Today, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled "Regulating and Resolving Institutions Considered ‘Too Big to Fail’" to discuss the systemic risks associated with large and complex financial institutions, capital standards and the advantages and disadvantages of creating an alternative "resolution regime" for larger, non-bank institutions.

The following witnesses appeared before the Committee: Panel 1

  • Sheila C. Bair, Chairman, Federal Insurance Deposit Corporation
  • Gary Stern, President, Federal Reserve Bank of Minneapolis

Panel 2

  • Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute for Public Policy Research
  • Martin Baily, Senior Fellow, Economic Studies, The Brookings Institution
  • Raghuram G. Rajan, Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago Booth School of Business

In response to a question from Ranking Member Richard Shelby (R-AL), Chairman Bair said she would define an entity as "too big to fail" if, were it to run into substantial difficulty or failed, there would be "collateral systemic impact." She addressed whether these large "too big to fail" institutions that pose such systemic risk "are necessary for the efficient functioning of our financial system." She acknowledged arguments that have been advanced about why financial organizations should be allowed to become larger and more complex, including the ability to "take advantage of economies of scale and scope, diversifying risk across a broad range of markets and products, and gaining access to global capital markets." However, she pointed out that when a financial system includes a small number of large organizations, "the ability to diversify risk is diminished as market concentration rises and institutions become larger and more complex." To create a "safer financial system," Chairman Bair suggested that financial firms that pose systemic risks should be subject to regulatory and economic incentives requiring them to "hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system." In addition, she suggested "centralizing the responsibility for supervising institutions that are deemed to be systemically important" through the imposition of a "systemic risk regulator," and creating a "systemic risk council" to address issues that pose risks to the broader financial system, including "identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards."

Finally, reiterating a suggestion she has made in a recent speech, Chairman Bair suggested the creation of a "resolution regime" that would apply to any financial institution, including a non-bank institution, that becomes a source of systemic risk, rather than continuing with the "ad-hoc response" frequently employed during the current crisis. The regime she envisions would provide for an "independent" resolution entity with the power to initiate action to assist troubled financial institutions, but any final decision would "involve other affected regulators" of the financial institution. Committee Chairman Christopher Dodd (D-CT) stated that a new resolution mechanism is something "we feel very strongly about."

Mr. Stern's approach to addressing the issue of too big to fail would be to "reduce substantially the negative spillover effects stemming from the failure of a systemically important financial institution" and change the expectation that the government will "provide protection from loss" for uninsured creditors when such institutions get into financial or operational trouble. Mr. Stern's recommendations include, first, "enact[ing] reforms that make policymakers more confident that they can impose losses on creditors without creating spillovers that would justify government protection," second, "reduce[ing] the losses that failing firms can impose on other firms or markets, which helps reduce spillovers," and third, "alter[ing] payments systems to reduce their transmission of losses suffered by one firm to others." Mr. Stern stated that this "multi-faceted approach" will improve the risks associated with those intuitions that are too big to fail.

Mr. Wallison strongly disagreed with Chairman Bair's proposed new "resolution regime" for non-bank entities, asserting that the "bankruptcy system will work better." In his view, it would not be appropriate to "designate in advance" those non-bank institutions, such as insurance companies or hedge funds, as too big to fail because it will "infer important benefits" to such firms such as lower cost of funding, which "inevitably" would lead to market dominance, thereby making the likelihood of a big firm collapse "greater and each collapse more disruptive."

Messrs. Bailey and Rajan both agreed with the need for large financial institutions in order to "sustain global prosperity," however there is a need for "better capital standards" for systemically important institutions. Mr. Rajan suggested the implementation of "contingent capital" for systemically important entities. With respect to systemically important banks for example, he recommended they issue debt which would automatically convert to equity when (i) the system is in crisis, either based on an assessment by regulators or based on objective indicators such as aggregate bank losses, and (ii) the bank’s capital ratio falls below a certain value. A second option is to have systemically important levered financial institutions buy fully collateralized insurance policies that will infuse capital into these institutions when the system is in trouble.