Current Developments in Monetary and Financial Law, Volume 6

Chapter 1: What Is the Right Response to the Too-Big-to-Fail Problem?

International Monetary Fund. Legal Dept.
Published Date:
February 2013
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The ongoing financial crisis—widely viewed as the worst since the Great Depression1—has inflicted tremendous damage on financial markets and economies around the world.2 The crisis has revealed fundamental weaknesses in the financial regulatory systems of the United States (“U.S.”), the United Kingdom (“U.K.”), and other European nations, making regulatory reforms an urgent priority. Publicly-funded bailouts of “too big to fail” (“TBTF”) financial institutions have provided indisputable proof that (i) TBTF institutions benefit from large explicit and implicit public subsidies, and (ii) those subsidies undermine market discipline and distort economic incentives for large, complex financial institutions (“LCFIs”).3 Accordingly, a primary objective of regulatory reforms must be to eliminate (or at least greatly reduce) TBTF subsidies, thereby forcing LCFIs to internalize the risks and costs of their activities.

The first two sections of this chapter survey the consequences and causes of the financial crisis. As discussed in those sections, LCFIs received the lion’s share of support from government programs established to preserve financial stability, and they were also the primary private-sector catalysts for the financial crisis. Public alarm over the severity of the financial crisis and public outrage over government bailouts of LCFIs have produced a strong consensus in favor of reforming financial regulation in the U.S., the U.K., and other developed nations.4

As the third section of this chapter explains, governmental rescues of LCFIs have highlighted the economic distortions caused by TBTF policies, as well as the urgent need to reduce public subsidies created by those policies. The final section proposes five reforms that are designed to prevent excessive risk-taking by LCFIs and to shrink TBTF subsidies in the U.S. financial system. The proposed reforms would (1) strengthen current statutory restrictions on the growth of LCFIs, (2) create a special resolution process to manage the orderly liquidation or restructuring of systemically important financial institutions (“SIFIs”), (3) establish a consolidated supervisory regime and enhanced capital requirements for SIFIs, (4) create a special insurance fund for SIFIs in order to cover the costs of resolving failed SIFIs, and (5) rigorously insulate banks that are owned by LCFIs from the activities and risks of their nonbank affiliates.

The Severity and Persistence of the Financial Crisis

The financial crisis caused governments and central banks around the globe to provide more than $11 trillion of assistance to financial institutions and to spend more than $6 trillion on economic stimulus programs. The largest financial support and economic stimulus programs were implemented by the U.S., the U.K., and other European nations, where the financial crisis inflicted the greatest harm.5 By October 2009, the U.S. had provided more than $6 trillion of assistance to financial institutions through central bank loans and other government loans, guarantees, asset purchases and capital infusions, while the U.K. and other European nations gave more than $4 trillion of similar assistance.6 The U.S. Congress passed an $800 billion economic stimulus bill in early 2009, and many other nations approved comparable measures to support their economies.7

Government agencies have acted most dramatically in rescuing LCFIs that were threatened with failure. U.S. authorities bailed out two of the three largest U.S. banks and the largest U.S. insurance company.8 In addition, (i) federal regulators provided financial support for emergency acquisitions of two other major banks, the two largest thrifts, and two of the five largest securities firms, and (ii) regulators approved emergency conversions of two other leading securities firms into bank holding companies (“BHCs”), thereby placing those institutions under the protective umbrella of the Federal Reserve Board (“FRB”).9 Federal regulators conducted “stress tests” on the nineteen largest BHCs—each with more than $100 billion of assets—and injected more than $220 billion of capital into eighteen of those companies.10 Before regulators performed the stress tests, they announced that the federal government would provide any additional capital that the nineteen banking firms needed but could not raise on their own. By giving that public assurance, regulators indicated that all nineteen firms were presumptively TBTF, at least for the duration of the current financial crisis.11

Similarly, the U.K. and other European nations adopted more than eighty rescue programs to support their financial systems. Those programs included costly bailouts of several very large European banks, including ABN Amro, Commerzbank, Fortis, ING, Lloyds HBOS (“Lloyds”), Royal Bank of Scotland (“RBS”) and UBS.12

Notwithstanding these extraordinary measures of governmental support, financial institutions and investors suffered huge losses in the U.S. and other developed nations. Between the outbreak of the crisis in the summer of 2007 and the spring of 2010, LCFIs around the world recorded $1.5 trillion of losses on risky loans and investments made during the preceding credit boom.13 During 2008 alone, the value of global financial assets fell by an estimated $50 trillion, equal to a year of the world’s gross domestic product.14 The financial crisis pushed the economies of the U.S., the U.K., and other EU nations into deep recessions during 2008 and the first half of 2009.15

Economies in all three regions began to improve in the second half of 2009, but the recoveries were tentative and fragile.16 During the first half of 2010, economies in all three areas continued to face significant challenges, including (i) high unemployment rates and shortages of bank credit that caused consumers to reduce spending and businesses to forgo new investments; and (ii) large budget deficits, caused in part by the massive costs of financial rescue programs, which impaired the ability of governments to provide additional fiscal stimulus.17

A major threat to economic recovery appeared in the spring of 2010, as Greece and several other deeply indebted European nations struggled to avoid defaulting on their sovereign debts.18 In May 2010, the European Union (“EU”) and the International Monetary Fund (“IMF”) announced a $1 trillion emergency package of loan guarantees to reassure investors that EU nations would continue to meet their debt obligations.19 However, many analysts questioned the rescue package’s adequacy, and bond investors shunned financial institutions with large exposures to heavily indebted countries.20

The European sovereign debt crisis, along with high unemployment rates, growing budget deficits and declining bank credit, created serious concerns about the prospects for continued economic growth in both the U.S. and Europe.21 The severity of the financial crisis and the rising costs of supporting troubled LCFIs also triggered public outrage and created a strong consensus in favor of reforming financial regulation in the U.S., the U.K., and other developed nations.22

LCFIs Played Key Roles in Precipitating the Financial Crisis

In order to design regulatory reforms that could prevent a similar crisis in the future, it is essential to understand that LCFIs were the primary private-sector catalysts for the current financial crisis. This section briefly summarizes the crucial roles played by LCFIs in helping to produce the financial and economic conditions that led to the crisis, as well as governmental policies that compounded the disastrous errors of LCFIs.

LCFIs Originated Huge Volumes of Risky Loans and Helped to Inflate a Massive Credit Boom That Precipitated the Crisis

During the past two decades, and especially between 2000 and 2007, LCFIs helped to generate an enormous credit boom that set the stage for the current financial crisis. LCFIs used securitization techniques to earn large amounts of fee income by (i) originating high-risk loans, including nonprime residential mortgages, credit card loans, commercial mortgages, and leveraged buyout (“LBO”) loans, and (ii) pooling those loans to create securities that could be sold to investors. LCFIs ostensibly followed an “originate to distribute” (“OTD”) business model, which caused regulators and market analysts to assume that LCFIs were successfully transferring the risks embedded in their securitized loans to widely dispersed investors.23

Securitization allowed LCFIs—with the blessing of regulators—to reduce their capital requirements and offload much of their apparent credit risk.24 LCFIs created structured-finance securities that typically included senior, mezzanine and junior (or equity) “tranches.” Those tranches represented a hierarchy of rights (along a scale from the most senior to the most subordinated) to receive cash flows produced by the pooled loans. LCFIs marketed the tranches to satisfy the demands of various types of investors for different combinations of yield and risk. Structured-finance securities included (1) asset-backed securities (“ABS”), which represented interests in pools of credit card loans, auto loans, student loans and other consumer loans; (2) residential mortgage-backed securities (“RMBS”), which represented interests in pools of residential mortgages; and (3) commercial mortgage-backed securities (“CMBS”), which represented interests in pools of commercial mortgages.25

LCFIs created “second-level securitizations” by bundling tranches of ABS and MBS into cash flow collateralized debt obligations (“CDOs”), and they similarly packaged syndicated loans for corporate leveraged buyouts (“LBOs”) into collateralized loan obligations (“CLOs”).26 LCFIs also created third-level securitizations by assembling pools of tranches from cash flow CDOs to construct “CDOs-squared.”27 The IMF estimated that private-sector financial institutions issued about $15 trillion of ABS, MBS, and CDOs in global markets between 2000 and 2007, including $9 trillion issued in the U.S.28 Another study determined that $11 trillion of structured-finance securities were outstanding in the U.S. market in 2008.29

LCFIs intensified the risks of securitization by writing over-the-counter (“OTC”) credit derivatives known as “credit default swaps” (“CDS”). CDS provided “the equivalent of insurance against default events” that might occur with reference to loans in securitized pools or tranches of ABS, MBS and CDOs.30 While CDS could be used for hedging purposes, financial institutions and other investors increasingly used CDS to speculate on the default risks of securitized loans and structured-finance securities.31 LCFIs further increased the financial system’s aggregate exposure to the risks of securitized loans by using pools of CDS to create synthetic CDOs. Synthetic CDOs were generally constructed to mimic the performance of cash flow CDOs, and synthetic CDOs issued yet another series of tranched, structured-finance securities to investors.32 By 2007, the total notional amounts of CDS and synthetic CDOs written with reference to securitized loans, ABS, MBS or cash flow CDOs may have exceeded $15 trillion.33

Thus, based on available estimates, approximately $25 trillion of structured-finance securities and related derivatives were outstanding in the U.S. financial markets at the peak of the credit boom in 2007.34 Eighteen giant LCFIs, including ten U.S. and eight foreign financial institutions, originated the lion’s share of those complex instruments.35 Structured-finance securities and related derivatives not only financed, but also far exceeded, about $9 trillion of risky private-sector debt that was outstanding in U.S. financial markets when the credit crisis broke out.36 The combined volume of MBS, cash flow CDOs, CDS and synthetic CDOs created an “inverted pyramid of risk,” which enabled investors to place “multiple layers of financial bets” on the performance of high-risk loans in securitized pools.37 Consequently, when the underlying loans began to default, the leverage inherent in this “pyramid of risk” produced losses that were far larger than the face amounts of the defaulted loans.38

LCFIs Used Credit Ratings to Promote the Sale of Risky Structured-Finance Securities

LCFIs made structured-finance securities attractive to investors by paying large fees to credit rating agencies (“CRAs”) in order to secure investment-grade ratings (BBB- and above) for most tranches of those securities.39 CRAs charged fees for their ratings based on an “issuer pays” business model, which required issuers of securities to pay fees to CRAs in order to secure credit ratings for their securities. The “issuer pays” model created an obvious conflict of interest between a CRA’s desire to earn fees from issuers of securities and the CRA’s stake in preserving its reputation for making reliable risk assessments. Structured-finance securitizations heightened this conflict of interest because LCFIs often paid additional consulting fees to obtain advice from CRAs on how to structure securitizations to produce the maximum percentage of AAA-rated securities.40

Moreover, a small group of LCFIs dominated the securitization markets and, therefore, were significant repeat players in those markets. Accordingly, LCFIs could strongly influence a CRA’s decision on whether to assign favorable ratings to an issue of structured-finance securities by threatening to switch to other CRAs to obtain higher ratings for subsequent issues of the same type of securities.41 Given the generous fees CRAs received from LCFIs for rating structured-finance securities and for providing additional consulting services, it is not surprising that CRAs typically assigned AAA ratings to three-quarters or more of the tranches of ABS, RMBS, CDOs and CDOs-squared.42

Investors relied heavily on credit ratings and usually did not perform any meaningful due diligence before deciding to buy structured-finance securities. In addition, regulations issued by the Securities and Exchange Commission (“SEC”) allowed issuers to sell ABS, RMBS and CDOs to investors based on limited disclosures beyond the instruments’ credit ratings.43 Many issuers provided descriptions of the underlying loans that were incomplete or misleading.44 The complexity of structured-finance transactions made it difficult for investors to evaluate the risks of first-level securitizations and nearly impossible for investors to ascertain the risks of second- and third-level securitizations.45

Investors also had strong incentives not to question the ratings assigned to structured-finance securities by CRAs. AAA-rated structured-finance securities paid yields that were significantly higher than other AAA-rated securities. Structured-finance securities were therefore very attractive to investors who were seeking the highest available yields on supposedly “safe” debt securities during the low-interest, low-inflation environment of the pre-crisis period.46 The AAA ratings issued by CRAs enabled LCFIs to transform “trillions of dollars of risky assets … into securities that were widely considered to be safe … [and] were eagerly bought up by investors around the world.”47

The CRAs’ pervasive conflicts of interest encouraged them to issue credit ratings that either misperceived or misrepresented the true risks embedded in structured-finance securities. CRAs, along with the LCFIs that issued the securities, made the following crucial errors: (i) giving too much weight to the benefits of diversification from pooling large numbers of high-risk loans; (ii) failing to recognize that RMBS and CDOs became more risky as mortgage lending standards deteriorated between 2004 and 2007; (iii) failing to appreciate that RMBS and CDOs often contained dangerous concentrations of loans from high-risk states like California, Florida and Nevada; (iv) underestimating the risk that a serious economic downturn would trigger widespread correlated defaults among risky loans of similar types; (v) relying on historical data drawn from a relatively brief period in which benign economic conditions prevailed; and (vi) assuming that housing prices would never decline on a nationwide basis.48 By mid-2009, CRAs had cut their ratings on tens of thousands of investment-grade tranches of RMBS and CDOs, and securitization markets had collapsed.49

LCFIs Promoted an Unsustainable Credit Boom That Set the Stage for the Financial Crisis

The LCFIs’ large-scale securitizations of credit helped to create an enormous credit boom in the U.S. financial markets between 1991 and 2007. Nominal domestic private-sector debt nearly quadrupled, rising from $10.3 trillion to $39.9 trillion during that period, and the largest increases occurred in the financial and household sectors.50 Total U.S. private-sector debt as a percentage of gross domestic product (“GDP”) rose from 150 percent in 1987 to almost 300 percent in 2007 and, by that measure, exceeded even the huge credit boom that led to the Great Depression.51 Financial sector debt as a percentage of GDP rose from 40 percent in 1988 to 70 percent in 1998 and 120 percent in 2008.52 Meanwhile, household sector debt grew from two-thirds of GDP in the early 1990s to 100 percent of GDP in 2008.53

The credit boom greatly enhanced the financial sector’s importance within the broader economy. Financial sector earnings doubled from thirteen percent of total corporate pretax profits in 1980 to twenty-seven percent of such profits in 2007.54 Stocks of financial firms included in the S&P 500 index held the highest aggregate market value of any industry sector of that index from 1995 to 1998, and again from 2002 to 2007.55

As the credit boom inflated and the financial sector grew in size and importance to the overall economy, LCFIs also became more leveraged, more fragile, and more vulnerable to a systemic crisis. At the end of 2007, the ten largest U.S. financial institutions—all of which were leading participants in structured-finance securitization—had an average leverage ratio of 27:1 when their off-balance-sheet (“OBS”) commitments were taken into account.56

As I noted in a previous article, “[b]y 2007, the health of the U.S. economy relied on a massive confidence game—indeed, some might say, a Ponzi scheme—operated by its leading financial institutions.”57 This “confidence game,” which sustained the credit boom, could continue only as long as investors were willing “to keep buying new debt instruments that would enable overstretched borrowers to expand their consumption and service their debts.”58 In the summer of 2007, when investors lost confidence in the ability of subprime borrowers to meet their obligations, “the game collapsed and a severe financial crisis began.”59

LCFIs Retained Exposures to Many of the Hazards Embedded in Their High-Risk Lending

During the credit boom, as explained above, LCFIs pursued a securitization strategy that produced highly leveraged risk-taking through the use of complex structured-finance products, CDS and OBS vehicles.60 This securitization strategy was highly attractive in the short term, because LCFIs (as well as the mortgage brokers, nonbank lenders and CRAs who worked with LCFIs) collected lucrative fees at each stage of originating, securitizing, rating and marketing the risky residential mortgages, commercial mortgages, credit card loans and LBO loans.61 Based on the widespread belief that LCFIs were following an OTD strategy, both managers and regulators of LCFIs operated under the illusion that the credit risks inherent in the securitized loans were being transferred to the ultimate purchasers of structured-finance securities.62 In significant ways, however, LCFIs actually pursued an “originate to not really distribute” program.63

For example, LCFIs decided to keep large amounts of highly-rated, structured-finance securities on their balance sheets because regulators allowed LCFIs to do so with a minimum of capital. In the U.S., LCFIs took advantage of a regulation issued by the federal banking agencies in November 2001, which greatly reduced the risk-based capital charge for structured-finance securities rated “AAA” or “AA” by CRAs. The 2001 regulation assigned a risk weighting of only twenty percent to such securities in determining the amount of risk-based capital that banks were required to hold.64 As a practical matter, the 2001 rule cut the risk-based capital requirement for highly-rated tranches of RMBS and related CDOs from four percent to only 1.6 percent.65

In Europe, LCFIs similarly retained AAA-rated structured-finance securities on their balance sheets because the Basel I and Basel II capital accords assigned very low risk weights to such securities. In contrast to the U.S., European nations did not require banks to maintain a minimum leverage capital ratio and instead required banks only to meet the Basel risk-weighted capital standards. As a result, European banks did not incur significant capital charges for holding on-balance-sheet, AAA-rated instruments, due to their low risk weights under Basel rules.66

LCFIs also had revenue-based incentives to keep highly-rated structured finance securities on their balance sheets. As the credit boom reached its peak, LCFIs found it difficult to locate investors to purchase all of the AAA-rated tranches they were producing. Managers at aggressive LCFIs decided to assume “warehouse risk” by keeping AAA-rated tranches on their balance sheets, because they wanted to complete more securitization deals, earn more fees, produce higher short-term profits, and distribute larger compensation packages to executives and key employees67 By 2007, Citigroup, Merrill, and UBS together held more than $175 billion of AAA-rated CDOs on their books.68 The huge losses suffered by those institutions on retained CDO exposures were a significant reason why all three needed extensive governmental assistance to avoid failure.69

In addition, LCFIs retained risk exposures for many of the assets they ostensibly transferred to OBS entities through securitization. Regulators in the U.S. and Europe allowed LCFIs to sponsor structured investment vehicles (“SIVs”) and other OBS conduits, which were frequently used as dumping grounds for RMBS and CDOs that LCFIs were unable to sell to arms-length investors. The sponsored conduits sold asset-backed commercial paper (“ABCP”) to investors and used the proceeds to buy structured-finance securities underwritten by the sponsoring LCFIs. The conduits faced a potentially dangerous funding mismatch between their longer-term, structured-finance assets and their shorter-term, ABCP liabilities. The sponsoring LCFIs covered that mismatch (in whole or in part) by providing explicit credit enhancements (including lines of credit) or implicit commitments to ensure the availability of liquidity if the sponsored conduits could not roll over their ABCP.70

U.S. regulators adopted capital rules that encouraged the use of ABCP conduits. Those rules did not assess any capital charges against LCFIs for transferring securitized assets to sponsored conduits. Instead, the rules required LCFIs to post capital only if they provided explicit credit enhancements to their conduits.71 Moreover, a 2004 regulation approved a very low capital charge for sponsors’ lines of credit, equal to only one-tenth of the usual capital charge of eight percent, as long as the lines of credit had maturities of one year or less.72

ABCP conduits sponsored by LCFIs grew rapidly during the peak years of the credit boom. As a result, the ABCP market in the United States nearly doubled after 2003 and reached $1.2 trillion in August 2007. Three-quarters of that amount was held in 300 conduits sponsored by U.S. and European LCFIs.73 Citigroup was the largest conduit sponsor, and seven of the top ten sponsors were members of the “big eighteen” club of LCFIs.74 As a result of their risk exposures to conduits and their other OBS commitments, many of the leading LCFIs were much more highly leveraged than their balance sheets indicated.75

After the financial crisis broke out in August 2007, conduits suffered large losses on their holdings of structured-finance securities. Many conduits were faced with imminent default because they could not roll over their ABCP. Investors refused to buy new issues of ABCP because of the presumed exposure of ABCP to losses from subprime mortgages.76 In order to avoid damage to their reputations, most LCFI sponsors went beyond their legal obligations and either brought conduit assets back onto their balance sheets or provided explicit credit enhancements that enabled conduits to remain in business.77

Thus, notwithstanding the widely-shared assumption that LCFIs were following an OTD strategy, in fact LCFIs did not transfer many of the credit risks created by their securitization programs. Instead, “they ‘warehoused’ nonprime mortgage-related assets … [and] transferred similar assets to sponsored OBS entities.”78 One study estimated that LCFIs retained risk exposures to about half of the outstanding AAA-rated ABS in mid-2008 through their “warehoused” and OBS positions.79 In many respects, LCFIs “pursued an ‘originate to not really distribute’ strategy, which prevented financial regulators and analysts from understanding the true risks created by the LCFIs’ involvement with nonprime mortgage-related assets.”80

LCFIs Were the Most Important Private-Sector Catalysts for the Financial Crisis

Excessive risk-taking by LCFIs was not the only cause of the current financial crisis. Several additional factors played important roles. First, many analysts have criticized the FRB for maintaining an excessively loose monetary policy during the second half of the 1990s and again between 2001 and 2005. Critics charge that the FRB’s monetary policy mistakes produced speculative asset booms that led to the dotcom-telecom bust in the stock market between 2000 and 2002 and the bursting of the housing bubble after 2006.81

Second, during the past decade several Asian nations that were large exporters of goods (including China, Japan, and South Korea) maintained artificially low exchange rates for their currencies against the dollar, the pound sterling, and the euro. Those nations preserved advantageous exchange rates for their currencies (thereby boosting exports) by purchasing Western government securities and investing in Western financial markets. In addition, many oil exporting countries invested large amounts in Western assets. Thus, nations with significant balance-of-trade surpluses provided large amounts of credit and investment capital that boosted the value of Western currencies, supported low interest rates, and thereby promoted asset booms in the U.S., the U.K., and other European countries.82

Third, Robert Shiller and others have argued that “bubble thinking” caused home buyers, LCFIs, CRAs, investors in structured-finance securities and regulators to believe that the housing boom would continue indefinitely and “could not end badly.”83 According to these analysts, a “social contagion of boom thinking” helps to explain both why the housing bubble continued to inflate for several years, and why regulators failed to stop LCFIs from making high-risk loans to borrowers who had no capacity to repay or refinance their loans unless their properties continued to appreciate in value.84

Finally, Fannie Mae (“Fannie”) and Freddie Mac (“Freddie”) contributed to the housing bubble by purchasing large quantities of nonprime mortgages and RMBS beginning in 2003. Those government-sponsored entities (“GSEs”) purchased nonprime mortgages and RMBS because (i) Congress pressured them to fulfill affordable housing goals, (ii) large nonprime mortgage lenders (including Countrywide) threatened to sell most of their mortgages to Wall Street firms if the GSEs failed to purchase more of their nonprime loans, and (iii) Fannie’s and Freddie’s senior executives feared the loss of additional market share to LCFIs that were aggressively securitizing nonprime mortgages into private-label RMBS. By 2007, the two GSEs held risk exposures to more than $400 billion of nonprime mortgages, representing a fifth of the nonprime market. Heavy losses on those risk exposures contributed to the collapse of Fannie and Freddie in 2008.85

Notwithstanding the significance of the foregoing factors, LCFIs were clearly “the primary private-sector catalysts for the destructive credit boom that led to the subprime financial crisis, and they [became] the epicenter of the current global financial mess.”86 As indicated above, the “big eighteen” LCFIs were dominant players in global securities and derivatives markets during the credit boom.87 Those LCFIs included most of the top underwriters for nonprime RMBS, ABS, CMBS and LBO loans as well as related CDOs, CLOs and CDS.88 While Fannie and Freddie funded about a fifth of the nonprime mortgage market between 2003 and 2007, they did so primarily by purchasing nonprime mortgages and private-label RMBS that were originated or underwritten by LCFIs.89 LCFIs provided most of the rest of the funding for nonprime mortgages, as well as much of the financing for risky credit card loans, CRE loans and LBO loans.90

The central role of LCFIs in the financial crisis is confirmed by the enormous losses they suffered and the huge bailouts they received. The “big eighteen” LCFIs accounted for three-fifths of the $1.5 trillion of total worldwide losses recorded by banks, securities firms and insurers between the outbreak of the financial crisis in mid-2007 and the spring of 2010.91 The list of leading LCFIs is “a who’s who of the current financial crisis” that includes “[m]any of the firms that either went bust … or suffered huge write-downs that led to significant government intervention.”92 Lehman failed, while two other members of the “big eighteen” LCFIs (AIG and RBS) were nationalized and three others (Bear, Merrill, and Wachovia) were acquired by other LCFIs with substantial governmental assistance.93 Three additional members of the group (Citigroup, BofA, and UBS) survived only because they received costly government bailouts.94 Chase, Goldman, and Morgan Stanley received substantial infusions of capital under the federal government’s Troubled Asset Relief Program (“TARP”). Goldman and Morgan Stanley also quickly converted to BHCs to secure permanent access to the FRB’s discount window as well as “the Fed’s public promise of protection.”95

Thus, only Lehman failed of the “big eighteen” LCFIs, but the U.S., the U.K. and European nations provided extensive assistance to ensure the survival of at least twelve other members of the group.96 In the U.S., the federal government guaranteed the viability of the nineteen largest BHCs as well as AIG.97 Those institutions received $290 billion of capital infusions from the federal government, and they also issued $235 billion of debt that was guaranteed (and thereby subsidized) by the Federal Deposit Insurance Corporation (“FDIC”). In contrast, smaller banks received only $41 billion of capital assistance and issued only $11 billion of FDIC-guaranteed debt.98 A prominent Federal Reserve official observed in 2009 that LCFIs “were central to this crisis as it expanded and became a global recession. … [S]tockholders and creditors of these firms enjoyed special protection funded by the American taxpayer.”99 He further remarked, “It is no longer conjecture that the largest institutions in the United States have been determined to be too big to fail. They have been bailed out.”100

Recent Government Bailouts Demonstrate That LCFIs Benefit from Huge TBTF Subsidies

As shown above, LCFIs pursued aggressive and speculative business strategies that exposed them to huge losses and potential failures when asset bubbles in U.S. and European housing markets, CRE markets and LBO markets burst in the second half of 2007.101 The systemic risk created by LCFIs during the credit boom caused the U.S. and other nations to implement massive bailouts of LCFIs, including leading securities firms and insurance companies as well as banks.102

At the height of the financial crisis in March 2009, FRB Chairman Bernanke declared that the federal government was committed to ensure the survival of “systemically important financial institutions” (“SIFIs”) in order to prevent a systemic collapse of the financial markets and an economic depression.103 Chairman Bernanke defended the federal government’s decision to ensure “the continued viability” of SIFIs in the following terms:

In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further serious destabilization of the financial system, and our commitment to avoiding such a failure remains firm.104

Chairman Bernanke admitted that “the too-big-to-fail issue has emerged as an enormous problem” because “it reduces market discipline and encourages excessive risk-taking” by TBTF firms.105 Several months later, Governor Mervyn King of the Bank of England condemned the perverse incentives created by TBTF subsidies in even stronger terms. Governor King maintained that “[t]he massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history.”106 He further argued that TBTF subsidies provided a partial explanation for decisions by LCFIs to engage in high-risk strategies during the credit boom:

Why were banks willing to take risks that proved so damaging to themselves and the rest of the economy? One of the key reasons—mentioned by market participants in conversations before the crisis hit—is that incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as ‘too important to fail.’ … Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.107

Industry studies and anecdotal evidence confirm that TBTF subsidies create significant economic distortions and promote moral hazard. In recent years, and particularly during the present crisis, LCFIs have operated with much lower capital ratios, and have benefited from a much lower cost of funds, compared with smaller banks.108 In addition, CRAs and bond investors have given preferential treatment to TBTF institutions because of the explicit and implicit government backing they receive.109 The preferential status of TBTF institutions is confirmed by the fact that they received by far the largest share of governmental assistance in the form of TARP capital assistance and FDIC debt guarantees.110 As noted above, the federal government publicly announced in early 2009 that it would ensure the survival of the nineteen largest BHCs, thereby certifying their TBTF status.111

Recognizing the enormous benefits of TBTF status, LCFIs pursued aggressive growth strategies during the past two decades in order to reach a size at which they would be presumptively TBTF.112 All of today’s four largest U.S. banks (BofA, Chase, Citigroup and Wells Fargo) are the products of serial acquisitions and explosive growth since 1990.113 BofA’s and Citigroup’s rapid expansions led them to brink of failure, from which they were saved by huge federal bailouts.114 Wachovia (the fourth-largest U.S. bank at the beginning of the crisis) pursued a similar path of frenetic growth until it collapsed in 2008 and was rescued by Wells Fargo in a federally-assisted merger.115 A comparable pattern of rapid expansion, collapse and bailout occurred among several European LCFIs.116

Unfortunately, the emergency acquisitions of LCFIs arranged by U.S. regulators have produced domestic financial markets in which the largest institutions hold even greater dominance.117 The four largest U.S. banks (BofA, Chase, Citigroup and Wells Fargo) now control 56 percent of domestic banking assets, up from 35 percent in 2000,118 while the top ten U.S. banks control 75 percent of domestic banking assets, up from 54 percent in 2000.119 The four largest banks also control a majority of the product markets for home mortgages, home equity loans, and credit card loans. Together with Goldman, the same four banks account for 97 percent of the aggregate notional values of OTC derivatives contracts written by U.S. banks.120 Thus, as Nomi Prins observed in September 2009, “[n]othing has changed [as a result of the financial crisis] except that we have larger players who are more powerful, who are more dependent on government capital and who are harder to regulate than they were to begin with.”121

Financial Regulation Must Be Reformed to Shrink TBTF Subsidies

In 2002, I warned that “the TBTF policy is the great unresolved problem of bank supervision” because it “undermines the effectiveness of both supervisory and market discipline, and it creates moral hazard incentives for managers, depositors and other uninsured creditors of [LCFIs].”122 During the current financial crisis, the U.S. and European nations followed a TBTF policy that embraced the entire financial sector. Recent studies have shown that the TARP capital infusions and FDIC debt guarantees announced in October 2008 represented very large transfers of wealth from taxpayers to the shareholders and creditors of the largest U.S. LCFIs.123

The enormous competitive advantages enjoyed by TBTF institutions must be eliminated (or at least significantly reduced) in order to restore a more level playing field for smaller financial institutions and to encourage the voluntary breakup of inefficient and risky financial conglomerates.124 The financial crisis has proven, beyond any reasonable doubt, that large universal banks operate based on a dangerous business model that is riddled with conflicts of interest and prone to speculative risk-taking.125

Accordingly, U.S. and European governments must rapidly adopt reforms that will (i) greatly reduce the scope of governmental safety nets and thereby significantly diminish the subsidies currently provided to LCFIs, and (ii) facilitate the orderly failure and liquidation of LCFIs under governmental supervision, with consequential losses to managers, shareholders and creditors of LCFIs. I believe that five key reforms are needed to accomplish those objectives: (1) strengthening current statutory restrictions on the growth of LCFIs, (2) creating a special resolution process to manage the orderly liquidation or restructuring of SIFIs, (3) establishing a consolidated supervisory regime and enhanced capital requirements for SIFIs, (4) creating a special insurance fund for SIFIs, in order to cover the costs of resolving failed SIFIs, and (5) rigorously insulating FDIC-insured banks that are owned by LCFIs from the activities and risks of their nonbank affiliates. The following sections provide an overview of my proposed reforms.

Statutory Limits on the Growth of LCFIs Should Be Strengthened

Congress authorized nationwide banking—via interstate branching and interstate acquisitions of banks by BHCs—when it passed the Riegle-Neal Interstate Banking and Branching Act of 1994 (“Riegle-Neal Act”).126 To prevent the emergence of dominant megabanks, the Riegle-Neal Act imposed nationwide and statewide deposit concentration limits (“deposit caps”) on interstate expansion by large banking organizations.127 Under the Riegle-Neal Act, a BHC may not acquire a bank in another state, and a bank may not merge with another bank across state lines, if the resulting banking organization (together with all affiliated FDIC-insured depository institutions) would hold (i) ten percent or more of the total deposits of all depository institutions in the U.S., or (ii) thirty percent or more of the total deposits of all depository institutions in any state.128

Unfortunately, the effectiveness of Riegle-Neal’s nationwide and statewide deposit caps is undermined by three major loopholes. First, the Riegle-Neal deposit caps do not apply to intrastate bank acquisitions or intrastate bank mergers. Second, the deposit caps do not apply to acquisitions of, or mergers with, thrift institutions and industrial banks, because those institutions are not treated as “banks” under the Riegle-Neal Act.129 Third, the deposit caps do not apply to acquisitions of, or mergers with, banks that are “in default or in danger of default” (the “failing bank” exception).130

The emergency acquisitions of Countrywide, Merrill, Wamu and Wachovia in 2008 demonstrated the significance of Riegle-Neal’s loopholes and the necessity of closing them. In reliance on the “non-bank” loophole, the FRB allowed BofA to acquire Countrywide and Merrill even though (i) both firms controlled FDIC-insured depository institutions (a thrift, in the case of Countrywide, and a thrift and industrial bank, in the case of Merrill), and (ii) both transactions allowed BofA to exceed the ten percent nationwide deposit cap.131 Similarly, after the FDIC seized control of Wamu as a failed depository institution, the FDIC sold the giant thrift to Chase even though the transaction enabled Chase to exceed the ten percent nationwide deposit cap.132 Finally, although the FRB determined that Wells Fargo’s acquisition of Wachovia gave Wells Fargo control of just under ten percent of nationwide deposits, the FRB probably could have approved the acquisition in any case by designating Wachovia as a bank “in danger of default.”133

The foregoing acquisitions enabled BofA, Chase and Wells Fargo to surpass the ten percent nationwide deposit cap.134 To prevent further breaches of the Riegle-Neal concentration limits, Congress should extend the nationwide and statewide deposit caps to cover all intrastate and interstate transactions involving any type of FDIC-insured depository institution, including thrifts and industrial banks. In addition, Congress should significantly narrow the failing bank exception by requiring federal regulators to make a “systemic risk determination” (“SRD”) in order to approve any transaction involving a failing FDIC-insured depository institution that would exceed the nationwide or statewide deposit caps.

Congress should establish the following procedural requirements for an SRD. First, the FRB and FDIC should determine jointly, with the concurrence of the Treasury Secretary, that the proposed transaction is necessary to avoid a substantial threat of severe injury to the banking system, the financial markets or the national economy. Second, each SRD should be audited by the Government Accountability Office (“GAO”) to determine whether regulators satisfied the criteria for an SRD. Third, each SRD should be reviewed in a joint hearing held by the House and Senate committees with oversight of the financial markets. The foregoing procedure for approving and reviewing an SRD (the “SRD Procedure”) would ensure much greater public transparency of, and scrutiny for, (i) any federal agency order that invokes the failing bank exception to the Riegle-Neal deposit caps, and (ii) regulatory decisions of similar importance, as described below.

The Obama Administration has announced its support for a proposal by former FRB Chairman Paul Volcker to prohibit mergers and acquisitions that would allow a single financial institution to acquire control of more than ten percent of total bank liabilities other than insured deposits (the “Volcker liabilities cap”). The Volcker liabilities cap would supplement the existing Riegle-Neal deposit caps and would be subject to the same exemption for acquisitions of banks “in default or in danger of default.”135 If enacted, the Volcker liabilities cap would present a significant barrier to further acquisitions of banks by BofA, Chase, and Citigroup.136 The Volcker liabilities cap would have the greatest impact on Citigroup, because Citigroup currently is not close to exceeding the Riegle-Neal nationwide deposit cap. In contrast, the Riegle-Neal nationwide deposit cap already blocks the three major rivals of Citigroup (BofA, Chase and Wells Fargo) from making further interstate acquisitions of banks.137

The Volcker liabilities cap has been criticized as vague and unworkable.138 It remains to be seen whether the proposal can be clarified in a manner that would give it a utility and ease of application comparable to the Riegle-Neal deposit caps. If it is appropriately clarified, the Volcker liabilities cap should be adopted as a supplemental method of restricting the growth of very large BHCs (e.g., Citigroup, Goldman, and Morgan Stanley) that rely mainly on the capital markets, rather than deposits, for their funding.139 For the reasons stated above with regard to the Riegle-Neal deposit caps, the Volcker liabilities cap should apply to all interstate and intrastate acquisitions of FDIC-insured depository institutions (including thrifts and industrial banks), and regulators should not be able to invoke the “failing bank” exception unless they comply with the SRD Procedure.

A Special Resolution Regime Should Be Established for Systemically Important Financial Institutions

During the financial crisis—as shown by the FRB’s assistance for Chase’s acquisition of Bear, the traumatic bankruptcy of Lehman, and the federal government’s massive bailout of AIG—federal regulators confronted a “Hobson’s choice of bailout or disorderly bankruptcy” when they decided how to respond to a SIFI’s potential failure.140 A statutory resolution process for SIFIs, similar to the existing resolution regime for FDIC-insured depository institutions, would be a highly beneficial “third way, between bankruptcy and bailout, that would either euthanize [SIFIs] peacefully or resuscitate them under new management.”141 The special resolution regime for SIFIs should include three essential elements.

First, Congress should establish a Financial Stability Oversight Council (“FSOC”) with voting members that include the leaders of the federal financial regulatory agencies and with additional non-voting members that represent state regulators of state-chartered banks, insurance companies and securities firms.142 By a two-thirds vote, the FSOC should be authorized to determine that a BHC or a nonbank financial company should be designated as a SIFI and should be subject to the special resolution regime for SIFIs. The criteria for identifying a financial firm as a SIFI should be based on factors relevant to systemic risk, including the firm’s size and the risk of contagion from the firm’s failure due to (i) the firm’s inter-connectedness or correlations of risk exposures with other important financial institutions or financial markets or (ii) the firm’s role as a key participant within one or more important sectors of the financial markets.143

Some commentators have opposed any public identification of SIFIs, due to concerns that firms designated as SIFIs would be treated as TBTF by the financial markets and would create additional moral hazard.144 However, moral hazard already exists in abundance because the financial markets are currently treating major LCFIs as TBTF. As noted above, during the current crisis federal regulators publicly identified and supported the nineteen largest BHCs, as well as Bear and AIG, as TBTF institutions.145 As a result of this massive and explicit governmental support, CRAs, depositors, and bondholders are currently giving highly preferential treatment to LCFIs that are viewed as TBTF.146

Accordingly, it is no longer credible for federal regulators to pretend that they can retreat to their former policy of “constructive ambiguity” by asserting their willingness to allow major LCFIs to collapse into disorderly bankruptcies similar to the Lehman debacle.147 Any such assertion would not be believed by the public or the financial markets.148 The best way to impose effective discipline on SIFIs, and to reduce the federal subsidies they receive, would be to designate them publicly as SIFIs and to impose stringent regulatory requirements that would force them to internalize the potential costs of their TBTF status.

Second, the FDIC should have authority to initiate the new special resolution regime for a failing SIFI by making an SRD (concurrently with the FRB and the Treasury Secretary). The SRD should follow the SRD Procedure and should require a finding that the SIFI either (i) has fallen below a specified minimum capital threshold or (ii) is facing a near-term risk of insolvency or bankruptcy due to a lack of adequate liquidity or a threatened acceleration of outstanding creditor claims. In addition, the SRD should include a finding that the systemic resolution process is needed to prevent the SIFI’s imminent failure from posing a risk of serious harm to the banking system, the financial markets or the national economy. The resolution process for a failed SIFI should be administered by the FDIC, given its experience in resolving large bank failures.149

Third, the resolution process for SIFIs should incorporate the following principles: (A) stockholders must lose their entire investment if the SIFI is unable to pay all valid creditor claims, (B) senior managers must be dismissed, together with other employees who were responsible for the SIFI’s failure, and (C) unsecured creditors must be required to accept meaningful “haircuts,” either in the form of a significant reduction in the amount of their debt claims or an exchange of a substantial amount of their debt claims for equity interests in a successor institution. In other words, the resolution process for a SIFI should resemble, to the maximum extent feasible, the outcome of a Chapter 11 bankruptcy proceeding.150 The FDIC should be required to prepare an SRD, and to comply with the SRD Procedure, if it decides either that (A) it must depart from any of the foregoing principles, or (B) it must advance funds to support the SIFI’s resolution without a reasonable assurance of repayment from the proceeds of the resolution. Any net proceeds realized by the FDIC from a SIFI’s resolution (over and above the FDIC’s expenses in carrying out the resolution) should be added to the Systemic Risk Insurance Fund (“SRIF”), described below.

SIFIs Should Be Subject to Consolidated Supervision by the FRB and Enhanced Prudential Requirements

Congress should designate the FRB as the consolidated supervisor for SIFIs, subject to the oversight of the FSOC. Given the FRB’s experience as the regulator of BHCs and as the “umbrella supervisor” for financial holding companies (“FHCs”), it is the logical choice as the consolidated supervisor for SIFIs.151

As consolidated supervisor, the FRB should have power to examine, and require reports from, SIFIs and their subsidiaries and affiliates. The FRB should also have authority to take enforcement actions (including cease-and-desist orders, civil money penalty orders, and orders removing directors and officers) against SIFIs and their subsidiaries and affiliates. The FRB’s authority in these matters should be direct. The FRB should not be required (as it is under current law) to rely primarily on actions taken by regulators of functionally regulated subsidiaries (e.g., banks, securities broker-dealers and insurance companies).152

If a functional regulator (e.g., the OCC or the SEC) believes that actions by the FRB as systemic risk regulator are creating an unwarranted conflict with the functional regulator’s supervision of a functionally regulated subsidiary, the functional regulator should have the right to appeal to the FSOC. By a two-thirds vote, the FSOC could require the FRB to rescind or modify any regulatory action with regard to a functionally regulated subsidiary of a SIFI that the FSOC determined was not necessary or appropriate to prevent a serious threat to the stability of the SIFI or any of the SIFI’s FDIC-insured subsidiaries.

The FRB should also have authority, with the concurrence of the FDIC, to establish systemic risk capital requirements (“SRCRs”) for SIFIs. The FDIC should be given a concurrent role in establishing SRCRs in view of its role as administrator of the SRIF. The FDIC’s responsibilities for administering the SRIF would encourage the FDIC to apply strict discipline against SIFIs in order to protect the SRIF’s solvency. Accordingly, the FDIC’s tendency toward supervisory stringency would serve as a desirable counterweight against the FRB’s tendency toward supervisory forbearance (which arises out of the FRB’s concern with preserving the stability of the financial markets).153 If the FRB and the FDIC disagreed over the appropriate level of SRCRs, the FSOC could resolve the disagreement and specify SRCRs by a vote of at least a majority of its voting members other than the representatives of the FRB and FDIC.

SRCRs should include a leverage capital requirement, which would be calculated based on the total (unweighted) assets of each SIFI. A leverage requirement is a useful tool for limiting excessive risk-taking by financial institutions, and it is an essential supplement to risk-based capital requirements. In 2007, European banks and U.S. investment banks operated with very high asset-to-equity ratios (usually above 30:1) because they were subject only to risk-based capital rules and did not have to satisfy a leverage capital requirement. By contrast, asset-to-equity ratios for U.S. commercial banks were typically below 25:1 because those banks had to comply with a leverage requirement as well as risk-based capital rules. To provide an additional margin for safety, the minimum leverage capital requirement for SIFIs should be increased to a level well above the current requirement of five percent for well-capitalized institutions.154

In addition to a leverage requirement, SRCRs should incorporate risk-based components, including rules that emphasize “the importance of common equity” as well as the need to “reduce pro-cyclical tendencies by establishing special capital buffers that would be built up in boom times and drawn down as conditions deteriorate.”155 The marginal rates for risk-based SRCRs should become progressively higher as a SIFI poses greater systemic risk due to (a) increases in its size, complexity or interconnectedness with other LCFIs, (b) hazards created by an aggressive compensation structure for managers or for key employees who work in high-risk areas (e.g., proprietary trading), and/or (c) weaknesses in the SIFI’s liquidity.156 In addition, SRCRs should take full account of all risk exposures of a SIFI, whether those exposures are held on the SIFI’s balance sheet or are linked to OBS entities.157

One intriguing proposal would require each SIFI to issue “contingent capital” as one component of its SRCR. This contingent capital would be issued in the form of convertible subordinated debt. That debt would convert automatically into common stock upon the occurrence of a designated event of financial stress, such as (i) a decline in the SIFI’s capital below a specified level that would “trigger” an automatic conversion, or (ii) the initiation by the FRB and the FDIC of the special resolution process for a SIFI. One advantage of contingent capital is that the SIFI’s common equity would be increased (due to the mandatory conversion of subordinated debt) at a time when the SIFI would face significant financial stress and probably could not sell stock in the market. Additionally, mandatory conversion would encourage holders of convertible subordinated debt to exercise greater discipline over the SIFI’s management, since those holders would risk losing their entire investment if mandatory conversion occurred.158

The biggest problem with the contingent capital proposal is that outside investors would be reluctant to purchase convertible subordinated debt unless the terms of the debt included a relatively high interest rate or other investor-friendly features (e.g., a voluntary conversion option on favorable terms) that would offset the risk of forfeiture due to a mandatory conversion event. SIFIs and outside investors therefore might not be able to agree on an interest rate and other terms for contingent capital that would acceptable to both sides.159

As I suggested in a previous article, contingent capital would be a particularly attractive option for compensating senior managers and other key employees. Managers and key employees should be required to accept convertible subordinated debentures in payment of a significant portion (e.g., one-third) of their annual compensation. Managers and key employees should not be allowed to make voluntary conversions of their subordinated debentures into common stock until the expiration of a minimum holding period (e.g., three years) after the termination date of their employment. Such a minimum post-employment holding period would discourage managers and key employees from taking excessive risks to boost the value of the conversion option during the term of their employment. At the same time, managers and key employees would know that their debentures are subject to mandatory conversion into common stock upon the occurrence of a designated event of financial stress. Thus, requiring managers and key employees to hold a significant portion of contingent capital would give them positive incentives to avoid excessive risk-taking and to manage their SIFI prudently in accordance with the interests of creditors as well as shareholders. Such a requirement would also force managers and key employees to share a significant portion of the loss if their SIFI was threatened with failure.160

SIFIs Should Pay Risk-Based Premiums to Establish a Systemic Risk Insurance Fund Administered by the FDIC

To accomplish a further reduction of TBTF subsidies, Congress should require SIFIs to pay risk-based insurance premiums to establish the SRIF.161 The FDIC should be required to assess risk-based SRIF premiums in order to establish, within a period not to exceed five years, a SRIF that would provide reasonable protection to taxpayers against the cost of a future systemic financial crisis. As explained above, federal regulators provided $290 billion of capital assistance to the nineteen largest BHCs (each with assets of more than $100 billion) and to AIG during the current crisis.162 It therefore appears that (i) $300 billion (appropriately adjusted for inflation) would be the minimum acceptable size for the SRIF, and (ii) SRIF premiums should be paid by all BHCs with assets of more than $100 billion (also adjusted for inflation) and by all other designated nonbank SIFIs. As with SRCRs, the marginal rates for SRIF premiums should become progressively higher as SIFIs pose greater systemic risk, adopt riskier compensation structures and/or maintain inadequate liquidity.163 In addition, the FDIC should impose additional assessments on SIFIs in order to replenish the SRIF within three years after the SRIF incurs any loss due to the failure of a SIFI.

For at least four reasons, it is essential to establish a pre-funded SRIF. First, it is unlikely that most SIFIs would have adequate financial resources to pay large SRIF premiums after one or more of their peers failed during a financial crisis. LCFIs are frequently exposed to highly correlated risk exposures during a serious financial disruption, because they followed similar high-risk business strategies (“herding”) during the credit boom that led to the crisis.164 Many LCFIs are therefore likely to suffer severe losses and to face a substantial risk of failure during a major disturbance in the financial markets.165 Consequently, a post-funded SRIF (i) would probably not be able in the short term to collect enough premiums from surviving SIFIs to cover the costs of resolving one or more failed SIFIs, and (ii) would therefore have to borrow large sums from the federal government to cover short-term resolution costs. Even if the SRIF ultimately repaid the borrowed funds by imposing ex post assessments on surviving SIFIs, the public and the financial markets would understandably conclude that the federal government provided bridge loans to bail out creditors of the failed SIFIs.166 Accordingly, a post-funded SRIF would not be successful in eliminating many of the implicit subsidies (and associated moral hazard) that our current TBTF policy has created.

Second, in a post-funded system, the most reckless SIFIs (which would be the most likely to fail) would effectively shift the potential costs of their risk-taking to the most prudent SIFIs, because the latter would be more likely to survive and bear the ex post costs of resolving failed SIFIs. Thus, a post-funded SRIF is undesirable because “firms that fail never pay and the costs are borne by surviving firms.”167

Third, a pre-funded SRIF would create beneficial incentives that would encourage each SIFI to monitor other SIFIs and to alert regulators to excessive risk-taking by those institutions. Every SIFI would know that the failure of another SIFI would deplete the SRIF and would also trigger future assessments that it and other surviving SIFIs would have to pay. Thus, each SIFI would have good reason to complain to regulators if it became aware of unsound practices or conditions at another SIFI.

Fourth, a pre-funded SRIF would reduce the TBTF subsidy for SIFIs by forcing them to internalize more of the “negative externality” (i.e., the potential public bailout cost) of their activities.168 A pre-funded SRIF would provide a reserve fund, paid for by SIFIs, that would protect governments and taxpayers from having to incur the expense of underwriting future bailouts of failed SIFIs.

To further reduce the potential TBTF subsidy for SIFIs, the SRIF should be strictly separated from the existing Deposit Insurance Fund (“DIF”). To ensure this separation, Congress should repeal the “systemic-risk exception” that is currently included in the Federal Deposit Insurance Act (“FDI Act”).169 The FDIC relied on that exception when it joined with the Treasury Department and the FRB in providing more than $400 billion of asset guarantees to Citigroup and BofA.170 The DIF should no longer be available as a potential source of protection for shareholders and creditors of SIFIs. Instead, the SRIF should be designated as the exclusive source of future funding for resolutions of failed SIFIs. Thus, the systemic-risk exception for the DIF should be repealed, and the FDIC should be required to apply the least-cost test in resolving all future bank failures.171 Repeal of the systemic-risk exception would ensure that the DIF is no longer viewed as a potential bailout fund for TBTF banking organizations.

Banks Controlled by Financial Holding Companies Should Operate as “Narrow Banks” so that They Cannot Transfer Their Federal Safety Net Subsidies to Their Nonbank Affiliates

In January 2010, President Obama announced his support for the “Volcker rule” proposed by former FRB Chairman Paul Volcker. The Volcker rule would prohibit FDIC-insured banks and companies controlling such banks from owning or controlling hedge funds or private equity funds or from engaging in proprietary trading (i.e., buying and selling securities, derivatives and other tradable assets for their own account). Trading in the capital markets by banks and their holding companies would be limited to “market making” activities conducted on behalf of clients.172 The primary purpose of the Volcker rule is to prevent government safety nets from “protecting and supporting essentially proprietary and speculative activities.”173 As this article went to press, it was uncertain whether Congress would adopt the Volcker rule. One of the most frequently-stated critiques of the rule was the difficulty in distinguishing between permissible market-making for clients and prohibited proprietary trading for a bank’s own account.174

In my view, the most feasible way to accomplish the basic purpose of the Volcker rule—namely, to prevent SIFIs from using the federal safety net to subsidize their speculative activities in the capital markets—would be to create a two-tiered structure of bank regulation and deposit insurance. As described below, the first tier of “traditional” banking organizations would provide a relatively broad range of banking-related services, but those organizations would not be allowed to engage, or to affiliate with firms engaged, in securities underwriting or dealing, insurance underwriting or derivatives dealing. In contrast, the second tier of “narrow banks” could affiliate with “nontraditional” firms engaged in capital markets activities, except for private equity investments. However, “narrow banks” would be prohibited from making any extensions of credit or other transfers of funds to their non-bank affiliates, except for lawful dividends paid to their parent holding companies. The “narrow bank” approach provides the most practicable method for ensuring that banks cannot transfer their safety net subsidies to affiliated companies engaged in speculative activities in the capital markets, and it is therefore consistent with the spirit of the Volcker rule.175

The First Tier of Traditional Banking Organizations

Under my proposal, the first tier of regulated banking firms would be “traditional” banking organizations that limit their activities (including the activities of all holding company affiliates) to lines of business that meet the “closely related to banking” test under Section 4(c)(8) of the Bank Holding Company Act (“BHC Act”).176 For example, this first tier of traditional banks could take deposits, make loans, offer fiduciary services, and act as agents in selling securities, mutual funds and insurance products underwritten by non-affiliated firms. Additionally, they could underwrite and deal solely in “bank-eligible” securities that national banks are permitted to underwrite and deal in directly.177 First-tier banking organizations could also purchase, as end-users, derivatives solely for bona fide hedging transactions that qualify for hedging treatment under Financial Accounting Standard (“FAS”) Statement No. 133.178

Most first-tier banking firms would probably be small and midsized community-oriented banks. Those banks do not have any comparative advantage—and therefore have not shown any substantial interest—in engaging as principal in insurance underwriting, securities underwriting or dealing, derivatives dealing or other capital markets activities. Community banks are well positioned to continue their established business of attracting core deposits, providing relationship loans to consumers as well as small and medium-sized business firms, and offering wealth management services to local customers through their fiduciary operations.179

In order to provide reasonable flexibility for this first tier of traditional banks, Congress should amend Section 4(c)(8) of the BHC Act by permitting the FRB to expand the list of “closely related” activities that are permissible for holding company affiliates of traditional banks.180 However, Congress should prohibit first-tier BHCs from engaging as principal in underwriting or dealing in securities, underwriting any type of insurance (except for credit insurance), dealing in OTC derivatives or making private equity investments. Furthermore, traditional banks and their holding companies should continue to operate under their current supervisory arrangements, and all of the banks’ deposits (up to the current statutory limit of $250,000) should be covered by deposit insurance.

The Second Tier of Nontraditional Banking Organizations

In contrast to first-tier banking firms, the second tier of “nontraditional” banking organizations would be allowed to engage in (i) underwriting and dealing (i.e., proprietary trading) in “bank-ineligible” securities, (ii) underwriting insurance, and (iii) dealing or trading in derivatives. Second-tier organizations would include: (A) FHCs registered under Sections 4(k) and 4(l) of the BHC Act,181 (B) holding companies owning grandfathered “nonbank banks,” and (C) grandfathered “unitary thrift” holding companies.182 In addition, firms controlling industrial banks should be required either to register as FHCs or to divest their ownership of such banks if they cannot comply with the BHC Act’s prohibitions against commercial activities.183 Second-tier holding companies would thus encompass all of the largest banking organizations, most of which are heavily engaged in capital markets activities, together with other financial conglomerates that control FDIC-insured depository institutions.

Congress Should Require a “Narrow Bank” Structure for Second-Tier Banks

Under my proposal, FDIC-insured depository institutions that are subsidiaries of second-tier holding companies would be required to operate as “narrow banks.” The purpose of the narrow bank structure would be to prevent a “nontraditional” second-tier holding company from transferring the bank’s deposit insurance subsidy to its nonbank affiliates.

Narrow banks could offer FDIC-insured deposit accounts, including checking and savings accounts and certificates of deposit. Narrow banks would hold all of their assets in the form of cash and marketable, short-term debt obligations, including qualifying government securities, highly-rated commercial paper and other liquid, short-term debt instruments that are eligible for investment by money market mutual funds (“MMMFs”) under the SEC’s rules. Narrow banks could not hold any other types of loans or investments, nor could they accept any uninsured deposits. Narrow banks would present a very small risk to the DIF, because (i) each narrow bank’s non-cash assets would consist solely of short-term securities that could be “marked to market” on a daily basis, and the FDIC could therefore readily determine whether a narrow bank was threatened with insolvency, and (ii) the FDIC could promptly convert a narrow bank’s assets into cash if the FDIC decided to liquidate the bank and pay off the claims of its insured depositors.184

Thus, narrow banks would effectively operate as FDIC-insured MMMFs. In order to prevent unfair competition with narrow banks, and to avoid future government bailouts of uninsured MMMFs, MMMFs should be prohibited from representing, either explicitly or implicitly, that they will redeem their shares based on a “constant net asset value” (“NAV”) of $1 per share.185 Currently, the MMMF industry (which manages $3.3 trillion of assets) leads investors to believe that their funds will be available for withdrawal (redemption) based on “a stable price of $1 per share.”186 Not surprisingly, “the $1 share price gives investors the false impression that money-market funds are like [FDIC-insured] banks accounts and can’t lose money.”187 However, “[t]hat myth was shattered in 2008” when Lehman’s default on its commercial paper caused Reserve Primary Fund (a large MMMF that invested heavily in Lehman’s paper) to suffer large losses and to “break the buck.”188 Reserve Primary Fund’s inability to redeem its shares based on a NAV of $1 per share caused an investor panic that precipitated runs on several MMMFs. The Treasury Department responded by establishing the Money Market Fund Guarantee Program (“MMFGP”), which protected investors in participating MMMFs between October 2008 and September 2009.189

Critics of MMMFs maintain that the Treasury’s MMFGP has created an expectation of similar government bailouts if MMMFs “break the buck” in the future. 190 In addition, former FRB chairman Paul Volcker has argued that MMMFs weaken banks because of their ability to offer bank-like products without equivalent regulation. MMMFs typically offer accounts with check-writing features, and they provide returns to investors that are higher than bank checking accounts because MMMFs do not have to pay FDIC insurance premiums or to comply with other bank regulations.191 A Group of Thirty report, which Mr. Volcker spearheaded, proposed that MMMFs “that want to offer bank-like services, such as checking accounts and withdrawals at $1 a share, should reorganize as a type of bank, with appropriate supervision and government insurance.”192 In contrast, MMMFs that do not wish to operate as banks “should not maintain the implicit promise that investors’ money is always safe” and should be required to base their redemption price on a floating NAV.193

For the above reasons, uninsured MMMFs should be prohibited from representing, explicitly or implicitly, that they will redeem shares based on a stable NAV. If Congress imposed this prohibition on MMMFs and adopted my proposal for a two-tiered structure of bank regulation, many MMMFs would probably reorganize as FDIC-insured narrow banks and would become subsidiaries of second-tier FHCs.194 As noted above, rules restricting the assets of narrow banks to commercial paper, government securities and other types of marketable, highly-liquid investments would protect the DIF from any significant loss if a narrow bank failed.

Four Additional Rules Would Prevent Narrow Banks from Transferring Safety Net Subsidies to Their Affiliates

Four supplemental rules are needed to prevent second-tier holding companies from exploiting their narrow banks’ safety net subsidies. First, narrow banks should be prohibited from making any extensions of credit or other transfers of funds to their affiliates, except for the payment of lawful dividends out of profits to their parent holding companies.195 During times of financial crisis, the FRB has repeatedly waived the current restrictions on affiliate transactions mandated by Sections 23A and 23B of the Federal Reserve Act.196 Those waivers allowed bank subsidiaries of FHCs to provide extensive support to affiliated securities broker-dealers and MMMFs. By granting those waivers, the FRB enabled banks controlled by FHCs to transfer the safety net subsidy provided by low-cost, FDIC-insured deposits to their nonbank affiliates.197 With respect to second-tier banking organizations, my proposal would replace Sections 23A and 23B with an absolute prohibition on any extensions of credit or other transfers of funds by second-tier banks to their nonbank affiliates. That reform would effectively prevent the FRB from approving any similar transfers of safety net subsidies by narrow banks to their affiliates.

Second, as discussed above, the “systemic risk” provision currently included in the FDI Act should be repealed. By repealing the “systemic risk” exception, Congress would require the FDIC to follow the least costly resolution procedure for every failed bank, and the FDIC could no longer rely on the TBTF policy as a justification for protecting uninsured creditors of a failed bank’s parent holding company or other nonbank affiliates of a failed bank.198

Insulating the DIF from any possibility of TBTF bailouts would have important benefits. It would make clear to the financial markets that the DIF could only be used to protect depositors of failed banks. Uninsured creditors of FHCs—regardless of their size—would no longer have any reasonable expectation of being protected by the DIF. Shareholders and creditors of FHCs and their nonbank subsidiaries would therefore have stronger incentives to monitor the financial condition of such entities.

Additionally, smaller banks would no longer bear any part of the cost of rescuing uninsured creditors of TBTF banks. Under current law, all FDIC-insured banks must pay a special assessment (allocated in proportion to their total assets) to reimburse the FDIC for the cost of protecting uninsured claimants of a TBTF bank under the “systemic risk” provision.199 A 2000 FDIC report noted the unfairness of expecting smaller banks to help pay for “systemic risk” bailouts when “it is virtually inconceivable that they would receive similar treatment if distressed.”200 The FDIC report suggested that the way to correct this inequity is “to remove the systemic risk exception from the [FDI Act],”201 as I have proposed here.

Third, second-tier narrow banks should be prohibited from dealing in derivatives or from purchasing derivatives except as end-users for bona fide hedging purposes pursuant to FAS 133.202 All other derivatives activities of second-tier banking organizations must be conducted through separate nonbank affiliates. This rule would prevent FHCs from continuing to exploit federal safety net subsidies by conducting risky derivatives activities within their FDIC-insured bank subsidiaries.

I have previously pointed out that bank dealers in OTC derivatives enjoy significant competitive advantages over nonbank dealers because of the banks’ explicit and implicit safety net subsidies.203 Banks typically borrow funds at significantly lower interest rates than their holding company affiliates because (i) banks can obtain direct, low-cost funding through FDIC-insured deposits, and (ii) banks present lower risks to their creditors because of their direct access to other federal safety net resources, including (A) the FRB’s discount window lending facility, (B) the FRB’s guarantee of interbank payments made on Fedwire, and (C) the greater potential availability of TBTF bailouts for uninsured creditors of banks (as compared to creditors of BHCs).204 The OCC has confirmed that FHCs generate higher profits when they conduct derivatives activities directly within their banks, in part because the “favorable [funding] rate enjoyed by the banks” is lower than “the borrowing rate of their holding companies.”205 Such an outcome may be favorable to FHCs, but it is certainly not beneficial to the DIF and taxpayers, since they are exposed to a higher risk of losses when derivatives activities are conducted directly within banks instead of within nonbank holding company affiliates.206

Fourth, second-tier banks and their affiliates should be prohibited from making private equity investments. To accomplish this reform, Congress must repeal Sections 4(k)(4)(H) and (I) of the BHC Act,207 which allow FHCs to make merchant banking investments and insurance company portfolio investments.208 Private equity investments by second-tier banking organizations should be banned because they involve a high degree of risk and have inflicted significant losses on FHCs in the past.209 In addition, private equity investments “could potentially weaken the separation of banking and commerce” by allowing FHCs “to maintain long-term control over entities that conduct commercial (i.e., nonfinancial) businesses.”210 Such affiliations between banks and commercial firms are undesirable because they are likely to create serious competitive and economic distortions, including the spread of federal safety net benefits to the commercial sector of our economy.211

In combination, the four supplemental rules described above would help to ensure that narrow banks cannot transfer their federal safety net subsidies to their nonbank affiliates. Restricting the scope of safety net subsidies is of utmost importance in order to restore a more level playing field between small and large banks, and between banking and nonbanking firms. Safety net subsidies have increasingly distorted our regulatory and economic policies over the past three decades. During that period, nonbanking firms have pursued every available avenue to acquire FDIC-insured depository institutions so that they can secure the funding advantages provided by low-cost, FDIC-insured deposits. At the same time, nonbank affiliates of banks have made every effort to exploit the funding advantages and other safety net benefits conferred by their affiliation with FDIC-insured institutions.212 The enormous benefits conferred by federal safety net subsidies are conclusively shown by the following facts: (i) no major bank organization has ever voluntarily surrendered its banking charter, and (ii) large nonbanking firms have aggressively pursued strategies to secure control of FDIC-insured depository institutions.213

The most practicable way to prevent the spread of federal safety net subsidies, as well as their distorting effects on regulation and economic activity, is to establish strong barriers that prohibit narrow banks from transferring their subsidies to their nonbanking affiliates, including those engaged in speculative capital markets activities.214 The narrow bank structure and the supplemental rules described above would force financial conglomerates to prove that they can produce superior risk-related returns to investors without relying on governmental subsidies. As I have previously explained elsewhere, economic studies have failed to confirm the existence of favorable economies of scale or scope in financial conglomerates, and those conglomerates have not been able to generate consistently positive returns, even under the current regulatory system that allows them to capture extensive federal subsidies.215

In late 2009, a prominent bank analyst suggested that if Congress enacted new rules that imposed severe restrictions on affiliate transactions, and thereby prevented nonbank subsidiaries of FHCs from relying on low-cost deposit funding provided by their affiliated banks, large FHCs would not be economically viable and would be forced to break up voluntarily.216 It is noteworthy that many of the largest commercial and industrial conglomerates in the U.S. and Europe have been broken up through hostile takeovers and voluntary divestitures during the past three decades because they proved to be “less efficient and less profitable than companies pursuing more focused business strategies.”217 It is long past time for financial conglomerates to be stripped of their safety net subsidies so that they will be subject to the same type of scrutiny and discipline that the capital markets have applied to commercial and industrial conglomerates during the past thirty years. The narrow bank concept provides a workable plan to impose such scrutiny and discipline on FHCs.

Responses to Critiques of the Narrow Bank Proposal

Critics have raised three major objections to the narrow bank concept. First, critics point out that the asset restrictions imposed on narrow banks would prevent them from acting as intermediaries of funds between depositors and most borrowers. As noted above, many narrow bank proposals would require such banks to invest their deposits in safe, highly marketable assets such as those permitted for MMMFs. Narrow banks would therefore be largely or entirely barred from making commercial loans. As a result, critics warn that a banking system composed exclusively of narrow banks could not provide credit to small and midsized business firms that lack access to the capital markets and depend on banks as their primary source of outside credit.218

However, my two-tiered proposal would greatly reduce any disruption of the traditional role of banks in acting as intermediaries between depositors and bank-dependent firms, because my proposal would allow first-tier “traditional” banks (primarily community-oriented banks) to continue making commercial loans that are funded by deposits. Community banks make most of their commercial loans in the form of longer-term “relationship” loans to small and midsized firms. Community banks have significant advantages in making such loans, because (i) their main offices are located in the communities where they make most of their commercial loans and their employees have superior access to information about the character, reputation, and skills of local business owners, (ii) they maintain greater continuity in their branch managers and loan officers, thereby creating stronger relationships with local business owners, and (iii) they typically provide greater flexibility to their loan officers and business customers.219 Under my proposal, community banks could carry on their deposit-taking and lending activities as first-tier banking organizations without any change from current law, and their primary commercial lending customers would continue to be smaller, bank-dependent firms.

In contrast to community banks, most big banks do not make a substantial number of relationship loans to small firms. Instead, big banks primarily make loans to large and well-established firms. In addition, when big banks do provide credit to smaller firms they primarily do so through automated “transaction-based” programs that (A) disburse loans in relatively small amounts (usually under $100,000), (B) use centralized, impersonal approval methods based on credit scoring, and (C) enable loans to be securitized into asset-backed securities sold to investors in the capital markets.220 Under my proposal, as indicated above, most large banks would operate as subsidiaries of second-tier “nontraditional” banking organizations. Second-tier holding companies would conduct their business lending programs through nonbank finance subsidiaries that are funded by commercial paper and other debt instruments sold to investors in the capital markets. This operational structure should not create a substantial disincentive for the small business lending programs offered by big banks, because major segments of those programs (e.g., business credit card loans) are already financed by the capital markets through securitization. Accordingly, my two-tier proposal should not cause a significant reduction in bank loans to bank-dependent firms, as big banks have already moved away from traditional relationship-based lending funded by deposits.

The second major criticism of the narrow bank proposal is that it would lack credibility because federal regulators would retain the inherent authority (whether explicit or implicit) to organize bailouts of major financial firms during periods of severe economic distress. Accordingly, some critics maintain that the narrow bank concept would simply shift the TBTF problem from the insured bank to its non-bank affiliates.221 However, the force of this objection would be greatly diminished if Congress establishes a new comprehensive regime for regulating SIFIs as described above, including a special resolution process, SRCRs, consolidated supervision, and mandatory payment of SRIF insurance premiums. This proposed systemic risk supervision regime would ensure that all nonbanking firms that might be considered for TBTF bailouts are designated and regulated as SIFIs. In addition, all SIFIs would be required to pay premiums to fund the SRIF, and a fund separate from the DIF would therefore exist to resolve the failure of major nonbanking firms.

Thus, the narrow bank structure would prevent FDIC-insured banks that are controlled by SIFIs from transferring their safety net subsidies to their nonbank affiliates, and the systemic risk supervisory regime would force nonbank SIFIs to internalize the potential risks to financial and economic stability that result from their operations. In combination, both regulatory reforms should greatly reduce any TBTF subsidies that might otherwise be available to large nonbank firms.

The third principal objection to the narrow bank proposal is that it would place U.S. FHCs at a significant disadvantage in competing with foreign universal banks that are not required to comply with similar constraints.222 Again, there are persuasive rebuttals to this objection. For one thing, government officials in the U.K. are giving serious consideration to the possible adoption of a narrow banking structure based on a proposal developed by John Kay.223 If the U.S. and the U.K. both decided to implement a narrow banking structure (together with other needed systemic risk regulations), their combined leadership in global financial markets would place considerable pressure on other developed countries to adopt similar financial reforms.224

Moreover, the financial sector accounts for a large share of the domestic economies of the U.S. and U.K., and both economies have suffered severe injuries from two financial crises during the past decade (the dotcom-telecom bust and the subprime lending crisis). Both crises were produced by the same set of LCFIs that continue to dominate the financial systems in both nations. Accordingly, regardless of what other nations may do, the U.S. and the U.K. have compelling national reasons to make sweeping changes to their financial systems in order to protect their domestic economies from the threat of a similar crisis in the future.225

Finally, the view that the U.S. and the U.K. must refrain from implementing fundamental financial reforms until all other major developed nations have agreed to do so rests upon two deeply flawed arguments: (i) the U.S. and the U.K. should allow foreign nations with the weakest systems of financial regulation to dictate the level of supervisory constraints on LCFIs, and (ii) until a comprehensive international agreement on reform is achieved, the U.S. and the U.K. should continue to provide TBTF bailouts and other safety net subsidies that impose huge costs, create moral hazard problems and distort economic incentives, simply because other nations provide similar benefits to their LCFIs.226 Both arguments are unacceptable and must be rejected.


The TBTF policy remains “the great unresolved problem of bank supervision,” more than a quarter century after the policy was invoked to justify the federal government’s rescue of Continental Illinois in 1984.227 The current financial crisis has proven, once again, that TBTF institutions “present formidable risks to the federal safety net and are largely insulated from both market discipline and supervisory intervention.”228 The crisis has also confirmed that TBTF institutions “pursue riskier and opaque activities and … increase their leverage, through capital arbitrage, if necessary, as they grow in size and complexity.”229 Accordingly, as I observed in 2002, “fundamentally different approaches for regulating financial conglomerates and containing safety net subsidies are urgently needed.”230

To respond to that need, this chapter has outlined a reform program to shrink safety net subsidies, force SIFIs to internalize the risks and costs of their activities, and create a more level playing field between smaller, traditional banks and LCFIs. My five-part program would (i) strengthen existing statutory limits on the growth of LCFIs, (ii) create a special resolution process to manage the orderly liquidation or restructuring of failed SIFIs, (iii) establish a consolidated supervisory regime and special capital requirements for SIFIs, (iv) create a special insurance fund (the SRIF), financed by assessments on SIFIs, in order to protect taxpayers against the costs of resolving failed SIFIs, and (v) mandate a “narrow bank” structure for FDIC-insured banks owned by LCFIs for the purpose of insulating those banks and the DIF from the risks of nonbank affiliates.

In combination, my proposed reforms would strip away many of the safety net subsidies that are currently exploited by LCFIs and would subject them to the same type of market discipline that the capital markets have applied to commercial and industrial conglomerates over the past thirty years. Financial conglomerates have never demonstrated that they can provide beneficial services to their customers and attractive returns to their investors without relying on safety net subsidies and massive taxpayer-funded bailouts. It is long past time for LCFIs to prove—based on a true market test—that their claimed superiority is a reality and not a myth.

Arthur E. Wilmarth, Jr., “The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis,” 41 Connecticut Law Review 963, 966 n.3 (2009), available at (quoting views of regulators and analysts describing the current financial crisis as the most serious since the Great Depression). See also The Causes and Current State of the Financial Crisis: Hearing Before the Financial Crisis Inquiry Commission 3, 4 tbl.1 (Jan. 13, 2010) (written testimony of Mark Zandi, Chief Economist and Cofounder of Moody’s Economy. com), available at (stating that the current financial crisis caused a “Great Recession” that is “the longest, broadest and most severe since the Great Depression”).

Portions of this chapter are adapted from the following article: Arthur E. Wilmarth, Jr., “Reforming Financial Regulation to Address the Too-Big-To-Fail Problem,” 35 Brooklyn Journal of International Law 707 (2010), available at

As used in this article, the term “large, complex financial institution” (LCFI) includes major commercial banks, securities firms and insurance companies as well as “universal banks” (i.e., financial conglomerates that have authority to engage, either directly or through affiliates, in a combination of banking, securities and insurance activities). See Wilmarth, supra note 1, at 968 n.15.

On June 30, 2010, the U.S. House of Representatives passed comprehensive financial reform legislation, which had been approved the previous day by a House-Senate conference committee. At the time this chapter was completed, it was not clear whether the U.S. Senate would vote to approve the legislation. Damien Paletta & Greg Hitt, “U.S. News: House Vote Sends Financial Overhaul to Senate,” Wall Street Journal, July 1, 2010, at A6; Alison Vekshin & Phil Mattingly, “U.S. Regulatory Bill’s Support May Weaken as Senate Delays Vote,”, July 1, 2010; David M. Herszenhorn, “Bank Tax Is Dropped in Overhaul of Industry,” New York Times, June 30, 2010, at B1. This chapter does not attempt to analyze the potential impact of the proposed reform legislation on the U.S. financial services industry if it is ultimately enacted.

Adrian Blundell-Wignall et al., “The Elephant in the Room: The Need to Deal with What Banks Do,” 2 Organisation for Economic Co-Operation & Development Journal: Financial Market Trends, Vol. 2009, No. 2, at 1, 4–5, 14, 15 tbl.4, available at (showing that leading nations around the world provided an estimated $11.4 trillion of capital infusions, asset purchases, asset guarantees, and debt guarantees to financial institutions through October 2009); David Dickson, “Debate Rages Over Stimulus Fallout,” Washington Times, Feb. 23, 2010, at A1. See also Int’l Monetary Fund, Global Financial Stability Report: Navigating the Financial Challenges Ahead 4–5, 6–10, 24–29 (Oct. 2009), available at [hereinafter October 2009 IMF GFS Report]; “Withdrawing the Drugs: Tightening Economic Policy,” Economist, Feb. 13, 2010, [hereinafter “Tightening Economic Policy”].

Blundell-Wignall et al., supra note 5, at 15 tbl.4 (showing that the U.S. provided $6.4 trillion of assistance to financial institutions, while the U.K. and other European nations provided $4.3 trillion of assistance).

See Dickson, supra note 5; Michael A. Fletcher, “Obama Leaves D.C. to Sign Stimulus Bill,” Washington Post, Feb. 18, 2009, at A5; William Pesek, “After the Stimulus Binge, A Debt Hangover,” Bloomberg BusinessWeek, Jan. 26, 2010, at 14; “Tightening Economic Policy,” supra note 5.

For discussions of the federal government’s bailouts of Citigroup, Bank of America (“BofA”) and American International Group (“AIG”), see Andrew Ross Sorkin, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis – and Themselves 373-407, 513-34 (New York: Viking, 2009); David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic 3, 25–26, 189–97, 239–41, 259–63 (New York: Crown Business, 2009); Patricia A. McCoy, Andrey D. Pavlov & Susan M. Wachter, “Systemic Risk Through Securitization: The Result of Deregulation and Regulatory Failure,” 41 Connecticut Law Review 1327, 1364–66 (2009); Wilmarth, supra note 1, at 1044–45.

For descriptions of the U.S. government’s support for the acquisitions of Wachovia by Wells Fargo, of National City Bank by PNC, of Bear Stearns (“Bear”) and Washington Mutual (“Wamu”) by JP Morgan Chase (“Chase”), and of Countrywide and Merrill Lynch (“Merrill”) by BofA, as well as the rapid conversions of Goldman Sachs (“Goldman”) and Morgan Stanley into BHCs, see Sorkin, supra note 8, at 414-503; David P. Stowell, An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm 182-84, 398-405, 410-17 (Amsterdam: Elsevier Academic Press, 2010); Wessel, supra note 8, at 8–9, 18–19, 147–72, 217–26, 239–41, 259–63; Wilmarth, supra note 1, at 1044–45; Arthur E. Wilmarth, Jr., Cuomo v. Clearing House: The Supreme Court Responds to the Subprime Financial Crisis and Delivers a Major Victory for the Dual Banking System and Consumer Protection 27–30 (Geo. Wash. U. Law Sch. Pub. L. & Leg. Theory, Working Paper No. 479, 2009), available at

Wilmarth, supra note 2, at 713.

In announcing the “stress test” for the 19 largest banking firms in early 2009, federal regulators “emphasized that none of the banks would be allowed to fail the test, because the government would provide any capital that was needed to ensure the survival of all nineteen banks.” Wilmarth, supra note 1, at 1050 n.449 (citing speech by Federal Reserve Bank of New York president William C. Dudley and congressional testimony by FRB chairman Ben Bernanke); Joe Adler, “In Focus: Stress Tests Complicate ‘Too Big to Fail’ Debate,” American Banker, May 19, 2009, at 1 (stating that “[b]y drawing a line at $100 billion of assets, and promising to give the 19 institutions over that mark enough capital to weather an economic downturn, the government appears to have defined which banks are indeed ‘too big to fail’”). Based on the stress tests, regulators determined that ten of the 19 firms required additional capital. Nine of those firms were successful in raising the needed funds, but the federal government provided $11.3 billion of additional capital to GMAC when that company could not raise the required capital on its own. Wilmarth, supra note 2, at 713 n.12.

For descriptions of governmental support measures for financial institutions in the U.K. and other European nations, see authorities cited in Wilmarth, supra note 2, at 714.

Rodney Yap & Dave Pierson, “Subprime Mortgage-Related Losses Exceed $1.77 Trillion: Table,” Bloomberg News, May 11, 2010 (showing that global banks, securities firms and insurers incurred $1.51 trillion of writedowns and credit losses due to the financial crisis, while Fannie Mae and Freddie Mac suffered an additional $270 billion of losses).

Shamim Adam, “Global Financial Assets List $50 Trillion Last Year, ADB Says,”, Mar. 9, 2009.

See Int’l Monetary Fund, World Economic Outlook, April 2009: Crisis and Recovery, at 1–96 (2009), available at A recent study concluded that the current recession is much more severe, both in the U.S. and globally, than the preceding recessions of 1975, 1982 and 1991. Stijn Claeesens et al., The Global Financial Crisis: How Similar? How Different? How Costly? (Mar. 17, 2010), at 3, 19-20, available at

Int’l Monetary Fund, World Economic Outlook, October 2009: Sustaining the Recovery, at 1–92 (2009), available at; Timothy R. Homan, “U.S. Economy Grew at 2.2 percent Annual Rate Last Quarter (Update 2),” (reporting that the U.S. economy grew during the third quarter of 2009 “at a slower pace than anticipated,” following a steep decline during the previous year); Marcus Walker & Brian Blackstone, “Euro-Zone Economy Returns to Expansion: Third-Quarter Growth Brings an End to Stretch of Contraction Dating to last Year, but Signals Fragility of Region’s Recovery,” Wall Street Journal, Nov. 14, 2009, at A6 (reporting that “[t]he euro-zone economy returned to modest growth in the third quarter [of 2009], marking an apparent end to five quarters of recession, but the region’s recovery looks set to be anemic”).

Peter Coy & Cotton Timberlake, “Funny, It Doesn’t Feel Like a Recovery,” Bloomberg BusinessWeek, May 31–June 6, 2010, at 9; Jon Hilsenrath, “U.S. News: Credit Remains Scarce in Hurdle to Recovery,” Wall Street Journal, Feb. 27, 2010, at A2; Neil Irwin & Lori Montgomery, “Dearth of new jobs threatens recovery: Data point to sluggish growth,” Washington Post, July 3, 2010, at A1; Simone Meier, “Europe’s Recovery Almost Stalls as Investment Drops (Update 2),”, Mar. 4, 2010; Mark Deen, “European Economy Risks Decoupling from Global Growth Recovery,”, Feb. 28, 2010; Howard Schneider & Anthony Faiola, “Debt is Ballooning into a Global Crisis: Developed Nations May Have To Raise Taxes and Cut Programs,” Washington Post, April 9, 2010, at A1.

Simon Kennedy & James G. Neuger, “EU Faces Demands to Broaden Crisis Fight as G-7 Meets (Update 2),”, May 7, 2010; Simon Kennedy, “Now It’s a European Banking Crisis,” Bloomberg BusinessWeek, May 3- May 9, 2010, at 11; Sandrine Rastello, “IMF Says Government Debt Poses Biggest Risk to Growth (Update 1),”, April 20, 2010.

Joe Kirwin et al., “International Economics: EU Ministers, ECB, IMF Marshal Forces To Stabilize Euro With Trillion Dollar Plan,” 94 Banking Report (BNA) 897 (May 11, 2010); Landon Thomas Jr. & Jack Ewing, “A Trillion for Europe, With Doubts Attached,” New York Times, May 11, 2010, at A1.

Gavin Finch & John Glover, “The Debt Crisis: Europe’s Banks Face A Funding Squeeze,” Bloomberg BusinessWeek, June 21-27, 2010, at 51; Carrick Mollenkamp et al., “Europe’s Banks Hit By Rising Loan Costs,” Wall Street Journal, May 25, 2010, at A1.

Irwin & Montgomery, supra note 17; Pierre Paulden, “Opening Remarks: When Banks Don’t Trust Banks,” Bloomberg BusinessWeek, May 31–June 6, 2010, at 11.

See, e.g., Phil Mattingly, “Frank Says Senate’s Stronger Rules Will Sway Financial Bill,”, May 17, 2010 (describing public pressure for stronger reform measures during the Senate’s consideration of financial reform legislation, because “[t]he public has gotten a lot angrier and the game has changed due to a rise in anti-bank fever”) (quoting Robert Litan); Simon Clark, “‘Lepers’ in London Defend Right To Make Money as Election Looms,”, Feb. 25, 2010 (describing public anger directed against large U.K. banks “after British taxpayers assumed liabilities of more than [$1.23 trillion] to bail out the country’s lenders”).

Wilmarth, supra note 1, at 988–91, 1037–40 (reporting that, in 2007, residential mortgage-backed securities accounted for nearly two-thirds of all U.S. residential mortgages, while commercial mortgage-backed securities represented almost a quarter of domestic commercial mortgages, asset-backed securities accounted for more than a quarter of domestic consumer loans, and collateralized loan obligations included more than a tenth of global leveraged syndicated loans); id. at 1025-30, 1040-43 (discussing widespread belief that the OTD business model enabled LCFIs to transfer the risks of securitized loans to investors); James Crotty, “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture,’” 33 Cambridge Journal of Economics 563, 567-68 (2009) (same).

Wilmarth, supra note 1, at 984–87, 994–97, 1008–43. Viral V. Acharya et al., “Prologue: A Bird’s-Eye View: The Financial Crisis of 2007-2009: Causes and Remedies,” in Restoring Financial Stability: How to Repair a Failed System 14–23 (Viral V. Acharya & Matthew Richardson eds., New York: John Wiley & Sons, Inc., 2009) [hereinafter Restoring Financial Stability]; Viral V. Acharya & Matthew Richardson, Causes of the Financial Crisis, 21 Critical Review 195, 198-200 (2009), available at

Wilmarth, supra note 1, at 984–90. See also Joshua Coval et al., “The Economics of Structured Finance,” 23 Journal of Economic Perspectives No. 1, at 3, 5–7 (2009); Efraim Benmelech & Jennifer Dlugosz, The Credit Rating Crisis 3–6, (Nat’l Bureau of Econ. Research, Working Paper No. 15045, 2009); Kenneth E. Scott, The Financial Crisis: Causes and Lessons: Ending Government Bailouts As We Know Them, Part I – The Crisis 6–8 (Rock Center for Corp. Governance, Working Paper Ser. No. 67, 2009). RMBS and CMBS are sometimes hereinafter collectively referred to as “mortgage-backed securities” (“MBS”).

Wilmarth, supra note 1, at 990–91. The term “CDOs” is hereinafter used to refer collectively to CDOs and CLOs as well as collateralized bond obligations (“CBOs”). Stowell, supra note 9, at 105–06, 456. As Frank Partnoy has noted, many CDOs functioned as “‘second-level’ securitizations of ‘first-level’ mortgage-backed securities (which were securitizations of mortgages).” Frank Partnoy, Overdependence on Credit Ratings was a Primary Cause of the Crisis 5 (U. San Diego School of Law Legal Studies Research Paper No. 09-015, 2009), available at CDOs consisting of tranches of MBS are sometimes referred to as collateralized mortgage obligations (CMOs) but are referred to herein as CDOs. Benmelech & Dlugosz, supra note 25, at 6.

LCFIs frequently used mezzanine tranches of CDOs to create CDOs-squared, because the mezzanine tranches were the least attractive (in terms of their risk-yield tradeoff) to most investors. Wilmarth, supra note 1, at 990–91, 1027–30. See also Scott, supra note 25, at 7–8, 8 slide 3. CDOs and CDOs-squared are sometimes hereinafter collectively referred to as “CDOs.”

October 2009 IMF GFS Report, supra note 5, at 84, fig.2.2 & fig.2.3 (indicating that $15.3 trillion of “private-label” issues of ABS, MBS, CDOs and CDOs-squared were issued in global markets between 2000 and 2007, of which $9.4 trillion was issued in the U.S.). “Private-label” securitizations refer to asset-backed securities issued by private-sector financial institutions, in contrast to securitizations created by government-sponsored enterprises such as Fannie Mae and Freddie Mac. Id. at 77. See also Wilmarth, supra note 1, at 988–89.

Benmelech & Dlugosz, supra note 25, at 1.

Jeffrey Manns, “Rating Risk After the Subprime Mortgage Crisis: A User Fee Approach for Rating Agency Accountability,” 87 North Carolina Law Review 1011, 1036-37 (2009). See also Wilmarth, supra note 1, at 991–93, 1031–32; Viral V. Acharya et al., “Centralized Clearing for Credit Derivatives,” in Restoring Financial Stability, supra note 24, at 251, 254 (explaining that “a [CDS] is like an insurance contract”).

Crotty, supra note 23, at 569 (citing (i) a 2007 report by Fitch Ratings, concluding that “58 percent of banks that buy and sell credit derivatives acknowledged that ‘trading’ or gambling is their ‘dominant’ motivation for operating in this market, whereas less than 30 percent said that ‘hedging/credit risk management’ was their primary motive,” and (ii) a statement by New York superintendent of insurance Eric Dinallo, concluding that “80 percent of the estimated $62 trillion in CDS outstanding in 2008 were speculative”); Manns, supra note 30, at 1036–37 (noting the use of CDS as “speculative instruments”); Michael Lewis, “Betting on the Blind Side,” Vanity Fair, April 2010 (explaining that “[i]n the beginning, credit-default swaps had been a tool for hedging. … Very quickly, however, the new derivatives became tools for speculation”).

Wilmarth, supra note 1, at 993–94, 1030–32.

Id. at 994 n.126, 1032 (citing estimates indicating that, at the peak of the credit boom, $1.25 to $6 trillion of synthetic CDOs were outstanding, and that about one-third of the $45 trillion of outstanding CDS were written to protect holders of CDOs, CLOs and other structured-finance instruments).

See supra notes 28-29, 33 and accompanying text.

During the credit boom that led to the financial crisis, the 18 leading LCFIs in global and U.S. markets for securities underwriting, securitizations, structured-finance products and OTC derivatives (the “big eighteen”) included the four largest U.S. banks (BofA, Chase, Citigroup and Wachovia), the five largest U.S. securities firms (Bear, Goldman, Lehman Brothers (Lehman), Merrill and Morgan Stanley), the largest U.S. insurer (AIG), and eight foreign universal banks (Barclays, BNP Paribas, Credit Suisse, Deutsche, HSBC, RBS, Société Générale and UBS). See Wilmarth, supra note 1, at 980–84, 989–90, 994–95, 1019–20, 1031–33; Wilmarth, supra note 2, at 721, 721 n.45. See also Dwight Jaffee et al., “Mortgage Origination and Securitization in the Financial Crisis,” in Restoring Financial Stability, supra note 24, at 61, 69 tbl.1.4 (showing that 11 of the “big eighteen” LCFIs ranked among the top 12 global underwriters of CDOs between 2004 and 2008); Anthony Saunders, Roy C. Smith & Ingo Walter, “Enhanced Regulation of Large, Complex Financial Institutions,” in Restoring Financial Stability, supra note 24, at 139, 142 tbl.5.2 (showing that all of the “big eighteen” LCFIs, except for AIG, ranked among the top 23 global providers of wholesale financial services in 2006 and 2007).

About $6.3 trillion of nonprime residential mortgage loans, credit card loans and CRE loans were outstanding in the U.S. market in 2008. Of that amount, about $2.8 trillion of loans were held in securitized pools, and many of the securitized loans and other loans were referenced by CDS. See Wilmarth, supra note 1, at 988–94, 1024–41. In addition, about $2.5 trillion of LBO loans and high-yield (“junk”) bonds were outstanding in the U.S. market in 2008, and a significant portion of that debt was securitized or referenced by CDS. Id. at 1039–43. See also Charles R. Morris, The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash 123–26, 134–39 (New York: PublicAffairs, 2d ed. 2008).

Wilmarth, supra note 1, at 991–94, 1027–32.

See Morris, supra note 36, at 73–79, 113–14, 123–32; Michael Lewis, “The End,”, Nov. 11, 2008, available at” (quoting hedge fund manager Steve Eisman, who explained that Wall Street firms built an “engine of doom” with cash flow CDOs and synthetic CDOs, because those instruments created “several towers of debt” on top of “the original subprime loans,” and “that’s why the losses are so much greater than the loans”).

Manns, supra note 30, at 1050–52; Timothy E. Lynch, “Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment,” 59 Case Western Reserve Law Review 227, 244-46 (2009); Frank Partnoy, Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective 4–6 (U. San Diego School of Law Legal Studies Research Paper No. 09-014, 2009), available at

See, e.g., Lynch, supra note 39, at 246–48, 256–61; Manns, supra note 30, at 1052; Partnoy, supra note 26, at 3–7; David Reiss, Rating Agencies and Reputational Risk 4–8 (Brooklyn Law School Legal Studies Research Paper No. 136, 2009), available at

Benmelech & Dlugosz, supra note 25, at 16–21, 25; Roger Lowenstein, “Triple-A Failure,” New York Times, Apr. 27, 2008, § MM (Magazine), at 36; Lynch, supra note 39, at 256–58; Wilmarth, supra note 1, at 988–94, 1011–12, 1017–20, 1027–42.

Benmelech & Dlugosz, supra note 25, at 4; Jaffee et al., supra note 35, at 73–74; Wilmarth, supra note 1, at 1028-29.

Kathleen C. Engel & Patricia A. McCoy, “Turning a Blind Eye: Wall Street Finance of Predatory Lending,” 75 Fordham Law Review 2039, 2070–73 (2007) (discussing limited disclosures given to institutional investors who bought structured-finance securities in private placements under SEC Rule 144A); Richard E. Mendales, “Collateralized Explosive Devices: Why Securities Regulations Failed to Prevent the CDO Meltdown, and How to Fix It,” 2009 University of Illinois Law Review 1359, 1360–62, 1373–87 (2009) (discussing additional reasons why SEC regulations failed to require adequate disclosures for offerings of CDOs and instead encouraged investors to rely on credit ratings).

Kurt Eggert, “The Great Collapse: How Securitization Caused the Subprime Meltdown,” 41 Connecticut Law Review 1257, 1305-06 (2009).

Wilmarth, supra note 1, at 1026–28; Jaffee et al., supra note 35, at 73–74; Scott, supra note 25, at 7–8, 16; October 2009 IMF GFS Report, supra note 5, at 81.

See Coval et al., supra note 25, at 4, 19; Wilmarth, supra note 1, at 1028–29; October 2009 IMF GFS Report, supra note 5, at 81. See also Acharya & Richardson, supra note 24, at 205 (stating that, in June 2006, “AAA-rated tranches of subprime CDOs offered twice the premium of the typical AAA credit-default swap of a corporation”); U.K. Fin. Serv. Auth., The Turner Review: A Regulatory Response to the Global Banking Crisis 12–15 (March 2009), available at [hereinafter Turner Review] (explaining that LCFIs created novel types of securitized credit instruments to satisfy “a ferocious search for yield” by investors in the context of “very low medium- and long-term real interest rates”); Mark Astley et al., “Global Imbalances and the Financial Crisis,” 178, 181, Bank of England Quarterly Bulletin, Q3, 2009, available at (concluding that “[t]he low interest rate environment seems to have interacted with strong competitive pressures on banks and asset managers to maintain returns, leading to a ‘search for yield’ in financial markets”) (footnote omitted).

Coval et al., supra note 25, at 3–4.

Coval et al., supra note 25, at 3–4, 8–21; Benmelech & Dlugosz, supra note 25, at 2, 13–15, 21–23, 25; Partnoy, supra note 26, at 6–11; Wilmarth, supra note 1, at 1034; Lowenstein, supra note 41.

October 2009 IMF GFS Report, supra note 5, at 93 fig.2.12 (reporting that, as of June 30, 2009, Standard & Poor’s (“S&P”) had (i) cut its ratings on 90 percent of AAA-rated tranches of ABS CDOs issued from 2005 to 2007, and 80 percent of those tranches were reduced to noninvestment-grade ratings of BB or lower, and (ii) lowered its ratings on 63 percent of AAA-rated tranches of private-label RMBS issued during the same period, and 52 percent of those tranches were reduced to noninvestment-grade ratings); Benmelech & Dlugosz, supra note 25, at 8–9, 31 tbl.2 (reporting that Moody’s issued 45,000 downgrades affecting 36,000 tranches of structured-finance securities during 2007 and the first nine months of 2008, and Moody’s average downgrade during that period was 5.2 rating notches).

Wilmarth, supra note 1, at 1002, 1002 nn.174–76 (reporting that financial sector debt accounted for $13 trillion of the increase in domestic nongovernmental debt between 1991 and 2007, while household debt grew by $10 trillion and nonfinancial business debt increased by $6.4 trillion).

Turner Review, supra note 46, at 18 exh. 1.10. See also Stowell, supra note 9, at 456 exh.5 (showing the rapid growth of total domestic nongovernmental debt as a percentage of GDP between the mid-1980s and the end of 2007); Wilmarth, supra note 1, at 974, 974 n.26 (referring to the credit boom of the 1920s that precipitated the Great Depression).

“The Gods Strike Back: A Special Report on Financial Risk,” Economist, Feb. 13, 2010, at 3, chart 1.

Peter Coy, “Why the Fed Isn’t Igniting Inflation,” Business Week, June 29, 2009, at 20, 21.

Justin Lahart, “Has the Financial Industry’s Heyday Come and Gone?” Wall Street Journal, Apr. 28, 2008, at A2. See also “Buttonwood: The Profits Puzzle,” Economist, Sept. 15, 2007, at 99 (reporting that the financial sector contributed “around 27 percent of the profits made by companies in the S&P 500 index [in 2007], up from 19 percent in 1996”).

Elizabeth Stanton, “Bank Stocks Cede Biggest S&P Weighting to Technology (Update 1),”, May 21, 2008. See also Tom Lauricella, “Crumbling Profit Center: Financial Sector Showing Life, but Don’t Bank on Long-Term Revival,” Wall Street Journal, Mar. 24, 2008, at C1 (reporting that financial stocks accounted for 22.3 percent of the value of all stocks included in the S&P index at the end of 2006, “up from just 13 percent at the end of 1995”).

Wilmarth, supra note 2, at 725-26.

Wilmarth, supra note 1, at 1008 (footnote omitted).



Viral V. Acharya & Philipp Schnabl, “How Banks Played the Leverage Game,” in Restoring Financial Stability, supra note 24, at 83–89; Blundell-Wignall et al., supra note 5, at 3–13; Saunders, Smith & Walter, supra note 35, at 140–45; Wilmarth, supra note 1, at 1027–41.

Crotty, supra note 23, at 565–66; Wilmarth, supra note 1, at 984–87, 995–96, 1017–20, 1034–42. See also id. at 995 (noting that “[f]ee income at the largest U.S. banks (including BofA, Chase and Citigroup) rose from 40 percent of total earnings in 1995 to 76 percent of total earnings in 2007”).

Wilmarth, supra note 1, at 995–96, 1030.

Id. at 970–71, 1032–35, 1039–43, 1046–48. See also Acharya & Richardson, supra note 24, at 198–201; Turner Review, supra note 46, at 15–21.

See Risk-Based Capital Guidelines, 66 Federal Register 59614, 59625-27 (Nov. 29, 2001) [hereinafter 2001 Risk-Based Capital Rule]; Arnold Kling, Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008, at 25–26 (Sept. 15, 2009), available at

Kling, supra note 64, at 25 fig.4.

Acharya & Schnabl, supra note 60, at 94–98; Andrew G. Haldane, “Banking on the State,” Bank Int’l Settlements Review 5–8 (Nov. 11, 2009), available at Because European banks did not have to comply with a minimum leverage capital ratio, the 13 largest European banks operated in 2008 with an average leverage ratio of 2.68 percent, compared to an average leverage ratio of 5.88 percent for the ten largest U.S. banks (which were required to maintain a leverage capital ratio of at least 4 percent). Similarly, the four largest U.S. securities firms had an average leverage ratio of only 3.33 percent, because the SEC did not require those firms to comply with a minimum leverage ratio. Adrian Blundell-Wignall & Paul Atkinson, “The Sub-prime Crisis: Causal Distortions and Regulatory Reform,” in Lessons from the Financial Turmoil of 2007 and 2008: Proceedings of a Conference on 14-15 July 2008, at 55, 93–94, 95 tbl.6 (Paul Bloxham & Christopher Kent eds., 2008), available at; McCoy et al., supra note 8, at 1358–60 (explaining that the SEC allowed the five largest U.S. securities firms to determine their capital requirements based on internal risk models, with the result that leverage at the five firms increased to about 30:1 by 2008).

Wilmarth, supra note 1, at 1032–33. See also Gian Luca Clementi et al., “Rethinking Compensation in Financial Firms,” in Restoring Financial Stability, supra note 24, at 197, 198–200; Crotty, supra note 23, at 568–69; Jaffee et al., supra note 35, at 71–73.

Clementi et al., supra note 67, at 198–200.

Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe 133-39 (2009); Blundell-Wignall et al., supra note 5, at 4, 7–11; Jaffee et al., supra note 35, at 68–69, 72–73.

For discussion of the risk exposures of LCFIs to SIVs and other sponsored conduits, see Tett, supra note 69, at 97–98, 127–28, 136, 196–98; Acharya & Schnabl, supra note 60, at 88–94; Wilmarth, supra note 1, at 1033.

Acharya & Schnabl, supra note 60, at 89.

Risk-Based Capital Guidelines, 69 Federal Register 44908, 44910-11 (July 28, 2004). See also Acharya & Schnabl, supra note 60, at 89 (noting that capital requirements for short-term “liquidity enhancements” were “only 0.8 percent of asset value”).

Martin Kacperczyk & Philipp Schnabl, “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009,” 24 Journal of Economic Perspectives 29, 32–34, 38 fig.1 (2010).

Acharya & Schnabl, supra note 60, at 93 tbl.2.1 (listing Citigroup, BofA, Chase, HSBC, Société Générale, Deutsche and Barclays among the top 10 conduit sponsors); supra note 35 (listing the “big eighteen” LCFIs).

Tett, supra note 69, at 97–98; Crotty, supra note 23, at 570.

Acharya & Schnabl, supra note 60, at 89–92.

Id. at 91–94. See also Wilmarth, supra note 1, at 1033 (observing that the conduit rescues “showed that LCFIs felt obliged, for reasons of ‘reputation risk,’ to support OBS entities that they had sponsored, even when they did not have explicit contractual commitments to do so”). Citigroup absorbed $84 billion of assets onto its balance sheet from seven SIVs, while HSBC and Société Générale took back $50 billion of assets from their SIVs. Id. at 1033 n.358.

Wilmarth, supra note 1, at 1033–34.

Acharya & Schnabl, supra note 60, at 97 tbl.2.2, 97–98.

Wilmarth, supra note 1, at 1034.

For critiques of the FRB’s monetary policy, see Wilmarth, supra note 1, at 1005–06 (summarizing analysis by various critics of the FRB); John B. Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis 1–6, 11–13 (Hoover Institution Press, 2009) (contending that the FRB’s “extra-easy [monetary] policy accelerated the housing boom and thereby ultimately led to the housing bust”); Kling, supra note 64, at 38–39. For an impassioned attack on the FRB’s monetary policy between the mid-1990s and 2005, see William A Fleckenstein & Frederick Sheehan, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (2008).

For discussions of the impact of large purchases of Western government securities and other investments in Western financial markets by Asian nations and oil exporting countries, see Morris, supra note 36, at 88–104; Wilmarth, supra note 1, at 1006–07; Astley et al., supra note 46, at 180–82.

Robert J. Shiller, The Subprime Solution 48–54 (2008). See also Morris, supra note 36, at 65–69; Wilmarth, supra note 1, at 1007–08; Astley et al., supra note 46, at 181.

Shiller, supra note 83, at 41–54. See also Wilmarth, supra note 1, at 1007–08, and sources cited therein.

For discussions of Fannie’s and Freddie’s purchases of nonprime mortgages and RMBS and the reasons for such purchases, see, e.g., Dwight Jaffee et al., “What to Do about the Government-Sponsored Enterprises,” in Restoring Financial Stability, supra note 24, at 121, 124–30; Christopher L. Peterson, “Fannie Mae, Freddie Mac, and the Home Mortgage Foreclosure Crisis,” 10 Loyola of Los Angeles Public Interest Law Journal 149, 163–168 (2009); Jo Becker et al., “White House Philosophy Stoked Mortgage Bonfire,” New York Times, Dec. 21, 2008, at A1; Paul Davidson, “Lawmakers Blast Former Freddie, Fannie CEOs: Execs Say Competition Played Role in Decisions,” USA Today, Dec. 10, 2008, at 3B; Charles Duhigg, “Pressured to Take More Risk, Fannie Reached Tipping Point,” New York Times, Oct. 5, 2008, at A1.

Wilmarth, supra note 1, at 1046.

See supra note 35 and accompanying text.

Wilmarth, supra note 1, at 982–84, 989–91, 1019–20, 1031–35, 1039–42. See also Jaffee, supra note 35, at 69 tbl.1.4 (showing that the “big eighteen” LCFIs included eleven of the twelve top global underwriters of CDOs during 2006 and 2007).

See supra note 85 and accompanying text; Peterson, supra note 85, at 167–69.

See supra notes 23–36 and accompanying text; Jaffee et al., supra note 35, at 68–73; Saunders, Smith & Walter, supra note 35, at 143–45.

Yap & Pierson, supra note 13 (showing that the “big eighteen” LCFIs accounted for $892 billion, or 59 percent, of the $1.51 trillion of losses suffered by banks, securities firms and insurers). See also Saunders, Smith & Walter, supra note 35, at 144–45 tbl.5.3 (showing writedowns by nine of the “big eighteen” LCFIs as of mid-2008).

Jaffee, supra note 35, at 69.

Stowell, supra note 9, at 182–84, 398–405, 408–17; Wilmarth, supra note 1, at 1044–45; Wilmarth, supra note 9, at 28–30.

Wilmarth, supra note 1, at 1044–45 (stating that Citigroup and BofA received “huge bailout packages from the U.S. government that included $90 billion of capital infusions and more than $400 billion of asset guarantees,” while UBS “received a $60 billion bailout package from the Swiss government”). See also Wessel, supra note 8, at 239–41, 259–63 (discussing bailouts of Citigroup and BofA).

Wessel, supra note 8, at 217–18, 227, 236–40 (noting that Chase received $25 billion of TARP capital while Goldman and Morgan Stanley each received $10 billion).

Because Lehman’s collapse created a severe disruption in global financial markets, federal authorities decided to take all necessary measures to prevent other major LCFIs from suffering comparable failures. That decision led to the federal government’s bailouts of AIG, Citigroup and BofA, the infusions of TARP capital into other LCFIs and other extraordinary measures of support for the financial markets. See generally Sorkin, supra note 8, at 373–537 (2009);Wessel supra note 8, at 189–241. See also supra notes 93-95 and accompanying text (explaining that Bear, Merrill and Wachovia avoided failure due to government-assisted acquisitions, while AIG, RBS, BofA, Citigroup, UBS, Chase, Goldman and Morgan Stanley received varying amounts of direct governmental assistance); Fabio Benedetti-Valentini, “SocGen Predicts ‘Challenging’ 2009, Posts Profit,”, Feb. 18, 2009 (reporting that the French government provided financial assistance to Société Générale by purchasing subordinated debt and preferred stock from the bank).

See supra notes 8-11 and accompanying text; Robert Schmidt, “Geithner Slams Bonuses, Says Banks Would Have Failed (Update 2),”, Dec. 4, 2009 (quoting statement by Treasury Secretary Timothy Geithner that “none” of the biggest U.S. banks would have survived if the federal government had not intervened to support the financial system).

Wilmarth, supra note 2, at 737-38.

Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City, Regulatory Reform and the Economy: We Can Do Better, Speech at the 2009 Colorado Economic Forums, Denver, Colo. (Oct. 6, 2009), at 8, available at [hereinafter Hoenig October 6, 2009 Speech].

Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City, Leverage and Debt: The Impact of Today’s Choices on Tomorrow, Speech at the 2009 Annual Meeting of the Kansas Bankers Ass’n (Aug. 6, 2009), at 4, available at [hereinafter Hoenig August 6, 2009 Speech]. See also Charles I. Plosser, President and CEO, Federal Reserve Bank of Philadelphia, Some Observations About Policy Lessons from the Crisis, Speech at the Philadelphia Fed Policy Forum (Dec. 4, 2009), at 3, available at (stating that “[d]uring this crisis and through the implementation of the stress tests, we have effectively declared at least 19 institutions as too big to fail”).

Wilmarth, supra note 1, at 1032–43; Saunders, Smith & Walter, supra note 35, at 143-45.

See supra notes 8–12, 93-100 and accompanying text (describing rescues of LCFIs by the U.S. and foreign governments); Liam Pleven & Dan Fitzpatrick, “Struggling Hartford Taps McGee as New CEO,” Wall Street Journal, Sept. 30, 2009, at C1 (reporting that Hartford, a large insurance company, received a capital infusion of $3.4 billion from the Treasury Department under the TARP program).

FRB Chairman Ben S. Bernanke, Financial Reform to Address Systemic Risk, Speech at the Council on Foreign Relations (Mar. 10, 2009), available at



Mervyn King, Governor of the Bank of England, Speech to Scottish Business Organizations in Edinburgh (Oct. 20, 2009), at 4, available at [hereinafter King 2009 Speech]. See also Richard S. Carnell, Jonathan R. Macey & Geoffrey P. Miller, The Law of Banking and Financial Institutions 326 (4th ed. 2009) (explaining that “moral hazard” results from the fact that “[i]nsurance changes the incentives of the person insured. … [I]f you no longer fear a harm [due to insurance], you no longer have an incentive to take precautions against it”).

King 2009 Speech, supra note 106, at 3.

See Allen Berger et al., “How Do Large Banking Organizations Manage Their Capital Ratios?” 34 Journal of Financial Services Research 123, 138–39, 145 (2008) (finding that banks with more than $50 billion of assets maintained significantly lower capital ratios, compared to smaller banks, between 1992 and 2006); Hoenig August 6, 2009 Speech, supra note 100 (observing that the ten largest U.S. banks operated with a Tier 1 common stock capital ratio of 3.2 percent during the first quarter of 2009, compared to a ratio of 6.0 percent for banks smaller than the top-20 banks); David Cho, “Banks ‘Too Big to Fail’ Have Grown Even Bigger; Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post, Aug. 28, 2009, at (reporting that “[l]arge banks with more than $100 billion in assets are borrowing at interest rates 0.34 percentage points lower than the rest of the industry,” compared to a borrowing advantage of 0.08 percent in 2007); Gretchen Morgenson, “The Cost of Saving These Whales,” New York Times, Oct. 4, 2009, § BU, at 1 (reporting on a study by Dean Baker and Travis McArthur, finding that (i) from 2000 through 2007, the average cost of funds for smaller banks was 0.29 percent higher than the average cost of funds for banks with $100 billion or more in assets, and (ii) “this spread widened to an average of 0.78 percentage point” from 2008 through June 2009, “when bailouts for large institutions became expected”); Arthur E. Wilmarth, Jr., “The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks,” 2002 University of Illinois Law Review 215, 295, 301–02 (citing additional studies finding that large banks operated with capital ratios that were much lower than those of smaller banks, and that large banks also paid significantly lower interest rates on their deposits in comparison with smaller banks), available at

See, e.g., Peter Eavis, “Bank’s Safety Net Fraying,” Wall Street Journal, Nov. 16, 2009, at C6 (reporting that “S&P gives Citigroup a single-A rating, but adds that it would be rated triple-B-minus, four notches lower, with no [governmental] assistance … [while] Morgan Stanley and Bank of America get a three-notch lift … [and] Goldman Sachs Group enjoys a two-notch benefit”); Gary H. Stern & Ron J. Feldman, Too Big to Fail: Policies and Practices in Government Bailouts, 30–37, 60–79 (Washington: Brookings Institution, 2004) (describing preferential treatment given to TBTF banks by CRAs and other participants in the financial markets); Wilmarth, supra note 108, at 301, 301 n.359 (citing study by Donald Morgan and Kevin Stiroh, which showed that “during 1993–98, (i) bond markets applied substantially less market discipline to banks larger than $85 billion, and (ii) bond markets applied the weakest market discipline to the eleven banks that the OCC publicly identified as TBTF in 1984”).

See supra notes 97–98 and accompanying text (stating that the 19 largest BHCs and AIG received $290 billion of TARP capital assistance and issued $235 billion of FDIC-guaranteed debt, while smaller banks received only $41 billion of capital infusions and issued only $11 billion of FDIC-guaranteed debt). In addition, “[d]uring the second half of 2007, the Federal Home Loan Bank System (FHLBS) provided more than $200 billion of secured credit to Citigroup, Countrywide, Merrill, Wachovia and Wamu after those institutions suffered severe losses from subprime mortgages and related assets. … Advances from the FHLBS helped Countrywide to survive until it received an emergency takeover offer from [BofA].” Arthur E. Wilmarth, Jr., “Subprime Crisis Confirms Wisdom of Separating Banking and Commerce,” Banking & Financial Services Policy Report, May 2008, at 1, 6, available at

See supra notes 10–11, 97–100 and accompanying text.

See, e.g., Robert De Young et al., “Mergers and Acquisitions of Financial Institutions: A Review of the Post-2000 Literature,” 36 Journal of Financial Services Research 87, 96–97, 104 (2009) (reviewing studies and finding that “subsidies associated with becoming ‘too big to fail’ are important incentives for large bank acquisitions”); Elijah Brewer & Julapa Jagtiani, How Much Would Banks Be Willing to Pay to BecomeToo-Big-to-Fail’ and to Capture Other Benefits? 9–20, 25–26 (Fed. Res. Bank of Kansas City Econ. Dep’t Research Working Paper 07-05, 2007) (determining that large banks paid significantly higher premiums to acquire smaller banks when (i) the acquisition produced an institution that crossed a presumptive TBTF threshold, such as $100 billion in assets or $20 billion in market capitalization, or (ii) a bank that was already TBTF acquired another bank and thereby enhanced its TBTF status); Todd Davenport, “Understanding the Endgame: Scale Will Matter, But How Much?” American Banker, Aug. 30, 2006, at 1 (describing the widespread belief among banking industry executives that “size is the best guarantor of survival” and that “[t]he best way—and certainly the quickest way—to achieve scale is to buy it”); Wilmarth, supra note 108, at 300–08 (citing additional evidence for the conclusion that “TBTF status allows megabanks to operate with virtual ‘fail-safe’ insulation from both market and regulatory discipline”).

Wilmarth, supra note 2, at 745.

See supra notes 8, 94 and accompanying text.

Wilmarth, supra note 2, at 746.

Id. at 746 n.153.

See supra notes 9, 93 and accompanying text (discussing acquisitions of Countrywide and Merrill by BofA, of Bear and Wamu by Chase, and of Wachovia by Wells Fargo).

Peter Eavis, “Finance Fixers Still Living in Denial,” Wall Street Journal, Dec. 16, 2009, at C18. Compare Peter Boone & Simon Johnson, “Shooting Banks,” New Republic, Mar. 11, 2010, at 20 (stating that the six largest U.S. banks currently have combined assets exceeding 63 percent of GDP, while the combined assets of the six largest banks in 1995 were equal to only 17 percent of GDP).

Heather Landy, “What’s Lost, Gained if Giants Get Downsized,” American Banker, Nov. 5, 2009, at 1.

Wilmarth, supra note 2, at 747.

Alison Fitzgerald & Christine Harper, “Lehman Monday Morning Lesson Lost with Obama Regulator-in-Chief,”, Sept. 11, 2009 (quoting Ms. Prins).

Wilmarth, supra note 108, at 475.

Elijah Brewer III & Anne Marie Klingenhagen, “Be Careful What You Wish For: The Stock Market Reactions to Bailing Out Large Financial Institutions,” 18 Journal of Financial Regulation and Compliance 56, 57–59, 64–66 (2010) (finding significant increases in stock market valuations for the 25 largest U.S. banks as a result of Treasury Secretary Paulson’s announcement, on Oct. 14, 2008, of $250 billion of TARP capital infusions into the banking system, including $125 billion for the nine largest banks); Pietro Veronesi & Luigi Zingales, Paulson’s Gift (Chicago Booth Research Paper No. 09-42, 2009), at 2-3, 11-31, available at (concluding that the TARP capital infusions and FDIC debt guarantees produced $130 billion of gains for holders of equity and debt securities of the nine largest U.S. banks, at an estimated cost to taxpayers of $21 to $44 billion).

As I have argued in a previous article, large financial conglomerates have never proven their ability to achieve superior performance without relying on the extensive TBTF subsidies they currently receive. Wilmarth, supra note 2, at 740–44, 748–49.

Saunders, Smith & Walter, supra note 35, at 143–47; Wilmarth, supra note 1, at 970–72, 994–1002, 1024–50; John Kay, Narrow Banking: The Reform of Financial Regulation 12–16, 41–44, 86–88 (Sept. 15, 2009) (unpublished manuscript), available at

Pub. L. No. 103-328, 108 Stat. 2338, Sept. 29, 1994.

See House Report No. 103-448, at 65–66 (1994) (additional views of Rep. Neal and Rep. McCollum) (explaining that the Riegle-Neal Act “adds two new concentration limits to address concerns about potential concentration of financial power at the state and national levels”), as reprinted in 1994 U.S.C.C.A.N. 2039, 2065–66.

Riegle-Neal Act, §§ 101, 102, 108 Stat. 2340, 2345 (codified as amended in 12 U.S.C. §§ 1831u(b)(2), 1842(d)(2)). The Riegle-Neal Act permits a state to waive or relax, by statute, regulation or order, the thirty percent statewide concentration limit with respect to interstate mergers or acquisitions involving banks located in that state. See 12 U.S.C. §§ 1831u(b)(2)(D), 1842 (d)(2)(D).

See “Order Approving the Acquisition of a Savings Association and an Industrial Loan Company (Bank of America Corporation),” Federal Reserve Bulletin B13, B14 (Mar. 2009) [hereinafter FRB BofA-Merrill Order] (noting that thrifts and industrial banks “are not ‘banks’ for purposes of the [Riegle-Neal] Act and its nationwide deposit cap”).

12 U.S.C. §§ 1831u(e), 1842(d)(5).

See “Order Approving the Acquisition of a Savings Association and Other Nonbanking Activities (Bank of America Corporation),” Federal Reserve Bulletin C81–C82, C83 n.13 (Aug. 2008) (approving BofA’s acquisition of Countrywide and Countrywide’s thrift subsidiary, even though the transaction resulted in BofA’s ownership of 10.9 percent of nationwide deposits); FRB BofA-Merrill Order, supra note 129, at B13–B14, B14 n.6 (approving BofA’s acquisition of Merrill and Merrill’s thrift and industrial bank subsidiaries, even though the transaction resulted in BofA’s ownership of 11.9 percent of nationwide deposits).

Joe Adler, “Thrift M&A Could Suffer As Frank Slams ‘Loophole’,” American Banker, Dec. 10, 2009, at 1.

See “Statement by the Board of Governors of the Federal Reserve System Regarding the Application and Notices by Wells Fargo & Company to Acquire Wachovia Corporation and Wachovia’s Subsidiary Banks and Non-banking Companies (Wells Fargo & Company),” Federal Reserve Bulletin B40, B41–42 (Mar. 2009) (determining that “the combined organization would not control an amount of deposits that would exceed the nationwide deposit cap on consummation of the proposal”); id. at B48 (concluding that “expeditious approval of the proposal was warranted in light of the weakened condition of Wachovia”).

See Matt Ackerman, “Big 3 Deposit Share Approaches 33 percent,” American Banker, Oct. 28, 2008, at 16 (reporting the nationwide deposit shares for BofA, Chase and Wells Fargo as 11.3 percent, 10.2 percent and 11.2 percent, respectively).

Rebecca Christie & Phil Mattingly, “‘Volcker Rule’ Draft Signals Obama Wants to Ease Market Impact,”, Mar. 4, 2010.

Id. (reporting that U.S. banks held $10.4 trillion of liabilities, while Chase, BofA and Citigroup held liabilities of $1.5 trillion, $1.3 trillion and $1 trillion, respectively).

See supra note 134 and accompanying text (citing news article reporting that BofA, Chase and Wells exceeded the Riegle-Neal 10 percent nationwide deposit cap); Kevin Dobbs, “Even After Infusion, Citi Seen Needing Fix,” American Banker, Nov. 25, 2008, at 1 (reporting that Citigroup had only $200 billion of domestic deposits, compared to the more than $600 billion of domestic deposits held by each of its three major rivals).

Cheyenne Hopkins, “Obama to Banks: Big Is Bad,” American Banker, Jan. 25, 2010, at 22 (quoting criticisms of the proposed Volcker liabilities cap by Jamie Cox of Harris Financial Group and Sean Ryan of Wisco Research).

See Heather Landy, “Review/Preview: Goldman and Morgan Stanley Ditch Banking Script, So Far,” American Banker, Dec. 30, 2009, at 1 (reporting that Goldman and Morgan Stanley relied primarily on the capital markets for funding, as each firm had less than $70 billion of deposits in 2009); supra notes 136–137 and accompanying text (stating that Citigroup had $1 trillion of liabilities but only $200 billion of domestic deposits).

FRB Governor Daniel K. Tarullo, “Financial Regulatory Reform,” Speech at the U.S. Monetary Policy Forum (Feb. 26, 2010) [hereinafter Tarullo Regulatory Reform Speech], available at

Alan Blinder, “Time for Financial Reform, Plan C,” The Economists’ Voice, Vol. 7, Issue 1, Article 5 (Feb. 2010), at 2, available at See also Senate Report No. 111-176, at 4 (2010) (explaining the Senate Banking Committee’s proposal for a special resolution regime for SIFIs).

See Senate Report No. 111-176, at 47 (explaining the Senate Banking Committee’s proposal for an FSOC, which would be chaired by the Secretary of the Treasury and would include the following additional voting members: the chairmen of the FRB and the FDIC, the Comptroller of the Currency, the chairmen of the Commodity Futures Trading Commission and the SEC, the director of the National Credit Union Administration, the chairman of the Federal Housing Finance Agency, the director of a proposed new Bureau of Consumer Financial Protection, and an independent member with insurance experience appointed by the President.

See, e.g., Viral V. Acharya et al., “Regulating Systemic Risk,” in Restoring Financial Stability, supra note 24, at 283, 283–92; Saunders, Smith & Walter, supra note 35, at 151–55; James B. Thomson, On Systemically Important Financial Institutions and Progressive Systemic Mitigation 1–6 (Fed. Reserve Bank of Clev. Policy Discussion Paper No. 27, 2009).

See Malini Manickavasagam and Mike Ferullo, “Regulatory Reform: Witnesses Warn Against Identifying Institutions as Systemically Significant,” 41 Securities Regulation Law Report (BNA) 502 (Mar. 23, 2009).

See supra notes 8–12, 93-100, 110-11 and accompanying text.

See supra notes 108-09 and accompanying text.

Thomson, supra note 143, at 8–9 (rejecting the former policy of “constructive ambiguity” and advocating public identification of SIFIs).

In March 2010, Treasury assistant secretary Herbert Allison received a hostile reception when he claimed at a hearing before the Congressional Oversight Panel (“COP”) that “‘[t]here is no ‘too big to fail’ guarantee on the part of the U.S. government.” Members of the COP responded to Mr. Allison’s claim with derision and disbelief. COP member Damon Silvers declared, “I do not understand why it is that the United States government cannot admit what everyone in the world knows.” Cheyenne Hopkins, “Pandit Sees a New Citigroup, But Others Aren’t Convinced,” American Banker, Mar. 5, 2010, at 1 (noting that Mr. Allison’s claim “angered and baffled the panelists”).

See Edward R. Morrison, Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of Systemically Important Institutions? 10–16 (Columbia L. & Econ. Working Paper No. 362, 2009), available at (concluding that creation of a new regulatory process for regulating SIFIs and resolving their failures would be preferable to an approach that would rely on Chapter 11 bankruptcy proceedings to resolve such failures). See also Carnell, Macey & Miller, supra note 106, ch. 13 (discussing the FDIC’s resolution regime for failed banks).

See Wilmarth, supra note 2, at 757.

See Carnell, Macey & Miller, supra note 106, at 437–40, 455–60, 465–74 (discussing the FRB’s supervision of BHCs and FHCs); Heidi Mandanis Schooner, “Regulating Risk Not Function,” 66 University of Cincinnati Law Review 441, 478–86 (1998) (contending that the FRB is best situated to act as “systemic risk regulator” for financial conglomerates).

Under current law, the FRB is required to rely “to the fullest extent possible” on reports provided and examinations conducted by primary regulators of functionally regulated subsidiaries of BHCs and FHCs. The FRB has only limited authority to require reports from, to conduct examinations of, or to take enforcement actions against, functionally regulated subsidiaries of BHCs and FHCs. See 12 U.S.C. §§ 1844(c), 1844(e), 1844(g), 1848a; Carnell, Macey & Miller, supra note 106, at 457–60.

For example, the conduct of the FRB and the FDIC during the negotiations that led to the Basel II international capital accord indicated that the FRB was more inclined than the FDIC to accommodate the interests and concerns of large banks. During those negotiations, the FRB actively supported an “advanced internal risk-based” (A-IRB) method for establishing capital requirements for the largest banks. The A-IRB method was favored by major banks because it allowed each bank to calculate its capital needs based on internal quantitative risk models, as long as those models satisfied supervisory criteria. Major banks supported the A-IRB method because that approach held out the possibility of significantly reducing their capital requirements. In contrast to the FRB, the FDIC expressed great skepticism about the A-IRB approach. The FDIC therefore insisted that federal regulations implementing Basel II must include transitional, phased-in capital floors to prevent any rapid drop in risk-based capital requirements under the A-IRB method. In addition, the FDIC fought hard to preserve the U.S. leverage capital requirement as an essential safeguard that would help maintain adequate capital levels at all U.S. banks, even though the Basel II accord did not include any leverage requirement. Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation 99–130 (Washington, DC: Peterson Institute for Int’l Economics, 2008). See also Wilmarth, supra note 108, at 470-73 (describing the extraordinary actions taken by the FRB to preserve financial market stability between 1970 and 2001).

For sources supporting the imposition of a leverage capital requirement, and noting the disparity between the asset-to-equity ratios at U.S. commercial banks and the significantly higher (and more risky) ratios at U.S. investment banks and European banks in 2007, see Blundell-Wignall & Atkinson, supra note 66, at 93–96; Blundell-Wignall et al., supra note 5, at 18–22; Haldane, supra note 66, at 7 (stating that “[o]ne simple means of altering the rules of the asymmetric [risk] game between banks and the state is to place heavier restrictions on leverage”).

Tarullo Regulatory Reform Speech, supra note 140.

For one approach to calculating SRCRs, see Acharya et al., “Regulating Systemic Risk,” supra note 143, at 289–93.

See supra notes 70–80 and accompanying text (describing how LCFIs retained large risk exposures to OBS conduits during the credit boom that led to the current financial crisis).

For discussion of proposals for a contingent capital requirement, see, e.g., Christopher L. Culp, “Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies,” Journal of Applied Corporate Finance, Fall 2009, at 17, 23–27; Emily Flitter, “Push for ‘Contingent Capital’ Has Momentum,” American Banker, Oct. 2, 2009, at 1; David Henry, “The Second Coming of ‘Safer’ Securities,” Business Week, Dec. 7, 2009, at 56.

See Culp, supra note 158, at 27; Flitter, supra note 158; Henry, supra note 158.

Wilmarth, supra note 2, at 761. For other recent proposals that call for managers and key employees to be receive part of their compensation in debt securities in order to encourage them to avoid excessive risk-taking, see Lucian Bebchuk & Holger Spamann, “Regulating Bankers’ Pay,” 98 Georgetown Law Journal 247, 283–86 (2010); Jeffrey N. Gordon, Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity Based Pay (Columbia Law & Economics Working Paper No. 373, July 9, 2010), at 11-14, available at; Frederick Tung, Pay for Banker Performance: Structuring Executive Compensation and Risk Regulation (Emory Law & Economics. Research Paper No. 10-60, Mar. 13, 2010), at 31-51, available at Professor Gordon’s proposal is closest to my own.

The following discussion of my proposal to establish a SRIF, funded by risk-based premiums paid by SIFIs, is adapted from Wilmarth, supra note 2, at 761-64. See also Arthur E. Wilmarth, Jr., “Viewpoint: Prefund a Systemic Resolution Fund,” American Banker, June 11, 2010, at 8.

See supra notes 8–11, 97–98 and accompanying text.

Acharya et al., “Regulating Systemic Risk,” supra note 143, at 293–94. See also Xin Huang et al., “A Framework for Assessing the Systemic Risk of Major Financial Institutions,” 33 Journal of Banking and Finance 2036 (2009) (proposing a stress testing methodology for calculating an insurance premium sufficient to protect against losses of more than 15 percent of the total liabilities of twelve major U.S. banks during the period 2001–2008, and concluding that the hypothetical aggregate insurance premium would have had an “upper bound” of $250 billion in July 2008).

A recent study concluded that market returns of the 100 largest banks, securities firms, insurers and hedge funds became “highly interconnected,” and their risk exposures became “highly interrelated,” during the current financial crisis as well as during (i) the dotcom-telecom bust of 2000–2002 and (ii) the crisis surrounding Russia’s debt default and the threatened failure of Long-Term Capital Management, a major hedge fund, in 1998. Monica Billio et al., Measuring Systemic Risk in the Finance and Insurance Sectors 16–17, 40–47 (MIT Sloan Sch. Mgmt. Working Paper 4774-10, 2010), available at For additional evidence indicating that banks and other financial institutions engage in herding behavior that can trigger systemic financial crises, see Viral V. Acharya & Tanju Yorulmazer, “Information Contagion and Bank Herding,” 40 Journal of Money, Credit and Banking 215, 215–17, 227–29 (2008); Viral V. Acharya & Tanju Yorulmazer, “Too Many To Fail—An Analysis of Time-Inconsistency in Bank Closure Policies,” 16 Journal of Financial Intermediation 1, 2–4, 18–19, 24–27 (2007); Raghuram G. Rajan, “Has Finance Made the World Riskier?” 12 European Financial Management 499, 500–02, 513–22 (2006). As described above, major LCFIs engaged in parallel behavior that resembled herding during the credit boom that precipitated the present crisis, particularly with regard to high-risk securitized lending in the residential and commercial mortgage markets and the corporate LBO market.

See supra notes 91–100 and accompanying text (showing that the “big eighteen” LCFIs accounted for nearly three-fifths of the $1.5 trillion of losses incurred by global banks, securities firms and insurers during the current crisis, and twelve of those institutions were bailed out or received substantial governmental assistance).

Statement by FDIC Chairman Sheila C. Bair on “The Causes and Current State of the Financial Crisis” before the Financial Crisis Inquiry Commission (Jan. 14, 2010), available at


Acharya et al., “Regulating Systemic Risk,” supra note 143, at 293–95.

12 U.S.C. § 1823(c)(4)(G) (2006) (allowing the FDIC, with the concurrence of the Treasury Secretary and the FRB, to disregard the least-cost requirement for bank resolutions if the failure of a bank “would have serious adverse effects on economic conditions or financial stability”). See also Carnell, Macey & Miller, supra note 106, at 731–32 (discussing “systemic-risk exception”).

Those asset guarantees protected shareholders and creditors of Citigroup and BofA and both companies’ nonbank subsidiaries, as well as uninsured depositors and other creditors of both companies’ subsidiary banks. See Press Release, Joint Statement by Treasury, Federal Reserve and the FDIC on Citigroup (Nov. 23, 2008), available at; Statement by FDIC Chairman Sheila C. Bair on “Bank of America Acquisition of Merrill Lynch” before the House Committee on Oversight and Government Reform and the Subcommittee on Domestic Policy (Dec. 11, 2009), available at

The least-cost test requires the FDIC to “meet the obligation of the [FDIC] to provide insurance coverage for the insured deposits” in a failed bank by using the approach that is “least costly to the [DIF].” 12 U.S.C. § 1823(c)(4) (A)(i), (ii) (2006).

See Cheryl Bolen et al., “Regulatory Reform: White House Seeks Tough Limits on Size, Trading Activities of Large Financial Firms,” 94 Banking Rep. (BNA) 127 (Jan. 26, 2010).

Brady Dennis, “Volcker Urges Senators to Adopt Obama’s Rules on Banking,” Washington Post, Feb. 3, 2010, at A11 (quoting testimony by Mr. Volcker). See also Senate Report No. 111-176, at 8-9, 90-92 (2010) (discussing proposed legislation adopted by the Senate Banking Committee to incorporate the “Volcker rule”).

Wilmarth, supra note 2, at 765. See Carnell, Macey & Miller, supra note 106, at 130, 528–29 (describing the roles of “dealers” (i.e., proprietary traders) and “market makers” and indicating that the two roles frequently overlap).

The following discussion of my proposal for a two-tiered structure of bank regulation and deposit insurance is adapted from Wilmarth, supra note 2, at 764-79. I am indebted to Robert Litan for a number of the concepts incorporated in my two-tiered proposal. See generally Robert E. Litan, What Should Banks Do? 164–89 (Washington, DC: Brookings Institution,1987). For additional works that favor the use of “narrow banks” to achieve a strict separation between banking institutions and affiliates engaged in capital markets operations, see, e.g., Emilios Avgouleas, The Reform of ‘Too Big-To-Fai’ Bank: A New Regulatory Model for the Institutional Separation of ‘Casino’ from ‘Utility’ Banking, Feb. 14, 2010, available at; Kay, supra note 125, at 39–92; Ronnie J. Phillips & Alessandro Roselli, How to Avoid the Next Taxpayer Bailout of the Financial System: The Narrow Banking Proposal (Networks Fin. Instit. Pol’y Brief 2009-PB-05, 2009), available at

See 12 U.S.C. § 1843(c)(8) (2006); Carnell, Macey & Miller, supra note 106, at 442–44 (describing “closely related to banking” activities that are permissible for nonbank subsidiaries of BHCs under § 4(c)(8)).

See Wilmarth, supra note 108, at 225, 225–26 n.30 (discussing “bank-eligible” securities that national banks are authorized to underwrite or purchase or sell for their own account); Carnell, Macey & Miller, supra note 106, at 132–34 (same).

See Wilmarth, supra note 2, at 766 (discussing FAS 133).

For a discussion of the business strategies typically followed by community banks, see, e.g., Wilmarth, supra note 108, at 268–72.

Unfortunately, the Gramm-Leach-Bliley Act (GLBA) prohibits the FRB from approving any new “closely related” activities for bank holding companies under Section 4(c)(8) of the BHC Act. See Carnell, Macey & Miller, supra note 106, at 444 (explaining that GLBA does not permit the FRB to expand the list of permissible activities under Section 4(c)(8) beyond the activities that were approved as of Nov. 11, 1999). Congress should revise Section 4(c) (8) by authorizing the FRB to approve a limited range of new activities that are “closely related” to the traditional banking functions of accepting deposits, extending credit, discounting negotiable instruments and providing fiduciary services. See Wilmarth, supra note 2, at 767.

12 U.S.C. § 1843(k),(l) (2006). See Carnell, Macey & Miller, supra note 106, at 467-68 (describing registration of FHCs under the BHC Act).

See Carnell, Macey & Miller, supra note 106, at 468-70 (discussing activities authorized for FHCs under the GLBA); Arthur E. Wilmarth, Jr., “WalMart and the Separation of Banking and Commerce,” 39 Connecticut Law Review 1539, 1569-71, 1584-86 (2007) (explaining that (i) during the 1980’s and 1990’s, many securities firms, life insurers and industrial firms used the “nonbank bank” loophole or the “unitary thrift” loophole to acquire FDIC-insured institutions, and (ii) those loopholes were closed to new acquisitions by a 1987 statute and GLBA, respectively), available at

For a discussion of my reasons for proposing that commercial firms should be prohibited from owning industrial banks, see Wilmarth, supra note 182, at 1543-44, 1554–1620 (arguing that commercial firms should not be permitted to acquire industrial banks because such acquisitions (i) undermine the long-established U.S. policy of separating banking and commerce, (ii) threaten to spread federal safety net subsidies to the commercial sector of the U.S. economy, (iii) threaten the solvency of the DIF, (iv) create competitive inequities between commercial firms that own industrial banks and other commercial firms, and (v) increase the likelihood of federal bailouts of commercial companies).

See Wilmarth, supra note 2, at 768; Kenneth E. Scott, “Deposit Insurance and Bank Regulation: The Policy Choices,” 44 Business Lawyer 907, 921–22, 928–29 (1989).

Cf. Daisy Maxey, “Money Funds Exhale After New SEC Rules, But Should They?” Wall Street Journal, Feb. 2, 2010, at C9 (describing the SEC’s adoption of new rules governing MMMFs, and reporting on concerns expressed by representatives of the MMMF industry that the SEC might someday force the industry to adopt a “floating NAV” in place of the industry’s current practice of quoting a constant NAV of $1 per share).

David Reilly, “Goldman Sachs Wimps Out in Buck-Breaking Brawl,”, Feb. 3, 2010.

Id. See also Kay, supra note 125, at 65 (arguing that an MMMF with a constant NAV of $1 per share “either confuses consumers or creates an expectation of government guarantee”).

Reilly, supra note 186. See also Christopher Condon, “Volcker Says Money-Market Funds Weaken U.S. Financial System,”, Aug. 25, 2009.

Reilly, supra note 186 (describing “panic” that occurred among investors in MMMFs after Lehman’s collapse forced the Reserve Primary Fund to “break the buck”); Malini Manickavasagam, “Mutual Funds: Citing Stability, Treasury Allows Expiration of Money Market Fund Guarantee Program, 93 Banking Report (BNA) 508 (Sept. 22, 2009) (reporting that “[t]o prevent other money market funds from meeting the Reserve fund’s fate, Treasury launched its [MMFGP] in October 2008” and continued that program until Sept. 18, 2009).

Jane Bryant Quinn, “Money Funds Are Ripe for ‘Radical Surgery’,”, July 29, 2009. See also Reilly, supra note 186 (arguing that the failure of federal authorities to reform the regulation of MMMFs “creates the possibility of future market runs and the need for more government bailouts”).

Condon, supra note 188; Quinn, supra note 190 (observing that “[b]anks have to hold reserves against demand deposits and pay for [FDIC] insurance” while “[m]oney funds offer similar transaction accounts without being burdened by these costs. That’s why they usually offer higher interest rates than banks”).

Quinn, supra note 190 (summarizing recommendation presented in a January 2009 report by the Group of Thirty). See Group of Thirty, Financial Reform: A Framework for Financial Stability 29 (2009) (recommending that “[m]oney market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par, should be required to reorganize as special-purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last resort facilities”) (Recommendation 3.a.), available at

Quinn, supra note 190 (summarizing recommendation of Group of Thirty). See Group of Thirty, supra note 192, at 29 (Recommendation 3.b., stating that MMMFs “should be clearly differentiated from federally insured instruments offered by banks” and should base their pricing on “a fluctuating NAV”). See also Reilly, supra note 186 (supporting the Group of Thirty’s recommendation that MMMFs “either use floating values—and so prepare investors for the idea that these instruments can lose money—or be regulated as if they are bank products”); Kay, supra note 125, at 65 (similarly arguing that “[i]t is important to create very clear blue water between deposits, subject to government guarantee, and [uninsured MMMFs], which may be subject to market fluctuation”).

See Quinn, supra note 190 (describing strong opposition by Paul Schott Stevens, chairman of the Investment Company Institute (the trade association representing the mutual fund industry), against any rule requiring uninsured MMMFs to quote floating NAVs, because “[i]nvestors seeking guaranteed safety and soundness would migrate back to banks” and “[t]he remaining funds would become less attractive because of their fluctuating price”).

Scott, supra note 184, at 929; Wilmarth, supra note 2, at 771.

12 U.S.C. §§ 371c, 371c-1 (2006).

Wilmarth, supra note 108, at 456–57, 472–73 (discussing the FRB’s waiver of § 23A restrictions so that major banks could make large loans to their securities affiliates after the terrorist attacks on September 11, 2001); Wilmarth, supra note 110, at 9 (describing the FRB’s waiver of § 23A restrictions in August 2007, so that major banks could provide credit to support their securities affiliates following the outbreak of the subprime lending crisis). See also Transactions Between Member Banks and Their Affiliates: Exemption for Certain Purchases of Asset-Backed Commercial Paper by a Member Bank From an Affiliate, 74 Fed. Reg. 6226 (Feb. 6, 2009) (to be codified at 12 C.F.R. pt. 223) (approving waivers of §§ 23A and 23B in order to “increase the capacity” of banks to purchase ABCP from affiliated MMMFs, and explaining that such waivers—which had originally been granted in September 2008—were justified “[i]n light of ongoing dislocations in the financial markets, and the impact of such dislocations on the functioning of the ABCP markets and on the operations of [MMMFs]”).

See supra notes 169-71 and accompanying text.

12 U.S.C. § 1823(c)(4)(G)(ii) (2006).

Federal Deposit Ins. Corp., Options Paper, Aug. 2000, at 33, available at


See supra note 178 and accompanying text (discussing FAS 133).

Wilmarth, supra note 108, at 336–37, 372–73.

Carnell, Macey & Miller, supra note 106, at 492; Wilmarth, supra note 110, at 5–7, 16 n.39.

Office of the Comptroller of the Currency, OCC Interpretive Letter No. 892, at 3 (2000) (from Comptroller of the Currency John D. Hawke, Jr., to Rep. James A. Leach, Chairman of House Committee on Banking & Financial Services), available at

Wilmarth, supra note 108, at 372–73. For general discussions of the risks posed by OTC derivatives to banks and other financial institutions, see, e.g., id. at 337-78; Richard Bookstaber, A Demon of Our Own Design: Markets: Hedge Funds, and the Perils of Financial Innovation 7–147 (New York: John Wiley & Sons, 2007); Tett, supra note 69, passim.

12 U.S.C. § 1843(k)(4)(H), (I) (2006).

See Carnell, Macey & Miller, supra note 106, at 483–85 (explaining that “through the merchant banking and insurance company investment provisions, [GLBA] allows significant nonfinancial affiliations” with banks).

See Wilmarth, supra note 108, at 330–32, 375–78.

Wilmarth, supra note 182, at 1581–82.

For further discussion of this argument, see id. at 1588–1613; supra note 183.

Wilmarth, supra note 182, at 1569–70, 1584–93; Wilmarth, supra note 110, at 5–8. See also Kay, supra note 125, at 43 (stating: “The opportunity to gain access to the retail deposit base has been and remains irresistible to ambitious deal makers. That deposit base carries an explicit or implicit government guarantee and can be used to leverage a range of other, more exciting, financial activities. The archetype of these deal-makers was Sandy Weill, the architect of Citigroup”).

Wilmarth, supra note 182, at 1590–93.

See Kay, supra note 125, at 57–59.

Wilmarth, supra note 2, at 748-49.

Karen Shaw Petrou, the managing partner of Federal Financial Analytics, explained that “[i]nteraffiliate restrictions would limit the use of bank deposits on nonbanking activities,” and “[y]ou don’t own a bank because you like branches, you own a bank because you want cheap core funding.” Ms. Petrou therefore concluded that proposed federal legislation, which would impose tough restrictions on affiliate transactions, “really strikes at the heart of a diversified banking organization” and “I think you would see most of the very large banking organizations pull themselves apart” if Congress passed such legislation. Stacy Kaper, “Big Banks Face Most Pain Under House Bill,” American Banker, Dec. 2, 2009, at 1 (quoting Ms. Petrou).

Wilmarth, supra note 108, at 284. See also Wilmarth, supra note 2, at 776.

See, e.g., Neil Wallace, “Narrow Banking Meets the Diamond-Dybvig Model,” 20 Quarterly Review (Fed. Res. Bank of Minneapolis, Winter 1996), at 3.

Wilmarth, supra note 108, at 261–66. See also Allen N. Berger et al., “Does Function Follow Organizational Form? Evidence from the Lending Practices of Large and Small Banks,” 76 Journal of Financial Economics 237, 239–46, 254–62, 266 (2005).

Wilmarth, supra note 108, at 264–66. See also Berger et al., supra note 219, at 240–41, 266.

See Scott, supra note 184, at 929–30 (noting the claim of some critics that there would be “irresistible political pressure” for bailouts of uninsured “substitute-banks” that are created to provide the credit previously extended by FDIC-insured banks).

See Kay, supra note 125, at 71–74; Scott, supra note 184, at 931.

See Kay, supra note 125, at 51–69 (describing the narrow bank proposal as a means for accomplishing “the separation of utility from casino banking”); King 2009 Speech, supra note 106, at 6–7 (expressing support for Kay’s narrow bank proposal and for the Volcker rule as two alternative possibilities for separating the “utility aspects of banking” from “some of the riskier financial activities, such as proprietary trading”); Treasury Committee, Too Important to Fail—Too Important to Ignore, 2009-10, H.C. 9-Vol. 1, at 52, 59, available at [hereinafter 2009 U.K. Treasury Committee Report] (expressing qualified support for Kay’s narrow banking proposal); Ali Qassim, “International Banking: U.K.’s Ruling Coalition to Investigate Separating Investment, Retail Banks,” 94 Banking Report (BNA) 1055 (May 25, 2010) (reporting that “the United Kingdom’s new coalition government … announced it will establish an independent commission to investigate separating retail and investment banking” in line with the views expressed by Bank of England Governor Mervyn King).

Kay, supra note 125, at 74; 2009 U.K. Treasury Committee Report, supra note 223, at 70–71 (quoting views of former FRB Chairman Paul Volcker). See also Tarullo, supra note 153, at 45–54 (describing how the U.S. and U.K. reached agreement on risk-based bank capital rules and then pressured other developed nations to agree to the Basel I international capital accord).

See e.g., Hoenig October 6, 2009 Speech, supra note 99, at 4–10; Kay, supra note 125, at 14–17, 20–24, 28–31, 39–47, 57–58, 66–75, 86–87; King 2009 Speech, supra note 106; 2009 U.K. Treasury Committee Report, supra note 223, at 71–74; Wilmarth, supra note 2, at 778–79.

See e.g., Hoenig October 6, 2009 Speech, supra note 99, at 4–10; Kay, supra note 125, at 42–46, 57–59, 66–75.

Wilmarth, supra note 108, at 475. See also id. at 300–01, 314–15.

Id. at 476.



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