Statement for Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection -- Hearing on 'Examining the GAO Report on Expectations of Government Support for Bank Holding Companies' Held July 31, 2014

Abstract

On July 31, 2014, the US Senate Subcommittee on Financial Institutions and Consumer Protection of the Committee on Banking, Housing and Urban Affairs held a hearing entitled "Examining the GAO Report on Expectations of Government Support for Bank Holding Companies." The hearing was related to a report of the Government Accountability Office (GAO) that became public on that day and which focused on assessing the possible funding advantage that large bank holding companies considered "too big to fail" might benefit from.

This document represents the statement (without appendices) that I submitted to accompany my testimony in this hearing. The statement discusses whether large bank holding companies can, or actually might, "fail," and, if so, how, addressing the difficulties associated with failure through bankruptcy as well as through the new FDIC-led resolution mechanism under Title II of the Dodd-Frank Act. My conclusion is that based on what we know today, it is virtually impossible, and there is clearly no way to assert that the large banking holding companies can go through either process without causing significant instability. This discussion highlights the critical importance of effective regulation of the indebtedness levels (or leverage) of these bank holding companies, which can be done through so-called capital regulation. I argue that the reform of these regulations is dangerously insufficient and flawed, thus exacerbating the problem of too-big-to-fail unnecessarily.

I discuss the basic framework of trying to estimate the subsidies associated with expectations for government support and make a set of observations on various attempts at this estimation. But I argue that the exact size of the subsidies is less relevant than the perverse and extremely distortive effects of the subsidies, which are due to the manner in which the subsidies are delivered. By enabling the institutions to borrow at terms that do not reflect appropriately the risks taken, implicit guarantees add to the distortion of a tax code that penalize equity funding relative to debt, thus encouraging and rewarding dangerous, excessive and inefficient levels of borrowing and reckless conduct. The overall effect is to widen the persistent gap between the interest of those who make decisions within the banks and what serves the broader public. I conclude with a set of urgent policy recommendations, warning that failure to take action to counter the distorted incentives puts the public at excessive risk and maintains harmful inefficiencies in the economy.

Keywords: banking regulation, too big to fail, implicit guarantees, capital regulation, living wills, Titles 1 and 2 of Dodd Frank Act, GAO report, funding subsidies

JEL Classification: G21, G28, G32, G38, H81, K23