dallas fed report
TRANSCRIPT
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2011 ANNUAL REPORTFEDERAL RESERVE BANK OF DALLAS
Choosing the Road to ProsperityWhy We Must End Too Big to FailNow
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CONTENTS
Letter rom the President 1
Choosing the Road to Prosperity 2
Year in Review 24
Senior Management, Ofcers and Advisory Councils 26
Boards o Directors 28
Financial/Audit 32
The too-big-to-ail institutions that amplifed and prolonged
the recent fnancial crisis remain a hindrance to ull
economic recovery and to the very ideal o American
capitalism. It is imperative that we end TBTF.
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Letter rom the
President
you are running one o the too-big-to-ail (BF) banksalternatively
known as systemically important
nancial institutions, or SIFIsI doubt you
are going to like what you read in this annual
report essay written by Harvey Rosenblum, the
head o the Dallas Feds Research Department,
a highly regarded Federal Reserve veteran o 40
years and the ormer president o the National
Association or Business Economics.
Memory ades with the passage o time.Yet it is important to recall that it was in recog-
nition o the precarious position in which the
BF banks and SIFIs placed our economy in
2008 that the U.S. Congress passed into law the
DoddFrank Wall Street Reorm and Consumer
Protection Act (DoddFrank). While the act
established a number o new macroprudential
eatures to help promote nancial stability, its
overarching purpose, as stated unambiguously
in its preamble, is ending BF.
However, DoddFrank does not eradi-
cate BF. Indeed, it is our view at the Dallas
Fed that it may actually perpetuate an already
dangerous trend o increasing banking industry
concentration. More than hal o banking
industry assets are on the books o just ve
institutions. Te top 10 banks now account
or 61 percent o commercial banking assets,
substantially more than the 26 percent o only
20 years ago; their combined assets equate to
hal o our nations GDP. Further, as Rosenblum
argues in his essay, there are signs that Dodd
Franks complexity and opaqueness may even
be working against the economic recovery.In addition to remaining a lingering threat
to nancial stability, these megabanks signi-
cantly hamper the Federal Reserves ability to
properly conduct monetary policy. Tey were a
primary culprit in magniying the nancial crisis,
and their presence continues to play an impor-
tant role in prolonging our economic malaise.
Tere are good reasons why this recovery
has remained rustratingly slow compared with
periods ollowing previous recessions, and Ibelieve it has very little to do with the Federal
Reserve. Since the onset o the Great Recession,
we have undertaken a number o initiatives
some orthodox, some notto revive and
kick-start the economy. As I like to say, weve
lled the tank with plenty o cheap, high-octane
gasoline. But as any mechanic can tell you, it
takes more than just gas to propel a car.
Te lackluster nature o the recovery is
certainly the byproduct o the debt-inused
boom that preceded the Great Recession, as
is the excessive uncertainty surrounding the
actionsor rather, inactionso our scal au-
thorities in Washington. But to borrow an anal-
ogy Rosenblum crated, i there is sludge on the
crankshatin the orm o losses and bad loans
on the balance sheets o the BF banksthen
the bank-capital linkage that greases the engine
o monetary policy does not unction properly to
drive the real economy. No amount o liquidity
provided by the Federal Reserve can change this.
Perhaps the most damaging eect o prop-
agating BF is the erosion o aith in American
capitalism. Diverse groups ranging rom theOccupy Wall Street movement to the ea Party
argue that government-assisted bailouts o
reckless nancial institutions are sociologically
and politically oensive. From an economic
perspective, these bailouts are certainly harmul
to the ecient workings o the market.
I encourage you to read the ollowing
essay. Te BF institutions that amplied and
prolonged the recent nancial crisis remain a
hindrance to ull economic recovery and to thevery ideal o American capitalism. It is impera-
tive that we end BF. In my view, downsizing
the behemoths over time into institutions that
can be prudently managed and regulated across
borders is the appropriate policy response. Only
then can the process o creative destruction
which America has perected and practiced
with such eectiveness that it led our country
to unprecedented economic achievement
work its wonders in the nancial sector, just as
it does elsewhere in our economy. Only then
will we have a nancial system t and proper
or serving as the lubricant or an economy as
dynamic as that o the United States.
Richard W. Fisher
Federal reserve Bank oF dallas 2011 annual report1
I
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As a nation, we ace a distinct choice. We can perpetu-
ate too big to ail, with its inequities and dangers, or we
can end it. Eliminating TBTF wont be easy, but the vitality
o our capitalist system and the long-term prosperity it
produces hang in the balance.
2Federal reserve Bank oF dallas 2011 annual report
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Choosing the Road to Prosperity
Why We Must End Too Big to FailNowby Harvey Rosenblum
Federal reserve Bank oF dallas 2011 annual report3
ore than three years ater a crippling nancial crisis, the American economy
still struggles. Growth sputters. Job creation lags. Unemployment remains high.
Housing prices languish. Stock markets gyrate. Headlines bring reports o a
shrinking middle class and news about governments stumbling toward bankruptcy, at
home and abroad.
Ordinary Americans have every right to eel anxious, uncertain and angry. Tey have
every right to wonder what happened to an economy that once delivered steady progress.
Tey have every right to question whether policymakers know the way back to normalcy.
American workers and taxpayers want a broad-based recovery that restores con-
dence. Equally important, they seek assurance that the causes o the nancial crisis have
been dealt with, so a similar breakdown wont impede the fow o economic activity.
Te road back to prosperity will require reorm o the nancial sector. In par-ticular, a new roadmap must nd ways around the potential hazards posed by the
nancial institutions that the government not all that long ago deemed too big to
ailor BF, or short.
In 2010, Congress enacted a sweeping, new regulatory ramework that attempts
to address BF. While commendable in some ways, the new law may not prevent the
biggest nancial institutions rom taking excessive risk or growing ever bigger.
BF institutions were at the center o the nancial crisis and the sluggish recov-
ery that ollowed. I allowed to remain unchecked, these entities will continue posing
a clear and present danger to the U.S. economy.
As a nation, we ace a distinct choice. We can perpetuate BF, with its inequities
and dangers, or we can end it. Eliminating BF wont be easy, but the vitality o our
capitalist system and the long-term prosperity it produces hang in the balance.
M
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When competition declines, incentives oten turn per-
verse, and sel-interest can turn malevolent. Thats what
happened in the years beore the fnancial crisis.
Flaws, Frailties and FoiblesTe nancial crisis arose rom ailures
o the banking, regulatory and political
systems. However, ocusing on acelessinstitutions glosses over the undamen-
tal act that human beings, with all their
faws, railties and oibles, were behind the
tumultuous events that ew saw coming
and that quickly spiraled out o control.
Complacency
Good times breed complacencynot
right away, o course, but over time as
memories o past setbacks ade. In 1983,the U.S. entered a 25-year span disrupted
by only two brie, shallow downturns, ac-
counting or just 5 percent o that period
(Exhibit 1). Te economy perormed
unusually well, with strong growth, low
unemployment and stable prices.
Tis period o unusual stability and
prosperity has been dubbed the Great
Moderation, a respite rom the usual tumult
o a vibrant capitalist economy. Beore the
Federal Reserves ounding in 1913, recession
held the economy in its grip 48 percent o
the time. In the nearly 100 years since the
Feds creation, the economy has been in
recession about 21 percent o the time.
When calamities dont occur, its hu-
man nature to stop worrying. Te world
seems less risky.
Moral hazard reinorces complacency.Moral hazard describes the danger that
protection against losses encourages riskier
behavior. Government rescues o troubled
nancial institutions encourage banks and
their creditors to take greater risks, know-
ing theyll reap the rewards i things turn
out well, but will be shielded rom losses i
things sour.
In the run-up to the crisis o 2008, the
public sector grew complacent and relaxed
the nancial systems constraints, explicitly
in law and implicitly in enorcement. Ad-
ditionally, government elt secure enough
in prosperity to pursue social engineering
goalsmost notably, expanding home
ownership among low-income amilies.
At the same time, the private sector
also became complacent, downplaying
the risks o borrowing and lending. For
example, the traditional guideline o 20
percent down payment or the purchase
o a home kept slipping toward zero, es-
pecially among lightly regulated mortgage
companies. More money went to those
with less ability to repay.1
Greed
You need not be a reader o Adam
Smith to know the power o sel-inter-
estthe human desire or material gain.Capitalism couldnt operate without it.
Most o the time, competition and the rule
o law provide market discipline that keeps
sel-interest in check and steers it toward
the social good o producing more o what
consumers want at lower prices.
When competition declines, incen-
tives oten turn perverse, and sel-interest
can turn malevolent. Tats what happened
in the years beore the nancial crisis. Newtechnologies and business practices reduced
lenders skin in the gameor example,
consider how lenders, instead o retaining
the mortgages they made, adopted the
new originate-to-distribute model, allowing
them to pocket huge ees or making loans,
packaging them into securities and selling
them to investors. Credit deault swaps ed
the mania or easy money by opening a
casino o sorts, where investors placed bets
onand a ew nancial institutions sold
protection oncompanies creditworthi-
ness.
Greed led innovative legal minds to
push the boundaries o nancial integrity
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0
5
10
15
20
25
30
35
40
45
50
Time spent in recession (percent) Time spent in recession, pre-Fed vs. post (percent)
2008201119832007196119821939196019151938
0
20
40
60
1915201118571914
37
16 17
5
38
21
48
Exhibit 1
Reduced Time Spent in Recession
52011 annual report Federal reserve Bank oF dallas
with o-balance-sheet entities and other ac-
counting expedients. Practices that werent
necessarily illegal were certainly mislead-
ingat least thats the conclusion o manypostcrisis investigations.2
Complicity
We admire success. When everybodys
making money, were eager to go along or
the rideeven in the ace o a suspicion
that something may be amiss. Beore the
nancial crisis, or example, investors relied
heavily on the credit-rating companies that
gave a green light to new, highly complex
nancial products that hadnt been tested
under duress. Te agencies bestowed their
top rating to securities backed by high-risk
assetsmost notably mortgages with small
down payments and little documentation
o the borrowers income and employment.
Billions o dollars o these securities were
later downgraded to junk status.
Complicity extended to the public
sector. Te Fed kept interest rates too low
or too long, contributing to the specula-
tive binge in housing and pushing investors
toward higher yields in riskier markets. Con-
gress pushed Fannie Mae and Freddie Mac,
the de acto government-backed mortgage
sourCe: ni B f ecmic rch.
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Assets as a percentage of total industry assets
1970 2010
12,500 smallerbanks
46%
16%
37% 32%
17%
52%
Top 5 banks
95 large andmedium-sized
banks
5,700smaller banks Top 5 banks
Exhibit 2
U.S. Banking Concentration Increased Dramatically
6Federal reserve Bank oF dallas 2011 annual report
Concentration amplifed the speed and breadth o the
subsequent damage to the banking sector and the
economy as a whole.
giants, to become the largest buyers o
these specious mortgage products.
Hindsight leaves us wondering what -
nancial gurus and policymakers could havebeen thinking. But complicity presupposes
a willul blindnesswe see what we want to
see or what lies experiences condition us to
see. Why spoil the party when the economy
is growing and more people are employed?
Imagine the political storms and public
ridicule that would sweep over anyone who
tried!
Exuberance
Easy money leads to a giddy sel-
delusionits human nature. A contagious
divorce rom reality lies behind many o his-
torys great speculative episodes, such as the
Dutch tulip mania o 1637 and the South
Sea bubble o 1720. Closer to home in time
and space, exuberance ueled the exas oil
boom o the early 1980s. In the rst decade
o this century, it ed the illusion that hous-
ing prices could rise orever.
In the run-up to the nancial crisis,
the certainty o rising housing prices
convinced some homebuyers that high-
risk mortgages, with little or no equity,
werent that risky. It induced consumers
note: a w cc ig h gy high h h f b mmig f h
b wih h m h g im f gizi- b .
sourCes: r f Cii Icm, F Fici Iii exmii Cci; ni IfmiC, F r sym.
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to borrow on rising home prices to pay or
new cars, their childrens education or a
long-hoped-or vacation. Prudence would
have meant sitting out the dance; buyinginto the exuberance gave people what they
wantedat least or a while.
All booms end up busts. Ten comes
the sad rerain o regret: How could we
have been so oolish?
Concentration
In the nancial crisis, the human traits o
complacency, greed, complicity and exuber-
ance were intertwined with concentration,
the result o businesses natural desire to
grow into a bigger, more important and
dominant orce in their industries. Concen-
tration amplied the speed and breadth
o the subsequent damage to the banking
sector and the economy as a whole.
Te biggest U.S. banks have gotten a
lot bigger. Since the early 1970s, the share
o banking industry assets controlled by
the ve largest U.S. institutions has more
than tripled to 52 percent rom 17 percent
(Exhibit 2).
Mammoth institutions were built on a
oundation o leverage, sometimes mislead-
ing regulators and investors through the
use o o-balance-sheet nancing.3 Equitys
share o assets dwindled as banks borrowed
to the hilt to chase the easy prots in new,
complex and risky nancial instruments.Teir balance sheets deterioratedtoo little
capital, too much debt, too much risk.
Te troubles werent always apparent.
Financial institutions kept marking assets
on their books at acquisition cost and
sometimes higher values i their proprietary
models could support such valuations.
Tese accounting expedients allowed them
to claim they were healthyuntil they
werent. Write-downs were later revised by
several orders o magnitude to acknowledge
mounting problems.
With size came complexity. Many big
banks stretched their operations to include
proprietary trading and hedge und invest-
ments. Tey spread their reach into dozens
o countries as nancial markets globalized.
Complexity magnies the opportunities
or obuscation. op management may not
have known all o what was going onpar-
ticularly the exposure to risk. Regulators
didnt have the time, manpower and other
resources to oversee the biggest banks vast
operations and erret out the problems that
might be buried in nancial ootnotes or
legal boilerplate.
Tese large, complex nancial institu-
tions aggressively pursued prots in the
overheated markets or subprime mort-gages and related securities. Tey pushed
the limits o regulatory ambiguity and lax
enorcement. Tey carried greater risk and
overestimated their ability to manage it.
In some cases, top management groped
around in the dark because accounting and
monitoring systems didnt keep pace with
the expanding enterprises.
Blowing a GasketIn normal times, fows o money and
credit keep the economy humming. A
healthy nancial system acilitates payments
and transactions by businesses and consum-
ers. It allocates capital to competing invest-
ments. It values assets. It prices risk. For the
most part, we take the nancial systems
routine workings or granteduntil the ma-
chinery blows a gasket. Ten we scramble to
x it, so the economy can return to the ast
lane.
In 2007, the nations biggest in-
vestment and commercial banks were
among the rst to take huge write-os on
mortgage-backed securities (Exhibit 3).
(continued on page 11)
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0
900
700
500
300
100
100
300
SepJunMarDecSepJunMarDecSepJunMarDecSepJunMar
2007 2008 2009 2010
8 9Federal reserve Bank oF dallas 2011 annual report 2011 annual report Federal reserve Bank oF dallas
Exhibit 3
Employment Plummets as Financial System Implodes
Selected Timeline, 20072010
Subprime mortgage
lenders show losses
and some go bankrupt:
New Century Financial
(4/07)
Losses spread to
investors in subprime
mortgage-backed se-
curities; Bear Stearns
fghts unsuccessully
to save two ailing
hedge unds (6/07)
Subprime
mortgage-related
and leveraged loan
losses mount amid
serial restatements o
write-downs; execs
at Citi and Merrill
Lynch step down
(07:Q4)
Nationalization o
systemically important
mortgage-lending
institutions: Northern
Rock (2/08); Fannie
Mae and Freddie Mac
(9/08)
Investment banks
acquired by largest
commercial banks
with government as-
sistance: Bear Stearns
(3/08); Merrill Lynch
(1/09)
Monoline insurers
downgraded (6/08)
Bank/thrit ailures:
IndyMac (7/08); Washington
Mutual (9/08)
Financial market
disarray Lehman
bankruptcy; AIG
backstopped
(9/08)
Banking behemoth consolidation Wells Fargo
acquires Wachovia; PNC acquires National City;
Goldman Sachs and Morgan Stanley become
bank holding companies (10/08)
Government interven-
tion Citi and Bank
o America receive
government guarantees;
troubled asset relie
program (TARP) unds
released, restrictions on
exec pay, stress tests
introduced; Fed pushes
policy rate near zero,
creates special liquidity
and credit acilities and
introduces large-
scale asset purchases
(08:Q409:Q1 )
TARP unds o largest
banks repaid at a
proft to taxpayers:
JPMorgan (6/09);
Bank o America,
Wells Fargo, Citi
(12/09)
NBER dates June
2009 as ofcial
recession end
(9/10)
Foreclosure procedure
questioned, halted an
ederally mandated t
be improved at sever
major banks/mortgag
servicers (10/10
Trouble starts with shadow banks Crisis spreads to larger shadow/investment banks Commercial banks are affected Smaller banks struggle amid a mixed recovery
Fallout through 2011
FDICs problem list reaches a peak asset total of $431 billion (3/10) and peak
number of 888 banks (3/11).
Roughly 400 smaller banks still owe nearly $2 billion in TARP funds (10/11).
Only two of the 249 banks that failed in 2010 and 2011 held more than
$5 billion in assets (12/11).
Small banks face rising uncertainty about compliance
costs, unknown implementation of complicated new
regulations and anemic loan demand
Roughly 800,000 jobs lost per month
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The term TBTF disguised the act that commercial banks hold-
ing roughly one-third o the assets in the banking system did
essentially fail, surviving only with extraordinary government
assistance.
10Federal reserve Bank oF dallas 2011 annual report
or capitalist economies to thrive, weak companies mustgo out o business. The reasons or ailure vary rom
outdated products, excess industry capacity, misman-
agement and simple bad luck. The demise o existing rms
helps the economy by reeing up resources or new enterprises,
leaving healthier survivors in place. Joseph Schumpeter coined
the term creative destruction to describe this ailure and
renewal processa major driver o progress in a ree-enterprise
economy. Schumpeter and his disciples view this process as
benecial despite the accompanying loss o jobs, asset values
and equity.
The U.S. economy oers a range o options or this pro-
cess o ailure and rebirth:
BankruptciesEnterprises beyond saving wind up in Chapter 7 bank-
ruptcy, with operations ended and assets sold o. Firms with
a viable business but too much debt or other contractual
obligations usually le or Chapter 11 bankruptcy, continuing
to operate under court protection rom creditors. Both orms
o bankruptcy result in a hit to stakeholders: shareholders,
employees, top managers and creditors are wiped out or
allowed to survive at a signicant haircut. Bankruptcy means
liquidation or reduction; whether the bankrupt rm dies com-
pletely or scales down and survives with the same or similar
name, the end game is reallocation o resources.
Buyouts
A company acing potential bankruptcy may insteadbe sold. The acquisition usually produces similar stakeholder
reduction results as a Chapter 11 bankruptcy, but without the
obliteration o equity ownership and creditor allout.
Bailouts
The government steps in to prevent bankruptcy by providing
loans or new capital. The government becomes the most
senior secured creditor and begins downsizing losses, man-
agement, the corporate balance sheet and risk appetite. Asthe company restructures, the government, oten very slowly,
weans the company o lie support.
Banks are special
The FDIC handles most bank ailures through a resolution
similar to a private-sector buyout. The FDIC is unded primarily
by ees garnered rom the banking industry. The ailed institu-
tions shareholders, employees, management and unsecured
creditors still generally suer signicant losses, while insured
depositors are protected.
In the wake o the nancial crisis, DoddFrank added a
new option: the Orderly Liquidation Authority (OLA). In theory,
OLA will ollow the spirit o a Chapter 7 bankruptcyliquida-
tion o the ailed rms assetsbut in an orderly manner.Orderly may involve some FDIC/government nancing to
maximize rm value prior to the sale, thus blending some o
the degrees o ailure already discussed.
Buyouts, bankruptcies and FDIC resolutions have a long
history o providing a reasonably predictable process that
imposes no costs to taxpayers. Bankruptcies and buyouts sup-
port creative destruction using private sector unding. By con-
trast, bailouts and OLA are specically aimed at dealing with
too-big-to-ail institutions and are likely to involve some orm o
taxpayer assistance since this degree o ailure comes ater
private sector solutions are deemed unavailable. Bailouts
provide delayed support o the creative destruction process,
using sometimes politically infuenced taxpayer unds instead
o the ree-enterprise route o reduction, rebirth and realloca-tion.
In essence, dealing with TBTF nancial institutions neces-
sitates quasi-nationalization o a private company, a process
antithetical to a capitalist system.
But make no mistake about it: A bailout is a failure, just
with a different label.
Box 1
Degrees of Failure: Bankruptcies, Buyouts and Bailouts
F
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As housing markets deteriorated, policy-
makers became alarmed, seeing the num-
ber o big, globally interconnected banks
among the wounded. Te loss o evenone o them, they eared, would create a
domino eect that would lead to a col-
lapse o the payment system and severely
damage an economy already battered by
the housing bust.
Capital markets did in act seize up
when Lehman Brothers, the ourth-largest
investment bank, declared bankruptcy in
September 2008. o prevent a complete
collapse o the nancial system and to
unreeze the fow o nance, the expedi-
ent x was hundreds o billions o dollars
in ederal government loans to keep these
institutions and the nancial system afoat.
In short, the situation in 2008
removed any doubt that several o the
largest U.S. banks were too big to ail.4 At
that time, no agency compiled, let alone
published, a list o BF institutions. Nor
did any bank advertise itsel to be BF.
In act, BF did not exist explicitly, in
law or policyand the term itsel dis-
guised the act that commercial banks
holding roughly one-third o the assets
in the banking system did essentially fail,
surviving only with extraordinary govern-
ment assistance (Exhibit 4).5 Most o the
largest nancial institutions did not ail in
the strictest sense. However, bankruptcies,buyouts and bailouts acilitated by the
government nonetheless constitute ailure
(Box 1). Te U.S. nancial institutions that
ailed outright between 2008 and 2011
numbered more than 400the most since
the 1980s.
Te housing bust and recessiondisabled the nancial system, stranding
many institutions on the roadway, creating
unprecedented trac jams. Struggling
Exhibit 4
Total Assets of Failed and Assisted Institutions Reached
Extraordinary Levels
sourCe: F di Ic C.
0
100
200
300
400
1006029894908682787470
Assisted institutions
1,306
1,917
0
1,000
2,000
0908
Total assets (billions of dollars)
0809$3.77 trillion
total failed/assisted
$3,223 assisted
Failed institutions
$542failed
372
170
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Realincomegrows
Spendingincreases
Profitsincrease
Realeconomyexpands
Equipment,software
and other businessinvestments increase
Creditexpands
Vehicle, home anddurable goodsales increase
Employmentincreases
Pro
gres
singExpansionGo
odbegetsgood
Exhibit 5
Positive Feedback
Psychological side eects o TBTF cant be measured,
but theyre too important to ignore because they aect
economic behavior.
12Federal reserve Bank oF dallas 2011 annual report
banks could not lend, slowing economic
activity. Massive layos ollowed, pinching
household and business spending, which
depressed stock prices and home values,urther reducing lending. Tese troubles
brought more layos, urther reduc-
ing spending. Overall economic activity
bogged down.
Te chain reaction that started in De-
cember 2007 became the longest recession
in the post-World War II era, lasting a total
o 18 months to June 2009. Real output
rom peak to trough dropped 5.1 percent.
Job losses reached nearly 9 million. Unem-
ployment peaked at 10 percent in October
2009.
Te economy began seeing a slight
easing o congestion in mid-2009. With the
roadway beginning to clear o obstacles,
households and businesses sensed an op-
portunity to speed up. New jobs, higher
spending, rising asset prices and increased
lending all reinorce each other, building
up strength as the economy proceeds on a
growth path(Exhibit 5).
Monetary Policy Engine
In an internal combustion engine,
small explosions in the cylinders combus-
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tion chambers propel a vehicle; likewise,
the monetary policy engine operates
through cylinders that transmit the impact
o Fed actions to decisions made by busi-nesses, lenders, borrowers and consumers
(Exhibit 6).6
When it wants to get the economy
moving aster, the Fed reduces its policy
interest ratethe ederal unds rate, what
banks charge one another or overnight
loans. Banks usually respond by mak-
ing more credit available at lower rates,
adding a spark to the bank loan cylinder
that drives borrowing by consumers and
companies. Subsequent buying and hiring
boost the economy.
Interest rates in money and capi-
tal markets generally all along with the
ederal unds rate. Te reduced cost o
nancing taking place in the securities
market cylinder enables many large busi-
nesses to nance expansion through sales
o stock, bonds and other instruments.
Increased activity occurs in the asset prices
and wealth cylinder stemming rom the
propensity o alling interest rates to push
up the value o assetsbonds, equities,
homes and other real estate. Rising asset
values bolster businesses balance sheets
and consumers wealth, leading to greater
capacity to borrow and spend.
Declining interest rates stimulate ac-
tivity in the exchange rate cylinder, makinginvesting in U.S. assets less attractive rela-
tive to other countries, putting downward
pressure on the dollar. Te exchange rate
adjustments make U.S. exports cheaper,
stimulating employment and economic
activity in export industries. However, what
other countries do is important; i they
also lower interest rates, then the eect on
exchange rates and exports will be muted.
From the rst moments o the
nancial crisis, the Fed has worked
diligentlyoten quite imaginativelyto
repair damage to the banking and nancial
sectors, ght the recession, clear away
impediments and jump-start the economy.
Te Fed has kept the ederal unds
rate close to zero since December 2008. o
deal with the zero lower bound on the ed-
eral unds rate, the Fed has injected billions
o dollars into the economy by purchasing
long-maturity assets on a massive scale,
creating an unprecedented bulge in its
balance sheet. Tat has helped push down
borrowing costs at all maturities to their
lowest levels in more than a hal century.
While reducing the interest burden or
borrowers, monetary policy in recent years
has had a punishing impact on savers,
particularly those dependent on shrinkinginterest payments.
In the United States, economic
growth resumed in mid-2009but it has
been tenuous and ragile through its rst
two-plus years. Annual growth has aver-
aged about 2.5 percent, one o the weakest
rebounds o any post-WWII recovery. Stock
prices quickly bounced back rom their
recessionary lows but seem suspended
in trendless volatility. Home prices have
languished.
At the same time, job gains have been
disappointing, averaging 120,000 a month
rom January 2010 to December 2011,
less than hal what they were in the mid-
to late 1990s when the labor orce was
considerably smaller. Trough 2011, only a
third o the jobs lost in the recession have
been regained.
Whats Dierent Now?
Te sluggish recovery has conounded
monetary policy. Much more modest Fed
actions have produced much stronger
results in the past. So, whats dierent now?
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Exhibit 6The Four Cylinders of the Monetary Policy Engine
Bank loan
Securitiesmarket
Asset pricesand
wealth Exchangerate
Crankshaft
Bank capital lubricant
Connected toeconomy:
households,businesses
and governments
A vehicles engine with one cylinder misfring may get you
where you want to go; it just takes longer. The same goes or
the machinery o monetary policy, largely because o the
interdependence o all the moving parts.
14Federal reserve Bank oF dallas 2011 annual report
Part o the answer lies in excesses that
havent been wrung out o the economy
alling housing prices have been a lingering
drag. Jump-starting the housing marketwould surely spur growth, but BF banks
remain at the epicenter o the oreclosure
mess and the backlog o toxic assets stand-
ing in the way o a housing revival. Mort-
gage credit standards remain relatively
tight.7
Loan demand lags because o uncer-
tainty about the economic outlook and
diminished aith in American capitalism.
Even though banks have begun easing
lending standards, potential borrowers be-
lieve the tight credit standards o 200810
remain in place.
Another part o the answer centers
on the monetary policy engine. It still isnt
hitting on all cylinders, impairing the Feds
ability to stimulate the real economys
growth o output and employment. As a
result, historically low ederal unds rates
havent delivered a large expansion o overall
credit. With bank lending weak, nancial
markets couldnt play their usual role in
recoveryrevving up lending by nonbanks
to the household and business sectors.
A vehicles engine with one cylinder
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16/34152011 annual report Federal reserve Bank oF dallas
misring may get you where you want to
go; it just takes longer. Te same goes or
the machinery o monetary policy, largely
because o the interdependence o all themoving parts. When one is malunction-
ing, it degrades the rest. A scarcity o bank
credit, or example, inhibits rms capacity
to increase output or exports, undermining
the power within the exchange rate cylinder.
Similarly, the contributions to recovery
rom securities markets and asset prices
and wealth have been weaker than expect-
ed. A prime reason is that burned investors
demand higher-than-normal compensation
or investing in private-sector projects. Tey
remain uncertain about whether the -
nancial system has been xed and whether
an economic recovery is sustainable. Tey
worry about additional nancial shocks
such as the euro zone crisis.
Sludge on the CrankshatA ne-tuned nancial system requires
well-capitalized banks, with the resources
to cover losses rom bad loans and invest-
ments. In essence, bank capital is a key
lubricant in the economic engine (see
Exhibit 6). Insucient capital creates a
grinding riction that weakens the entire
nancial system. Bank capital is an issue o
regulatory policy, not monetary policy. But
monetary policy cannot be eective when
a major portion o the banking system isundercapitalized.
Te machinery o monetary policy
hasnt worked well in the current recovery.
Te primary reason: BF nancial institu-
tions. Many o the biggest banks have sput-
tered, their balance sheets still clogged with
toxic assets accumulated in the boom years.
In contrast, the nations smaller banks
are in somewhat better shape by some mea-
sures. Beore the nancial crisis, most didnt
make big bets on mortgage-backed securi-
ties, derivatives and other highly risky assets
whose value imploded. Tose that did were
closed by the Federal Deposit Insurance
Corp. (FDIC), a government agency.
Coming out o the crisis, the surviving
small banks had healthier balance sheets.
However, smaller banks comprise only one-
sixth o the banking systems capacity and
cant provide the nancial clout needed or
a strong economic rebound.
Te rationale or providing public
unds to BF banks was preserving the
nancial system and staving o an even
worse recession. Te episode had its
downside because most Americans came
away rom the nancial crisis believing that
economic policy avors the big and well-
connected. Tey saw a topsy-turvy worldthat rewarded many o the largest nancial
institutions, banks and nonbanks alike, that
lost risky bets and drove the economy into
a ditch.8
Tese events let a residue o distrust
or the government, the banking system,
the Fed and capitalism itsel(Box 2). Tese
psychological side eects o BF cant be
measured, but theyre too important to
ignore because they aect economic be-
havior. People disillusioned with capitalism
arent as eager to engage in productive ac-
tivities. Teyre likely to approach economic
decisions with suspicion and cynicism,
shying away rom the risk taking that drives
entrepreneurial capitalism. Te ebbing o
aith has added riction to an economy try-
ing to regain cruising speed.
Shiting into GearLooking back at the nancial crisis, re-
cession and the tepid recovery that ollowed
points to two challenges acing the U.S.
economy in 2012 and beyond. Te short
term demands a ocus on repairing the
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Box 2
TBTF: A Perversion of Capitalism
n unortunate side eect o the governments massive aid to TBTF
banks has been an erosion o aith in American capitalism. Ordinary
workers and consumers who might usually thank capitalism or their
higher living standards have seen a perverse side o the system, where
they see that normal rules o markets dont apply to the rich, powerul and
well-connected.
Here are some ways TBTF has violated basic tenets o a capitalist sys-
tem:
Capitalism requires the freedom to succeed and the freedom to fail.
Hard work and good decisions should be rewarded. Perhaps more impor-
tant, bad decisions should lead to ailureopenly and publicly. Econo-
mist Allan Meltzer put it this way: Capitalism without ailure is like religion
without sin.
Capitalism requires government to enforce the rule of law. This requires
maintaining a level playing eld. The privatization o prots and socializa-
tion o losses is completely unacceptable. TBTF undermines equal treat-
ment, reinorcing the perception o a system tilted in avor o the rich and
powerul.
Capitalism requires businesses and individuals be held accountable
for the consequences of their actions. Accountability is a key ingredient
or maintaining public aith in the economic system. The perceptionand
the realityis that virtually nobody has been punished or held account-
able or their roles in the nancial crisis.
The idea that some institutions are TBTF inexorably erodes the founda-tions of our market-based system of capitalism.
The verdict on DoddFrank will depend on what the fnal rules
look like. So ar, the new law hasnt helped revive the economy
and may have inadvertently undermined growth.
16Federal reserve Bank oF dallas 2011 annual report
A
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nancial systems machinery, so the impacts
o monetary policy can be transmitted to
the economy quickly and with greater orce.
o secure the long term, the country mustnd a way to ensure that taxpayers wont be
on the hook or another massive bailout.
Both challenges require dealing with
the threat posed by BF nancial institu-
tions; otherwise, it will be dicult to restore
condence in the nancial system and the
capitalist economy that depends on it.
Te governments principal response to
the nancial crisis has been the DoddFrank
Wall Street Reorm and Consumer Protec-
tion Act (DoddFrank), signed into law on
July 21, 2010. Its a sprawling, complex piece
o legislation, addressing issues as diverse as
banks debit card ees and systemic risk to
the nancial system. Since DoddFrank be-
came law, at least a dozen agencies, includ-
ing the Fed, have been working to translate
its provisions into regulations to govern the
nancial system. Teyre unlikely to nish
until 2013 at the earliest.
Te verdict on DoddFrank will
depend on what the nal rules look like.
So ar, the new law hasnt helped revive the
economy and may have inadvertently un-
dermined growth by adding to uncertainty
about the uture.
A prolonged legislative process preced-
ed the protracted implementation period,
with bureaucratic procedure trumpingdecisiveness. Neither banks nor nancial
markets know what the new rules will be,
and the lack o clarity is delaying repair o
the bank-lending and nancial market parts
o the monetary policy engine.
Te laws sheer length, breadth and
complexity create an obstacle to transpar-
ency, which may deepen Main Streets
distrust o Washington and Wall Street,
especially as big institutions use their law-
yers and lobbyists to protect their tur. At
the same time, small banks worry about a
massive increase in compliance burdens.
Policymakers can make their most im-
mediate impact by requiring banks to hold
additional capital, providing added protec-
tion against bad loans and investments. In
the years leading up to the nancial crisis,
BF banks squeezed equity to a minimum.
Tey ran into trouble because they used
piles o debt to expand risky investments
in the end nding that excessive leverage is
lethal.
Te new regulations should establish
basic capital levels or all nancial institu-
tions, tacking on additional requirements
or the big banks that pose systemic risk,
hold the riskiest assets and venture into the
more exotic realms o the nancial land-scape.9 Mandating larger capital cushions
tied to size, complexity and business lines
will give BF institutions more skin in
the game and restore some badly needed
market discipline. Overall, the revised regu-
latory scheme should provide incentives to
cut risk. Some banks may even rethink their
mania or growing bigger.
Higher capital requirements across
the board could burden smaller banks and
probably urther crimp lending. Tese insti-
tutions didnt ignite the nancial crisis. Tey
didnt get much o a helping hand rom
Uncle Sam. Tey tend to stick to traditional
banking practices. Tey shouldnt ace the
same regulatory burdens as the big banks
that ollow risky business models.
BF banks sheer size and their
presumed guarantee o government help
in time o crisis have provided a signicant
edgeperhaps a percentage point or
morein the cost o raising unds.10 Mak-
ing these institutions hold added capital
will level the playing eld or all banks,
large and small.
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Higher capital requirements across the board could bur-
den smaller banks and probably urther crimp lending.
These institutions shouldnt ace the same regulatory bur-
dens as the big banks that ollow risky business models.
18Federal reserve Bank oF dallas 2011 annual report
Facing higher capital requirements,
the biggest banks will need to raise addi-
tional equity through stock oerings or in-
creased retained earnings through reduceddividends. Attracting new investment will
be comparatively less burdensome or the
healthiest institutions, dicult or many
and daunting or the weaker banks.
DoddFrank leaves the details or
rebuilding capital to several supervisory
agencies. Te specics are still being worked
out; it appears banks will have until 2016 or
2017 to meet the higher thresholds.
Given the urgent need or restoring
the vitality o the banking industry, this may
seem a long wait. However, capital rebuild-
ing will likely take place aster as the stronger
banks recognize the advantages o being
rst movers. Recently, many o the largest
banks have made eorts to raise capital and
have met or surpassed supervisory expecta-
tions or capital adequacy under stress
tests.11
Banks that quickly clean up their
balance sheets will have a better chance
o raising new undsso they can then be
in shape to attract even more new capital.
Past evidence shows that nancial markets
avor institutions that oer the best pros-
pects or returns with acceptable risk.12
Laggards will be worse o, nding it
even more dicult to attract new inves-
tors. Ultimately, these institutions willurther weaken and may need to be broken
up, their viable parts sold o to competi-
tors. With the industry already too concen-
trated, its important to redistribute these
banking assets in a way that enhances
overall competition.
Ensuring that banks have adequate
capital is essential to eective monetary
policy. It comes back to the bank capital
linkage, which recognizes that banks must
have healthy capital ratios to expand
lending and absorb losses that normally
occur. Repairing the damaged mechanism
through which monetary policy impacts
the economy will be the key to accelerating
positive eedbacks.
o some extent, the Feds zero interest
rate policy, adopted in December 2008 at
the height o the nancial crisis, assisted
the banking industrys capital rebuilding
process. It reduced banks costs o unds
and enhanced protability. But short-term
interest rates cannot cross the zero lower
bound, limiting any additional impact rom
this capital-building mechanism. It could
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20/34192011 annual report Federal reserve Bank oF dallas
be argued that zero interest rates are taxing
savers to pay or the recapitalization o the
BF banks whose dire problems brought
about the calamity that created the origi-nal need or the zero interest rate policy.
Unortunately, the sluggish recovery is
a cost o the long delay in establishing the
new standards or bank capital. Given the
urgent need to restore economic growth
and a healthy job market, the guiding prin-
ciples or bank capital regulation should
be: codiy and clariy, quickly. Tere is no
statutory mandate to write hundreds o
pages o regulations and hundreds more
pages o commentary and interpretation.
Millions o jobs hang in the balance.
A Potential RoadblockDoddFrank says explicitly that
American taxpayers wont again ride to the
rescue o troubled nancial institutions. It
proposes to minimize the possibility o an
Armageddon by revamping the regulatory
architecture.
As part o its strategy to end BF,
DoddFrank expanded the powers o the
Fed, FDIC and most other existing regula-
tors. New watchdogs will be put on alert.
A 10-member Financial Stability Oversight
Council (FSOC), aided by a new Oce
o Financial Research, has been charged
with monitoring systemic risk. It will try to
identiy and resolve problems at big banksand other nancial institutions beore they
threaten the nancial system. In an eort
to increase transparency, much o the new
inormation will be made public. Opaque
business practices thwart market discipline.
Can DoddFrank do what was
unthinkable back in 2008identiy and
liquidate systemically important nancial
institutions in an orderly manner that
minimizes risk to the nancial system and
economy?
Te current remedy or insolvent
institutions works well or smaller banks,
protecting customers money while
the FDIC arranges sales or mergers that
transer assets and deposits to healthy
competitors. During the nancial crisis,
however, the FDIC didnt have the sta,
nancial resources and time to wind down
the activities o even one truly mammoth
bank. Tus, many BF institutions stayed
in business through government support.13
DoddFrank envisions new proce-
dures or troubled big banks and nancial
institutions, directed by the FSOC watch-
dog and unded by ees charged to the
biggest nancial institutions.
Te goal is an alternative to the BF
rescues o the past three decades. In prac-tice, these rescues have penalized equity
holders while protecting bond holders and,
to a lesser extent, bank managers. Disciplin-
ing the management o big banks, just as
happens at smaller banks, would reassure a
public angry with those whose reckless de-
cisions necessitated government assistance.
Will the new resolution procedures
be adequate in a major nancial crisis?
Big banks oten ollow parallel business
strategies and hold similar assets. In hard
times, odds are that several big nancial
institutions will get into trouble at the
same time.14 Liquid assets are a lot less
liquid i these institutions try to sell them
at the same time. A nightmare scenario o
several big banks requiring attention might
still overwhelm even the most ar-reaching
regulatory scheme. In all likelihood, BF
could again become MFtoo many to
ail, as happened in 2008.
A second important issue is credibil-
ity. Going into the nancial crisis, markets
assumed there was government backing
or Fannie Mae and Freddie Mac bonds
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A fnancial system composed o more banksnumerous
enough to ensure competition but none o them big enough
to put the overall economy in jeopardywill give the United
States a better chance o navigating through uture fnancial
potholes, restoring our nations aith in market capitalism.
20Federal reserve Bank oF dallas 2011 annual report
despite a lack o explicit guarantees. When
push came to shove, Washington rode to
the rescue. Similarly, no specic mandate
existed or the extraordinary governmentalassistance provided to Bear Stearns, AIG,
Citigroup and Bank o America in the midst
o the nancial crisis.15 Lehman Brothers
didnt get government help, but many o
the big institutions exposed to Lehman
did.16
Words on paper only go so ar. What
matters more is whether bankers and their
creditors actually believe DoddFrank puts
the government out o the nancial bailout
business. I so, both groups will practice
more prudent behavior.
DoddFrank has begun imposing
some market discipline and eroding the big
banks cost-o-unds advantage. Credit-
rating agencies have lowered the scores
or some larger banks, recognizing that the
law reduces government bailout protec-
tions that existed just a ew years ago and
that Washingtons scal problems limit its
ability to help beleaguered nancial institu-
tions in a nancial emergency.
While decrying BF, DoddFrank
lays out conditions or sidestepping the
laws proscriptions on aiding nancial insti-
tutions. In the uture, the ultimate decision
wont rest with the Fed but with the rea-
sury secretary and, thereore, the president.
Te shit puts an increasingly politicalcast on whether to rescue a systemically
important nancial institution. (It may be
hard or many Americans to imagine politi-
cal leaders sticking to their anti-BF guns,
especially i they ace a too-many-to-ail
situation again.)
I the new law lacks credibility, the
risky behaviors o the past will likely recur,
and the problems o excessive risk and
debt could lead to another nancial crisis.
Government authorities would then ace
the same edge-o-the-precipice choice they
did in 2008aid the troubled banking
behemoths to buoy the nancial system or
risk grave consequences or the economy.
Te pretense o toughness on BF
sounds the right note or the atermath o
the nancial crisis. But it doesnt give the
watchdog FSOC and the reasury secretary
the oresight and the backbone to end
BF by closing and liquidating a large
nancial institution in a manner consistent
with Chapter 7 o the U.S. Bankruptcy Code
(see Box 1). Te credibility o DoddFranks
disavowal o BF will remain in question
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until a big nancial institution actually ails
and the wreckage is quickly removed so the
economy doesnt slow to a halt. Nothing
would do more to change the risky behav-ior o the industry and its creditors.
For all its bluster, DoddFrank leaves
BF entrenched. Te overall strategy
or dealing with problems in the nancial
industry involves counting on regulators to
reduce and manage the risk. But huge insti-
tutions still dominate the industryjust as
they did in 2008. In act, the nancial crisis
increased concentration because some
BF institutions acquired the assets o
other troubled BF institutions.
Te BF survivors o the nancial
crisis look a lot like they did in 2008. Tey
maintain corporate cultures based on the
short-term incentives o ees and bonuses
derived rom increased oligopoly power.
Tey remain dicult to control because
they have the lawyers and the money to re-
sist the pressures o ederal regulation. Just
as important, their signicant presence in
dozens o states coners enormous political
clout in their quest to reocus banking stat-
utes and regulatory enorcement to their
advantage.
Te Dallas Fed has advocated the ulti-
mate solution or BFbreaking up the
nations biggest banks into smaller units.17
It wont be easy or several reasons. First,
the prospect raises a range o thorny issuesabout how to go about slimming down the
big banks. Second, the level o concentra-
tion considered sae will be dicult to
determine. Is it rolling things back to 1990?
Or 1970? Tird, the political economy o
BF suggests that the big nancial institu-
tions will dig in to contest any breakups.
aking apart the big banks isnt cost-
less. But it is the least costly alternative, and
it trumps the status quo.18
A nancial system composed o
more banks, numerous enough to ensure
competition in unding businesses and
households but none o them big enough
to put the overall economy in jeopardy,
will give the United States a better chance
o navigating through uture nancial
potholes and precipices. As this more
level playing eld emerges, it will begin to
restore our nations aith in the system o
market capitalism.
Taking the Right RoutePeriodic stresses that roil the nancial
system cant be wished away or legislated
out o existence. Tey arise rom human
weaknessesthe complacency that comes
rom sustained good times, the greed and
irresponsibility that run riot without mar-ket discipline, the exuberance that over-
rules common sense, the complicity that
results rom going along with the crowd.
We should be vigilant or these ailings, but
were unlikely to change them. Teyre a
natural part o our human DNA.
By contrast, concentration in the
nancial sector is anything but natural.
Banks have grown larger in recent years be-
cause o articial advantages, particularly
the widespread belie that government will
rescue the creditors o the biggest nancial
institutions. Human weakness will cause
occasional market disruptions. Big banks
backed by government turn these manage-
able episodes into catastrophes.
Greater stability in the nancial sector
begins when BF ends and the assump-
tion o government rescue is driven rom
the marketplace. DoddFrank hopes to
accomplish this by oreswearing BF,
tightening supervision and compiling more
inormation on institutions whose ailure
could upend the economy.
Tese well-intentioned initiatives may
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The road to prosperity requires recapitalizing the fnancial sys-
tem as quickly as possible. Achieving an economy relatively
ree rom fnancial crises requires us to have the ortitude to
break up the giant banks.
22Federal reserve Bank oF dallas 2011 annual report
be laudable, but the new law leaves the
big banks largely intact. BF institutions
remain a potential danger to the nancial
system. We cant be sure that some uturegovernment wont choose the expediency
o bailouts over the risk o severe recession
or worse. Te only viable solution to BF
lies in reducing concentration in the bank-
ing system, thus increasing competition
and transparency.
Te road to prosperity requires re-
capitalizing the nancial system as quickly
as possible. Te saer the individual banks,
the saer the nancial system. Te ultimate
destinationan economy relatively ree
rom nancial criseswont be reached
until we have the ortitude to break up the
giant banks.
Harvey Rosenblum is the Dallas Feds
executive vice president and director of
research. Special mention and thanks go
to Richard Alm for his journalistic assis-
tance, to David Luttrell for research and
documentation, and to Samantha Coplen
and Darcy Melton for their artistry in the
exhibits.
Notes1 Taming the Credit Cycle by Limiting High-Risk
Lending, by Jeery W. Gunther, Federal Reserve
Bank o Dallas Economic Letter, vol. 4, no. 4, 2009.
2 See speech by U.S. Attorney General Eric
Holder, Columbia University Law School, New
York City, Feb. 23, 2012, in which he noted that
much o the conduct that led to the nancial
crisis was unethical and irresponsible but this
behaviorwhile morally reprehensiblemay
not necessarily have been criminal. www.
justice.gov/iso/opa/ag/speeches/2012/ag-
speech-120223.html
3 A structured investment vehicle (SIV) is an o-
balance-sheet legal entity that issues securities
collateralized by loans or other receivables rom
a separate but related entity while investing in
assets o longer maturity. Several o the largest
banks used SIVs to issue commercial paper tound investments in high-yielding securitized
assets. When these risky assets began to deault,
the banks reluctantly took them back onto their
balance sheets and suered large write-downs.
4 In conjunction with the 1984 rescue o Con-
tinental Bank, the Comptroller o the Currency,
the supervisor o nationally chartered banks,
acknowledged the TBTF status o the largest
banks. See U.S. Wont Let 11 Biggest Banks in Na-
tion Fail, by Tim Carrington,Wall Street Journal,
Sept. 20, 1984.
5 In 2008 and 2009, the Federal Deposit Insur-
ance Corp. (FDIC) acilitated the ailure o 165institutions with $542 billion in assets. The largest
bank ailure in history occurred when Washing-
ton Mutual shuttered its doors in late September
2008, its $307 billion in assets accounting or
the lions share o the $372 billion total o ailed
institutions assets that year. Although staggering,
the amount o capital drained rom the banking
system due to ailures during the crisis pales in
comparison with the $3.2 trillion in assets as-
sociated with institutions receiving extraordinary
assistance rom the FDIC during this period, most
o it involving just two entities, Citigroup and
Bank o America.
6 Regulatory and Monetary Policies Meet Too
Big to Fail, by Harvey Rosenblum, Jessica K.
Renier and Richard Alm, Federal Reserve Bank o
Dallas Economic Letter, vol. 5, no. 3, 2010.
7 According to the July 2011 Federal Reserve
Senior Loan Ocer Opinion Survey, a majority
o large banks have eased standards or con-
sumer loans and or commercial and industrial
loans. However, credit standards on residential
and commercial real estate lending remain
tight over the period since 2005.
8 Taxpayers money wasnt given to the banks.
It was loaned, and most loans have been
repaid with interest. Nevertheless, the percep-
tion remains that bailout dollars were gits. And
perception drives public sentiment.
9 At this time (March 2012), it appears that bank
capital regulations under DoddFrank will ollow
the Basel III ramework, with capital surcharges
o at least 1 percentage point imposed on
global systemically important nancial institu-
tions (G-SIFIs). In addition, a more realistic
denition o capital is likely to be put in place to
avoid a repeat o the situation in 200809, when
two o the largest banks were never rated lessthan adequately capitalized at the height o
the crisis, while at the same time they together
received hundreds o billions in capital inusions
and loan guarantees and never made it onto
the FDICs Problem Bank List.
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10 See How Much Did Banks Pay to Become
Too-Big-to-Fail and to Become Systemically
Important?, by Elijah Brewer III and Julapa
Jagtiani, Federal Reserve Bank o Philadelphia,
Working Paper no. 11-37, 2011, and the literature
cited therein.
11 The Federal Reserves Comprehensive Capital
Analysis and Review (CCAR) evaluates the capi-
tal planning processes and capital adequacy
o the largest bank holding companies. This exer-
cise includes a supervisory stress test to evaluate
whether rms would have sucient capital in
times o severe economic and nancial stress.
In the CCAR results released on March 13, 2012,
15 o the 19 bank holding companies were
estimated to maintain capital ratios above
regulatory minimum levels under the hypotheti-
cal stress scenario, even ater considering the
proposed capital actions, such as dividend
increases or share buybacks. For more inorma-tion, see www.ederalreserve.gov/newsevents/
press/bcreg/20120313a.htm.
12 In the early 1990s, nancial markets rewarded
banks or increasing their capital-to-asset ratios.
Banks that held more capital had higher returns
on equity (ROE) primarily because o reduced
interest rates paid or uninsured liabilities.
See Banking in the 21st Century, by Alan
Greenspan, remarks at the 27th Annual Coner-
ence on Bank Structure and Competition, Federal
Reserve Bank o Chicago, May 2, 1991, especially
pp. 910. In addition, banks were rewarded with
higherequity prices or dividend retention and
issuance o new stock, two methods o raisingcapital that bankers generally claim will reduce
stock prices. See Bank Capital Ratios, Asset
Growth and the Stock Market, by Richard Can-
tor and Ronald Johnson, Federal Reserve Bank
o New York FRBNY Quarterly Review, Autumn
1992, pp. 1024 (emphasis added).
13 For other large nonbank nancial rms (or
example, Lehman Brothers, AIG and Bear
Stearns) and or bank holding companies, there
was no resolution authority at all. The choice
came down to buyouts, bankruptcies or bailouts
(see Box 1). With no private-sector buyers willingto step up, and with bankruptcy generally a
long and uncertain process, government inter-
vention in the orm o bailouts became the least
disruptive alternative, at least in the short run.
14 The FDIC estimates that it could have
perormed an orderly liquidation o Lehman, i
it had DoddFrank powers six months beore
Lehman declared Chapter 11 bankruptcy in
September 2008, and would have paid creditors
97 percent o what they were owed. But this as-
sumes that other giant nancial institutions did
not require simultaneous and similar attention.
15 On March 24, 2008, the Federal Reserve Banko New York announced that it would provide
term nancing to acilitate JPMorgans buyout
o Bear Stearns at $10/share, or $1.4 billion. On
Sept. 15, 2008, the worlds largest underwriter o
mortgage bonds, Lehman Brothers, led or the
worlds largest bankruptcy with listed liabilities o
$613 billion. The ollowing day, one o the worlds
largest insurance organizations and counter-
parties or credit deault swaps, AIG, received
Federal Reserve support: an $85 billion secured
credit acility amid credit rating downgrades
and nancial market panic. On Nov. 23, 2008,
the Treasury, Federal Reserve and the FDIC
entered into an agreement with Citigroup to
provide a package o guarantees, liquidity ac-cess and nonrecourse capital to protect against
losses on an asset pool o approximately $306
billion o loans and securities. On Jan. 16, 2009,
a similar government loan-loss agreement was
oered to Bank o America, backstopping an as-
set pool o $118 billion, a large majority o which
was assumed as a result o BoAs acquisition o
broker-dealer Merrill Lynch.
16 More than three years have passed since
the Lehman bankruptcy. A vigorous debate
persists regarding (1) whether the Fed could
have ound a way to bail out Lehman and
(2) whether this might have avoided a global
nancial and economic collapse. Using datarom late 2008 and early 2009 shown in Exhibit
3, the inescapable answer to both questions is:
It would not have mattered. Two days later, AIG
was essentially nationalized, and within a matter
o a ew months, the already imbedded but un-
recognized and undisclosed losses at Citigroup
and Bank o America necessitated a combined
Fed and FDIC assistance package that quasi-
nationalized these institutions. The extent o
these losses was disavowed by managements
up until assistance packages were announced.
17 Taming the Too-Big-to-Fails: Will DoddFrank
Be the Ticket or Is Lap-Band Surgery Required?,
speech by Richard Fisher, president and chieexecutive ocer o the Federal Reserve Bank o
Dallas, Columbia Universitys Politics and Busi-
ness Club, New York City, Nov. 15, 2011; Financial
Reorm or Financial Dementia?, by Richard
Fisher, Southwest Graduate School o Banking
53rd Annual Keynote Address, Dallas, June 3,
2010; Paradise Lost: Addressing Too Big to Fail,
speech by Richard Fisher, Cato Institutes 27th
Annual Monetary Conerence, Washington, D.C.,
Nov. 19, 2009.
18 Evidence o economies o scale (that is, re-
duced average costs associated with increased
size) in banking suggests that there are, at best,
limited cost reductions beyond the $100 billionasset size threshold. Cost reductions beyond this
size cuto may be more attributable to TBTF sub-
sidies enjoyed by the largest banks, especially
ater the government interventions and bailouts
o 2008 and 2009. See Scale Economies Are a
Distraction, by Robert DeYoung, Federal Reserve
Bank o Minneapolis The Region, September
2010, pp. 1416, as well as Brewer and Jagtiani,
note 10. However, DoddFrank seeks to reduce
these TBTF subsidies.
http://www.federalreserve.gov/newsevents/press/bcreg/20120313a.htmhttp://www.federalreserve.gov/newsevents/press/bcreg/20120313a.htmhttp://www.federalreserve.gov/newsevents/press/bcreg/20120313a.htmhttp://www.federalreserve.gov/newsevents/press/bcreg/20120313a.htm -
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Year in ReviewEleventh Federal Reserve District
T
24Federal reserve Bank oF dallas 2011 annual report
he vibrant economy o the Eleventh
Federal Reserve District became
the ocus o national attention in
2011 as the region grew signicantly aster
than the nation. Employment increased by 2
percent212,000 jobscompared with 1.3
percent nationally. Te district employs over
11 million workers.
exas, which makes up the major part o
the Eleventh District, was the last state to en-ter the recent recession and one o the stron-
gest coming out, moving rom recovery to
expansion in 2011. A source o exas economic
strength, oil and gas extraction recorded a 25
percent increase in the number o drilling rigs
in 2011, almost reaching its mid-2008 peak.
exas exports grew at a aster pace than in
the rest o the U.S., and housing continued to
mend.
Te districts economy appears poised or
another year o moderate growth as leading
economic indicators increased at the end o
2011. Slower growth in exports and energy will
likely be oset by a gradual improvement in
construction and ewer cuts in state and local
government jobs.
Monetary Policy and ResearchTe Dallas Fed began providing to the
public a timely state-level gauge o service
sector activity with the introduction midyear
o the exas Service Sector Outlook Survey
(SSOS). Te service sector drives the exas
economy, and SSOS lls a regional data
gap. Both SSOS and the established exas
Manuacturing Outlook Survey (MOS) are
routinely cited in the business media and have
proved to be reliable indicators o the exas
economy.
Te Bank conducts high-level research
that contributes to the understanding o our
dynamic economy. Research sta had 27 new
submissions and nine acceptances in reereed
journals. Te Banks economists presented
research at 40 meetings, organized or chairedsessions or served as discussants at 20 coner-
ences, gave 31 academic seminars at universi-
ties, central banks or other research institu-
tions and presented over 260 speeches to area,
district and national audiences.
Te Globalization and Monetary Policy
Institute continued to expand its reach and
activities. Te institutes sta, ellows and
research associates circulated working papers
that were read extensively worldwide, and
several o those papers were accepted or
publication in leading international academic
journals, such as theJournal of International
Economics. Te institute cosponsored a coner-
ence with the Swiss National Bank in Zurich
on the globalization o ination and held its
inaugural public lecture, Globalization and
Monetary Policy: From Virtue to Vice?, deliv-
ered by Jrgen Stark, member o the executive
board o the European Central Bank.
Financial ServicesTe new Go Direct Contact Center be-
gan operations in March 2011 to support the
All-Electronic reasury Initiative. o accom-
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One o the most diverse regions o the country, culturally, economically and geographically
252011 annual report Federal reserve Bank oF dallas
modate expansion o Go Direct operations,
sta members were relocated to a new space
on the ground oor o the Dallas building that
was previously used or check processing. Sta
levels were increased to handle phone calls
generated by the reasurys announcement
and promotion o the initiative, designed to
move ederal benet recipients rom paper to
electronic payments.
o reduce operating costs , the Bankreplaced the San Antonio oces cash services
operation with a cash depot administered
by the Houston Branch. Te Dallas Fed has
completed a multiyear upgrade to its high-
speed currency processing machines, thereby
increasing processing capability to 100,000
notes per hour.
Banking Supervision andDiscount and Credit
Te Bank continued its active participa-
tion in the implementation o the Dodd
Frank Wall Street Reorm and Consumer
Protection Act, signed into law in July 2010. In
addition to the 39 state member banks and
459 bank holding companies the Dallas Fed
supervises, the Bank on July 21, 2011, became
the ederal supervisor or 23 savings-and-loan
holding companies (SLHCs) in the Eleventh
District, ranging in size rom less than $150
million to more than $100 billion in assets.
Banking Supervision added sta to oversee
SLHCs and to prepare or implementing
enhanced supervision standards or the largest
nancial services organizations as required by
DoddFrank.
o reduce the cost to and burden on
depository institutions, the Federal Reserve
System announced an initiative to simpliy
administration o the ramework under which
organizations calculate and maintain reserves.
Ofce o Minority and WomenInclusion
As mandated by the DoddFrank Act, theBank established an Oce o Minority and
Women Inclusion (OMWI). Te OMWI is
designed to ensure that minorities and women
are airly included in employment-related ac-
tivities and that minority- and women-owned
businesses have an increasing role as providers
o goods and services. Further, the OMWIs in-
uence extends to eorts to support nancial
literacy and economic education in the Banks
service areas.
Public OutreachTe Bank remains committed to provid-
ing high-quality inormational and educational
programs that improve nancial literacy and
help the public know and understand the
structure and role o the Fed.
Te Banks economic education pro-
grams reach several thousand educators each
year, and through them, tens o thousands o
students. Te Economics Scholars Program,
presented in cooperation with Austin College,
brought together 150 participants rom 44
universities and colleges across 14 states.
Te Community Development pro-
gram advanced the concept o asset building
through events across exas. Partnering with
RAISE exas, exas Rural Innovators and local
hosts, Bank sta brought together practitio-
ners, service providers and policymakers in
exas rural communities to explore innovative
ways to help amilies achieve nancial security.
Te Bank also organized and hosted coner-
ences on Hispanic migration, labor and social
trends to widen understanding o this dynamicpopulation; social inuences on health to
understand how groups are collaborating
with leaders in community development and
health; and housing issues or people with dis-
abilities to identiy challenges, new initiatives
and nancing opportunities.
Te Dallas Fed held events across the
Eleventh District to provide an opportunity
or CEOs o nancial institutions to meet with
the Banks top leaders and discuss regional eco-
nomic issues and matters aecting banking. Te
Bank reached more than 3,000 banks and credit
unions at roundtables on economic topics in
communities across the district and hosted our
webcasts on current economic issues.
Te Banks Community Depository
Institutions Advisory Council and San Antonio
Regional Bank Council continued to provide
essential inormation about the changing
practices o nancial institutions, in particular
community banks. In 2011, the Bank ormed
a Corporate Payments Councilwhose
members represent large retail operationsso
it can stay in touch with the evolving payment
services practices o the corporate community.
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Richard W. FisherPresident and CEO
Helen E. HolcombFirst Vice President and COO
Robert D. HankinsExecutive Vice President
Harvey RosenblumExecutive Vice President andDirector o Research
Meredith N. BlackSenior Vice President
J. Tyrone GholsonSenior Vice President andOMWI Director
Joanna O. KolsonSenior Vice President
Kenneth V. McKeeSenior Vice President and
General Auditor
Senior Management
Millard E. SweattSenior Vice President andSecretary
Robert W. GilmerVice President in ChargeEl Paso Branch
Blake HastingsVice President in ChargeSan Antonio Branch
Daron D. PeschelVice President in ChargeHouston Branch
26Federal reserve Bank oF dallas 2011 annual report
(Let to right) seated: Holcomb and Fisher; standing: Kolson, Gholson, McKee, Peschel, Hastings, Black, Hankins, Rosenblum, Sweatt and Gilmer.
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Eleventh DistrictAdvisory Council 2011
Jerred G. Blanchard Jr.(Chairman)Principal, Ernst & Young LLPHouston
Charles E. AmatoChairman, SWBCSan Antonio
Crawford BrockOwner, Stanley KorshakDallas
Henry Hernandez
CEO, Las Palmas Medical CenterEl Paso, Texas
Renard U. JohnsonPresident and CEO, METI Inc.El Paso, Texas
Frank MihalopoulosPresident, Corinth PropertiesDallas
John P. NicholsProessor and HeadDepartment o Agricultural EconomicsTexas A&M UniversityCollege Station, Texas
Deborah RogersOwner, Deborahs FarmsteadFort Worth
Gerald J. RubinChairman, President and CEOHelen o Troy Ltd.El Paso, Texas
G.P. SinghOwner, Gur Parsaad Properties Ltd.San Antonio
Dale W. TremblayPresident and CEOC.H. Guenther & Son Inc.
San Antonio
Debby A. WeberSole ProprietorWeber Design AssociatesDallas
Federal AdvisoryCouncil Member
Richard W. Evans Jr.Chairman and CEOCullen/Frost Bankers Inc.San Antonio
As o December 31, 2011
Dallas
Richard W. FisherPresident and CEO
Helen E. HolcombFirst Vice President and COO
Robert D. HankinsExecutive Vice President
Harvey RosenblumExecutive Vice President andDirector o Research
Meredith N. BlackSenior Vice President
J. Tyrone Gholson
Senior Vice President andOMWI Director
Joanna O. KolsonSenior Vice President
Kenneth V. McKeeSenior Vice President andGeneral Auditor
Millard E. SweattSenior Vice President andSecretary
Earl AndersonVice President
Diane M. de St. GermainVice President
John V. DucaVice President andSenior Policy Advisor
Robert G. FeilVice President andAssociate Secretary
Sherry Kidd GarvinVice President
KaSandra GouldingVice President
Jeffery W. GuntherVice President
Kathy K. JohnsrudVice President
Evan F. KoenigVice Presidentand Senior Policy Advisor
Harvey R. Mitchell IIIVice President
William C. Morse Jr.Vice President
Alfreda B. NormanVice Presidentand Community Development Ofcer
Sharon A. SweeneyVice President,Acting General Counseland Associate Secretary
Robert L. Triplett IIIVice President
E. Ann WorthyVice President
Mark A. WynneVice President andDirector o the Globalizationand Monetary Policy Institute
Mine YcelVice President
Tommy E. AlsbrooksAssistant Vice President
Glenda S. BalfantzAssistant Vice Presidentand Assistant General Auditor
Stephan D. BookerAssistant Vice President
Claude H. DavisAssistant Vice President
Paul T. ElznerAssistant Vice President
Rob JolleyAssistant Vice President
Richard J. Mase Jr.Assistant Vice President
Dana S. MerrittAssistant Vice Presidentand OMWI Assistant Director
Dean A. PankonienAssistant Vice President
Rita RileyAssistant Vice PresidentMargaret C. SchiefferAssistant Vice President
William W. Shaffer Jr.Assistant Vice President
Michael N. TurnerAssistant Vice President
Marion E. WhiteAssistant Vice President
Hazel W. AdamsCredit Risk Systems Ofcer
Laurel M. BrewsterPublic Aairs Ofcer
Bobby E. Coberly Jr.Examining Ofcer
Jeffrey L. GarrettFinancial Management Ofcer
D. Kay GribbinAdministrative Ofcer
James R. HoardPublic Aairs Ofcer
Robert R. Moore
Research Ofcer
Pia M. OrreniusResearch Ofcer
Vincent G. PachecoExamining Ofcer
Allen E. QualmanOperations Ofcer
Kenneth J. RobinsonResearch Ofcer
Thomas F. SiemsEconomic Outreach
Senior Proessional
Jay SudderthRelationship Management Ofcer
El Paso
Robert W. GilmerVice President in Charge
Javier R. JimenezAssistant Vice President
Houston
Daron D. PeschelVice President in Charge
Donald N. Bowers IIAssistant Vice President
Randy L. SteinleyAssistant Vice President
Michelle D. TrevioAdministrative Ofcer
Federal Reserve Bank o DallasOcers/Senior Proessionals
San Antonio
Blake HastingsVice President in Charge
D. Karen DiazAssistant Vice President
272011 annual report Federal reserve Bank oF dallas
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Herbert D. Kelleher(Chairman)Founder and Chairman Emeritus,Southwest Airlines Co.
James B. BexleyProessor o Finance,Sam Houston State University
Myron E. Ullman III(Deputy Chairman)Executive Chairman,J.C. Penney Co. Inc.
Pete CookCEO,First National Bankin Alamogordo
Elton HyderPresident,The EMH Corp.
George F. Jones Jr.CEO,Texas Capital Bank
Renu KhatorChancellor and President,University o Houston
Margaret H. JordanPresident and CEO,Dallas Medical Resource
Joe Kim KingCEO,Brady National Bank
Dallas
Boards o Directors
28Federal reserve Bank oF dallas 2011 annual report
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D. Kirk Edwards(Chairman)President,MacLondon Royalty Co.
Laura M. ConniffQualiying Broker,Mathers Realty Inc.
Cindy J. Ramos-Davidson(Chairman Pro Tem)President and CEO,El Paso HispanicChamber o Commerce
Martha I. DickasonPresident,dmDickason Personnel Services
Robert E. McKnight Jr.Owner,McKnight Ranch Co.
Larry L. PattonPresident and CEO,Bank o the West
Robert NachtmannDean,College o Business Administration,University o Texas at El Paso
El Paso
292011 annual report Federal reserve Bank oF dallas
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Paul W. Hobby(Chairman)Chairman and Managing Partner,Genesis Park LP
Greg L. ArmstrongChairman and CEO,Plains All American Pipeline LP
Jorge A. Bermudez(Chairman Pro Tem)President and CEO,Byebrook Group LLC
Kirk S. HachigianChairman and CEO,Cooper Industries Ltd.
Paul B. Murphy Jr.President and CEO,Cadence Bank
Gerald B. SmithCoounder, Chairman and CEOSmith, Graham and Co.Investment Advisors LP
Ann B. SternExecutive Vice President,Texas Childrens Hospital
Houston
30Federal reserve Bank oF dallas 2011 annual report
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Steven R. Vandegrift(Chairman)Founder and President,SRV Holdings
Curtis V. AnastasioPresident and CEO,NuStar Energy LP
Catherine M. Burzik(Chairman Pro Tem)President and CEO,Kinetic Concepts Inc.
Thomas E. DobsonChairman and CEO,Whataburger Restaurants LP
Ygnacio D. GarzaPartner,Long Chilton LLP
Guillermo F. TrevinoPresident,Southern Distributing Co.
Josue Robles Jr.President and CEO,USAA
San Antonio
312011 annual report Federal reserve Bank oF dallas
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Financial/Audit
32Federal reserve Bank oF dallas 2011 annual report
Examinations o theReserve BankTe Reserve Banks and the consolidated
limited liability company (LLC) entities are
subject to several levels o audit and review.
Te combined nancial statements o the
Reserve Banks as well as the annual nancial
statements o each o the 12 Banks and the
consolidated LLC entities are audited annually
by an independent auditing rm retained
by the Board o Governors. In addition, theReserve Banks, including the consolidated LLC
entities, are subject to oversight by the Board
o Governors, which perorms its own reviews.
Te Reserve Banks use the ramework
established by the Committee o Sponsoring
Organizations o the readway Commission
(COSO) to assess their internal controls over
nancial reporting, including the saeguarding
o assets. Within this ramework, the manage-
ment o each Reserve Bank annually provides
an assertion letter to its board o directors that
conrms adherence to COSO standards.
In 2011, the Board o Governors engaged
Deloitte & ouche LLP (D&) to audit the
combined and individual nancial statements
o the Reserve Banks and those o the con-
soli