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[Senate Hearing 114-115]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 114-115

    MEASURING THE SYSTEMIC IMPORTANCE OF U.S. BANK HOLDING COMPANIES

=======================================================================

                                HEARING

                               BEFORE THE

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             FIRST SESSION

                                   ON

 EXAMINING THE APPROPRIATE CRITERIA THAT THE FEDERAL RESERVE AND OTHER 
   REGULATORS COULD USE TO DETERMINE WHETHER AN INSTITUTION POSES A 
                 SYSTEMIC RISK TO THE FINANCIAL SYSTEM

                               __________

                             JULY 23, 2015

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs
                                
                                
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

MICHAEL CRAPO, Idaho                 SHERROD BROWN, Ohio
BOB CORKER, Tennessee                JACK REED, Rhode Island
DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois                  JON TESTER, Montana
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina            JEFF MERKLEY, Oregon
BEN SASSE, Nebraska                  ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas                 HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota            JOE DONNELLY, Indiana
JERRY MORAN, Kansas

           William D. Duhnke III, Staff Director and Counsel

                 Mark Powden, Democratic Staff Director

          Dana Wade, Deputy Staff Director and Senior Counsel

                    Jelena McWilliams, Chief Counsel

            Laura Swanson, Democratic Deputy Staff Director

                Graham Steele, Democratic Chief Counsel

                       Dawn Ratliff, Chief Clerk

                      Troy Cornell, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)

                            C O N T E N T S

                              ----------                              

                        THURSDAY, JULY 23, 2015

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Brown................................................     2

                               WITNESSES

Robert DeYoung, Capital Federal Professor in Financial Markets 
  and Institutions, University of Kansas School of Business......     3
    Prepared statement...........................................    25
    Responses to written questions of:
        Chairman Shelby..........................................    37
Deborah Lucas, Sloan Distinguished Professor of Finance, and 
  Director, MIT Center of Finance and Policy, Sloan School of 
  Management.....................................................     5
    Prepared statement...........................................    26
Jonathan R. Macey, Sam Harris Professor of Corporate Law, 
  Corporate Finance, and Securities Law, Yale Law School.........     7
    Prepared statement...........................................    29
Michael S. Barr, Roy F. and Jean Humphrey Proffitt Professor of 
  Law, University of Michigan Law School.........................     8
    Prepared statement...........................................    31

                                 (iii)

 
    MEASURING THE SYSTEMIC IMPORTANCE OF U.S. BANK HOLDING COMPANIES

                              ----------                              

                        THURSDAY, JULY 23, 2015

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:32 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Richard C. Shelby, Chairman of the 
Committee, presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    Today, we will hear from experts on the best criteria and 
methods to determine the systemic importance of U.S. banks.
    For nonbanks, Dodd-Frank set up a process governed by a 
council of Federal regulators to determine if an institution is 
systemically important. As imperfect as this process is, there 
is no such process for banks. Instead, Dodd-Frank deems a bank 
systemically risky if it has $50 billion or more in total 
assets. Moreover, once a bank reaches this arbitrary threshold, 
it is automatically designated as systemically important. Under 
this automatic framework, where there is no clear exit from the 
designation, a bank has little incentive to reduce its level of 
systemic risk.
    Many experts have expressed concerns about the arbitrary 
$50 billion threshold as an automatic cutoff for systemic risk. 
Many of us share their concerns. In March, financial regulators 
testified right here that there are currently banks above $50 
billion that were regulated as if they were systemically risky, 
even though they were not considered to be so. This regulatory 
framework should not capture institutions whose failure would 
not lead to systemic contagion. Doing so has a true cost to the 
financial system.
    First, it imposes a layer of regulation on financial 
institutions that lend primarily to small businesses and local 
or regional communities.
    Second, it unnecessarily spreads too thin the important 
resources of our financial regulators. This does not make the 
financial system safer.
    As I have said before, systemic risk is difficult to 
measure, but 5 years after Dodd-Frank, the law that mandates 
systemic risk regulation, we have better tools to assess it and 
we should use them.
    Last week at a hearing here in this Committee, Chairperson 
Yellen of the Federal Reserve testified that she would support 
giving some flexibility to the Federal Reserve to determine 
which banks should be subject to enhanced standards based on 
their set of multiple criteria. In fact, the Federal Reserve 
uses a similar approach to determine the systemic importance of 
banks in its regulation of bank capital.
    Earlier this week, the Federal Reserve finalized a capital 
surcharge rule for the Nation's largest and most systemically 
risky banks. This rule incorporates a framework based on many 
factors, including not only size, but also interconnectedness, 
cross-jurisdictional activity, substitutability, and 
complexity. According to the Fed, these five broad categories, 
quote, ``are viewed as good proxies for and are correlated with 
systemic importance.''
    Today, I look forward to hearing the views of our panel of 
witnesses on measures that can be used by regulators to 
determine if a bank poses a systemic risk. Improving such 
measures will allow our regulators to focus their resources on 
the systemically important banks in order to protect American 
taxpayers and the U.S. economy from the next financial crisis.
    Senator Brown.

               STATEMENT OF SENATOR SHERROD BROWN

    Senator Brown. Thank you, Mr. Chairman, for holding this 
hearing. It was almost a year ago I held a similar Subcommittee 
hearing in which Professor DeYoung testified. Thank you again. 
I thank him and all of our witnesses for being here today.
    Tuesday, as we know, is the fifth anniversary of the day 
that President Obama signed the Wall Street Reform Act into 
law. Our country was emerging from a devastating economic 
crisis, one caused in large part by financial institutions that 
ran wild and regulators that did little or nothing about it. 
Some Americans have recovered, but it is a slow process and 
every household's story is different. Wall Street Reform 
stabilized and strengthened our economy despite dire Republican 
predictions.
    The financial crisis was caused by poor mortgage 
underwriting, lax capital standards, lax liquidity standards, 
inadequate risk management, regulators that failed to challenge 
the banks that they supervised. Congress through Dodd-Frank 
crafted a reasonable response, directing agencies to institute 
standards for capital and liquidity and risk management and 
stress testing to lower the likelihood and the costs of large 
bank holding company failures, called for heightened rules for 
banks over $50 billion in total assets, 31 of the largest bank 
holding companies. It urged regulators not to take a one-size-
fits-all approach, allowing for tailoring based upon a variety 
of factors, so the $50 billion bank would not be treated the 
same way as a $2 trillion bank.
    On Tuesday, for example, as the Chairman said, the Fed 
finalized a rule to increase capital standards. That rule 
applied to the eight largest United States banks. Many of the 
powers in Title I of Dodd-Frank were not new, but after 
regulators failed to use their authority leading up to the 
crisis, Congress wanted to ensure that regulators used their 
authorities in ways that have teeth. The new rules were not 
meant to cover only systemically important or too-big-to-fail 
banks. In fact, these words are not even used in the law. 
Enhanced prudential standards are intended to respond to the 
last crisis, more importantly, though, to prevent the next one.
    We all agree that a regional bank is not systemic in the 
same way that a large money center bank is. The failure of one 
regional bank, assuming it is following a traditional model, 
will not threaten the entire system.
    But, as we have heard in past hearings, the failure of a 
single large institution can create systemic risk, but so can 
multiple failures of similar small or midsize institutions, as 
we saw in 2008. Systemic importance is also about the 
importance of an institution to homeowners and small businesses 
in the economic footprint where that bank operates. Congress 
should only open up Dodd-Frank if it can identify real problems 
affecting actual institutions, and it should be careful to do 
so without undermining safety and soundness or consumer 
protection.
    That is why I am concerned by Title II of the bill that was 
passed by this Congress along party lines in May and the 
language that was included in an appropriations markup 
yesterday. Secretary Lew said this proposal was, quote, 
``designed to gut the heart of Dodd-Frank,'' unquote. So, if 
the goal is to have something signed into law, we need to take 
a more modest approach.
    I would appreciate hearing today which specific prudential 
standards are inappropriate for regional banks and why, and 
whether the concerns being raised stem from implementing 
regulations or from the law itself. We need to strike the right 
balance. If the Fed should use its authority to tailor its 
regulations to the institutions and activities that it thinks 
present the most risk, but it should not become complacent and 
take its eyes off of all possible sources of risk.
    I thank the witnesses for joining us today.
    Chairman Shelby. Thank you, Senator Brown.
    Our witnesses today include, and we will start with 
Professor DeYoung. He is the Capital Federal Distinguished 
Professor of Finance at the University of Kansas.
    Professor Deborah Lucas, the Sloan Distinguished Professor 
of Finance and Director at the MIT Center for Finance and 
Policy.
    Professor Jonathan Macey, the Sam Harris Professor of 
Corporate Law, Corporate Finance, and Securities Law at the 
Yale Law School.
    And the Honorable Michael Barr, who is no stranger to this 
Committee, the Roy F. and Jean Humphrey Proffitt Professor of 
Law at the University of Michigan Law School.
    All of your written testimony will be made part of the 
hearing record.
    We will start with you on the left, Professor DeYoung. You 
are recognized.

   STATEMENT OF ROBERT DEYOUNG, CAPITAL FEDERAL PROFESSOR IN 
FINANCIAL MARKETS AND INSTITUTIONS, UNIVERSITY OF KANSAS SCHOOL 
                          OF BUSINESS

    Mr. DeYoung. Thank you, Chair. You asked us to share our 
perspective on which factors are important for determining the 
systemic risk of bank holding companies and to provide explicit 
examples of which rules and regulations or factors might be 
inappropriate, and I will get to the latter during the 
discussion. I will get to the former during my remarks here.
    Bank size is, of course, the most immediate consideration. 
Larger bank holding companies tend to have more volatile 
earnings, tend to be less liquid, tend to be more 
interconnected, and tend to be more difficult to value in a 
resolution. But, by itself, as we all have discussed, the bank 
size is neither a necessary nor a sufficient indicator of its 
systemic risk. Drawing a bright line at $50 billion, or at $200 
billion, or at any other place, will capture some nonsystemic 
banks.
    A good example is Washington Mutual, which held over $300 
billion in assets at the time of its failure in 2008. The FDIC 
was able to resolve WAMU without systemic consequences, without 
Government financial support. So, resolvability, in addition to 
assets, is another important factor in addition to bank size 
for determining whether or not a banking company poses a 
systemic threat.
    The bill in question here would redraw the bright line at 
$500 billion of assets, but it is not as bright a line as that 
seems. It would also rely on the Federal Reserve and the 
Financial Stability Oversight Council to evaluate the systemic 
importance of banking companies below this asset size 
threshold. This approach would automatically define the six 
largest bank holding companies in the U.S. as systemically 
important and, of course, not so coincidentally at all, on 
Monday, the Federal Reserve announced systemic risk capital 
surcharges on these same six firms.
    For smaller firms, the Fed and the FSOC will be free to 
consider multiple indicators of systemic risk other than asset 
size--off-balance sheet positions, earnings volatility, 
interconnectedness, cross-country exposures, and many others.
    A good example, I think, of this type of multifactor 
approach could be found in a recent policy brief from the 
Office of Financial Research. Now, I am not in a position to 
endorse the exact formulations within the OFR methodology, but 
I do strongly endorse the general approach that it takes. It 
uses predefined weights to translate each bank's size, business 
activities, financial complexity, and interconnectedness into a 
quantitative score that represents each bank's relative 
systemic importance. This approach applies the same filters to 
every banking company, so in a way, human discretion does not 
play a role in determining the relative outcomes.
    Now, the natural concern is that one or more banks that 
pose systemic threats would be mistakenly left off this list, 
and in order to err on the side of caution, we should maintain 
a low asset size threshold. I understand this concern, but 
given what we have learned, I believe it is somewhat 
unwarranted. In any case, mistakenly putting nonsystemic banks 
on the list imposes costs, as well, and we have to recognize 
those costs. The size of a banking company is just one 
potential indicator of systemic risk.
    For example, consider four U.S. bank holding companies that 
are each similar sized, between $300 and $400 billion: U.S. 
Bank Corp., PNC, Bank of New York Mellon, and State Street. In 
the Office of Financial Research's scoring exercise, two of 
these banks, U.S. Bank Corp. and PNC, get relatively low 
systemic risk scores because they practice traditional banking. 
They hold a diversified portfolio of loans. Those loans are 
fully funded by stable core deposits. They have very little 
off-balance sheet exposures, and their clientele is almost 
completely domestic.
    The other two banks, in contrast, the Bank of New York 
Mellon and State Street, get relatively high systemic risk 
scores in this method because they hold very few loans, rely on 
relatively unstable deposit funding, have large cross-country 
exposures, and provide infrastructure and logistics that are 
essential for the smooth operations of securities markets.
    Of course, under such an approach, the Fed and the FSOC 
would still have to determine where to draw the line. That is 
where discretion happens. I strongly suspect that these 
agencies will err on the side of caution when drawing this 
line, and I think we can look at the example of MetLife, which 
was designated as a SIFI, as a case study of this.
    In closing, I want to reemphasize one of the factors I 
talked about before, and that is the importance of 
resolvability in determining a bank's systemic importance. If a 
bank holding company can be resolved without causing 
disruptions in financial markets or contagion to other banks, 
either through regular bankruptcy or through orderly 
liquidation authority, then that bank should not be considered 
to be systemically important.
    It is not the job of bank regulators to prevent 
insolvencies at poorly run banking companies. I think we could 
all agree that poorly run banking companies should exit the 
market and stop wasting society's scarce resources. Our goal 
should be a safe resolution for these banks, not additional 
regulatory and supervisory safeguards that, by keeping poorly 
run banks out of trouble, keeps them operating and keeps them 
in business.
    So, I will end there. Thanks for your time this morning. I 
hope my remarks are useful. I look forward to answering your 
questions.
    Chairman Shelby. Thank you.
    Professor Lucas.

 STATEMENT OF DEBORAH LUCAS, SLOAN DISTINGUISHED PROFESSOR OF 
FINANCE, AND DIRECTOR, MIT CENTER OF FINANCE AND POLICY, SLOAN 
                      SCHOOL OF MANAGEMENT

    Ms. Lucas. Thank you. Chairman Shelby, Ranking Member 
Brown, distinguished Members of the Committee, thank you for 
inviting me to speak with you today. I have been asked, too, to 
comment on the appropriate criteria for determining whether a 
bank holding company poses the systemic risk to the financial 
system.
    Banks deemed to be strategically important financial 
institutions, or SIFIs, are subject to a higher level of 
oversight and, often, higher capital requirements. Those 
measures reduce the likelihood of distress and spill-overs to 
the financial system, but also entail additional costs for the 
banks. Ideally, banks would only be designated as SIFIs when 
the financial stability benefits outweigh those costs.
    Unfortunately, those cost-benefit tradeoffs are difficult 
to quantify. Major systemic risk events are rare, but extremely 
costly. History may be a poor guide to the future.
    The good news is that, despite the challenges, the results 
of recent analyses using new data suggest that the current 
criteria used for SIFI designation could be improved upon in 
several ways. I have two main conclusions.
    The first is that the threshold for automatic SIFI 
designation for bank holding companies could be raised 
substantially from its current level of $50 billion of assets 
without significantly increasing systemic risk. That conclusion 
rests on the findings of several regulatory and academic 
studies that use a variety of approaches to identify SIFIs. It 
also reflects the common sense observation that the very 
largest bank holding companies are enormously more complex and 
interconnected than their midsized or even large peers.
    What is striking about those analyses is that quite 
different measurement approaches come to very similar 
conclusions, with just eight of the largest U.S. bank holding 
companies standing out for their likely systemic importance. 
The smallest of those, State Street, has assets now of about 
$280 billion, which is more than five times the current $50 
billion threshold for SIFI designation.
    Consistent with that emerging evidence, and as Senator 
Shelby and Senator Brown noted, the Federal Reserve issued a 
white paper last week that contemplates replacing the $50 
billion asset size threshold with one of three alternatives 
that effectively would increase the cutoff to at least $250 
billion. The Fed's analysis also suggests the possibility of 
setting a threshold based on the relative systemic risk score 
rather than setting a dollar-size cutoff. Such an approach 
would have the advantage of automatically adjusting over time 
and certainly deserves further consideration.
    My second conclusion is that it would be advisable for 
regulators to use several criteria in addition to asset size to 
more accurately identify SIFIs. There seems to be general 
agreement that size alone is not the best proxy for an 
institution's contribution to systemic risk, and financial 
regulators in the U.S. and abroad have identified five broad 
categories of factors to consider, including size, 
interconnectedness, substitutability, complexity, and cross-
jurisdictional activity. Several of the analyses I referred to 
earlier incorporate those criteria into the risk scores used to 
identify the most systemically risky bank holding companies.
    Nevertheless, incorporating multiple criteria involves 
several significant challenges. The first is creating well-
defined metrics for each criterion. The second is designing a 
weighting scheme that determines the relative importance of 
each in an overall risk score. And making those choices, 
considerations, include data availability, stability of 
outcomes, avoiding excessive complexity, and preserving 
transparency.
    Choosing a weighting scheme is particularly difficult. 
There is not a precise definition nor even complete agreement 
about what makes a financial institution systemically risky, 
and there is little evidence about the relative importance of 
the different criteria or their predictive accuracy. It is, 
nevertheless, promising that the various approaches now under 
consideration point to a consistent set of bank holding 
companies as SIFIs and that asset size is highly correlated 
with all of the leading measures.
    However, the metrics that regulators are beginning to adopt 
are still new and evolving. Hence, I think it is advisable to 
allow some latitude for revising the methodology as new data 
becomes available and as market practices and perceived risks 
change over time.
    I only have a few seconds left, so I would like to use this 
opportunity to just briefly discuss what I see as the most 
serious deficiency in systemic risk oversight as it is 
currently conducted, and that is the exemption of major 
Government-run financial institutions from SIFI designation 
and, hence, from any formal oversight by systemic risk 
regulators.
    Government financial institutions, particularly Fannie Mae, 
Freddie Mac, FHA, and so forth, are collectively much larger 
than the bank holding companies currently classified as SIFIs. 
They satisfy most of the other criteria for SIFI designation, 
such as high degrees of interconnectedness. So, these sorts of 
considerations support the idea that Government financial 
institutions are an important source of systemic risk and, 
hence, also should fall under FSOC's mandate.
    Thank you very much.
    Chairman Shelby. Thank you.
    Professor Macey.

    STATEMENT OF JONATHAN R. MACEY, SAM HARRIS PROFESSOR OF 
CORPORATE LAW, CORPORATE FINANCE, AND SECURITIES LAW, YALE LAW 
                             SCHOOL

    Mr. Macey. Thank you, Senator Shelby and Ranking Member 
Brown and Members of the Committee, former law professor 
colleagues. It is a professor to be here to talk about whether 
it is appropriate to continue to assume that all banking 
companies with more than $50 billion in assets are systemically 
important and, therefore, subject to a heightened level of 
prudential regulation.
    Currently under consideration is a proposal that would move 
the automatic threshold to $500 billion and then authorize the 
Fed and the Financial Stability Oversight Council to evaluate 
the systemic importance of banking companies below that $500 
billion asset size threshold. This bill would reduce from 36 to 
6 the number of financial institutions subject to the automatic 
designation as systemically important, and I support this 
approach for the following five reasons.
    First, the bill would reduce some of the distortive effect 
of the current regulatory regime, which provides incentives for 
midsize banks to stop growing in order to avoid the SIFI 
designation and provides incentives for institutions above the 
threshold to grow until they approach the size of the so-called 
big six in order to be able to amortize the additional cost of 
regulation placed on such institutions designated as 
systemically important.
    Second, the bill would inject a greater degree of 
intellectual rigor into the SIFI designation process. In 
particular, regulators would not be able to focus solely on an 
arbitrary measure and would have to look at the kinds of 
objective factors that Professor Lucas was describing, and I 
think it is useful to remember that when Dodd-Frank was 
initially proposed, it was marketed as eliminating the 
longstanding practice of treating some institutions as too big 
to fail. But, if we look at what I regard as the flawed process 
by which MetLife was designated as a SIFI, we do have a need to 
impose better analytics and more intellectual rigor on the 
designation process.
    Third, I think that the bill would promote fairness by 
reducing reliance on an arbitrary line of demarcation that 
nobody has been able to support or defend, either analytically 
or empirically.
    Fourth, I think the bill would reduce some of the 
pathologies in bank regulation that Dodd-Frank created. The 
financial system is more concentrated, more interconnected, and 
more opaque than it was before the financial crisis. Much of 
this, I acknowledge, happened during the financial crisis, but 
things are not getting any better. Massive concentration caused 
by Bank of America acquiring Countrywide and Merrill Lynch, 
JPMorgan acquiring Washington Mutual--although that was a good 
deal, I agree with that--and also acquiring Bear Stearns, and 
Wells Fargo's acquisition of Wachovia. Now, the six largest 
financial institutions hold over 60 percent of all of the 
assets in the financial system and hold a virtual 100 percent 
market share of shadow banking activities.
    For people like me who think that the administrative State 
should be subject to the rule of law, Dodd-Frank poses 
significant challenges. Never has so much rulemaking authority 
and discretion been granted so broadly. As I have observed 
before, Dodd-Frank, for all of its merits, it is not really 
directed at people. It is an outline, a very long outline, 
directed at bureaucrats and it instructs them to make still 
more regulation and to create still more bureaucracies. And, 
the efforts to designate mutual funds and other businesses that 
really do not provide any systemic risk are really illustrative 
of that.
    And, fifth, the--for people like me who think the best way 
to avoid having financial institutions that are too big to fail 
is to reduce to zero the number of institutions that are too 
big to fail, the proposed legislation provides positive 
incentives for banks to be smaller and negative incentives on 
banks to become larger. Like the Fed's new capital requirements 
for the eight largest financial institutions, the proposed 
statute imposes some cost on the very largest financial 
institutions, which I support.
    Regulators, left to their own devices, have incentives to 
increase the list of systemically important financial 
institutions. These incentives are unfortunate. Regulators 
should be given incentives to reduce, not to expand, the list 
of SIFIs, and if the concept of systemic risk is to have any 
meaning, it must be the case that reducing systemic risk by 
reducing the number of firms that pose such risk is an 
important goal for any regulator.
    Thank you.
    Chairman Shelby. Thank you.
    Professor Barr.

STATEMENT OF MICHAEL S. BARR, ROY F. AND JEAN HUMPHREY PROFFITT 
      PROFESSOR OF LAW, UNIVERSITY OF MICHIGAN LAW SCHOOL

    Mr. Barr. Chairman Shelby, Ranking Member Brown, 
distinguished Members of the Committee, it is my pleasure to 
appear before you today, 5 years after enactment of the Dodd-
Frank Wall Street Reform and Consumer Protection Act.
    That Act was passed in response to the worst financial 
crisis since the Great Depression. In 2008, the United States 
plunged into a severe financial crisis that shuttered American 
businesses, that cost millions of households their jobs, their 
homes, and their livelihoods. The crisis was rooted in years of 
unconstrained excess and prolonged complacency in major 
financial capitals around the world. The crisis demanded a 
strong regulatory response.
    I want to focus today on aspects of prudential oversight 
established in the Dodd-Frank Act. Under the Act, the Fed is 
directed to provide for a graduated system of regulation with 
increased stringency depending on the risk that the firm poses 
to financial stability. The Fed may tailor these prudential 
standards for individual firms or categories of firms.
    The enhanced prudential measures include risk-based capital 
requirements and leverage limits, liquidity requirements, risk 
management, resolution planning, credit exposure reporting, 
concentration limits, and annual stress tests.
    The Fed under the Act is not required to apply these more 
stringent standards to bank holding companies with assets under 
$50 billion. Annual firm-led stress tests, however, are 
required for firms between $10 and $50 billion in size, and 
publicly traded bank holding companies $10 billion and above 
must establish risk committees.
    None of these enhanced measures apply to about 95 percent 
of banks, the category commonly described as community banks, 
those under $10 billion in assets, more than 6,000 banks in 
communities all across the country.
    Graduated standards are already at work. Fed stress testing 
applies to the largest firms in the country, the 31 firms with 
assets of $50 billion and above. The largest and most complex 
banks face more stringent standards. The Fed, for example, 
imposes a supplementary leverage ratio, a countercyclical 
capital buffer, and detailed liquidity coverage rules on only 
14 firms with over $250 billion in assets. The eight largest 
banks are subject to even tougher standards, including capital 
surcharges, more stringent leverage ratios, and long-term debt 
requirements. This graduated approach makes sense.
    Some have argued that the size threshold for heightened 
prudential standards should be substantially increased, while 
others have argued that banks should not be subject to any 
heightened standards unless they are specially designated as 
systemic. Both approaches, in my judgment, are mistaken.
    First, some have mistakenly said that the Act describes 
firms with $50 billion in assets as systemic, but that is 
simply not the case. There is no automatic designation under 
the Act. Congress set the $50 billion threshold as a floor, to 
establish a floor under which smaller firms would know that 
they are not subject to the new rules. But, the rules were not 
meant to apply only to the very few largest firms in the 
country. They are not intended to apply only to systemically 
important firms. They are designed, as I said, to work in a 
graduated and tailored way.
    Second, others have argued that bank holding companies 
should have to be designated for heightened supervision by the 
same process FSOC uses for nonbank firms. But, that runs 
counter to the purposes of nonbank designation. Bank holding 
companies should not be required to be designated in order to 
be supervised. Bank holding companies are already supervised by 
the Fed, and the Fed already has the authority to impose 
heightened prudential standards on such firms on a graduated 
basis as they increase in size and complexity.
    The reason for the designation process for nonbank 
financial institutions is that such institutions were not 
subject to meaningful consolidated supervision by the Fed at 
all. Firms such as Lehman Brothers and AIG could operate with 
less oversight, more leverage, and riskier practices. 
Recognizing that policing the boundaries of financial 
regulation is critical to making the financial system safer, 
the Dodd-Frank Act established a process for bringing such 
nonbank financial institutions into the system of regulatory 
oversight. It makes little sense to require designation of 
firms that are already supervised by the Fed, and it will 
dramatically slow down and disrupt the Fed's existing 
oversight.
    None of these changes would help community banks. There is 
undoubtedly much that could be done to reduce the regulatory 
burden on the smallest banks. For example, small community 
banks would benefit from clear safe harbors and short plain 
language version of rules that apply to them, longer exam 
cycles, and streamlined reporting.
    Today, the U.S. financial system is more resilient, but 
there is still much more work to do together. Thank you.
    Chairman Shelby. The Federal Reserve currently employs a 
multifactor test to determine if a bank is globally 
systemically important for the purposes of determining capital 
requirements. I will direct this to you, Professor Lucas and 
Professor Macey. In your opinions, what are the greatest 
benefits of using criteria like this rather than solely the $50 
billion asset threshold to regulate systemic risk?
    Ms. Lucas. Well, the reason is, as some of the examples 
cited, demonstrated that there are financial institutions that 
are larger than $50 billion who, nevertheless, operate as very 
traditional banks. There is nothing particular about their 
activities that would suggest singling them out as being 
systemically important. As people have noted, you can get 
systemic importance when a lot of banks act in the same way, 
but it does not make sense to apply special regulations to 
banks that in most respects act like much smaller institutions.
    Chairman Shelby. Professor Macey.
    Mr. Macey. Yes. I mean, it seems kind of straightforward to 
me, simple, really. If I am running a bank, because being 
designated as systemically important is costly, if there were a 
multifactor approach and not a bright line $50 billion 
approach, then I could take steps to avoid being systemically 
important without shrinking dramatically, and I think that is 
the kind of incentives we, as a regulatory--as people thinking 
about regulation--want to give to people running banks, that we 
want them to engage in activities that do not impose systemic 
risk, to, all else equal, decline or refrain from excessive 
engagement in activities that are systemically risky, and this 
sort of multifactor test is the only way to get there. Or, to 
put it differently, having a bright line cutoff at $50 billion 
eliminates that incentive.
    Chairman Shelby. Thank you.
    Professor DeYoung, how does resolvability relate to 
systemic risk, and is it possible for a bank to be large in 
terms of total assets but still be easy to resolve if they had 
some challenges?
    Mr. DeYoung. Yes. We often equate the two terms, 
systemically important and too big to fail, correct. But, now, 
I would not necessarily divide things up that way. I would say 
that if a bank can be resolved, then I think what I stated was 
that I do not think we should--we should not consider that bank 
to be systemically important.
    Now, what does it take for a bank to be resolved? A bank 
needs to have assets that are easily valued, right. We need to 
have buyers who can take a look at that bank, or FDIC 
evaluation staff and take a look at that bank----
    Chairman Shelby. Sure.
    Mr. DeYoung. ----and figure out what the assets are worth, 
play that off against the liabilities, do this to some high 
degree of accuracy, not perfectly, but a high degree of 
accuracy, and at that point, we have a value for the bank.
    Once we have a value for the bank, two things could happen. 
Another bank could purchase that failed bank, or we could have 
a resolution process in which the bank's assets are sold off in 
pieces, because, as I said, they are easy to value.
    Now, if we have an organization that has much off-balance 
sheet activity, a lot of counterparties, derivatives that are 
traded over the counter which are not always easily valued, any 
kind of assets or liabilities that are traded in thin markets, 
these are the kind of banks that----
    Chairman Shelby. That situation makes everything more 
complex, does it not?
    Mr. DeYoung. Yes, that is exactly right. And a key--I want 
to come back just to the key--is that at that point, we cannot 
value the bank, in which case makes resolution very difficult, 
because we cannot find a buyer for the bank or we cannot find--
we do not know how big the hole is, right. We do not know what 
the cost would be to resolving that bank.
    Chairman Shelby. Thank you.
    Mr. DeYoung. So, banks like that need to operate under 
different rules.
    Chairman Shelby. Professor Lucas, what are the risks of 
grouping banks whose failure would not be contagious to the 
system with banks who are systemically risky institutions?
    Ms. Lucas. I do not think it is a risk to the system to 
include those smaller banks, but I think the integrity of the 
regulatory process should not draw into its net institutions 
that do not need to be there. So, that is basically the 
argument. And, actually, to take what Dr. Barr said and turn it 
a little bit, those smaller banks are already heavily regulated 
by the Federal Reserve, and so if I did not believe that there 
was already a substantial amount of oversight, I might not be 
arguing for lifting the limit, but because there is, it is not 
clear that you need this additional layer of regulation.
    Chairman Shelby. Professor DeYoung--my last question--you 
said in your testimony that even large banks with total assets 
of over $300 billion might have little systemic risk. Other 
witnesses give some examples. Could you explain to the 
Committee how a bank might be so large and yet exhibit little 
systemic risk. It is because of what kind of banking they are 
doing and the risk they take?
    Mr. DeYoung. Yes. We speak about traditional banking, and 
this is an excellent question. If you look at a bank that is 
very large and then you take a look at its balance sheet and it 
has got the loans, maybe the mortgage loans, maybe the business 
loans, maybe the credit card loans, whatever, and they are 
performing, the other side of the balance sheet shows how those 
loans are funded. If these loans are funded with stable deposit 
liabilities, which we tend to call core deposits, these are 
deposits that will not run if there is some kind of financial 
crisis, so we will not have a liquidity problem, OK, so that we 
will not have a liquidity problem there.
    On the other side of the balance sheet, these loans are 
easy to value in whole or in part, depending on what kind of 
loans they are. So, once again, I get back to my point that if 
a bank can be valued, then it becomes resolvable and 
nonsystemic.
    Chairman Shelby. Thank you.
    Senator Brown.
    Senator Brown. Thank you, Mr. Chairman.
    Professor Barr, thank you for pointing out, in spite of 
what we hear from many in this town and at many different 
hearings, that Dodd-Frank does not actually designate banks 
systemically important, that it is just not part of Dodd-Frank 
and to suggest that is not showing sufficient intellectual 
rigor and insight and understanding or something worse than 
that.
    I want to ask Professor Barr a series of yes or no 
questions, if I could, pretty simple questions.
    Is it a good thing that large banks have more capital and 
less leverage?
    Mr. Barr. Yes.
    Senator Brown. Is it a good thing for large banks to have 
more liquidity than they did before the crisis?
    Mr. Barr. Yes.
    Senator Brown. Comptroller of the Currency Tom Curry has 
made it his mission, in part, to install a more enhanced 
prestige and stature with higher compensation for a risk 
officer at medium-sized and large banking institutions. Is that 
a good idea?
    Mr. Barr. Yes.
    Senator Brown. And, I assume that means large banks should 
have a whole strong risk management structure to them?
    Mr. Barr. Yes.
    Senator Brown. Professor DeYoung mentioned resolvability. 
This question, again, is for you, Professor Barr. Should large 
banks be able to detail how they can fail safely?
    Mr. Barr. Yes.
    Senator Brown. Is it appropriate for large banks to conduct 
regular stress tests?
    Mr. Barr. Yes.
    Senator Brown. Dodd-Frank contains all these provisions, so 
it sounds like Dodd-Frank, in your mind, has made the financial 
system stronger?
    Mr. Barr. Yes.
    Senator Brown. Thank you.
    One more yes or no question, and I want to ask you a little 
bit more detail to test your reasoning ability, which you have 
not yet--you have showed in your testimony, but not yet in the 
questions and answers.
    Factors like capital structure and riskiness and complexity 
and financial activity size, other risk-related factors, are 
they appropriate criteria for use as a basis for crafting 
prudential standards?
    Mr. Barr. I think they are. I think the important thing is 
we do not need them in the particular provision that has been 
subject to controversy in this hearing thus far because, as I 
said, bank holding companies are already subject to 
supervision. You do not need them to bring them into the system 
of supervision. They are useful tools to then decide, once 
firms are supervised, what is the appropriate level of capital, 
how stringent should the regulation be, what is the supervisory 
expectation with respect to risk management of the firm, how do 
you deal with resolvability. All those are really important 
factors.
    I agree that they are and should be graduated and that the 
very largest firms that are the most complex firms, that are 
firms that are the most interconnected, should have the highest 
capital requirements, for sure. That is what is already in the 
Dodd-Frank Act. It is what is already in Fed regulation. And, I 
think, you know, one of the problems sometimes is that Dodd-
Frank is too big to read.
    Senator Brown. You were looking forward to using that line 
today.
    Mr. Barr. I was.
    Senator Brown. That was very well done.
    [Laughter.]
    Senator Brown. Let me explore what you just said about the 
way that Dodd-Frank authorizes the Fed to tailor its standards. 
A Fed official said in 2012, quote, ``Dodd-Frank was spot on in 
requiring the Fed to make sure that we do not apply a one-size-
fits-all approach to every bank holding company above $50 
billion.'' Discuss, if you would in the last couple minutes, 
how well you think has the Fed tailored its rule sufficiently 
and fairly and precisely enough for bank holding companies over 
$50 billion in assets, or could they do more. Give me thoughts 
and suggestions.
    Mr. Barr. Well, I think, overall, I have been impressed 
with the Fed's ability to tailor and provide a graduated 
approach under the rule. As I said, for the eight largest bank 
holding companies, quite stringent regulation, capital 
requirements, liquidity rules, and stress testing. Slightly 
less stringent but still quite tough rules over 250. And a more 
graduated approach between 250 and 50. I think that is 
appropriate. There may be some additional measures, simplifying 
stress tests for firms between 50 and the 250 range that could 
be done within the existing framework.
    And then, I think, really, the area where I would like to 
see the most work done is for small banks. I think that small 
banks face regulatory burden that could be addressed both by 
the Fed and the other regulators in a productive way under 
current law, and it is the small banks that, I think, are 
facing, really, the kind of burden we ought to be worried about 
and they need clearer rules, more safe harbors, and a lighter 
touch.
    Senator Brown. Yesterday, the U.S. Senate in a vote has 
declared that community banks are now one billion instead of 
the 10 billion that I thought we mostly agreed on here. When 
you say small banks, are you saying a billion or are you saying 
ten billion? The ten billion is legislation that we have worked 
on here, but the Senate yesterday spoke fairly resoundingly 
that it is now one billion. Your thoughts?
    Mr. Barr. Well, I think, generally speaking, there is some 
variation, but people think of ten billion as the marking point 
below which firms are thought of as community banks. And then 
there is some gradation within that. I mean, a firm--a bank 
that is a $900 million bank needs a lot lighter touch than a 
firm that is close to a $10 billion bank. So, I think there 
needs to be graduation, even within the community bank 
standard, but ten billion and below is generally thought of as 
in the category of community bank.
    Senator Brown. Thank you.
    Chairman Shelby. Senator Toomey.
    Senator Toomey. Thank you, Mr. Chairman.
    My friend from Ohio, the Ranking Member, began with a 
celebration of the anniversary of Dodd-Frank, so I thought I 
would just share my observations on this occasion, as well, 
which is that after a crisis which was caused by the Federal 
Government, monetary policy and lending regulations and 
mandates that created a housing bubble, we discovered that, in 
the crisis, that we did not have an adequate resolution 
mechanism for the failure of a large complex institution. I 
mean, that was pretty clear.
    Rather than addressing that problem, which I think should 
have been done through reforms of the bankruptcy code, we 
created Dodd-Frank, and what we have to show for that now is 
big banks are now essentially public utilities, completely 
controlled by regulators who operate with enormous 
subjectivity, stifling innovation, reducing liquidity in all 
kinds of important markets.
    Medium banks, medium-sized banks have been saddled with all 
kinds of costs, which means they are--and regulations--which 
means they are necessarily lending less than they otherwise 
would be lending.
    And, we have managed to completely eliminate--we have 
completely destroyed the entire de novo banking industry of 
America. While we used to routinely launch 100, 200 new 
community banks every year all across America, the last 5 years 
since Dodd-Frank, through this morning, we have had one de novo 
community bank in America, which I think can only be attributed 
to some combination of the outrageous monetary policy and the 
unbelievable level of regulation. That is, I think, a pretty 
disturbing outcome.
    But, I want to get to the questions addressed at this 
hearing specifically. I wonder if anybody on the panel could 
name a single $50 billion bank in America--just name one--the 
failure of which would result in a measurable impact on 
American GDP. Is there one bank that comes to mind, a $50 
billion bank?
    Mr. Barr. I think, Senator, if I might say, if you get a 
series of smaller banks that fail at the same time----
    Senator Toomey. OK. OK.
    Mr. Barr. ----they can have an impact in the economy----
    Senator Toomey. So----
    Mr. Barr. ----and that is true for the largest 
institutions, too.
    Senator Toomey. Got you. OK. So, nobody has named a single 
bank. I think you are implicitly suggesting that probably the 
answer to my question is there is not a single bank, but if 
many banks all failed simultaneously.
    So, now, let us ask a different question. What is the 
chance--Professor Macey, maybe you could address this--do you 
think there is any chance at all that the regulation of these 
banks that do not individually pose any systemic risk creates a 
risk correlation that might actually enhance the risk of a wave 
of failures? What I am getting at is, certainly, the regulators 
can identify some risks and they will surely force these banks 
to go at great lengths to avoid those risks. Is there any risk 
that regulators, being human, might not see a risk that is out 
there, but will have driven all these individually unrisky 
banks to a very similar profile and have actually increased the 
risk that multiple failures could occur for some reason that 
they are not anticipating? Is there any risk of that at all?
    Mr. Macey. I think there is a huge risk. I think it is even 
larger than the problem associated with the inevitable fact 
that regulators are not perfect, that once a regulation is 
promulgated, rational financial institutions will respond by 
looking for the most profitable unregulated niches. This 
reaction, in turn, creates a kind of lemmings problem which is 
really the quintessential kind of essence of systemic risk, 
because what is dangerous is if you have a whole bunch of banks 
entering into the same line of business at the same time, if 
that line of business, like the residential mortgage-backed 
securities or CDOs, turns sour, then you have a--by definition, 
then you have a systemic risk problem of major proportions.
    Senator Toomey. So, I just want to underscore this point 
that you are making, which is that when we add this additional 
layer of regulation on institutions that are not individually 
systemicly risky, we actually increase the risk that we will 
have a widespread problem.
    Mr. Macey. Unless we can invent a world in which regulated 
entities do not respond to regulation in ways that are----
    Senator Toomey. Which is, of course, inconceivable. All 
right. Let me ask a specific----
    Mr. Macey. Did not even have it in the Soviet Union.
    Senator Toomey. Right. Let me ask a question of Professor 
DeYoung. I am going to run out of time here. You mentioned PNC. 
PNC is roughly $350 billion. If you look at their activity, 
they look at lot like a community bank. They have almost no 
international activity. They have a very small derivatives 
portfolio. What they do is they take deposits and they make 
loans to consumers and small- and medium-sized businesses, and 
yet they are currently going to be subject to the liquidity 
coverage rules that was meant by Basel to apply to much larger, 
multinational, international, and complex institutions. Is it 
not the case that the liquidity coverage ratio, when applied to 
someone who does not pose this risk, necessarily means less 
lending will occur?
    Mr. DeYoung. Well, I share your observation that PNC is a 
very large but very traditional bank, right, we say a very 
traditional community--or maybe a very large community bank, 
and they are not systemically important in the ways we think of 
other banks of similar size. You mentioned liquidity. The 
liquidity risk at banks like this is low because they do not 
fund themselves--they are not funded with market--market 
instruments that will fail to refinance when there is financial 
market distress. They are funded with deposit customers who 
have multiple reasons for staying with the bank.
    So, on the issue of liquidity, this is one of those 
potentially inappropriate regulatory answers. I share your 
concern that liquidity coverage ratios and net stable funding 
ratios, when applied to banks whose main business is lending, 
will reduce their lending capacity. I think this is, obviously, 
a true thing, either by reducing the amount of loans they can 
hold or by increasing their cost of funding, one way or the 
other.
    I will also point out that there is no academic study yet--
I know there are some studies underway, one of which I have 
just begun--that takes a look at the effect of liquidity 
minimums on banks that are also constrained with capital 
minimums. We have not imposed binding liquidity minimums on 
banks in the past. We have always--supervisors have always and 
bankers have always known this is important and they have 
informally made sure liquidity was good. But, once you have 
binding liquidity requirements, along with binding capital 
requirements, now you have two constraints on a bank's balance 
sheet, and, frankly, we do not know how that is going to play 
out because we have not observed it before.
    Senator Toomey. Thank you. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Warren.
    Senator Warren. Thank you, Mr. Chairman, and thank you all 
for being here today.
    You know, there is a lot of talk about Section 165 of Dodd-
Frank, which requires the Fed to impose some tougher rules on 
banks with more than $50 billion in assets. The main question 
seems to be whether a bank with more than $50 billion in assets 
poses more risk than a smaller bank. It is an interesting 
theoretical question, but we are not engaged in a theoretical 
exercise here. We are dealing with the very practical issue of 
trying to keep the financial system from melting down, because 
when it did in 2008, it cost this economy an estimated $14 
trillion. That is a lot on the cost side.
    In theory, the Fed could tailor its rules to fit each one 
of the 7,000 banks in the country, but we do not live in 
theory. We live in the world. We know that is impossible and 
that Congress is going to have to give the Fed some basic 
guidance on where they should direct their attention. We have 
to draw some lines. The question is, how do we draw lines to 
ensure the safety of the system?
    So, I want to follow up on Senator Toomey's question. In 
recent weeks, I have asked both Professor Simon Johnson of MIT 
and Chair Yellen of the Fed whether or not the failure of two 
or three banks of $50 billion in assets could pose a systemic 
risk and both said yes. So, Professor Barr, you have been doing 
yes/no questions. Do you agree----
    [Laughter.]
    Senator Warren. ----with Chair Yellen and with Simon 
Johnson on this?
    Mr. Barr. Yes, I do. I think that if there are multiple 
institutions of that size that are failing at the same time, it 
is usually an indication that there is broader weakness in the 
financial system, and that is why it is important for the 
Federal Reserve to be regulating for resiliency across the 
financial system and not just at the very largest firms.
    Senator Warren. OK. So, you talk about--it sounds to me 
like we have consensus that two or three $50 billion banks 
could pose a systemic risk. Let us as the auto-correlation 
question that Senator Toomey asked. First, I want to ask it the 
other way around. Did we see correlated risk before Dodd-Frank, 
Professor Barr?
    Mr. Barr. I think there was undoubtedly correlated risk in 
the financial system leading up to the financial crisis of 
2008. We had widespread use of mortgage assets, for example, 
throughout the financial system as collateral for repo 
transactions, securities financing transactions, and other 
items, and underlining special purpose vehicles used in 
derivatives transactions. So, there was a significant degree of 
auto-correlation in the lead-up to the crisis. And, of course, 
during the crisis, most asset classes became correlated and 
that crushed the system.
    Senator Warren. That is right. Indeed, if we had not had 
correlation, we would not have had the collapse, would we. Is 
the Fed aware of the problem of correlation?
    Mr. Barr. I think they are quite aware of it.
    Senator Warren. You think they are quite aware of the 
problem and try to cope with it. This is part of what they look 
for in their regulations, right?
    Mr. Barr. Correct.
    Senator Warren. OK. So, thank you. On the other hand, I 
want to look at the other half of this. The $50 billion banks 
generally pose less risk than a $1 trillion bank or a $2 
trillion bank. It would make no sense for the Fed to require 
the same rules and impose the same rules on a $50 billion bank 
as it does on a $2 trillion bank.
    So, Professor Barr, you helped write Dodd-Frank, so let me 
ask. Does the Fed currently have all the legal authority it 
needs to tailor the rules so that a $2 trillion bank is subject 
to much tougher regulation than a $50 billion bank?
    Mr. Barr. Yes, they have all the authority they need, and, 
in fact, they have exercised that authority to impose massively 
tougher rules on the largest institutions than on smaller ones.
    Senator Warren. OK. And, then, one more practical question 
on this. Let us say Congress raises the threshold to $250 
billion or $500 billion, as has been suggested, but gives the 
Fed discretion to impose tougher standards on banks below the 
threshold. That is, you move the threshold and then say you can 
impose tougher standards.
    Professor Barr, do you think it is likely that the Fed 
would actually use that discretion to apply tougher standards 
to banks below the threshold?
    Mr. Barr. I worry about whether they would, in fact, do 
that. I mean, I think Congress decided in the Dodd-Frank Act in 
a number of instances that the Federal Reserve had too much 
discretion in the past, and in this instance and in a number of 
other instances reined in Fed discretion, and I think that was 
a wise choice.
    Senator Warren. All right. Well, you worry about it, and I 
have to remember what hangs in the balance is the entire 
economy, not just of the United States, but the world. You 
know, Congress chose a very practical approach in Section 165. 
Any bank that hits $50 billion in assets, a bank that is one of 
the 40 or so largest banks in this country, will generally be 
subject to some tougher rules. But that bank can go to the Fed 
and make the case for tailoring the rules to fit its specific 
risks.
    If the Fed is not doing a good job of using its existing 
authority to tailor the rules appropriately, then Congress 
should demand that the Fed do a better job. I am willing to 
hold the Fed's feet to the fire to do what the statute says. 
But simply raising the $50 billion threshold and cutting a 
whole bunch of big banks loose is a dangerous overreaction, and 
if it goes badly, it is the American people who will end up 
paying.
    Thank you, Mr. Chairman.
    Senator Crapo. [Presiding.] Senator Cotton.
    Senator Cotton. Thank you.
    Professor Macey, I want to touch on a couple points in your 
testimony in which you say that the Shelby bill would reduce 
from 36 to 6 the number of financial institutions subject to 
the automatic cutoff and that you support it for a few 
different reasons. One of those reasons, and I quote from your 
testimony, is for people like you who believe the 
administrative State should be subject to the rule of law, 
Dodd-Frank poses significant challenges. Never has so much 
rulemaking authority and regulatory discretion been granted so 
broadly. As I--you--previously argued, laws classically provide 
people with rules. Dodd-Frank is not directed at people. It is 
an outline directed at bureaucrats and it instructs them to 
make still more regulations and to create more bureaucracies. 
Could you please elaborate on this analysis.
    Mr. Macey. Yes. Thank you for giving me the opportunity. 
This hearing has been something of an epiphany for me because 
people universally have been talking about what I call the 
spoke regulation, which is regulation directed at a particular 
firm, as being a good thing. The idea of having a one-size-
fits-all approach is bad. What was called tailored regulation 
is good.
    I understand that Dodd-Frank makes it very difficult to 
have any other kind of regulatory approach, but generally 
speaking, it is not really consistent with the rule of law or 
what I think is kind of the American way, that you have 
regulation that is directed at particular firms. The idea is, 
you know, firms in the economy should be treated the same way.
    You know, you look at the designation of General Electric 
Capital Corporation as a SIFI. Putting aside the merits of 
that, what then ensued was a bunch of corporate governance 
rules for General Electric Capital that defined things like, 
you know, independent director for that entity different than 
the way an independent director would be defined at JPMorgan 
Chase or some other firm.
    You know, I think it is a healthy thing, I think it is 
important to say to the extent that Dodd-Frank compels us to do 
this, it is an unfortunate cost or consequence of the 
regulation. So, I think that the ultimate goal that we need to 
think about is to think about ways in which we can reduce the 
number of institutions that are systemically important and 
thereby subject to this kind of particular bespoke regulation 
rather than embrace this idea of bespoke regulation as the new 
normal. Thank you.
    Senator Cotton. Professor Macey, when you describe bespoke 
regulation, I have to say, I do not hear the term regulation, 
or I do not hear anything like the rule of law, which is to 
prescribe standards of conduct that will apply prospectively 
with general application to all actors. When I hear you say 
bespoke regulation, I hear arbitrary discretion in the hands of 
regulators and bureaucrats.
    Mr. Macey. Right. Well, I think that that is a tremendous 
danger, that, you know, I am kind of with the Federalist 10 
idea that enlightened statesmen will not always be at the 
helm----
    Senator Cotton. Shocking, I know.
    Mr. Macey. ----and that seems to be true of bank regulatory 
agencies as well as other places. So, I share your view 
entirely.
    Senator Cotton. Do you think our political and financial 
elites over the last, say, eight or 10 years, have demonstrated 
the ability to conduct such a bespoke regulation in an 
effective manner in forums like the FSB and the FSOC, the IMF, 
the Federal Reserve, and so forth?
    Mr. Macey. You know, you kind of--I think one should hope 
for the best, expect the worst. The reality is that the people 
who are promulgating these regulatory reactions are moving back 
and forth to the banking sector and they are not moving back 
and forth randomly to financial institutions. They are moving 
back and forth to the largest ones. And, I think that as the 
CEO of JPMorgan Chase recently said to his shareholders, this 
being all things to all people and the biggest possible firm is 
good for us, and he is right.
    Senator Cotton. Mm-hmm. Well, I do not mean to question 
anyone's integrity or motives, just to say that in the 
incredibly complex international financial markets, it is hard 
for me to imagine any one person or any small group of people 
have all of the wisdom and especially all of the knowledge 
necessary to engage in such kind of one-off case-by-case 
decisions in a prudent manner as opposed to laying out clear 
criteria well in advance that is well known to all market 
players.
    Mr. Macey. I agree, and I do think that markets have a 
certain element of wisdom that bureaucracies and individual 
people cannot manage to reflect, and I think it would be nice 
if regulation reflected that notion a little bit more, in my 
opinion.
    Senator Cotton. Thank you.
    Senator Crapo. Senator Heitkamp.
    Senator Heitkamp. Thank you, Mr. Chairman.
    It has been interesting, because there has been a lot of 
rewriting of history, I think, today, and a lot of concern for 
the sense that this, almost for some of the panel members, that 
what happened in 2008 did not happen, and it did not happen 
because people made bad decisions, people who were acting in a 
regulatory environment, but also had an obligation, in many 
cases a fiduciary obligation, to actually be honest about what 
their products were. And, so, I am a little perplexed by this, 
although I tend to share an attitude that we have an obligation 
to constantly look back on a regulatory scheme and say, is this 
working? Is this right?
    But, to not go down the rabbit hole too much, Professor 
Macey, is it possible for Congress to legislate broadly, the 
end result of which would be only one entity would fall within 
a constitutional classification?
    Mr. Macey. Sure. I think----
    Senator Heitkamp. That is----
    Mr. Macey. Oh, sure.
    Senator Heitkamp. ----the only point I wanted to make, that 
we best not get so embroiled in the consequences and look 
instead at the regulation.
    And, so, this hearing is about 165 and, obviously, a 
critical component, and I am curious--and I am going to open 
this up to anyone--when we look at the tailored application of 
165, and I think the intent probably was that we cannot simply 
just always put a monetary value and assume that we are going 
to achieve the intended result. Congress does this very often, 
maybe perhaps too often, turfing a lot of responsibility to the 
regulators, and then sits in panels like this and complains 
because the regulators have done what we gave them the 
authority to do.
    And, so, if--you know, we will let you play Fed for the day 
and talk about the current exercise of 165 policy, I guess, 
Professor Lucas, and say, where do you think the Fed is getting 
it right and where are they getting it wrong, and if we were 
going to not look at a broad sweeping change of 165 and the 
categories of 165, where should we be looking that makes the 
most amount of sense?
    Ms. Lucas. OK. So, I am sympathetic to much of what you 
said and I think that the reason that I came down where I did, 
which was that it would be reasonable to raise the threshold, 
is that there are some things that the Fed is doing where, 
although if I did believe that it would significantly reduce 
systemic risk, it would not bother me, but I believe that when 
you do something like ask a very simple but fairly large bank 
to undergo stress tests, that is a fairly significant 
regulatory burden that will not result in any reduction at all 
of systemic risk.
    And, I think that just for general respect for the 
regulatory system, you want to set up the rules so that you do 
not annoy or impose costs on institutions----
    Senator Heitkamp. With no benefits.
    Ms. Lucas. ----where it is certainly not necessary. So, I 
think it is the stress testing and just the heightened 
examination.
    So, again, I think that it comes down to the transparency 
that is already there for those banks, or as Dr. DeYoung put 
it, the resolvability. It is not clear to me that the Fed does 
not already know everything it needs to know about those banks 
to deal with the systemic risk, whether they fail individually 
or collectively, because the--you know, if you think about what 
these regulations are doing, it is actually extremely small.
    So, we are talking about it like it makes a big difference, 
but, in fact, it is a very small difference, because even the 
ones that are subject to higher capital requirements, it is a 
very small increment to their capital requirements. So, it is 
not going to make much difference to the total amount of 
failures and----
    Senator Heitkamp. Mr. Barr, do you have input there, too?
    Mr. Barr. I think that, overall, the graduated tailored 
approach the Fed has taken makes a lot of sense, and it has 
particularly been effective at the very largest institutions--
--
    Senator Heitkamp. Could you give your response to Professor 
Lucas's point about, you know, a lot of this is ``make work'' 
and it does not add to the quality of the regulation in terms 
of preventing systemic risk.
    Mr. Barr. You know, my experience with stress testing is 
that it makes a big difference inside the firm in terms of 
improvements in risk management, attention to appropriate 
capital planning, organizational structure, and data integrity. 
So, I think it actually makes quite a big difference to risk 
management at the firm and I think it would be a mistake to not 
apply that stress testing approach more broadly in the economy.
    Senator Heitkamp. I am out of time, but I think what you 
can see here is obviously a difference of opinion. There is not 
anyone on this panel--I hope there is not anyone on this panel 
who wants to impose burdens that do not have a public good, 
instead are just ``make work,'' and that is the balance we are 
at. We have litmus tests that set a target to provide 
certainty. I am sympathetic to the argument that we are not 
really--that is not always necessarily the right indicator of 
what we need to do, but it does provide a bright line.
    With that said, the response to that when we are looking at 
systemic risk may be to give the regulators more authority, 
which I have a sense here some of the folks would not be 
particularly supportive of. It is objective versus the 
subjective and it is a tough balance. But, I was not here when 
Dodd-Frank was written, but I am certainly interested in 
hearing how we can make it better and how we can streamline it, 
especially for the small community banks.
    So, thank you. It has been a really engaging panel.
    Senator Crapo. Thank you.
    I will take my turn at the questions now, and I want to 
follow up on this same line of questioning, and to do so go 
back to last week when we had Chair Yellen, Janet Yellen, here 
in front of us. I reminded her that I asked this same question 
to Governor Tarullo, I believe it was last year now. It has 
been a while back. And, the question basically was, is there 
some flexibility that we can have that would actually help to 
reduce burdens on the regulatory system that we are imposing in 
this context but still maintain the necessary prudential 
standards and protection.
    Governor Tarullo and Chair Yellen, in my opinion, gave the 
same answer. I am going to quote what Chair Yellen said in the 
hearing last week, where I asked her the question of whether 
some kind of an adjustment of the $50 billion threshold would 
be livable or appropriate, even. Her answer was yes, that she 
would be open to a, what she called a modest increase in the 
threshold, and she wanted to make it very clear that in her 
concept, the banks that were below the threshold would still be 
subject to a significant amount of regulatory authority.
    I am going to use her own words here. She said, ``I guess 
the reason I would be open to it is that, as he indicated, 
Governor Tarullo, and as you just stated, we do have some 
smaller institutions that under Section 165 are required to do, 
for example, supervisory stress testing and resolution 
planning, and for some of those institutions, it does look from 
our experience like the costs exceed the benefits.''
    As I hear that, when I hear that the costs of a rule or a 
system exceed the benefits, I can extrapolate that into a lot 
of things, but one of the things that it extrapolates into in 
this context is that the consumers are going to be paying a 
higher price for their services in this industry if we require 
this.
    She went on to talk--I am skipping down a little bit. She 
said, ``At present, every firm over $50 billion has to do 
things like supervisory stress testing, and I think that what 
we have found is, in some cases, the burden associated with 
that for many of those firms really exceeds the benefit to 
systemic stability.''
    Now, she--to be careful here, I want to make it clear that 
she said that she thought the Fed ought to have the authority 
to look carefully at the risk profiles of all the banks that 
they are regulating, and for some of those banks that may fall 
below whatever threshold Congress might set, there may be a 
risk profile for that particular bank or a set of banks that 
should have heightened scrutiny and perhaps even be required to 
do stress testing, or whatever it may be, but that not every 
single solitary bank under any standard, just an arbitrary 
dollar number, should be subject to the same, what I will call, 
rigid rule.
    I would just like to have each of you comment on that. We 
will start on the left with you, Mr. DeYoung. I have already 
used up three of my 5 minutes, so if you guys could each be 
relatively brief, I would appreciate it.
    Mr. DeYoung. OK. I will attempt to be brief. I think banks 
should do stress tests without being asked to do them. I think 
a poorly run bank will not do a stress test and it will not be 
forewarned or guarded and will not be able to prepare against 
stress. So, I do not think stress tests are a bad thing or make 
work or a waste of time. For many firms that are not 
systemically important, though, there should be--I have stated 
before, there should be no--the Federal Reserve, I think, would 
have no interest in applying that to firms for which there is a 
zero, a zero marginal benefit in terms of its systemic 
importance.
    In terms--I just want to mention an offer that was made in 
the American Banker by Tom Hoenig a couple of weeks ago in an 
op-ed, that for small banks that have traditional balance 
sheets and do not have a lot of off-balance sheet activities 
and do not have over-the-counter derivatives, Vice Chairman 
Hoenig said we should roll back even the Basel III increments 
on higher capital. So, I think there is an example there of 
graduated supervision and applying these things appropriately. 
Of course, Mr. Hoenig is not in a position to deliver on this 
promise, of course, but I think----
    Senator Crapo. Understood.
    Mr. DeYoung. ----up and down the size of banks, there is 
room for a graduated authority and regulation.
    Senator Crapo. Thank you.
    Professor Lucas.
    Ms. Lucas. OK. I will be very brief. I basically agree with 
you, but I do think it is important to really leave open the 
possibility for the Fed to use discretion. Particularly, they 
have to be able to do that quickly when events are unfolding 
that might create systemic risk at a very short time scale. 
But, with that proviso, I think it is quite safe to raise the 
limits for the reasons you said.
    Senator Crapo. Thank you.
    Professor Macey.
    Mr. Macey. Yes. I think one can divide all these 
regulations up into basically two categories. One are 
regulations that presume--that in order to be effective require 
the regulator to be smarter than the bankers and to figure out 
when the bankers are engaging in risky behavior that they are 
kind of trying to hide.
    And then the second category of regulation, which is the 
category that I like, are regulations which incentivize the 
regulated entities to do the right thing, that is to say, to 
the extent that shareholders of financial institutions have to 
internalize or bear the cost of a bank failure, then I would 
believe those firms are going to do what Professor DeYoung was 
talking about and have incentives to do these stress tests 
themselves or take other steps to be meaningfully prudential. 
And, we have seen--so that good regulations have that 
characteristic.
    And, we have seen--if we take, for example, risk-based 
capital requirements or that this is a private sector invention 
that was a terrific idea, but once it got internalized in a 
regulation it became kind of ossified, I am not opposed to 
them. I think they are better than nothing, but they never 
really got up to the, I think, to the promise that the 
technology initially promised. I think the same is exactly true 
for so-called value at risk, VAR, models.
    So, I think we just need to regulate with incentives rather 
than regulate from a central planning point of view.
    Senator Crapo. Thank you.
    Mr. Barr.
    Mr. Barr. Senator Crapo, I think we need to focus the 
attention on the regulatory relief that the smallest banks 
need. I think the banks under a billion, banks under ten 
billion, often face regulatory burdens that are quite difficult 
for them to handle with very small compliance staff. So, I 
think if we can focus attention on the need to get longer exam 
cycles for strong compliant institutions at that level, clear 
safe harbors from rules where appropriate, much shorter plain 
language versions or regulations so they do not have to hire an 
army of consultants to comply with them, I think that is really 
the area that ought to be the focus, and I think we are doing 
OK on the larger institutions, I really do.
    Senator Crapo. All right. My time has more than expired.
    Did you have any more questions?
    Senator Brown. [Shakes head side to side.]
    Senator Crapo. All right. That concludes the questions. I 
want to thank this panel. Chairman Shelby had to leave for 
another committee which he chairs, and so he wants to also give 
you his thanks for being an excellent panel. He told me when I 
came in to relieve him that we had an outstanding panel of 
experts here that we could well learn from. We appreciate you 
bringing your expertise to us today. Thank you.
    This hearing is adjourned.
    [Whereupon, at 10:48 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                  PREPARED STATEMENT OF ROBERT DEYOUNG
   Capital Federal Professor in Financial Markets and Institutions, 
                University of Kansas School of Business
                             July 23, 2015
    Thank you for the opportunity to address the Committee. The 
Chairman has asked me to share my perspective on which factors are 
important for determining the systemic risk of bank holding companies. 
I am pleased to do so.
    Bank size is the most immediate consideration. Larger banking 
companies tend to have more volatile earnings, tend to be less liquid, 
tend to be more interconnected, and tend to be more difficult to value. 
The raw data shows that bank failure during and after the financial 
crisis was clearly correlated with bank asset size.
    But by itself, a bank's size is neither a necessary nor a 
sufficient indicator of its systemic risk. Regulators currently treat 
all banking companies with more than $50 billion of assets as 
systemically important. But this single-factor, bright line approach 
will is far too simple. A good example is Washington Mutual, which held 
over $300 billion in assets at the time of its failure in 2008. The 
FDIC was able to resolve WAMU without systemic consequences and without 
Government financial support. So resolvability is another important 
factor, in addition to bank size, for determining whether or not a 
banking company poses a systemic threat.
    The Shelby bill would redraw the bright line at $500 billion in 
assets, and rely on the Federal Reserve and the Financial Stability 
Oversight Council to evaluate the systemic importance of banking 
companies below this asset size threshold. This approach would 
automatically define the six largest bank holding companies in the U.S. 
as systemically important--not coincidentally, on Monday of this week 
the Federal Reserve announced systemic risk capital surcharges for 
these same six firms. For smaller firms, the Fed and FSOC would be free 
to consider multiple indicators of systemic risk other than asset size, 
such as off-balance sheet positions, earnings volatility, 
interconnectedness, and cross-country exposures. Both sets of banks 
would be subject to enhanced regulatory and supervisory treatment.
    A good example of this type of multifactor approach can be found in 
a recent policy brief from the Office of Financial Research (OFR 15-01, 
February 12, 2015). While I am not in a position to endorse the exact 
formulations within the OFR method, I strongly endorse its general 
approach. It uses predefined weights to translate each bank's size, 
business activities, financial complexity, and interconnectedness into 
a quantitative score that represents each bank's relative systemic 
importance. This approach applies the same risk filters to every 
banking company, so human ``discretion'' plays no role in determining 
the relative outcomes. And while the calculations may appear 
complicated, both the results and the reasoning are transparent.
    The natural concern is that one or more banks that pose systemic 
threats could be mistakenly left off the list, and to avoid this we 
should err on the side of caution and maintain the $50 billion 
threshold. I think this concern is unwarranted; and in any case, 
mistakenly putting nonsystemic banks on the list imposes costs as well. 
The size of a banking company is just one potential indicator of 
systemic risk, it is an incomplete and sometimes misleading indicator.
    For example, consider four U.S. bank holding companies, each with 
assets in the neighborhood of $300 to $400 billion: U.S. Bancorp, PNC, 
Bank of New York Mellon, and State Street. In the OFR's scoring 
exercise, U.S. Bancorp and PNC get relatively low systemic risk scores 
because they practice traditional banking: they hold diversified 
portfolios of loans, fully funded by stable deposits, have very little 
off-balance sheet exposures, and their clientele is almost completely 
domestic. In contrast, Bank of New York Mellon and State Street get 
relatively high systemic risk scores, because they hold very few loans, 
rely on relatively unstable deposit funding, have large cross-border 
exposures, and provide infrastructure and logistics that are essential 
for the smooth operations of securities markets.
    Of course, the Fed and FSOC would still need to determine where to 
draw the line between SIFI and non-SIFI. I strongly suspect that these 
agencies will err on the side of caution when drawing this line. The 
designation of MetLife as a SIFI provides a case study.
    In closing, I want to reemphasize the importance of resolvability 
in determining a bank's systemic importance. If a bank holding company 
can be resolved without causing disruptions in financial markets or 
contagion to other banks--either through regular bankruptcy or via 
orderly liquidation authority--then such a bank should not be 
considered systemically important. It is not the job of bank regulators 
to prevent insolvencies at poorly run banking companies. I think we can 
all agree that poorly run banks should exit the market and stop wasting 
society's scarce resources. Our goal should be safe resolutions for 
these banks--not additional regulatory and supervisory safeguards that, 
by keeping poorly run banks out of trouble, keeps them operating and in 
business.
    Thank you for your time this morning. I hope that my remarks have 
been useful. I look forward to your questions.
                                 ______
                                 
                  PREPARED STATEMENT OF DEBORAH LUCAS
 Sloan Distinguished Professor of Finance, and Director, MIT Center of 
             Finance and Policy, Sloan School of Management
                             July 23, 2015
    Chairman Shelby, Ranking Member Brown, distinguished Members of the 
Committee, thank you for inviting me speak with you about the 
appropriate criteria for determining whether a financial institution 
poses a systemic risk to the financial system. \1\
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     \1\ The views expressed are my own and do not represent those of 
the MIT Center for Finance and Policy.
---------------------------------------------------------------------------
    My main focus today is on that issue as it applies to bank holding 
companies (BHCs). My basic conclusions are that: (1) the threshold for 
automatic SIFI designation for BHCs could be raised substantially from 
its current level of $50 billion in assets without measurably 
increasing systemic risk; and (2) it would be advisable for regulators 
to use several criteria in addition to asset size to more accurately 
identify SIFIs. In fact, regulators have been exploring multifactor 
approaches for SIFI designation, and those methods appear to be able to 
more accurately identify the institutions most likely to cause 
contagion than a crude size cutoff. However, best practices in this 
area are still evolving. Any formulaic approach that regulators adopt 
may need to be revised as new data become available and as market 
practices change.
    I also would like to use this opportunity to briefly discuss what I 
see as the most serious deficiency in systemic risk oversight as it is 
currently conducted. That is the exemption of major Government-run 
financial institutions from SIFI designation, and hence from any formal 
oversight by systemic risk regulators. Those Government institutions--
such as Fannie Mae, Freddie Mac, FHA, the Federal student loan 
programs, and perhaps State and local pension funds--are collectively 
much larger than the BHCs currently classified as SIFIs. They also 
satisfy most of the other criteria suggested for SIFI designation such 
as a high degree of interconnectedness. \2\ Federal mortgage guarantors 
were at ground zero of the financial crisis. Those considerations 
support the idea that such institutions represent an important source 
of systemic risk and hence should fall under FSOC's mandate.
---------------------------------------------------------------------------
     \2\ Other examples of governmental activities that could pose 
systemic risk include the student loan programs of the U.S. Department 
of Education and the many pension-related activities of State and local 
governments.
---------------------------------------------------------------------------
    The Dodd-Frank Wall Street Reform and Consumer Protection Act was 
passed in the wake of the most severe financial crisis and subsequent 
economic downturn since the Great Depression. Those events revealed the 
vulnerability of the global financial system and the real economy to 
cascading failures of complex, highly interconnected financial 
institutions, and were the impetus for the enhanced regulatory 
framework established. At this 5-year anniversary of the Act, and with 
the benefit of experience and new data, it makes sense to consider ways 
to improve its implementation so as to more effectively reduce systemic 
risk while minimizing the associated regulatory burden.
SIFI Designation for Bank Holding Companies
    BHCs deemed to be SIFIs are subject to a higher level of oversight 
and additional restrictions, such as increased capital requirements and 
stress testing. Those provisions reduce the likelihood of spillovers of 
financial distress to the broader market, but entail costs for the 
affected institutions. The cost-benefit tradeoffs are difficult to 
quantify. Major systemic risk events are rare but the potential private 
and social costs are enormous. There is little data to assess 
probabilities or likely costs, and history may be a poor guide to the 
future. There also is considerable disagreement about magnitude of the 
costs imposed by SIFI status.
    Despite the measurement challenges, recent analyses of newly 
collected data suggest that the current criteria used for SIFI 
designation could be improved upon in several ways.
Asset Size Threshold
    A growing body of evidence suggests that the asset size threshold 
of $50 billion for BHCs to be automatically deemed as SIFIs is much 
lower than is necessary to protect financial stability. That conclusion 
rests on the findings of several studies that employ a variety of 
approaches to identifying SIFIs. It is also supported by the 
commonsense observation that however one measures it, the very largest 
BHCs are enormously more complex and interconnected than their midsized 
peers.
    The OFR recently released a policy brief showing that a 
multidimensional measure of systemic risk only identifies the very 
largest U.S. banks as SIFI candidates. \3\ That analysis identifies the 
eight BHCs listed in Table 1 as standing out for their systemic 
importance. The smallest of those, State Street, had assets of $279 
billion as of March 2015.
---------------------------------------------------------------------------
     \3\ ``Systemic Importance Indicators for 33 U.S. Bank Holding 
Companies: An Overview of Recent Data'', by Meraj Allahrakha, Paul 
Glasserman, and H. Peyton Young, Office of Financial Research Brief, 
February 12, 2015.

    A very different approach to identifying systemically important 
banks has been proposed and implemented by Professor Robert Engle of 
NYU and his colleagues. \4\ Their method relies on statistical analysis 
of stock price dynamics and bank leverage. It currently identifies five 
of the eight institutions listed in Table 1 as being in the top 10 of 
systemically risky U.S. financial institutions. I mention this study 
primarily because it demonstrates that very different methodologies 
seem to come to similar conclusions on which BHCs are most systemically 
important.
---------------------------------------------------------------------------
     \4\ Those statistics and a description of the methodology are 
available at: http://vlab.stern.nyu.edu/.
---------------------------------------------------------------------------
    Just last week, the Federal Reserve issued a White Paper that 
discusses replacing the $50 billion asset size threshold with one of 
three alternatives that effectively would increase the cutoff to at 
least $250 billion. \5\ They consider two related formulas, one 
developed by the Bank for International Settlements (based on size, 
interconnectedness, complexity, cross-jurisdictional activity, and 
substitutability). The second replaces substitutability with reliance 
on short-term wholesale funding. Both formulas identify the group of 
banks shown in Table 1 as having the highest systemic risk. The White 
Paper also suggests the possibility of setting a threshold for the 
determining globally systemically important BHCs based on relative 
systemic risk scores rather than setting a dollar size cutoff. Such an 
approach has the advantage of automatically adjusting over time, and 
certainly deserves further consideration.
---------------------------------------------------------------------------
     \5\ ``Calibrating the GSIB Surcharge'', Board of Governors of the 
Federal Reserve System, July 20, 2015.
---------------------------------------------------------------------------
Criteria for SIFI Designation
    There is general agreement that size alone is not the best proxy 
for an institution's contribution to systemic risk. Financial 
regulators in the U.S. and abroad have identified five broad categories 
of factors to consider. Those include size, interconnectedness, 
substitutability, complexity, and cross-jurisdictional activity. The 
OFR and Federal Reserve analyses described above incorporate those 
criteria into the risk scores used to identify the most systemically 
risky BHCs.
    Incorporating those multiple criteria involve two sets of 
challenges: (1) creating well-defined metrics for each criterion; and 
(2) laying out a weighting scheme that determines the relative 
importance of each in an overall risk score. Broad considerations in 
making those choices include data availability, stability of outcomes, 
avoiding excessive complexity, and preserving transparency.
    To illustrate the complexity of constructing a risk score based on 
multiple characteristics, it is telling that even the definition of 
size is not straightforward to determine. For example, the OFR and 
other regulators measure size in the risk scores they report by 
including total assets plus the net value of certain securities 
financing transactions plus credit derivatives and commitments as well 
as counterparty risk exposures.
    Choosing a weighting scheme is especially difficult. There isn't a 
precise definition or complete agreement about what makes a financial 
institution systemically risky, and there is little evidence about the 
relative importance of the different criteria or their predictive 
accuracy.
    It is promising that the various approaches now under consideration 
point to a consistent set of BHCs as SIFIs, and that size is highly 
correlated with all of the leading measures. However, the metrics that 
regulators are beginning to adopt are still new and evolving. Hence it 
seems prudent to allow some latitude for revising the methodology used 
as new data become available and as market practices and perceived 
risks change over time.
SIFI Designation for Nonbank Financial Institutions
    It is beyond the scope of this testimony to discuss in detail the 
criteria for SIFI designation of nonbank financial institutions. 
However, similar issues regarding size cutoffs and what other criteria 
to include will certainly arise. In making those rules, a caution is 
that the relevance and relative importance of various criteria will 
differ considerably across different types of institutions. For 
example, major exchanges such as the CBOT are likely to be deemed 
systemic because of their centrality in certain derivatives markets, 
but the overall size of their balance sheets is largely irrelevant to 
their contribution to systemic risk. Therefore it will be important to 
think carefully about the specific mechanisms that generate systemic 
risk in each instance, and to avoid using a one-size-fits-all approach.
Government Financial Institutions as SIFIs
    Several factors support the contention that the Government is a 
significant source of systemic risk. The most obvious is its sheer size 
in its role as a financial institution (or more accurately, a 
collection of loosely affiliated financial institutions). My 
calculations show that just through its traditional credit programs, 
the Government comprised a $3 trillion financial institution in 2013, 
and that figure increases to over $18 trillion when Fannie Mae, Freddie 
Mac, the Federal Home Loan Banks, deposit insurance, and the Pension 
Benefit Guarantee Corporation are included. \6\ Figure 1 illustrates 
the size of those Government institutions relative to the largest BHCs.
---------------------------------------------------------------------------
     \6\ ``Evaluating the Government as a Source of Systemic Risk'', 
Deborah Lucas, Journal of Financial Perspectives, November, 2014.
---------------------------------------------------------------------------
    Many of the other criteria identified as important for BHCs, 
including interconnectedness, substitutability, and complexity, also 
apply to these Government financial institutions. Lack of transparency 
and light supervision also contribute to the likelihood that they are a 
source of systemic risk.
    However, probably more important for systemic risk than the 
Government's direct effect on the allocation and riskiness of credit is 
its influence on the incentives facing private individuals and 
institutions through its regulatory, tax and other policies. The 
Government's policies reflect a variety of sometimes competing 
political objectives, and there is no ``invisible hand'' guiding the 
Government toward adopting policies that foster efficiency and avoid 
the buildup of systemic risks. In fact, systemic risks arising from 
Government actions may be relatively hard for policymakers and the 
public to identify because of the lack of transparency surrounding 
Government activities.

    For those reasons, bringing large Government financial institutions 
under the oversight of FSOC would have important benefits for the 
stability of the financial system. Actions that FSOC could consider 
include initiating a regulatory audit, whereby the OFR would be 
directed to undertake a systematic evaluation of Federal financial 
regulations across agencies to identify unintended consequences that 
could give rise to systemic risk. It could also require the improvement 
and standardization of certain financial disclosures by those 
institutions.
    Thank you for the opportunity to share these ideas. I look forward 
to your questions.
                                 ______
                                 
                PREPARED STATEMENT OF JONATHAN R. MACEY
     Sam Harris Professor of Corporate Law, Corporate Finance, and 
                    Securities Law, Yale Law School
                             July 23, 2015
    Chairman Shelby, Ranking Member Brown, Members of the Committee, 
and panel colleagues, I am grateful for the opportunity to talk to you 
today. My name is Jon Macey, and I am a professor of law at Yale Law 
School. I am here only in that capacity. I represent no firm, industry, 
organization, or party. It is a pleasure to be here. Thank you giving 
me the opportunity to address your Committee on the important topic of 
measuring systemic risk in U.S. Bank Holding Companies.
    The central question for today is whether it makes sense to 
continue to assume that all banking companies with more than $50 
billion of assets are systemically important and therefore subject to a 
heightened level of prudential regulation. Currently under 
consideration is Senator Shelby's proposal to reduce the central 
reliance on a bright line test by moving the automatic threshold to 
$500 billion in assets, and authorize the Federal Reserve and the 
Financial Stability Oversight Council to evaluate the systemic 
importance of banking companies below this asset size threshold.
    The Shelby bill would reduce from 36 to 6 the number of financial 
institutions subject to the automatic cutoff. I support this new 
approach for five reasons.
    First, the bill will reduce the distortive effect of the current 
regulatory regime, which provides incentives for midsize banks to stop 
growing to avoid the SIFI designation, provides incentives for 
institutions above the threshold to grow at least until they approach 
the size of the so called ``big six'' financial institutions in order 
to be able to amortize the additional costs of regulation placed on 
institutions designated as systemically important.
    Second, the proposal in the bill under consideration would inject a 
degree of intellectual rigor into the SIFI designation process that is 
currently lacking. Regulators would have to pay more attention to 
factors besides asset size. The role played by other factors, such as 
operational complexity, balance between the liquidity characteristics 
and maturity dates of assets and liabilities, off-balance sheet 
positions, earnings volatility, interconnectedness, and cross-country 
exposures would receive attention. While supporters of Dodd-Frank 
initially marketed the legislation as eliminating the long-standing 
practice of treating certain financial institutions as ``too big to 
fail,'' nobody seriously asserts that financial institutions designated 
as SIFIS would be allowed to disappear. In my view the flawed process 
by which MetLife was designated as a SIFI illustrates the need to 
impose more intellectual rigor on the SIFI designation process. The 
MetLife designation process ignored basic principles of risk 
regulation, failed to distinguish plausible risks from implausible 
risks, and failed to appreciate the differences between MetLife's 
business and balance sheet and the business and balance sheets of bank 
holding companies. Requiring regulators to rely less on the $50 billion 
Maginot Line would incentivize regulators to be more analytically 
rigorous in the designation process.
    A third reason to support this bill is that the new approach to 
SIFI designation reflected in the statute would make the regulatory 
system more fair by reducing reliance on an arbitrary line of 
demarcation that nobody has been able to support or defend either 
empirically or theoretically.
    Fourth the change would reduce some of the current pathologies in 
bank regulation that Dodd-Frank created. The financial system is more 
concentrated, more interconnected and more opaque than it was before 
the financial crisis. Almost all of this increase occurred during the 
crisis as regulators encouraged big distressed financial firms to 
acquire other even more distressed financial firms. Bank of America 
acquired Countrywide and Merrill Lynch, JPMorgan acquired Washington 
Mutual and Bear Stearns, and Wells Fargo acquired Wachovia. Now the six 
largest financial institutions hold over 60 percent of all of the 
assets in the financial system and hold a near-100 percent market share 
of shadow banking sector activities.
    For people who, like me, believe that the administrative State 
should be subject to the rule of law, Dodd-Frank poses significant 
challenges. Never has so much rulemaking authority and regulatory 
discretion been granted so broadly. As I previously observed in the 
Economist Magazine, ``Laws classically provide people with rules. Dodd-
Frank is not directed at people. It is an outline directed at 
bureaucrats and it instructs them to make still more regulations and to 
create more bureaucracies.''
    The key term ``systemically important financial institution'' is 
not defined, other than with reference to the fact that financial firms 
that are designated as systemically important are systemically 
important. Since systemic failure is, by definition, catastrophic, 
regulators feel justified in acting aggressively to reduce the 
likelihood that such failure will occur.
    The efforts of regulators to have money market funds and mutual 
funds designated as SIFIs is a prime example of the regulatory over-
reaching that is not merely enabled but encouraged by Dodd-Frank. 
Simply by recognizing the primordial fact that the assets in these 
funds belongs to the investors and not to the funds themselves, so that 
losses in the value of the assets held by these funds is not a loss for 
the entity, but rather for the investors who hold shares in the entity.
    Recently we have seen bespoke regulations imposed on General 
Electrical Capital Corporation (GECC), as well as with the recent 
imposition of customized capital requirements on JPMorgan Chase, 
Citigroup, Bank of America, and the five other largest U.S. banks that 
are tailored to the perceived riskiness of each of these financial 
institutions. My point is not that such firm-by-firm regulation is bad. 
My point is that such regulation is inevitable, and that it inevitably 
creates an uneven competitive playing field among institutions. It is 
only modestly comforting that these financial institutions are so 
complex that it is not possible to tell, a priori which institutions 
advantaged and which are disadvantaged by the Federal Reserve's new 
rules. We are clearly not living in a first or even second best 
regulatory environment as we pass the fifth anniversary of Dodd-Frank. 
From a policy perspective, as regulations increasingly are tailored to 
reflect regulators' views of banks' riskiness as measured by the 
formulas they themselves develop, exposure to the risk of favoritism, 
capture and other symptoms of a runaway regulatory State multiply 
exponentially.
    Fifth, for those who, like me, believe that the best way to avoid 
having financial institutions that are too big to fail is to reduce to 
zero the number of institutions that are too big to fail, the proposed 
legislation provides positive incentives for banks to be smaller and 
negative incentives on banks to become larger. Like the Fed's new 
capital requirements for the eight largest financial institutions, the 
proposed statute imposes some costs on the very biggest financial 
institutions.
    On the bright side, it is worth noting that the proposed statute 
would require the FSOC to provide any BHC under review for possible 
designation as a SIFI with (1) a ``detailed explanation'' for any 
proposed or final designation as a SIFI, (2) opportunities to meet with 
FSOC members and staff, and (3) the opportunity to submit a ``remedial 
plan'' prior to final designation to avoid a SIFI designation. Further, 
the FSOC must reevaluate existing BHC SIFIs with assets of less than 
$500 billion at the request of the Federal Reserve and at least every 5 
years. These aspects of the legislation seem modest and 
uncontroversial, but in my view they are an important first step in 
restoring a measure of the regulatory accountability that was lost with 
the passage of Dodd-Frank.
    Regulators have incentives to increase the list of systemically 
important financial institutions and to regulate those institutions 
expansively. These incentives are unfortunate. Regulators should be 
given incentives to reduce, not to expand the list of SIFIs. Unless our 
regulators have truly lost their way, it must be the case that reducing 
and indeed eliminating the number of financial institutions designated 
as SIFIs is a key goal of our public servants. The probability of 
failure of every firm in the private sector except for those that are 
too big to fail is above zero. For financial institutions the 
probability of failure can change dramatically in a very short period 
of time. The more systemically risky firms there are in the economy, 
the more risky the economy will be. If the concept of systemic risk has 
any meaning whatsoever it must be the true that reducing systemic risk 
by reducing the number of firms that pose such risk is an important 
goal of any regulator worth her salt.
                                 ______
                                 
                 PREPARED STATEMENT OF MICHAEL S. BARR
   Roy F. and Jean Humphrey Proffitt Professor of Law, University of 
                          Michigan Law School
                             July 23, 2015
    Chairman Shelby, Ranking Member Brown, distinguished Members of the 
Committee, it is my pleasure to appear before you today, 5 years after 
enactment of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act.
    That Act was passed in response to the worst financial crisis since 
the Great Depression. In 2008, the United States plunged into a severe 
financial crisis that shuttered American businesses, and cost millions 
of households their jobs, their homes and their livelihoods. The crisis 
was rooted in years of unconstrained excesses and prolonged complacency 
in major financial capitals around the globe. The crisis demanded a 
strong regulatory response in the U.S. and globally as well as 
fundamental changes in financial institution management and oversight 
worldwide. The U.S. has led these reforms, both domestically and 
internationally.
    In the U.S., the Dodd-Frank Act created the authority to regulate 
Wall Street firms that pose a threat to financial stability, without 
regard to their corporate form, and to bring shadow banking into the 
daylight; to wind down major firms in the event of a crisis, without 
feeding a panic or putting taxpayers on the hook; to attack regulatory 
arbitrage, restrict risky activities through the Volcker Rule and other 
measures, regulate repo and other short-term funding markets, and beef 
up banking supervision and increase capital; to require central 
clearing and exchange trading of standardized derivatives, and capital, 
margin and transparency throughout the derivatives market; to regulate 
payments, settlement, clearance, and other systemic activities; to 
improve investor protections; and to establish a new Consumer Financial 
Protection Bureau to look out for the interests of American households.
    I want to focus today on aspects of the system of prudential 
oversight established in the Act.
Supervision of Bank Holding Companies
    The Federal Reserve has supervisory authority, as it has long had, 
over bank holding companies. The Fed is directed under section 165 of 
the Act to provide for a graduated system of regulation, with 
increasing stringency, depending on the risk that the firm poses to 
financial stability, based on its nature, scope, size, scale, 
concentration, interconnectedness, or other factors. The Fed may tailor 
these more stringent prudential standards for individual firms or 
categories of firms, based on a similar set of factors regarding risk.
    These enhanced prudential measures include risk-based capital 
requirements and leverage limits, liquidity requirements, risk 
management, resolution planning, credit exposure reporting, 
concentration limits, and annual stress tests.
    The Fed is not required under this provision to apply these more 
stringent standards to bank holding companies with assets under $50 
billion. Annual firm-led stress tests, however, are required for firms 
between $10 and $50 billion in size, and the Fed must itself stress 
tests firms over $50 billion in size, in addition to such firms semi-
annual firm-led stress tests. Publicly traded bank holding companies 
$10 billion in asset size and above must establish risk committees. (I 
should also note that under the Act, the Federal Reserve may, upon 
recommendation of the Financial Stability Oversight Council, raise the 
threshold above $50 billion for certain prudential standards, those 
involving contingent capital, resolution planning, concentration 
limits, enhanced public disclosures and short-term debt limits.)
    None of these enhanced measures apply to about 95 percent of banks, 
the category commonly described as community banks, those under $10 
billion in assets--more than 6,000 banks in communities all across the 
country.
    Graduated standards are already at work. Fed stress testing applies 
to the largest firms in the country, the 31 firms with assets of $50 
billion and above. Such firms represent a wide variety of risk 
profiles, business strategies, sizes, specializations, and include both 
foreign and domestic firms. The largest, most complex financial 
institutions face the most stringent standards, as provided for under 
the Act. The Fed, for example, imposes a supplementary leverage ratio, 
a countercyclical capital buffer, and detailed liquidity coverage rules 
only on 14 firms with over $250 billion in assets. The very largest 
U.S. banks on a global basis, currently eight bank holding companies, 
are subject to even tougher standards, including capital surcharges, 
more stringent leverage ratios, and long-term debt requirements.
    In my view, this graduated approach to supervision and regulation 
makes sense. Some have argued that the size threshold for heightened 
prudential standards should be substantially increased, while others 
have argued that banks should not be subject to any heightened 
standards unless they are specially designated as systemic. Both 
approaches, in my judgment, are mistaken.
    First, as to size, some have mistakenly said that the Act describes 
firms with only $50 billion in assets as systemic. But that is simply 
not the case. Congress set the $50 billion threshold, and another 
threshold for other measures at $10 billion, to provide a floor under 
which smaller firms would know that they are not subject to the new 
sets of rules. But the rules were not meant to only apply to the very 
few largest firms in the country. They are not intended to apply only 
to systemically important firms.
    They are designed to work in a graduated, tailored way to increase 
the resiliency of the financial system as a whole. Risks aggregate 
across the financial system, including from institutions of a variety 
of sizes and types. It is the very antithesis of macroprudential 
supervision to focus only on the very largest handful of financial 
firms and to ignore risks elsewhere in the system. Moreover, smaller 
financial institutions themselves face risk from larger institutions 
and from activities across the system as a whole. Understanding those 
risks is essential if we are to have a safer financial system than the 
one we had before the financial crisis. We must not intentionally blind 
regulators to these risks in advance.
    Second, as to the idea of designation, others have argued that bank 
holding companies should have to be designated for heightened 
supervision by the same process the FSOC uses for nonbank firms. But 
that runs counter to the purpose of nonbank designation. Bank holding 
companies should not be required to be designated for heightened 
supervision. Bank holding companies are already supervised by the Fed, 
and the Fed already has authority to impose heightened prudential 
supervision on such firms, on a graduated basis, as they increase in 
size and complexity.
    The reason for the designation process, under section 113 of the 
Act, for nonbank financial institutions is that such institutions were 
not subject to meaningful, consolidated supervision by the Fed at all. 
Firms such as Lehman Brothers and AIG could operate with less 
oversight, more leverage and riskier practices. Recognizing that 
policing the boundaries of financial regulation is critical to making 
the financial system safer, fighting regulatory arbitrage, and 
providing oversight of shadow banking, the Dodd-Frank Act established a 
process for bringing such nonbank financial institutions into the 
system of regulatory oversight.
    It makes little sense to require designation of firms that are 
already supervised by the Fed, and it will dramatically slow down and 
disrupt the Fed's existing oversight system. It will make the financial 
system weaker, not stronger.
    None of these changes will help truly small, hometown banks. There 
is undoubtedly much that could be done to reduce regulatory burden on 
the smallest banks. Small banks could benefit from clear safe harbor 
rules and short, plain-language versions of regulations that do apply 
to them. The Fed can continue to improve its tailored and graduated 
approach to supervision. Strong, compliant small banks should have 
longer examination cycles and streamlined reporting requirements. 
Regulators and the industry should come together in a task force to 
come up with better ways to implement the goals of the Bank Secrecy Act 
and related rules to make it more likely that we catch terrorists and 
criminals, with lower regulatory burden. And we need a level playing 
field for small business lending, so community banks can compete with 
nonbank providers to provide safe, transparency, consumer-friendly 
loans to small businesses and entrepreneurs.
Nonbank Designations and the Financial Stability Oversight Council
    Critics have also attacked the work of the Financial Stability 
Oversight Council, or FSOC. FSOC has authority to designate 
systemically important firms and financial market utilities for 
heightened prudential oversight by the Federal Reserve; to recommend 
that member agencies put in place higher prudential standards when 
warranted; and to look out for and respond to risks across the 
financial system.
    One of the major problems in the lead up to the financial crisis 
was that there was not a single, uniform system of supervision and 
capital rules for major financial institutions. The Federal financial 
regulatory system that existed prior to the Dodd-Frank Act developed in 
the context of the banking system of the 1930s. Major financial firms 
were regulated according to their formal labels--as banks, thrifts, 
investment banks, insurance companies, and the like--rather than 
according to what they actually did. An entity that called itself a 
``bank,'' for example, faced tougher regulation, more stringent capital 
requirements, and more robust supervision than one that called itself 
an ``investment bank.'' Risk migrated to the less well-regulated parts 
of the system, and leverage grew to dangerous levels.
    The designation of systemically important nonbank financial 
institutions is a cornerstone of the Dodd-Frank Act. A key goal of 
reform was to create a system of supervision that ensured that if an 
institution posed a risk to the financial system, it would be 
regulated, supervised, and have capital requirements that reflected its 
risk, regardless of its corporate form. To do this, the Dodd-Frank Act 
established a process through which the largest, riskiest, and most 
interconnected financial firms could be designated as systemically 
important financial institutions and then supervised regulated by the 
Federal Reserve. The Council has developed detailed interpretive 
guidance and a hearing process that goes beyond the procedural 
requirements of the Act, including extensive engagement with the 
affected firms, to implement the designation process outlined in Dodd-
Frank. The approach provides for a sound deliberative process; 
protection of confidential and proprietary information; and meaningful 
and timely participation by affected firms. The Council has already 
designated a number of firms under this authority.
    Critics of designation contend that it fosters ``too big to fail,'' 
but the opposite is true. Regulating systemically important firms 
reduces the risk that failure of such a firm could destabilize the 
financial system and harm the real economy. It provides for robust 
supervision and capital requirements, to reduce the risks of failure, 
and it provides for a mechanism to wind down such a firm in the event 
of crisis, without exposing taxpayers or the real economy to the risks 
of their failure. The FDIC is developing a ``single point of entry'' 
model for resolution that would allow it to wind down a complex 
financial conglomerate through its holding company with ``resolution-
ready'' debt and equity, while permitting solvent subsidiaries to 
continue to operate. Similar approaches are being developed globally.
    Other critics argue that the FSOC should be more beholden to the 
regulatory agencies that are its members, but again, the opposite is 
true: Congress wisely provided for its voting members, all of whom are 
confirmed by the Senate, to participate based on their individual 
expertise and their own assessments of risks in the financial system, 
not based on the position of their individual agencies, however 
comprised. Members must individually attest to their assessments in the 
FSOC's annual reports. The FSOC has the duty to call on member agencies 
to raise their prudential standards when appropriate, and member 
agencies must respond publicly and report to Congress if they fail to 
act. This system of checks and balances requires that FSOC members 
leave their agency's ``turf'' at the door, and focus on systemwide 
risks and responses. If anything, the FSOC's powers should be 
strengthened, so that fragmentation in the financial regulatory system 
does not expose the United States to enormous risk, as it did in the 
past.
    Some critics contend that certain types of firms in certain 
industries or over certain sizes should be categorically walled off 
from heightened prudential supervision, but such steps will expose the 
United States to the very risks we faced in the lead up to the last 
devastating crisis. The failure of firms of diverse types and diverse 
sizes at many points in even very recent memory--from Lehman and AIG to 
Long Term Capital Management--suggest that blindspots in the system 
should at the very least not be intentionally chosen in advance by the 
Congress. The way to deal with the diversity of sizes and types of 
institutions that might be subject to supervision by the Federal 
Reserve is to develop regulation, oversight and capital requirements 
that are graduated and tailored to the types of risks that such firms 
might pose to the financial system, as the agencies have been doing. 
FSOC and member agencies also have other regulatory tools available 
with respect to risks in the system for firms not designated for Fed 
supervision, including increased data collection and transparency, 
collateral and margin rules for transactions, operational and client 
safeguards, risk management standards, capital requirements, or other 
measures.
    Some critics complain that the FSOC's work is too tied to global 
reforms by bodies such as the Financial Stability Board (FSB). But 
global coordination is essential to making the financial system safe 
for the United States, as well as the global economy. The United States 
has led the way on global reforms, including robust capital rules, 
regulation of derivatives, and effective resolution authorities. These 
global efforts, including designations by the FSB, are not binding on 
the United States. Rather, the FSOC, and U.S. regulators, make 
independent regulatory judgments about domestic implementation based on 
U.S. law. And U.S. regulators follow the normal notice and comment 
process when developing financial regulations. The FSB itself has 
become more transparent over time, adopting notice and comment 
procedures, for example, but it could do more to put in the place the 
kind of protections that the FSOC has established domestically. \1\
---------------------------------------------------------------------------
     \1\ See Michael S. Barr, ``Who's in Charge of Global Finance?'', 
Georgetown Journal of International Law 45, no. 4 (2014): 971-1027.
---------------------------------------------------------------------------
    As with designation, global coordination--and independent 
regulatory judgment--is essential to capital rules. Strong capital 
rules are one key to a safer system. Before the crisis, the financial 
system was woefully undercapitalized, and that the system was saved 
only with a massive infusion of taxpayer-funded capital, and a wide 
variety of unprecedented guarantees, liquidity provision and other 
backstops by the FDIC, the Federal Reserve, and Treasury. There's 
already double the amount of capital in the major U.S. firms than there 
was in the lead up to the financial crisis. Globally, regulators are 
developing more stringent risk-based standards and leverage caps for 
all financial institutions, and tougher rules for the biggest players. 
In the U.S., regulators have proposed even stronger leverage and 
capital requirements for the largest U.S. firms, and other countries 
are putting in place stricter approaches when warranted by their local 
circumstances.
    In my judgment, the local variation based on a strong minimum 
standard is healthy for the system, taking into account the different 
relative size of financial sectors and differing local economic 
circumstances. There's been progress on the quality of capital--
focusing on common equity--and on better and more comparable measures 
of the riskiness of assets, but more could be done to improve 
transparency of capital requirements across different countries and to 
make them stronger buffers against both asset implosions and liquidity 
runs. We need to continue to insist that European capital standards and 
derivatives regulations are strong--and enforced even-handedly across 
the board.
    The United States has taken a strong lead in pursuing global 
reforms, galvanizing the G20, pushing for the creation of the global 
Financial Stability Board, and pursuing strong global reforms on 
capital, derivatives, resolution, and other matters.
    The G20 has been driving financial reforms at a global level; the 
Financial Stability Board pursues agreement among regulators; and 
technical teams at the Basel Committee on Banking Supervision, the 
International Organization of Securities Commission, and the 
International Association of Insurance Supervisors hash out industry-
relevant reforms. While the process of reaching global agreement has at 
times been quite messy, divisive, and incomplete, the last thing we 
need is to hamstring global cooperation or U.S. regulation. These 
mechanisms should be strengthened and improved, not ignored or 
weakened.
    Strong U.S. financial rules are good for the U.S. economy, American 
households and businesses, and we also need a stronger, harder push to 
reach global agreement on core reforms. In fact, such an approach is 
essential in order to reduce the chances of another devastating global 
financial crisis that crushes the U.S. economy.
Measuring Risk
    The 2007-2009 financial crisis revealed the pressing need to 
develop better methods to understand and manage risk in the financial 
system. Since the crisis, financial regulators, scholars, and the 
financial industry have turned their attention to these issues, and 
made progress, but our ability to identify, monitor, and mitigate risk 
in the financial system remains far behind where we need to be. This is 
particularly challenging because many of the risks that are of central 
concern are low probability events with unacceptably high costs for the 
real economy.
    Stress testing is a central and innovative risk management tool 
used since the financial crisis by both regulators and practitioners. 
Stress testing attempts to capture the effects of macro-shocks on the 
balance sheets and activities of firms. Unlike fixed capital ratios, of 
either the risk-based or leverage ratio type, stress testing seeks to 
understand how macro-shocks would deplete capital. Moreover, the stress 
tests are not as easy as fixed capital rules for firms to game. Despite 
these advantages, stress testing remains crude and static with respect 
to systemic effects, and is focused on the risks facing each individual 
firm. Although the goal of stress testing is to analyze and measure 
systemic risk, it is in many ways still stuck measuring the static 
effects of macro-shocks on units of capital at individual firms.
    While there have been significant recent advancements, our current 
stress tests fail to account for the increased interconnectedness and 
complexity of the financial system. The models do not yet capture the 
complex network of financial transactions that connect firms and that 
can spread and magnify risk in the event of a crisis. The models are 
not dynamic--meaning, they do not account for market participants' 
responses to stressful events. Such responses themselves may change the 
nature of the events in question. Moreover, even if these more robust 
models existed today, regulators do not, at least as of yet, have full 
access to the financial data needed to use the models to measure 
systemic risk.
    We need to continue to develop new ways of thinking about how to 
identify, measure, and mitigate systemic risks by drawing on methods 
from other disciplines and experience from other sectors that face 
systemic risks. We should explore how methods from other disciplines--
such as system analysis, agent-based modeling, machine-based learning, 
behavioral finance, and data visualization and security--can be used to 
improve stress testing and financial risk management practices and 
regulation. We should also examine how risk is measured, monitored, and 
mitigated in other sectors and contexts, such as in supply chains and 
electrical grids, and in the context of climate change; how 
stakeholders in these contexts make tradeoffs between stability, 
efficiency, and innovation; and how lessons from these contexts should 
be applied or adapted to understand risks in the financial system.
    At the end of the day, no one model will be adequate to 
understanding and measuring risk in the financial system. We will need 
to improve stress testing, early warning, macro asset, equity, and 
credit price models, and other ex ante measures of risk. We will need 
to do better at crisis monitoring and response, including resolution of 
failing firms during a crisis. We will also need to develop better ex 
post analytics to understand the crisis that have occurred.
The Path of Reform
    The Dodd-Frank Act laid a firm foundation for a more resilient 
financial sector, one that works for American families, instead of 
exposing us all to needless risk and harm. Since enactment, a new 
Consumer Financial Protection Bureau has been built from scratch. New 
rules governing derivatives have been implemented to bring trading out 
of the shadows and reduce risk through central clearing, capital and 
margin requirements. A resolution authority has been put in place to 
deal with failing firms so we are no longer faced with the devastating 
consequences of the failure of a firm like Lehman Brothers or the 
untenable bailouts of firms like AIG. Regulators have the ability to 
designate large firms for supervision by the Fed, so the financial 
sector can no longer avoid stringent regulation just by altering their 
corporate form. The largest firms have to hold a lot more equity 
capital as a buffer against losses, and the Volcker Rule, heightened 
prudential supervision, stress tests, and other measures are reining in 
risk.
    The U.S. financial system is more resilient than it was in 2008. 
But there's still much work to do.
    We need to keep pushing for stronger reforms of the largest, most 
complex banks and other financial institutions. Stress testing and new 
capital rules have dramatically increased the levels of capital at the 
largest firms, but we do not yet know whether these levels are 
sufficiently robust to withstand a severe financial crisis. A bank 
liability tax could help further reduce incentives to take on risky 
short-term debt. And shadow banking activities, repo and securities 
financing transactions, and other activities need to be made safer with 
strong margin and collateral rules. We need to better align manager's 
incentives with financial stability, by putting banker bonuses at risk 
when a firm's capital level drops below specified levels or when the 
firm is hit with fines or sanctions.
    More broadly, Fannie Mae and Freddie Mac remain in conservatorship 
without a decision about long-term housing finance; money market mutual 
funds remain susceptible to runs; certain high-frequency trading 
strategies and market structure problems threaten financial stability 
and undermine the fairness of our markets; and critical investor 
protection authorities have gone unused.
    To be clear: the financial system is safer, consumers and investors 
better protected, and taxpayers more insulated, than they were in 
2008--by a lot. But that is not enough. We need to stay on the path of 
reform to make the financial system safer, fairer, and better harnessed 
to the needs of the real economy. We need to keep pushing for a 
financial system that works for us.
       RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN SHELBY
                      FROM ROBERT DEYOUNG

    Thank you for inviting me to appear before the Committee on 
July 23, 2015, at the hearing on ``Measuring the Systemic 
Importance of U.S. Bank Holding Companies''. It is my pleasure 
to provide written answers to these additional questions.
    Please note that I have added one additional question to 
this list. Question (11) below is a question that was asked at 
the hearing by Senator Warren, but was not directed to me.

Q.1. Enhanced prudential standards pursuant to Section 165 of 
Dodd-Frank impose additional costs and burdens on financial 
institutions and on the broader economy. Please identify what 
you believe to be the costs attributable to the current 
regulatory regime for bank holding companies above $50 billion 
because of the Section 165 requirements. In your opinion, has 
the Federal Reserve done an adequate analysis to determine how 
these burdens affect both the banks subject to Section 165 and 
the economy as a whole?

A.1. All banks with more than $50 billion in assets should 
regularly perform some type of macroeconomic stress testing, 
regardless of whether it is mandated by Government regulators. 
Prudent risk management requires these banks to understand 
their vulnerabilities to potential changes in macroeconomic 
conditions.
    Stress testing requires increased spending on internal 
labor and/or external consultants. When these expenses result 
from a bank's internal risk management practices, they cannot 
be characterized as ``burden.'' However, any additional 
expenses beyond these--that is, expenses incurred by the bank 
to perform additional layers of testing mandated by Government 
regulators--by definition constitute regulatory burden. The 
expenses associated with preparing and submitting the Federal 
Reserve's annual CCAR fall largely into this category.
    Banks do not report these expenses publicly. However, in a 
May 18, 2015, American Banker article (``Banks Keep Mum About 
Stress-Test Costs, Clouding Reg Debate''), Chris Cumming 
reports that Wells Fargo allocated 128,000 labor hours to the 
CCAR task in the fourth quarter of 2014. Assuming a relatively 
low figure for salaries and benefits of $30 per hour, this 
amounts to $3.84 million in expenses for one quarter, or just 
over $15 million on an annual basis. This is a very rough 
estimate of the CCAR burden. It might be too high (e.g., the 
fourth quarter may have been peak time for the CCAR exercise) 
or too low (e.g., it does not include expenditures on external 
consulting, nor the lost output from diverting these workers 
from other tasks). In any case, this rough estimate 
demonstrates that the regulatory burden imposed on banks by the 
CCAR is nontrivial.
    It is important to note that the costs of complying with 
CCAR cannot simply be scaled up or down based on a bank's size, 
because much of the CCAR exercise entails fixed costs. For 
example, if a bank is only one-tenth the size of Wells Fargo 
($160 billion in assets, versus $1.6 billion for Wells), the 
burden associated with CCAR will be substantially more than 10 
percent of the burden on Wells Fargo.

Q.2. Is it possible that a very large bank could fail without 
causing widespread damage to the financial system? Please 
explain.

A.2. This is surely possible. If the FDIC is allowed to 
exercise its Orderly Liquidation Authority (OLA), a large 
insolvent bank will be able to continue its operations. That 
is, the bank will be able to provide payments services for its 
depositors, make its insured depositors fully liquid, fulfill 
all of the credit commitments it has made to its borrowers, 
honor all of its short-term credit market contracts (e.g., 
commercial paper, Treasury repos, purchased Fed funds), and 
honor all of its derivatives counterparty obligations.
    Under this scenario, there may be short-run spikes in 
financial markets, but these will be temporary and will 
dissipate as market participants observe that the bank is 
honoring all of its contracts and obligations. There should not 
be any widespread damage to financial markets. Indeed, as the 
FDIC establishes its reputation by exercising its OLA authority 
on multiple occasions, even these temporary disruptions should 
lessen.
    This is not to say that losses will not be taken. The 
bank's equity holders will take a 100 percent loss. Some or 
perhaps all of the bank's bondholders will take partial or full 
losses. And some of the bank's uninsured depositors may take 
partial losses. It is likely that the FDIC will also take 
losses in the short run, as it injects the funds necessary to 
recapitalize the bridge bank, as well as to offset any ongoing 
operational losses of the bridge bank and its subsidiaries. 
However, in the long run, the FDIC should be able to recover 
these losses with increased charges to the banking industry.

Q.3. Is it possible that regulating all banks with $50 billion 
in assets as systemically important might actually encourage 
systemic risk rather than reduce it? Please explain.

A.3. This is a novel theory. It is based on the presumption 
that any bank declared to be systemically important (a SIFI) 
will change its risk-taking behavior and begin to act like it 
is too big to fail (TBTF). But this is a false presumption. If 
a bank will not be bailed out, it cannot be a TBTF bank, and 
hence it will not take the additional risks typically 
associated with TBTF banks. Indeed, the FDIC has already 
established its ability to resolve banks in the general size 
range of $50 billion (e.g., IndyMac) and beyond (e.g., 
Washington Mutual). For banking companies that are larger or 
more complex than these examples, the FDIC can now use its OLA 
powers of seizure and resolution. So if the FDIC is allowed to 
exercise its new resolution authority, then SIFI designation by 
itself will not encourage banks to take or create systemic 
risks.

Q.4. At the hearing, you did not get an opportunity to respond 
to certain questions. I would be interested in your response to 
the following questions:
    Is it a good thing that large banks have more capital and 
less leverage?

A.4. The increased equity capital requirements in Basel III for 
the most part represent an improvement. The inclusion of a 
plain vanilla minimum leverage ratio for all banks (which the 
U.S. has required for many years) was an important step. Even 
more important is the adoption of procyclical capital 
minimums--a macroprudential tool that will help reduce the 
buildup of excess bank credit during economic expansions, and 
will help prevent harmful reductions in bank credit during 
economic recessions.

Q.5. Is it a good thing for large banks to have more liquidity 
than they did before the crisis?

A.5. We have very little understanding of how mandatory 
liquidity minimums, such as Basel III's LCR and the NSFR, will 
influence bank risk taking in general or bank insolvency in 
specific.
    By itself, establishing higher capital minimums should 
prevent banks experiencing liquidity problems from failing. A 
clearly solvent bank can always access short run liquidity from 
the interbank market or from its central bank. This allows the 
bank to honor its short-term financial obligations, thus 
eliminating fire sales that drive down asset prices and 
investor flight from short-term credit markets.
    My fear is that the main effect of regulatory liquidity 
mandates, when placed on top of higher regulatory capital 
mandates, will be to reduce the creation of bank credit.

Q.6. Comptroller of the Currency Tom Curry has made it his 
mission, in part, to install more enhanced prestige and stature 
with higher compensation for Chief Risk Officers at medium-
sized and large banking institutions. Is that a good idea?

A.6. It is a great idea, but it is unlikely to be effective. To 
the extent that Chief Risk Officers at large banking companies 
have too little prestige and stature, this is because of faulty 
corporate cultures. Regulators have a poor track record of 
affecting changes to corporate cultures.

Q.7. Should large banks have strong risk management structures 
in place?

A.7. Of course they should. For example, see my answer to 
question (1) above, regarding internal stress testing. But the 
most effective way to encourage strong risk management at banks 
is to credibly ensure that failed banks are never bailed out.

Q.8. Should large banks be able to detail how they could fail 
safely?

A.8. Again, we have very little understanding of how a 
resolution plan or ``living will'' will make it easier for 
either the FDIC or a bankruptcy court to efficiently resolve a 
failed complex banking company. These efforts may end up being 
helpful . . . or they may end up being 100 percent burden, 
imposed partially on bank shareholders and partially on 
taxpayers (who are paying for this new regulatory effort). All 
we really have at this point is a hope for the former.

Q.9. Is it appropriate for large banks to conduct regular 
stress tests?

A.9. Yes. See my answer to question (1) above.

Q.10. Are capital structure, riskiness, complexity, financial 
activities, size, and other risk-related factors appropriate 
criteria to use as a basis for crafting prudential standards?

A.10. Prudential standards start with capital structure. Banks 
should hold enough capital to (i) absorb 100 percent of the 
losses that a bank expects to incur under a historical worst 
case scenario and (ii) allow Government supervisors to observe 
large losses occurring in real time, well before the bank 
actually becomes insolvent.
    Banks' riskiness and banks' financial activities stem from 
banks' business models. They are of secondary importance for 
prudential regulation; regulators should set bank-specific 
capital minimums high enough to reflect these risks. Moreover, 
regulatory interference with banks' business models has the 
potential to cause more harm than good.
    Complexity for complexity's sake is not desirable and 
should be discouraged. Complexity that arises naturally from a 
bank's business model should be allowed. Complexity that arises 
due to compliance with Government regulation (e.g., the 
multibank holding company structures necessary to legally 
operate an interstate bank prior to 1996) calls for a 
reexamination of that regulation.
    Bank size should influence prudential regulation only for 
banks that are too large to fail. This would also hold for 
banks that are too complex to fail. In both of these cases, 
systemic risk is the underlying worry. But given the FDIC's new 
OLA powers, I believe that neither of these cases will be 
operative going forward, so long as the FDIC is permitted to 
seize and resolve large and complex insolvent banking 
companies.

Q.11. At the hearing, I did not have the opportunity to answer 
the following question, which Senator Warren directed to just 
one of the other panel members. I paraphrase: ``Could the 
simultaneous failure of multiple banks, each of which holds 
assets of $100 billion, cause systemic risk?''

A.11. Again, I point out that the FDIC has already established 
its ability to resolve banks in this general size range 
(IndyMac, Washington Mutual) during quite difficult 
macroeconomic conditions. The FDIC's ability to perform large 
bank resolutions has only been strengthened by its new OLA 
powers.
    There is nothing about ``simultaneous'' large bank failures 
that changes this assessment. If an OLA-based seizure and 
resolution works as designed, the failed bank will not default 
on any contracts or obligations with its insured depositors, 
with its line of credit customers, with its counterparties in 
credit markets, or with its counterparties in derivatives 
markets. As it becomes clear that all of these contracts are 
being honored, any disruptions in credit markets (e.g., 
commercial paper) and asset markets (e.g., loan-backed 
securities) will be minimal.
    One potentially limiting factor is the length of time that 
the FDIC needs operate these banks prior to selling their 
assets (in whole or in parts) back into private hands. If these 
multiple bank failures occur during a recession, the FDIC will 
likely need to operate these banks for several years before 
they are stabilized. In this case, many commentators will argue 
that ``we have nationalized these banks.'' This is obviously an 
incorrect statement, as the goal is stabilization, not 
ownership. But such an argument could create political pressure 
for the FDIC to sell the insolvent banks too quickly--or 
perhaps even create pressure to bail out these banks rather 
than invoke OLA powers.
    Thank you again for soliciting my opinion on these issues 
of importance to the U.S. banking industry. Please do not 
hesitate to contact me regarding clarification or additional 
questions.
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