[Senate Hearing 111-638]
[From the U.S. Government Publishing Office]
S. Hrg. 111-638
IMPLICATIONS OF THE ``VOLCKER RULES'' FOR FINANCIAL STABILITY
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE IMPLICATIONS OF THE ``VOLCKER RULES'' FOR FINANCIAL
STABILITY
__________
FEBRUARY 4, 2010
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Marc Jarsulic, Chief Economist
Joe Hepp, Professional Staff Member
Amy S. Friend, Chief Counsel
Drew Colbert, Legislative Assistant
Mark Oesterle, Republican Chief Counsel
Heath P. Tarbert, Republican Special Counsel
Jeffrey M. Wrase, Republican Chief Economist
Rhyse Nance, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
----------
TUESDAY, FEBRUARY 4, 2010
Page
Opening statement of Chairman Dodd............................... 1
Opening statements, comments, or prepared statements of:
Senator Shelby
Prepared statement....................................... 39
WITNESSES
E. Gerald Corrigan, Managing Director, Goldman, Sachs and Co..... 4
Prepared statement........................................... 39
Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship,
Sloan School of Management, Massachusetts Institute of
Technology..................................................... 6
Prepared statement........................................... 45
John Reed, Retired Chairman, Citigroup........................... 7
Prepared statement........................................... 49
Hal S. Scott, Nomura Professor of International Systems, Harvard
Law School..................................................... 9
Prepared statement........................................... 50
Barry L. Zubrow, Executive Vice President and Chief Risk Officer,
JPMorgan Chase and Company..................................... 11
Prepared statement........................................... 63
(iii)
IMPLICATIONS OF THE ``VOLCKER RULES'' FOR FINANCIAL STABILITY
----------
TUESDAY, FEBRUARY 4, 2010
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:39 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order. Let me
first of all apologize to my colleagues and our witnesses. I
was just chatting with Senator Shelby. Our colleagues from
North Carolina invited me to come by this morning and speak to
the North Carolinian community bankers, and so--I can see all
the heads nodding. I am going to be speaking to every community
banking group here on this table, I guess, before long. But I
spent a few extra minutes with them and I apologize for being a
few minutes late.
Senator Warner. You have some extra time now.
Chairman Dodd. I am sorry, Senator?
Senator Warner. You have some extra time on your hands.
Chairman Dodd. Yes, extra time on my hands.
Senator Johnson. The South Dakota community----
Chairman Dodd. South Dakota, that will be next.
Well, we are going to meet again this morning. As all of
you know, we met last Tuesday, or this Tuesday, with Paul
Volcker and Neal Wolin who testified about the so-called
``Volcker Rule'' and we welcome our witnesses here this
morning, as well, many of whom I know well and some I am
welcoming back to the Committee. Mr. Reed, it is good to see
you again back before this Committee. It has been a long time
and you are always welcomed here.
The ``Implications of the `Volcker Rules' for Financial
Stability.'' And I am going to make a couple of brief opening
comments, turn to Senator Shelby, and then we will turn to our
witnesses, beginning with you, Gerry, at that end of the table,
and then work down. I will ask you to be relatively brief, if
you can, in your comments. I read, Gerry, your testimony--there
is nothing brief about your testimony--last evening, another
voluminous and----
Mr. Corrigan. I cannot resist.
Chairman Dodd. I know. Everything is big at Goldman, you
know.
[Laughter.]
Chairman Dodd. So we are going to make sure it is included
in the record, along with any other supporting documents and
evidence that all of you would like to offer this morning, and
then I will turn to my colleagues for some questions here.
We have some votes around 12:30, so we are going to try and
move along if we can this morning, rather than bring you back
again in the afternoon. I again thank all of you for being
here.
As I said a moment ago, this is our second hearing this
week on the Obama administration's proposal to crack down on
excessive consolidation and risk taking within our financial
system.
I would like to start by clarifying something that I said
on Tuesday. Folks may have noticed I sounded a little
frustrated, and they were correct in that observation. The fact
is, I think all of us are to one degree or another frustrated
with the present situation in our country and all anxious to
see us get back on our feet and back on track again.
The issues that Senator Shelby and I and the Members of the
Committee are grappling with are difficult, they are
complicated, and they are terribly important. But as we have
been debating them for months--in fact, some of these issues we
have been debating for years in this institution as well as
elsewhere. But nearly 2 years after the collapse of Bear
Stearns, we still have not updated the laws governing our
financial sector, leaving our fragile economy with the same
vulnerabilities that led to the economic crisis in the first
place. I think we are at a critical point and juncture at this
particular hour.
Now, as my colleagues know, I laid out a discussion draft
in November and Members of this Committee have been working
together across the aisle to come up with a compromise, if we
can, ever since, and I thank all of them. This has been a very
difficult job, but they have spent countless hours on working
on proposals here that we could present to our colleagues, and
more importantly, to the country as to how we think we ought to
fill in these gaps and move forward. We are now getting to the
point where we need to sort of pull the trigger, in a sense,
because hard-working American families can't wait much longer
for a return to economic security and certainty.
If I have heard one word over and over and over again, it
is the lack of certainty that is out there, and part of our job
is to help clarify and provide some certainty as to where we
are headed, and our hope is with our legislation to do that.
It is tough to take on another issue at this point. I made
that point. There are wonderful ideas out there. There are a
lot of things that we need to be talking about in the area of
financial services. It was never my intention or, I believe,
the intention of this Committee to solve every issue
surrounding the financial services sector. We tried to focus on
some critical ones that we think would make a fundamental
difference, but never the assumption we could take on all the
issues that people would like to raise in a moment like this.
And we need to not only talk about filling in the gaps of
the problems that existed, but looking ahead, which is our
responsibility. What can we do to set up an architecture that
would minimize the kind of problems we saw occurring again. If
not in this particular environment or sector, where else could
they emerge? And are we building the structural institutions
that will minimize that from happening again beyond what we can
imagine today, something 10 years, 20 years from now? And that
is also part of our function and obligation, in my view, on
this Committee.
But while the specific proposals announced by the
Administration have come late in the game, they deserve our
serious consideration, as well, and I believe the
Administration is on the right track, but finding a way to
implement these proposals is no easy feat, as well. These are
complicated issues meant to address complicated problems that
leave our Nation's economy at risk and we need to find a
balance between giving them their due consideration and
appreciating the urgency with which we need to act given what
is at stake.
On Tuesday, we heard from Chairman Volcker and Treasury
Secretary Wolin, and I appreciate the strong cases that they
made for the Administration's proposals, as well as their
thoughts on how we ought to move forward.
Today, we have before us a very impressive panel of experts
from the industry and academia to discuss the possible
consequences of these proposals. I look forward to hearing from
each and every one of you. What is more, I understand that for
our industry friends, this might be a little like walking into
the lion's den. But our intention here is to probe these ideas
and solicit your thoughts and background and experience as to
how to move forward.
Let me just say, we did not embark on financial reform
because we wanted to punish the industry. I certainly didn't,
at all. We all want to create a system where business, large
and small, can thrive, and that the users, the customers, the
people who come through your doors, can have that confidence
restored that our system is sound, it is safe, and they can
rely on it, whether depositing their paycheck, buying a stock,
an insurance policy, taking out a mortgage. It is the people
not in this room today that want to know whether or not we get
it and you get it, and we are going to create that structure
that allows them then to have that sense of confidence and
optimism that is the critical element for our economy recovery,
in my view.
So I have heard the arguments again and the industry's
refusal, and I am not going to single out our witnesses, but
the refusal of large firms to work constructively with Congress
on this effort. It borders on insulting to the American people
who have lost so much in this crisis. And from where I am
sitting, it looks like instead of investing in improvements
that would secure their financial strength, too many people in
the industry have decided to invest in an army of lobbyists
whose only mission is to kill the common sense financial
reforms that we are working so hard up here to try to achieve,
and we have been working on for a number of months.
I have heard all the arguments for business as usual, but
the American people have been through too much. Unemployment is
still too high. The economy remains too vulnerable to support
the status quo. That is unacceptable and we need to move
forward.
So I am determined as ever to get this strong bill to the
floor of the Senate in an appropriate amount of time to allow
full consideration of us here on this Committee and then by our
colleagues, and then to work out our differences with the House
and put a bill on the desk for his signature.
So with that, let me turn to Senator Shelby for any opening
comments, and then we will turn to our witnesses.
Senator Shelby. Mr. Chairman, I would just like to ask you
to put my statement in the record so we can go on with the
panel.
Chairman Dodd. Done. Consider it done.
Does anyone feel obligated to speak? Otherwise, the Corker
Rule prevails.
Our first witness is Gerald Corrigan, Managing Director
with Goldman Sachs. He has been there for a long time. Prior to
that, he was the Vice Chairman of the Federal Open Market
Committee. Mr. Corrigan is also a native of the town of
Waterbury, Connecticut. We don't often get to say that about
witnesses here, that they come from Connecticut. We are proud
of Gerry. He earned his Bachelor's degree from Fairfield
University in Connecticut, as well.
Simon Johnson is the Ronald A. Kurtz Professor of
Entrepreneurship at MIG Sloan School of Management. He also
serves as a Senior Fellow at the Peterson Institute for
International Economics. Previously, Professor Johnson was the
IMF's Chief Economist, from 2007 to 2008.
John Reed, I have already mentioned here, is the former
Chairman of Citigroup. He was also Chairman of the New York
Stock Exchange from 2003 to 2005. He currently serves on the
MIT Leadership Center Advisory Council, and John, we welcome
you back to the Committee.
Hal Scott is the Nomura Professor and Director of the
Program of International Financial Systems at the Harvard Law
School. Again, he has been before this Committee on numerous
occasions in the past. He has taught there since 1975. Much of
his work focuses on international financial issues. He is also
the Director of the Nonprofit Committee on Capital Markets
Regulation.
And Barry Zubrow, again, who we know well, is the Chief
Risk Officer and Executive Vice President for JPMorgan Chase,
and again, someone we are very familiar with on this Committee.
Prior to that, he was the Chief Operating Officer of Goldman
Sachs, where he has worked since 1979.
We thank all of you for being here this morning on
relatively short notice, as well, to share your thoughts on
this issue and related matters, and Gerry, we will begin with
you.
STATEMENT OF E. GERALD CORRIGAN, MANAGING DIRECTOR, GOLDMAN,
SACHS AND CO.
Mr. Corrigan. Thank you very much, Mr. Chairman. I have
again provided the Committee with a rather long statement which
seeks to provide for you and your staffs some meaningful
perspective on this financial reform process as a whole. And
trust me, I am not going to go into the details of that, except
to say that one key fact that we have to keep in mind
throughout these deliberations is that the single most
important proximate cause of the financial crisis was lending
in all of its forms. I might just remind the Committee,
probably not necessary, that based on my association with
crises back in the 1980s and early 1990s, that was also true in
those episodes, as well.
My starting point for all of this, Mr. Chairman, is that I
fully and enthusiastically agree that we have to put ``too big
to fail'' behind us. My statement includes a summary of what I
consider to be the financial reform agenda, the architecture,
to use the word that you used, Mr. Chairman, and all I would
say about that is that it is urgent that we move ahead with
this. The execution will be very challenging. It is a package
deal. If you fail on part of it, it will compromise other parts
of it. And again, it is just a very, very difficult task.
I think as a matter of perspective, it is important to keep
in mind that there are a rich framework for existing rules and
regulations out there already that are being enhanced by the
legislative process that I think deal quite effectively with
some of the issues that were raised by Chairman Volcker. I
certainly do think that well managed and well supervised large
institutions play a necessary and constructive role.
Now, with regard to the Volcker plan itself, I would just
make a couple of quick introductory remarks. First of all,
there are many important definitional and details that yet need
to be clarified, and in those circumstances, I have to say that
it is not at all clear to me, at least at this stage, that the
focus is on the issues that really were at the heart of the
crisis itself. Certainly, we need greater clarification on
that.
Much of the focus is on so-called ``proprietary trading,''
and that, too, is a very difficult subject to define. But what
I can say, based on my own kind of common sense effort to
define proprietary trading at Goldman Sachs, is that over the
cycle, the net revenues associated with so-called ``proprietary
trading'' are 10 percent or less of firmwide revenues at
Goldman Sachs.
I also think that client-driven market making and hedging
and risk management activities are, in my judgment, natural
activities for well managed and well supervised banking groups.
I think the outliers can be dealt with on a case-by-case basis,
either with existing rules, much less with the enhanced rules
that I am sure will flow out of the reform process.
I also included in my statement, Mr. Chairman, a discussion
of the issues associated with resolution authority, and
resolution authority is critical to dealing with the ``too big
to fail'' problem. And I have spelled out certain principles
and prerequisites that I think are absolutely essential if we
are to make resolution authority work, and ultimately, that,
together with the other parts of the agenda I have specified,
is how we will find success in the future and a safer, sounder,
and more efficient financial system, while at the same time
putting ``too big to fail'' behind us.
I should also in closing, Mr. Chairman, say that, as I
think you and others know, my respect and admiration for
Chairman Volcker is unlimited. He is, in my judgment, one of
the great, great figures of the past half-century or more. So
it is not altogether the easiest thing in the world for me to
take exception at least with some of the details that the
Chairman has suggested. But I want to assure you and everyone
else that I have more respect and more admiration for Paul
Volcker than I do for any man or woman alive.
Thank you very much, Mr. Chairman.
Chairman Dodd. Thank you very much, Gerry. I appreciate it
very much.
Mr. Johnson.
STATEMENT OF SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF
ENTREPRENEURSHIP, SLOAN SCHOOL OF MANAGEMENT, MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
Mr. Johnson. Thank you, Senator. I strongly support the
Volcker Rules, as everybody is starting to call them, in terms
of the principles they put forward.
I think there are two main principles. The first is that we
should redesign the size cap that does already exist for U.S.
banks, the size cap from the 1994 Riegle-Neal Act. We should
redesign it to reflect current realities. And second, we should
address the issue that has arisen, in particular over the past
few years, of U.S. Government backing for very large financial
enterprises that have basically an unlimited ability to take
risk around the world.
I do not, however, think that the exact formulation of the
Volcker Rules as put forward is the right way to go. I think,
actually, you should consider tightening the restrictions on
the largest banks and reducing the size cap, and I would
emphasize that our banks are now already much larger as a
percent of the--our largest banks as a percent of the economy,
a percent of total financial assets, than we have ever seen
before in the United States.
Our largest six banks have assets worth over 60 percent of
GDP. This reflects, in addition to what has happened in the
financial crisis and the bailout and the rescue, it reflects
the underlying concentration of these financial markets. So the
big four banks now have more than half of the mortgage market
in this country and two-thirds of the market for credit cards.
This is unfair competition. Because these banks are too big to
fail, they have lower funding costs, they are able to attract
more capital, they make more money over the cycle, and they
continue to get larger. And I do not think that we have seen
the end of this.
If you look at the European situation today, for example,
it is much worse than what we have in this country with regard
to the size of the largest banks. Just as one example, the
Royal Bank of Scotland peaked with total assets at 125 percent
of U.K. GDP. That is a seriously troubled bank that is now the
responsibility of the U.K. taxpayer. If we allow our biggest
banks to continue to build on these unfair market advantages
and the lower funding costs, we will head in the same
direction.
I think I would suggest to you that you consider imposing a
size cap on banks relative not to total normal assets or
liabilities, which is the Volcker proposal, because that is not
bubble-proof. If you have a massive increase in house prices,
real estate prices, such as happened in Japan in the 1980s, you
will have a big increase in the normal size of bank balance
sheets. And when the bubble bursts, you are going to have a big
problem. I think the size cap should be redefined as a percent
of GDP.
And I think that while the science on bank size is, to be
sure, incomplete and inexact, there is no evidence that I can
find of any kind, and I have spent a lot of time talking to
technical people from they financial sector and people at
central banks, people in the banking system themselves have
impressed various points on me. I cannot find anything--I put
this in the written testimony--that supports the idea that
societies such as ours should have banks with total assets
larger than around $100 billion in today's money.
Now, if you were to impose a size cap of, say, 3 or 5
percent of GDP, no bank can be larger than that size, that
would return our biggest banks roughly to the position that
they had in the early 1990s. Now, our financial system worked
very well in the early 1990s. Goldman Sachs, as one example,
was one of the world's top investment banks. I don't think
anyone questioned the competitive sector. But since the early
1990s, we have developed a lot more system risk focused on the
existence of these very big banks.
So, as Mr. Corrigan said, the essence of this crisis was
lending, but it was lending that at the heart of it was based
on the idea you could make nonrecourse loans to people who can
walk away from their homes when the house value falls, leaving
the bank with huge losses. How do people think this was a good
idea? Why did they think that this would survive as a business
model? Well, I think it was very much about the size of these
banks and very much about the support they expected to receive
when they are under duress.
So in conclusion, I think the Volcker principles are
exactly right. I think they are long overdue. I think you
should--I hope that you will take them up and develop them
further. I think the degree of unfair market competition, the
degree to which the community banks are disadvantaged by the
current situation, because they have to pay a lot more money--
they pay higher interest for funds, their cost of capital is
higher--this is unfair. This dynamic will continue unless you
put an effective cap on it. The biggest banks will become even
larger and even more dangerous.
Thank you very much.
Chairman Dodd. Thank you very much.
John, welcome again.
STATEMENT OF JOHN REED, RETIRED CHAIRMAN, CITIGROUP
Mr. Reed. Mr. Chairman, thank you very much for your kind
welcome. Senator Shelby and everybody, I appreciate the
opportunity to be with you. I had never anticipated as a
retired citizen that I would find myself here, but I really am
here to voice support for Mr. Volcker's suggestion, the Volcker
Rule.
I do think that while details have to be worked out and so
forth, I think that it is a good suggestion and one that is
worthy of consideration by this Committee and the Congress in
general.
I don't say this because I think the absence of that rule
was central to the difficulties that we have just come through.
I don't think that is the case. But I do say it from the point
of view that if we were take a blank piece of paper and we were
to say to ourselves, how can we design a financial system that
would both serve the public and also be relatively safe and
relatively unlikely to have a repeat of what we had, you would
start out certainly with capital, which needs to be augmented.
You would certainly look at the structure of the regulatory
framework, which I believe this Committee is doing. But I would
argue that you would also look to maybe compartmentalize the
industry, not deny any function to the industry in general, but
compartmentalize it so as to limit economic spillover.
But as somebody who has run a large company in this
industry for a long time, because of the impact that it has on
the culture and the makeup of the various firms, dealing with
the capital markets, proprietary trading, proprietary
investing, hedge fund market, so forth and so on, each of these
bring with them their own culture. These are cultures that have
to exist for the particular purpose, but they have their own
particular characteristics and there is no question in my mind
but these cultures have an impact on the institution within
which they are embedded.
And if I were asked to design a system, I would not allow
these kind of cultures and activities to be a part of large
depository and traditional lending institutions. It is not that
I feel these functions shouldn't exist. I would simply separate
them from institutions that are the deposit takers and
basically the traditional lenders for much of the economy. And
I do this because I think the culture from the capital markets
that rubs off has to do with risk taking. It certainly has to
do with compensation, and it has to do with the nature of the
human fabric of the various entities that we are talking about.
So I believe as a part of a comprehensive reform that Mr.
Volcker's idea with regard to separation of some of these
functions makes a lot of sense, not because I am concerned
about the economics, but because I am concerned of the nature
of the impact that these various activities have on the players
and the financial markets.
With regard to size, I would differ a little bit with
Professor Johnson. I think the antitrust laws are quite capable
of dealing with size in the marketplace. The place where size
is the problem has to do with the intra-industry transactions,
the so-called ``counterparty risk.'' This is where the ``too
big to fail'' comes into play. It isn't the balance sheet of
the bank that is the problem on ``too big to fail.'' It is the
interconnectedness of one financial institution with virtually
all other financial institutions. And so this is where I
believe we must be concerned about size.
You could deal with size by having capital requirements
that relate to the size of intra-industry activity, and
obviously increasing capital as intra-industry activity goes
up. You also, and this has been proposed and I think it is a
good idea, can ask that certain instruments be traded through
exchanges. This acts as a circuit breaker, the exchanges. It
acts as a circuit breaker in the transmission of difficulties.
And you could deal with size by simply putting limitations on
counterparty risk, on the degree of leverage that can exist
with regard to intra-industry trading.
So the issue of size, I think, is also relevant, and so I
think the two keys to Mr. Volcker's suggestion, that of
segregation of function within the industry and particularly
the protection of the large deposit-taking institutions and the
idea of being concerned about size, have merit and deserve the
consideration of this Committee.
A final comment, if I could. I believe that one of the
reasons that JPMorgan Chase did better than many others during
this recent crisis is they did not have embedded in that
institution a real money market activity, a trading house.
JPMorgan Chase was the amalgam of about five commercial banks,
but none of them had a big investment banking trading activity
in it, and the absence of that kind of function turned out in
the crisis to give them a relative strengthened position.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very, very much.
Mr. Scott, welcome back to the Committee.
STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR OF INTERNATIONAL
SYSTEMS, HARVARD LAW SCHOOL
Mr. Scott. Thank you. Thank you, Chairman Dodd, Ranking
Member Shelby, and Members of the Committee for permitting me
to testify before you today on the Volcker rules and related
size limitations.
Chairman Dodd. Mr. Scott, I am going to interrupt you for a
minute if I can here. I rarely get a full quorum in the
Committee, and we have got one here for at least a couple of
minutes. We have some nominees that I am going to quickly try
and take care of. I do not think they cause any controversy,
but I will take a fair crack at it anyway.
[Whereupon, at 11:04 a.m., the Committee proceeded to other
business and reconvened at 11:05 a.m.]
Chairman Dodd. The Committee will now turn to Professor
Scott. How was that for speed? If I can just get financial
reform through.
[Laughter.]
Chairman Dodd. I was going to slip it in. Smuggle it in.
Senator Shelby. Maybe you can.
[Laughter.]
Mr. Scott. This Committee has been hard at work for several
months on a broad range of issues of financial reform that are
crucial to our Nation's future, including new resolution
procedures to protect the taxpayers from loss, reduction of
systemic risk through better capital requirements and central
clearing for over-the-counter derivatives, and enhanced
measures of consumer protection.
Less than 2 weeks ago, the Administration announced the so-
called ``Volcker rules.'' Whatever one thinks of the merits of
these new proposals, it is undeniable that they will take
considerable time to develop and debate. Tuesday's hearing
certainly underscored this point. These new proposals should
not hold up action on the pressing fundamental issues much
further down the track, and I encourage this Committee's
continuing efforts to reach a bipartisan consensus on these
issues.
The asserted objective of the new proposed rules is to
limit systemic risk. In my judgment, they fail to do so. If the
limits on proprietary trading only apply where banking
organizations take positions ``unrelated to serving
customers,'' they will have little impact. For example, with
respect to Wells Fargo and Bank of America, such activity
represents around 1 percent of revenues. While this has been
estimated to be 10 percent of the revenues of Goldman Sachs,
Goldman could easily avoid the requirements by divesting itself
of its banking operations since deposit-taking constitutes only
5.19 percent of its liabilities.
The real source of systemic risk in the banking system, as
demonstrated by this crisis, is old-fashioned lending. It was
mortgage lending that was at the heart of the financial crisis.
I do not agree with Mr. Volcker that these traditional
activities, by the way, are entitled to a safety net. Banks
should not be bailed out, whatever the reason for their losses.
Indeed, the focus should be, as it is in the pending
legislation, to control risky activities of whatever kind.
The Volcker rules would also prohibit banks from investing
in, or sponsoring, private equity including venture capital
funds. This would have little impact on the large banks whose
investment in private equity accounted for less than 2 percent
of their balance sheets.
On the other hand, bank private equity investments are
important to the private equity industry as a whole, accounting
for $115 billion or 12 percent of private equity investment.
Depriving the industry of this important source of funds could
impede our economic recovery.
Turning to the size limitation proposal, let me stress that
this proposal does not purport to decrease the present size of
any U.S. financial institution nor would it prevent any
financial institution from increasing its size through internal
growth. The proposal, as I understand it, would only limit the
growth of nondeposit liabilities achieved through acquisition.
Accordingly, if banks or other financial institutions are
too big to fail, this proposal will have no impact on them.
Indeed, it even permits them to get bigger.
In thinking about size, our concern should be with the size
of a bank or other financial institution's interconnected
positions, not its total size, because it is the degree of
interconnectedness that drives bailouts, and here I fully agree
with what Mr. Reed said on this. I fail to see how market share
of nondeposit liabilities could be a proxy for position size.
Let me briefly turn to the international context. Without
international consensus, adopting these proposals will only
harm the competitive position of U.S. financial institutions.
These proposals have not been agreed to, even in principle, by
the G-20 or major market competitors, unlike most of the other
proposals that the House has considered and that are presently
before your Committee. While major market leaders and
international organizations have been polite in welcoming these
proposals, they have not endorsed them.
In conclusion, do these proposals deserve further
consideration and debate? Absolutely.
But are they central to reform? In my view, they are not,
and I would stress the fact that they should not in any event
hold up action on the complex matters already before your
Committee.
Thank you.
Chairman Dodd. Thank you very, very much.
Mr. Zubrow, welcome to the Committee again.
STATEMENT OF BARRY L. ZUBROW, EXECUTIVE VICE PRESIDENT AND
CHIEF RISK OFFICER, JPMORGAN CHASE AND COMPANY
Mr. Zubrow. Thank you very much, Chairman Dodd, Ranking
Member Shelby, Members of the Committee. Thank you for giving
us the opportunity to appear this morning.
While the history of the financial crisis has yet to be
written conclusively, we know enough about the causes to
recognize that we need substantial regulatory reform. Our
current framework was patched together over many decades. When
it was tested, we saw its flaws all too clearly.
Mr. Chairman, I want to assure you and the other Members of
the Committee that we strongly support your efforts to craft
and pass meaningful regulatory legislation. In our view, the
markets and the economy reflect continued uncertainty about the
regulatory environment. However, the details matter a great
deal, and a bill that creates further uncertainty or undermines
the competitiveness of the U.S. financial sector will not serve
our goal of a strong, stable economy.
At a minimum, we need a systemic regulator to monitor risk
across our financial system. In addition, as we at JPMorgan
Chase have stated repeatedly, no firm, including our own,
should be too big to fail. Regulators need enhanced resolution
authority to wind down failing firms, in a controlled way that
does not put taxpayers' dollars at risk or the broader economy
at risk.
Other aspects of the regulatory system also need to be
strengthened, including consumer protection, capital standards
and the oversight of OTC derivatives. But I emphasize systemic
risk regulation and resolution authority because they provide a
useful framework for consideration of the most recent proposals
from the Administration.
Two weeks ago, the Administration proposed new restrictions
on certain activities related to proprietary trading, hedge
funds and private equity. The new proposals are a divergence
from the hard work being done by legislators, central banks and
regulators around the world to address the root causes of the
financial crisis and to establish robust mechanisms to properly
regulate systemically important financial institutions. While
there may be valid reasons to examine these activities, there
should be no misunderstanding. The activities the
Administration proposes to restrict did not cause the financial
crisis.
Further, regulators currently have the authority to ensure
that these risks are adequately managed in the areas that the
Administration proposes to restrict. We need to take the next
logical step of extending these authorities to all systemically
important firms regardless of their legal structure. If the
last 2 years have taught us anything, it is that threats to our
financial system can and do originate in nondepository
institutions.
Thus, any new regulatory framework should reach all
systemically important entities, including investment banks
whether or not they have insured deposits. All systemically
important institutions should be regulated to the same rigorous
standards. If we leave some firms outside the scope of this
regulation framework, we will be right back where we were
before the crisis started. We cannot have two tiers of
regulation for these systemically important, interconnected
firms.
As I noted at the outset, it is also very important that we
get the details right. Thus far, the Administration has offered
few details on what is meant about proprietary trading. Any
individual trade taken in isolation might appear to be
proprietary trading, but in fact is part of a mosaic of serving
clients and properly managing the firm's risks. If defined
improperly, this proposal could reduce the safety and soundness
of our banking institutions, raise the cost of capital
formation and restrict the availability of credit for
businesses, large and small, all with no commensurate benefit
to reducing systemic risk.
Similarly, the Administration has yet to define what
ownership or sponsorship of hedge funds and private equity
activities means. Asset managers, including JPMorgan, serve a
broad range of clients including individuals, universities and
pensions, and need to offer these investors a broad range of
investment opportunities across all types of asset classes. In
each case, investments are designed to meet the needs of our
clients. While we agree that the United States must show
leadership in regulating financial firms, if we take an
approach that is out of sync with other major countries,
without any demonstrable risk reduction benefit, we will
dramatically weaken our firms' ability to serve our clients in
this Country.
The Administration also proposed certain limits on the size
of financial firms. If you consider the institutions that
failed during the crisis, some of the largest and most
consequential failures were standalone investment banks,
mortgage companies, thrifts and insurance companies, not the
diversified financial firms that appear to be the target of the
Administration's proposals. It is not AIG's or Bear Stearns's
size that led to their problems, but rather the interconnection
of those firms that required the Government to step in.
In fact, our capabilities, size and diversity were
essential to both withstanding the impacts of the crisis and
emerging as a stronger firm, but equally importantly putting us
in a position to acquire Bear Stearns and Washington Mutual
when the Government asked us to help.
An artificial cap on liabilities will likely have
significant negative consequences. Banks' liabilities and
capital support the asset growth of their lending activities.
By artificially capping liabilities, banks may be incented to
reduce the growth of assets or the size of their existing
balance sheets, which in turn would restrict our ability to
make loans to consumers, to businesses, as well as to invest in
Government securities.
While numerical limits and strict rules may sound simple.
There is great potential that they would undermine the goals of
economic stability, growth and job creation. The better
solution is modernization of our financial regulatory regime
that gives regulators the authority and the resources needed to
do the rigorous oversight involved in examining firms' balance
sheets and lending practices.
Let me conclude by just noting that it is vital that you as
policymakers and those like us, with a stake in our financial
system, work together to overhaul regulation thoughtfully and
well. While the specific changes may seem arcane and technical,
they are critical to the future of our economy. We look forward
to working with the Committee to enact reforms that will
position our financial industry and economy for sustained
growth for decades to come.
Thank you and I look forward to your questions.
Chairman Dodd. Thank you very, very much.
I will ask the clerk to put on, let's say, 6 minutes. So we
will try and get through. We have a lot of good participation
here this morning.
Let me begin on the issue and ask all of you briefly to
comment on it. There are a lot of issues surrounding this
proposal, and I am going to focus on the issue of the
proprietary trading side. I think some of you made a pretty
good case, and I find myself sympathetic to the notion of the
size question, that this is very difficult. It is the
interconnectedness that I think makes a lot of sense to me.
So, in my time, I want to focus on the other matter where
there seems to be a little bit more of diversity of opinion,
and the issue is the effective ability, in my view, to
effectively draw that bright line between proprietary trading
and these other activities.
I know there was some interest. Bob Diamond, who is the CEO
of Barclays, reportedly made a speech in this recent matter at
a gathering in Switzerland. Let me tell you the quote. He said,
and I am quoting here. This is the report of the quote: ``It is
very, very difficult to think that we can differentiate between
the risk bank's stake and the normal course of business for
their clients and customers and proprietary trading.''
Then another of his colleagues, apparently at the same
setting, said the following: ``I can find a way to say that
virtually any trade we make is somehow related to serving one
of our clients. They can go ahead and impose the rule on
Friday, and I can assure you that by Monday we will find a way
around it. Nothing will change unless the definition is
ironclad.''
Now I do not know who said that at that meeting, but that
was the report of the meeting. And I have said that yesterday
as well, that before even the ink dries on a proposal here,
there will be very bright, young people who will sit and figure
out some way to do a dodge. Is that your conclusion?
Putting aside whether or not you agree whether we ought to
do it or not, can we write such a thing here that would be
ironclad, that would actually prohibit this kind of activities,
and to such a degree?
John, why do you not go ahead?
Mr. Reed. Mr. Chairman, I believe you can. If you run a
bank, you know what you are doing. You have to have limits for
the various activities in your trading floor. There is no
question that people can cheat and break rules. It happens all
the time. Regulators, on the other hand, can catch them.
If you say to a financial institution that proprietary
trading is not an accepted practice, any well-managed financial
institution knows how to run its business in such a way as not
to be engaged in proprietary trading. And people who argue that
you cannot find this out have not in fact run these
institutions.
Chairman Dodd. Mr. Johnson.
Mr. Johnson. Senator, I tend to agree with you completely
on this question. You can. Within the banks, if the executives
decide to shut down proprietary trading, they can do it. Sandy
Weil, if I am not mistaken, closed the proprietary desk of
Solomon Smith Barney in 1998 because he did not like the
positions and the losses that they had incurred.
But to come in from the outside and to say to legislators,
or have regulators say, no more proprietary trading would I
think lead to exactly the kind of evasion, evasive tactics you
are talking about because there are many other ways to
construct the same sort of risk return profile, which is what
really they are going for with proprietary trading.
They will not call it proprietary trading. It can
disbursed. It can be put in different ways. So I agree with
John Reed, that if the management really wants to do this, they
will do it.
But to impose it from the outside I think would be illusory
at best and could lead to all kinds of dangerous distortions.
Chairman Dodd. Gerry, in asking you to respond to the same
question, tell us here what the impact would be on Goldman in
terms of revenue and profits. Would it put a prohibition on
hedge fund activity, private equity activity? As a practical
matter, what happens at Goldman if we have an ironclad rule?
Mr. Corrigan. The answer is not as much as some people tend
to think.
I think it is theoretically possible, Mr. Chairman, to
construct a very tight regime for a very, very limited class of
activities that you could call proprietary trading, where there
is absolutely no interaction whatsoever between a group of
proprietary traders and clients, and that activity is totally
walled off within a given institution. But that would be a
situation which I think would provide some liquidity to markets
and price discovery, and that is fine.
But to take the Goldman Sachs situation, if you took the
net revenues associated with the best I can do to imagine a
sensible definition, for example, of proprietary trading and
hedge funds and private equity funds, we are, in net revenue
terms, talking about something over the cycle in the broad
order of magnitude of 10 percent of firmwide net revenues.
Now I say over the cycle because in good years it could be
a little higher, in bad years a little lower. But if you want a
reference point, at least using Goldman Sachs as the example,
that I think is as good as I can do right now since I do not
know what the definitions that other people would have in mind
when they talk about these alternative schemes.
Chairman Dodd. Let me ask. Paul Volcker said he used, I
believe it was Potter Stewart in his definition of pornography:
You know it when you see it.
I am hesitant to go down this road, but nonetheless since
he used Paul Volcker talk, which gets to the point in a sense
that Professor Johnson and John Reed were making, that if it is
the bank institution looking at it, and they know it when they
see it, that is one thing. When the regulator is looking at it,
you could end up with two different people with a very
different analysis of whether or not something is pornography.
So the lack of clarity and the lack of certainty seem to be
affected.
So I have to look at this from the standpoint of not only
the institution, what the effect is on the institution and the
risk posed by it, but can you define it in a clear enough way
so that a good regulator would be able to identify it and see
it and respond do it. And that is really the prism I think
through which we have to look at this--not to exclude how the
institution looks at it, but more importantly I see it as how
the regulator would look at it.
Do you agree with that? And, if so, then I pose the
question again. Can you do this?
Mr. Zubrow. Mr. Chairman----
Chairman Dodd. And put it this way, I really do not like
it. But could you do it?
Mr. Zubrow. I do think it is also important to remember
that Justice Potter Stewart's remark also went on to say, with
respect to pornography, that this is not it. And I think Mr.
Volcker is also having the difficulty in saying that it is a
very simple definition and it is very easy to see, but he seems
to be having difficulty coming up with what that pure
definition should be.
I think that one of the significant issues that the
Committee should is that proprietary trading not only means
different things to different people, but in different contexts
can mean different things. So, for instance, we obviously, in
our regular market-making activities and client-facing
activities, often take on positions from clients. We then need
to hedge those risks. Now is that proprietary trading?
Those risks have been given to us. They came out of client
market-making activities, but now they are the bank's risks.
So, if we want to go out and hedge those risks prior to being
able to flatten those positions, that obviously could be
interpreted by some as a form of proprietary trading.
I would agree with Gerry's comment--if you take the
extremely narrow definition and say that you put a group of
traders in walled-off area, give them an amount of capital.
That is not a business that we are in. That is not something
that we find strategically attractive. Obviously, if we were to
eliminate that type of activity, that would not have a
particular impact on the firm.
Chairman Dodd. Thank you.
I have gone over my time, and I apologize to my colleagues.
Senator Shelby.
Senator Shelby. Mr. Corrigan, under existing authorities
today, regulators are able to ensure the safety and soundness
of an institution. I think that underlies everything here.
Do you believe that regulators presently have the ability
to restrict a firm's activities, including their proprietary
trading, if they deem this not to be a safe and sound practice?
Mr. Corrigan. I do not think there is any question at all,
Senator, that they have the authorities. That is a no-brainer.
One of the principles----
Senator Shelby. If they have the authority, then it is a
question of do they have the will to use their authority. Is
that right?
Mr. Corrigan. That is precisely the point, Senator. One of
the principles that I articulated in the statement that I gave
you is that going forward the official community has to conduct
its affairs in such a way that what we call prompt corrective
action becomes a reality rather than a slogan, and that I think
is one of the great challenges that we face in the context of
this whole effort of regulatory reform. I do think there have
been some cases in the past where this notion of prompt
corrective action works, but I think in the future we need to
make it work better.
Two elements, Senator, that go into that are a much, much
more aggressive framework of stress testing. One of my favorite
inventions that Mr. Zubrow knows about, reverse stress tests
and extreme contingency analysis have to play a much bigger
role in the future than they have in the past. If we can do
that appropriately, which I think we can, I think that that is
one of the absolute prerequisites for making resolution
authority work.
Senator Shelby. Speaking of that, Mr. Zubrow, Senator
Corker and Senator Warner on this Committee have spent a lot of
time on how do we find resolution authority here in our hopeful
legislation, piece of legislation. If we basically all agree--
and I hope we do--that nothing is too big to fail, and if we
have sound regulation, the power, that regulators have the
tools to regulate and do their job, safety and soundness
trumps.
What are a couple of things that you would suggest, and
they may have covered already, these two Senators, in any
resolution authority that would be deemed so important?
Mr. Zubrow. Well, thank you very much, Senator for that
question, and I agree with you. I think Senator Warner and
Senator Corker are doing a terrific job leading the effort to
really focus on what we mean by resolution authority.
Senator Shelby. Absolutely.
Mr. Zubrow. And I think that, first and foremost, it is
very important that there be a clear regime in which firms can
be allowed to fail. And part of that is obviously a recognition
that when a firm gets into trouble, that they managements of
those firms should be eliminated, the shareholders should be
wiped out, and the creditors should be able to be dealt with
through the existing regimes of the bankruptcy laws.
Senator Shelby. Hopefully, the taxpayer will not have to
step up, right?
Mr. Zubrow. Absolutely. And if you eliminate the
shareholders' equity, if you have the ability to eliminate
unsecured debt to the extent that is needed, then obviously
there should be more than enough resources in those
circumstances, so that the taxpayers do not have to be involved
in any way in a bailout of those firms.
I think it is also very important that large, complex firms
be prepared with their regulators for that potential
eventuality. We have already begun discussions with our lead
regulator, the Fed, about how would we think about how a
regulator would step in, in a resolution regime, because I
think it is very important that the regulator as well as the
firms themselves think about the various steps that might
happen under that situation.
Senator Shelby. Is it in your mind very, very important
that any legislation dealing with resolution authority be
unambiguous that nothing is too big to fail, and if it bellies
up we are going to close it down?
Mr. Zubrow. I think that it is absolutely critical that
that be clear in the legislation.
Senator Shelby. Professor Johnson, you have a comment?
Mr. Johnson. If I may, Senator, in the whole discussion of
resolution authority, if I could just speak from the
perspective of my previous job at the International Monetary
Fund, that the hottest issue is the cross-border resolution. I
think all the firms that are represented here and most of them
sitting behind me are cross-border firms with massive,
complicated international pressures. One thing we learned from
the failure of Lehman is that regulators have just different
statutory frameworks. There is a massive conflict over that.
And the only way around that, at least on an interim basis,
is to have a conservatorship, which is not exactly failing.
That is the Government putting in money into AIG type
situation. Unless you have cross-border authority----
Senator Shelby. That is what these two Senators I mentioned
have in mind, but they can speak for themselves.
Mr. Johnson. My basic point from the perspective of the
IMF, I would suggest, is that unless you have a cross-border
resolution authority, which even the Europeans have struggled
to establish within Europe, let alone U.S. to Europe, let alone
U.S. to emerging markets, any resolution authority based just
on the U.S. is not going to achieve the goals that you quite
rightly are emphasizing.
Senator Shelby. Professor Scott.
Mr. Scott. To come back to what the ``too big to fail''
problem is, I think it is the degree of interconnectedness. So
what you have to ask yourself, in addressing your question, is:
Will we have the insolvency of a large institution which we
have to rescue because it is too interconnected to let it fail?
That might not be affected by the size of the total
institution. It is a function of its positions with other
parties.
So, in answering the question, should a resolution
authority not be permitted to bail out an institution, I think
it would have to have a very high degree of confidence that you
would not have a situation in which an institution failed that
was highly interconnected because if you did not bail it out,
then you risk a chain reaction of failures.
So I think it is really important to understand the degree
of interconnectedness of our institutions, and I think we have
done a woeful job at uncovering that and that a lot more
attention needs to be focused on what these connections are.
For instance, I think we thought when AIG was rescued that it
had to do with their counterparty positions. But then we are
told by some of their counterparties, one of whom is sitting at
this table, that they were totally protected in the event of an
AIG failure.
And I am not questioning that, but what I am questioning or
asking is if you are going to design a resolution authority
that says we will never rescue an institution, you have to have
a high degree of confidence that you will never be in a
position where these large connected positions could create a
chain reaction of failures if you did not rescue the
institution.
Senator Shelby. Mr. Reed, do you believe that regulators
lacked necessary authority and power to rein in reckless
activities or do you think that regulators simply failed to use
their available tools? And do you believe that regulators have
been held accountable for their failure?
Mr. Reed. Well, I agree with Gerry, the regulators clearly
have the authority to rein in any practice. They have failed to
do so for the human reason that they get captured and caught up
with the current wisdom. It is very difficult to organize a
structure that can systematically have a contrary view and
divorce itself from current wisdom.
The regulators have the authority. It is rare indeed that
the regulators have anticipated and stopped problems.
I do not think many people at all have been held
accountable for what is going on. The regulators certainly have
not been held accountable nor necessarily have the managements
and boards of some of the financial institutions involved--so,
in terms of who has been held accountable, not many.
Can we rely solely on regulation, I do not believe so. You
certainly need regulation. You need the right regulation. And
you need a strong regulatory structure, but it is not in
itself, I believe, sufficient.
Senator Shelby. You got to have good management.
Mr. Reed. And that is why I like this compartmentalization.
Everybody is playing around with what is proprietary
trading. That, with due respect, if you are running a company,
you know if you are in the business or not. You do not hire the
kind of people who want to be in that kind of business if you
are not supposed to be in it.
I believe that the nature, the human makeup of an
institution is extremely important, and that is why I tend to
favor Mr. Volcker's thought on regulating some of these types
of activities that bring in a different kind of culture to big
depository institutions.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Dodd. Thank you.
Senator Johnson.
Senator Johnson. Mr. Reed, would the Volcker Rules be
difficult to implement? What challenges would it pose to the
regulators?
Mr. Reed. Senator, I don't think they would be difficult to
implement and I don't think it would be a regulatory issue. I
think it would be a management issue. In other words, if there
were rules with regard to the nature of businesses that certain
entities could be engaged in, you could count on most good
management to try to follow those rules. Regulators might well
debate with the management whether certain practices are, in
fact, OK or not. But those kind of debates are quite healthy
and the regulators, if they insist, have the authority to have
their views hold.
When I was in the banking business, there were any number
of activities that were not permitted of the banks that I was
responsible for running at the time. We never had any problem
knowing where the rules were and we didn't specialize in trying
to get around the rules. The regulators are quite able to spot
when a management is behaving differently than the rules call
for and they certainly have the capacity to stop it. So I don't
believe this is a real issue.
Senator Johnson. Professor Scott, there are concerns that
allowing commercial banks to engage in proprietary trading
activities unrelated to serving customers creates unmanageable
conflicts of interest. Can you provide some examples of these
conflicts of interest in our marketplace?
Mr. Scott. Not in the actual marketplace, Senator, but I
think I could talk about the hypothetical marketplace.
Senator Johnson. Yes.
Mr. Scott. And I could see a situation in which a
customer's interest was adverse to the interest of a
proprietary trader. The customer would have a position that the
trader was taking the opposite side of. It could hurt the
customer's position. Now, my understanding is, of course, that
these activities are walled off and that the proprietary
trading desk is totally separate from the people who would be
dealing with the customers and that that really handles the
situation.
I should say that commercial banking is full of potential
conflicts. This is not the only conflict. And indeed, in the
debate over Glass-Steagall, the emphasis was not on this. It
was actually on underwriting, which nobody is attacking here,
and the thought was that banks who took positions in
underwriting, were potentially exposed to risk on underwriting,
would not act in the interest of their customers and force them
to buy something in order to protect the bank from risk. Again,
we handled that situation by trying to isolate activities
within the organization.
So I don't think--if you are really worried about
conflicts, this is a much bigger issue, and I wouldn't start
with proprietary trading if I were worried about it.
Senator Johnson. Mr. Zubrow, at Tuesday's hearing with
Chairman Volcker and Secretary Wolin, there was much discussion
about how to define proprietary trading. In your testimony, you
echo those concerns. If you were trying to prevent or stop the
riskiest types of proprietary trading activities at commercial
banks, how would you define proprietary trading?
Mr. Zubrow. Thank you, Senator. As I said, I think that it
is very important to make sure that banks are able to continue
to trade in ways that will allow them to hedge exposures that
they take on. And so if I were to come up with a definition
that was trying to wall off something that was pure proprietary
trading, it would be utilizing the definition of taking a group
of traders, putting them into a separate area, having the firm
invest capital in that, and have that group not be engaged at
all in any client or market making or other activities other
than just trading of that particular capital.
I do think, as I said before, that it is very important
that firms like ours have the ability to continue to manage the
various risks that we take on in our client-facing businesses
and to not allow some broad definition to be enacted that would
limit our ability to properly manage those risks.
Senator Johnson. Professor Johnson, some preliminary
analysis of the Volcker Rules contend that this proposal could
have profound effects on the profits and business models of
large U.S. financial firms, particularly those whose
proprietary trading functions are fully integrated into the
firm's global business. Do you agree with this statement?
Mr. Johnson. Senator, the evidence that I have seen
suggests it would have a relatively small impact on the
profitability of these banks, with the possible exception of
Goldman Sachs, as Mr. Corrigan emphasized. That 10 percent over
the cycle of net revenues is probably an outlier for a bank
holding company, and, of course, there is discussion about
whether people who have bank licenses would be allowed to hand
those licenses back and go off and become some independent
structure not regulated by the Federal Reserve.
If that were to be the outcome of the Volcker Rule, if that
were permitted by the rules that you draw up and how they are
implemented, that would be a complete disaster, because you
can't have a situation where banks are very big doing banking
activities not subject to comprehensive, tough regulation,
which is, I hope, what we will get out of the regulatory
structure that you create. You can't just go off and take those
massive risks and then when you face a collapse say, oh, I
would like my banking license back. And Goldman Sachs, I think,
got a one-time-only pass--I hope--when they were allowed to go
to bank holding company in September 2009--2008.
Senator Johnson. My time has expired.
Chairman Dodd. Senator Corker.
Senator Corker. Mr. Chairman, thank you, and thank all of
you for your testimony. I think the Volcker Rule is--I think
the goal of it is one that all of us would like to achieve, and
that is figuring out a way that institutions are not too big to
fail. I think the abstract nature of it made it difficult.
I want to agree with our Ranking Member. I think there is a
lot of regulation in place, if regulators will just do what
they are supposed to do to keep much of what has happened from
happening. And I do think there ends up being a capturing of
those regulatory. They are embedded in your institutions. They
get to know you. They are having coffee with you every day.
They are going to lunch. And the next thing you know, things
happen. So I hope we can figure out a way to keep that from
happening in the future.
But Mr. Corrigan, I understand that in many ways, if the
Volcker-like Rule was put in place, Goldman would be the Br'er
Rabbit of this whole deal, that you drop your holding company
situation and have less competition. I wonder if you might
respond to that.
Mr. Corrigan. Well, first of all, it is not entirely clear
to me that that would be the result, but let me come back to
that in a minute.
Under the House bill, and I hope that under the Senate bill
and the ultimate legislation, we would have a regime in which
any systemically important institution would still be subject
to consolidated supervision, presumably by the Fed.
Senator Corker. Now, you are answering a question I didn't
ask, so since it is my time, I am going to--so you can either
go right to that question----
Mr. Corrigan. But that is the starting point for your
question.
Senator Corker. OK.
Mr. Corrigan. So whether Goldman Sachs continued to be a
bank holding company or not, it would still be subject to
consolidated prudential supervision. I think that is the way it
should be.
Senator Corker. I was struck by your testimony regarding
all institutions, that no institutions should be too big to
fail, and then your solution was that if a company failed, they
would go into temporary conservatorship. That is not much of a
failure. So I am shocked by that and I wonder----
Mr. Corrigan. Well, let me----
Senator Corker. ----I think what we have all been talking
about is that if you fail, you don't exist anymore and a
temporary conservatorship is much like what we have just gone
through.
Mr. Corrigan. Well, let me define terms a little bit better
here, if I may. First of all, when I talk about temporary
conservatorship, I have in mind that this feature of the
process would exist only for a very short period of time, a
matter of days or weeks. And I am not sure that conservatorship
technically is the right legal word. But what I feel very
strongly about is that we need to have a limited period of time
after the institution in question has been taken over by the
authorities--the shareholders are out, the managers are out,
the board is out--we need a limited period of time to be able
to put ourselves in a position where we can, in fact, execute a
prompt, timely, orderly wind-down of an institution.
Senator Corker. Or receivership.
Mr. Corrigan. That is correct.
Senator Corker. Let me move on. I appreciate very much your
testimony. I would say that even under the Volcker Rule, if you
had consolidated supervision but didn't have a bank holding
company status, you would not be under the Volcker Rule. So
consolidated supervision is not what is relevant.
But let me move to Mr. Reed. I found your comments
interesting, and certainly I respect each of you very, very
much, as I do Mr. Volcker. But the comments about separating
these, you were Chairman of Citigroup when all of this was put
together. I think that is fascinating for all of us to know
that you kind of put all this together and now are an advocate
of separating, and I just wondered what you might share that
you have learned since that time.
And I would add another question, since I may run out of
time. A lot of people think that Citigroup is one of those
organizations--and I was watching the body language when we
were talking about failure--that Citigroup is one of these
companies, because of payment mechanisms that exist around the
world with sovereign governments and others, that Citigroup
cannot fail, OK, that they are so interconnected. And I think
what all of us are seeking, even Chairman Volcker and others,
is figuring out a way that regardless of the
interconnectedness, there never will exist again in our country
a financial institution that is too big to fail. We don't like
that moral hazard. It goes against the American way.
And yet there are people who come in, I think, and believe
that a Citigroup, I am sorry, they are so interconnected, they
have payment systems, and I wonder if guys like you and others
laugh at us when we say that we want to create a regime that
absolutely ends forever in the American vocabulary that any
company is too big to fail. I think that is the goal of many
people on this Committee, maybe not everybody, but I think many
people. And I ask everything I have just asked with respect. I
do find it fascinating, your position.
And then, second, I wish you would respond to the issue of
``too big to fail.''
Mr. Reed. Senator, I learned a lot. There is no question
that when we put Travelers and Citi together, we created a
monster, and most of the difficulties we have had have stemmed
from the Salomon Brothers side. Salomon had just been recently
acquired by Travelers, but this is why I am so sensitive to the
cultural impact.
I am suggesting that it would be healthier for the system--
it may not be healthier for Citi's stockholders, but I am
retired. I am free to speak as an individual citizen----
Senator Corker. It is kind of like a Senator who is not
running again.
Mr. Reed. That is right.
[Laughter.]
Mr. Reed. So my honest belief, having experienced it and
having lived with it for years, is that the system would be
stronger if we could provide for some separation where major
depositories are not major actors in the capital markets. And
you will notice that as I made my comments about these
cultures, I didn't talk only about proprietary trading and
proprietary investing. I talk about this interface with the
capital markets.
I believe that it is very difficult to manage these
cultures. It is not impossible, but it is very difficult. They
are hard to contain. They have big impacts on the risk taking
sort of attitudes at the top of the company and the nature of
the people who are working in the company. I think the system
would be sounder if we had a couple major institutions that
were a little pedestrian and that weren't occupied by all my
colleagues from MIT who are pretty good at math.
So I have come to the conclusion, having lived it, that the
system would be better if we allowed for some
compartmentalization. And as I said in my testimony, as I said
in my written remarks, I would look at compartmentalization of
culture as much as of economic function because it is the
people within the company.
So I have learned from my experience, and I think probably
there wasn't a much more relevant experience around, and my
conclusion is the system would be better. I am not speaking for
the stockholders. The system would be better if we allowed for
the type of separation that Mr. Volcker is talking about, and I
think he probably comes at it from the same point of view. I
saw him recently and he said, ``John, it is the first time you
and I have ever agreed, isn't it,'' because we have had a
number of issues where we didn't. But I think he saw it from
the same point of view.
Too big to fail, Senator, I am totally on your side. We
have to come up with a mechanism that, regardless of the
particular interconnectedness--Gerry is correct, we may need
time to get this organized, but you have to be able to let
institutions fail and I think you have to wipe the stockholders
out. I think you have to wipe the board and the management out.
And we have to have that mechanism.
And it is true that Citi, in its current structure, would
be very difficult to unwind, and the global issue would come up
right away. And this global issue is real. There is no
question. I forget the name of the British institution that
failed in Singapore--Barings failed in Singapore. The Bank of
England could not control the unwinding of this because the
Singaporian authorities got into the middle of it and you had
this cross-legal jurisdiction problem.
So I do think Professor Johnson is correct in that regard,
but I am on your side totally that we must come up with an
architecture that allows us to say any person that gets in big
trouble must be permitted to fail, and the bias has to be in
that direction.
The question, Senator, why did we save Long-Term Capital?
It was alone. It could have been allowed to fail. But the
instinct of regulators is to organize a rescue mission. And so
I think you need a structure that sort of dampens that
instinct.
Senator Corker. I would love to hear from everybody, and I
don't want to be rude to my colleagues by asking another
question, but I do hope in another setting we can, on the phone
or by e-mail, talk more about the interconnectedness Professor
Scott and many of you have brought up. I thank each of you for
your testimony and I do hope we figure out a way to deal with
the interconnectedness in a way that, through legislation or
some other mechanism, regulation, that allows big companies to
fail.
I just want to say, it seems like every crisis we have had
since I have been alive, and I am 57, has centered on real
estate--just about--and somehow or another we still don't talk
about that and we talk about all these other things, but that
is a subject for another day.
Thank you, Mr. Chairman. Thank you for your testimony.
Chairman Dodd. Thank you, and let me just say again, I said
at the outset in my remarks, having now just chaired this
Committee in my third year, since January of 2007, the
tremendous talent on this Committee. This is a hard subject
matter and all of you have spent your lives involved in this.
None of us claim to have lifetime experiences in all of these
matters, but we have had tremendous contributions from Bob
Corker and Mark Warner, Jack Reed, so many people on this
Committee, delving into the various aspects of this, and it is
hard work. It is difficult work.
It is arcane work, in many ways, and we are all very
sensitive to the notion that every good idea has an unintended
consequence and trying to think through all the ripple effects
of what you are suggesting. At one level, it can seem like the
best idea in the world. And as you delve into it--I said the
other day on these matters, I kind of regret we are not back 5
or 6 years ago when we knew a lot less about all of this than
we have learned. It was easier when you knew less in terms of
the answers for things. So I thank the Senator from Tennessee.
He has been tremendously valuable on this Committee, along with
others.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman.
Mr. Reed, I have been struck by what you have learned. I
think we have learned something, too, and I think we have to
carry it into the formulation of new regulations. First, we
can't assume regulatory capacity adequate to the complexity of
the financial markets. That is a function of funding and
appropriations. It is a function of ideology. It is a function
of personalities. But many of the discussions that we have
heard, I think assume that, and I think that is an assumption
that we have to question.
The other aspect of this is managerial capacity, as you
point out in your comments on culture. This would have been a
different world if there had been different individuals at
different institutions, but they were there. And I think also,
too, in terms of who rises to the top of these complex
institutions is a function not sometimes of who they are but
what they do and how much money they make for the company. So I
sense all of that.
I think in that regard Chairman Volcker has raised the
right sort of issue, but I think perhaps we have sort of taken
the wrong path and we are now talking about proprietary trading
and how to define it, et cetera. I think your approach is much
more, I think, on target, which is what do we want? We want
financial institutions, commercial banks, who focus on serving
customers, who are businesses, consumers, basically, and we
want them to be their core competency, et cetera.
So one way to look at this is to say rather than you can't
do proprietary trading, is that if your core business is just a
fraction of what you do, then why should we allow you to get to
the discount window? Why should we include you in Section
13(3)? That is not our policy. Our policy is to support a
vigorous commercial banking system. What about that approach,
Mr. Reed?
Mr. Reed. Senator, I agree with you. I think what we are
striving is to have a healthy commercial banking sector. I
think it is very important that there be a Goldman Sachs in the
world and so forth and so on, and no one is suggesting that
these activities be prohibited, simply that they not be in
these big depository institutions.
Commercial banks used to focus on customers and basically
provide working capital finance. And if you needed to get into
exotic instruments and so forth, the commercial banks didn't do
that.
I think the recent crisis through which we are stumbling
would have been much different had there been three or four
large depository institutions that weren't in the center of it.
I think one reason why JPMorgan Chase was able to play a
positive role is that they did not have in the core of their
business these kind of activities. They had some problem
activities in terms of sourcing mortgages from third parties
and so forth, but they played a positive role. The Bank of
America, which absorbed Merrill Lynch, had the capacity because
they didn't have these kind of problems. I think it served the
country well to have some of these institutions that were not
tainted by these kind of activities.
But I don't think the solution is to now say we will let
everybody do everything. I think we want our big depository
institutions to focus on serving their customers, providing
working capital, finance, deposits, consumer, and so forth.
Mr. Reed. Mr. Johnson.
Mr. Johnson. If I could just add to that, Goldman Sachs in
1997 was about a $200 billion bank in terms of assets. It was
about $270 billion in today's money. It peaked at about $1.1
trillion. Now, I completely agree with Mr. Reed that having
risk takers and risk-taking institutions in our economy is
useful. I am a professor of entrepreneurship at MIT. I am
completely supporting that. But if you let these risky
enterprises become big relative to the system, when a crisis
comes, even if you have a relatively stable core--and I do
fully endorse what Mr. Reed is calling for here--you have this
rather stable core and you have got very big other parts of the
financial system that fail or are in danger of failing, then
you let them into the discount window, which is what we did in
September of 2008. So the size of these risk-taking parts
matters, even if we are able to achieve a stable base, which is
what Mr. Reed is rightly arguing for.
Mr. Reed. Mr. Corrigan, I think you need to have a chance.
You should turn on your microphone, because we want to hear
this.
Mr. Corrigan. Today, the balance sheet side at Goldman
Sachs is something in roughly $800 million-plus or something
like that, so it has contracted in size relative to what it was
a few years ago. But I would also observe that at least half,
and perhaps more than half of the growth in Goldman Sachs over
the past 10 or 12 years has been international, not in the
United States but around the world, and I think that is an
important factor, as well.
But I really want to focus on these comments about discount
windows and discount rates. I completely agree with what John
Reed said a few minutes ago about discount window and discount
rates. And as I am sure your staffs will note, in my
statement----
Senator Reed. I noted it directly.
Mr. Corrigan. ----I had two things to say about discount
window. One was that as the Fed winds down its heavy crisis
intervention, in my judgment, we should go back to the old-days
regime of the discount window, and under that old regime, even
if you were a bank holding company, the bank itself had access
to the discount window, but under the old rules, the bank could
not take funds that it got through the discount window and
cross-stream them to nonbank affiliates or to the holding
company. Once we get this crisis behind us, that is what we
should go back to.
In addition to that, in my statement, I was very clear in
saying that going forward, we need to modify the so-called
``13(3) rules'' as they apply to the extreme emergency
situations using the discount window, and what I personally
have in mind is something along the lines of what I think is in
the House bill, and I think, Senator Dodd, I think you have
been contemplating this, as well, is that at a minimum, to use
13(3) under any set of circumstances, the Federal Reserve would
have to get the consent of the Treasury.
So I am not by a long shot even close to a point of view
about the discount window that is anything other than extremely
conservative, both for so-called ``regular use'' of the
discount window and emergency use. I think that, again, the
traditional roles that said a bank in a bank holding company
has access to the discount window, that is where we should get
back to.
Senator Reed. My time has expired, but I just raise the
question--I think like Senator Corker, this will be an ongoing
dialogue, but the crisis that we saw last year, getting the
permission of the Secretary of Treasury to use 13(3) would not
be too hard, because I would suspect he was begging the Federal
Reserve to use 13(3). So we have to--and that, I think, is the
ultimate. When we talk about ``too big to fail,'' we are
basically saying there are some institutions that don't get
13(3). I mean, that is when you cut it to the core.
Mr. Corrigan. I agree with you on that, too, Senator Reed,
but if I could, I would like to go back to this
interconnectedness question and ``too big to fail'' and
resolution authority, because I am convinced, absolutely
convinced, that we have to get this resolution authority right.
And in my statement, for example, I have laid out a bill of
particulars that take the form of prerequisites that have to be
in place for every large integrated financial intermediary that
would make it possible for resolution authority to work the
right way. Every one of these particulars deals in very
specific terms with interconnectedness.
I don't want to sound like--but I think that over the
years, I probably have thought more about interconnectedness
and the plumbing of the financial system, as I like to call it,
than most everybody. But I think it is urgently important that
the regulators, working with the major institutions, have to
focus on these prerequisites, because I will tell you that in
my judgment, if we don't get that right, we will not be able to
close down ``too big to fail.''
Senator Reed. My time has expired. I thank my colleagues
for indulging.
Chairman Dodd. Thank you, Jack.
Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair, and thank
you all for testifying today on these issues that are so
important to our future economic health.
Mr. Reed, you noted the question as to why do we rescue
Long-Term Capital Management, and you noted that it stood
alone, and I think you said, but there is an instinct in the
system to save a major player. I want to turn back to that
example to pursue that a little bit further.
This was at the end of the 1990s and there were a lot of
investments by major financial houses in Russian derivatives.
If I recall right, Long-Term Capital Management, had it gone
under, it would have been selling at fire sale prices. Many of
these investments, which I believe we also had a number of
large financial houses deeply invested in, including, I
believe, Goldman and JPMorgan both had positions that were at
risk, and so these other entities came together to help bail
out Long-Term Capital Management to avoid at that point
interconnections that were driven by market considerations.
That is, one piece of the interconnectedness, if one firm fails
and has to sell at fire sale prices, it drives down everybody
else's asset portfolios. That is another form of
interconnectedness or risk in the system.
So could those of you who were involved in this or who have
studied it share just a little bit more about the lessons to be
learned from that setting, that form of risk, how that can be
addressed? And it also certainly came up in mortgage-backed
securities, the potential for them to be sold, and so forth.
Mr. Reed. Well, Senator, I think you are absolutely correct
as to what drove the rescue, that people felt that it was
easier to rescue than to allow it to go broke. But this is why
people are going to be very reluctant ever to say we are going
to allow a given company to basically go bankrupt, because
there is this level of interconnectedness.
The lesson we should have derived from that is we didn't
have enough capital. There wasn't enough capital in the system
to take the risks that were there. And we didn't learn that.
Had we learned that with Long-Term----
Senator Merkley. Are you speaking of the issue of leverage?
I remember at one point----
Mr. Reed. There was a tremendous amount of leverage.
Senator Merkley. ----101 or something like that.
Senator Reed. Yes, it was tremendous leverage, and what we
should have learned was that there wasn't enough capital to
absorb the risks that were in the system, and therefore, when
the risks manifest themselves, the human reaction is, let us
gang together and we will see if we can take this together.
Well, we had a situation there that was a one-institution
version of what later happened to all of us and where basically
the taxpayer had to step in because there wasn't enough capital
in the private sector to cover the risks that were manifesting
themselves in this crisis we have gone through.
And so my question about Long-Term Capital was there was
the anatomy of the problem that we are today wrestling with. It
was alone that sat there. It was tremendously interconnected.
As you say, it had counterparty lines. It had all sorts of
assets which conceivably would have been liquidated at very
distressed prices and so forth, which would have impacted the
market. And yet as a system, we sort of ganged together,
papered it over, and went on having learned nothing.
Mr. Zubrow. Senator?
Senator Merkley. Yes, Mr. Zubrow?
Mr. Zubrow. Senator, if I could just add one point, which
is that I also think that that is an example of how we allowed
fundamental regulatory arbitrage to lead to a very difficult
situation. And obviously, Long-Term Capital was outside of the
regulatory regime. It wasn't subject to the same capital
requirements or oversight as other institutions. And so I think
that one of the lessons that we learned from that is that all
firms that are systemically important need to come under the
same umbrella of regulation, the same capital regimes, and the
same oversight of regulators and not allow the form of
ownership or the type of business they are in to allow those
institutions to escape that type of comprehensive regulation.
I would just comment that I, frankly, was somewhat
surprised in Secretary Wolin's testimony last week, or on
Tuesday, that he suggested that we could sort of allow certain
institutions to be able to escape the regulatory situation if
they were to divest their banks, and I think that it is very
important that in that situation, all organizations that are
systemically important be treated the same.
Senator Merkley. I will ask both of you to be brief,
because I am down to less than a minute. Mr. Scott.
Mr. Scott. I think addressing Long-Term Capital Management,
the first issue is protecting the institution from failing,
capital. But then we come to, well, maybe we will not succeed
at that, it is failing. Now we have to deal with
interconnectedness. We have done all we can, it wasn't enough.
If you look at the present world of interconnectedness, it
is not about equity. Equity is not an interconnectedness
problem. I do not think it is about debt. I do not think that
we are worried particularly from an interconnected point of
view who is holding the bank debt. We may have other issues
about that. It is really counterparty. It is really
derivatives, in my view. And the answer to this is
clearinghouses.
If you go back to the years when Mr. Corrigan was serving
very adequately in the Federal Reserve Bank of New York, his
major concern was the payment system, and particularly the
clearinghouse interbank payment system, because if there was a
default, you would have a systematic chain reaction of
failures.
What did we do about that? Well, we managed to figure out a
way that that thing could function without causing that
problem. It now settles continuously. You do not have end of
the day large net positions that could endanger the system if
there is a settlement failure.
So we have to address the same problem now in the context
of derivatives. And I think that needs to be the focus here,
because that is, in my view, the interconnectedness problem
today.
Senator Merkley. I am over my time. Shall I allow Mr.
Johnson to respond, as well?
Chairman Dodd. Sure.
Mr. Johnson. I am afraid we haven't learned the lesson of
LTCM, which is the capital that needs to be held with regard to
derivative positions is still far too low. And that is where
the regulatory arbitrage exists and it is still engaged in on a
massive basis every day by the firms represented on this panel.
We have not learned that lesson.
In my written testimony, we have a very specific proposal
about how you can change those capital requirements. But I
think it is going to be hard to do because you are going to be
fought every inch of the way by the people who make a lot of
money on this regulatory arbitrage.
Senator Merkley. Thank you.
Chairman Dodd. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Let me thank all
of our witnesses.
As I approach this issue, I look at it as how do we strike
the right balance, the appropriate regulations at the end of
the day to make sure we don't have another taxpayer bailout,
and at the same time the opportunity to make sure that growth
can take place in our country.
But I have to be honest with you. I was reading through the
written testimonies and I get a sense that while we take--it is
like a Texas two-step. We claim the veneer of saying that we
understand and need reform. And then we have so many caveats to
it that we, in essence, undermine the very essence of reform.
And that just--that dog simply is not going to hunt because if,
in fact, we have what we had in the past, we are destined to
relive it again.
And I hope the financial institutions, those that are here
and others, understand that because they would be far better
served in helping us strike the right balance on the pendulum
than going ahead and just fighting us tooth and nail.
I have got to be honest with you, when I walk the streets
of New Jersey, the average person comes up to me and says you
know what? When I make a mistake, I have to pay for my mistake.
And when they--meaning some of our financial institutions--make
a mistake, I also have to pay for their mistake. Something is
wrong with that, Senator.
And so I think sometimes my friends on the street have a
disconnect with average Americans in this country, and it is a
dangerous disconnect. It is a dangerous disconnect. I think
everybody would be better served in honestly moving forward on
this.
Let me ask you, Mr. Corrigan, I read your written statement
and, you know, on page 10 you say that there is no question
that the drive to shrink the size and activities of large and
complex financial institutions is understandably driven by the
political and public outrage about the use of taxpayer money to
bail out institutions that were deemed too big to fail. And
then you go on to say that because of that, observers believe
that the easiest way to solve the problem is some combination
of shrinking the size of these institutions and restricting
their activities.
But it is really more than the public and political
outrage. You are not dismissing the fact that there is a need
to actually do something here?
Mr. Corrigan. Of course not, Senator.
Senator Menendez. If you would put your microphone on, I
would appreciate it.
Mr. Corrigan. I am sorry. Of course not, Senator.
Senator Menendez. The statement seems sort of like
dismissive, in my mind.
Mr. Corrigan. Then I did not do a very good job of drafting
the statement, because if you look at the second section of
that statement, it talks in very concrete detail of what I call
the essential financial reform agenda going forward, and it is
a line-by-line recitation of the things that I think must be
done to get ourselves ahead of the curve for the next problem.
I talk, for example, about the need for substantial
increases in both capital and liquidity, the need to look at
capital and liquidity as a singular integrated discipline. I
talk about the enhancements we need to the financial
infrastructure. I talk about the improvements we need in
supervision and regulation.
So again, if that is the interpretation, Senator, that you
are drawing, I did not do a very good job of drafting that
statement.
Senator Menendez. Well, let me ask you, do you believe that
there is any disconnect between entities like Goldman Sachs and
the public at large?
Mr. Corrigan. Unfortunately, I would have to agree that
there is.
Senator Menendez. You know, I think part of that
disconnect, when I look at that Goldman has set aside an
astronomical sum of $16.2 billion in compensation for 2009,
that is 50 percent more than in 2008, and that is happening in
a year in which the financial system nearly collapsed and
Goldman Sachs received at least $24 billion in taxpayer
assistance, including $14 billion from the bailout of AIG.
And so I look at that and I look at that in the
juxtaposition of what Goldman is trying to do, which I think is
laudable, but definitely underfunded in terms of your small
business project, where you are basically going to put out
maybe $500 million, which is about 3 percent of the amount
Goldman has allotted to compensation about 2 percent of the
amount Goldman has received in taxpayer assistance, and I say,
how is that being responsive to these times? Sixteen-billion
dollars in compensation, $500 million to lend to small
businesses.
Mr. Corrigan. Well, let me respond to that on two levels.
First of all, as I said before, I do agree with you that there,
unfortunately, is a disconnect here. But having said that, I
would just make a couple of observations.
First of all, I do think it is entirely accurate to say
that the compensation framework at Goldman Sachs as it was
amended further this year, I think is consistent to both the
letter and the spirit of the various G-20 and other official
guidelines on compensation. Now, that doesn't change the facts
of the arithmetic, but I think that is a factually accurate
statement.
With regard to your comment on our small business
initiative, I guess, again, I would make two or three
observations. First of all, if that initiative turns out to be
as successful as the earlier initiative we did on 10,000 women,
it will be quite successful.
Second, as that program begins to get legs, which is
hopefully quite soon, I, for example, look forward personally
myself, as being one of the mentors that will work with small
business and small business leaders in the New York
metropolitan area, and I am not suggesting you can put a price
tag on that, but there will be hundreds, I suspect thousands of
officials at Goldman Sachs that will be doing that as part of
their personal contribution to the thing.
And the last point I would make, Senator, is that in the
general area of providing financial support to medium-sized
businesses and to some extent small businesses, Goldman, as you
know, essentially is a wholesale firm. But the fact of the
matter is that we are in the process of stepping up our
programs and one of our business units aimed at both debt and
equity support for small and medium-sized companies. We are in
the process also of putting into place in the Goldman Sachs
Bank, which is quite small, another program that is
specifically targeted and directed at small and medium-sized
businesses.
So it is not as if I think we are perfect. We are not. But
I think we are sensitive to the very issues that you have
raised.
Senator Menendez. Mr. Chairman, if I just may, one last
minute----
Chairman Dodd. [Nodding head.]
Senator Menendez. You know, I appreciate what you are
saying, but the numbers belie it and this is my concern. The 22
banks that received the greatest amount of TARP funding have
dropped their small business lending portfolio by $10 billion
over the past 6 months. So as I said, your goal at Goldman is
desirable, but you are significantly, in my view, underfunding
it, especially when I look at the amount of money that is going
to compensation. It is, like, 3 percent of that amount.
And last, you know, this disconnect--I know people don't
want to hear about it, but for a while, it just seems to me
that the industry would be best served--the Times of London
reported that your CEO is likely to receive even more money
this year than his record $68 million a year. Is that true?
Mr. Corrigan. That is nonsense.
Senator Menendez. OK.
Mr. Corrigan. Total and absolute nonsense.
Senator Menendez. I am glad to hear that, because that is
the type of challenge--I mean, $68 million, I am happy for----
Mr. Corrigan. Trust me, it is not going to be that.
Senator Menendez. ----to be able to get $68 million, but at
the end of the day, if we see that type of reported increases--
--
Mr. Corrigan. It is not going to happen.
Senator Menendez. ----it just makes it very difficult----
Mr. Corrigan. It is not going to happen.
Senator Menendez. ----for people on Main Street to continue
to understand why their taxpayer dollars should continue to
fund institutions that, one, don't get it; two, fight financial
reform; and three, ultimately have them holding the bag. And we
need to change that if we want to strike the right balance
here.
Thank you, Mr. Chairman.
Mr. Corrigan. Senator, please. Personally, I have a great
deal of sympathy for everything you have just said.
Chairman Dodd. Very good. As I said earlier, we have a vote
that will be occurring shortly, so I am going to ask a couple
of quick questions, then I will turn to Senator Shelby and
Senator Corker. We will stay on as long as we can before we
have to leave for the vote. I am not bringing people back.
Let me ask you to respond to--other Members to respond to
what Professor Scott said earlier, and Senator Corker began
that conversation, as well, and it is the interconnectedness
issue, John, because I think we have wrestled with that in our
conversations, as well. We clearly want--and there is a
growing, I think almost unanimous consensus here, although I
hesitate to say that until we actually get to the bill itself--
but a consensus about the ``too big to fail'' notion. And I
think, again, you have all expressed your views on it, as well.
Having said that, and in getting from Point A to Point B,
where, again, the interconnectedness issue is not an irrelevant
issue in today's economy and probably going to be a growing one
in the global economic sense. So to what extent--what is the
impact of that, potentially, on institutions' behavior? If we
write in this matter here, what is likely to occur if we write
this in a way that does make this about as, to use the word
euthanasia that Paul Volcker used here, what are the
implications of that for you?
You have all agreed with this, but what if what Professor
Scott raised is accurate and, in fact, you face a situation
where one institution should fail. No one questions that at
all. What they have engaged in is clearly behavior of their own
making, their own fault. Shut them down. Put them in
receivership. But a lot of these other healthy companies out
there, good companies, operating well, but are connected with
the failure of that institution. Is that a legitimate question
Professor Scott raises, and if so, what are going to be the
behavior changes that will occur institutionally, particularly
in global markets? Gerry.
Mr. Corrigan. This is really, Mr. Chairman, the crux of the
issue. Let me give you, again, an example or two of the kinds
of things we can be doing to make it much easier to deal with
interconnectedness when we find ourselves in the very situation
that you have described, the next train wreck.
One example: Some institutions, certainly Goldman Sachs is
one of them, have gone through--and I know about this because
it was another one of my ideas--a very rigorous exercise that I
call close-out stress test. It is very complicated. I am not
going to bother you with the details. But what it is designed
to do is to take hypothetical but very real world situations in
which you say, just for the hell of it, let us assume that X
and Y hit the tank. What do I do? How do I know what my
exposures are? What do I do to manage those exposures? What
approaches can I or can I not take in terms of closing out
positions?
Now, I have been arguing--and Barry Zubrow can be my
witness--I have been arguing for years that one of the basic
standards that should apply to all large integrated financial
intermediaries is that those institutions should be able in a
matter of a couple of hours to put together counterparty
exposures across--to particular counterparties across all
products, across all locations, across all markets, both gross
and net, and to do that within a couple of hours, because that
is how you begin to get your arms around interconnectedness.
I, Barry, don't want to get myself too far out on a limb
here, but I think I can probably say that the world is not full
of institutions that even today can do that. Goldman Sachs can
do that, and I suspect JPMorgan can do it, but I am not so sure
how far that goes.
So that is, again, a very concrete example of the things
that we can and must do to put ourselves in a position to
better deal with the interconnectedness. This list of
prerequisites that is on the last page of my statement for
winding down and closeout is another.
So I am not ready to accept for 1 minute, and I don't
think, Hal, you are, either, that we are hostage to a system
that is so complicated that we can't deal with it. I just don't
buy that. But I also say we have got a hell of a lot of work to
do to get to that point.
Chairman Dodd. Does anyone else want to comment on this?
Mr. Johnson.
Mr. Johnson. I think Professor Scott made a very deep point
with regard to LTCM, certainly. It is the surprise
interconnectedness. Now, maybe we can measure these. Maybe the
regulator will catch up, to some degree, with the technology.
But you are always going to be surprised in a big crisis.
And then I think it comes down to two things. First, how
big is this problem relative to the economy? Take CIT Group,
for example, that failed last year. CIT Group had a balance
sheet of $80 billion. There was a big debate, as you know, in
Washington about whether they were too big to fail, and it was
decided, rightly, despite their interconnections that were
known and unknown, that they could fail--and did fail, have
essentially failed--without disrupting the system. That is what
we know. That is the biggest financial institution we have let
fail and it hasn't had the systemic implications. Eighty-
billion, that is what we know.
In addition to the size, it is about capital. It is about
capital and derivative positions. I mean, that is the part that
we know about, the part that Professor Scott and Mr. Reed have
been emphasizing. These derivative positions with low capital
requirements are asking for trouble. They are still there and
they are not going away in the existing framework.
Chairman Dodd. In fact, Barry raised the issue--I think it
was he--do you see any deeper threats with banks that are
creating over-the-counter derivatives, for instance. That kind
of a matter poses some additional--when you start getting
specific about the kind of proprietary trading that can occur,
then you do begin to see some potential here for a larger
question. Do you agree with that?
Mr. Scott. Well, I think a lot of the derivatives business
is client-based, and so--and hedged--so I am not sure it is a
problem. But I think Mr. Corrigan has raised a very good point.
As part of our arsenal of weapons against interconnectedness,
perhaps there should be a requirement that every large or
important financial institution stress test itself, supervised
by the regulators, so that they could survive a failure of
their major counterparties. This would be basically what
Goldman Sachs is doing. I think this is something that every
financial institution should do and the regulators should
require it.
Chairman Dodd. Yes, go ahead, quickly.
Mr. Johnson. I have to ask the question, if Goldman Sachs
is the gold standard of stress testing, why did they need to be
rescued by being converted into a bank holding company in
September of 2008? I don't understand. That is a disconnection.
Mr. Corrigan. That is a gross overstatement.
Mr. Johnson. Well, I am not sure if you had a chance to
look at Mr. Paulson's book yet. I don't think he regards it as
an overstatement.
Mr. Corrigan. Well, I mean, clearly, and Goldman Sachs and
Morgan Stanley were made bank holding companies at the height
of the crisis, and I think that turned out to be a very good
thing. As I say in my statement--I was very clear about this--
that we do benefit unquestionably from the intensity of the
Federal Reserve's consolidated supervision of Goldman Sachs.
But I don't think it follows from any or all of that that the
mere fact--the mere fact of making Goldman Sachs a bank holding
company constituted a bailout of Goldman Sachs. That is kind of
pushing it.
Chairman Dodd. Let me turn to Senator Shelby.
Senator Shelby. A few observations. Professor Scott, on the
Volcker Rule, in your judgment, the spirit of the Volcker Rule,
I think, is a good idea. It is how you implement it and under
what circumstances, how you do it, who would do it. Do
regulators at the present time have the power to deal with
that, or would we need to give the regulators some specific
power outside of what they have, whoever winds up as the
regulator--it might not be the Fed--and so forth. Do you have
any documents?
Mr. Scott. I think they have the power as part of their
general safety and soundness responsibility, and examining
institutions, if they find----
Senator Shelby. But they have got to have the will, haven't
they? They have got to have the will.
Mr. Scott. Well, that is another question. You know, if I
look at the Kanjorski Amendment, for instance, which is
basically saying I want to give you this power, OK, to deal
with large risks if banks are taking them, it is duplicating--
--
Senator Shelby. They already have it, don't they?
Mr. Scott. ----what powers are already there. But it is
kind of underlining. Maybe there is a value to that, of just
underlining the importance that the Congress sees in exercising
that responsibility. But in terms of legally, yes, I think they
have the power.
Senator Shelby. And what about what Senator Dodd and
Senator Corker have raised, and you have, too, on the panel,
the problem of interconnectedness? That is in ``too big to
fail.''
Mr. Scott. That is the absolute----
Senator Shelby. Can the regulator deal with that now under
the safety and soundness, in your judgment?
Mr. Scott. Yes. I think if a regulator believed today that
an institution that they were supervising were not able to
survive the failure of their significant counterparties, they
could do something about it. Now, that being said, the ability
to understand that----
Senator Shelby. That is right.
Mr. Scott. ----that is hard.
Senator Shelby. Professor Johnson.
Mr. Johnson. I think that the evidence is very clear, that
even the FDIC, which is actually pretty good, arguably even
world class, at taking over relatively small- and medium-sized
banks, even they come in too late. If the FDIC were doing its
job properly, we would never need any taxpayer money. They
would always come in while there was still enough capital
left----
Senator Shelby. Prevent it, in other words?
Mr. Johnson. Absolutely. Preventive action doesn't take
place, even for the relatively less political ones. In terms of
the point about the power and the caps here, let me remind you
that under the Riegle-Neal Act, there is a cap on the size of
our largest banks. That cap was waived every time the big banks
asked for it. So JPMorgan Chase, Wells Fargo, and Bank of
America all exceed the cap in that law, just because they asked
for it. They were allowed to become bigger. So it is the same
thing that would happen with all these other----
Senator Shelby. And who waived it? The regulator. And who
was the regulator? The Federal Reserve, right?
Mr. Johnson. Absolutely.
Senator Shelby. OK. Now, as we wrestle with this, we all
know, and you know because you spend your life in this as
either a professor or consultant or a banker, it is very
complex, and as Senator Dodd said, there always--when we raise
a question, then it begets another one to deal with. But do you
know--do any of you know of any institution, financial
institution, that has been well capitalized--we talked about
capital here earlier--well capitalized, well managed, Mr. Reed,
and well regulated that has failed? Do you?
[Witnesses shaking heads.]
Senator Shelby. I don't, either.
Thank you, Mr. Chairman.
Chairman Dodd. Jack.
Senator Reed. Well, thank you very much.
This issue of regulatory capacity, I think is important.
Professor Scott, if someone called you up and said, the Fed is
threatening me, shutting me down because they think my
counterparties are unreliable, could you come up with some
legal arguments why the Fed couldn't do that? Is it so clear
they have that authority?
Mr. Scott. No, I would not say they could shut you down,
but what I think they could do is tell you to change your
business to get rid of that problem.
Senator Reed. Are there any examples where the Fed has
actually gone in and told people to change their business?
Mr. Scott. That happens every day to banks across the
United States.
Senator Reed. But apparently it didn't happen with respect
to some critical issues.
Mr. Reed, you look like you want to say something. Do you
have some experience with this?
Mr. Reed. I am just smiling because you are absolutely
correct. It didn't happen with--I don't think there are many
examples where regulatory structures have been able to
anticipate these kind of problems. You know, it didn't happen
in Germany, which has a very different structure. It didn't
happen in England, which has a quite different structure. And
it didn't happen in this country.
Senator Reed. I want to get to an issue that we have been
spending some time on, and that is derivatives. One argument
that end users are making is that this would deny them sort of
a great financial benefit which would cause them to retract in
many different ways. But, Mr. Reed, you ran a major financial
institution which presumably did derivatives, end user
derivatives?
Mr. Reed. Yes, sir.
Senator Reed. Did you, when your people were selling these,
did you reserve the margin that you needed to cover the risk
and did the ultimate end user pay for that margin, or----
Mr. Reed. Yes. No, I mean, we put caps on the size of the
business within the total company. You know, you run these
businesses with caps, and this is why I think this argument
that you don't know what you are doing just doesn't make any
sense. If a trading room has a certain limit to take to have
open positions, you know what those limits are. So we did have
a derivative function and it was global. In other words, we
operated in the derivative markets around the world. But we had
limits with regard to positions. We had limits with regard to
counterparties. And you run the business so, hopefully, it
can't produce a massive problem for the institution.
Senator Reed. This is a very lucrative business with banks,
and at least one could argue that in either a clearing platform
or a trading situation, that this would be much more cost
effective for end users. But there seems to be this willingness
to pay significantly for these credit default swaps, these
over-the-counter devices. What is your sense on that, if I----
Mr. Reed. Well, I think what happened is that they didn't
attract much capital and so it appeared that you were able to
significantly augment your earnings. I mean, what happened is
the banks were basically using capital both for their customer
business and for their trading businesses and they were
doubling up on it. Obviously, this causes your return on
capital to go way up.
I mean, the Deutsche Bank is a wonderful example. They
announced publicly that they were going to get their return on
capital up to 20 percent. Anybody who has done business in
Germany knows that sort of a natural rate in the German market
is maybe 7 or 8 percent. The only way they were able to do that
was to build a significant trading and proprietary investing
business on top of their banking business, and they did, in
fact, achieve that result. They also ducked the great bulk of
the problems that we are today confronting. They never did get
any form of government assistance in Europe or elsewhere. So it
can be done.
But the point is, the attractiveness of this kind of
activity is that it hasn't brought capital with it and
therefore you are basically doubling up and you are able to
earn better returns for your stockholders.
Senator Reed. Mr. Johnson.
Mr. Johnson. Senator, we also have to remember that the
``too big to fail'' is a form of implicit subsidy from the
taxpayer, which lowers the cost of funding for these derivative
transactions. So one reason the massive banks were able to
dominate this market is because they are viewed by the credit
markets themselves as too big to fail. That gives them an
unfair advantage that enables them to scale up and create even
more risk for the taxpayer.
The Bank of England financial stability people are calling
this entire structure a ``doom loop'' because it is a repeated
cycle of boom, bust, bailout, and we are just running through
this again.
Senator Reed. We have talked about interrelatedness, and I
think that is a theme that everyone agrees to. But, Mr.
Johnson, in terms of derivative trading, to what extent is that
a key factor in this interrelatedness? I know there is no magic
one thing, but it strikes me, given the notional size of
derivative trading, given the fact that it inherently is
staking your future to somebody else's future, would be one of
the key drivers in some of these interrelated issues we have.
Mr. Johnson. Absolutely, Senator. So Mr. Corrigan said a
little while ago that the total balance sheet of Goldman Sachs
right now is about $800 billion. But what is the balance sheet
if you take into account derivative positions? That depends on
risk models that they run that they report to other people.
Perhaps the regulator has some independent ability to assess
that. Perhaps the market has some ability to see through what
they are doing. I actually don't think that they do.
So derivatives are very important because that is the
complexity and it is where a lot of the interconnectedness
today is manifested in problems that will always be there, and
it is where a great deal of problems occur whenever there is a
crisis. We just don't know what is the true balance sheet, what
are the true risks, what is the true capital of these financial
institutions without relying on their own risk models, and
those risk models failed dramatically and repeatedly in the
run-up to September of 2008.
And with respect to Mr. Corrigan and the idea that Goldman
Sachs was not saved by becoming a bank holding company, what
would have happened to Goldman Sachs if it had not become a
bank holding company, particularly based on its derivative
exposure and what had happened in and around AIG?
Senator Reed. You should turn on your microphone, Mr.
Corrigan, because we want to hear you.
Mr. Corrigan. This is getting a little frustrating. In
terms of derivatives, first of all, as a general matter, and I
will come to Goldman Sachs in a minute, the fact of the matter
is that over the past few years, there have been substantial
improvements made in the entire infrastructure surrounding the
way derivatives are traded, the practices for margining, the
practices for collateral, the practices for closeout, and we
are now, as you know, in the first stages of getting most
derivatives through so-called ``CCPs,'' central clearing
counterparty things, that clearly is a potentially huge
reduction in systemic risk associated with derivatives
activities in general. And that effort is still ongoing. I
personally am very involved with that effort and Goldman Sachs
certainly is one of the most enthusiastic supporters of all of
those initiatives.
Now, on the risk profile questions, as I think everyone
knows, balance sheets are an imperfect indicator of financial
profiles in general. But it is also true that in all of the
risk metrics that organizations like Goldman Sachs and others
use these days, in terms of all forms of stress tests and other
contingent-type analyses that are done daily. All aspects of
exposures, gross and net, margined, unmargined, et cetera, are
taken into account in a context in which risk models in and of
themselves are only one metric that is used in this process.
And there are literally dozens of other metrics that are used
to try to take account of the fact that risk models by their
very nature are backward-looking, and as a result, are
inherently flawed. We all know that and we try in the best ways
that we can to take account of that in terms of how we think
about risk.
In addition to that, all of the stress tests and other
things that are done in risk mitigation efforts are done and
are looked at by the authorities, not just in the United States
but around the world.
So again, I am not Pollyanna-ish. I think I understand the
risks associated with derivatives and most other things that
you think about as well as anybody else. I spend a substantial
part of my time trying to build and help the industry build
better mousetraps to be able to deal with risk and risk
mitigation.
So again, I am sure I make mistakes. I am sure I don't get
it right every time. But I also am sure that I have had as much
experience over what is now 43 or 44 years in dealing with
these questions and these issues on both sides of the street.
Senator Reed. No, we appreciate that, Mr. Corrigan. Your
leadership of the Federal Reserve Bank of New York was a great
contribution.
Mr. Corrigan. Thank you.
Senator Reed. I have this feeling, though, in terms of
regulation that there is a 27-year-old----
Mr. Corrigan. There is.
Senator Reed. ----across the table from you talking about
why your risk models are wrong, and I think you win that
conversation every time, and that is one of the problems we
have in terms of----
Mr. Corrigan. I agree with that, Senator.
Chairman Dodd. Jack added to the age. I said they were 22
yesterday.
[Laughter.]
Senator Reed. They spent some time in the Army.
Chairman Dodd. There you go. That is a good thing to do.
Senator Merkley, I am going to let you know we have got a
couple of minutes left before the vote closes out, so why don't
you go ahead and finish up.
Senator Merkley. I have the same microphone problem. There
we go.
Mr. Corrigan, you seemed a little sensitive when it was
suggested that Goldman Sachs was bailed out, if I caught your
reaction right there. So to the----
Mr. Corrigan. Let me just, if I could, be very clear on
this. I was reacting more to the specific language that was
used. Look, there is no question--none whatsoever--that when
you look at the totality of the steps that were taken by
central banks and governments, particularly in 2008, that
Goldman Sachs was the beneficiary of this. There is no doubt
whatsoever about that, as well as everybody else. I mean, that
is what those extraordinary measures were all about.
So again, I am not suggesting for 1 minute that Goldman
Sachs was not a beneficiary of these initiatives. It was,
clearly.
Chairman Dodd. Let me--Senator, we have a minute left on
the vote on the floor. I will leave the record open, but I am
afraid we are going to have to leave ourselves or else we will
miss a vote, so we are going to have to terminate the hearing.
I apologize.
Senator Merkley. Thank you all very much.
Chairman Dodd. And let me thank all of you very, very much.
We could literally go on all day. You have been tremendously
valuable, your testimony. We would like to follow up with you
on some of these ideas and suggestions as we are trying to
draft this legislation. I think we need further conversation.
Gerry, we thank you for your long testimony you submitted.
It is very valuable to have that, as well, as part of the
record.
John Reed, good to see you again, as well.
Hal, we love having you back here.
Barry, you are always welcome at the Committee.
And Professor Johnson, thank you for your presence here
today, as well.
The Committee will stand adjourned.
[Whereupon, at 12:48 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Thank you Mr. Chairman.
On Tuesday, we heard from Paul Volcker, Chairman of the President's
Economic Recovery Advisory Board, and from Treasury Deputy Secretary
Wolin, about the Administration's most recent regulatory reform
proposals.
I remain willing to consider any proposal that will strengthen our
regulatory framework and help our economy.
Before we do so, however, we must understand the objectives of any
proposal, and how those objectives are to be met.
The newest proposals are the so-called ``Volcker Rule'' to ban
proprietary trading and hedge fund activities from firms with insured
depositories, as well as limits on a bank's share of market
liabilities.
The stated objective of the Administration's newest proposals is to
enhance the safety of the banking system. I certainly agree with that.
Unfortunately, the manner in which the Administration's proposals
will accomplish that objective remains elusive.
With respect to placing limitations on the proprietary trading
activities of banks, Chairman Volcker and Mr. Wolin seem conflicted on
how regulators could, in practice, distinguish proprietary trades from
trades made by banks to help fulfill customer needs.
Chairman Volcker said that regulators should not be given the
discretion to place restrictions on proprietary trading. Yet, when
pressed for details on how the regulations would be implemented, Mr.
Wolin stated: ``Like an awful lot of banking law and a lot of the
proposals, lots will be left to the regulators to implement in a very
detailed way.''
When I asked about size limits, and how regulators would define
``excessive growth,'' Chairman Volcker paraphrased the late Justice
Potter Stewart: ``You know it when you see it.''
Mr. Wolin failed to provide any more clarity when he said: ``We do
not have the details of that fully nailed down.''
As I stated on Tuesday, the manner in which the President
introduced these new ideas is not conducive to developing thoughtful,
comprehensive reform legislation.
Chairman Dodd and I have made meaningful progress in our
discussions on regulatory reform. It is my hope that we will continue
to do so.
Our overarching goal must remain eliminating taxpayer bailouts
while establishing the strongest, most competitive, and economically
efficient regulatory structure possible.
Achieving this goal will involve consolidating our financial
regulators, modernizing derivatives regulation, and strengthening
consumer protection without undermining the safety and soundness of our
financial institutions. In my view, these goals are not negotiable.
We have a unique opportunity to make significant and necessary
changes on a bipartisan basis. Whether we seize this opportunity
remains to be seen.
Thank you Mr. Chairman.
______
PREPARED STATEMENT OF E. GERALD CORRIGAN
Managing Director, Goldman, Sachs and Co.
February 4, 2010
Introduction
Chairman Dodd, Ranking Minority Member Shelby, and Members of the
Committee, I am thankful for this opportunity to share with you my
views on the urgently needed financial reform process in the wake of
the financial crisis. As the Committee knows, in my earlier career at
the Fed and in my current second career in the private sector, public
policy issues relating to the quest for greater financial stability
have been a subject of continuing interest to me.
The views I will express today on financial reform are very much
driven by what I consider to be in the best interest of long-term
financial stability. Having said that, I cannot deny that there are
instances in which my thinking about specific issues has been
influenced by my tenure as an employee of Goldman Sachs and by what I
have seen transpire during that period. To cite one clear example, in a
sharp departure with my earlier thinking, I now recognize the value and
importance of the so-called ``fair value'' or mark-to-market
accounting.
At the center of the great debate about financial reform is the
universal agreement that the ``Too Big to Fail'' problem must be
forcefully resolved in order to provide comfort that future problems
with failures of large and complex financial institutions will not be
``bailed out'' with tax payer money. Achieving that goal will not be
easy but it is not impossible.
My formal statement contains four sections as follows:
Section I: The Financial Reform Agenda
Section II: Alternative Financial Structures in Perspective
Section III: The Merits of Alternative Financial Structures
Section IV: The Challenges Associated With Enhanced
Resolution Authority
Section I: The Financial Reform Agenda
In looking to the future, almost everyone who has seriously studied
the causes of the crisis agrees that certain basic reforms are a must.
In summary form, those basic reforms include the following:
1. The creation of a so-called ``systemic regulator.'' Among other
things, the mission of the systemic regulator would include
oversight of all systemically important institutions and,
importantly, looking beyond individual institutions in order to
better anticipate potential sources of economic and financial
contagion risk including emerging asset price bubbles.
Anticipating future sources of contagion is difficult but not
impossible.
2. Higher and more rigorous capital and liquidity standards that
recognize the compelling reality that managing and supervising
capital adequacy and liquidity adequacy must be viewed as a
single discipline.
3. Substantial enhancement in risk monitoring and risk management
and more systematic prudential oversight of these activities.
4. The increased reliance by institutions and their supervisors on
(1) stress tests; (2) so-called ``reverse'' stress tests; and
(3) rigorous scenario analysis of truly extreme contingencies.
5. Efforts to intensify the never ending task of strengthening the
infrastructure of the global financial system.
6. The creation of a flexible and effective framework for the timely
and orderly wind-down of failing large and complex financial
institutions (the Enhanced Resolution Authority discussed in
Section IV).
7. Substantially enhanced cross-border cooperation and coordination
on a wide range of issues from accounting policy and practice
to more uniform prudential standards to better coordinated
macroeconomic policies.
I believe that these measures--coupled with others that are in the
House Bill such as tightening up the administration of Section 13 (3)
of the Federal Reserve Act--will, over time, reduce the probability of
future financial crises and materially help to limit or contain the
damage caused by crises. Having said that, I want to underscore three
key points: First; the execution challenges associated with this reform
agenda are enormous. Second; the reforms are a ``package deal'' such
that if we fail to achieve any one of these measures the prospects for
success in the others will be compromised. Third; if we are successful
in implementing the agenda over a reasonable period of time the case
for wholesale restructuring of the financial system would hardly be
compelling.
Section II: Alternative Financial Structures in Perspective
At the risk of considerable oversimplification, there are three
somewhat overlapping suggestions on the table that are calling for a
major restructuring of the core of the financial system both
domestically and internationally. The more extreme of the three is the
so-called ``Narrow Bank Model'' which, in effect, suggests that
``banks'' should essentially take deposits and make loans. The second
approach would limit the scope of activities in banks and in companies
that own banks but would allow nonbank affiliates of bank holding
companies to conduct certain other financial activities including the
underwriting of debt and equity securities while sharply curtailing or
prohibiting banks and bank holding companies from engaging in
``proprietary'' trading and operating or sponsoring hedge funds and
private equity funds.
The third approach is the view that subject to a comprehensive and
rigorous family of reforms as outlined in Section I, most large
integrated financial institutions would be allowed to maintain much of
their current configuration while being subject to much more demanding
consolidated supervision.
To many, the frame of reference surrounding the debate on these
alternatives seems to be very much a matter of black and white. If we
were starting with a clean slate, that might be the case.
Unfortunately, we are not starting with a clean slate--far from it.
Therefore, allow me to briefly focus on a few observations that--in my
judgment--frame the perspective to be considered in shaping the debate
on alternative financial structures.
First; I have always believed that banks (whether stand alone or
part of a Bank Holding Company) are special. Among other things, that
is one of the reasons I agreed to take on the role of nonexecutive
chairman of the Goldman Sachs Bank when Goldman became a Bank Holding
Company in the fall of 2008.
Second; under existing law and regulation there are now in place
rigorous restrictions as to the activities that may be conducted in a
bank that is part of a Bank Holding Company and even more rigorous
standards limiting transactions that can occur between the bank, its
holding company and its nonbank affiliates. Also, under precrisis rules
regarding the administration of the discount window, access to the
discount window applied only to the bank and such access did not
extend, either directly or indirectly, to the Holding Company or the
Bank's nonbank affiliates. As the Fed winds down its crisis driven
extraordinary interventions, I believe we should return to the
precrisis rules regarding access to the discount window so long as
Section 13 (3) lending remains a possibility in extreme circumstances.
Third; under existing law and regulation, the Federal Reserve, as
the consolidated prudential supervisor of all U.S. Bank and Financial
Services Holding Companies, already has broad discretionary authority
to remove officers and directors, cut or eliminate dividends, shrink
the balance sheet, etc. The Bill passed by the House in December would
further strengthen this authority and extend it to systemically
important financial institutions even if they do not own or control a
bank.
While on the subject of consolidated supervision, allow me to say a
few words about the experience of Goldman Sachs since the Fed (working
with other regulators) became its consolidated supervisor 16 months
ago. First, and most importantly, I would describe that relationship as
open, highly constructive, and very demanding. The Fed has now
completed comprehensive full scale examinations of the Bank and the
Group and reported the results of such examinations to both the Boards
of the Group and the Bank. In addition, a large number of targeted
exams and so-called ``discovery reviews'' have been completed or are in
progress. In the case of major forward-looking supervisory initiatives
on the part of the Fed in collaboration with other supervisory bodies--
both domestic and international--I personally have actively
participated in all such discussions. Finally, and to put a little
color on this subject, on more than a few occasions my high-level
associates at Goldman Sachs have said to me something along the
following lines: ``these guys (referring to the supervisors) ask damn
good questions.''
Fourth; given all that we have been through over the past 2 years,
many observers are raising the perfectly natural question of whether
society really needs large and complex financial institutions. Whatever
else can be said about such large and complex financial institutions,
financial services is one of the few sectors of the economy that make a
consistent positive contribution to the U.S. balance of payments.
Balance of payment issues aside, I strongly believe that well
managed and supervised large integrated financial institutions play a
constructive and necessary role in the financial intermediation process
which is central to the public policy goals of economic growth, rising
standards of living and job creation.
While the business models of the relatively small number of large
and complex financial institutions in the U.S. and abroad differ
somewhat from one to another, as a broad generalization most are
engaged to varying degrees in (1) traditional commercial banking; (2)
securities underwriting; (3) a range of trading activities including at
least some elements of ``proprietary'' trading; (4) financial advisory
services; (5) asset management services including the management of so-
called ``alternative'' investments; (6) private banking; and (7)
elements of principal investing.
All of these large integrated financial groups are indeed large
with balance sheets ranging from the high hundreds of billions to $2.0
trillion or so. Among other things, it is their size that allows these
institutions to meet the financing needs of large corporations--to say
nothing of the financing needs of sovereign governments. The fact that
so many of these large corporations operate on a global scale is one of
the reasons why almost all large financial intermediaries also have a
global footprint. As an entirely practical matter, it is very difficult
to imagine how the vast financing needs of corporations and governments
could be met on anything like today's terms and conditions absent the
ability and willingness of these large intermediaries to place at risk
very substantial amounts of their own capital in serving these
companies and governments. One of the best examples of this phenomenon
is the role large intermediaries have played in the recent past in
raising badly needed capital for the financial sector itself.
For example, over the past 2 years banking institutions in the U.S.
and abroad have raised more than one-half trillion dollars in fresh
private capital and the capital raising meter is still running. While
there were some private placements, the overwhelming majority of such
capital was raised in the capital markets and the associated
underwriting, operational and reputational risks associated with such
capital raising, were absorbed by various combinations of the small
number of large integrated financial groups. Moreover, many of these
transactions took the form of rights offerings which involve extended
intervals of time between pricing and final settlement thus elevating
underwriting risks. The ability and willingness of these large
integrated financial groups to assume these risks depends crucially on
large numbers of experienced investment bankers and highly skilled
equity market specialists who are able to judge the tone and depth of
the markets in helping clients shape the size, structure, and pricing
for such transactions.
More broadly, to a greater or lesser degree, most of these large
integrated financial groups also act as day-to-day market makers across
a broad range of financial instruments ranging from Treasury securities
to OTC derivatives. The daily volume of such market activities is
staggering and can be measured in hundreds of thousands--if not
millions--of transactions. As market makers, these institutions stand
ready to purchase or sell financial instruments in response to their
institutional (and sometimes governmental) clients and counterparties.
As such, market-making transactions--by their very nature--entail
substantial capital commitments and risk-taking by the market maker.
However, the capital that is provided in the market-making process is
the primary source of the liquidity that is essential to the efficiency
and price discovery traits of financial markets. Moreover, in today's
financial environment, market makers are often approached by clients to
enter into transactions that have notional amounts that are measured in
hundreds of millions, if not billions, of dollars. Since transactions
of these sizes cannot be quickly laid off or hedged, the market makers
providing these services to institutional clients must have world-class
risk management systems and robust amounts of capital and liquidity.
Thus, only large and well capitalized institutions have the resources,
the expertise and the very expensive technological and operating
systems to manage these market-making activities. Having said that, it
is also true that some of these activities are, indeed, high risk in
nature. Thus, the case for greater managerial focus, heightened
supervisory oversight and still larger capital and liquidity cushions
for certain activities are all part of the postcrisis reform agenda.
Fifth; in terms of both competition and regulatory arbitrage there
is a critical international component to the outcome of the debate on
alternative financial market structure in the U.S. That is, if the
United States adopted a materially different and more restrictive
statutory framework for banking and finance than, for example, Europe,
the outcome could easily work to the competitive disadvantage of U.S.
institutions. Similarly, such an outcome would, inevitably, introduce
new pressures in the area of financial protectionism which, given the
existing threats on the trade protection front, is one of the last
things our country and the world need. Finally, if there are material
international differences in financial structure and the ``rules of the
road'' governing banking and finance, it is inevitable that one way or
another, clever people, aided by highly sophisticated technology, will
find ways to game the system.
To summarize, even before approaching the very complex issue
surrounding the pros and cons of alternative financial structures and
effectively resolving the ``Too Big to Fail'' problem, we must
recognize that even modest financial restructurings that would directly
affect only a small number of institutions worldwide raise many
questions about the laws of unintended consequences especially in the
context of the larger agenda for reform discussed in Section I.
Section III: The Merits of Alternative Financial Structures
There is no question that the drive to shrink the size and
activities of large and complex financial institutions is
understandably driven by the political and public outrage about the use
of tax payer money to ``bail out'' institutions that were deemed to be
``Too Big to Fail.'' Given that reality, it follows that many observers
believe that the easiest way to solve the problem is via some
combination of shrinking the size of these institutions, and/or
restricting their activities in ways that will curtail risk and
mitigate the conflicts of interest.
Having said that, it is also true that while financial excesses
were unquestionably one of the causes of the crisis, shortcomings in
public policy were important contributing factors. Similarly, not all
``banks'' that received direct tax payer support were large and complex
institutions. Moreover, the largest single source of write-downs and
losses in financial institutions--complex or not--occurred in
traditional lending activities not trading activities. Regrettably,
these lending driven losses and write-downs were magnified by certain
classes of securitization especially very complex and highly leveraged
instruments. Finally, it is also undeniable that all classes of
financial institutions--big banks, small banks, investment banks
(including Goldman Sachs) and so-called ``near banks''--to say nothing
of businesses small and large--benefited substantially from the large
scale extraordinary measures taken by governments and central banks to
cushion the economic and financial fallout of the crisis.
The most radical of the restructuring suggestions is the so-called
``narrow bank'' which would essentially take deposits and make loans.
As I see it, and with the exception of community banks, this approach
is a nonstarter given the long history of credit problems over the
business and credit cycle. In other words restricting diversification
of risk and revenues is hardly a recipe for stability.
A less extreme, but still transformational structural change has
been suggested by Chairman Volcker and endorsed by President Obama.
While the broad intent of the Volcker approach is quite clear there are
a number of open definitional and important technical details that are
yet to be clarified. One area of particular importance relates to the
definition of proprietary trading and, in particular, the distinction
between ``prop'' trading and market making. As I see it, client-driven
market making and the hedging and risk management activities growing
out of such market making are natural activities of banks and Bank
Holding Companies. As such, these activities are subject to official
supervision, including on site inspections, capital and liquidity
standards and various forms of risk related stress tests.
The Volcker plan would also prohibit ``banks'' and Bank and
Financial Services Holding Companies from owning or sponsoring hedge
funds and private equity funds. I believe that the financial risks
associated with such ownership or sponsorship can be effectively
managed and limited by means short of outright prohibition although
bank owners or sponsors of such funds should not be permitted to inject
fresh capital into an existing fund without regulatory approval.
More generally, it should be noted that hedge funds and private
equity funds are providing both equity and debt financing to small and
medium sized businesses in such vital areas as alternative energy and
technology ventures. Given the long term benefits of these activities,
I also believe there is something to be said for the proposition that,
subject to appropriate safeguards, regulated Bank Holding Company
presence in the hedge fund and private equity fund space can help to
better promote best industry practice.
I am also mindful of the conflict of interest issue raised by
Chairman Volcker. There is nothing new about potential conflicts in
banking and finance. However, it cannot be denied that in the world of
contemporary finance--with all of its complexities and applied
technology--managing potential conflicts has become much more
challenging. Reflecting that fact of life, so-called ``Chinese Walls''
segregating some business units from others is a necessary, but not
sufficient, condition for managing potential conflicts. That is why at
Goldman Sachs (and other large integrated intermediaries) conflict
management policies and procedures are constantly evolving and
improving.
Goldman Sachs has established numerous committees and processes to
help mitigate potential conflicts. We have a high level Firmwide
Business Practices Committee which focuses on operational and
reputational risk, including conflict management. We have a dedicated
and independent high level worldwide Conflict Management team. We have
a Firmwide Risk Committee which focuses on financial risk. The Firm's
independent Legal and Compliance divisions, both of which have
centralized teams of experts and high level officials who are embedded,
but still independent, within all of the revenue producing business
units, contribute to conflicts management. All of these committees and
business areas are headed by senior officers who sit on the Management
Committee. Side by side we have a Suitability Committee and a New
Products Committee. In addition, our Capital Committee and Commitments
Committee as well as all Division Heads share in the responsibility of
helping to manage conflicts and reputational risk.
Section IV: The Challenges Associated With Enhanced Resolution
Authority
There is little doubt that a well designed and well executed
framework of Enhanced Resolution Authority can address the Too Big to
Fail problem and the related Moral Hazard problem. However, it is also
true that a poorly designed and poorly executed approach to Enhanced
Resolution Authority could produce renewed uncertainty and instability.
Indeed, under the very best of circumstances, the timely and orderly
wind-down of any systemically important financial institution--
especially one with an international footprint--is an extraordinarily
complex task. That is why, at least to the best of my recollection, we
have never experienced such an orderly wind-down anywhere in the world.
In other words, even if we successfully implement all of the reforms
outlined in Section I of this statement, that success by itself, will
not ensure that Enhanced Resolution Authority can achieve its desired
effects. Thus, great care must be used in the design of the approach to
law and regulation for a system of Enhanced Resolution Authority.
I, of course, have no monopoly on thoughts on how to best approach
this task. On the other hand, as someone who has devoted much of my
career to improving what I like to call the plumbing of the financial
system I do have some suggestions as to (1) certain principles that I
believe should guide the effort and (2) certain prerequisites that
should be in place to guide the execution of a timely and orderly wind-
down or merger of a failing systemically important financial
institution.
Guiding Principles
First; the authorizing legislation and regulations must not be so
rigid as to tie the hands of the governmental bodies that will
administer those laws and regulations because it is literally
impossible to anticipate the future circumstances in which the
authorities will be required to act.
Second; in my judgment, the authority and responsibility to carry
out Enhanced Resolution Authority in a given situation should be vested
in governmental bodies that have sufficient experience with the type of
institution being resolved.
Third; Enhanced Resolution Authority should be administered using
the ongoing approach which probably means the troubled institution
would be placed into temporary conservatorship or a similar vehicle
allowing that institution to continue to perform and meet its
contractual obligations for a limited period of time.
As a precondition for conservatorship, one or more of the Executive
Officers and the Board of the institution would be removed. The ongoing
approach has many benefits including (1) preserving the value of assets
that might be sold at a later date; (2) minimizing the dangerous and
panic prone process of simultaneous close out by all counterparties and
the need of such counterparties to then replace their side of many of
the closed-out positions; and (3) reducing, but by no means
eliminating, the very difficult and destabilizing cross-border events
that could otherwise occur as witnessed in the Lehman episode. However,
the ongoing approach is not without its problems, one of which is the
sensitive question of how well an institution in conservatorship for a
limited period of time can fund itself.
Fourth: to the maximum extent possible, the rights of creditors and
the sanctity of existing contractual rights and obligations need to be
respected. Indeed, if the exercise of Enhanced Resolution Authority is
seen to arbitrarily violate creditor rights or override existing
contractual agreements between the troubled institution and its
clients, its creditors, and its counterparties, the goal of orderly
wind-down could easily be compromised and the resultant precedent could
become a destabilizing source of ongoing uncertainty.
Finally; the orderly wind-down of any large institution--
particularly such an institution having a global footprint--is a highly
complex endeavor that will take patience, skill and effective
communication and collaboration with creditors, counterparties and
other interested parties. Shrinking a balance sheet or selling distinct
businesses or classes of assets or liabilities may prove relatively
simple but the winding down of trading positions, hedges, positions in
financial ``utilities'' such as payments, clearance and settlement
systems is quite another matter.
Prerequisites for Success:
First; as a part of the reform of supervisory policy and practice,
supervisory authorities responsible for systemically important
institutions must work to insure that ``prompt corrective action''
becomes a reality not merely a slogan.
Second; the official community must work with individual
systemically important institutions to ensure that all such
institutions have--or are developing--the systems and procedures to
provide the following information in a timely fashion.
Comprehensive data on all exposures to all major
counterparties and estimates of all such exposures of
counterparties to the failing institution
Valuations consistent with prevailing market conditions
that are available across a substantially complete range of the
firm's asset classes (including derivative and securities
positions)
Accurate and comprehensive information on a firm's
liquidity and the profiles of its assets and liabilities
Fully integrated, comprehensive risk management frameworks
capable of assessing the market, credit, and liquidity risks
associated with the troubled institution
Legal agreements and transaction documents that are
available in an organized, accessible form
Comprehensive information on the firm's positions with
exchanges, clearing houses, custodians and other institutions
that make up the financial system's infrastructure
I am under no illusion that these guiding principles and
prerequisites are anything close to the last word in seeking assurances
that Enhanced Resolution Authority can deliver on the promise of a
stability driven solution to the ``Too Big to Fail'' problem. On the
other hand, I very much hope these suggestions will help to stimulate
discussion and debate on this critically important subject.
______
PREPARED STATEMENT OF SIMON JOHNSON
Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of
Management; and
Senior Fellow, Peterson Institute for International Economics; and
Cofounder of BaselineScenario.com
February 4, 2010
A. General Principles \1\
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\1\ This testimony draws on joint work with James Kwak, including
``13 Bankers'' (forthcoming, March 2010) and ``The Quiet Coup'' (The
Atlantic, April, 2009), and Peter Boone, particularly ``The Next
Financial Crisis: It's Coming and We Just Made It Worse'' (The New
Republic, September 8, 2009). Underlined text indicates links to
supplementary material; to see this, please access an electronic
version of this document, e.g., at http://BaselineScenario.com, where
we also provide daily updates and detailed policy assessments for the
global economy.
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1) The broad principles behind the so-called ``Volcker Rules'' are
sound. As articulated by President Obama at his press conference on
January 21, the priority should be to limit the size of our largest
banks and to reduce substantially the risks that can be taken by any
financial entity that is backed, implicitly or explicitly, by the
Federal Government.
2) Perceptions that certain financial institutions were ``too big
to fail'' played a role in encouraging reckless risk-taking in the run-
up to the financial crisis that broke in September 2008. Once the
crisis broke, the Government took dramatic and unprecedented steps to
save individual banks and nonbanks that were large relative to the
financial system; at the same time, relatively small banks, hedge
funds, and private equity and other investment funds were either
intervened by the FDIC (for banks with guaranteed deposits) or just
allowed to go out of business (including through bankruptcy).
3) Looking forward, we face a major and undeniable problem with the
``too big to fail'' institutions that became more powerful (in economic
and political terms) as a result of the 2008-09 crisis and now dominate
our financial system. Implementing the principles behind the Volcker
Rules should be a top priority.
4) As a result of the crisis and various Government rescue efforts,
the largest 6 banks in our economy now have total assets in excess of
63 percent of GDP (based on the latest available data; details of the
calculation and related information are available in ``13 Bankers'').
This is a significant increase from even 2006, when the same banks'
assets were around 55 percent of GDP, and a complete transformation
compared with the situation in the U.S. just 15 years ago--when the 6
largest banks had combined assets of only around 17 percent of GDP.
5) The credit markets are convinced that the biggest banks in the
United States are so important to the real economy that, if any
individual bank got into trouble, it would be rescued in such a way
that creditors would be fully protected. As a result, the implied
probability of default on debt issued by these mega-banks is very low--
as reflected, for example, in their current credit default swap
spreads.
6) The consequent low cost of credit for mega-banks--significantly
below what is paid by smaller banks that can fail (i.e., banks that can
realistically be taken over through a FDIC intervention)--constitutes a
form of unfair subsidy that enables the biggest banks to become even
larger. Without a size cap on individual bank size, we will move toward
the highly dangerous situation that prevails in some parts of Western
Europe--where individual banks hold assets worth more (at least on
paper, during a boom) than their home country's GDP.
7) Just to take one example, the Royal Bank of Scotland (RBS) had
assets--at their peak--worth roughly 125 percent of U.K. GDP. The
mismanagement and effective collapse of RBS poses severe risks to the
U.K. economy, and the rescue will cost the taxpayer dearly. Iceland is
widely ridiculed for allowing banks to build up assets (and
liabilities) worth between 11 and 13 times GDP, but the biggest four
banks in the U.K. had bank assets worth over 3 times GDP (and total
bank assets were substantially higher, by some estimates as much as 6
times GDP)--and the two largest banks in Switzerland held assets that
were worth over 8 times GDP. When there is an implicit Government
subsidy to bank size and growing global opportunities to export
(subsidized) financial services, market forces do not limit how large
banks and nonbank financial institutions can become relative to the
domestic economy. In fact, as financial globalization continues, we
should expect the largest U.S. banks--left unchecked--to become even
bigger in dollar terms and relative to the size of our economy.
8) At the same time, under the current interpretation of our
financial rules, a bank such as Goldman Sachs now has full access to
the Fed's discount window (as a bank holding company)--yet also retains
the ability to make risky investments of all kinds anywhere in the
world (as it did when it was an investment bank, before September
2008). In a very real sense, the U.S. Government is now backing the
world's largest speculative investment funds--without any effective
oversight mechanisms.
9) Under the framework now in place, we are set up for another
round of the boom-bailout-bust cycle that the head of financial
stability at the Bank of England now terms a ``doom loop.'' The likely
consequences range from terrible, in terms of pushing up our net
Government debt by another 40 percentage points of GDP (or more), as we
struggle again to prevent recession from becoming depression, to
catastrophic--if we fail to prevent a Second Great Depression.
10) In this context, reining in the size of our largest banks is
not only an appealing proposition, it is also compelling. There is no
evidence for economies of scale in banking over $100 billion of total
assets (measured in today's dollars). As a result, the growth of our
largest banks since the early 1990s has been entirely without social
benefits. At the same time, the crisis of 2008-09 manifestly
demonstrates the very real social costs: the revised data will likely
show more than 8 million net jobs lost since December 2007--due to more
than a decade of reckless risk-taking involving large financial
institutions.
11) The Riegle-Neal Interstate Banking and Branching Efficiency Act
of 1994 specified a size cap for banks: No single bank may hold more
than 10 percent of total retail deposits. This cap was not related to
antitrust concerns as 10 percent of a national market is too low to
imply pricing power. Rather this was a sensible macroprudential
preventive measure--don't put all your eggs in one basket.
Unfortunately, since 1994 two limitations of Riegle-Neal have become
clear, (1) the growth of big banks was not fueled by retail deposits
but rather by various forms of ``wholesale'' financing, and (2) the cap
was not enforced by lax regulators, so that Bank of America, JPMorgan
Chase, and Wells Fargo all received waivers in recent years.
12) While the U.S. financial system has a long tradition of
functioning well with a relatively large number of banks and other
intermediaries, in recent years it has become transformed into a highly
concentrated system for key products. The big four have half of the
market for mortgages and two-thirds of the market for credit cards.
Five banks have over 95 percent of the market for over-the-counter
derivatives. Three U.S. banks have over 40 percent of the global market
for stock underwriting. This degree of market power is dangerous in
many ways.
13) These large banks are widely perceived--including by their own
management, their creditors, and Government officials--as too big to
fail. The executives who run these banks obviously have an obligation
to make money for their shareholders. The best way to do this is to
take risks that pay off when times are good and that result in
bailouts--creating huge costs for taxpayers and all citizens--when
times are bad. \2\
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\2\ For more analytical analysis and relevant data on this point,
see ``Banking on the State'', by Andrew Haldane and Piergiorgio
Alessandri, BIS Review 139/2009.
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14) This incentive system distorts market outcomes, encourages
reckless risk-taking, and will lead to serious trouble. While reducing
bank size is not a panacea and should be combined with other key
measures that are not yet on the table--including a big increase in
capital requirements--finding ways to effectively reduce and then limit
the size of our largest banks is a necessary condition for a safer
financial system.
B. Assessment of Bank Size
1) The counterargument is that big banks provide benefits to the
economy that cannot be provided by smaller banks. There are also claims
that the global competitiveness of U.S. corporations requires American
banks be at least as big as the banks in any other country. Another
argument is that large financial institutions enjoy significant
economies of scale and scope that make them more efficient, helping the
economy as a whole. Finally, it is argued global banks are necessary to
provide liquidity to far-flung capital markets, making them more
efficient and benefiting companies that raise money in those markets.
2) There is weak or no hard empirical evidence supporting any of
these claims.
3) Multinational corporations do have large, global financing
needs, but there are currently no banks that can supply those needs
alone; instead, corporations rely on syndicates of banks for major
offerings of equity or debt. And even if there were a bank large enough
to meet all of a large corporation's financial needs, it would not make
sense for any nonfinancial corporation to restrict itself to a single
source of financial services. It is much preferable to select banks
based on their expertise in particular markets or geographies.
4) In addition, U.S. corporations already benefit from competition
between U.S. and foreign banks, which can provide identical financial
products; there is no reason to believe that the global competitiveness
of our nonfinancial sector depends on our having the world's largest
banks.
5) There is also very little evidence that large banks gain
economies of scale beyond a low size threshold.
a. Economies of scale vanish at some point below $10 billion in
assets. \3\
---------------------------------------------------------------------------
\3\ Dean Amel, Colleen Barnes, Fabio Panetta, and Carmelo Salleo,
``Consolidation and Efficiency in the Financial Sector: A Review of the
International Evidence'', Journal of Banking and Finance 28 (2004):
2493-2519. See also Stephen A. Rhoades, ``A Summary of Merger
Performance Studies in Banking, 1980-93, and an Assessment of
the`'Operating Performance' and 'Event Study' Methodologies'', Federal
Reserve Board Staff Studies 167, summarized in Federal Reserve Bulletin
July 1994, complete paper available at http://www.federalreserve.gov/
Pubs/staffstudies/1990-99/ss167.pdf: ``In general, despite substantial
diversity among the nineteen operating performance studies, the
findings point strongly to a lack of improvement in efficiency or
profitability as a result of bank mergers, and these findings are
robust both within and across studies and over time.'' See also Allen
N. Berger and David B. Humphrey, ``Bank Scale Economies, Mergers,
Concentration, and Efficiency: The U.S. Experience'', Wharton Financial
Institutions Center Working Paper 94-24, 1994, available at http://
fic.wharton.upenn.edu/fic/papers/94/9425.pdf.
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b. The 2007 Geneva Report on ``International Financial
Stability'', coauthored by former Federal Reserve vice chair Roger
Ferguson, found that the unprecedented consolidation in the financial
sector over the previous decade had led to no significant efficiency
gains, no economies of scale beyond a low threshold, and no evident
economies of scope. \4\
---------------------------------------------------------------------------
\4\ Roger W. Ferguson, Jr., Philipp Hartmann, Fabio Panetta, and
Richard Portes, International Financial Stability (London: Centre for
Economic Policy Research, 2007), 93-94.
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c. Since large banks exhibit constant returns to scale (they are
no more or less efficient as they grow larger), and we know that large
banks enjoy a subsidy due to being too big to fail, ``offsetting
diseconomies must exist in the operation of large institutions''--that
is, without the ``too big to fail'' subsidy, large banks would actually
be less efficient than midsize banks. \5\
---------------------------------------------------------------------------
\5\ Edward J. Kane, ``Extracting Nontransparent Safety Net
Subsidies by Strategically Expanding and Contracting a Financial
Institution's Accounting Balance Sheet'', Journal of Financial Services
Research 36 (2009): 161-168.
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d. There is evidence for increased productivity in U.S. banking
over time, but this is due to improved use of information technology--
not increasing size or scope. \6\
---------------------------------------------------------------------------
\6\ Kevin J. Stiroh, ``Information Technology and the U.S.
Productivity Revival: What Do the Industry Data Say?'' American
Economic Review 92 (2002): 1559-1576.
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6) Large banks do dominate customized (over-the-counter)
derivatives. But this is primarily because of the implicit taxpayer
subsidy they receive--again, because they are regarded as too big to
fail, their cost of funds is lower and this gives them an unfair
advantage in the marketplace. There is no sense in which this market
share is the outcome of free and fair competition.
7) The fact that ``end-users'' of derivatives share in the implicit
Government subsidy should not encourage the continuation of ``too big
to fail'' arrangements. This is a huge and dangerous form of support
for private interests at the expense of the taxpayer and--because of
the apparent downside risks--of everyone who can lose a job or see
their wealth evaporate in the face of an economic collapse.
8) There are no proven social benefits to having banks larger than
$100 billion in total assets. Vague claims regarding the social value
of big banks are not backed up by data or reliable estimates. This
should be weighed against the very obvious costs of having banks that
are too big to fail.
C. Actions Needed
1) While the general principles behind the Volcker Rules make sense
and there is no case for keeping our largest banks anywhere near their
current size, the specific proposals outlined so far by the
Administration are less persuasive.
2) Capping the size of our largest banks at their current level
today does not make much sense. It is highly unlikely that, after 30
years of excessive financial deregulation, the worst crisis since the
Great Depression, and an extremely generous bailout that we found
ourselves with the ``right'' size for big banks.
3) Furthermore, limiting the size of individual banks relative to
total nominal liabilities of the financial system does not make sense,
as this would not be ``bubble proof''. For example, if housing prices
were to increase ten-fold, the nominal assets and liabilities of the
financial system would presumably also increase markedly relative to
GDP. When the bubble bursts, it is the size of individual banks
relative to GDP that is the more robust indicator of the damage caused
when that bank fails--hence the degree to which it will be regarded as
too big to fail.
4) Also, splitting proprietary trading from integrated investment-
commercial banks would do little to reduce their overall size. The
``too big to fail'' banks would find ways to take similar sized risks,
in the sense that their upside during a boom would still be big and the
downside in a bust would have dramatic negative effects on the
economy--and force the Government into some sort of rescue to prevent
further damage.
5) The most straightforward and appealing application of the
Volcker Principles is: Do not allow financial institutions to be too
big to fail; put a size cap on existing large banks relative to GDP,
forcing these entities to find sensible ways to break themselves up
over a period of 3 years.
6) CIT Group was not too big to fail in summer 2009; it then had
around $80 billion in total assets. Goldman Sachs was too big to fail
in fall 2008, with assets over $1 trillion. If Goldman Sachs were to
break itself up into 10 or more independent companies, this would
substantially increase the likelihood that one or more could fail
without damaging the financial system. It would also greatly improve
the incentives of Goldman management, from a social perspective,
encouraging them to be much more careful.
7) Addressing bank size is not a panacea. In addition, capital
requirements need to be strengthened dramatically, back to the 20-25
percent level that was common before 1913, i.e., before the creation of
the Federal Reserve, when the Government effectively had no ability to
bail out major banks. Capital needs to be risk-weighted, but in a broad
manner that is not amenable to gaming (i.e., quite different from Basel
II and related approaches).
8) Such strengthening and simplifying of capital requirements would
go substantially beyond what the Obama administration has proposed and
what regulators around the world currently have in mind. In November
2009, Morgan Stanley analysts predicted that new regulations would
result in Tier 1 capital ratios of 7-11 percent for large banks--i.e.,
below the amount of capital that Lehman had immediately before it
failed. \7\
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\7\ Research Report, Morgan Stanley, ``Banking--Large and Midcap
Banks: Bid for Growth Caps Capital Ask'', November 17, 2009.
---------------------------------------------------------------------------
9) The capital requirements for derivative positions also need to
be simplified and strengthened substantially. For this purpose
derivative holdings need to be converted according to the ``maximum
loss'' principle, i.e., banks should calculate their total exposure as
they would for a plain vanilla nonderivative position; they should then
hold the same amount of capital as they would for this nonderivative
equivalent. For example, if a bank sells protection on a bond as a
derivative transaction, the maximum loss is the face value of the bond
so insured. The capital requirement should be the same as when the bank
simply holds that bond.
10) A strengthened and streamlined bankruptcy procedure for nonbank
financial institutions makes sense. This will help wind up smaller
entities more efficiently.
11) But improving the functioning of bankruptcy does not make ``too
big to fail'' go away. When they are on the brink of failing, ``too big
to fail'' banks are ``saved'' from an ordinary bankruptcy procedure
because creditors and counterparties would be cut off from their money
for months, which is exactly what causes broader economic damage. You
can threaten all financial institutions with bankruptcy, but that
threat is not credible for the biggest banks and nonbanks in our
economy today. And if the Government did decide to make an example of a
big bank and push it into bankruptcy, the result would likely be the
kind of chaos--and bailouts--that followed the failure of Lehman in
September 2008.
12) A resolution authority as sought by the Obama administration
could help under some circumstances but is far from a magic bullet in
the global world of modern finance. Some of the most severe
complications of the Lehman bankruptcy occurred not in the United
States, but in other countries, each of which has its own laws for
dealing with a failing financial institution. These laws are often
mutually inconsistent and no progress is likely toward an integrated
global framework for dealing with failing cross-border banks. When a
bank with assets in different countries fails, it is in each country's
immediate interest to have the strictest rules on freezing assets to
pay off domestic creditors (and, in some jurisdictions, to protect
local workers). No other G-20 country, for example, is likely to cede
to the United States the right to run a resolution process for banking
activities that are located outside the U.S.
13) More broadly, solutions that depend on smarter, better
regulatory supervision and corrective action ignore the political
constraints on regulation and the political power of today's large
banks. The idea that we can simply regulate huge banks more effectively
assumes that regulators will have the incentive to do so, despite
everything we know about regulatory capture and political constraints
on regulation. It assumes that regulators will be able to identify the
excess risks that banks are taking, overcome the banks' arguments that
they have appropriate safety mechanisms in place, resist political
pressure (from the Administration and Congress) to leave the banks
alone for the sake of the economy, and impose controversial corrective
measures that will be too complicated to defend in public. And, of
course, it assumes that important regulatory agencies will not fall
into the hands of people like Alan Greenspan, who believed that
Government regulation was rendered largely unnecessary by the free
market.
14) The ``rely on better regulation'' approach also assumes that
political officials, up to and including the president, will have the
backbone to crack down on large banks in the heat of a crisis, while
the banks and the Administration's political opponents make accusations
about socialism and the abuse of power. FDIC interventions (i.e.,
taking over and closing down banks) currently do not face this
challenge because the banks involved are small and have little
political power; the same cannot be said of JPMorgan Chase or Goldman
Sachs.
15) There are no perfect solutions to the problem we now face: a
handful of banks and other financial institutions that are too big to
fail. The Volcker Principles are sound--we should reduce the size of
our largest banks and ensure that banks with implicit (and explicit)
Government subsidies are not allowed to engage in risky
undercapitalized activities.
16) However, the proposed details in the Volcker Rules do not go
far enough. We should put a hard size cap, as a percent of GDP, on our
largest banks. A fair heuristic would be to return our biggest banks to
where they were, relative to GDP, in the early 1990s--the financial
system, while never perfect, functioned fine at that time and our banks
were internationally competitive, and there is no evidence that our
nonfinancial companies were constrained by lack of external funding.
(More details on this proposal are available in ``13 Bankers''.)
17) Much stronger capital requirements will reduce the chance that
any individual financial institution fails. But financial failure is a
characteristic of modern market economies that cannot be legislated out
of existence. When banks and nonbank financial institutions fail, there
is far less damage and much less danger if they are small.
______
PREPARED STATEMENT OF JOHN REED
Retired Chairman, Citigroup
February 4, 2010
It is probably too early to fully assess the nature and causes of
our recent financial meltdown but the conversation about potential
remedies is well underway. Given that fact, a few thoughts could be
useful.
First, some ``framing.''
One, the crisis was clearly ``man made,'' this was not the result
of long standing and cumulative imbalances.
Second, there seems to have been a key failure that none of us
anticipated, namely, individual institutions which are thought to take
steps and exercise judgments to ensure their self-preservation turned
out ``not to have'' or been incapable of so doing. (This clearly means
that in designing a robust system, we cannot count on that capacity.)
Third, a financial system cannot be permitted to impact the real
economy to the extent that it has.
Fourth, while much has been made of the low interest rate
environment that accompanied the build up to the crisis, one would not
design a financial system that could not function in such an
environment.
Second, some casual factors that are worth noting.
One, a dominant business philosophy focusing on ``shareholder
value''.
Two, almost frenetic activity in the creation and distribution of
securitized products and derivatives. These turned out to be flawed as
credits but further were not fully distributed to ``knowledgeable
investors'' but to an incredible extent were inventoried on the balance
sheet of ``intermediaries'' (e.g., Merrill Lynch, Citi).
Third, the absolute failure of the rating agencies in the
performance of their only mission.
Fourth, the failure of supervision,
In allowing the decapitalization of the sector.
In ignoring the implications of ``low doc, no doc''
lending.
In ignoring the levels of counterparty risk.
In ``missing'' the fact that credit default swaps were
insurance products, requiring reserves and oversight.
Fifth, the failure of policy in pushing the mortgage market through
Freddie Mac and Fannie Mae to an uneconomic extent.
Third, if the aim is to create rules and limits, which on the one
hand would significantly reduce the likelihood of a repeat of our
recent experience, and on the other would support a healthy and
creative industry, what would the rules and limits be?
First, capital should be significantly increased, maybe doubled. (I
personally think the concept of Risk Adjusted Capital is flawed.)
Second, the funding structure (liquidity) of each institution
should be the subject of annual review (not just ``point in time'',
averages and extremes over the year) and assessment by regulators and
boards.
Third, the industry should be compartmentalized so as to limit the
propagation of failures and also to preserve cultural boundaries.
Fourth, to the extent possible, traded products should flow through
Exchanges.
Fifth, there is a good reason to create a Consumer Protection
Agency with a clear and separate mandate.
______
PREPARED STATEMENT OF HAL S. SCOTT
Nomura Professor of International Financial Systems at Harvard Law
School; and
Director of the Committee on Capital Markets Regulation
February 4, 2010
Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the
Committee for permitting me to testify before you on the implications
of the Volcker Rules for Financial Stability (Volcker Rules), as well
as President Obama's proposed size limitations on banks. I am
testifying today in my own capacity and do not purport to represent the
views of the Committee on Capital Markets Regulation.
Let me preface my testimony by stressing the urgent need for broad
regulatory reform in light of the financial crisis on matters ranging
from the structure of our regulatory system, to the reduction of
systemic risk in the derivatives market, to improving resolution
procedures for insolvent financial companies, to increasing consumer
protection, and to revamping the GSEs. The Committee on Capital Markets
Regulation dealt with these issues in its May 2009 Report titled ``The
Global Financial Crisis: A Plan for Regulatory Reform''. \1\ These
issues were also fully laid out in the Treasury Department's June 2009
proposal on financial regulatory reform, \2\ and have been vigorously
debated in public meetings, the press, and Congressional hearings for
months. These efforts have so far culminated in the Wall Street Reform
and Consumer Protection Act (H.R. 4173) as well as in Senator Dodd's
thoughtful Discussion Draft. And I applaud the ongoing efforts of this
Committee to reach bipartisan consensus on these issues. In my
judgment, we should not hold up these important reforms while we debate
activity and size limitations.
---------------------------------------------------------------------------
\1\ This report contains 57 recommendations for making the U.S.
financial regulatory structure more integrated, more effective and more
protective of investors. Comm. on Capital Mkts. Reg., The Global
Financial Crisis: A Plan For Regulatory Reform (May 2009).
\2\ U.S. Dep't of the Treasury, Financial Regulatory Reform, A New
Foundation: Rebuilding Financial Supervision And Regulation (June 2009)
[hereinafter Treasury White Paper], http://www.financialstability.gov/
docs/regs/FinalReport_web.pdf.
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The Volcker Rules would limit the ability of banks \3\ to own,
invest in, or sponsor a hedge fund or private equity fund, or to engage
in ``proprietary trading.'' The size limitation would limit the market
share of all financial institution liabilities beyond the current 10
percent market share cap applied to bank deposits.
---------------------------------------------------------------------------
\3\ We use the term ``banks'' to refer generally to bank holding
companies and their subsidiaries.
---------------------------------------------------------------------------
At the outset, it is important to focus on the stated objective of
these new proposals--to reduce bank risk so as to minimize the
necessity of public rescue of banks that are ``Too Big to Fail.'' There
is no question that we need to address the ``Too Big to Fail'' issue.
We need to understand whether the conventional wisdom--that we cannot
let large financial institutions fail, in the sense of imposing a full
measure of losses on the private sector, whether they be equity or
unsecured debt holders or counterparties--is actually true. The concern
rests on an assumption that we cannot permit certain large and
interconnected financial institutions to fail because such failure
would trigger a chain reaction of other financial institution failures,
with disruption to the entire economy.
In the notable $85 billion Federal bailout of AIG, however, some
question whether the asserted prospect of severe counterparty losses
actually existed. Goldman Sachs, one of AIG's major counterparties, has
stated that it had adequate cash collateral to survive an AIG default.
\4\ We need to be careful that ``Too Big to Fail'' does not become a
self-fulfilling prophecy.
---------------------------------------------------------------------------
\4\ Transcript of F3Q09 Earnings Call (David Viniar, Chief Fin.
Officer, Goldman Sachs Group, Inc.) (Oct. 15, 2009).
---------------------------------------------------------------------------
Clearly, the absolute size of an institution is not the predicate
for systemic risk; it is rather the size of its debt, its derivatives
positions, and the scope and complexity of many other financial
relationships running between the firm, other institutions, and the
wider financial system. As Senator Schumer's example at Tuesday's
hearing illustrates, 50 small but highly correlated hedge funds might
combine to create systemic risk. In short, the proper focus is on a
bank's interconnectedness with other financial institutions, and we
have only a primitive understanding of the nature and extent of these
connections. To the extent interconnectedness is a problem, the most
fundamental way to attack it is to reduce the interconnections so that
we can allow institutions to fail safely. This will also require that
Federal regulators be given enhanced resolution authority, as set forth
in H.R. 4173 and Senator Dodd's Discussion Draft. \5\ And as Secretary
Geithner recently acknowledged, ``the Bankruptcy Code is not an
effective tool for resolving the failure of a global financial services
firm in times of severe economic stress.'' \6\
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\5\ H.R. 4173, 111th Cong. Subtitle G (2009); Restoring American
Financial Stability Act, 111th Cong. Title II (2009) (mark by the
Chairman of the S. Comm. on Banking, Housing and Urban Affairs).
\6\ Systemic Regulation, Prudential Matters, Resolution Authority
and Securitization: Hearing Before the H. Comm. On Financial Services,
111th Cong. 2 (2009) (written testimony of Timothy F. Geithner).
---------------------------------------------------------------------------
To address our ``Too Big to Fail Problem,'' we need to modernize
financial regulation to address the problems of today, not of the past.
Let me now turn in more depth to the Volcker Rules.
I. Proposed Restrictions on the Scope of Bank Operations
A. Proprietary Trading and ``Too Big to Fail''
The Volcker Rules would prohibit banks and bank holding companies
from engaging in proprietary trading ``unrelated to serving customers
for [their] own profit,'' as well as from investing in or sponsoring
hedge fund and private equity fund operations. \7\ Given that Mr.
Volcker is the Chairman of the Trustees as well as the Chairman of the
Steering Committee of the Group of 30 (G-30), it is worth noting that
the Volcker Rules are significantly more aggressive than the G-30's
recent proposal to merely limit proprietary trading by ``strict capital
and liquidity requirements.'' \8\
---------------------------------------------------------------------------
\7\ Press Release, The White House, Remarks by the President on
Financial Reform (Jan. 21, 2010), available at http://
www.whitehouse.gov/the-press-office/remarks-president-financial-reform.
\8\ Group of 30, Financial Reform: A Framework for Financial
Stability 8 (Jan. 15, 2009), http://www.group30.org/pubs/
recommendations.pdf.
---------------------------------------------------------------------------
The objective embodied in the Volcker Rules is to restrict banks
that are ``Too Big to Fail'' from participating in nontraditional risky
investment activity, thus minimizing the chance they might fail and
have to be rescued to avoid endangering uninsured depositors or the
FDIC insurance fund. This might have been the concern in the past but
it misses the mark today. The reason for the rescues during the crisis,
such as AIG, or the TARP injections to forestall failures, was not to
protect depositors of banks or the FDIC insurance fund. The reason was
rather to avoid a chain reaction of failures set off by
interconnectedness. Furthermore, this need for rescue does not depend
on what activity gives rise to the potential bank failure. We will have
to rescue banks whose failure will endanger other banks even if these
failing banks are engaging in traditional activities. Mr. Volcker seems
to imply that it is acceptable to rescue banks engaging in traditional
activities. I disagree. Quite frankly, I do not think a taxpayer would
feel better about rescuing a bank that made risky loans than he would
rescuing a bank that engaged in less traditional risky activity.
As a solution to the problem of ``Too Big to Fail,'' the Volcker
Rules are over-inclusive because not all banks, and not even all large
banks, pose chain-reaction risks to the financial system. The Rules are
also potentially under-inclusive, because many interconnected financial
institutions which do pose systemic risks are not deposit-taking banks.
Goldman Sachs--which is the only U.S. bank with significant revenue
exposure to proprietary trading \9\--could avoid falling under the
Volcker Rules by divesting itself of its small deposit-taking
operations, which account for only 5.19 percent of its liabilities.
\10\ Similarly, Morgan Stanley would lose only 8.70 percent of its
liability base by giving up bank holding company status. \11\ None of
the most prominent failures of the financial crisis--Fannie Mae,
Freddie Mac, AIG, Bear Stearns, or Lehman Brothers--were deposit-taking
banks.
---------------------------------------------------------------------------
\9\ Goldman's management has stated that proprietary trading
accounts for 10 percent of its total revenues. Transcript of F4Q09
Earnings Call (David Viniar, Chief Fin. Officer, Goldman Sachs Group,
Inc.) (Jan. 21, 2010). Citigroup reportedly maintains proprietary
trading operations accounting for 5 percent of revenues. Jonathan
Weisman, Damian Paletta and Robin Sidel, New Bank Rules Sink Stocks--
Obama Proposal Would Restrict Risk-Taking by Biggest Firms as Battle
Looms, Wall St. J., Jan. 21, 2010, available at http://online.wsj.com/
article/SB10001424052748703699204575016983630045768.html; Citigroup
Inc., Quarterly Report (Form 10-Q), at 88 (Nov. 7, 2009).
\10\ See, Goldman Sachs Group, Inc., Quarterly Report (Form 10-Q),
at 5 (Nov. 4, 2009).
\11\ Morgan Stanley, Quarterly Report (Form 10-Q), at 2 (Nov. 9,
2009).
---------------------------------------------------------------------------
Furthermore, major U.S. banks that do have high levels of deposits
relative to total liabilities derive only a marginal fraction of their
revenues from walled off proprietary trading activities, if
``proprietary trading'' is understood as trading activity carried out
on internal trading desks purely for a bank's own account. Wells Fargo
and Bank of America, two of the largest deposit-funded banks, report
deposits accounting for approximately 72 percent and 49 percent of
their total liabilities, respectively, but are both estimated to earn
less than 1 percent of revenues from proprietary trading. \12\ These
data show that U.S. banks with significant deposit bases assume little
to no balance sheet risk from proprietary trading. Riskier institutions
that do have exposure, if forced to choose between proprietary trading
and deposits, may opt to ``de-bank.'' But because banks are highly
regulated entities, regulators are in a good position to respond to
bank failures. By encouraging banks to take themselves off the
regulatory radar, the Volcker Rules could actually increase systemic
risk. The regulatory and supervisory system is much better able to deal
with controlling the risky activity of regulated banks than of
unregulated investment banks, insurance companies, hedge funds, or
commercial companies with large financial operations. The migration of
risky bank activities to other large firms that may be ``Too Big to
Fail'' would compound, rather than reduce, the systemic risk problem.
The Administration's earlier proposals envision some level of
regulation of systemically important institutions other than banks, but
such regulation will be much less comprehensive than it is for banks.
---------------------------------------------------------------------------
\12\ See, Bank of America Corp., Quarterly Report (Form 10-Q), at
4 (Nov. 7, 2009); Wells Fargo and Co., Quarterly Report (Form 10-Q), at
63 (Nov. 7, 2009); Brooke Masters, ``Alert Over Proprietary Trading
Clamp'', Fin. Times, Jan. 28, 2010, available at http://www.ft.com/cms/
s/0/0293b842-0bab-11df-9f03-00144feabdc0.html.
---------------------------------------------------------------------------
The original proposal was somewhat ambiguous as to the level of the
banking organization at which the Rules would apply. Unless the Rules
limit the activities of bank holding companies and all holding company
subsidiaries, banks could evade the restrictions by shifting hedge fund
or private equity investments and proprietary trading activities to
nonbank subsidiaries. This would, perhaps, protect bank depositors, but
it would not solve the need to rescue bank holding companies to avoid
the chain-reaction-of-failures problem. Because proprietary trading,
hedge fund, and private equity investments could pose the same threat
to other financial institutions because of connectedness, regardless of
whether they occur in a bank or its holding company, the Volcker Rules
only make sense if they apply to bank holding companies and all of
their subsidiaries (including banks and nonbanks).
B. What Is Proprietary Trading?
Mr. Volcker is confident that he as well as bankers know
proprietary trading when they see it. Yet it is notable that neither
Mr. Volcker nor the Treasury Department has presented a workable
definition of this term. The suggestion that it can be measured by a
pattern of large gains and losses is unclear. Hedges or positions taken
for customers can exhibit the same pattern.
Defining ``proprietary trading'' presents tremendous difficulties.
Too narrow a definition, limited to discrete internal hedge fund and
private equity activity undertaken by banks for their own accounts, is
unlikely to lead to material reduction of risk, since these activities
account for only a small fraction of most banks' operations. Defining
proprietary trading too broadly, meanwhile, might seriously impair the
basic function of modern banks as market-makers in Government and
nongovernment securities, and as securitizers of consumer debt. Neither
of these options is very attractive.
1. Proprietary Trading as ``Internal Hedge Funds'' Is Insignificant
to Banks.--Strictly construed, proprietary trading ``unrelated to
serving customers'' encompasses any trading activity carried out on
internal trading desks for a bank's own account, but not on behalf of
clients. \13\ Writing in the New York Times on Sunday, Mr. Volcker
echoed this definition, identifying proprietary trading as ``the search
[for] speculative profit rather than in response to customer need.''
\14\ Generally speaking, there are at least two reasons why this narrow
definition of the activity is unlikely to reduce systemic risk. First,
in absolute terms, the scale of such internal, noncustomer, proprietary
trading is too negligible to drastically impact banks that engage in
it. As outlined above, most U.S. banks, with the exception of Goldman
Sachs, report minimal proprietary trading activity so defined.
---------------------------------------------------------------------------
\13\ Bernstein Research, Quick Take--Thoughts About Proposed
Trading Constraints and Investment Prohibitions 1 (Jan. 22, 2010).
\14\ Paul Volcker, ``Op-Ed, How To Reform Our Financial System'',
N.Y. Times, Jan. 31, 2010, available at http://www.nytimes.com/2010/01/
31/opinion/31volcker.html?hp. (This article was attached to Mr.
Volcker's testimony on Feb. 2, 2010.)
---------------------------------------------------------------------------
Second, proprietary trading through internal hedge funds and other
non-customer-related trading desks was not the source of the damaging
losses that fatally impaired many of the banks at the center of the
financial crisis. According to one Wall Street analyst's estimate, of
the approximately $1.67 trillion of cumulative credit losses reported
by U.S. banks, losses taken on trading activities and derivatives
accounted for less than $33 billion, or 2 percent, of this total. \15\
And as Bernstein Research notes in a recently published analysis, a
construction of the Volcker Rules confined exclusively to internal
hedge fund activity would not, for example, have reached the
significant mortgage positions and unsecuritized loans held by Lehman
Brothers that plummeted in value as liquidity drained from the market
during the crisis. These positions, while proprietary, were not trading
positions assumed by an internal trading desk for Lehman's own account.
\16\ Instead, they were accumulated as part of Lehman's mortgage-
underwriting and securitization businesses.
---------------------------------------------------------------------------
\15\ Goldman Sachs Group, Inc., Goldman Investment Research,
United States: Banks 6 (Nov. 30, 2009).
\16\ Bernstein Research, supra note 13, at 1.
---------------------------------------------------------------------------
2. Loan and Securitization Losses Were at the Heart of the
Financial Crisis.--The losses at the center of the financial crisis
mainly resulted from the credit, lending, and securitization functions
of U.S. banks. To date, the vast majority of overall credit losses--
approximately 80 percent--have been linked to lending and
securitization operations. \17\ Goldman Sachs estimates that
approximately $577 billion, or 34 percent, of cumulative losses were
incurred by banks on direct real-estate-related lending, including
mortgages, commercial real-estate loans, and construction lending. An
additional $338 billion of losses on non-real-estate loans accounted
for 20 percent of cumulative losses. A further $519 billion, or 31
percent, represented losses on indirect real-estate-backed
securitizations, including RMBS, CMBS, and CDOs. The loss experiences
of smaller regional banks, where poor-quality mortgage and construction
loans drove the largest failures, confirm the centrality of credit and
lending to bank losses. For example, option ARMs represented 65 percent
of total loans at Downey Savings, 59 percent at BankUnited, 29 percent
at Indymac, and 22 percent at Washington Mutual. Construction loans
accounted for 88 percent of Corus Bank's loan book. \18\ At regional
U.S. banks, just as at the national and global levels, under-priced
credit risk embedded in loans and securitized debt, and not speculative
internal hedge funds, generated the lion's share of the losses that led
to financial collapse.
---------------------------------------------------------------------------
\17\ Goldman Sachs Group, Inc., supra note 15.
\18\ Id. at 7.
---------------------------------------------------------------------------
To be clear, portfolios of securitized debt instruments held on-
and off-balance sheet by banks were responsible for roughly one-third
of total credit losses. Broadening the definition of ``proprietary
trading'' to restrict banks from holding securitized debt instruments
might address one of the central risks banks were exposed to in the
financial crisis. But do we really want to prevent banks from investing
in securitized debt altogether? The question is complicated by the fact
that owning securitized assets typically serves several purposes for
banks, including making markets in securitized assets and assuring
clients that the banks that structured their deals will have ``skin in
the game,'' particularly by holding junior tranches of securitized
debt. \19\ Indeed, recently adopted legislation in the European Union
requires banks to retain a 5 percent interest in securitizations. \20\
While it was also true that banks held securitized debt for speculative
reasons, it would be difficult to separate such positions from those
needed to engage in the securitization business. A blanket rule
preventing banks from holding securitized debt might interfere with the
revival of our already moribund securitized debt markets, \21\ since it
would deprive banks of an important way of signaling the quality of
issuances. Because restoring these markets is crucial to fueling new
lending and economic growth \22\--Mr. Volcker himself, in his opinion
piece, cited the ``large challenge in rebuilding an efficient,
competitive private mortgage market, an area in which commercial bank
participation is needed'' \23\--regulators must bear this risk in mind
when implementing reforms.
---------------------------------------------------------------------------
\19\ Morgan Stanley, Annual Report (Form 10-K), at 54 (Jan. 29,
2008) (for a discussion of these different roles of VIEs/SPVs in owning
securitized assets).
\20\ Regulations in the European Union permit ``credit
institutions'' to have securitization exposures only if the
``originator, sponsor or original lender'' (a) retains no less than 5
percent of the nominal value of each of the tranches sold or
transferred; (b) in the case of securitization of revolving exposures,
retains of the originator's interest no less than 5 percent of the
nominal value of the securitized exposures; (c) retains randomly
selected exposures, equivalent to less than 5 percent of the
securitized exposures, where such exposures would otherwise have been
securitized in the securitization, provided that the number of
potentially securitized exposures is no less than 100 at origination;
or (d) retains the first loss tranche, and if necessary, other tranches
having the same or more severe risk profile than those transferred or
sold to investors and not maturing any earlier than those transferred
or sold to investors, so that retention equals in total no less than 5
percent of the nominal value of the securitized exposures. European
Parliament and Council Directive 2009/111/EC, Sept. 16, 2009, http://
eur-lex.europa.eu/LexUriServ/
LexUriServ.do?uri=OJ:L:2009:302:0097:0119:EN:PDF.
\21\ Data from the Securities Industry and Financial Markets
Association show that there were approximately $146 billion of asset
backed securities issued in the U.S. in 2009, as compared to about $754
billion when issuance of asset backed securities was at its peak in
2006. See, Sec. Indus. and Fin. Mkt. Ass'n, U.S. ABS Issuance, http://
www.sifma.org/uploadedFiles/Research/Statistics/
SIFMA_USABSIssuance.pdf.
\22\ Int'l Monetary Fund, Global Financial Stability Report 78
(Oct. 2009), available at http://www.imf.org/external/pubs/ft/gfsr/
2009/02/index.htm.
\23\ Volcker, supra note 14 (emphasis added).
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3. Market-Making in Securities Is a Core Function of Banks.--In its
most expansive formulation, proprietary trading could include any
activity that places principal at risk, including the longstanding role
that banks have played in modern capital markets as market-makers in
U.S. Government, agency, and nongovernment securities. A rule which
restricts the scope of this function by classifying market-making as a
form of proprietary trading would reduce liquidity and increase
borrowing costs throughout a wide range of securities markets,
including the market for GSE and U.S. Treasury securities. This
activity cannot easily be performed by other institutions--it requires
the large balance sheets of banks.
According to Federal Reserve data cumulating securities ownership
across all bank securities portfolios (including held-to-maturity,
available for sale, and trading), over 60 percent of the securities
held by banks are agency MBS and Treasuries. \24\ Forced reductions in
this inventory under the Volcker Rules would drain liquidity from
important Government funding markets and entail higher borrowing costs
for the U.S. Government and its sponsored entities, negatively
impacting economic recovery. \25\ Mr. Volcker likewise recognizes what
he has called the ``essential intermediating function'' banks serve in
meeting the ``need for reliable sources of credit for businesses,
individuals, and governments.'' \26\ And Glass-Steagall itself
recognized the linkage between liquidity in Government debt markets and
proprietary trading by banks in Government securities, providing for an
exception authorizing banks to deal in, underwrite, and purchase for
their own account securities issued by the U.S. Government. \27\ So the
area which comprises the largest portion of bank trading, U.S.
Government securities, would have to be preserved.
---------------------------------------------------------------------------
\24\ Fed. Res. Bd., Assets and Liabilities of Commercial Banks in
the United States (Jan. 29, 2010), http://www.federalreserve.gov/
releases/h8/current/h8.pdf.
\25\ These portfolio breakdowns illustrate how banks manage cash
through treasury operations on an ongoing basis by investing it in U.S.
Treasuries, GSE securities, and other fixed-income securities in order
to manage risk and improve their financial position. While treasury
operations are largely fungible with running an ``internal hedge
fund,'' they are an inevitable part of running a bank. This suggests
that trying to prevent banks from running internal hedge funds may be
an exercise in futility.
\26\ Volcker, supra note 14 (emphasis added).
\27\ 12 U.S.C. 24 (Seventh) provides that ``[t]he limitations and
restrictions herein contained as to dealing in, underwriting, and
purchasing for its own account, investment securities shall not apply
to obligations of the United States, or general obligations of any
State or of any political subdivision thereof.''
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4. Proprietary Trading Is a Source of Diversification for Banks.--
Portfolio diversification reduces risk. All else being equal, more
concentrated portfolios are more volatile than portfolios containing an
array of uncorrelated earnings streams, even when parts of the
uncorrelated income are volatile. As the breakdowns discussed earlier
illustrate, a substantial portion of bank losses sustained in the 2007-
2008 financial crisis emanated from highly concentrated exposures to
direct real-estate loans. And past financial crises, like the sovereign
debt and thrift crises of the 1980s and the Asian crises of the 1990s,
also involved lending operations. Proprietary trading (excluding
securitization, as discussed earlier), which barely contributed to
losses in these earlier periods, is a source of diversification that
may help to mitigate, not aggravate, the risk profile of U.S. banks in
the future. During the financial crisis, firms with significant
proprietary trading operations like Goldman Sachs, or those that ran
complex, interconnected books of business, including Goldman, Morgan
Stanley, and JPMorgan, survived. Indeed, this diversification helped
protect them in the crisis. By contrast, firms that concentrated their
exposures in real-estate, like Lehman, or isolated these exposures in
large, undercapitalized, off-balance sheet silos either did not
survive, or needed Government capital injections to keep them afloat.
C. Limitations on Private Equity and Hedge Fund Investing by Banks
The Volcker Rules, in addition to limiting proprietary trading
activity, would also restrict banks from owning, investing in, or
sponsoring private equity funds (including venture capital funds whose
activity is crucial to small business) and hedge funds.
Worldwide, banks and investment banks account for $115 billion, or
12 percent, of the $1.1 trillion of investment by limited partners
including coinvestments in private equity funds involved in corporate
finance and buyouts. \28\ Indeed, banks are a larger source of capital
as private equity limited partners than endowments or sovereign wealth
funds. \29\ Historically, banks have also represented an important
source of direct proprietary involvement in private equity as general
partners, raising an estimated $80 billion in committed capital from
investors over the past 5 years. \30\ Mandating the exit of banks from
involvement in these activities could force the withdrawal of a
substantial fraction of the private equity industry's available
investment capital. This would deal a disruptive blow to the recovery
of the private equity industry on the heels of serious setbacks in
terms of both fundraising and transaction activity which the industry
sustained from 2007 to 2008. U.S. and global private equity fundraising
activity remains at or below 2004 levels, with less than $10 billion
raised by U.S. funds in Q4 2009 as compared to an excess of $100
billion raised in the same period in 2007. \31\ Nonetheless, private
equity is still an important financing source for the U.S. economy,
providing needed investment to undercapitalized or recapitalizing U.S.
industries, including the financial sector. In Q4 2009, as investment
activity began to recover, private equity funds invested $8 billion in
U.S. buyouts (executing $48 billion in M and A transaction volume).
\32\ At a moment when private equity activity is starting to rebound,
rules that would force a withdrawal or reconfiguration of significant
capital in the industry could chill investment in U.S. industry.
---------------------------------------------------------------------------
\28\ Private Equity Council, Private Equity and Banks 1, Jan. 22,
2010; see also Press Release, Preqin, Effects of Obama's Proposal on
Alternatives Industry Significant (Jan. 22, 2010), http://
www.preqin.com/docs/press/Preqin-PR-Potential-effects-of-Obamas-
proposals-on-alternatives.pdf.
\29\ Private Equity Council, supra note 28, at 1.
\30\ Id.
\31\ Private Equity Council, 2009 Year End Update 5-6, Jan. 4,
2010.
\32\ Id. at 2.
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These prospective costs to the economy might be acceptable if they
were offset by a commensurate reduction in bank balance sheet risk. But
while bank investment is an important source of capital to private
equity, it is not a meaningful proportion of bank assets. \33\ As of
September 30, 2009, investment in private equity accounted for less
than 3 percent of the aggregate reported trading and/or ``other''
assets of the six largest U.S. banks. As a percentage of total bank
assets, private equity investments accounted for less than 1 percent of
the total consolidated balance sheet of Bank of America, JPMorgan,
Wells Fargo, and Citigroup, and less than 2 percent of the total
balance sheet assets of Goldman Sachs and Morgan Stanley. \34\ While
relatively little bank capital is at risk in the private equity
business, private equity nevertheless represents an important source of
advisory, syndication, and underwriting revenues for banks which
sponsor private equity funds. \35\ Mandating the spin-off or closure of
these funds would not improve the composition of bank balance sheets or
the profile of bank riskiness, but would terminate a lucrative source
of earnings at a time when banks are focused on recapitalizing.
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\33\ Indeed, of the 10 largest private equity firms worldwide,
only one--Goldman Sachs--is a U.S. bank. Bernstein Research, supra note
13, at 3.
\34\ Private Equity Council, supra note 28, at 1-8.
\35\ Bernstein Research, supra note 13, at 3.
Proprietary Investment in Private Equity as a Percentage of Trading and Other Assets (Q3 2009)\36\ ($ millions)
----------------------------------------------------------------------------------------------------------------
Proprietary PE Investment %
Investment in Trading and Other of Trading and
Private Equity Assets Other Assets
----------------------------------------------------------------------------------------------------------------
Bank of America.......................................... $13,500 $280,000 4.8%
Goldman Sachs............................................ $12,480 $381,000 3.3%
Morgan Stanley........................................... $8,500 $340,000 2.5%
JPMorgan................................................. $6,836 $351,000 1.9%
Wells Fargo.............................................. $2,771 $98,827 2.8%
Citigroup................................................ $359 $118,000 0.3%
----------------------------------------------------------------------------------------------------------------
Total................................................ $44,446 $1,568,827 2.8%
----------------------------------------------------------------------------------------------------------------
Although we have not been able to gather much data regarding bank
exposure to the hedge fund industry, \37\ the information we do have
suggests that eliminating these activities will not significantly
reduce bank risk profiles either. Analysis by Preqin shows that banks
directly invest only $10 billion (or 0.9 percent) of the total capital
invested by U.S. investors in hedge funds. \38\ In addition, banks have
fund-of-funds units that are responsible for channeling $180 billion
(or 16 percent) of all U.S. capital flowing to hedge funds. \39\ It is
unclear what percentage of this $180 billion represents banks' own
capital. But even on the implausible assumption that all of $180
billion comes from banks, it likely represents a negligible portion of
bank risk. \40\ It is far more likely that a significant portion of the
$180 billion is money that banks are managing on behalf of clients.
Managing client funds (apart from the use of seed money) generally does
not place bank capital at risk, and therefore does not implicate the
underlying rationale of the Volcker Rules. \41\
---------------------------------------------------------------------------
\36\ Private Equity Council, supra note 28.
\37\ This is a distinct topic from what we referred to in section
I.B.1 as ``internal hedge fund activity'' at banks. The focus there was
on trading activity carried out on internal trading desks that are for
a bank's own account. Here, the focus is investments banks make
directly, as limited or general partners, or indirectly, through funds
of funds products, to hedge funds established as distinct legal
entities. Some such hedge funds are managed by third-parties, while
others are managed by bank affiliates.
\38\ Preqin, supra note 28.
\39\ Id.
\40\ To provide a very rough sense of scale, as of September 2009,
Goldman Sachs and JPMorgan held assets worth approximately $882 billion
and $2.04 trillion, respectively. Goldman Sachs Group, Inc., Quarterly
Report (Form 10-Q) (Nov. 4, 2009); JPMorgan Chase and Co., Quarterly
Report (Form 10-Q) (Nov. 10, 2009).
\41\ Industry sources indicate that banks make small contributions
of ``seed money'' to new funds to get them off the ground. Even if the
Volcker Rules are enacted, the ability to make such contributions
should be preserved through de minimus carveouts.
---------------------------------------------------------------------------
In his written testimony, Deputy Secretary Wolin seemed to refer to
Bear Stearns when he wrote that ``[m]ajor firms saw their hedge funds
and proprietary trading operations suffer large losses in the financial
crisis. Some of these firms `bailed out' their troubled hedge funds,
depleting the firm's capital at precisely the moment it was most
needed.'' \42\ Although Bear Stearns later pledged $3.2 billion to
bailout Bear Stearns High-Grade Structured Credit Fund and Bear Stearns
High-Grade Structured Enhanced Leverage Fund, Bear's original principal
exposure was only $40 million. Clearly, Bear's real exposure, on a
reputational basis, exceeded its investment. The same was true for many
banks' SIVs and conduits. This problem is best addressed by FASB's new
consolidation accounting rules, FAS 166 and 167, \43\ which effectively
require banks to hold capital against these exposures. There is no need
to ban these sponsorships entirely.
---------------------------------------------------------------------------
\42\ Prohibiting Certain High-Risk Investment Activities by Banks
and Bank Holding Companies: Hearing Before the S. Comm. on Banking,
Housing and Urban Affairs, 111th Cong. 3 (Feb. 2, 2010) (statement of
Neal S. Wolin, Deputy Secretary, U.S. Dep't of the Treasury)
[hereinafter Wolin Testimony].
\43\ Fin. Accounting Standards Bd., Statement of Financial
Accounting Standard 166, Accounting for Transfers of Financial Assets,
an Amendment of FASB Statement No. 140 and Fin. Accounting Standards
Bd., Statement of Financial Accounting Standards No. 167, Amendments to
FASB Interpretation No. 46(R).
---------------------------------------------------------------------------
As the above analysis suggests, bank involvement with private
equity and hedge funds can benefit bank customers in significant ways.
Banks that sponsor or invest in private equity funds and hedge funds
are better positioned to serve their global clients, who increasingly
look to banks for ``one-stop shopping'' in financial products and
services. Given the dramatic rise in assets under management in the
private equity and hedge fund industry, \44\ it is fair to infer that
clients are particularly interested in these offerings. In addition, to
the extent that banks are permitted to continue managing funds or fund-
of-funds, allowing them to invest their own money alongside customers'
is an important way to align interests.
---------------------------------------------------------------------------
\44\ Private Equity Council, supra note 31, at 1-8; Hedge Funds
2009 (Int'l Fin. Serv. London Research), Apr. 2009, http://
www.thehedgefundjournal.com/research/ifsl/cbs-hedge-funds-2009-2-.pdf.
---------------------------------------------------------------------------
Taking a more skeptical view of the implications for customers of
bank involvement in proprietary trading as well as private equity funds
and hedge funds, Mr. Volcker recently argued that these activities
``present virtually insolvable conflicts of interest with customer
relationships, conflicts that simply cannot be escaped by an
elaboration of so-called `Chinese walls' between different divisions of
an institution.'' \45\ Mr. Volcker elaborated on this point in his
testimony before the Committee:
---------------------------------------------------------------------------
\45\ Volcker, supra note 14.
I want to note the strong conflicts of interest inherent in the
participation of commercial banking organizations in
proprietary or private investment activity. That is especially
evident for banks conducting substantial investment management
activities, in which they are acting explicitly or implicitly
in a fiduciary capacity. When the bank itself is a
``customer'', i.e., it is trading for its own account, it will
almost inevitably find itself, consciously or inadvertently,
acting at cross purposes to the interests of an unrelated
commercial customer of a bank. ``Inside'' hedge funds and
equity funds with outside partners may generate generous fees
for the bank without the test of market pricing, and those same
``inside'' funds may be favored over outside competition in
placing funds for clients. More generally, proprietary trading
activity should not be able to profit from knowledge of
customer trades. \46\
---------------------------------------------------------------------------
\46\ Prohibiting Certain High-Risk Investment Activities by Banks
and Bank Holding Companies: Hearing Before the S. Comm. on Banking,
Housing and Urban Affairs, 111th Cong. (Feb. 2, 2010) (statement of
Paul A. Volcker, Chairman, President's Economic Recovery Advisory
Board) [hereinafter Volcker Testimony].
If there is a sound justification for the Volcker Rules, it is that
they would limit systemic risk, not that they would prevent conflicts
of interest. Moreover, the issue of conflicts of interest was
considered and rejected during the repeal of Glass-Steagall. If Mr.
Volcker's contention were correct, it would be equally applicable to a
much wider range of bank activities than proprietary trading and
investment in hedge funds and private equity. It would extend to bank
involvement in the underwriting of securities, for example, where the
argument has long been made that a banker underwriting a faltering
securities offering would encourage clients to invest in the
securities. \47\ Given that there is no proposal to limit bank
underwriting, or other securities services that raise potential
conflicts, \48\ it is unclear why conflict of interest concerns justify
restricting bank investments.
---------------------------------------------------------------------------
\47\ Joseph Michael Heppt, ``An Alternative to Throwing Stones: A
Proposal for the Reform of Glass-Steagall'', 52 Brook. L. Rev. 281, 289
(1986).
\48\ In, Investment Company Institute v. Camp, 401 U.S. 617
(1971), the Supreme Court discussed several additional conflicts that
arise when commercial banking and securities services are combined.
These include that banks involved in securities activities would: (a)
lose the confidence of the public if their securities affiliates
experienced business difficulties; (b) fail to act as ``impartial
sources of credit,'' giving preference to their securities affiliates
or to borrowers that use securities services; (c) make unsound loans to
their securities affiliates or to borrowers who use their securities
services; (d) become unable to act as disinterested advisors to their
commercial banking clients; and (e) divert talent and resources to
their securities businesses.
---------------------------------------------------------------------------
II. Proposed Restrictions on the Size of Banks and other Financial
Institutions
A. Proposed Limitations on the Size of Banks
The actual operation of the size limitations is even less clear
than the meaning of the Volcker Rules on bank activity. The
Administration has referred to ``limits on the excessive growth of the
market share of liabilities at the largest firms, to supplement
existing caps on the market share of deposits.'' \49\ This appears to
mean that the size limit would apply to banks' market share of
nondeposit liabilities.
---------------------------------------------------------------------------
\49\ The White House, supra note 7.
---------------------------------------------------------------------------
Deputy Secretary Wolin's recent testimony that the ``size limit
should not require existing firms to divest operations,'' but will
instead ``serve as a constraint on future excessive consolidation among
our major financial firms,'' would appear to be addressed to market
concentration and antitrust concerns since they carry the striking
implication that no firm is currently ``Too Big to Fail.'' \50\ If
market concentration is the concern, we need to understand why existing
antitrust law is not up to the task of dealing with this problem, while
if systemic risk is the issue, it is puzzling why the size caps should
apply only to firms that grow by acquisition. Presumably we should be
concerned about the size (or the interconnectedness) of firms, whether
the result of acquisition, organic growth, or otherwise.
---------------------------------------------------------------------------
\50\ Wolin Testimony, supra note 42, at 4.
---------------------------------------------------------------------------
To the extent systemic risk is the issue, the central questions
are: (a) whether larger banks are more or less likely to fail than
smaller banks; (b) whether the failure of large banks generates higher
levels of systemic risk; and (c) whether the Administration's proposal
to cap each banks' market share of liabilities is a plausible remedy
for the problem.
If larger banks are riskier than smaller ones, the differences are
likely to be relatively minor. \51\ Studies have found that large banks
hold more diversified portfolios and are engaged in a wider range of
business, and that such diversification serves as a source of strength.
\52\ Scholars have also found that size promotes stability since it is
easier for large banks to obtain funding in the capital markets. \53\
On the other hand, larger banks tend to use size advantages to make
riskier loans, conduct more off-balance sheet activities, and maintain
more aggressive leverage ratios. \54\ As banks grow larger, they may
take on additional risk by becoming reliant on noninterest income and
nondeposit funding. \55\ On net, this combination of considerations may
roughly balance out.
---------------------------------------------------------------------------
\51\ Rebecca Demsetz and Philip Strahan, ``Historical Patterns and
Recent Changes in the Relationship Between Bank Holding Company Size
and Risk'', 1 Econ. Pol. Rev. 13 (July 1995); see also Rebecca Demsetz
and Philip Strahan, ``Diversification, Size, and Risk at Bank Holding
Companies'', 29 J. Money, Credit, and Banking 300, 308 (1997).
\52\ See, e.g., Rebecca Demsetz and Philip Strahan,
``Diversification, Size, and Risk at Bank Holding Companies'', 29 J.
Money, Credit, and Banking 300 (1997).
\53\ Jith Jayaratne and Donald P. Morgan, ``Capital Market
Frictions and Deposit Constraints at Banks'', 32 J. Money, Credit, and
Banking 74 (2000).
\54\ See, e.g., Demsetz and Strahan, supra note 52, at 312.
\55\ Asli Demirguc-Kunt and Harry Huizinga, ``Bank Activity and
Funding Strategies: The Impact on Risk and Return'' 29 (European
Banking Center Discussion Paper No. 2009-01, 2009).
---------------------------------------------------------------------------
Turning to the second question, the surprising fact is that we do
not know whether larger institutions pose greater systemic risk and, if
so, whether that increase is significant. As discussed above, this
question requires more data and discussion. The issue is whether larger
banks are more interconnected in such a way that their failure would
set off a chain reaction of failures. This should not be accepted on
faith.
To the extent that systemic risk does increase with ``size,'' it is
unclear that broad-brush restrictions on nondeposit liabilities are the
solution. First, the focus on liabilities ignores the fact that a
bank's riskiness is determined in large part by the assets it holds.
Some of the most prominent victims of the financial crisis failed
because of the interactions between different parts of their balance
sheets (e.g., funding risky assets with overnight loans). Second, a
bank could comply with the general liability restrictions while
maintaining risky assets. The Volcker Rules would not limit the ability
of banks to make risky loans. Thus, the somewhat smaller bank, faced
with Volcker Rules and size caps, may shift its activity to overall
higher levels of risk in search of return. As Raghuram Rajan, Professor
of Finance at the University of Chicago and author of a prescient paper
anticipating the financial crisis, \56\ recently wrote:
---------------------------------------------------------------------------
\56\ See, Raghuram G. Rajan, Fed. Res. Brd. of K.C., ``Has
Financial Development Made The World Riskier?'' (2005), http://
www.kc.frb.org/publicat/SYMPOS/2005/PDF/Rajan2005.pdf.
Crude asset size limits, for example, would probably ensure a
lot of financial activity is hidden from the regulator, only to
come back to light (and to the balance sheets) at the worst of
times. There are many legal ways to mask size. Banks can offer
guarantees to assets placed in off-balance sheet vehicles, much
like the conduits of the recent crisis. If, instead, capital is
the measure, then we will be pushing banks to economize on it
as much as possible, hardly a recipe for safety. \57\
---------------------------------------------------------------------------
\57\ Raghuram Rajan, Op-Ed., ``A better way to reduce financial
sector risk'', Fin. Times, Jan. 25, 2010.
Finally, we should consider if overall size limitations are
preferable to an approach targeted at individual institutions. It
appears that, at most, only six banking institutions would be impacted.
Assuming, for example, that a 10 percent of domestic wholesale funding
market share ceiling is imposed on U.S. banks--analogous to the deposit
market share limits already in place--Bank of America, Citigroup,
Goldman Sachs, JPMorgan Chase, and Morgan Stanley are the only
institutions that appear to approach this ceiling level. \58\ If a
higher ceiling than 10 percent wholesale funding market share is
imposed, it is possible that only the very largest domestic users of
wholesale funding--Bank of America and JPMorgan Chase, the only two
institutions with wholesale funding market shares significantly greater
than 10 percent--would be impacted. We note that beyond these six
institutions, the U.S. bank wholesale funding market is highly
fragmented; no other institution has more than a 3 percent market
share. Given that the size limitations might affect only a handful of
banks, a better policy would be to address issues at those banks
individually through better and more intense supervision.
---------------------------------------------------------------------------
\58\ This judgment is subject to some measurement error due to the
difficulty of determining the precise domicile of particular wholesale
funding sources. Apart from defining what types of nondeposit
liabilities count as wholesale funding, the specific data issue that
arises in determining U.S. wholesale funding market shares relates to
determining sources of wholesale funding. While the Federal Reserve
reports wholesale funding data for the U.S. banking system as a whole
(see, Bd. of Gov. of the Fed. Res., Assets and Liabilities of
Commercial Banks in the United States (Jan. 29, 2010), available at
http://www.federalreserve.gov/releases/h8/current/default.htm#fn21),
individual banks with significant international operations (i.e., the
six institutions mentioned above) generally do not disclose what
portions of their nondeposit funding come from U.S. versus
international sources. Thus determining the U.S.-only wholesale funding
market shares for these institutions requires making some estimates
about the proportion of wholesale funding that comes from the United
States.
---------------------------------------------------------------------------
We must also take into account that size limitations on our biggest
banks will negatively affect their global competitiveness. \59\ Size
limitations could cause U.S. banks to lose the business of their
largest and most important customers, who will prefer to work with
banks that have the capacity to address their global needs. Larger
banks and their customers also benefit from the economies of size and
scope that exist when banks are large enough to offer a wider range of
products, such as lending and derivatives. One study by an economist at
the New York Federal Reserve found that bank productivity grew more
than 0.4 percent per year during the bank merger wave of the early
1990s, \60\ while Charles Calomiris of Columbia Business School
suggests that the increasing size of banks has lowered underwriting
costs associated with accessing public equity markets by as much as 20
percent. \61\ As it is, as of the end of 2008, the United States only
had two of the 10 largest banks in the world, Bank of America (6th) and
JPMorgan Chase (9th). \62\ The world's five biggest banks are BNP
Paribas (France), Royal Bank of Scotland (U.K.), Barclays (U.K.),
Deutsche Bank (Germany), and HSBC (U.K.).
---------------------------------------------------------------------------
\59\ Charles Calomiris, Op-Ed., ``In the World of Banks, Bigger
Can Be Better'', Wall St. J., Oct. 19, 2009.
\60\ Kevin J. Stiroh, ``How did bank holding companies prosper in
the 1990s?'', 24 J. Banking and Fin. 1703 (Nov. 2000).
\61\ Calomiris, supra note 59.
\62\ Data from Capital IQ as reported in Damian Paletta and
Alessandra Galloni, Europe, U.S. Spar on Cure for Banks, Wall St. J.,
Sept. 23, 2009, available at http://online.wsj.com/article/
SB125366282157932323.html.
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In this connection, it is worth recalling that a major motivation
for the decision to repeal Glass-Steagall was the need to increase the
competitiveness of U.S. financial institutions. \63\ At the time,
Senator Proxmire noted that Glass Steagall's ``restrictions inhibit a
U.S.-based firm from offering the entire range of financial services to
both domestic and foreign customers in the United States.'' \64\
Therefore, many U.S. and foreign financial institutions were choosing
to locate offshore, where they could provide such products to foreign
clients. \65\ Furthermore, although U.S. banks had expertise as
underwriters through offshore activity, they could not achieve the
economies of scale attainable through underwriting domestically. \66\
Any limitation on U.S. bank activities that did not extend to foreign
banks would be damaging to their future profitability.
---------------------------------------------------------------------------
\63\ Comm. on Capital Mkts. Reg., supra note 1.
\64\ 134 Cong. Rec. S3,382 (1988) (statement of Sen. Proxmire).
\65\ Id. at S3,385 and S3,382.
\66\ Id. at S3,382.
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B. Proposed Limitations on the Size of Other Financial Institutions
To the extent that the proposed rules regarding nondeposit
liability market share addresses financial institutions other than bank
holding companies, it is important to consider the potential impact on
four additional groups. First, there are a number of U.S. wholesale-
funded lending businesses--most notably credit card lenders and nonbank
commercial lenders--that are not typically grouped with banks in
regulatory discussions. Many of the largest of these lending businesses
are subsidiaries of bank holding companies. Of those that are not bank
holding company subsidiaries, although some are large within the
context of their narrowly defined business segments (credit carding
lending, etc.), even the largest have modestly sized wholesale funding
bases compared to the largest bank holding companies. In credit cards,
for example, American Express and Capital One Financial (the largest
pure-play card lenders by wholesale liabilities) have only 3 percent
and 1 percent wholesale funding market shares, respectively. \67\
Similarly, GMAC and CIT, the largest wholesale-funded commercial
lending businesses have only 4.5 percent and 2.2 percent nondeposit
liability market shares, respectively. \68\ Though the precise details
on the proposed wholesale funding limits are not yet available, it is
hard to imagine that the market share ceiling would be set low enough
to impact even the largest of these lenders.
---------------------------------------------------------------------------
\67\ See, American Express, Financial Supplements (Q4 2009) and
Capital One, Financial Supplements (Q4 2009).
\68\ See, GMAC, Quarterly Report (Form 10-Q) (Nov. 4, 2009) and
CIT, Quarterly Report (Form 10-Q) (Nov. 7, 2009). Note that even before
its bankruptcy, at the end of 2008, CIT's nondeposit liability market
share was only slightly higher, at 2.5 percent.
---------------------------------------------------------------------------
Second, a number of U.S. insurance companies also have sizable
balance sheets, with ostensibly sizable nondeposit liability bases.
Although these large liability bases may seem to place insurers within
the purview of the proposed liability size restrictions, the size caps
are unlikely to apply to these institutions for two reasons: (1)
insurers in general simply do not rely heavily on wholesale funding as
part of their business models--the majority of the large funding bases
of these institutions consists of expected future benefits or actuarial
estimates of unpaid claims (classic insurance ``float'' funding that
appears to fall outside the definition of the funding targets) \69\ and
(2) as the last crisis has shown, the riskiest insurance institutions,
like AIG, suffered primarily from underwriting risk--much of which was
opaquely held in off-balance sheet vehicles--not from funding risk per
se.
---------------------------------------------------------------------------
\69\ As examples, consider leading insurer Metlife's balance
sheet--though its liability base is roughly 70 percent of Morgan
Stanley's, its wholesale funding base is only 10 percent of Morgan
Stanley's. Put differently, if Metlife were a bank holding company it
would have a U.S. nondeposit liability funding market share of only
about 2 percent. See, Metlife, Quarterly Report (Form 10-Q) (Nov. 4,
2009) and Morgan Stanley, Financial Supplement (Q4 2009).
---------------------------------------------------------------------------
Third, there are money market mutual funds that as of the week
ended January 27, had assets totaling $3.218 trillion. \70\ The five
largest money market fund families managed roughly 15 percent
(Fidelity), 11 percent (JPMorgan), 8 percent (Federated), 7 percent
(Blackrock) and 6 percent (Dreyfus) of this amount. \71\ Since even the
largest money market fund family does not have a dominant share of the
market, and there are numerous fund families with substantial levels of
assets under management, the case for capping the size of money market
mutual funds based purely on market concentration of liabilities
appears weak.
---------------------------------------------------------------------------
\70\ Inv. Co. Inst., Money Market Mutual Fund Assets (Jan. 28,
2010), available at http://www.ici.org/research/stats/mmf/mm_01_28_10.
\71\ Crane Data, Largest Money Fund Managers, Dec. 21, 2009,
available at http://www.cranedata.us.
---------------------------------------------------------------------------
Fourth, though GSEs are not bank holding companies, the largest
GSEs use sufficient wholesale funding to make them worth discussing
here. Freddie Mac and Fannie Mae each have roughly $800 billion in
wholesale funding, an amount that dwarfs the domestic wholesale funding
requirements of all bank holding companies, except that of Bank of
America whose wholesale funding is slightly over $1 trillion. \72\
Given these very large nondeposit liability requirements--together
these two GSEs use more wholesale funding than half of the entire U.S.
bank holding company total--excluding them from any new size
restrictions would seem highly inconsistent with the treatment of
banks.
---------------------------------------------------------------------------
\72\ See, Freddie Mac, Quarterly Report (Form 10-Q) (Nov. 6,
2009); Fannie Mae, Quarterly Report (Form 10-Q) (Nov. 5, 2009); Bank of
America Corp., Quarterly Report (Form 10-Q), at 4 (Nov. 7, 2009).
---------------------------------------------------------------------------
In concluding the discussion of liability size restrictions, it is
important to keep in mind that regardless of the liability size of any
bank or nonbank financial institution, the proposed rules fail to
address the more fundamental issue that nondeposit liability market
share is not a good proxy for an institution's broader systemic risk.
Even if a commercial lender or an insurer does not rely on systemically
large amounts of wholesale funding, the interconnectedness of these and
similar institutions could ultimately make them ``Too Big to Fail.''
Any set of new regulations designed to reduce systemic risk must focus
not just on the size of institutions' wholesale liabilities, but also
on institutions' connections with the broader financial system.
III. There Has Been a Lack of International Coordination in the Newest
Proposals
Up to this point, the Obama administration wisely and appropriately
has been careful to coordinate its regulatory reform recommendations
with international efforts. In the Treasury White Paper, the
Administration stressed the importance of international coordination
stating, ``The United States is playing a strong leadership role in
efforts to coordinate international financial policy through the G-20,
the Financial Stability Board, and the Basel Committee on Banking
Supervision. We will use our leadership position in the international
community to promote initiatives compatible with . . . [U.S.] domestic
regulatory reforms.'' \73\ Regrettably, this has not been the case with
the Volcker Rules or size limitations.
---------------------------------------------------------------------------
\73\ Treasury White Paper, supra note 2, at 80.
---------------------------------------------------------------------------
Based on the initial reaction from international financial and
regulatory bodies, we are far from reaching consensus on this issue.
Speaking at the Davos economic summit, Dominique Strauss-Kahn--head of
the International Monetary Fund--highlighted the lack of international
cooperation behind President Obama's proposed banking reforms saying,
``The question of coordinating the financial reform is key and I'm
afraid we're not going in that direction.'' \74\ The Financial
Stability Board says that the proposals are ``amongst the range of
options and approaches under consideration'' and that a ``mix of
approaches will be necessary to address the [`Too Big to Fail']
problem,'' \75\ hardly an endorsement. And earlier this week, the
Deputy Director-General of the European Commission's internal market
and services division, David Wright, said he was surprised the U.S. had
taken a radical line on the structure of banking without first
consulting European leaders--especially in light of U.S. discontent
last year when the European Commission took the lead on securitization
and credit rating agency reforms. \76\ Wright added that it might be
difficult to find the right definition of ``proprietary trading'' to
satisfy the Obama administration's goals without inflicting unintended
consequences on the industry, emphasizing that Europe traditionally
prefers to reform processes rather than change bank structure. \77\
---------------------------------------------------------------------------
\74\ Simon Carswell, ``IMF Head Calls for Financial Reform'',
Irish Times, Jan. 30, 2010, available at http://www.irishtimes.com/
newspaper/breaking/2010/0130/breaking13.htm.
\75\ Press Release, Fin. Stability Bd., ``FSB Welcomes U.S.
Proposals for Reducing Moral Hazard Risks'' (Jan. 22, 2010), http://
www.financialstabilityboard.org/press/pr_100122.pdf.
\76\ Joel Clark, ``EC Says Obama Prop Trading Plans Would Be
`Difficult' to Implement'', Risk Magazine, Feb. 1, 2010, available at
http://www.risk.net/risk-magazine/news/1589763/ec-obama-prop-trading-
plans-difficult-implement.
\77\ Id.
---------------------------------------------------------------------------
National leaders have also emphasized the need for a coordinated
approach. French President Nicolas Sarkozy stressed that all regulation
concerning banks should be dealt with at an international level,
coordinated by the G-20. \78\ Sarkozy called the current crisis a
``crisis of globalization itself,'' urging broad coordination of
regulation and accounting rules. \79\ In Germany, the Finance Ministry
merely referred to the President's proposals as ``helpful
suggestions,'' with Chancellor Angela Merkel stating that her
Government will offer its own proposal to prevent G-20 banks from
getting too big or interconnected. \80\
---------------------------------------------------------------------------
\78\ Katrin Benhold, At Davos, Sarkozy Calls for Global Finance
Rules, N.Y. Times, Jan. 27, 2010, available at http://www.nytimes.com/
2010/01/28/business/global/28davos.html.
\79\ Id.
\80\ Andrea Thomas, 2nd Update: Germany: Need International Review
of Obama Plan, Wall St. J., Jan. 22, 2010, available at http://
online.wsj.com/article/BT-CO-20100122705666.html?mod=WSJ-World-
MIDDLEHeadlinesEurope.
---------------------------------------------------------------------------
As Mr. Volcker asserted in his testimony before this Committee on
Tuesday:
A strong international consensus on the proposed approach would
be appropriate, particularly across those few nations hosting
large multinational banks and active financial markets. The
needed consensus remains to be tested. However, judging from
what we know and read about the attitude of a number of
responsible officials and commentators, I believe there are
substantial grounds to anticipate success as the approach is
fully understood. \81\
---------------------------------------------------------------------------
\81\ Volcker Testimony, supra note 46.
In his appearance before the Committee, Mr. Volcker added that
London was the other financial center whose acceptance of the Volcker
Rules would be critical. Yet Prime Minister Gordon Brown of the United
Kingdom, while welcoming the suggestion, stated the U.K. should
consider similar rules only if there is an international agreement.
\82\ The U.K.'s Chancellor of the Exchequer, Alistair Darling,
expressed concerns that separating banks does not solve the problem
posed by interconnectivity. \83\ To the extent there is a solution, he
noted that ``everything we do has to be a global solution otherwise we
will get arbitrage.'' \84\ Such comments are anything but an
endorsement.
---------------------------------------------------------------------------
\82\ Terence Roth and Laurence Norman, Europe Divided of U.S. Bank
Proposal, Seeks global Pact, Wall St. J., Jan. 22, 2010, available at
http://online.wsj.com/article/
SB10001424052748704509704575018622712047044.html?mod=WSJ-Markets-
LEFTTopNews.
\83\ Philip Aldrick, Alistair Darling Dismisses Obama's Plan to
Break Up Banks as Ineffective, Telegraph, Jan. 28, 2010, available at
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/
7093796/Alistair-Darling-dismisses-Obama-plan-to-break-up-banks-as-
ineffective.html.
\84\ Id.
---------------------------------------------------------------------------
IV. The Perlmutter-Miller and Kanjorski Amendments Suggest a Preferable
Approach
If Congress were to conclude that bank activities and the size of
financial companies were a problem, the Perlmutter-Miller and the
Kanjorski Amendments to the House Bill are better solutions than the
Volcker Rules and size limitations.
The Perlmutter-Miller Amendment would allow the Federal Reserve
Board (Board) to prohibit a systemically important financial holding
company that is subject to stricter prudential supervision from
engaging in all proprietary trading activities when the Board finds
that trading activities threaten the safety and soundness of such
company or of the U.S. financial system. \85\ The Amendment defines
``proprietary trading'' broadly, as ``trading of stocks, bonds,
options, commodities, derivatives, or other financial instruments with
the company's own money and for the company's own account.'' \86\
However, the Board has the flexibility to ban certain forms of
proprietary trading at a company without putting an end to all of
company's proprietary trading activities. Instead, the Board can exempt
proprietary trading activities that are ``ancillary to other operations
of the company'' and do not pose a threat to the company or U.S.
financial stability, provided they are carried on for the purpose of
making a market in securities issued by the company, hedging or
managing risk or other purposes permitted by the Board. \87\ While it
would be preferable to extend this exemption to market making in a
broader range of securities, allowing the Board to address proprietary
trading at individual institutions and to distinguish between different
trading activities is a better approach than the Volcker Rules.
---------------------------------------------------------------------------
\85\ H.R. 4173, 111th Cong. 1117(a) (2009).
\86\ Id. 1117(e).
\87\ Id. 1117(b).
---------------------------------------------------------------------------
If the Perlmutter-Miller Amendment is a better way of addressing
proprietary trading, the Kanjorski Amendment is a better solution to
the broader problem of all activities and size. \88\ The Kanjorski
Amendment would allow a new Financial Services Oversight Council to
require ``mitigatory actions'' whenever an individual firm that has
been subject to stricter prudential supervision is deemed to pose a
``grave threat to the financial stability or economy of the United
States.'' \89\ The Amendment anticipates that such a threat could arise
from a wide range of sources--including the amount and nature of a
company's financial assets and liabilities, off-balance sheet
exposures, reliance on leverage, interconnectedness with other firms,
the company's importance as a source of credit for households and
businesses and the scope of its activities. \90\ It considers a wide
range of remedies: requiring the institutions to terminate one or more
of its activities; restricting its ability to offer financial products;
and requiring the firm to sell, divest or otherwise transfer business
units, branches, assets or off balance sheet items. \91\ Firms that are
subject to mitigatory actions have the right to a hearing \92\ and can
seek judicial review if such actions are imposed on an arbitrary or
capricious basis. \93\
---------------------------------------------------------------------------
\88\ Id. 1105.
\89\ Id. 1105(a).
\90\ Id. 1105(c).
\91\ Id. 1105(d)(1).
\92\ Id. 1105(e)(1).
\93\ Id. 1105(h).
---------------------------------------------------------------------------
I am not endorsing these amendments but do believe they are
preferable to the Volcker Rules and size limitations.
Thank you and I look forward to your questions.
______
PREPARED STATEMENT OF BARRY L. ZUBROW
Chief Risk Officer and Executive Vice President, JPMorgan Chase and Co.
February 4, 2010
Good morning Chairman Dodd, Ranking Member Shelby, Members of the
Committee. My name is Barry Zubrow, and I am the Chief Risk Officer and
Executive Vice President of JPMorgan Chase and Co. Thank you for the
opportunity to appear before the Committee today to discuss the
Administration's recent proposals to limit the size and scope of
activities of financial firms.
While the history of the financial crisis has yet to be written
conclusively, we know enough about the causes--poor underwriting, too
much leverage, weak risk management, excessive reliance on short-term
funding, and regulatory gaps--to recognize that we need substantial
reform and modernization of the regulatory structure for financial
firms. Our current framework was patched together over many decades;
when it was tested, we saw its flaws all too clearly.
We at JPMorgan Chase strongly support your efforts to craft and
pass meaningful regulatory reform legislation that will provide clear,
consistent rules for our industry. It is our view that the markets and
the economy reflect continued uncertainty about the regulatory
environment. I believe that economic recovery would be fostered by
passage of a bill that charts a course for strong, responsible economic
leadership from U.S. financial institutions. However, the details
matter a great deal, and a bill that creates uncertainty or undermines
the competitiveness of the U.S. financial sector will not serve our
shared goal of a strong, stable economy.
At a minimum, reform should establish a systemic regulator
responsible for monitoring risk across our financial system. Let me be
clear that responsibility for a company's actions rests solely with the
company's management. However, had a systemic regulator been in place
and closely watching the mortgage industry, it might have identified
the unregulated pieces of the mortgage industry as a critical point of
failure. It might also have been in a position to recognize the one-
sided credit derivative exposures of AIG and the monoline insurers.
While it may be unrealistic to believe that a systemic regulator could
prevent future problems entirely, such a regulator may be able to
mitigate the consequences of some failures and prevent them from
collectively becoming catastrophic.
As we at JPMorgan Chase have stated repeatedly, no firm--including
our own--should be too big to fail. The goal is to regulate financial
firms so they don't fail; but when they run into trouble, all firms
should be allowed to fail, regardless of their size or interconnections
to other firms.
To ensure that this can happen--especially in times of crisis--
regulators need enhanced resolution authority to wind down failing
firms in a controlled way that does not put taxpayers or the broader
economy at risk. Such authority can be an effective mechanism that
makes it absolutely clear that there is no financial safety net for
managements or shareholders.
Under such a system, a failed bank's shareholders should lose their
investments; unsecured creditors should be at risk and, if necessary,
wiped out. A regulator should be able to terminate management and
boards and liquidate assets. Those who benefited from mismanaging risks
or taking on inappropriate risk should feel the pain. Other aspects of
the regulatory system also need to be strengthened--including consumer
protection, capital standards and the oversight of the OTC derivatives
market--but I emphasize systemic risk regulation and resolution
authority specifically because they provide a useful framework for
consideration of the most recent proposals from the Administration.
Restrictions on Proprietary Trading and Bank Ownership of Private
Equity and Hedge Funds
Two weeks ago, the Administration proposed new restrictions on
financial firms. The first would prohibit banks from ``owning,
investing in or sponsoring a hedge fund or a private equity fund, or
proprietary trading operations'' that are not related to serving
customers. The new proposals are a divergence from the hard work being
done by legislators, central banks and regulators around the world to
address the root causes of the financial crisis and establish robust
mechanisms to properly regulate systemically important financial
institutions.
While there may be valid reasons to examine these activities, there
should be no misunderstanding: the activities the Administration
proposes to restrict did not cause the financial crisis. In no case
were bank-held deposits threatened by any of these activities. Indeed,
in many cases, those activities diversified financial institutions'
revenue streams and served as a source of stability. The firms that
failed did so largely as a result of traditional lending and real
estate-related activities. The failures of Wachovia, Washington Mutual,
Countrywide, and IndyMac were due to defaulting subprime mortgages.
Bear Stearns, Lehman, and Merrill Lynch were all damaged by their
excessive exposure to real estate credit risk.
Further, regulators currently have the authority to ensure that
risks are adequately managed in the areas the Administration proposes
to restrict. Regulators and capital standards-setting bodies are
empowered, and must utilize those powers, to ensure that financial
companies of all types are appropriately capitalized at the holding
company level (as we are at JPMorgan Chase).
While bank holding companies may engage in proprietary trading and
own hedge funds or private equity firms, comprehensive rules are in
place that severely restrict the extent to which insured deposits may
finance these activities. And regulators have the authority to examine
all of these activities. Indeed, existing U.S. rules require that firms
increase the amount of capital they hold as their private equity
investments increase as a percentage of capital, effectively
restraining their private equity portfolios.
While regulators have the tools they need to address these
activities in bank holding companies, we need to take the next logical
step of extending these authorities to all systemically important firms
regardless of their legal structure. If the last 2 years have taught us
anything, it is that threats to our financial system can and do
originate in nondepository institutions. Thus, any new regulatory
framework should reach all systemically important entities--including
investment banks--whether or not they have insured deposit-based
business; all systemically important institutions should be regulated
to the same rigorous standard. If we leave outside the scope of
rigorous regulation those institutions that are interconnected and
integral to the provision of credit, capital and liquidity in our
system, we will be right back where we were before this crisis began.
We will return to the same regime in which Bear Stearns and Lehman
Brothers both failed and other systemically important institutions
nearly brought the system to its knees. We cannot have two tiers of
regulation for systemically important firms.
As I noted at the outset, it is also very important that we get the
details right. Thus far, the Administration has offered few details on
what is meant by ``proprietary trading.'' Some traditional bank holding
company activities, including real estate and corporate lending, expose
these companies to risks that have to be managed by trading desks. Any
individual trade, taken in isolation, might appear to be ``proprietary
trading,'' but in fact is part of the mosaic of serving clients and
properly managing the firm's risks. Restricting activities that could
loosely be defined as proprietary trading would reduce the safety and
soundness of our banking institutions, raise the cost of capital
formation, and restrict the availability of credit for businesses,
large and small--with no commensurate benefit in reduced systemic risk.
Similarly, the Administration has yet to define ``ownership or
sponsorship'' of hedge fund and private equity activities. Asset
managers, including JPMorgan Chase, serve a broad range of clients,
including individuals, universities, and pensions, and need to offer
these investors a broad range of investment opportunities in all types
of asset classes. In each case, investments are designed to meet the
specific needs of the client.
Our capital markets rely upon diversified financial firms equipped
to meet a wide range of financing needs for companies of all sizes and
at all stages of maturity, and the manner in which these firms are
provided financing is continually evolving in response to market
demand. Codifying strict statutory rules about which firms can
participate will distort the market for these services--and result in
more and more activities taking place outside the scope of regulatory
scrutiny. Rather, Congress should mandate strong capital and liquidity
standards, give regulators the authority they need to supervise these
firms and activities, and conduct rigorous oversight to ensure
accountability.
While we agree that the United States must show leadership in
regulating financial firms, if we take an approach that is out of sync
with other major countries around the world without demonstrable risk-
reduction benefits, we will dramatically weaken our financial
institutions' ability to be competitive and serve the needs of our
clients. Asset management firms (including hedge funds and private
investment firms) play a very important role in today's capital
markets, helping to allocate capital between providers and users. The
concept of arbitrarily separating different elements of the capital
formation process appears to be under consideration only in the U.S.
Forcing our most competitive financial firms to divest themselves of
these business lines will make them less competitive globally, allowing
foreign firms to step in to attract the capital and talent now involved
in these activities. Foreign banks will gain when U.S. banks cede the
field.
Concentration Limits
The second of the recent Administration proposals would limit the
size of financial firms by ``growth in market share of liabilities.''
Again, while the Administration has not provided much detail, the
proposal appears to be based on the assumption that the size of
financial firms or concentration within the financial sector
contributed to the crisis.
If you consider the institutions that failed during the crisis,
some of the largest and most consequential failures were stand-alone
investment banks, mortgage companies, thrifts, and insurance
companies--not the diversified financial firms that presumably are the
target of this proposal. It was not AIG's and Bear Stearns' size but
their interconnection to other firms that prompted the Government to
step in. In fact, JPMC's capabilities, size, and diversity were
essential to our withstanding the crisis and emerging as a stronger
firm--and put us in a position to acquire Bear Stearns and Washington
Mutual when the Government asked us to. Had we not been able to
purchase these companies, the crisis would have been far worse.
With regard to concentration specifically, it is important to note
that the U.S. financial system is much less concentrated than the
systems of most other developed nations. Our system is the 2nd least
concentrated among OECD countries, just behind Luxembourg; the top 3
banks in the U.S. held 34 percent of banking assets in 2007 vs. an
average for the rest of the OECD of 69 percent.
An artificial cap on liabilities will likely have significant
negative consequences. For the most part, banks' liabilities and
capital support the asset growth of its loan and lending activities. By
artificially capping liabilities, banks may be incented to reduce the
growth of assets or the size of their existing balance sheet, which in
turn would restrict their ability to make loans to consumers and
businesses, as well as to invest in Government debt. Capping the scale
and scope of healthy financial firms cedes competitive ground to
foreign firms and to less regulated, nonbank financial firms--which
will make it more difficult for regulators to monitor systemic risk. It
would likely come at the expense of economic growth at home. No other
country in the world has a Glass-Steagall regime or the constraints
recently proposed by the Administration, nor does any country appear
interested in adopting one. International bodies have long declined to
embrace such constraints as an approach to regulatory reform.
Conclusion
We have consistently endorsed the need for meaningful regulatory
reform and have worked hard to provide the Committee and others with
information and data to advance such reform. We agree that it is
critically important to eliminate any implicit financial ``safety net''
by assuring appropriate capital standards, risk management and
regulatory oversight on a consistent and cohesive basis for all
financial firms, and, ultimately, having a robust regime that allows
any firm to fail if it is mismanaged.
While numerical limits and strict rules may sound simple, there is
great potential that they would undermine the goals of economic
stability, growth, and job creation that policymakers are trying to
promote. The better solution is modernization of our financial
regulatory regime that gives regulators the authority and resources
they need to do the rigorous oversight involved in examining a firm's
balance sheet and lending practices. Effective examination allows
regulators to understand the risks institutions are taking and how
those risks are likely to change under different economic scenarios.
It is vital that policymakers and those with a stake in our
financial system work together to overhaul our regulatory structure
thoughtfully and well. Clearly such work needs to be done in harmony
with other countries around the world. While the specific changes
required by reform may seem arcane and technical, they are critical to
the future of our whole economy. We look forward to working with the
Committee to enact the reforms that will position our financial
industry and economy as a whole for sustained growth for decades to
come.
Thank you.