HFSC Hearing on the Role of Capital and Liquidity
House Financial Services Committee
“Ending ‘Too Big to Fail’: What is the Proper Role of Capital and Liquidity?”
Thursday, July 23, 2015
Key Topics & Takeaways
- CoCos: Columbia University’s Calomiris proposed that banks hold contingent convertible debt (CoCos) that converts to equity when capital levels fall below 10 percent of total assets, explaining that this would give bank management a strong incentive to hold equity well above the 10 percent trigger and “virtually preclude taxpayer bailouts.”
- Impact of Capital Requirements: Rep. Luetkemeyer (R-Mo.) noted that the European Commission has launched a consultation on the impact of capital requirements on lending and the economy, and expressed support for a similar study in the U.S.
- Risk-Weighting: Rep. Rothfus (R-Pa.) asked if risk-weighting determined by the Basel Committee amounts to “credit allocation” and “managing the economy.” Michel agreed that this is a concern and said the “entire system is a mess.”
Witnesses
- Dr. Charles Calomiris, Columbia University Graduate School of Business
- Dr. Sujit Chakravorti, Managing Director and Chief Economist, The Clearing House
- Dr. John Parsons, Massachusetts Institute of Technology
- Dr. Norbert Michel, Heritage Foundation
Opening Statements
In his opening statement, Chairman Jeb Hensarling (R-Texas) noted that many people, this week, have commemorated the anniversary of the Dodd-Frank Act, whether they “celebrated or bemoaned” it. He also mentioned that an article claimed moderate Democrats have been frustrated with their leadership for not being open to making changes to Dodd-Frank, and stated that the Republican majority “stands ready” to work with them to clarify, improve, and fix the unintended consequences of the law.
Hensarling said that “regardless of what you believe to be the genesis of the crisis, capital and liquidity were insufficient.” He commented that American regulators, by adopting standards from Basel, “essentially encouraged” banks to hold mortgage backed securities and fueled financial instability by concentrating risk. Noting that banks have raised hundreds of billions in new capital since the crisis, Hensarling stated that this is “generally a good thing.” However, he was critical of “already complex standards” being made more complex and being based on models that neither market participants nor regulators understand.
Rep. Brad Sherman (D-Calif.) touted his proposed bill, H.R. 2600, the Too Big to Fail, Too Big to Exist Act , arguing that it is “not a bill supported only by socialists,” but also by 95 percent of bankers in the country. He said too big to fail (TBTF) puts smaller banks at a disadvantage, and warned that TBTF should not just be “watched” by the government, but brought to an end.
In her opening statement, Ranking Member Maxine Waters (D-Calif.) recalled that as Dodd-Frank was debated and implemented, critics warned about the consequences of capital requirements on the lending abilities of financial institution. However, she said that as requirements have gone into effect, “the world has not ended.” She credited new requirements for making the financial system safer and more resilient than ever before by setting capital and liquidity standards that ensure banks “risk their own money, not taxpayers’.”
Witness Testimony
Dr. Charles Calomiris, Columbia University Graduate School of Business
In his testimony, Calomiris said Title II of Dodd-Frank, while intended to ensure the orderly liquidation of TBTF banks, has actually institutionalized TBTF. He stressed that regulators should instead focus on preventing such banks from becoming insolvent by raising capital requirements further. He proposed that banks hold contingent convertible debt (CoCos) that converts to equity when capital levels fall below 10 percent of total assets, explaining that this would give bank management s strong incentive to hold equity well above the 10 percent trigger and “virtually preclude taxpayer bailouts.”
Calomiris also warned that real estate lending creates systemic risks because real estate risks are closely linked to the business cycle and are difficult to liquidate. He argued that the banking system’s exposure to real restate risk should be limited.
Dr. Sujit Chakravorti, Managing Director and Chief Economist, The Clearing House
Chakravorti, in his testimony, said the strength and resilience of the American banking system are essential as the modern economy relies on banks for critical intermediation functions. He then offered five observations: 1) robust capital requirements are an essential tool for financial stability as a cushion to absorb losses; 2) significant improvements have been made to bank capital since the crisis as regulators have overhauled the regulatory capital framework; 3) along with its benefits, increased capital also has costs that affect key banking activities that support the economy; 4) there is no consensus on the optimal level of capital, but there is a tradeoff between financial stability and growth; and 5) the full consequences of the new regulatory regime should be taken into account to evaluate “where we have landed” in the tradeoff.
Dr. John Parsons, Massachusetts Institute of Technology
In his testimony, Parsons said it was very interesting to hear “significant unanimity” that supervisors have substantially improved bank capital requirements to make the system safer. He agreed with Chakravorti that capital has costs, but stressed that “we are nowhere near worrying about major costs to the financial system.” He dismissed concerns that regulation has diminished liquidity in corporate bond markets, commenting that he has only seen “vague worries and phrases.” He added that any impact regulation has had should be considered “a feature, not a bug,” and that the financial system is safer with the removal of some trading activity from bank balance sheets.
Parsons defended stress tests, crediting them for being “very forward looking” and allowing regulators to “question convenient assumptions that are relatively weak.” He said the stress tests help to prepare banks and regulators by identifying major risks.
Dr. Norbert Michel, Heritage Foundation
Michel, in his testimony, said argued that risk-weighted capital requirements should be eliminated in favor of promoting market discipline as a force for financial stability. He said Basel requirements contributed to the financial crisis because regulators failed to properly measure risk and steered banks to specific assets. All the banks had similar assets, he explained, and during the crisis they suffered the same losses. He claimed that there is “no doubt” that statutory capital requirements failed, and that their whole framework is flawed.
Michel expressed that there is no reason to think Basel III will perform any better because it maintains “the same flaw” that regulators are thought to be better than markets at determining capital standards. He advocated instead for simple standards that allow markets to properly price risk, and called for a repeal of Titles I and II of Dodd-Frank to eliminate the perception of TBTF and encourage better market discipline.
Questions and Answers
Basel Process and Gold-Plating
Hensarling asked Michel if there is “any hope” that a Basel IV or V could “get it right,” or if there is systemic risk in a single world view on capital being imposed on the financial system. Michel answered that forcing the entire financial systemic into the same asset classes hurts the entire industry, and questioned how many times regulators would go through the Basel process “before we figure out we’re doing something wrong.”
Rep. Randy Neugebauer (R-Texas) pointed out that the Federal Reserve has gone beyond Basel standards with many of its regulations, including the capital surcharge. He asked if this raises concerns for U.S. competitiveness. Chakravorti answered that the Fed going “over and above” Basel requirements “certainly leaves U.S. banks at a disadvantage” to foreign competition, and that the Fed was not justified in doing this.
Contingent Convertible Debt and Market Discipline
Hensarling asked Calomiris to expand on his proposal to require that banks hold CoCos as an incentive to build a stronger capital buffer. Calomiris explained that the “basic principle is simple” and that if banks hold the true economic value of their capital above 10 percent then they would never approach a point where they need a bailout. He said the conversion of debt to equity is something that a bank CEO would never want to see happen, so the proposal puts accountability on people to replace lost capital quickly.
Calomiris further stressed that supervisors often “go along with bankers in understating losses” in times of stress, so an automatic trigger for conversion rather than one controlled by regulators would be critical.
Rep. Scott Garrett (R-N.J.) commented that until the creation of the Federal Reserve and Federal Deposit Insurance Corporation (FDIC), market discipline was the “overriding principle” in financial markets because there was no chance of a government bailout. He stated that Dodd-Frank has codified the idea of TBTF and the expectation of government bailouts.
Garrett said the part of an effective regulatory regime going forward would include ensuring that banks hold “the right type” of capital. Calomiris said his CoCo proposal is “all about” bringing market discipline back to the capital discussion. He suggested that in addition to holding 10 percent of capital in the form of equity, banks should also hold an additional 10 percent in CoCos. Michel agreed that CoCos could support market discipline.
Rep. Sean Duffy (R-Wis.) asked if the financial system has the right balance of regulation and market discipline. Calomiris responded that it does not, while Parsons argued that regulation and market discipline should not be regarded as being opposed to one another. Parsons explained that CoCos would be an example of a regulation designed to create market incentives.
Rep. Bill Foster (D-Ill.) said he was “thrilled” that there seems to be bipartisan interest in CoCos. He commented that it was difficult to adopt them during the original Dodd-Frank debates because there was no experience with them, but that Europeans have had success with them since then, especially in Switzerland. He asked what can be learned from the European experience. Calomiris noted that many people were concerned that there would be not enough of a market to by CoCos, but that they were, in fact, oversubscribed. He added that a market trigger is better than the regulator trigger because regulators cannot be relied upon to implement the trigger.
Rep. Robert Pittenger (R-N.C.) asked if the witnesses support the proposal by Sens. Sherrod Brown (D-Ohio) and David Vitter (D-La.) to raise capital requirements to 15 percent for large financial institutions. Michel said he is sympathetic to the idea of holding more capital, but that CoCos are a better idea. Calomiris similarly supported the logic behind the Brown-Vitter proposal, but touted his proposal for 10 percent equity and 10 percent CoCos as producing even more capital. Chakravorti said capital requirements require a “belt and suspenders approach,” and that regulators should look at all the different capital regulations in combination.
Impact of Capital Requirements
Waters asked if capital standards are hurting lending to consumers. Parsons replied that bank capital can still be “put to work” in purchasing assets and making loans, so the idea that capital is “immobilized” is not accurate. He denied that capital requirements are preventing banks from making loans to consumers.
Garrett asked if regulation is affecting lending in the marketplace and liquidity. Michel answered that liquidity is mainly a “supply issue” because regulations have forced banks to hold more liquid assets.
Rep. Blaine Luetkemeyer (R-Mo.) noted that the European Commission has launched a consultation on the impact of capital requirements on lending and the economy. He asked if any U.S. regulators have considered a similar study. Chakravorti said he “applauds” the decision of the European Commission, and hopes that U.S. regulators would conduct impact studies before going forward with new rulemakings.
Rep. Stephen Lynch (D-Mass.) recalled that Calomiris had admitted that there are costs associated with capital requirements, but that “we should go on anyway.” Calomiris stressed that capital requirements can have huge effects on lending to non-financial firms, but that it is worth it because it helps to avoid an “implosion” of the banking system.
Rep. Mick Mulvaney (R-S.C.) asked the witnesses for their thoughts on creating a different regulatory system where banks that are not sophisticated and do not present systemic risk can opt out of some regulatory requirements. All the witnesses agreed that this would be a sensible idea, with Calomiris saying any system where bankers are “playing with their own money” and not consumers’ would be positive.
Living Wills
Waters asked Parsons what he thought of the living will process. Parsons said the living wills are one step through which regulators and banks work together to develop “a more rational structure” that regulators can understand and that is more easily resolved. He added that much complexity remains in the system that must be “worked out.”
Fed Lending Powers
Rep. Ruben Hinojosa (D-Texas) noted that Michel has spoken against the Fed lending money during the crisis and saying it should, instead, stick to traditional open market operations to provide market liquidity. Michel explained that an ideal system would not allow the Fed to lend money directly to firms and would involve all banks in the private auction process.
Hinojosa asked if regulators should “get rid of” risk-based capital standards. Parsons answered that he sees no alternative to the government playing some role in establishing capital standards to ensure that the financial system works in times of turbulence. He said risk-weighting is just one way for public authorities to pay attention to risks at different banks.
Rep. Ed Rothfus (R-Pa.) asked if risk-weighting determined by the Basel Committee amounts to “credit allocation” and “managing the economy.” Michel agreed that this is a concern and said the “entire system is a mess.”
Swaps
Lynch commented that foreign affiliates of U.S. banks deal in uncleared swaps and then transfer the risk back deposit-backed banks in the U.S. He asked if capital requirements or stress testing could account for this risk, stating that there seems to be a “disconnect.” Parsons replied that the Federal Reserve has the authority to examine a company’s full trading in swaps, and agreed that it is a problem that some trading could somehow be covered by FDIC insurance. He said there a number of actions going on that could address this, such as capital requirements at the bank-holding company level, and that living wills could shape how risk travels across boundaries.
Rep. David Scott (D-Ga.) said the Basel regulations are a necessary means to ensure banks are properly capitalized, but expressed concern that end-user customer margin is treated punitively, as if banks are able to leverage it, even though it is required under U.S. law to be segregated from the banks’ own accounts. Parsons responded that futures commission merchants or swaps dealers are businesses that do carry risks, and customer margin is one measure to estimate the size of risk. He said it is wrong to think that there is no risk in customer margin just because it is segregated.
Scott answered that he believes this issue is overlooked as an unintended consequence of regulation that will significantly increase costs for end-users and lessen their ability to use derivatives to hedge risk.
Real Estate Lending
Rep. Bill Huizenga (R-Mich.) asked Calomiris to clarify his views on real estate lending. Calomiris said 75 percent of loans are in real estate, but that it is highly correlated with the business cycle and risks are hard to shed in downturns. He further said it is “crazy” to finance real estate lending with short-term debt, and advocated for reducing banks’ roles in real estate.
Municipal Bonds as HQLA
Rep. Luke Messer (R-Ind.) noted that municipal bonds were excluded from treatment as high quality liquid assets (HQLA) in the liquidity coverage ratio (LCR) rule. He said the exclusion of investment grade municipal bonds makes no sense when foreign sovereign debt can be included. Chakravorti said he supports the idea that HQLA should be as broad as possible and that he supports the inclusion of municipal bonds if they satisfy HQLA requirements. Calomiris commented that the Basel Committee is a “political G-7 dining room,” and that the U.S. should not have to accept whatever Basel decides.
Rep. Bruce Poliquin (R-Maine) said it does not seem “fair or right” that municipals bonds as whole asset class have been excluded from HQLA. He said the exclusion would raise borrowing costs on municipalities and consequently force families to pay higher taxes.
Cross-Border Resolution
Rep. Ed Royce (R-Calif.) said the need for a cross-border resolution mechanism for major financial institutions was made clear by the crisis. He noted that during a recent update on Title II progress, FDIC Chairman Martin Gruenberg said progress has been impressive, but expressed doubts about cross-border progress. Chakravorti said cross-border resolution is a very difficult issue, but that much of the concern is with just “a few countries” though he added that there has been great movement towards an agreement with these countries.
Calomiris said the problem with cross-border resolution is deciding which regulator takes control of different assets. He called orderly liquidation “a pipe dream” but suggested that one solution is ring-fencing that would make it clear what assets are controlled by different entities. He explained that global financial institutions can operate internationally, but that legal entities should be defined within borders.
For more information on this event, please click here.
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House Financial Services Committee
“Ending ‘Too Big to Fail’: What is the Proper Role of Capital and Liquidity?”
Thursday, July 23, 2015
Key Topics & Takeaways
- CoCos: Columbia University’s Calomiris proposed that banks hold contingent convertible debt (CoCos) that converts to equity when capital levels fall below 10 percent of total assets, explaining that this would give bank management a strong incentive to hold equity well above the 10 percent trigger and “virtually preclude taxpayer bailouts.”
- Impact of Capital Requirements: Rep. Luetkemeyer (R-Mo.) noted that the European Commission has launched a consultation on the impact of capital requirements on lending and the economy, and expressed support for a similar study in the U.S.
- Risk-Weighting: Rep. Rothfus (R-Pa.) asked if risk-weighting determined by the Basel Committee amounts to “credit allocation” and “managing the economy.” Michel agreed that this is a concern and said the “entire system is a mess.”
Witnesses
- Dr. Charles Calomiris, Columbia University Graduate School of Business
- Dr. Sujit Chakravorti, Managing Director and Chief Economist, The Clearing House
- Dr. John Parsons, Massachusetts Institute of Technology
- Dr. Norbert Michel, Heritage Foundation
Opening Statements
In his opening statement, Chairman Jeb Hensarling (R-Texas) noted that many people, this week, have commemorated the anniversary of the Dodd-Frank Act, whether they “celebrated or bemoaned” it. He also mentioned that an article claimed moderate Democrats have been frustrated with their leadership for not being open to making changes to Dodd-Frank, and stated that the Republican majority “stands ready” to work with them to clarify, improve, and fix the unintended consequences of the law.
Hensarling said that “regardless of what you believe to be the genesis of the crisis, capital and liquidity were insufficient.” He commented that American regulators, by adopting standards from Basel, “essentially encouraged” banks to hold mortgage backed securities and fueled financial instability by concentrating risk. Noting that banks have raised hundreds of billions in new capital since the crisis, Hensarling stated that this is “generally a good thing.” However, he was critical of “already complex standards” being made more complex and being based on models that neither market participants nor regulators understand.
Rep. Brad Sherman (D-Calif.) touted his proposed bill, H.R. 2600, the Too Big to Fail, Too Big to Exist Act , arguing that it is “not a bill supported only by socialists,” but also by 95 percent of bankers in the country. He said too big to fail (TBTF) puts smaller banks at a disadvantage, and warned that TBTF should not just be “watched” by the government, but brought to an end.
In her opening statement, Ranking Member Maxine Waters (D-Calif.) recalled that as Dodd-Frank was debated and implemented, critics warned about the consequences of capital requirements on the lending abilities of financial institution. However, she said that as requirements have gone into effect, “the world has not ended.” She credited new requirements for making the financial system safer and more resilient than ever before by setting capital and liquidity standards that ensure banks “risk their own money, not taxpayers’.”
Witness Testimony
Dr. Charles Calomiris, Columbia University Graduate School of Business
In his testimony, Calomiris said Title II of Dodd-Frank, while intended to ensure the orderly liquidation of TBTF banks, has actually institutionalized TBTF. He stressed that regulators should instead focus on preventing such banks from becoming insolvent by raising capital requirements further. He proposed that banks hold contingent convertible debt (CoCos) that converts to equity when capital levels fall below 10 percent of total assets, explaining that this would give bank management s strong incentive to hold equity well above the 10 percent trigger and “virtually preclude taxpayer bailouts.”
Calomiris also warned that real estate lending creates systemic risks because real estate risks are closely linked to the business cycle and are difficult to liquidate. He argued that the banking system’s exposure to real restate risk should be limited.
Dr. Sujit Chakravorti, Managing Director and Chief Economist, The Clearing House
Chakravorti, in his testimony, said the strength and resilience of the American banking system are essential as the modern economy relies on banks for critical intermediation functions. He then offered five observations: 1) robust capital requirements are an essential tool for financial stability as a cushion to absorb losses; 2) significant improvements have been made to bank capital since the crisis as regulators have overhauled the regulatory capital framework; 3) along with its benefits, increased capital also has costs that affect key banking activities that support the economy; 4) there is no consensus on the optimal level of capital, but there is a tradeoff between financial stability and growth; and 5) the full consequences of the new regulatory regime should be taken into account to evaluate “where we have landed” in the tradeoff.
Dr. John Parsons, Massachusetts Institute of Technology
In his testimony, Parsons said it was very interesting to hear “significant unanimity” that supervisors have substantially improved bank capital requirements to make the system safer. He agreed with Chakravorti that capital has costs, but stressed that “we are nowhere near worrying about major costs to the financial system.” He dismissed concerns that regulation has diminished liquidity in corporate bond markets, commenting that he has only seen “vague worries and phrases.” He added that any impact regulation has had should be considered “a feature, not a bug,” and that the financial system is safer with the removal of some trading activity from bank balance sheets.
Parsons defended stress tests, crediting them for being “very forward looking” and allowing regulators to “question convenient assumptions that are relatively weak.” He said the stress tests help to prepare banks and regulators by identifying major risks.
Dr. Norbert Michel, Heritage Foundation
Michel, in his testimony, said argued that risk-weighted capital requirements should be eliminated in favor of promoting market discipline as a force for financial stability. He said Basel requirements contributed to the financial crisis because regulators failed to properly measure risk and steered banks to specific assets. All the banks had similar assets, he explained, and during the crisis they suffered the same losses. He claimed that there is “no doubt” that statutory capital requirements failed, and that their whole framework is flawed.
Michel expressed that there is no reason to think Basel III will perform any better because it maintains “the same flaw” that regulators are thought to be better than markets at determining capital standards. He advocated instead for simple standards that allow markets to properly price risk, and called for a repeal of Titles I and II of Dodd-Frank to eliminate the perception of TBTF and encourage better market discipline.
Questions and Answers
Basel Process and Gold-Plating
Hensarling asked Michel if there is “any hope” that a Basel IV or V could “get it right,” or if there is systemic risk in a single world view on capital being imposed on the financial system. Michel answered that forcing the entire financial systemic into the same asset classes hurts the entire industry, and questioned how many times regulators would go through the Basel process “before we figure out we’re doing something wrong.”
Rep. Randy Neugebauer (R-Texas) pointed out that the Federal Reserve has gone beyond Basel standards with many of its regulations, including the capital surcharge. He asked if this raises concerns for U.S. competitiveness. Chakravorti answered that the Fed going “over and above” Basel requirements “certainly leaves U.S. banks at a disadvantage” to foreign competition, and that the Fed was not justified in doing this.
Contingent Convertible Debt and Market Discipline
Hensarling asked Calomiris to expand on his proposal to require that banks hold CoCos as an incentive to build a stronger capital buffer. Calomiris explained that the “basic principle is simple” and that if banks hold the true economic value of their capital above 10 percent then they would never approach a point where they need a bailout. He said the conversion of debt to equity is something that a bank CEO would never want to see happen, so the proposal puts accountability on people to replace lost capital quickly.
Calomiris further stressed that supervisors often “go along with bankers in understating losses” in times of stress, so an automatic trigger for conversion rather than one controlled by regulators would be critical.
Rep. Scott Garrett (R-N.J.) commented that until the creation of the Federal Reserve and Federal Deposit Insurance Corporation (FDIC), market discipline was the “overriding principle” in financial markets because there was no chance of a government bailout. He stated that Dodd-Frank has codified the idea of TBTF and the expectation of government bailouts.
Garrett said the part of an effective regulatory regime going forward would include ensuring that banks hold “the right type” of capital. Calomiris said his CoCo proposal is “all about” bringing market discipline back to the capital discussion. He suggested that in addition to holding 10 percent of capital in the form of equity, banks should also hold an additional 10 percent in CoCos. Michel agreed that CoCos could support market discipline.
Rep. Sean Duffy (R-Wis.) asked if the financial system has the right balance of regulation and market discipline. Calomiris responded that it does not, while Parsons argued that regulation and market discipline should not be regarded as being opposed to one another. Parsons explained that CoCos would be an example of a regulation designed to create market incentives.
Rep. Bill Foster (D-Ill.) said he was “thrilled” that there seems to be bipartisan interest in CoCos. He commented that it was difficult to adopt them during the original Dodd-Frank debates because there was no experience with them, but that Europeans have had success with them since then, especially in Switzerland. He asked what can be learned from the European experience. Calomiris noted that many people were concerned that there would be not enough of a market to by CoCos, but that they were, in fact, oversubscribed. He added that a market trigger is better than the regulator trigger because regulators cannot be relied upon to implement the trigger.
Rep. Robert Pittenger (R-N.C.) asked if the witnesses support the proposal by Sens. Sherrod Brown (D-Ohio) and David Vitter (D-La.) to raise capital requirements to 15 percent for large financial institutions. Michel said he is sympathetic to the idea of holding more capital, but that CoCos are a better idea. Calomiris similarly supported the logic behind the Brown-Vitter proposal, but touted his proposal for 10 percent equity and 10 percent CoCos as producing even more capital. Chakravorti said capital requirements require a “belt and suspenders approach,” and that regulators should look at all the different capital regulations in combination.
Impact of Capital Requirements
Waters asked if capital standards are hurting lending to consumers. Parsons replied that bank capital can still be “put to work” in purchasing assets and making loans, so the idea that capital is “immobilized” is not accurate. He denied that capital requirements are preventing banks from making loans to consumers.
Garrett asked if regulation is affecting lending in the marketplace and liquidity. Michel answered that liquidity is mainly a “supply issue” because regulations have forced banks to hold more liquid assets.
Rep. Blaine Luetkemeyer (R-Mo.) noted that the European Commission has launched a consultation on the impact of capital requirements on lending and the economy. He asked if any U.S. regulators have considered a similar study. Chakravorti said he “applauds” the decision of the European Commission, and hopes that U.S. regulators would conduct impact studies before going forward with new rulemakings.
Rep. Stephen Lynch (D-Mass.) recalled that Calomiris had admitted that there are costs associated with capital requirements, but that “we should go on anyway.” Calomiris stressed that capital requirements can have huge effects on lending to non-financial firms, but that it is worth it because it helps to avoid an “implosion” of the banking system.
Rep. Mick Mulvaney (R-S.C.) asked the witnesses for their thoughts on creating a different regulatory system where banks that are not sophisticated and do not present systemic risk can opt out of some regulatory requirements. All the witnesses agreed that this would be a sensible idea, with Calomiris saying any system where bankers are “playing with their own money” and not consumers’ would be positive.
Living Wills
Waters asked Parsons what he thought of the living will process. Parsons said the living wills are one step through which regulators and banks work together to develop “a more rational structure” that regulators can understand and that is more easily resolved. He added that much complexity remains in the system that must be “worked out.”
Fed Lending Powers
Rep. Ruben Hinojosa (D-Texas) noted that Michel has spoken against the Fed lending money during the crisis and saying it should, instead, stick to traditional open market operations to provide market liquidity. Michel explained that an ideal system would not allow the Fed to lend money directly to firms and would involve all banks in the private auction process.
Hinojosa asked if regulators should “get rid of” risk-based capital standards. Parsons answered that he sees no alternative to the government playing some role in establishing capital standards to ensure that the financial system works in times of turbulence. He said risk-weighting is just one way for public authorities to pay attention to risks at different banks.
Rep. Ed Rothfus (R-Pa.) asked if risk-weighting determined by the Basel Committee amounts to “credit allocation” and “managing the economy.” Michel agreed that this is a concern and said the “entire system is a mess.”
Swaps
Lynch commented that foreign affiliates of U.S. banks deal in uncleared swaps and then transfer the risk back deposit-backed banks in the U.S. He asked if capital requirements or stress testing could account for this risk, stating that there seems to be a “disconnect.” Parsons replied that the Federal Reserve has the authority to examine a company’s full trading in swaps, and agreed that it is a problem that some trading could somehow be covered by FDIC insurance. He said there a number of actions going on that could address this, such as capital requirements at the bank-holding company level, and that living wills could shape how risk travels across boundaries.
Rep. David Scott (D-Ga.) said the Basel regulations are a necessary means to ensure banks are properly capitalized, but expressed concern that end-user customer margin is treated punitively, as if banks are able to leverage it, even though it is required under U.S. law to be segregated from the banks’ own accounts. Parsons responded that futures commission merchants or swaps dealers are businesses that do carry risks, and customer margin is one measure to estimate the size of risk. He said it is wrong to think that there is no risk in customer margin just because it is segregated.
Scott answered that he believes this issue is overlooked as an unintended consequence of regulation that will significantly increase costs for end-users and lessen their ability to use derivatives to hedge risk.
Real Estate Lending
Rep. Bill Huizenga (R-Mich.) asked Calomiris to clarify his views on real estate lending. Calomiris said 75 percent of loans are in real estate, but that it is highly correlated with the business cycle and risks are hard to shed in downturns. He further said it is “crazy” to finance real estate lending with short-term debt, and advocated for reducing banks’ roles in real estate.
Municipal Bonds as HQLA
Rep. Luke Messer (R-Ind.) noted that municipal bonds were excluded from treatment as high quality liquid assets (HQLA) in the liquidity coverage ratio (LCR) rule. He said the exclusion of investment grade municipal bonds makes no sense when foreign sovereign debt can be included. Chakravorti said he supports the idea that HQLA should be as broad as possible and that he supports the inclusion of municipal bonds if they satisfy HQLA requirements. Calomiris commented that the Basel Committee is a “political G-7 dining room,” and that the U.S. should not have to accept whatever Basel decides.
Rep. Bruce Poliquin (R-Maine) said it does not seem “fair or right” that municipals bonds as whole asset class have been excluded from HQLA. He said the exclusion would raise borrowing costs on municipalities and consequently force families to pay higher taxes.
Cross-Border Resolution
Rep. Ed Royce (R-Calif.) said the need for a cross-border resolution mechanism for major financial institutions was made clear by the crisis. He noted that during a recent update on Title II progress, FDIC Chairman Martin Gruenberg said progress has been impressive, but expressed doubts about cross-border progress. Chakravorti said cross-border resolution is a very difficult issue, but that much of the concern is with just “a few countries” though he added that there has been great movement towards an agreement with these countries.
Calomiris said the problem with cross-border resolution is deciding which regulator takes control of different assets. He called orderly liquidation “a pipe dream” but suggested that one solution is ring-fencing that would make it clear what assets are controlled by different entities. He explained that global financial institutions can operate internationally, but that legal entities should be defined within borders.
For more information on this event, please click here.