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From Banking and Finance Law Daily, June 25, 2014

Lew shies away from bank size limits, defends FSOC processes

By Mark S. Nelson, J.D.

Treasury Secretary Jacob J. Lew, in testimony that was often eclipsed by repeated queries about the ongoing crisis at the Internal Revenue Service (IRS), deflected calls to refocus Dodd-Frank Act reforms on bank size, instead saying he prefers to focus on risk-based reforms and complexity rather than “arbitrary size limits.” Lew also backed the Financial Stability Oversight Council’s (FSOC’s) process for labeling some firms systemically important.

Lew said in his testimony and prepared remarks to the Senate Banking Committee on the FSOC’s 2014 annual report that the FSOC should continue to ask important questions about the ongoing stability of financial firms despite criticism by some that doing so may signal impending regulation. Lew said the failure to probe key issues facing the economy today may lead regulators to overlook “unseen risks” that may one day have a serious economic impact.

“Today, there are even some who challenge the notion that the Council should ask questions about whether certain activities or companies might pose risks to the stability of the U.S. financial system,” said Lew. “But asking questions does not equal regulatory action. We learned from the financial crisis that regulators should have asked more, not fewer, questions about the institutions and activities that they oversaw.”

Lew’s latest testimony was mostly in step with remarks he made to the House Financial Services Committee yesterday.

Complexity versus size. In one of the more dramatic exchanges, but for those dealing with the IRS, Lew said he was hesitant to follow the call of Sen. Elizabeth Warren (D-Mass.) to refocus Dodd-Frank Act reforms on bank size. The senator noted that the 2010 reforms tackled the risk aspect of banking, but left room for regulators to address banks’ size. To Sen. Warren, the combination of risk and size in the largest banks is a regulatory blind spot.

Specifically, Sen. Warren noted that the largest U.S. banks had grown even larger during and after the 2008 financial crisis, in part, by taking on risker activities, such as securitizations backed by subprime auto loans and by entering the physical commodities markets. She likened these developments to a game of regulatory whack-a-mole in which existing problems are quickly replaced by new ones.

Lew replied that complexity may be a better touchstone than size. Lew also noted that progress has been made via the roll-out of higher capital reserves and other tougher standards to get banks to better understand internalized costs associated with risks.

Senator Warren asked how Lew planned to respond to a forthcoming GAO study of bank profits and the too-big-to-fail model. Lew said he eagerly awaited the GAO report because more data is needed to get a better grasp of whether the largest banks enjoy a funding advantage. But Lew rejected “arbitrary size limits” for banks.

SIFI transparency. The FSOC’s designation of some firms as systemically important financial institutions (SIFIs) has drawn a lot of criticism, especially as the FSOC considers whether to extend the SIFI designation to asset managers.

Senate Banking Committee Chairman Tim Johnson (D-S.D.) opened the meeting by reciting the many regulatory advances since the FSOC’s last annual report, including the final Volcker rule and numerous SIFI designations. He also raised the possibility that new issues may need to be addressed. These emerging worries include short-term wholesale funding and other operation risks.

Against this backdrop, Ranking Member Mike Crapo (R-Idaho) said he had asked the GAO to look at the FSOC’s process for making non-bank SIFI designations. Sen. Crapo also said the FSOC should make these criteria more transparent by following the SEC’s lead in making the Office of Financial Research’s report on asset managers available for public comment. “I encourage Secretary Lew to consider making non-bank SIFI designation criteria also available for public comment.”

According to Lew, the FSOC has explained how the SIFI designation process works. Said Lew: “Some also claim that the Council’s processes are opaque and its outcomes are predetermined, but that is simply wrong. The Council has voluntarily adopted a robust transparency policy and put in place a comprehensive, deliberative approach to its evaluation of risks, and it solicits public input and carefully considers all points of view.”

Senator Jerry Moran (R-Kan.) pressed Lew further on why the FSOC is not more transparent about its SIFI designations. The senator said he would like for the FSOC to publish objective criteria for making SIFI designations. He also said firms that could become SIFIs should be given time to rethink their business models and make needed changes to avoid a SIFI designation.

Lew acknowledged that Sen. Moran asked a “fair question,” but he noted that the FSOC tries to “appropriately” balance the interests that arise in SIFI designations. Lew also said that stage three of the SIFI process provides firms with enough information to make business decisions and that a given business model can be reviewed as part of the annual FSOC review process.

Ex-Im Bank. The reauthorization of the Export-Import Bank of the United States (Ex-Im Bank) continues to hit snags in Congress. The debate has focused on the role of U.S. taxpayer funding and equivalent programs in other countries.

Senator Joe Manchin, III (D-W. Va.) asked Lew what consequences may ensue if the Ex-Im Bank is not reauthorized. Lew said the Ex-Im Bank is a “pathway to understanding how to export” for smaller firms. Lew noted that access to exports is “enormous” for big and small firms because it can level the global playing field, a key reason to maintain the Ex-Im Bank.

Lew also said in reply to Sen. Manchin that failure to reauthorize the Ex-Im Bank would, at the least, jeopardize new guarantees. Lew said he would have to do more research on the likely impact for existing guarantees if the Ex-Im Bank is not reauthorized.

In earlier questioning by Sen. Moran, Lew doubted that a unilateral pull-back from Ex-Im sponsorship would be workable. Sen. Moran had asked about U.S. efforts to urge other countries to ease their support for home-grown businesses in order to allow the U.S. to cut taxpayer exposure to these programs.

Lew told Sen. Moran that while there are some discussions between the U.S. and other countries about government sponsorship of exports, he is “not optimistic” that other countries will reduce the scale of their programs.

The Ex-Im Bank seeks to promote U.S. jobs via programs that fund business deals overlooked by private financiers. Earlier this year, Ex-Im Bank Chairman and President, Fred P. Hochberg, urged members of the Senate Banking Committee to recommend the bank’s reauthorization.

In April, at the 2014 Export-Import Bank Annual Conference, Hochberg said the Ex-Im Bank has an 80-year track record of helping U.S. businesses get treated fairly overseas. Said Hochberg, “At Ex-Im, that’s where we come in. By breaking down barriers to financing, we level the playing field for American businesses, and deliver a good night’s sleep to entrepreneurs who might otherwise be worried whether they’ll get paid for overseas sales.”

Student loans. Legislators’ and regulators’ interests have been piqued by debt issues that now plague many college graduates, but there remains much disagreement on a solution. Senator Jack Reed (D-R.I.) asked if this is a problem the FSOC could address.

Lew replied that while student debt may be a macroeconomic problem, it is likely not something for the FSOC to deal with. Lew noted, however, that the overhang of student loan debt can cause individuals to delay home purchases or to be more limited in their career options.

Lew also said he backs a bill introduced by Sen. Warren and that Treasury is working with the Department of Education to ease student loan burdens. But Lew said there are still many dimensions of student loans that need further study.

IRS computers. Republican Senators repeatedly pressed Lew about the IRS scandal. These senators want an independent investigation that goes beyond work already being done by the IRS inspector general.

Senator David Vitter (R-La.) asked if it was merely an accident that the IRS apparently lost emails that may shed light on whether IRS officials targeted certain political groups. Lew replied that he was unaware of any political involvement in the matter and that some IRS decision makers could be replaced.

In reply to a follow-up question by Sen. Vitter about IRS computer crashes that may have caused the lost emails, Lew said he had no reason to believe the emails were lost because of anything other than broken computer hard drives. “Senator,” Lew said, “sometimes a broken hard drive is just a broken hard drive.”

Senator Dean Heller (R-Nev.) queried Lew about Treasury’s “hands-off approach” to its oversight of the IRS. Lew said even though the IRS is part of Treasury, the IRS enjoys a degree of independence to avoid political conflicts.

In other questioning about the IRS, Lew agreed with Sen. Richard C. Shelby (R-Ala.) that the integrity of the IRS is “critical.” Senator Shelby had followed-up Sen. Heller’s questions by reading from a Treasury order specifying the department’s structure in which the IRS is one of 11 agencies that report to the deputy Treasury secretary, who in turn reports to Lew. According to Sen. Shelby it may be time for a special prosecutor to investigate how the IRS handled its review of certain political groups.

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