solvent after 

the loss in asset value that completely crippled the bank with only 5 percent initial 

capital. Unlike the poorly capitalized bank, the better-capitalized bank requires no 

Government bailout. In fact, even after the drop in asset value, our better-capitalized bank’s capital ratio is 8.1 percent (150/1850 = 8.1 percent), higher than the initial capital ratio of the poorly capitalized bank. The better-capitalized bank can sustain even further losses without requiring Government support. 

Because of the possibility of Government support, shareholders will prefer that 

their bank be thinly capitalized. In other words, they will prefer the left-hand sides 

of Figures 4 and 5, not the right-hand sides. To see why, we must keep track of 

the money. Assume we start with the bank being well capitalized as shown on the 

right-hand side of Figure 4. The shareholders can either leave their bank well-cap-
42 

5See Alan Greenspan, ‘‘The Crisis,’’ Brookings Papers, April 15, 2010. 

italized at 15 percent, or they can have the bank borrow 200 and pay out the 200 

in proceeds as a dividend to the shareholders. If they do the latter, they convert 

their well-capitalized bank into the bank with 5 percent capital shown on the lefthand side of figure 4. We can now compare their positions after the bank loses 25 

on trading assets and 125 on its loan portfolio. 

• If they had converted their bank into a thinly capitalized bank, they would have 

the 200 they received as a dividend plus the 5 in shareholder equity shown on 

the left-hand side of Figure 5. 

• If they had left their bank well capitalized, they would end up with 150 in 

shareholder equity, as shown on the right-hand side of Figure 5. 

In other words, they end up with 205 with the thinly capitalized bank and only 150 

with the better capitalized bank. The difference of 55 is exactly what the Government puts into the bank to bail it out. 

Something very important is evident in Figures 4 and 5: losses are socialized on 

the left-hand sides and losses are privatized on the right-hand sides. As well as imposing unwarranted costs on the taxpayers, socializing losses creates all kinds of incentive problems. For example, socializing losses creates incentives for inefficient 

and excessive risk taking, since the shareholders get the benefits of the ‘‘upside’’ and 

the Government and taxpayers bear the costs of the ‘‘downside.’’ 

Figure 5, however, doesn’t reveal all the advantages of higher equity capital. The 

left-hand side of Figure 5 may lead to a financial crisis and collateral damage to 

the rest of the economy. This is much less likely on the right-hand side. The benefits 

of having more equity in preventing a crisis are widely recognized. For example, 

Alan Greenspan wrote in 2010:5

Had the share of financial assets funded by equity been significantly higher 

in September 2008, it seems unlikely that the deflation of asset prices 

would have fostered a default contagion much, if any, beyond that of the 

dotcom boom. 

One Must Not Confuse Private With Social Costs 

Requiring banks to have much more prudent levels of equity capital clearly produces many benefits, but bankers insist that ‘‘equity is expensive’’ and must be used 

sparingly. These claims are also based on confusions and fallacies. Perhaps most 

egregious among them is the confusion between private and social costs. 

Consider again the uranium processing plant example discussed above. Assume 

that the Government has a perverse policy on plant location: the firm will receive 

tax breaks and free Government insurance against health risks only if the plant is 

located in a crowded residential area. The firm’s managers can legitimately say that 

it would be costly for them to locate the processing plant far away from a crowded 

residential area. It would be costly for them because they would be giving up both 

the favorable tax treatment and the freely provided Government insurance that is 

protecting them against health claims. But giving these subsidies up is a private 

cost to the firm, not a social cost. The tax benefits and insurance all come at the 

expense of the general taxpayer. What the firm loses in giving these up, the general 

public gains. Of course the general public gains much more because it is much safer 

to have the plant located away from a crowded area. 

The situation is precisely the same for banks. If banks are required to fund themselves with more equity, they will give up tax benefits (the debt tax shield) and freely provided or underpriced Government guarantees (particularly for banks that are 

considered ‘‘too-big-to-fail’’). Giving up these subsidies is a private cost to the banks, 

not a social cost. And just like moving the uranium processing plant away from a 

crowded residential area produces a huge social benefit, so does moving the banks 

away from imprudent levels of equity capital with all the risks this brings to the 

economy. 

It is clear that our system subsidizes banks by making debt cheap. It might be 

argued that these subsidies are good if the banks pass them on to borrowers in the 

form of lower lending rates. If we remove the subsidies that make it cheap for the 

banks to fund with debt, won’t the banks increase the rate they charge to borrowers 

and won’t this hurt the economy? Let us pose the exact analogue of this question 

in the context of the uranium processing plant: Won’t forcing the uranium processing firm to locate its processing plant far away from a crowded residential area 

reduce the subsidy the firm gets, and won’t this force the firm to charge more for 

processed uranium? Whether or not it makes sense for the Government and its tax-
43 

payers to subsidize uranium processing, it certainly does not make sense for a subsidy to be given in a way that requires the processing firm to locate its dangerous 

plant in a crowded residential area. Now consider banks. Whether or not it makes 

sense for the Government to subsidize banks’ lending, it certainly does not make 

sense for a subsidy to be given in a way that requires banks to fund themselves in 

a fragile way that is dangerous to the rest of the economy. Arguments that bank capital requirements should not be significantly increased because this would remove 

a subsidy that the banks use to keep lending costs low are completely unfounded. 

If bank lending needs to be subsidized, this should be done in a direct way that does 

not put the economy at risk. 

Arguments Based on a Fixed Required Return on Equity (ROE) are Flawed 

Another source of confusion and fallacious reasoning about equity capital requirements for banks is associated with the notion of a fixed, required rate of return on 

equity for banks. It is well established that investors are risk averse and they must 

be compensated for the risk they bear. Prices are set in markets so that securities 

that add more risk to investors’ portfolios have higher expected returns than those 

that add less risk. There is absolutely no reason to think that investors ignore risk 

when investing in banks’ equity. 

The risk that a bank’s shareholders bear depends on how that bank funds itself. Consider two banks of equal size. Assume that the first bank is funded with $40 

billion in equity and $960 billion in debt, while the second is funded with $100 billion in equity and only $900 billion in debt. Now consider what happens if each 

bank suffers a loss of $8 billion. For the first bank this $8 billion loss is spread 

across a small equity base and results in a 20 percent loss for the shareholders (– 

8/40 = –20 percent). For the second bank the $8 billion loss is spread across a bigger 

equity base and results in only an 8 percent loss (–8/100 = –8 percent). By concentrating its losses on a smaller equity base, the first bank makes its equity returns 

much riskier than the second bank’s equity returns. Because of this the first bank’s 

shareholders will have a higher required rate of return on their equity to compensate for this risk. 

The claim is often made that bank shareholders have a required return that is 

fixed and will not change when the bank funds itself with more equity and less 

debt, even though this reduces the riskiness of equity returns. This notion of a rigid 

required rate is used to argue that increasing equity requirements will increase 

banks’ funding costs. The implicit assumption behind this claim appears to be that 

bank investors fail to account for the risk they are bearing or are somehow fooled. 

If this is true, we must seriously question the ability of markets to properly allocate 

capital in the financial sector. In fact, there is no reason to come to any drastic conclusions. A required return on (or cost of) equity that is independent of the risk of 

a bank’s equity makes no sense and violates all we know about security markets. 

Arguments based on this reasoning are deeply flawed. 

It should also be noted that return on equity (ROE) is often used as a performance 

measure and the compensation of many bank managers appears to be tied to ROE. 

This creates perverse incentives for funding banks with minimal amounts of equity. 

Consider two bank managers whose banks have similar assets. Manager A’s bank 

is more prudently funded with 10 percent equity, while Manager B’s bank has only 

3 percent equity. In addition to having a safer bank, assume that Manager A has 

managed his bank’s assets very well, earning a return on assets (ROA) of 3 percent, 

while Manager B has managed his assets quite poorly, earning a return on assets 

of only 2.5 percent. As the table below shows, Manager B posts a much higher ROE 

despite the fact that Manager A is the better manager. 

Manager B’s ROE exceeds Manager A’s ROE only because Manager B’s bank is 

more highly leveraged and more fragile. If Manager A is compensated on the basis 

of ROE, he has incentives to reduce his equity funding and the safety of his bank. 

Requiring Banks to Fund with More Equity is Not Socially Costly 

Many policy decisions are quite challenging since they involve difficult tradeoffs 

between social costs and benefits. For an example, consider levees that are built for 
44 

flood protection. Should a levee be built for the once-in-a-100-year flood or the oncein-500-year flood? Building a safer levee produces clear social benefits, but it also 

entails social costs, since the construction of a safer levee requires the use of more 

resources (e.g., more labor) that could have been used elsewhere for other purposes. 

Fortunately we do not face this sort of difficult tradeoff when thinking about bank 

capital requirements. This is because requiring banks to fund with more equity does 

not use up any social resources that could have been used for other purposes. It only 

entails that banks change the nature of the contractual promises that they make 

to those providing their funding. Some securities that would have been sold by a 

bank with the label ‘‘debt’’ must now be sold with the label ‘‘common share.’’ In fact, 

banks can over relatively short periods of time increase their equity capital significantly by not making dividend or other payments to shareholders, but instead using 

the cash that they would have paid out to shareholders to pay off their debt and 

reduce their overall leverage. Of course we know that banks will not do this voluntarily since it will reduce the subsidies that they get from the Government. In addition, managers may be concerned because this will mechanically reduce the return 

on equity (ROE) even as it makes their banks safer and less of a danger to the economy. The reduction in bank subsidies and the reduced return on equity due to lower 

risk and lost subsidies are private costs to the managers and shareholders of the 

bank (when considering only their holdings in the banks, not necessarily their entire 

portfolio or economic welfare), but they are not social costs. 

Requiring banks to fund more with significantly more equity will make our financial system safer and substantially reduce the risk of another financial crisis that 

imperils the rest of the economy. Of course, a significant increase in required equity 

funding is not a panacea that solves all problems and removes the need for any 

other types of regulation or supervision. However, contrary to the flawed arguments 

against it, requiring significantly more bank equity produces significant social benefits at little or no social cost. 

Note that it does not follow from this that banks should be funded with 100 percent equity. A nontrivial portion of bank liabilities, e.g., deposits, is socially valuable. But much of the debt that banks have used in funding is used simply because 

incentives (tax and guarantee subsidies, compensation based on ROE measures) 

make it privately, but not socially, desirable. 

Level Playing Fields and Playing in the Shadows 

It is often argued that our overriding concern must be that playing fields are 

level. The claim is that if other jurisdictions permit their banks to be thinly capitalized, we also must permit our banks to be thinly capitalized. Otherwise our banks 

will be unable to compete. It is important to understand what is really being said 

by those making this argument. They are really contending that if other countries 

provide too-big-to-fail and other types of subsidies (at taxpayer expense) to their 

banks and these subsidies encourage their banks to be highly leveraged and fragile, 

posing a threat to their economies, we must provide similar subsidies to our banks 

(at taxpayer expense), so that our banks are fragile and highly leveraged and pose 

a danger to our economy. This makes no sense. In broad terms banks can generate 

profits in three ways: 

• They can make and monitor loans to households and commercial enterprises. 

• They can facilitate payments, transactions and the issuance and trading of various securities. 

• They can exploit their ability to borrow at Government subsidized rates, becoming highly leveraged, thinly capitalized and systemically risky in the process. 

True social value is potentially created by the first two activities, but not by the 

third, even though the third can be a great source of bank profits. Taking away the 

third activity is not socially costly and actually produces significant social benefits. 

As mentioned above, if either of the first two activities requires a Government subsidy, that subsidy should not be provided through the third activity. Arguing that 

other jurisdictions permit their banks to earn great profits through the third activity 

is not an argument for saying this should be permitted in our country. 

It is also often claimed that if higher capital and other regulatory requirements 

are imposed, banks and other entities will just find a way to do ‘‘risky stuff’’ in the 

shadows (e.g., the unregulated shadow banking sector). This claim sounds a bit like 

the unruly teenager who argues that if his parents don’t permit him to take illegal 

drugs in their house, he will simply do it at his friend’s house. It is clearly a challenge for regulators to monitor risk and make sure that it is not being hidden in 

ways that ultimately burden the taxpayer and put the economy at risk. But this is 

not an insurmountable challenge. It should, for example, be noted that before the 
45 

crisis much of the shadow banking system relied on support from regulated entities. 

This meant that regulators had the potential to control it. 

We Need the Government to be Less Involved 

Because of too-big-to-fail guarantees and other subsidies our Government is enmeshed in the financial system. As a consequence prices and decisions are distorted 

and private markets are not working as they should. Figure 5 shows the difference 

between the system that we have now (the left side of the figure) in which losses 

are socialized and the system we should have (the right side) in which losses are 

privatized. Some may contend that the imposition of higher capital requirements is 

a case of the Government interfering with private markets. This is completely 

wrong. Higher capital requirements that lead to prudent bank funding actually take 

the Government out of the system and put the responsibility for bearing risk on the 

private markets, not the taxpayer. In addition they produce a huge social benefit by 

making the risk of another devastating financial crisis much lower. 

(47) 

RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY 

FROM JOSEPH E. STIGLITZ 

Q.1. Did Dodd-Frank end too-big-to-fail? 

A.1. Dodd-Frank did not end the risk of too-big-to-fail. Indeed, in 

the aftermath of the crisis, the banking sector is more concentrated 

and the problem of too-big-to-fail has, in that sense, become worse. 

These large banks are too big to fail—and allowing them to fail 

would potentially cause large disruption to the market. 

Some argue that ‘‘resolution authority’’ will prevent the kind of 

massive bail-out that occurred in 2008–2009. I am unconvinced. 

The Government had powers at its disposal even then that would 

have reduced the magnitude of the risk to which taxpayers were 

exposed. They could have used standard procedures of conservatorship. The Fed and Treasury were evidently afraid to do so. In the 

midst of another crisis, they are likely to use emergency powers to 

engineer a bail-out. In the alternative, they may (as in the case of 

Lehman Brothers) not do enough to ensure an orderly process, in 

which the institution is saved by bondholders and shareholders 

bear most of the costs. The result could be massive disruption. 

There are some who believe that there is no way that a truly effective ‘‘living will’’ could be established for these mega-institutions, 

and rigid enforcement of living will requirements would force the 

break up of these banks. I am less sanguine that there will be such 

effective enforcement-and certainly so far that has not been the 

case. Certainly, as of today, the problem of too-big-to-fail and toointertwined-to-fail institutions persists. 

RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY 

FROM EDWARD J. KANE 

Q.1. Did Dodd-Frank end too-big-to-fail? 

A.1. No. The Dodd-Frank Act puts the responsibility for ending 

Government credit support of large, complex, and politically powerful financial firms on the backs of incentive-conflicted future regulators. But the Act does not lessen the force of political incentives 

to rescue these firms when they get into trouble. To contain these 

forces, further legislation is needed whose object would be to realign bureaucratic incentives and reporting responsibilities with 

taxpayer interests in accountable ways. In the absence of such legislation, it is unreasonable to believe that authorities either can or 

will adequately measure and contain tail risk at large, politically 

powerful firms or sectors. The presumption that regulators can succeed year after year in these tasks—in the face of perverse Congressional pressures and recruitment procedures—ignores the facts 

and mechanisms of regulatory capture. 

What we can call a cycle of temporarily successful regulatory reforms repeats itself in a dialectical fashion. For example, important 
48 

new powers were conferred on regulators by the FDIC Improvement Act of 1991, but over time hidden risk-taking and self-serving 

lobbying pressure from elite sectors neutralized these powers and 

enfeebled rulemaking and oversight during the housing and 

securitization bubbles. The hard-to-document nature of safety-net 

benefits in good times and the financial industry’s overwhelming 

lobbying power provide good reason to doubt that the financial 

rules U.S. regulators are struggling to develop today can come close 

to meeting the aspirations that the Act sets for them. 

Financial-sector lobbyists’ ability to influence regulatory and supervisory decisions remains strong because the Dodd-Frank framework that regulators are trying to implement gives a free pass to 

the dysfunctional ethical culture of exploitive lobbying that helped 

both to generate the crisis and to dictate the extravagant costs that 

poorly conceived financial-sector bailouts imposed on ordinary citizens. Framers of the Act ignored mountains of evidence that, 

thanks in large part to industry pressure, top officials tend to suppress and deny evidence of developing industry weakness in good 

times and have almost never detected and resolved widespread financial-institution insolvencies in a fair, timely, or efficient fashion. 

Part of the problem is that Government regulators’ conception of 

systemic risk neglects the pivotal role they themselves play in generating it. Officials are conditioned to tolerate innovative forms of 

contracting that are designed to be hard to supervise (such as the 

shadow banking system) and to rescue loss-making creditors and 

derivatives counterparties by nationalizing their losses in crisis situations. Although the fiscal deficits this behavior implies cannot be 

sustained forever, the predictability of bailout policies encourages 

opportunistic financial firms to foster and to exploit incentive conflicts that undermine the effectiveness of the various private and 

governmental watchdog institutions that society expects to identify 

and police complicated forms of leveraged risk-taking. 

The U.S. regulatory system broke down in the 2000s because 

Government-sponsored enterprises, OTC derivatives dealers, and 

other systemically important financial institutions could not resist 

opportunities to shift risks to the taxpayer in clever but exploitive 

ways and private and Government supervisors did not adapt their 

surveillance systems conscientiously to curtail these opportunities 

by consolidating off-balance-sheet leverage and counteracting 

surges in taxpayer loss exposure in a timely manner. Risk managers at too-big-to-fail firms used changes in contracting forms and 

information technology to promote and expand regulatory and accounting loopholes that invited supervisory blindness and subsidysustaining mistakes by society’s private and governmental watchdog institutions. Far from gratefully thanking taxpayers for rescuing them, these firms refuse to acknowledge their moral obligation to provide meaningful information to taxpayers on the value 

of Government credit support or to offer taxpayers a fair return for 

providing this support. 

To build a robust, reliable, and fair system of financial regulation, relationships between financial regulators and the firms they 

regulate must be restructured to acknowledge their obligations to 

taxpayers in accountable ways. Good corporate governance requires 
49 

that financial-institution managers and Federal regulators accept 

joint responsibility for identifying and disclosing taxpayers’ de facto 

equity stake in financial firms. Until taxpayers’ stake is made observable, incentives to manage the distributional consequences of 

regulation-induced innovation will remain weak. 

RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY 

FROM EUGENE A. LUDWIG 

Q.1. Did Dodd-Frank end too-big-to-fail? 

A.1. The Dodd-Frank Wall Street Reform and Consumer Protection 

Act (Dodd-Frank) takes a number of important steps toward ending 

too-big-to-fail and ensuring that the U.S. Government will no 

longer need to sustain a failing financial institution in order to prevent catastrophic damage to the American financial system. 

First, if executed properly, the heightened prudential requirements in Dodd-Frank will make large, interconnected U.S. financial institutions less likely to fail. Measures such as increased capital and broader liquidity standards could strengthen these firms 

and make them more resistant to future shocks. Concentration limits will prevent risk from pooling rapidly in one corner of the financial sector, ensuring regulators can both minimize and effectively 

monitor systemic dangers to the financial system. 

Second, Dodd-Frank’s orderly liquidation process and living will 

provisions give the Government tools to unwind a systemically important financial company minimizing the imposition of costs on 

the taxpayer. Whether the new resolution authority can be successfully deployed remains to be seen, and difficult issues of cross-border resolution linger. 

Taken together, these steps have begun to shift market expectations that the Government will rescue large collapsing financial institutions. Belief in a Government backstop can foster inappropriate risk-taking by banks, in addition to fostering false hope in 

investors. Dodd-Frank is a serious step in the direction of lessening 

the use of the safety net. 

RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY 

FROM PAUL PFLEIDERER 

Q.1. Did Dodd-Frank end too-big-to-fail? 

A.1. Despite the fact that Dodd-Frank has a number of provisions 

designed to ‘‘streamline’’ the failure of SIFIs and make sure that 

losses are properly imposed on creditors rather than taxpayers, I 

firmly believe Dodd-Frank falls short of eliminating too-big-to-fail. 

In many respects the too-big-to-fail problem has become more acute 

after the subprime crisis than it was before. By a number of measures the banking sector has become more concentrated as a result 

of the financial meltdown with, for example, Wells Fargo acquiring 

Wachovia and JP Morgan Chase acquiring Washington Mutual. 

This, coupled with the continued weakness of the U.S. (and global) 

economy and the precarious state of Europe and its banks, means 

that too-big-to-fail risks are still pronounced. 

The main problem that I see in the Dodd-Frank approach to toobig-to-fail is that it presumes that it is possible to quickly resolve 
50 

the complicated set of claims issued by very large and complex 

global financial institutions in a way that does not have significant 

adverse effects on the functioning of credit markets and the financial system. It attempts to do this in part by requiring that SIFIs 

demonstrate up front that they can be resolved under the bankruptcy code in situations of distress or insolvency. It also creates 

an alternative to bankruptcy by giving the FDIC ‘‘Orderly Liquidation Authority (OLA)’’ to impose a resolution through FDIC receivership of a SIFI. 

The key question is whether, taken together, these measures are 

enough to remove the uncertainties and systemic risks that compel 

regulators and the Government to support too-big-to-fail entities. 

Our financial sector is still highly interconnected and much of it is 

opaque. This means that distress in one institution can create uncertainties throughout system. As we saw in 2008, these uncertainties can lead to credit freezes and the shutdown of key markets. In 

crisis situations there will be strong pressure on regulators and the 

Government to remove these uncertainties in order to protect the 

economy, and arguably the most effective (and perhaps only) way 

to do this is to inject liquidity (i.e., money) into the banks and other 

systemically important entities (e.g., AIG). If this were truly ‘‘liquidity support’’ and the solvency of the institutions were not in 

question, the problem would not be as bad, but knowing whether 

a complex financial institution is solvent when it is highly leveraged and many of its assets are illiquid makes this very difficult. 

In such cases the line between ‘‘liquidity support’’ and bailout becomes quite unclear. 

As a thought experiment, assume that Institution A (a SIFI) is 

distressed and may be insolvent. Having a plan in place for it to 

be resolved under the bankruptcy code or by the FDIC through its 

Orderly Liquidation Authority doesn’t remove the systemic uncertainty in the market. Which other systemically important entities 

hold claims on A or will be affected through a chain of claims by 

A’s losses? How large will these losses be and how exactly will they 

be allocated among A’s creditors? Will the FDIC (if it is resolving 

A) distribute losses in a way that protects other SIFIs and if so, 

which ones? If the financial sector, and particularly the large 

banks, continues to be highly leveraged and fragile, these uncertainties can easily lead to a crisis of the sort we experienced in 

2008. The pressure on regulators to keep things afloat through 

some sort of bailout program that might include asset purchase, 

guarantees, or capital injection will be enormous. Since ex ante 

commitments not to use tax payer money to bail out financial institutions are difficult to make ironclad given the many ways support 

can be given, bailouts are still possible. Even if it were possible to 

make absolutely ironclad commitments up front, it may not be desirable to do so, as this puts the economy at risk in extreme situations when bailouts may be the best of bad alternatives. 

This does not mean that attempts to make the resolution of distressed financial institutions simpler and less disruptive are futile. 

In my view increasing transparency and reducing unnecessary 

complexity in the system are both very important steps to take. 

However, they unfortunately do not eliminate too-big-to-fail. I believe that one of the most important steps in reducing the problems 
51 

of too-big-to-fail is to reduce the risk of failure by requiring much 

more equity (capital) and restricting leverage. Reducing the fragility of our financial system through significantly higher equity requirements is a straight-forward way to make sure that losses are 

borne by investors and not taxpayers and that these losses do not 

paralyze financial markets and the economy. 

I fear that provisions such as the OLA will be viewed as a substitute for higher equity requirements, rather than a complement. 

They may serve as an excuse to allow SIFIs to continue to operate 

with fairly low levels of equity capital, creating the false sense of 

security that resolution mechanisms will be able to resolve them 

quickly when they fail. As suggested above, these mechanisms 

don’t remove the systemic uncertainties that can lead to a crisis, 

and they also put tremendous burden on the regulators. It is quite 

obvious that an FDIC resolution of a SIFI such as the Bank of 

America will be a much taller order than the resolution of 

Indymac. Requiring much more equity reduces the regulatory burden and lowers both the risk of SIFI failures and a future crisis.