What makes a bank systemically important?

Chairman Brown, Ranking Member Toomey, and distinguished members of the Subcommittee, thank you for convening today’s hearing, “What Makes a Bank Systemically Important?” and thank you for inviting me to testify. I am a resident scholar at the American Enterprise Institute, but this testimony represents my personal views. My research is focused on banking, regulation, and financial stability. I have years of experience working on banking and financial policy as a senior economist at the Federal Reserve Board, as a Deputy Director at the IMF and most recently for almost ten years as Director of the FDIC Center of Financial Research where I served a three-year term as chairman of the Research Task Force of the Basel Committee on Bank Supervision. It is an honor for me to be able to testify before the subcommittee today.

I will begin with a high-level summary of my testimony:

•    There is a trade-off between financial intermediation and economic growth.  When prudential regulations reduce financial intermediation, they will restrict economic growth. The Dodd-Frank Act (DFA) does not recognize this trade-off.
•    The DFA does not define systemic risk, and this ambiguity allows regulators wide discretion to interpret new DFA powers.
•    When designated non-bank financial firms, DFA criteria is unclear. Should the firm be designated if its isolated failure causes financial instability, or is the criterion that the firm’s failure in the midst of crisis and many other financial failures will cause financial instability? These two cases represent very different standards for designation. 
•    Because DFA assigns regulators with the (impossible) task of ensuring financial stability without recognizing and limiting regulators’ ability to slow economic growth by over-regulating the financial system, DFA builds in a bias toward over-regulation of the financial system.
•    DFA gives regulators many powers to meet vague objectives.  There are few controls over the exercise of regulators’ powers and extremely limited ability to appeal regulatory decisions to judicial review. In many cases these regulatory powers can be exercised arbitrarily resulting in limiting or even canceling investor property rights without compensation or due process.
•    Designating bank holding companies larger than $50 billion for enhanced prudential supervision and regulation is arbitrary and a clear case of over regulation. 
•    The imposition of explicit enhanced prudential regulations for the largest institutions creates a two-tied system of regulation that will have long run negative implications for the structure of the financial industry.
•    The provision of enhanced prudential power to limit the use of short-term debt does not recognize that a substantial finance literature finds that the use of short-term (uninsured) debt is a method investors use to control risk-taking by borrowers. Short-term debt is cheaper, in part, because of this risk control mechanism and the imposition of binding short-term debt restrictions will lead to higher borrowing costs.
•    Mandatory Board of Governor stress tests have many negative side effects. They involve highly intrusive and detailed modeling of individual bank operations. Stress loss estimates are not the output of pure modeling exercises, but loss estimates depend to a substantial degree on judgments made by the Board of Governors.  Along with enhanced prudential regulations for the largest institutions, the stress test process creates investor perceptions that the largest institutions are too-big–to-fail.  Since the historical track record of stress-test based regulation is checkered at best, it is likely that there may be a time when the Board of Governors has the largest financial firms fully prepared for the wrong crisis.
•    A Title II resolution using the FDIC’s single point of entry (SPOE) strategy does not fix the too-big-to-fail problem.  In order to keep subsidiaries open and operating to avoid creating financial instability, in many cases, SPOE will require the extension of government guarantees that are far larger than those that would be provided under a bankruptcy proceeding and Federal Deposit Insurance Act (FDIA) resolution.
•    The Title II and SPOE create new uncertainty regarding which investors will be forced to bear losses when a bank holding company fails.
•    When Title II is used on a bank holding company because a subsidiary bank failed, it creates a conflict of interest between contributors to the deposit insurance fund and contributors to the orderly liquidation fund.
•    Title II and SPOE alter investor property rights without prior notice, compensation, or due process and with little scope for judicial protection. 
•    Contingent capital is a more attractive means for address the consequences of the distress of a large and important financial intermediary.   Its benefits are even more apparent in a crisis, when multiple financial institutions may be in distress.
•    The FDIA resolution process should be improved to avoid creating too-big-to-fail banks. Title I orderly resolution plan powers can be used to require the FDIC to plan to break up large institutions in an FDIA resolution rather than use a whole bank purchase.  This may require legislation to amend the FDIC’s least cost mandate if favor of requiring large institutions to be broken up in the resolution process even if it imposes a larger loss on the insurance fund.
•    Improvements in the FDIA resolution process can be a substitute for mandatory enhanced supervision and prudential standards that apply to many institutions that exceed the Section 165 size threshold.

What makes a bank systemically important? by American Enterprise Institute

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Paul H.
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