On July 21, the House Financial Services Committee held a hearing entitled, “Systemic Risk: Are Some Institutions Too Big to Fail and If So, What Should We Do About It?” The Committee heard testimony from the following witnesses:
- Alice M. Rivlin, Senior Fellow, Brookings Institution
- Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute
- Simon Johnson, Professor, Massachusetts Institute of Technology
- Mark Zandi, Chief Economist, Moody’s Economy.com
- Paul G. Mahoney, Dean, University of Virginia School of Law
In her opening remarks, Rep. Carolyn Maloney focused on looking at ways to prevent future risks to avoid future crises. She stated that, "[c]ompetition and innovation should be encouraged, but not to a point that potential failure causes an economic crisis."
Ms. Rivlin offered the following three reasons as to why the system failed: (i) no one was in charge of spotting the risks that could bring it down; (ii) an expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities; and (iii) large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets.
Mr. Wallison offered five solutions to deal with “too big to fail” institutions:
- creating a systemic risk council to monitor the worldwide financial system and report to Congress and the public on the possible growth of systemic risk or the factors that might produce a serious common shock;
- requiring that bank supervisors, working with banks and bank analysts to develop metrics and indicators of risk-taking that all banks would be required to publish regularly;
- requiring the largest bank to issue subordinated debt that by law could not be bailed out by the government;
- reconsidering the benefits of size by imposing higher capital requirements as banks grow above a certain level;
- regulatory requirements that would operate counter cyclically, tending to restrain bank growth when asset prices are rising and cushion bank losses when asset prices are falling; and
- allowing the systemic risk council to establish an acceptable level of bank growth and impose appropriate limits on growth that are not consistent with these limits.
Mr. Johnson suggested, among other things, the most direct way to limit the power of individual institutions is to make banks more costly to operate. This could be accomplished by requiring any or all of the following: higher capital requirements, larger insurance premiums paid to the FDIC, or caps on compensation. As the economy recovers, Mr. Johnson stated that these constraints could be tightened, thereby pushing large banks to divest themselves of standalone units. While appreciating the cost associated with breaking up banks, Mr. Johnson testified that one would need to weigh those cost against the benefits of eliminating banks that are too big to fail and stated that, “[a]nything that is ‘too big to fail’ is now ‘too big to exist.’”
Mr. Zandi’s stated that while the Obama Administration’s regulatory reform proposal is “much-needed” and “reasonable well-designed” believed that the proposal fails to “adequately identify the lines of authority among regulators and the mechanisms for resolving differences.” Although the proposed Financial Stability Oversight Council would bring the regulators together, the system would offer little change to current interagency meetings. The regulator’s inability to agree on guidance for financial institutions’ lending practices played a large role to the current crisis.
Mr. Mahoney stated his concern that the Obama Administration’s Tier 1 Financial Holding Company (FHC) structure would increase and not decrease the concentration of risks. He stated that once a firm is considered a Tier 1 FHC, other institutions will believe that it will have an implicit government guarantee. Having this implicit guarantee Tier 1 FHCs will be more attractive counterparties because risk transferred to the institution would be essentially transferred to the federal government. Mr. Mahoney also stated that Tier 1 FHC’s will have a “valuable asset (the implicit guarantee) that can sell in quantities limited only by the Fed’s oversight.” These institutions will have strong incentives to find ways to avoid “any limits on the risks they can purchase from the remainder of the financial sector.” He went on to say that banks that are not Tier 1 FHCs will have similar incentives to grow, thereby taking more risks, so that they, too, can become Tier 1 FHC’s to gain access to bailout funds. Mahoney believed that, “[a]ny institution that can keep its gains while transferring catastrophic losses to the government will find a way to engage in excessive risk-taking and expansion, and the financial system as a whole will suffer more frequent crises.”