The Senate Banking Committee is holding a hearing on how to regulate institutions that are too big to fail. The first panel, on which Federal Deposit Insurance Corp. Chariman Sheila Bair and Federal Reserve Bank of Minneapolis President Gary Stern testified, addressed the timing and composition of a systemic resolution authority. Now the second group of witnesses has assembled at the table.

They include the American Enterprise Institute´s Peter Wallison; The Brookings Institution´s Martin Baily; and University of Chicago Finance Professor Raghuram G. Rajan.

10:44am: Wallison is giving his opening statement. He's saying banks are special and can cause a systemic breakdown but other financial firms such as insurance companies and hedge funds can't. These firms' creditors don't expect to be able to access their investment instantaneously.

10:46am: Wallison is saying large financial institutions shouldn't be broken up. If we broke them up on the hint of trouble, we would deprive the economy of the services they perform without getting anything in return for sure.

This is so different from the prevailing view in the room, that BankThink has to ask: Will someone tell Wallison that he is insane?

10:48am: Wallison says there's no reason that non-bank financial institutions should be able to be resolved the way banks are. After he finishes, Sen. Mark Warner, D-Va., who is temporarily presiding over the hearing, calls his comments "interesting."

10:49am: Baily's giving his opening statement now. He does not support "preemptive nationalization" of banks. "If Americans want a growing economy next year...I think Congress will have to provide the Treasury more Tarp funds, and perhaps on a greater scale."

10:50am: Baily is agreeing with Wallison. "I think we actually need large institutions..some of the institutions are going to end up being too big to fail whether we like it or not."

Baily's saying financial regulators should have "special ability to look at these institutions' portfolios to make sure they're not taking on too much risk." He also supports limitations on mergers to prevent the creation of more too-big-to-fail institutions.

But the ones that exist shouldn't be broken up. "On the other hand, if we are dealing with another failure," there shouldn't be a move to make an even bigger bank out of the failed one.

10:52am: Now Baily's saying that the big banks need to be specially regulated according to their size, and perhaps an additional fee should be levied against them, but it should be too onerous.

He throws in a shout-out to the hybrid security, a debt-to-equity convertible instrument.

10:54am: He concludes by stating the need for "good, well-paid regulators" and strong regulatory frameworks.

10:54am: Rajan has begun his testimony. He's saying too-big-to-fail is definitely a problem. There different possibilities for fixing it: Preventing them from getting too big; providing additional buffers to their failure; and giving authorities special powers to resolve them.

He agrees with Baily that "a crude size limit across the board" won't work.

10:56am: Activity and size limits, if there are any, would have to come with regulator discretion, Rajan is saying, "and that poses its own problems."

"The regulated would be strongly tempted to arbitrage the regulations," Rajan adds.

Instead, there should be better buffers against the failure of large institutions.

10:58am: Rajan is saying capital requirements aren't enough. Contingent capital is important too--that's the convertible security that others have mentioned. Rajan mentions Squam Lake, a group of academics (of which he and Baily are a part) that has been putting out white papers on regulatory restructuring recently.

11:00am: Rajan suggests "a shelf bankruptcy plan" for large institutions. They would have to create their own bankruptcy plan that would be stress tested periodically. That would make resolution easier.

11:01am: Rajan has finished; Warner, still chairing, begins questioning. He addresses Wallison's assertions first. Without a systemic resolution authority, how would we deal with the AIGs of the world? He asks. And to the other two witnesses, he wants to know how they would define too-big-to-fail if the size issue isn't enough.

Warner has also made an interesting point: Baily and Rajan both said that many of the large institutions "grew organically" to their current size, but Warner brings up Bank of America, which merged with Merrill Lynch under duress.

11:02am: Wallison has taken up the issue of defining too-big-to-fail. He says Congress shouldn't be backed into a definition of the issue.

Wallison says AIG should have gone into bankruptcy. "There wouldn't have been any substantial impact on the economy." The turmoil following Lehman Brothers' failure was simply a result of the market's extreme fragility at the time.

11:04am: Saving Bear Stearns from failure was "a classic case of moral hazard," Wallison says.

Now Baily's saying he disagrees with Wallison on AIG. He also thinks it was a mistake to force BofA to buy Merrill. "We are now stuck with those institutions," though, he says.

11:06am: Rajan: "I think it's a mistake to identify systemically important institutions" or create differences between them and other institutions. They would receive special treatment by the market. Regulators should deal with systemic risk without identifying the specific institutions.

11:07am: The senators have gone to vote--the committee is in recess. Stay tuned for more after the break.

11:40am: The hearing has reconvened. Sen. Daniel Akaka, D-Hi. is chairing.

11:40am: Akaka: Should congress impose a new regime to prevent institutions from getting too big to fail?

Wallison: I don't think that's a good policy to keep institutions from growing. My colleagues here agree, for the most part. If a big institution is competitive and efficient, it shouldn't be penalized.

11:42am: "We have very large operating companies in this country," Wallison is saying. Those large companies can't operate without large banks.

Baily: I agree that "we've failed to address the risks and companies failed to manage the risks." UBS wrote a report describing its risk management procedures and how they had failed. It's very interesting.

Baily: I agree that we need these large banks. For example, global trade relies on financing from Wall Street. We need these services. But I also think that as banks get bigger and more interconnected, we need special supervision. Either increased capital requirements or something else.

11:45am: Rajan: "Size limits are relatively crude and very hard to enforce, because there are ways around it."

Also, Rajan points out, why should we trust the regulators that have already failed?

We should try to find ways to make activities safer, but we should also make these institutions easier to fail. "If we could make these instutitions less complex," it would go a long way to reducing the problem.

11:48am: "We have to put some boundaries around what we mean by 'too-big-to-fail.'"

Bailing out institutions that have been deemed too big to fail is equally dangerious, Wallison is saying.

11:50am: Baily: "I have studied the automobile industry..." I think we should have let big car companies fail in the past. "Let the market work." But during the current crisis I agreed that they shouldn't be allowed to fail. Such a bankruptcy in that current context would have been too severe.

I agree with the sentiment that we should have plans in place to resolve large banks, but the solution has to account for the context.

Baily: Rajan has argued that banks should make their own "funeral plans." I'm skeptical. It's sort of not the way businesses really work.

11:52am: Rajan: "The one concern is that a number of institutions and the way they structure their activities essentially make themselves too big to fail and I think you want to give them incentives not to make themselves that way."

For example, the way the settlement system relies on the existence of some of these banks for derivative contracts. "These kinds of interconnections actually make the bank essentially to complicated, too big to fail." They should think about their own demise and convince regulators that they could be failed over a week. The rationale is you want to incent them not to make themselves excessively complicated.

11:54am: What about pro-cyclicality? How do we address that?

Wallison: Banks are the only organization that really require serious regulation...they can create systemic risk but other companies can't. On the subject of capital, what to do with banks that are growing, and yet they still have the same amount of capital, which increases their leverage, I believe we should increase capital requirements a profitability and growth occurs so that it can perform the function that it is supposed to perform. Today, we see that the 10% risk-based capital requirement imposed by the Basel frameworks was insufficient.

Wallison: This would also help address the question of institutions getting too large and complex.

11:57am: Baily: We do need to increase capital requirements.

11:58am: Baily: US banks' capital requirements exceed other banks' requirements already, so we need global cooperation. But global cooperation is hard and hasn't worked very well, but we have to at least try.

12:00pm: Rajan: "I think that capital can do a little bit; I would be skeptical about putting too much weight on it." Markets, during good times, tolerate high levels of leverage. When the market's willing to tolerate that, somebody who's sitting on capital is incented to reduce that capital. That's what led to SIV's and conduits, and other off-balance sheet activity.

12:03pm: Akaka is asking about convertible debt instruments.

Rajan: This would be a way to get capital onto balance sheets during bad times without having banks take too many risks during good times.

Rajan: The Squam Lake reverse convertible debt would change to equity if the bank's capital fell below a certain level.

Another idea would be capital insurance bonds. In bad times, the bonds would start paying out to banks as equity.

12:06pm: Wallison: "I have this concern: If we keep our eye on the ball, we are talking about systemic risk." When a large bank fails, it has effects on other institutions in the economy. Converting debt into equity is good for the bank, but what does it do to the holders who previously had debt to now have equity? It makes THEM more risky.

Good point, Wallison.

12:07am: Rajan: The quick response is, this is a clear problem. The answer is the holders of this debt should not be levered financial institutions. It should be pension funds, mutual funds, sovereign wealth funds.

But would there be buyers among these?

Yes. There is a very liquid market in credit default swaps on bank debt. People are willing to buy these instruments, and they would likely buy the convertible instruments because they're similar.

12:09pm: Baily: There could be severe instances in which this convertible instrument won't be enough, of course--but having this kind of capital would make those instances less likely.

12:09pm: Akaka is thanking the witnesses. Hearing is coming to an end.

The discussion that took place after the break was witnessed in person by only one member of the committee. None of the other senators returned to question the witnesses.