Today, the Joint Economic Committee (“JEC”) held a hearing entitled, “Too Big Too Fail or Too Big to Save?: Examining the Systemic Threats of Large Financial Institutions.” The hearing focused on the criteria that legislators and regulators should use to determine the point at which financial institutions pose systemic risks and how regulators should handle these institutions upon failure. In her opening statements, Committee Chairman, Carolyn Maloney noted that allowing large financial institutions to fail could create a “significant threat to the financial system,” but cautioned that “unconditional support for large failing firms can be just as dangerous.” She also stated that “[i]mplicit guarantees give firms incentives to take bigger risks. Allowing firms to escape the consequences of bad business decisions could prompt even riskier behavior.” She concluded her remarks by stating that the federal regulators lack the authority to conduct an “orderly unwinding of large financial institutions,” but expressed her confidence that Congress could work with the Obama Administration to provide regulators with better tools to prevent and handle future crises.

Testifying before the Committee were:

In his remarks, Mr. Johnson articulated his belief that “a network of connections and ideology give the financial sector a veto over public policy.” To counter this, he suggested breaking up “oversized institutions” that have a “disproportionate influence on public policy.” To accomplish this he offered the following solutions: (i) bank recapitalization; (ii) forcing new private equity owners of banks to break them up; and (iii) delaying or deterring the emergence of a “new oligarchy” by placing further regulations of behavior, such as placing caps on executive compensation for all banks receiving any government assistance.

Mr. Stiglitz stated that some institutions have “grow[n] too big to fail – or, at the very least, very expensive to save. Some of them have demonstrated that they are too large to be managed.” Echoing Mr. Johnson, Mr. Stiglitz also suggested breaking up institutions and imposing more stringent regulations. Recognizing that the process of breaking up these institutions may be slow, he suggested that any new regulations should place strong restrictions on institutions that engage in risky activities. For example, he suggested: (i) that no institution should be allowed to have any off-balance sheet activities; (ii) employee incentive structures that encourage excessive risk taking and short sighted behavior should be prohibited; (iii) use of credit default swaps should be limited to exchange traded transactions and other situations where there is an “insurable risk” and (iv) there should be limits of permitted leverage and more stringent capital adequacy standards.

Mr. Hoenig expressed the view that some banks should be allowed to fail. Specifically, he suggested employing more frequently the process used to handle the 1984 failure of Continental Illinois, which at the time was one of the largest financial institutions to fail. When applying this process, at failure, instead of arranging for the sale of the failed bank’s assets to another institution through a purchase and assumption agreement, large institutions should be temporarily operated as a conservatorship or a bridge organization and then re-privatized “as quickly as is economically feasible.” He further added that, “[w]e cannot simply add more capital without a change in the firm’s ownership and management and expect different outcomes in the future.”