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May 10, 2012

Tough Leverage and Trading Rules Are Key to Prevent Next Too-Big-To-Fail Crisis

In testimony before a congressional committee, Marc Jarsulic, chief economist of Better Markets, a nonprofit, nonpartisan organization promoting the public interest in financial reform, called today on regulators to impose strict leverage and trading requirements on big banks so they do not trigger another financial crisis requiring a taxpayer bailout.

“The financial crisis was arrested through massive intervention by the federal government. The demonstrated willingness of the government to take such actions continues to reassure financial markets. However, many of the underlying structural problems that led to the crisis remain unresolved,” Mr. Jarsulic said in prepared remarks at a Senate Banking Financial Institutions and Consumer Protection Subcommittee hearing on limiting the federal support for large banks.

Mr. Jarsulic detailed in his testimony why large banks were extremely vulnerable during the financial crisis because of their size and leverage. For instance, he highlighted how Citigroup was forced to take a $39 billion loss on just one type of a risky debt product during the crisis, contributing to its need for an unprecedented government bailout.

“The leverage of large bank holding companies (LBHC) is not yet constrained. Effective limitations on bank trading, much of which takes place in LBHCs, have yet to be put into place. Steps have not been taken to prevent runs on short term finance from putting the LBHCs in jeopardy once again,” he added.

In his testimony, Mr. Jarsulic outlined steps regulators should take now under the Dodd-Frank Act to curb threats posed by megabanks to the financial system and the economy:

• Impose strong leverage requirements on big banks that increase with their asset size. Proposed international Basel III standards are not likely to constrain bank leverage for big banks. The Federal Reserve should reconsider its decision to rely on the Basel standards, and take into account recent research by the Centre for Economic Policy Research indicating that a maximum leverage ratio for risk-weighted assets should be five to one.

• Require a strong Volcker Rule that will take away incentives to place risky bets that can put financial markets at risk when they turn bad. Regulators should limit “market making” compensation to only spread, fees and commissions; impose tough sanctions for violations; and narrowly limit the hedging exemption so it does not disguise speculative trading.

• Regulate the multitrillion-dollar shadow banking system to provide accountability and oversight. The Financial Stability Oversight Council has adopted rules to cover significant nonbank firms and products. Regulators should especially focus on the repo and asset-backed commercial paper markets, which both experienced runs during the financial crisis, to prevent a repeat that would put the U.S. economy and taxpayers at risk

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