Notwithstanding the fact that the law does not prescribe broad structural changes, some observers may judge whether reform has gone far enough based on the extent of changes in the scope or scale of the U.S. systemic banking institutions relative to the crisis. These eight banking institutions now hold $10.6 trillion in total assets and account for 57 percent of total assets in the U.S. banking system today--not materially different from the $9.4 trillion and 60 percent of total assets in 2009. And while some of the U.S. systemic banking institutions have reduced their capital markets activity, they remain the largest dealers in those markets. To be fair, we are entering an important period when the more stringent standards that we are putting in place to reduce expected losses to the system should inform the cost-benefit analysis of these institutions' size and structure. As standards for systemically important firms tighten, some institutions may determine that it is in the best interest of their stakeholders to reduce their systemic footprint.

[The regulatory reforms that have taken place since the financial crisis] are well advanced and, in my view, have left the global systemically important banks far stronger than they were before the crisis. Together, they significantly reduce the probability of a large bank failure. But they would leave us short of meeting the overriding objective of eliminating the too-big-to-fail conundrum without a fourth reform--a viable resolution mechanism that could handle the failure of these institutions without severe damage to the economy. Until recently, no nation has had a way of handling such failures without that degree of damage.

CCPs must adopt plans and tools that will help them recover from financial shocks and continue to provide their critical services without government assistance. It has been a challenge for some market participants to confront the fact that risks and losses, however well managed, do not simply disappear within a CCP but are ultimately allocated in some way to the various stakeholders in the organization--even if the risk of loss is quite remote. This realization has generated a healthy debate among CCPs, members, and members' clients and regulators that has provided fertile ground for new thinking about risk design, risk-management tools, and recovery planning. To ensure that CCPs do not themselves become too-big-to-fail entities, we need transparent, actionable, and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government.

What we have is a fundamental flaw in the relationship between government and the financial sector resulting from the inability or unwillingness to find a way to forgo intervention in crises. And the impact of this flaw is growing. At the end of 1999, the government safety net including both the implicit support I just outlined and explicit support provided by programs such as deposit insurance and pension guarantees covered 45 percent of financial sector liabilities, according to Richmond Fed researchers. By the end of 2011, that number had grown to 57 percent, about the same size it was at the end of 2009, despite the many new regulations we have put in place since the crisis.

Greater capital buffer requirements and measures to beef up ex-ante constraints on risk-taking are important, but theyre not infallible. New opportunities for risk-taking will always emerge as financial markets and economies evolve, and it is asking too much to expect front-line supervisors to forever substitute for well-aligned incentives. Moreover, stronger restraints on risk-taking increase the incentive for market participants to find a way to operate outside the regulated sector. This regulatory bypass gives rise to whats come to be called shadow banking

a topic we will be hearing more about this afternoon

The Dodd-Frank Act lays out a path toward making bankruptcy workable for large financial institutions. The Act requires these institutions to create resolution plans, also known as living wills. These are detailed plans that explain how a financial institution could be wound down under U.S. bankruptcy laws without threatening the rest of the financial system or requiring government assistance. The plans explain how to disentangle the many different legal entities sometimes numbering in the thousands that make up a large financial firm. Under the Dodd-Frank Act, large banks and other systemically important firms are required to submit these plans on an annual basis for review by the Fed and the FDIC.

Resolution planning provides a structured approach for understanding whats likely to happen in the event a large financial firm fails. In contrast, in past crises policymakers found themselves with little or no preparatory work to draw on. In fact, the process has already proven valuable by giving firms a better and more detailed understanding of their legal structure, and many have used the process to reorganize themselves and eliminate unneeded legal entities.

Resolution planning wisely does not take the current operating profile of large financial firms as given; the current characteristics of these firms evolved in response to the precedents set by regulators avoiding the use of bankruptcy.

It could be that large banks can finance themselves more cheaply because they are more efficient, that is, that there are economies of scale in banking. For some time, the received wisdom was that there was no evidence of such economies beyond relatively modest-sized banks, with balance sheets of approximately $100 billion. More recently, several papers have found that economies of scale may continue beyond that level. For example, the title of a paper by Joseph Hughes and Loretta Mester, "Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return Driven Cost Function" suggests that large institutions may be better able to manage risk more efficiently because of "technological advantages, such as diversification and the spreading of information...and other costs that do not increase proportionately with size." That said, these authors conclude that "[W]e do not know if the benefits of large size outweigh the potential costs in terms of systemic risk that large scale may impose on the financial system." They add that their results suggest that "strict size limits to control such costs will likely not be effective, since they work against market forces..."

The TBTF theory of why large banks are a problem has to contend with the history of the Canadian and Australian banking systems. Both these systems have several very large banks, but both systems have been very stable--in the Canadian case, for 150 years. Beck, Demirguc-Kunt, and Levine (2003) examined the impact of bank concentration, bank regulation, and national institutions on the likelihood of a country suffering a financial crisis and concluded that countries are less likely to suffer a financial crisis if they have (1) a more concentrated banking system, (2) fewer entry barriers and activity restrictions on bank activity, and (3) better-developed institutions that encourage competition throughout the economy.32 The combination of the first finding with the other two appears paradoxical, but the key barrier to competition that was absent in Canada was the prohibition of nationwide branch banking, a factor emphasized by Calomiris and Haber in their discussion of the Canadian case. In addition, I put serious weight on another explanation offered in private conversation by a veteran of the international central banking community, "Those Canadian banks aren't very adventurous," which I take to be a compliment.

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Why is the TBTF phenomenon so central to the debate on reform of the financial system? It cannot be because financial institutions never fail. Some do, for example, Lehman Brothers and the Washington Mutual failed in the Great Recession

Almost certainly, TBTF is central to the debate about financial crises because financial crises are so destructive of the real economy. It is also because the amounts of money involved when the central bank or the government intervenes in a financial crisis are extremely large Another factor may be that the departing heads of some banks that failed or needed massive government assistance to survive nonetheless received very large retirement packages.

One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs. In the United States, the Dodd-Frank Act has provided the FDIC with the Orderly Liquidation Authority (OLA)--a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. And the FDIC's single-point-of-entry approach for effecting a resolution under the new regime is a sensible proposed implementation path for the OLA.

Closely associated with the work on resolution mechanisms is the living will exercise for SIFIs. In addition, there are the proposed G-SIB capital surcharges and macro stress tests applied to the largest BHCs ($50 billion or more). Countercyclical capital requirements are also likely to be applied primarily to large banks. Similarly the Volcker rule, or the Vickers rules in the United Kingdom or the Liikanen rules in the euro zone, which seek to limit the scope of a bank's activities, are directed at TBTF, and I believe appropriately so.

What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. At the analytical level, there is the question of what the optimal structure of the financial sector should be. Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? That depends on whether there are economies of scale in the financial sector and up to what size of firm they apply--that is to say it depends in part on why there is a financing premium for large firms. If it is economies of scale, the market premium for large firms may be sending the right signals with respect to size. If it is the existence of TBTF, that is not an optimal market incentive, but rather a distortion

Would breaking up the largest banks end the need for future bailouts? That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants--except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, "too many to fail." Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble.

In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.

Given the rescue expectations that have built up over the last several decades, I believe it will take more than a sincere pledge to limit central bank lending to solve the time consistency problem. The resolution planning provisions of the Dodd-Frank Act — often called “living wills” — require the creation of credible plans for resolving large institutions in bankruptcy without government funding. Work is underway implementing these provisions, but much more is needed. It’s worth emphasizing, however, that such plans should not take the current complexity and scale of large institutions as immutably given. The strategy should be to work backward from resolvability, without government funding backstops, to deduce how their current operations and funding need to be structured. Significant changes may be required, but resolution planning appears to be the only plausible way to dismantle “too big to fail.”

BROWN: The nation's foremost expert on banking regulations, your once fellow Governor Dan Tarullo said on Tuesday that we're, quote, "not even close," unquote, to ending too-big-to- fail.

YELLEN: Well, I'm slightly surprised he said we're nowhere close, because I personally think we've mad a lot of progress in putting in place regulations that will make a huge difference to this.

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WARREN: So my question is, what evidence would you need to see before you could declare with confidence that too-big-to-fail has ended?

YELLEN: So I'm not positive that we can declare, with confidence, that too-big-to-fail has ended until it's tested in some way. I mean I do believe that there are demonstrable improvements in terms of the amount of capital and liquidity that we have, you know, put in place, both through stress testing and Dodd-Frank regulations. There is more to come in the form of SIFI surcharges and likely a supplemental leverage ratio. You know, there is a whole agenda here of minimum debt requirements. I think it is important to feel that we have solved too-big-to-fail that we have the confidence that if an institution were to get in trouble that we could actually resolve that institution.

I do agree with these observers that the size of a financial institution is likely to be a useful source of information about the magnitude of that institution’s TBTF problem. At the same time, though, policymakers should guard against relying too much on this single metric. We should always keep in mind that the term too-big-to-fail is highly misleading. The TBTF problem is about creditor perceptions of loss protection. Creditors might well see the smaller of two institutions as being more likely to receive that protection, if the smaller institution is engaged in some kind of activity that is seen by government agencies as being especially vital. Thus, if we go back to 2008, government funds were used to facilitate the purchase of Bear Stearns by JP Morgan Chase. No such government funds were made available to facilitate the resolution of Lehman—and Lehman was certainly larger than Bear Stearns.

I am committed to using the Fed's supervisory and regulatory role to reduce the threat of another financial crisis. I believe that capital and liquidity rules and strong supervision are important tools for addressing the problem of financial institutions that are regarded as "too big to fail." In writing new rules, however, the Fed should continue to limit the regulatory burden for community banks and smaller institutions, taking into account their distinct role and contributions. Overall, the Federal Reserve has sharpened its focus on financial stability and is taking that goal into consideration when carrying out its responsibilities for monetary policy. I support these developments and pledge, if confirmed, to continue them.

Today, I will evaluate three broad sets of choices: 1) Building a credible resolution regime and more resiliency in the financial system that together reduce the systemic costs of failure sufficiently so that large, complex firms can be allowed to fail; 2) taking steps, such as tougher prudential standards, that further reduce the probability of failure of such firms; and 3) breaking up the too big to fail firms so that no firm is so large that its failure would threaten financial stability in the first place.

To summarize, I conclude that building a credible resolution regime is necessary but not sufficient… I will argue that at least as much effort should be made to lower the risk of failure of such large, complex firms. Not only does this include higher capital and liquidity requirements, which we are implementing, but also building incentives into the system so that firm managements will act more forcefully and much earlier to put their firms on more solid ground before they encounter greater difficulties.

Finally, I am not yet convinced that breaking up large, complex firms is the right approach. In particular, these firms presumably exist, in large part, because there are scale or network effects that allow these firms to offer certain types of services that have value to their global clients. These benefits might be lost or diminished if such firms were broken up…

Resolution planning will require a great deal of hard work. But I see no other way to ensure that policymakers have confidence in unassisted bankruptcy and that investors are convinced that unassisted bankruptcy is the norm, both of which strike me as necessary to solving the "too big to fail" problem. Resolution planning provides a framework for identifying the actions we need to take now to ensure that the next financial crisis is handled appropriately, in a way that is fair to taxpayers and establishes the right incentives.

But still, the TBTF behemoths were indisputably what the Bank of England’s Andy Haldane called “super-spreaders” of the virus that brought our financial system and economy to its knees.[10] They retain that potential today. For in the aftermath of the crisis and the passage of Dodd–Frank, the giants have gotten bigger, and the profitability of the community and regional banks that might pose meaningful, healthy competition has been undermined by the legislation’s complexity.

Dodd–Frank claims to end TBTF. Instead, as the Wall Street Journal editorialized, it entrenches the TBTF pathology. The megabanks remain a potential lethal force. As mentioned, I will be speaking at length on this subject in New York in October.

[E]arlier this week the federal banking agencies jointly issued a proposal to implement higher leverage ratio standards for the largest, most systemically important U.S. banking organizations. We have already finalized the rules on resolution planning and stress testing, and we are working diligently this year toward finalization of the remaining standards.

Another reform that will take time to complete is the establishment of a global framework for resolving large, systemically important banks...  As many of you know, in the United States, the Federal Deposit Insurance Corporation is developing a preferred approach to resolution for such rare cases: the single-point-of-entry (SPOE) approach. This approach may be gaining some traction internationally. In my view, SPOE can be a classic "simplifier," making theoretically possible something that seemed impossibly complex.

Under the SPOE approach, the home country resolution authority for a failing banking firm would effect a creditor-funded parent company recapitalization of the failed firm. To do so, the resolution authority would first use available parent company assets to recapitalize the firm's critical operating subsidiaries, and then would convert liabilities of the parent company into equity of a surviving entity. This approach would have the effect of concentrating the firm-wide losses on the parent company's private sector equity holders and creditors. The SPOE approach places a high priority on what your own President Weidmann recently described as "the principle of liability," meaning that those who benefit should also bear the costs.

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I will briefly discuss the Fed's proposal for oversight of foreign banks operating in the United States, which carries out a mandate from the Congress under the Dodd-Frank Wall Street Reform and Consumer Protection Act.2 Our proposal represents a targeted set of adjustments aimed at reducing the risks posed by the U.S. operations of large foreign banks to U.S. financial stability that were revealed during, and in the aftermath of, the recent financial crisis. The proposal is not intended to create a disadvantage for foreign banks in the U.S. market. Rather, the proposal is part of a larger set of regulatory reforms that substantially raises standards for all banking organizations operating in the United States and aims to achieve the goals we share with Germany: vigorous and fair competition and a stable financial system. Indeed, in some sense it follows the lead of the European Union and its member states in ensuring that all large subsidiaries of globally active banks meet Basel capital rules. We believe that our foreign bank proposal, which would increase the strength and resiliency of the U.S. operations of these firms, would meaningfully reduce the likelihood of disruptive ring-fencing at the moment of crisis that could undermine an SPOE resolution of a large foreign bank. We are fully committed to the international efforts to address cross-border resolution issues and to maintaining strong cooperation between home and host supervisors during normal and crisis periods.

I think there's still a ways to go.  My concern, in particular, is the intersection of too-big-to-fail, our very large institutions, with very large wholesale funding markets that are subject to runs and, eventually then, to liquidity freezes.