Enhanced Regulation of Large Complex Financial Institutions  Group: Saunders, Smith & Walter

I. What Are LCFIs?

Large Complex Financial Institutions (LCFIs) can be defined as financial intermediaries engaged in some combination of commercial banking, investment banking, asset management and insurance, whose failure poses a systemic risk or “externality” to the financial system as a whole. This externality can come through multiple forms including an informationally contagious effect on other FIs, a depressing effect on asset prices and/or reduction in overall market liquidity. The key factors that define LCFIs are size, complexity and financial interrelatedness. LCFIs present special “boundary” problems in regulation by crossing traditional (historic) and functional lines, and in many cases cutting across national domains on both financial and regulatory fronts. LCFIs are always likely to be considered “too big to fail” (TBTF) because of potential financial system externalities relating to their failure. This white paper discusses the evolution of LCFIs, surveys alternative approaches to their regulation, and recommends the adoption of a single, separate LCFI regulator, while utilizing separate functional regulatory apparatus for all other financial institutions. We argue that the LCFI regulator should be focused exclusively on those institutions viewed as imposing systemic risk on the financial system.

II. Where Did They Come From?

LCFIs began to appear in the post-1984 period, following the failure of Continental Illinois Bank & Trust Co. The decade 1984-1994 involved heavily restrained operations on the part of major banks in the United States. Passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and the broadening of banks’ powers to include securities activities using regulatory exemptions to Section 20 of the Glass-Steagall provisions of the Banking Act of 1933 fundamentally altered the playing field. These regulatory changes greatly expanded the power of banks to spread their activities both geographically and functionally. As a result, many banks were consolidated with others to provide a more stable, cost-effective business platform with larger market shares. Such platforms were thought to be necessary in order for larger US commercial banks to be able to compete with European and Japanese rivals. These foreign-based firms had taken up increased market share while US banks were under regulatory restraints on the growth of their assets and nonbanking activities. They were

2

also less able to compete effectively in the capital market, which had emerged as a principal source of both working capital and long term finance for US and international corporations. Exhibit 1 shows the volume of non-governmental financing in global capital markets - comprising the flow of transactions for which all wholesale financial intermediaries must compete - for the period 1997-2007.

To improve the ability of banks to compete in providing capital market services, the 1933 Glass-Steagall legislation was repealed in 1999 and replaced by the Gramm-Leach-Bliley Financial Services Modernization Act, which not only expanded banks’ securities powers but also their ability to enter into insurance and other financial services businesses, and vice-versa. Some of the largest US banks moved vigorously and successfully to build significant market share in investment banking by offering favorable lending terms in exchange for commitments to include them in underwriting and M&A advisory work. Meanwhile, certain large insurance companies (Equitable Life, Prudential) acquired investment banking units to engage in capital market activities (subsequently selling these units after not being able to manage them effectively) and other insurers (AIG, Allianz) became engaged in the writing and selling of credit and other derivatives contracts. The activities of the larger banks - including some additional large-scale mergers with other banks and the acquisition of investment banking businesses by commercial banks - led to enhanced competition in global capital markets, and a rising (and ultimately leading) market share for US banks in underwriting bonds and stocks. (Exhibit 2). These activities were increasingly aggressive and driven by the need to capture important corporate mandates, greatly increasing the risk exposures that banks were willing to take on their own books. Further, like their investment banking competitors, the banks increasingly relied on proprietary trading revenues as competitive pressure eroded intermediation margins. Some also expanded off-balance sheet activities in swaps and other derivatives as well as special-purpose, structured, off-balance-sheet investment vehicles (SIVs) as a then perceived profitable way of circumventing regulatory capital requirements and expanding their overall leverage.

III. The Big Balance Sheet Business Model The largest banks (having evolved into LCFIs) announced their commitment to “a big balance sheet business model” that would enable them to dominate wholesale finance, command large market shares and substantially increase the contribution to total profit of non-lending businesses. LCFIs’ expansive efforts over two decades were principally aimed at persuading investors that they were capable of high rates of profit growth (15% to 20% annual increases in earnings per share) and that such prospective growth rates could justify high price-earnings multiples for their stock (15 to 20 times earnings). The LCFIs, however, proved unable to deliver on these claims. In the 2000-2002 recession that followed the collapse of Enron, WorldCom and numerous hi-tech firms, the leading banks reported heavy losses from loan and securities write-offs, class action

3

litigation, as well as fines and penalties imposed by regulators. These losses largely offset the cumulative wholesale and investment banking profits the LCFIs had earned since the 1999 repeal of Glass-Steagall. As a result, their price-earnings ratios dropped into the single digits, bringing pressure on some LCFIs to increase earnings from whatever sources were available, so as to demonstrate to the market that the business model remained intact and that their stock prices would return to higher levels. Several LCFIs vigorously pursued the origination, underwriting syndication and warehousing of mortgage-backed securities and corporate loans as well as credit derivatives as ways to boost earnings. As a result, when the markets turned down in 2007-2008 -- which most LCFIs were late to recognize -- substantial realized and unrealized losses were incurred that required significant additional capital to be raised. (Exhibit 3) By this time, the population of LCFIs had grown to include historically specialized investment banks (such as Merrill Lynch) and insurance companies (such as AIG), all of which met as competitors in the derivatives, wholesale lending and securities markets. Like bank-based LCFIs, the nonbank LCFIs had also become very large and complex institutions. Exhibit 4 illustrates the degree of complexity that may characterize LCFIs, regardless of their historic “industry” origins. The 2007-2008 global financial crisis demonstrated repeated instances of LCFIs that lost control of their risk management functions after having committed themselves to unusual degrees of leverage and other business practices on and off the balance-sheet to ramp-up earnings but which at the time jeopardized their institution’s safety and soundness, ultimately imposing a high level of risk on the financial system as a whole. This generalization applied equally to LCFIs originating in commercial banking, insurance, or investment banking. There is no evidence, based on recent asset-related losses, that one cohort performed better than another in the context of the current financial crisis. All types of LCFIs contributed to placing the financial system and consequently the real economy at severe risk. However, intermediaries that relied exclusively on wholesale market financing for their trading positions were disadvantaged against those able to access retail deposits, and therefore bank-based LCFIs were more resistant to “runs” on funding sources.

IV. Is There Value in LCFIs? The rise of LCFIs as competitors in global markets should imply that beneficial scale, operating-efficiency and scope effects, as viewed from the private welfare perspective of the shareholder, outweighed their corresponding costs. On the contrary, however, various academic studies suggest that, while LCFIs may have important efficiency advantages, there is little convincing evidence of either economies of scale or scope due to the greater size or activity-range among banking and financial firms. Moreover, there is credible evidence of a significant holding-company discount in broad-gauge LCFIs as compared to the stand-alone value of their various businesses, as has often been the case for industrial conglomerates.

4

The key issue is that the risk exposures of LCFIs can trigger externalities on the rest of the financial system – thereby creating social costs of failure far exceeding private costs. But, since all LCFIs are inside the too big to fail boundary, implicit bailout guarantees may well have been sufficient to shift the competitive balance in their favor, thereby supporting their growing importance in the US financial system.

V. Broadening of LCFI Bailout Guarantees The broadening of LCFI bailout guarantees in 2008 includes the Fed’s absorption of risk in JP Morgan Chase’s acquisitions of Bear Stearns and Washington Mutual and public funding infusions into AIG. It also includes use of the first $125 billion in TARP funding to acquire government equity holdings in Citigroup, Goldman Sachs, Wells Fargo, JP Morgan Chase, Bank of America - Merrill Lynch, Morgan Stanley, State Street, and Bank of New York-Mellon, all of them LCFIs. Conversion of Morgan Stanley, Goldman Sachs, American Express, CIT Financial and possibly others to bank holding companies was clearly designed to get them inside the TBTF boundary and have access to government provided and potentially underpriced implicit and explicit guarantees. Wells Fargo’s acquisition of Wachovia, Bank of America’s acquisition of Countrywide and Merrill Lynch, and PNC’s acquisition of National City represent further strengthening of the role of LCFIs in the US financial system, albeit always with explicitly government guaranteed retail deposits as part of the capital structure.1 Finally, the $306 billion bailout of Citigroup in November 2008 has emphasized just how failure-proof LCFI’s are. The Fed and the Treasury appear to be actively encouraging consolidation among US financial intermediaries and expanding the size of LCFIs as an essential tool in ongoing financial stabilization efforts. In the process they appear to be promoting the consolidation of smaller financial intermediaries with existing LCFIs. In effect, they are engineering a financial system that favors a much greater role for LCFIs, and a potential expansion of the future TBTF guarantee pool. It remains to be seen whether this represents real progress in balancing stability along with efficiency and competitiveness in the US financial system, or whether it encourages creation of large financial oligopolies that are as difficult to manage as they are to regulate – all of them with explicit and implicit TBTF guarantees and wholesale socialization of risk.

VI. The Regulatory Challenge The Government’s numerous emergency actions to date have been relatively ad hoc, aimed at containing recurring financial crises. These actions were supplemented by the submission of a longer-term regulatory reform proposal (the “Blueprint”) by the Treasury Department. This proposal, which has not been acted upon as yet, represents a studied view of the key regulatory problems of the financial system and possible regulatory and structural remedies. Other proposals have come from a variety of sources, including

1 The placing of Fannie Mae and Freddie Mac under government conservatorship is not considered here, although both institutions were clearly TBTF. Whether they will be fully nationalized or restructured into LCFIs remains to be seen.

5

proposals and declarations by the G-7 and G-20 groups of countries and the EU finance ministers. There seems to be an emerging consensus that serious regulatory weaknesses exist relating to LCFI’s which urgently need to be corrected. The challenge is to identify those dimensions of the regulatory infrastructure that need correction, together with the means of doing so, in ways that do not unnecessarily depreciate the competitive and innovative effectiveness of the global capital markets and the financial system as a whole.

A. Considering the Alternatives. Several regulatory alternatives are available for consideration:

1. Retain the “historic” regulatory structure. This has been based on industry segments – commercial banking, investment banking, insurance, and asset management. In the US, this involves mainly the Fed, the OCC, the CFTC and the SEC as well as state insurance regulators, all implementing banking, insurance and securities laws as they have evolved over time.

2. Functional regulation by type of activity. Alter the regulatory structure to create

a commercial banking regulator (including responsibility for deposit insurance), a securities regulator, a national insurance regulator and an asset management regulator. LCFIs would be cross-regulated based on their specific activity domains. (Exhibit 5).

3. A single regulator. Models of unified regulation exist in the UK (Financial Services

Authority – SFA), Singapore (Monetary Authority of Singapore – MAS) and elsewhere. In the former case the monetary authority (Bank of England) is theoretically (if not practically) confined exclusively to the conduct of monetary policy, but of necessity works closely with the regulator. The single regulator may be organized according to financial function, business practices or other criteria.

4. Regulation by objective. Define the principal targets of regulation -- e.g., market

stability in order to minimize systemic risk, prudential regulation to prevent institutional collapse -- using a combination of market discipline, insurance and guarantees (as practiced for example in Australia and Holland), alongside business conduct regulation to protect consumers and investors by assuring transparency and a level playing field in financial markets.

5. Modified regulation by objectives. This is best represented by the 2008 US

Treasury plan. It involves creation of successors to the current US regulatory structure consisting of five agencies – a prudential financial regulatory agency, a market stability regulator, a corporate finance regulator, a conduct of business regulator and a guarantee agency covering bank deposits and insurance

6

contracts. This approach would apply to all financial institutions, whether or not they are considered TBTF (See Exhibits 6 and 7).

6. A single separate LCFI regulator. This would create a dedicated regulator for

those institutions viewed as imposing systemic risk exposure to the financial system and separate functional regulators for so-called non-LCFIs (See Exhibit 8).

B. Framework for the LCFI-Specific Enhanced Regulation System We would advocate the sixth option representing an alternative regulatory structure that involves separate regulation of LCFIs which are too big to fail – the SSW proposal. Non-systemic risk institutions whose failure would not impose serious externalities on the financial system would be regulated by authorities focusing on their core financial functions. Each regulator would specialize in its own regulatory domain and ultimately develop deep expertise both in its specific functional domain and in the institutions which focus on that domain. This regulatory specialization would allow a certain degree of granular “fitness and properness” to be incorporated into the regulatory process. Systemic (or TBTF) institutions would be the sole domain of a special LCFI regulator. This regulator would encompass all of the constituent functional areas of the existing system, and at the same time be familiar with the consequences and the complex interlinkages between the various financial activities of LCFIs that could lead to potential systemic risks. The regulator would also serve as an efficient collector and transferor of information within the institution with respect to exposures in particular activity areas. This structure is likely to be more successful than other alternatives in capturing key risk exposures and their interrelationships within these massive organizations, as well as the kinds of risk management failures and governance problems that characterize the ongoing financial crisis. Finally, and most importantly, the LCFI regulator, using information collected in this role, will be able to more accurately ex-ante risk price any explicit and implicit guarantees provided to LCFIs. For example, a base insurance or guarantee premium might be set – one that is linked to the asset size and non-systematic risk attributes of the LCFI – with additional surcharges based on ex-ante measurable systemic risk exposure variables.2 We believe the SSW proposal may dominate the alternatives for the following reasons:

1. The financial regulatory structure that currently exists in our view is at best adequate in controlling activities of regulated entities other than LCFIs, which need special attention because they are invariably TBTF. Regulating LCFIs is much more complex, and must involve powers not normally ceded to financial regulators to force compliance with safety and soundness and competition measures even at the expense of growth and profitability objectives. Without this power, the LCFIs would only be subjected to additional private regulatory costs without any assurance that the public was being better protected from systemic

2 See the Stern white paper on pricing of guarantees.

7

risk. These enhanced powers need not be applied to other types of regulated entities, and the skill-sets required for enhanced LCFI regulation will be different from those of the functional regulators.

2. Complexity requires unique insight into the structure of LCFIs. Risks that surface in

one domain of their activities can trigger risks in one or more other domains. At issue here is the need for “integrated regulatory risk control,” by an enhanced regulator.

3. LCFI corporate governance requires sound general understanding of risk

exposures. This combines reliance on appropriate models with a solid basis of common sense. Recent events have exposed potentially serious lapses among boards of directors in their duties of care and loyalty. Interactions with, and the monitoring of, a capable LCFI regulator could have a salutary effect in improving the quality of LCFI corporate governance.

4. Other regulatory approaches, such as that proposed by the US Treasury, involve the potential for cross-regulation and conflict among various regulatory bodies, as well as informational fault-lines at the LCFI level that could be exploited. A dedicated LCFI regulator offers a solution to this problem.

5. Perhaps most importantly, the LCFI regulator by gathering information within the LCFI, will be better able to ex-ante price both the explicit and implicit TBTF guarantees prevalent today in the financial system. As discussed above a LCFI regulator offers our best hope for more accurate risk pricing of TBTF guarantees.

C. Determining Which Firms Are LCFIs This approach to regulation would require identifying LCFIs, beginning with an agreed cohort of such firms. At the initial stage, this might be measured by both on- and off-balance sheet size. Later a regulator could set standards also taking into account balance sheet trading exposures and other factors that could cause an intermediary to be considered TBTF. LCFIs would certainly include the largest banks, investment banks and insurance companies plus large financial units of industrial conglomerates such as Berkshire Hathaway and General Electric, as well as any asset managers or hedge funds that could generate concentrated size and exposures constituting a systemic danger to the financial system if the institution should fail. Once an institution is designated TBTF in one country, other countries in which it operates would be advised and encouraged to regulate it accordingly.3 At the same time, firms may opt-out of LCFI regulatory overview by breaking themselves up into smaller businesses or reducing risky areas of activity exposure that cause them to be classified as such. A key initial issue will be determining the size breakpoint that defines an institution as TBTF, such an analysis is beyond the scope of this white paper.

3 See the Stern White Paper on Regulating System Risk by Thomas Phillipon

8

The Annex to this white paper lists a number of US and foreign-based financial services firms that might be included among the LCFI cohort.

VII. Global Dimensions It is clear that the proposed approach cannot be confined to the US alone or to US-based LCFIs. For example, US regulators must have oversight powers extended to American LCFI activities overseas since size (both on- and off-balance sheet) has global dimensions. A large number of LCFIs are based in Europe and elsewhere, and their failure could have systemic effects locally and on globalized financial markets. LCFIs, such as HSBC and UBS, have large-scale operations in the US and would have to be regulated in the US as LCFIs. To make this work effectively there would have to be alignment of national LCFI regulators on joint approaches to key issues, perhaps organized under a Basel Accord type structure.4 National LCFI regulators would participate in a special unit of a supranational organization, with a mandate to coordinate LCFI regulation and impede regulatory arbitrage on the part of systemically sensitive institutions. The advantage of this “regulatory college” approach is that it allows considerable international diversity in regulating non-systemic institutions while maintaining safeguards against systemic collapse via a coordinated approach to LCFIs. The proposed SSW model would involve a limited number of LCFIs in each country, all of which to be subject to focused regulation aimed at insuring the safety and soundness of the financial intermediaries concerned, and by implication the financial system as a whole.

4 The broad outlines, falling short of a new Bretton Woods Agreement, can be found in the text of the November 2008 G-20 summit at http://www.nytimes.com/2008/11/16/washington/summit-text.html?pagewanted=2&_r=1&sq=g-20&st=cse&scp=1

9

Exhibit 1

Exhibit 2Global Wholesale Finance League Tables, 2006-07

10

EQUITY (US$bn) 2Q08 31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006 2Q08

31.12. 2006

Equity attr. to shareholders 43.5 40.5 35.8 21.3 50.3 43.3 127 115.8 109 118.8 21.1 35.9 33.4 34.3 39.7 32.7 19.3 18.1

WRITEDOWNS (US$bn) 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative 2Q08 Cumu-

lative

Leveraged loans¹ 0.2 0.5 0.1 2.8 0.3 3.9 0.7 3.1 0.4 4.2 0.3 1.9 0.5 2.3 0.8 2.8 0.4 1.3

Total subprime2 1.1 22.4 (0.5) 4.4 0.3 0.3 0.4 2.2 6.0 32.5 6.9 34.2 0.4 8.8 2.0 3.6

Other MBS/ABS 3.4 18.7 0.5 1.9 2.9 5.9 1.4 0.9 2.5 0.7 2.3 0.3 2.1 1.0 1.7 2.8

Total MBS/ABS write-downs

4.5 41.1 (0.1) 6.3 3.2 6.2 0.4 3.6 6.9 34.9 7.6 36.5 0.7 10.9 0.0 1.0 3.7 6.4

Total 4.7 41.6 0.0 9.1 3.5 10.0 1.1 6.7 7.3 39.1 8.0 38.3 1.2 13.2 0.8 3.8 4.1 7.7

EXPOSURES (US$bn) 2Q08 2Q08 2Q08 2Q08 2Q08 2Q08 2Q08 2Q08 2Q08

Leveraged loans 6.8 14.0 38.3 18.9 24.2 7.5 22.3 11 11.5

US Subprime exposure3 6.7 1.9 2.9 1.9 22.5 8.3 0.3 1.8 3.4

US Alt-A exposure 6.4 1.1 5.9 10.6 16.4 1.5 2.4 4.710.2

US Prime exposure 6.1 0.7 8.9 33.74.3

8.5

Other MBS/ABS exp. 11.8 2.7 7.4 11.3

CMBS exposure 6.5 14.7 16.7 11.6 45.1 14.9 6.4 17.0 29.4

Total MBS/ABS exposure 37.5 21.1 25.5 33.0 84.0 65.8 13.4 32.0 54.3

Total 44.3 35.1 63.8 51.9 108.2 73.3 35.7 43.0 65.8

SOURCE: Competitor 2Q result announcements and pre-announcements; transcripts; brokers’ notes; 10-Q filings 1. Net of hedges and underwriting fees 2. Net of hedges 3. Exposure net of hedges (except for LEH) or monoline insurance

Exhibit 3Major Wholesale Banks Write-downs and Exposures - Q2-08

SECURITIES ASSET MANAGEMENT

COMMERCIAL BANKING INSURANCE

Retail& SME

Whole-sale

Life Non-Life

Bro-kerage

Invest-mentBanking

Retail &PrivateClients

Institu-tional

Exhibit 4The Complexity of LCFIs

11

LCFIs

DI Regulator

SI Regulator

Insurance Regulator

Depository Institution Activities

Broker-Dealer

Activities

Insurance Activities

Exhibit 5Regulation by Function or Activity

FiduciaryRegulator

AssetManagement

Activities

Exhibit 6Redesigning the Financial Regulatory Architecture – US Treasury

Prudential Fin. Regulatory Agency•Absorbs regulatory and monitoring functions of the Fed, FDIC, OCC, and OTS for all intermediaries subject to explicit government guarantees.

Market Stability Regulator• Fed to monitor systemic threats in Banks, broker-dealers, insurance companies, hedge funds, etc.

• Intervention only if stability is threatened.

Conduct of Business Reg. Agency• Absorbs regulatory and monitoring functions SEC and CFTC plus some Fed, FTC and state insurance regulatory functions.

Federal Insurance Guarantee Corp.• Replaces FDIC and adds insurance guarantee function.

Corporate Finance Regulator• Replaces SEC in corporate disclosure,

regulation, governance, accounting oversight, etc.

12

Exhibit 7Treasury Proposals: Regulation by Type of Charter

1. Market Stability Regulator

(Federal Reserve)

2. Prudential Regulator

(PERA)

3. Business Conduct Regulator

(CBRA)

1. FIDI Charter(DI)

2. FII Charter(Retail financial

products & insurance)

3. FFSP Charter(all other financial

products)

4. Federal Insurance

Regulator (FIGF)

5. Corporate Finance Regulator

LCFI Regulator

LCFIs

DI Regulator

SI Regulator

Insurance Regulator

Depository Institution Activities

Broker-Dealer

Activities

Insurance Activities

“Systemic”(TBTF)

“Non-systemic”

Exhibit 8SSW Proposal: Regulation by Function

FiduciaryRegulator

AssetManagement

Activities

13

Annex Examples of LCFIs

US Bank-based LCFIs

• Bank of America (incl. Merrill &Countrywide) • Citigroup • J.P. Morgan Chase (incl. Bear Stearns & Washington Mutual) • Wells Fargo (incl. Wachovia • Goldman Sachs Group • Morgan Stanley

US Insurance-based LCFIs

• American International Group • Berkshire Hathaway • Prudential Financial

Other US LCFIs

• American Express (now a BHC) • Bank of New York - Mellon • CIT Financial (now a BHC) • General Electric Capital • Fidelity Investments • State Street Global

Foreign Bank-based LCFIs With Major US Businesses

• Barclays PLC • Deutsche Bank AG • HSBC Holdings • ING Group • UBS AG

Foreign Insurance-based LCFIs With Major US Businesses Allianz SE Groupe AXA Munich Re Swiss Re