House Financial Services Committee Hearing
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Chairman Hensarling, Ranking Member Waters, and distinguished members of the Committee, thank you for convening today's hearing, "Assessing the Impact of the Dodd-Frank Act Four Years Later" and thank you for inviting me to testify. I am a resident scholar at the
The theme of my testimony is that the Dodd-Frank Act has failed to achieve its stated goals of ending too-big-too-fail and reducing the fragility of the U.S. financial system. Instead, the balance of accumulating evidence suggests that Dodd-Frank has reinforced investor's perceptions that the largest financial institutions enjoy an extended government safety net. Rather than ending too-big-to-fail, Dodd-Frank's provisions create new uncertainties around the resolution process for large financial institutions.
Dodd-Frank's mandatory enhanced supervision and prudential standards for the largest institutions discourage investor due diligence and monitoring since government regulators are now intimately involved in the management of the largest designated financial institutions. Dodd-Frank's intrusive rules and supervision impose undue regulatory burdens that are constraining economic growth without providing any clear measureable stability benefits. Dodd-Frank's enhanced prudential supervision and regulation do not provide a guarantee against a large institution failure nor can they prevent a future financial crisis since the exercise of most of these new powers are based on regulatory judgment alone. There is no proven economic science to guide the identification of "systemic risk" let alone pin-point regulations that can mitigate it.
Ironically, Dodd-Frank's heightened expectations of a government's commitment to remove the possibility of a future financial crisis may increase the probability that such a crisis will occur and require government support for the largest financial institutions that have been identified as too-big-to-fail. The future under Dodd-Frank is foreshadowed by the famous words of the Irish philosopher
A guide to the remainder of my testimony follows. Section I provides empirical evidence based on large bank funding costs that Dodd-Frank did not end too-big-to-fail. Section II discusses how the Dodd-Frank combination of vague policy goals and unchecked grants of new regulatory powers creates a bias for over-regulation of the financial sector that reinforces investor perceptions that the largest institutions are too-big-to-fail. Section III discusses the trade-off between financial safety and soundness regulation and economic growth and how over-regulation of financial institutions reduces economic growth. Section IV discusses Title II Orderly Resolution Powers and the
A high-level summary of my testimony follows:
* Four years after its passage, there is no evidence that the Dodd-Frank Act has ended too-big-to-fail, indeed Dodd-Frank has probably reinforced investor expectations that the largest financial institutions benefit from government safety net protections that are not available to smaller institutions.
* Dodd-Frank grants financial regulators, especially the
* In the current environment, the mix of ill-defined duty and unconstrained regulatory power is a recipe for over-regulation and slower economic growth.
* A Dodd-Frank Title II resolution using the
* The Title II and SPOE create new uncertainty regarding which investors will be forced to bear losses when a bank holding company fails. This increased uncertainty will undermine investor confidence and financial stability and could create a political crisis.
o Title II creates a conflict of interest between contributors to the deposit insurance fund and contributors to the orderly liquidation fund.
o Title II and SPOE alter investor property rights without prior notice, compensation, or due process and with little scope for judicial protection.
* Dodd-Frank does not amend deposit insurance laws to require the
One of the primary goals of the Dodd-Frank Act was to end investor's perceptions that the largest financial institutions are too-big-to-fail (TBTF). The recent financial crisis confirmed investor perceptions that the largest financial institutions will benefit from government support in a financial crisis while smaller institutions will be allowed to fail and impose losses on their investors. Large institutions were extended extraordinary government support that shielded many of their investors from loss while hundreds of small financial institutions were allowed to fail. A primary goal of Dodd-Frank is to reduce if not completely remove investor expectations of TBTF.
TBTF benefits are reflected in the largest institutions' funding costs. Institutions that are perceived to be TBTF will have lower funding costs compared to smaller institutions, holding constant other important factors such as the risk of an institution's assets, its leverage, and the intensity of regulatory monitoring.
Following the financial crisis, there has been a lot of economic research focused on estimating bank TBTF funding cost subsidies. Many studies find that the largest institutions enjoy a funding cost advantage that was especially pronounced during the financial crisis. There is on-going debate about whether the funding costs advantages that have been identified reflect a subsidy conveyed by an implicit government guarantee, or whether other technical factors can explain its existence and magnitude.
Instead of reviewing technical details of studies that estimate too-big-to-fail funding cost subsidies, I will provide some new simple data analysis that clearly demonstrates that Dodd-Frank did not erase or even reduce large-banks' funding cost advantage. Indeed this statistical evidence shows that, on average, after Dodd-Frank, the largest banks enjoy a statistically significant funding cost advantage that they did not enjoy before the financial crisis. A large bank funding advantage is clearly evident in multiple years since the passage of Dodd-Frank, and this advantage was not apparent in the data during multiple years before the passage of Dodd-Frank. While this evidence does not prove that TBTF is the source of the funding advantage, it does show that post -Dodd-Frank, there is a pronounced funding cost advantage for the largest banks that was not there before Dodd-Frank.
I use
After calculating each bank's average interest rate, I separate banks into two groups: banks with total assets larger than
It is also important to recognize that I am using individual bank data, not consolidated data for bank holding companies. I use bank data because most of the liabilities issued by a consolidated bank holding company are issued by the insured depository and not the parent holding company.
Moreover, if small banks face higher costs of funds, the use of holding company data will bias the results since a large number of small bank holding companies must be omitted from the analysis because small bank holding companies are not required to file bank holding company regulatory reports. In contrast, all banks regardless of size must file quarterly regulatory reports that include their total liabilities and interest expenses.
Using
The results in Table 1 show that in every pre-crisis pre-Dodd-Frank year, the largest banks paid more for their liabilities on average, but the difference in the average interest rates paid by large banks relative to small banks is not statistically significant. Post Dodd-Frank, the situation is very different. After Dodd-Frank, the largest banks pay a lower average interest rate on their liabilities, and the difference between the average rate paid by the largest banks and small banks is highly statistically significant.
Whatever Dodd-Frank accomplished, it clearly did not erase any funding cost advantage that was enjoyed by the largest banks prior to the crisis. Instead, the evidence suggests that after Dodd-Frank, the largest banks have a consistent funding advantage of more than 20 basis points on an annual basis. n1
Why post Dodd-Frank do the largest banks enjoy a statistically significant and stable funding cost advantage? In the following sections I will argue that the provisions of Dodd-Frank creates a rational perception among investors that the largest institutions are TBTF, and should these institutions become distressed, the government will likely provide guarantees that will shield investors from loss.
Political rhetoric aside, it is completely rational for investors to conjecture TBTF status on the largest institutions for two important reasons. First, the Dodd-Frank Act explicitly designates the largest financial institutions as "systemically important," and imposes on them much higher prudential standards and intrusive government monitoring and supervision. For these institutions, government regulators are supposed to closely monitor the risks that are being taken by these institutions. Regulators have a duty and powers to mitigate any risks these institutions might take that, in their judgment, would endanger these institutions' liquidity and solvency. Second, should these institutions become distressed,
II. Dodd-Frank's Emphasis on Heighted Supervision and Regulation Increases Investor Expectations that Designated Firms Have a TBTF Guarantee
The Dodd-Frank Act requires financial regulations to undertake extensive supervision and regulation of the largest financial firms. Most of the new regulatory powers are based on the premise that financial regulators can identify and stop the largest institutions from engaging in risky activities that might increase the risk that they will fail and the risk that their failure could have spillover effects on the financial system and economy more generally.
The problem with Dodd-Frank is that tries to accomplish an ill-defined goal without identifying any specific activities or establishing any specific thresholds for regulators to follow to achieve its ill-defined goal. Dodd-Frank grants regulators vast new powers that are at best only weakly constrained, and financial regulators are instructed to use their best judgment to exercise these wide-ranging authorizes in ways that that promote "financial stability," a goal with characteristics that are also set by the regulators' judgment. The regulators are given almost complete discretion to use their new powers to change the financial system in ways that the regulators themselves deem apprpriate, and the regulators decide when the changes they mandate have achieved "financial stability." In the post-crisis environment, this is a clear recipe for over-regulation.
For example, the Dodd-Frank Act uses the phrase "systemic risk" 39 times in directing the financial regulatory agencies to identify, mitigate, and minimize "systemic risk," but the Act never defines systemic risk. This is not an accident or oversight. The Act is vague because there is no widely-accepted definition of systemic risk.
Much of the post-crisis banking and finance literature is focused on theoretical models that try to explain aspects and potential origins of systemic risk or empirical approaches that purport to measure an institution's potential for creating systemic risk should it fail. However, this literature is at an early stage of development, and it has produced no practical guidelines that can be used to positively identify systemic risk or a systemically important institution. But the lack of a proper economic foundation has not constrained regulators from acting as if they can identify and control systemic risk.
Thus far, the academic literature has created many theoretical models that can explain why a failing institution might create financial instability. The potential channels identified are largely consistent with the designation factors identified in Section 113 of the DFA. These theoretical channels identify an institution's size, its over-use of collateralized borrowing, and financial network interconnections as possible sources of systemic risk. At the current stage of development, few if any theoretical models focus on an institution's complexity as a separate source of systemic risk.
Most economists would probably agree that an institution's size is directly related to its potential to create financial instability should it fail. Many economists would likely also agree that the failure of a very large institution that makes heavy use of short-term collateralized lending could create liquidity stresses and systemic risk in the form of "asset fire sales" should it default on its secured funding. In contrast, financial network models have not yet provided much insight into systemic risk. Network models are less prone to generate failure contagion than many economists initially anticipated.
Because the term "systemic risk" is ambiguous, Dodd-Frank provides the regulatory agencies with wide discretion to interpret their new powers. The DFA directs agencies to draft and implement rules to control and minimize "systemic risk" without requiring the agencies to identify specifically what they are attempting to control or minimize. Instead of legislating appropriate measures to attain clear goals, the Dodd-Frank Act essentially defines financial stability as the absence of systemic risk and then assigns regulators the responsibility of ensuring U.S. financial stability.
The overall effect is to promote a naive strategy for promoting financial stability: identify and restrict any financial intermediation that regulators perceive as a potential source of systemic risk. Dodd-Frank encourages regulators to separate "good" financial intermediation from "bad" financial intermediation and to impose rules to stop bad intermediation. The problem with this strategy is that it is unclear that any person or agency has the capacity to distinguish good intermediation from bad intermediation, and stopping financial intermediation has negative consequences for economic growth.
While this problem is inherent to some degree in any form of financial regulation, Dodd-Frank's extensive new regulatory powers can be exercised without any requirement that regulators recognize the cost on economic growth. The Dodd-Frank approach for ensuring financial stability sets up a clear bias for over-regulation.
Post Dodd-Frank, if we do not achieve "financial stability," the public and many in
A. Section 113: Regulators are Given the Power to determine their Own Jurisdiction
The bias in favor of over-regulation created by the Dodd-Frank mix of new unconstrained powers and vague policy goals is already apparent. In Section 113, Dodd-Frank empowers the FSOC to designate non-bank financial institutions for enhanced prudential supervision and regulation by the
For example, under Section 113, the FSOC is not obliged to identify specific issues or features that mandate designation, nor must it demonstrate how the designation will mitigate risks. Title I of Dodd-Frank includes a requirement that, once designated, firms must file an annual orderly resolution plan that explains how they can be reorganized in a commercial bankruptcy without creating financial instability. However, Section 113 does not require the FSOC to request a so-called Orderly Resolution Plan as part of the designation process.
The ambiguity of the designation standards provides the FSOC with virtually unlimited discretion. For example, under what conditions should the consequences of failure be evaluated: when the firm fails in isolation, or when the firm fails in a recession during which many other financial institutions are also distressed? Two very different standards that may generate very different FSOC conclusions, and yet Dodd-Frank is silent on the issue.
One particularly egregious Dodd-Frank shortcoming is that it allows the FSOC to make designations without knowing what heighted prudential regulatory standards will apply to designated firms. Not only has the FSOC designated nonbank firms without knowing the consequences of designation, but the justifications it has issued are so broad that companies are not provided with any guidance on how they might avoid designation.
In practice, Section 113 guidelines merely restrict the FSOC's designation discussion and the case (if any) the FSOC makes to support its decision, but the designation outcome is completely governed by the Council vote. Moreover, since the directive lacks objective standards for designation, the criterion used to designate firms will almost certainly change over time with changes in administrations. Without objective minimum quantitative standards for designation, there is little scope for continuity over time or for a designated firm to use data, analysis, or case precedent to avoid or overturn an opinion rendered by the Council.
Given these clear defects in Dodd-Frank, it should not be a surprise that financial regulators are exercising their new powers without constraint. For example, all of the Council's designations to date have been made without any Council recommendations for specific heightened prudential standards and before the Federal Reserve has revealed how it will supervise designated non-bank financial institutions or what heightened prudential standards the designated firms must satisfy. Once the Council has taken an interest in designating an institution, there is little or no objective information the target institution can use to proactively modify its operations, capital, or organizational structure to reduce its "systemic risk" to acceptable levels.
In summary, the legislation that guides the designation process for non-bank financial institutions gives targeted financial firms little or no ability to protect themselves against an arbitrary designation by the
B.
Section 165 directs the
Section 165 also requires the
Section 165 also provides the
These new Section 165 powers raise a number of important issues. I will discuss some of these issues in the remainder of this Section.
1. When does a bank become systemic and require heighted prudential standards?
There is no science evidence that supports a threshold of
As of
There are huge differences in the characteristics of the 39 bank holding companies that are subjected to enhanced prudential supervision by the
2. Enhanced capital and leverage requirements for designated companies
The enhanced capital and leverage requirements that have been implemented by the
Section 165 seems to give the
The issue of the applicability of Section 165 enhanced prudential standards highlights fundamental weakness in the drafting and implementation of the Dodd-Frank Act.
3. A two-tiered system of bank regulations will stimulate the growth of large institutions
A second issue raised by the imposition of enhance prudential standards on the largest institutions in the banking system is that a two-tiered system of regulations officially recognizes two distinct types of banks: (1) those that are small and can be allowed to fail without social cost; (2) those that are very large and create large failure costs that must be avoided by stricter regulation. Under this system, the smaller banks may benefit from less burdensome regulation, but investors understand that these institutions will be allowed to fail and softer regulations seemingly makes their failure more likely. In contrast, large banks have added regulatory burden, but they also have been explicitly identified by the government as so important that they need additional regulation to ensure their continued existence.
The differences in capital and leverage regulations between small and large banks mandated by Section 165 and implemented as Basel III are mechanical and are exercised without imposing additional regulatory judgments about critical firm operations. However, the
When the government is intimately involved in planning and approving large bank operations, investors will rationally conjecture that their investments are safer in the largest banks. The enhanced prudential standards imposed by Section 165 contribute to investor perceptions that the largest banks are too big to fail.
Over time, the two-tiered approach to banking regulation will erode the ability of small banks to compete for uninsured deposits and reduce their ability to issue unsecured liabilities. Since Dodd-Frank also prohibits the use of trust preferred securities, small bank options to fund growth beyond their retail deposit bases are severely limited. As a consequence, Section 165 requirements are likely to encourage additional consolidation in the U.S. banking system. Deposits and assets will further migrate into the institutions that are required to meet enhanced prudential standards.
4. Limits on the use of short-term debt will raise the cost of borrowing
Section 165 gives the
Short-term debt restrictions limit one of the most visible symptoms of a financial crisis--the inability of financial firms to roll-over their maturating debt. Regulators are now empowered to alleviate this problem by requiring that firms have, on average, a longer time buffer before they face the inevitable maturing debt roll-over. But all going-concern debt eventually becomes short-term and must be refinanced.
The idea for short-term debt restrictions is popular in many post-crisis academic papers that argue that there is an underlying market failure that can be fixed by short-term debt limits. Banks gain private benefit from funding short term because they have a monopoly on issuing demandable deposits and an implicit guarantee advantage in issuing other short-term deposit-like liabilities. The bank benefit is that short-term funding is usually the cheapest source of finance.
The market failure arises when there is a liquidity shock and investors for some reason become unwilling to roll-over banks' short-term liabilities and banks are forced to sell assets to meet redemption requirements. Because many banks are using "excess" short-term funding because of the apparent interest cost savings, they must all shed assets, and this depresses the market price of assets, causing a so-called "fire-sale" decline is asset prices. The decline is asset prices must be recognized by all institutions, even ones that may not be funding with excess short term-debt. And so the lesson from these models is that "asset fire sales" are an externality attached to the over-use of short-term debt, and if regulators restrict bank's ability is fund short term, then the externality can be controlled.
While restrictions on the use of short term debt may reduce the probability of "asset fire sales," the restriction will also impose real economic costs that are not recognized in these models.
First, all debt eventually become short term, so limiting the amount of short-term credit banks and other financial firms issue does not remove the issue that all debt must eventually be rolled over regardless of maturity.
The economic models that demonstrate "fire sale" externalities are highly stylized and static. In these models, if banks fund long term (in the third and final model period) they do not have to refinance in the second period when the fire sale occurs. By forcing banks to issue claims in the "last" period of the model, the claims magically never have to be refunded in the horizon examined. While this solves the fire sale problem in these simple economic models, it does not fix the real life problem that seemingly far-off future periods have a habit if turning into tomorrow, and debt that was once long-term, becomes short term and must be rolled over.
The "fire sale" models of short-term debt also ignore a large literature in corporate finance that argues that short-term debt is cheaper because it is a mechanism for controlling the risk that the managers of a financial institution (or any corporation for that matter) take. If the manager of a corporation is faced with the discipline of continuously rolling over a significant share of the corporation's funding, then the manager must ensure that the corporations finances are always sound and its debt holders are never surprised by the firm's is investments.
Short-term debt is a bonding device. The need to roll over debt helps to keep the manager from investing in longer-term risky investments with uncertain payoffs unless debt holders are fully aware and approve (i.e. are already compensated) for such investments. If the manager conveys that the firm investments are short term and relatively safe activities, should debt holders learn otherwise, they may refuse to roll over the debt at existing rates and the manager will be forced to abandon longer term investments before they can (possibly) produce the desired high payoff.
When short-term debt controls the risks the manager takes, investors can charge lower interest rates. Thus, short-term debt provides cheaper funding in part because it limits borrower risk-taking. Indeed many academic papers argue that, before deposit insurance, banks funded themselves with demandable deposits because depositors required the demandable feature to discipline the bank, since the soundness of the bank's assets could not otherwise be verified by depositors. Deposit insurance largely destroys the risk control benefits of demandable deposits. I say largely because there is evidence that some insured deposits still run.
Thus, there are sound economic reasons for arguing that short-term debt restrictions on designated financial firms may be less advantages than they might at first seem. Short-term (noninsured deposit) debt controls risk taking, and the current wave of theoretical economic models that produce "asset fire sales" do not consider the risk control benefits of short-term debt. If financial firms are forced to fund themselves using longer-term debt, their cost of debt will increase, and either the institutions will absorb these costs and be less profitable or pass these cost on to customers in the form of higher loan rates and lower returns on deposits. Section 165, and indeed the current wave of macroprudential economic models, do not recognize that short-term debt restrictions are likely to have real economic costs for borrowers.
5. Mandatory
Section 165
Aside from the confidence expressed by senior Federal Reserve officials, there is no evidence that coordinated macroeconomic stress tests will be effective in preventing future financial crisis. Already, these stress tests have missed the "London Whale" at JPM Chase and a multibillion dollar hole in
A stress-test based approach for setting bank capital has two gigantic measurement problems. First, the macroeconomic scenario must actually anticipate the next financial crisis. And secondly, regulators must be able to translate the macroeconomic crisis scenario into accurate predictions about actual bank profits and losses.
Few regulators possess the prescience necessary to accomplish this first step. Rewind your clock to 2006 and ask yourself if the
Even if the
Because of these measurement issues, bank loss predictions from macroeconomic stress tests have very little objective accuracy. Even using the best models, there remains a great deal of uncertainty surrounding how each bank may actually perform in the next crisis, presuming the stress scenario anticipates the crisis.
These issues are real and serious and they make macroeconomic stress testing more of an art than a science. There is no formula or procedure that will lead to a single set of stress test bank loss estimates that can be independently calculated by different stress test modelers. Thus, it is not surprising that the
The stress test process requires the
It may not be widely appreciated, but the coordinated macroeconomic stress test approach to regulation also encourages a "group think" approach to risk management that may actually increase the probability of a financial crisis. Stress test crisis scenarios have to be specific so that banks and regulators can model the same event. Moreover, the
The finial Section 165 issue I will discuss is related to the requirement that designated firms must file an annual orderly resolution plan. Section 165 directs the
6. Orderly Resolution Plans are not Pre-Packaged Bankruptcies
The recently released report from the
Orderly liquidation plans are drafted by designated financial institutions and reviewed and (potentially) approved by the
Second 165 does not include any objective thresholds or standards that the
7. Orderly Resolution Plans Should be used to Improve FDIC Resolutions
Historically, when large banks fail, the
The problem with whole bank resolutions is that there needs to be a bigger heathier bank to purchase the failing institution, and even when one exists, if a sale is successful, it creates a new larger institution. One step toward fixing the too-big-to-fail problem, is to require the
There are costs associated with changing the public policy priorities in an
There may be practical ways to reduce the cost of requiring the
There are many complicated, complex, and potentially costly issues that must be solved before a large bank could be successfully dismantled and sold in pieces in an
Once large regional banks can be managed and downsized in the course of a normal bank resolution, there would no longer be a case to require these banks to meet heightened prudential capital, leverage, stress test, or other regulatory standards prescribed by Section 165 (excepting the requirement to submit a satisfactory orderly resolution plan). Improvements in the resolution process can substitute for overly-rigorous prudential regulations that limit economic growth.
III. Over-Regulation Stifles Financial Intermediation and Reduces Economic Growth
Since financial regulations are designed around the idea that banks and financial intermediaries play a special role in the economy, it is useful to briefly review the economic functions of banks and financial intermediaries to highlight the link between financial regulation and economic growth.
In many capitalist economies, banks are the only intermediaries that collect consumer savings and channel them into private sector investments. In bank-centric economies, if banks make sound investment decisions, the economy grows, banks profit, and consumers earn interest and their deposits are safe. If banks make poor investment choices, their investments fail, consumers lose their savings and economic growth plummets.
Some economies, including the U.S. economy, also benefit from non-bank financial intermediation, sometimes called "shadow banking" by bank regulators. Non-bank financial intermediation occurs when consumers channel their savings into private sector investments without the intermediation of a bank. In the most common form of non-bank intermediation, firms issue publicly-traded securities that consumers can purchase and own directly, but savers may also purchase and own securities indirectly through collective investment vehicles like mutual funds, insurance companies, private equity, hedge funds or other non-bank financial institutions. These intermediaries along with broker-dealers are part of the financial infrastructure that makes it possible for consumers to purchase and sell securities and thereby channel their savings into investments without using the banking system as the investing intermediary.
The ability to invest saving using non-bank forms of intermediation generally gives savers more control over their investment decisions as well as the ability retain a larger share of the profit (or the loss) generated by their investment decisions. Non-bank intermediation is typically a cheaper source of funding for firms that have achieved a good reputation among investors by repeatedly honoring the financial claims they have issued in the past and through public disclosures that helps to make their operations and financial condition as transparent as possible to investors. Economists generally believe that economic growth is stronger when consumers can invest their savings using the wide range of invest opportunities available through non-bank intermediation.
Against this background, it is useful to consider a definition for systemic risk. My preferred definition of systemic risk is that systemic risk is the possibility that a disruption in the financial intermediation process could cause a significant sharp reduction in real economic growth.
The Dodd-frank Act operates under the theory that regulators have an ability to identify and stop "bad" financial intermediation, and by eliminating bad intermediation, regulators can remove the possibility that the failure of an institutions could disrupt financial intermediation and cause a recession. But slowing financial intermediation will slow economic growth. So within Dodd-Frank there is an implicit unrecognized trade-off between slowing economic growth in all periods against the benefit of reducing the probability of periodic recessions brought on by a financial crisis.
There is scant evidence to guide policymakers in choosing between financial stability and economic growth. History clearly demonstrates that financial safety and soundness regulations cannot prevent financial crisis. Perhaps financial regulation can reduce the probability that financial crisis occur, but even this is an unsettled issue. Safety and soundness regulations may merely replace investor monitoring with regulatory monitoring with little or no net change in the overall risk control exercised by financial institutions. Alternatively, regulation might replace investor monitoring with much more restrictive controls on financial intermediary risk taking. Whether additional restrictive regulations benefits society depends in part on consequences of these additional restrictions for economic growth. Too much regulation is a recipe for a financially stable but economically stagnant economy.
A handful of studies have assessed the potential economic impact of Basel III heightened prudential capital and liquidity regulations. Industry studies have argued that the Basel III regulations will increase the cost and decrease the supply of bank credit and ultimately lower GDP growth in non-crisis periods. A 2010 study by the
In contrast to industry-sponsored studies, pro-regulatory studies commissioned by the
These Basel III impact assessments use simplistic macroeconomic models and reduced-form relationships to estimate the potential impacts of Basel III regulations on GDP. Basel III regulatory changes are assumed to increase the interest rates banks will charge their customers. The studies differ, however, in their assessment of likely increases in loan rates and the impact that these increases will have on reducing consumption and investment demand, and, ultimately, GDP. n8
IV. Title II Reduces "Systemic Risk" by Extending New Government Guarantees
Title II creates a special process to "liquidate failing financial companies that pose a significant risk to the financial stability of
Title II creates a new
The SPOE strategy is intended to minimize market disruption by isolating the failure and associated losses in a
The parent holding company shareholders and most of its liabilities will remain in the receivership to absorb the failed institutions' losses. Since most holding company liabilities would not be transferred into the bridge holding company, the new bridge company would be predominately equity funded. With the help of government guarantees and OLF funding as necessary, the bridge bank will issue new debt instruments and downstream the proceeds to recapitalize any subsidiaries that suffered losses or replace subsidiary funding to prevent asset "fire sales" to meet redemption demands.
The SPOE is designed to have the equity and debt holders of the parent company absorb all of the losses of holding company subsidiaries, but the
The
A. Most large financial firms that might be subject to Title II are primarily banks
Most of the large financial institutions that might be candidates for a Title II resolution are bank holding companies. For the majority of these institutions, their primary asset is a bank or a subsidiary bank holding company. Figure 1 shows, for all bank holding companies larger than
B. For most Title II candidates, parent equity = consolidated holding company equity
To understand how well the SPOE might work in practice, it is instructive to take a closer look at the equity and liability characteristics of bank holding companies larger than
Table 2 shows that, for most of these institutions, once the parent is facing insolvency because losses exhaust its equity, any equity in its remaining solvent subsidiaries would be consumed by the losses in the holding company's insolvent subsidiaries. So if the parent's equity is exhausted or nearly exhausted when it is taken into a Title II receivership, then parent liability holders must be relied on to bear the receivership losses.
In the most recent financial crisis, the government rescue of non-bank firms like AIG and
In each case, the parent company received a very large amount of government funding that was used to keep the institutions' open and operating. In the case of AIG, government funds provided to the parent were down streamed to subsidiaries where they were used to cover losses on securities lending and meet collateral calls on credit derivatives written by AIG's London Financial Products subsidiary. In the case of the housing GSEs, government funding was used to pay interest and principle due on the agencies' outstanding bonds, to pay indemnities and other contractual obligations related to the mortgage-back securities they had insured and issued, and to raise new funds to continue mortgage guarantee operations.
There is a very close correspondence between the Title II SPOE resolution strategy proposed by the
If the SPOE were employed to resolve AIG, the
Thus, in a repeat case of AIG distress, the SPOE would downstream the proceeds it borrows from
Aside from providing a mechanism to fund the
To keep a financial firm's subsidiaries open and operating in a Title II resolution, the
The final column of Table 2 shows that, in most cases, the parent's liabilities comprise only a small fraction of the consolidated liabilities in most financial holding companies larger than
The
Crafting holding company minimum debt requirements is a process that is analogous to the process of setting bank holding company regulatory capital requirements. The development of regulatory capital requirements has taken tremendous resources on the part of both banks and regulators, not to mention more than 15 years of development time. Moreover, holding company minimum debt requirements will also have international competitive implications if large foreign banks do not face similar requirements. This sets up the case for another yet another extensive Basel Committee-type process to set international requirements for holding company debt issuance.
F. The OLF is a new guarantee fund that conflicts with the deposit insurance fund
If the parent holding company liabilities are insufficient to support receivership losses and distressed subsidiary recapitalization needs, the
The OLF Title II mechanism sets up a new government guarantee fund. Under the SPOE, it will guarantee all but the parent holding company liabilities of the failing financial firm unless the
Among bank holding companies with consolidated assets greater than
A bank resolution uses the
Under a Title II resolution, the investors that own senior and subordinated debt in the bank will be fully protected under the SPOE strategy. Bank deposits, insured and uninsured, will also be fully protected under a Title II resolution. The SPOE will impose losses on investors in senior and subordinated parent holding company debt if the receivership losses cannot be fully absorbed by the holding company's equity. Any additional losses and recapitalization needs that cannot be covered by the parent holding company debt will be borrowed from the OLF. Repayment of these OLF funds will be assessed against any financial firm with assets greater than
G. With Presidential approval, Title II empowers the Secretary of the Treasury to change property rights without prior notice, public debate, or Congressional action.
The decision to use an
If Title II is invoked, losses are shifted onto holding company debt holders while bank deposits, investors in bank debt, and the deposit insurance fund are fully protected against any losses.
Title II allows the President and his appointed Secretary of Treasury to completely change property rights and shift losses among distinctly different investors without prior notice, public debate, or any vote from
Unless the holding company has characteristics that are uncommon among the largest holding companies, invoking Title II has the potential to provide government guarantees far in excess of those that might be in force under an FDI Act resolution. The last column of Table 3 reports the liabilities of the parent holding company as a percentage of the subsidiary bank liabilities. Except for
The SPOE raises a few additional issues. Under Title II, access to OLF funds are limited to 10 percent of the value consolidated assets of the failed financial firm as reported on its last financial statement. After 30 days, or when the
It is highly unlikely that a large financial institution fails because it prepares its financial statements and discovers that it is undercapitalized. Instead, long before financial statements reflect true distressed values, market investors lose confidence and withdraw funding from the firm. The firm ultimately suffers a liquidity crisis that forces it to find a buyer or to reorganize. In the case of
When the
I. How will Title II work when and a bank subsidiary is also being resolved by the
Some of my criticisms of the SPOE have been anticipated in the
The
J. Does Title II work in a true financial crisis?
The last and biggest issue is how Title II and the SPOE would work when multiple large financial firms are simultaneously in distress. Would SPOE be used to simultaneously to resolve multiple large financial institutions through bridge banks? How different is this from nationalizing banks which could comprise a large part of the U.S. banking system?
Title II and SPOE do not fix the too-big-to-fail resolution problem in a true financial crisis when the distress of large financial institutions is mostly likely to arise. Instead, Title II will complicate and compound the too-big-to-fail issue when a single large institution fails in isolation without providing a practical resolution solution in a financial crisis when many large financial firms are likely to be distressed simultaneously.
n1 Because interest expense is reported as the cumulative expense in a calendar year, June estimates are doubled to estimate annual benefits; the March estimate must be multiplied by 4.
n2 "Basel III Capital Standards: IIF Preliminary Analysis,"
n3
n4 See, Angelini, P.,
n5 See, Slovik, P. and B. Cournede (2011), "Macroeconomic Impact of Basel III", OECD Economics Department Working Papers, No. 844,
n6 See, Elliott, D.J., (2009). "Quantifying the Effects on Lending of Increased Capital Requirements,"
n7 Santos, A.E. and
n8
n9 http://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-b_fr.pdf
n10 AIG's 2007 financial statement indicates it had issued more than
n11 For example, the senior and subordinated debt holders in WAMU bank suffered large losses while the senior and subordinated debt in the holding company had a 100 percent recovery on their securities.
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