House Holds Hearing on Systemic Risk

By W. Bernard Mason

On July 21, 2009 the House Financial Services Committee heard testimony on systemic risk and issues surrounding the concept of “too big to fail”. Appearing as witnesses were: Alice Rivlin, Senior Fellow, Brookings Institution; Peter Wallison, Fellow, American Enterprise Institute; Simon Johnson, Professor, Massachusetts Institute of Technology; Mark Zandi, Chief Economist, Moody’s Economy.com, and Paul Mahoney, Dean, University of Virginia School of Law.

Committee Chairman Barney Frank opened the hearing by stating that he believes no one favors the concept of “too big to fail”, but there seems to be no consensus on what to do about it. He observed that it seemed to be much more easily denounced than dismantled. He said this hearing was not meant as a step toward structuring an approach for government “bail outs”, but instead is part of an effort to avoid the situation faced by the Bush Administration that had no alternative beyond providing government funding to large entities whose failures posed a risk to our financial system.

Ms. Rivlin began her prepared remarks by observing there is no permanent fix to this problem. She said we need some government entity charged with looking continuously at the regulatory system and markets and at whatever perverse incentives may have crept into the system, because whatever rules are adopted will become obsolete as financial innovation progresses and market participants find their way around the rules. She pointed out that the Administration makes a case for such an institution and places the responsibility with a new oversight council. She said this seems to be a cumbersome mechanism and she believes this type of responsibility should be given to the Federal Reserve. She believes this would actually enhance the Fed’s effectiveness as the central bank. Conversely, she believes designating the Federal Reserve as the consolidated regulator for systemic risk would be a mistake. She believes designating systemically important entities and giving them their own regulator would institutionalize “too big to fail” and create a new GSE-like class of institutions. Higher capital requirements and stricter regulation for these entities makes sense, but without granting them their own regulator.

Mr. Wallison stated that, if there is an entity that is "too big to fail", it can only be a large commercial bank. He said in order to be "too big to fail", its collapse must have a major adverse effect on the entire economy – not simply a mere disruption. In his view, only the failure of a large commercial bank could cause this kind of systemic breakdown. He said it would be difficult to see how a large, non-bank institution (bank holding company, securities firm, finance company, hedge fund, etc.,) can cause systemic risk and thus, be too big to fail. He pointed out that these entities do not hold deposits, and if they fail, their creditors do not suffer any immediate cash losses that would make it difficult to pay their bills. No household or business operating funds are placed with these companies. Further, he believes the freeze in lending that followed the Lehman Brothers collapse has led some to believe that Lehman caused that event. In his view, Lehman’s failure did not cause this systemic problem – it caused what he termed a “common shock” where a market freezes up because new information has come to light. This new information was the fact that the government was not going to rescue every firm larger than Bear Stearns. In this new light, every market participant had to re-evaluate the risks of lending to everyone else. He said it is no wonder lending ground to a halt. He said the government’s focus should be on keeping commercial banks sound and healthy; all other entities should be viewed as risk-takers and should be allowed to fail. He recommends that capital requirements for large banks be increased as the banks get larger. Higher capital requirements will cause banks to reconsider whether growth for its own sake really makes sense. He said regulators should develop indicators of risk-taking that banks should be required to publish regularly. Also, Congress should establish a “systemic risk council” consisting of all the bank supervisors and other financial regulators, and it should be charged with spotting conditions in the banking industry (like the acquisition of “toxic” assets) that might make all major banks weak or unstable. He said if we keep our banks stable, we will keep our financial system stable. He concluded by saying that, as a member of the Financial Crisis Inquiry Commission, he would urge Congress to wait until the Commission has delivered its report before adopting legislation.

Mr. Johnson said the issue before us is simple: we must avoid the situation where a large entity comes before the government and says "either you bail us out, or the system will collapse". He believes there are two ways to address this problem: (1) change the regulatory and bankruptcy system; and (2) reduce the size of the institutions. He does not believe the first approach will solve the fundamental problem. He said the banking system has been very persuasive in convincing itself and others (investors, regulators, Congress) that it knows how to manage risks. He pointed out that Alan Greenspan admits it was a mistake to believe that, because banks had a great deal to lose if things went bad, they understood these risks and would control and manage them – they didn’t. This was a failure of risk management, and Mr. Johnson said he sees no evidence either that the banks have improved their management of risk or that regulators have become better at spotting such a problem. He agrees that some sort of systemic risk oversight entity is desirable, but it seems we are a long way from achieving that. He believes the best approach is ratcheting up capital requirements and deposit insurance assessments as entities grow larger. He said the country has encountered massive costs in our efforts to forestall another depression, and the result has been concentration of more power and influence by these larger entities. He observed that, for this cost, we have bought nothing in terms of actually improving the financial system.

Mr. Zandi said, overall, the Administration’s plan is reasonable and well-designed. He believes the Federal Reserve is the right choice for systemic risk regulator. However, he doesn’t see the proposed new regulatory council as providing any value beyond what is already in place. He said the crisis has shown an uncomfortably large number of institutions are too big to fail. He understands the desire to break up these entities, but he believes such efforts would be futile. Breaking up large institutions would be too wrenching and would put U.S. institutions at a distinct disadvantage relative to their large, global competitors. He said large institutions are also needed to back-stop the rest of the financial system. He believes it is better to provide tighter regulation of these entities, with higher capital and liquidity requirements, greater disclosure requirements and higher deposit insurance premiums commensurate with the risks they take and present.

Mr. Mahoney described the Administration’s proposed systemic risk resolution structure as a "bail out" mechanism. He said there are two schools of thought on how to best prevent future financial crises leading to wide-scale bailouts. The first says it was wrong to bail out creditors of failed institutions so that they avoided losses they otherwise would have realized in a normal bankruptcy proceeding and the policy going forward should not be repeated. The second concedes that the government will ordinarily bail out large, systemically important entities. Under this approach, Congress should seek to limit the risks those institutions can take in order to minimize the likelihood that they will become financially distressed, because failure would result in a bail out as a matter of course. This is the Administration’s approach. Mr. Mahoney believes the first approach will produce a healthier financial services industry that will make fewer claims on taxpayers in the future. It is based on a sounder premise – that the best way to reduce moral hazard is to ensure that economic agents bear the costs of their own mistakes. He said the Administration’s plan suggests that regulatory oversight will compensate for misaligned incentives. This position is based on the premise that some institutions are too big to fail. Mr. Mahoney says it is not clear that the magnitude of this problem justifies the scale of the government intervention that we have seen in the past year. He believes bankruptcy is a more appropriate mechanism to deal with these failures, although he admits that the bankruptcy system may need to be refined and enhanced. The other approach furthers moral hazard that impacts the industry continuously, not just in times of crisis. He said that is because perceived systemically important firms ultimately do not pay a sufficient price for taking risks. The result is a dangerous feedback loop: large banks have access to cheap capital, which causes them to grow even larger and more systemically important while taking excessive risks. This all results in the higher probability of a crisis, thus a bailout regime leads to more frequent crises. He disagrees with the Administration’s premise that the higher requirements and regulatory scrutiny proposed for Tier 1 Financial Holding Companies reduces a firm’s desire to be so designated. He believes that the implicit "too big to fail" designation will cause firms to desire inclusion within such a designation. He believes that the Administration’s conclusion that the imposition of higher capital and liquidity requirements on these firms will increase their cost of capital is "wildly optimistic". Firms with an implicit government guarantee will have a valuable commodity to sell, he stated. They will have a powerful incentive to find financial products, off-balance sheet devices, and any other means to evade any limits on the risks they can purchase from others in the financial system.

Chairman Frank made it clear that there will be no official designation of any entities as Tier 1 Financial Holding Companies or any hard and fast rules or criteria for otherwise identifying systemically important firms. He said each case will be unique and will have to be judged independently. There will be no official list of systemically important entities. He said he believes the Administration now sees the weakness in the originally-announced approach. Chairman Frank asked Mr. Johnson if it would be feasible to adjust deposit insurance premiums to account for the higher risks posed by these types of entities. Mr. Johnson said this would be a workable concept and would have the effect of discouraging excessive risk-taking by insured institutions.

In response to a question, Mr. Wallison observed that no one can yet agree on what systemic risk really is; therefore, we need to concentrate on ensuring the banking industry is safe and sound and not worry about extending regulation to firms outside the banking industry.

Rep. Paul Kanjorski (D – PA) asked Ms. Rivlin to clarify whether she believes the Federal Reserve should be the systemic risk regulator. She responded that she did not hold that view for two reasons: first, she does not think there should be such a separately designated regulator; and, if there were, the Fed would not “be very good at it”. Rep. Kanjorski said he agreed with that assessment. He next asked Mr. Wallison how he could possibly believe that only banks present systemic risk, when he had just witnessed what had occurred with regard to the auto industry and the ripple effect failures of those firms would have caused. Mr. Wallison said this is an example of his observation that we don’t have a firm grasp on what systemic risk really is. He viewed the auto industry situation as a “disruption”, not a crisis.

Ranking Member Spencer Bachus (R – AL) observed that several witnesses have essentially concluded that the government’s actions in the recent crisis have increased systemic risk and created a more dangerous environment. Mr. Wallison agreed. He said every time we bail out one institution, we create the belief that others will be bailed out, creating risk and moral hazard. Mr. Bachus said he believed some firms have become bigger and more politically powerful as a result of the crisis – the competition has been eliminated. He said they have no incentive to bring down the level of risk they pose. Mr. Johnson agreed with that assessment. In response to another question from Rep. Bachus, Mr. Johnson responded that the best way to deal with large firms would be to add a new chapter to the bankruptcy code that would set forth more defined procedures for unwinding a failure. Mr. Zandi disagreed, saying he didn’t think bankruptcy courts would operate quickly enough to deal with such large failures. Public confidence would be a major issue in a situation such as this.

Chairman Frank next attacked a statement in Mr. Johnson’s prepared remarks referring to the short-term measures particularly undertaken by the Obama Administration. Mr. Frank wanted to clarify that every activity now being characterized as a "bail out" was initiated by the Bush Administration (AIG, Bear Stearns, Merrill Lynch/Bank of America, General Motors, and Chrysler). He said the first proposal for a bail out that came before the Obama Administration was CIT, and they said "no".

Rep. Scott Garrett (R – NJ) noted Mr. Zandi’s statement that he would place systemic risk regulation with the Federal Reserve, and asked "why them"? Mr. Garrett pointed out the failures of the Fed in previous situations (the tech and real estate bubbles) where he noted Alan Greenspan later had said "maybe I missed that one". Mr. Garrett said if you review the minutes of the Federal Reserve meetings, there was no acknowledgement of a “bubble”; instead the Fed was viewing this as an increase in productivity. Rep. Garrett also noted the Fed’s “wrong” approach on Basel II. Further, he said the Fed had authority to raise capital requirements for Citibank and others, and did nothing. He then asked Mr. Zandi how he could possibly think the Fed was the best choice to assume this new responsibility. Mr. Zandi’s response was that the Fed was the best of a group of bad choices.

Rep. Kenny Marchant (R – TX) asked Mr. Wallison if it was true that he believed AIG was not too big to fail, and that AIG had not defaulted on its obligations. Mr. Wallison said that was true. He said AIG’s credit default swaps did not cause any losses to counterparties; the counterparties merely lost the “insurance” protection they had purchased. Mr. Wallison said, in his view, there is a lot of misinformation regarding the nature of credit default swaps suggesting that they are very dangerous. He believes they are not, and there was no need for the government to take action such as it did with AIG. He said Goldman Sachs, AIG’s largest CDS counterparty, was fully protected from loss by collateral and other measures, but he said due to AIG’s size and interconnectedness, the government mistakenly believed intervention was necessary. In response to another question from Rep. Marchant, Mr. Zandi offered his opinion that the primary cause of the crisis was the fact that the securitization process was “fundamentally broken”. He said no one in the securitization chain had a clear understanding of all the risks. He further said the securitization process has economic value and makes sense under certain circumstances, but the process got abused. Mr. Zandi then said he disagreed with Mr. Wallison regarding AIG and said it is very clear that, if AIG had failed, there would have been substantive risk to the entire system. He said “too big to fail” may refer to relationships such as counterparties, but it also relates to confidence, and had AIG failed, many other entities would have failed and the whole financial system might have collapsed.

Chairman Frank then asked if any of the panel members favored an outright limitation on the growth and size of institutions. Mr. Johnson was the only witness to favor a cap on growth.

Rep. Brad Sherman (D – CA) noted that in his view, the Administration’s systemic resolution proposal represents “permanent, unlimited TARP”. “Wall Street will love the money, government will love the power”. He said this proposal has no chance of passing in the House on a straight up-or-down vote.

In closing the hearing Chairman Frank indicated that there appeared to be consensus regarding the need to correct the problems caused by the credit rating agencies and he stated that, as part of this legislative process, any and all existing statutory mandates to rely upon the credit rating agencies will be repealed, and the Congress will instruct the regulatory agencies to examine theirs.