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On the Need for Increased Capital Requirements for Ban s andFurther Actions to I mprove the Safety and Soundness

of AmericasBan ing SystemTestimony before the Sen ate Ban ing CommitteeAugust 3, 2011 Joseph E. Stiglitz 1 Than you for this opportunity to address the question of the financialstructur e of the ban ing industry, which I believe is central to the futurestability and prosperity of the American and global economy. Two fundamental analytic insight s, buttressed by some empiricalobservations should inform our thin ing about the appropriate regulation of ban s, including capital requirements and ris ta ing . The first is that wheninformation is imperfect and ris mar ets incompletethat is, alwaysthereis no presumption that unfettered mar ets will result in efficient outcomes. The reason is that actions give rise to externalities, consequences t hat are 1 University Professor, Columbia University; recipient of the 2001 Nobel Memorial Prize inEconomics; former Chair, President Clintons Council of Economic Advisers , Former Chair,Commission of Experts on Reforms of the International Monetary and Financial System,appointed by the President of the General Assembly of the Unite d Nations, 2009, Presidentof the International Economic Association. All views a re personal. 1 not borne by those underta ing them. 2 There is a misalignment of privateand social returns. This result is of central importance in ban ing and finance, because thevery rationale for the sector aris es out of ris management and theacquisition and utilization of information nece ssary for the efficient allocationof capital. The externalities consequent to th e excessive ris ta ing of theban s are manifest: it is not just the costs of th e bailouts and the millions of Americans who have lost their homes, but the lite rally trillions of dollars of lost output, the gap between the economys actual an d potential output, thepredictable and predicted fallout of the crisis. The resu lting sufferingincluding that of the 25 million Americans who would li e a full-t ime job andcant get oneis incalculable. The budgetary problems facing the countryt oo are in no small measure a result of the inevitable decline in revenues andinc rease in expenditures that follow. It is well- nown that recoveries fromfinancia l crises are slow and painful. 3 This crisis not only demonstrated the importance of the externalities towhich failures in financial mar ets give rise, but also the importance of whateconomis ts call agency problemsthose, li e ban officials, who aresupposed to ta e action s on behalf of others, who have a fiduciary 2 See B. Greenwald and J. E. Stiglitz, Externalities in Economies with Imperfect In formationand Incomplete Mar ets, Quarterly Journal of Economics , Vol. 101, No. 2 (May), pp. 229-264, 1986. For an excellent discussion of these externalities at the macro-economic level,see A. Korine , Systemic Ris -Ta ing: Amplification Effects, Externalities, and RegulatoryResponses, wor ing paper, Uni versity of Maryland, 2011 3 See, e.g. C. Reinhardt, and K. Rogoff, 2009, This Time Is Different: Eight Centuries of Financial Folly . Princeton University Press or J. E. Stiglitz , Rethin ing Macroeconomics: WhatFailed and How to Repair It, Journal of the European Economic Association, 2011

2 responsibility, often have incentives that lead them to ta e actions thatbenefit themselves at the expense of those that they are supposed to serve. The so-call ed incentive systems in place in the financial sector may haveserved the ban ma nagers well, but they did not serve well shareholders orbondholders, let alone t he rest of society. 4 The second fundamental insight is that increased leverage in generaldoes not c reate value, but simply shifts ris as leverage increases,increased ris is placed on the equity base. This is the central insight of theModigliani-Miller theorem . 5 In the 1960s and 1970s, I showed that that resultwas far more general than Modig liani-Miller had thoughtbut that therewere limitations too, most of which caution ed against excessive leverage: if there were real costs to ban ruptcy (as there are), then increased leverageincreased the li elihood of these dissipative costs . 6 4 There is by now a large literature explaining and documenting this observation. See, e.g. J.E. Stiglitz, Freefall: America, Free Mar ets, and the Sin ing of the World Economy, New Yor :W.W. Norton, 2010. Indeed, well before the crisis, it was noted that ma nagerial incentivestructures (incentive pay) had perverse effects, not only in enc ouraging excessive ris ta ing and shortsighted behaviorwhich is particularly cost ly when it occurs in the financialsectorbut also in encouraging dishonest account ing, so manifest not only in this crisis, butin the scandals that mar ed the beg inning years of this decade, epitomized by the Enronban ruptcy, the largest ban ruptcy up to that point. See, e.g. J. E. Stiglitz, 2003, TheRoaring Nineties, New Yor : W.W. Norton. 5 F. Modigliani and M. Miller, 1958, "The Cost of Capital, Corporation Finance and the Theoryof Investment," American Economic Review, 48, 1958, pp. 261-267. From early on, it wasrecognized that theorem was relevant to financial firms as well as non-financial firms. SeeM. Miller, 1995, Do the MM propositions apply to ban s?, Journal of Ban ing and Finance ,19(3), pp.483-489. 6 See, in particular, J. E. Stiglitz, 1969, A Re-Examination of the Modigliani-Mill er Theorem, American Economic Review , 59(5), December, pp. 784-793 and J. E. Stiglitz, 1974, On theIrrelevance of Cor porate Financial Policy, American Economic Review , 64(6), December,pp. 851-866. In particular, I showed that the ind of arbitrag e that Modigliani and Miller hadinvo ed in their analysis was not necessary to e stablish the result. I established that theredid not have to exist a set of ris classes as they had assumed; and that the conclusionsheld in a very generally s pecified general equilibrium model. What was required was thatthe level of debt was not so high that there was a ris of ban ruptcy. For a discussion of some of the other restrictions that have to be satisfied for the result to be true, see thefootnotes below. 3