Professor Arthur E. Wilmarth, Jr., Professor Emeritus of Law at George Washington University Law School – Written evidence (PMG0022)

The Dangers of the Current “Global Deregulatory Drive” in Financial Regulation

Summary of Written Evidence

1. We are currently experiencing a “global deregulatory drive” in financial regulation.  Past deregulatory episodes warn us that aggressive deregulation is likely to produce greater risk-taking by banks and other regulated financial institutions, as well as higher levels of “shadow banking” activities by unregulated or lightly-regulated competitors of banks, generating dangerous concentrations of risky private-sector debts.  Past deregulatory episodes created toxic credit booms that led to destructive busts, imposing severe economic losses and requiring costly government bailouts. [¶¶ 1-5]

2. Strong capital and liquidity requirements are essential to ensure the strength and resilience of banks against adverse shocks.  Robust leverage capital requirements are necessary to maintain the stability of the banking system and sustain lending by banks through the business cycle.  Stronger leverage capital requirements, which require higher levels of common equity capital, are the most effective method for enhancing the viability of large, complex banks and traditional banks.  [¶¶ 6-18]

3. Community banks play a vital role in the U.S. economy by providing credit to consumers, farmers, and small businesses, and by supporting the civic life of rural communities, small towns, and smaller cities.  Community banks continue to follow a traditional, relationship-based business model, serving as reliable intermediaries between depositors and borrowers.  [¶¶ 19-27]

4. During the past four decades, large, complex banks (“universal banks”) have developed extensive and hazardous connections with nonbank financial intermediaries (“shadow banks”), whose functions mimic the traditional roles of commercial banks.  Universal banks and shadow banks have created a “toxic symbiosis,” which has promoted the rapid expansion of all types of debt obligations, including risky and illiquid private credit obligations.  [¶¶ 28-40]

5. Private equity funds face severe challenges and are imposing growing risks on bank lenders and captive life insurers.  Private equity funds and private credit funds are currently seeking to sell risky and illiquid investments to retail investors as well as pension funds and investment funds that serve those investors.  [¶¶ 41-46]

6. The inadequate reforms adopted by G20 nations after the global financial crisis of 2007-09 have allowed the “toxic symbiosis” between universal banks and shadow banks to continue and become much stronger.  The unhealthy partnerships between universal banks and shadow banks have produced uncontrolled growth in public-sector and private-sector debts.  Governments and central banks have arranged a series of massive bailouts and an ever-expanding array of financial backstops to prevent the collapse of national and global financial markets that are dangerously over-leveraged.  Those bailouts and backstops have produced an asymmetric risk curve, which encourages universal banks, shadow banks, and investors to take excessive risks with the expectation that governments and central banks will maintain a “floor” under financial markets and prevent serious financial disruptions.  [¶¶ 47-54]

7. The enormous costs of rescuing universal banks, shadow banks, and financial markets during the financial crises of 2007-09 and 2020-21 have imposed huge fiscal burdens on governments and left central banks with bloated balance sheets.  It is highly doubtful whether governments and central banks could respond to a future systemic financial crisis with comparable bailouts without risking severe and destabilizing sovereign debt crises.  [¶¶ 55-64]

8. Global financial regulators should adopt reforms to address the unacceptable dangers created by universal banks and shadow banks.  Those reforms should include:

1. Prohibiting nonbank financial institutions from offering “shadow deposits,” which enable them to compete with traditional banks by issuing short-term, deposit-like financial claims that are highly vulnerable to investor runs.  Only regulated banks protected by deposit insurance should be allowed to issue deposit-like claims.

2. Requiring large, complex banks to hold significantly higher levels of common equity capital based on strong leverage capital ratios, and to undergo rigorous stress tests to ensure their resilience and the viability of their business models. 

3. Encouraging the formation of new banks by reducing application burdens and providing tax credits for owners who start new banks in underserved communities. 

4. Reducing compliance burdens for traditional banks by exempting them from Basel III’s standardized risk-based capital requirements if they maintain strong leverage capital ratios above 9% and demonstrate that their management and business operations are consistent with sound banking practices. 

5. Implementing the Financial Stability Board’s recommendations to monitor and reduce leverage among broker-dealers, hedge funds, and private equity funds through (a) enhanced reporting and disclosure requirements; (b) mandates for central clearing of systemically important trading markets, including those for government securities, repos, and derivatives; (c) strong capital requirements for clearing members and robust margin requirements for customers of clearing facilities; and (c) increased margin requirements, position limits, and concentration limits for non-centrally-cleared financial instruments held by nonbank financial institutions.

6. Adopting stronger reporting obligations, capital requirements, asset quality and diversification standards, and supervisory procedures for life insurance and reinsurance companies that are affiliated with private equity firms. 

7. Establishing stronger disclosure and reporting requirements, stress tests, and supervisory standards, including asset concentration and diversification rules, for large private equity firms, hedge funds, and other systemically important asset managers. 

8. Prohibiting – or establishing very strong presumptions against – offerings of private equity funds and private credit funds to retail investors or to investment funds and pension funds that serve those investors.

9. In addition to the foregoing reforms, policymakers should adopt a plan to restructure financial institutions and financial markets by separating banks from securities broker-dealers and other firms engaged in capital markets activities, comparable to the separation established by the U.S. Glass-Steagall Act of 1933 (which was repealed in 1999).

1. Under the proposed separation, banks would issue all deposit-like claims, provide payment services, and provide loans to consumers and business firms.  Banks would not underwrite or trade in securities except for government bonds.  Nonbanks (including those engaged in capital markets activities) would not be allowed to issue deposit-like claims and would be required to fund their operations with equity stock and longer-term debt (Reform H.1). 

2. The proposed separation would create a more stable banking system and improve the effectiveness of central bank monetary policies because all short-term, deposit-like claims would be issued by banks.  Removing the capital markets operations of large banks would give them strong incentives to serve all segments of business and society – including consumers and small businesses that lack access to funding from the capital markets – instead of focusing their efforts on multinational corporations, wealthy investors, and speculators in the capital markets.  Community-oriented banks would be likely to attract more deposits and provide more loans as universal banks are broken up and nonbanks are barred from issuing deposit-like claims.

3. Securities firms and other nonbanks would be subject to much more effective market discipline because they could not fund their operations with short-term, deposit-like claims and would be required to rely on equity capital and longer-term debt.  Governments would no longer be compelled to bail out capital markets to prevent the failures of universal banks and shadow banks. 

The Dangers of the Current “Global Deregulatory Drive” in Financial Regulation

1. We are currently experiencing a “global deregulatory drive” in financial regulation.  Past deregulatory episodes warn us that aggressive deregulation is likely to produce greater risk-taking by banks and other regulated financial institutions as well as higher levels of “shadow banking” activities by unregulated or lightly-regulated competitors of banks, generating dangerous concentrations of risky private-sector debts.  Past deregulatory episodes created toxic credit booms that led to destructive busts, imposing severe economic losses and requiring costly government bailouts.

1. Legislators and regulators in many countries are pursuing a “global deregulatory drive.”[1]  “Memories have faded from the [global financial crisis of 2007-09], when thinly capitalized banks, stuffed with toxic mortgages, fell prey to a confidence crisis that sank the global economy.  Governments, eager to spur growth, also see reduced regulation as a way to juice the economy.”[2]  Legislators and regulators have adopted, or are actively considering, initiatives that would (i) significantly reduce capital requirements, weaken stress tests, and relax other prudential standards for large, complex banks, (ii) allow crypto firms and fintechs to offer deposit, payment, and investment services to the public under “light touch” regulatory regimes, and (iii) liberalize “private offering” rules to allow the offering and sale of risky private equity and private credit investments to retail investors and their investment and pension funds without complying with the investor protections applicable to public securities offerings.

2. During the past century, the U.S., UK, and EU have experienced past episodes of aggressive financial deregulation, which led to systemic financial crises.  In the U.S., three major deregulatory cycles occurred during (i) the 1920s, when commercial banks were allowed to conduct extensive securities activities in direct competition with investment banks; (ii) a partial deregulation of financial institutions and financial markets during the 1970s and 1980s; and (iii) a much more far-reaching deregulation of the financial sector in the 1990s and early 2000s, when large banks were allowed to become “universal banks” engaged in a full range of capital markets activities, and large securities firms were permitted to engage in bank-like activities that transformed them from “shadow banks” into de facto universal banks.[3]  The UK and EU experienced a comparable deregulatory cycle from the 1980s through the early 2000s, facilitated by developments such as London’s “Big Bang” of 1986 and the EU’s Second Banking Directive of 1992.[4]

3. The foregoing deregulatory cycles produced (i) unsustainable credit booms and busts in U.S. real estate, consumer goods, and securities markets during the “Roaring Twenties,” which culminated in the Great Crash of 1929 and paved the way for the Great Depression of the 1930s, (ii) unsustainable credit booms and busts in U.S. real estate, energy, and corporate buyout markets during the 1970s and 1980s, leading to the savings and loan and banking crises of the 1980s and early 1990s, resulting in the failures of nearly 3,000 U.S. depository institutions, which inflicted losses of almost $200 billion on U.S. deposit insurance funds and taxpayers; and (iii) toxic credit booms and busts in U.S., UK, and European real estate markets and corporate buyout markets during the 2000s, precipitating the global financial crisis of 2007-09, which required massive government bailouts in many nations (discussed below in ¶¶ 10-11, 15, 18, 47-54).  Those credit booms and busts were driven by excessive risk-taking and the production of enormous credit exposures by the largest financial institutions, while the resulting bailouts reinforced the dominance of many of the same big institutions that were responsible for the destructive booms and busts.[5] 

4. As recent months have shown, advocates for financial deregulation are likely to obtain favorable responses from legislators and regulators when (i) their demands for deregulation are supported by well-organized and well-funded lobbying campaigns led by financial industry trade groups, and (ii) ordinary citizens and nonprofits are unable to block the financial industry’s proposals because memories of recent financial crises have faded and are not strong enough to mobilize effective public opposition to deregulation.[6]

5. Big banks and large nonbank financial institutions are constantly pushing for deregulation.  At the same time, big financial institutions are usually the leading catalysts for the dangerous credit booms that deregulation makes possible.  A comprehensive 2023 study, which examined financial crises in 17 advanced economies since 1870, determined that “large banks account for a rising share of the aggregate financial cycle, take more risk during pre-crisis credit booms and have higher losses during the crisis. . . . Our results are consistent with theories of excessive risk taking of large banks and implicit bailout guarantees and show that large banks have been at the epicenter of financial instability and risk taking throughout history.”  That study also found that government rescues of banks “on the verge of failure . . . are very common for top-5 banks but a lot less common for banks 6-20, which instead tend to be merged away or wound down.”  Based on those findings, the study’s authors recommended that “policy objectives focused on restraining risk-taking and excessive credit growth should primarily target the very largest banks.”[7]

2. Strong capital and liquidity requirements are essential to ensure the strength and resilience of banks against adverse shocks.  Robust leverage capital requirements are necessary to maintain the stability of the banking system and sustain lending by banks through the business cycle.  Stronger leverage capital requirements, which require higher levels of common equity capital, are the most effective method for enhancing the viability of large, complex banks and traditional banks.

6. Strong capital and liquidity requirements are necessary to ensure the survival of banks during prolonged periods of economic and financial stress.  Banks require robust equity capital and liquidity buffers to absorb unexpected losses and satisfy unexpected demands for withdrawals by depositors.  The need for bank capital and liquidity buffers arises out of the core function of banks – to serve as intermediaries between depositors, who want the right to withdraw their deposits on demand or within a relatively short period of time, and borrowers, who want to obtain longer-term loans.  The core intermediary function of banks inevitably creates a mismatch between their longer-term and less liquid assets and their shorter-term and more liquid liabilities.  If policymakers wish to support the traditional role of banks as intermediaries between depositors, who need a safe and convenient place for their savings, and borrowers, who need a reliable source of credit, policymakers must establish sound prudential requirements for banks that include strong capital and liquidity buffers, stringent stress tests, and other regulatory tools designed to assess the viability and resilience of bank business models, especially for large, complex banks.[8]

7. Strong equity capital requirements are an essential foundation for effective banking regulation because high levels of equity capital are the most important determinant of strength and resilience for banks.  Common equity capital is the most durable and resilient form of bank capital because (i) common stock is “permanent capital” that never needs to be repurchased or redeemed by the issuing bank, (ii) common stock does not obligate the issuing bank to pay dividends, and (iii) if the issuing bank fails, claims by its common shareholders are subordinated to the claims of depositors, other creditors, and preferred shareholders.  A higher level of common equity capital provides a crucial buffer to absorb losses and reduce the risks of insolvency from external shocks or internal mistakes or misconduct by management.  A higher level of common equity capital also ensures that bank shareholders have sufficient “skin in the game” by holding substantial ownership interests in their bank.  Higher levels of common equity capital encourage shareholders to support compensation plans that deter managers from taking excessive risks.  In contrast, lower levels of common equity capital create perverse incentives for shareholders to support high-risk business strategies that produce abnormal profits for shareholders during credit booms, while imposing most of the losses from credit busts on debtholders, including bondholders, government deposit insurers, and uninsured depositors.[9]

8. Empirical data confirm that large banks with higher levels of equity capital are more stable, more resilient, and more likely to be reliable lenders through the business cycle.[10]  Many experts believe that required equity capital ratios for global systemically important banks (G-SIBs), measured as a percentage of their total unweighted assets (the leverage capital ratio), should be in the range of 12-15% to provide a reasonable degree of assurance of their survival during periods of severe economic and financial stress.[11]

9. Strong leverage capital requirements are essential to prevent large banks from (a) manipulating their risk-based capital requirements by using unreliable and aggressive internal risk models, and (b) using off-balance-sheet securitizations and “synthetic risk transfers” to (ostensibly) transfer the banks’ risks to other parties while retaining significant contingent exposures to future default risks.[12]

10. Most of the big banks and securities broker-dealers that failed or required bailouts during the global financial crisis of 2007-09 used internal risk models, off-balance-sheet securitizations, and credit derivatives to create dangerously leveraged balance sheets.  Between 1994 and 2008, a group of fifteen systemically important banks in the U.S., UK, and Europe effectively cut their risk-based capital requirements in half by reducing the average ratio of their risk-weighted assets to their total (unweighted) assets from 65% to 33%.  Northern Rock achieved one of the more dramatic reductions, slashing its capital requirements more than 40% and increasing its dividends over 30% after adopting internal risk-based models under Basel II.[13]

11. In 2007, the unweighted assets-to-equity (leverage) ratios for several major UK and European banks exceeded 30:1, including 50:1 for UBS.  Goldman Sachs had an unweighted assets-to-equity ratio of 26:1, and the leverage ratios for the other “Big Five” U.S. securities firms (Bear Stearns, Lehman Brothers, Merrill Lynch, and Morgan Stanley) were all above 30:1.  None of the foregoing institutions was required to satisfy a minimum leverage capital ratio.  In contrast, U.S. banks were required to maintain a 4% leverage capital ratio.  Bank of America and Citigroup pushed that ratio to the limit, as their total unweighted assets-to-equity ratios were 21:1 and 25:1 in 2007.  The foregoing U.S. institutions – except for Lehman Brothers, which was allowed to fail – received huge bailouts during the global financial crisis, as did ABN Amro, Commerzbank, ING, Lloyds, RBS, UBS and other large UK and European banks.  AIG, the world’s largest insurance company, issued credit derivatives that substantially reduced the risk-based capital requirements of many global banks, but those derivatives exposed AIG to fatal contingent credit risks and required a costly rescue of AIG. The total amount of outstanding capital injections, emergency loans, and financial guarantees provided to large troubled financial institutions by the U.S., the UK, and European governments peaked at about $14 trillion in 2009.[14]

12. Since the global financial crisis, large banks have continued to use aggressive internal risk models and other forms of “capital arbitrage” to operate with dangerously low levels of equity capital.  An International Monetary Fund (IMF) staff report issued after the banking crises of 2023 stated that Switzerland’s bank capital requirements had been compromised by “the use of the internal models that served to aggressively deflate balance-sheet risks that the capital was providing protection against—in combination, [Credit Suisse and UBS used] risk-weighted measure of total assets [that] deflated their asset exposures by around 70 percent.”[15]

13. Leverage capital ratios for U.S. G-SIBs have declined substantially since 2016, as federal regulators allowed G-SIBs to pay very large distributions to shareholders (including dividends and stock buybacks) that exceeded those banks’ combined net profits in 2017, 2018, and 2019.[16]  The average Tier 1 leverage ratio for U.S. G-SIBs dropped from 9% to 7% between 2016 and 2024.  During the same period, the average enhanced supplementary leverage ratio (SLR) for U.S. G-SIBs – which takes account of off-balance-sheet and derivatives exposures – declined from 7% to 6%.  In contrast to the declining leverage ratios for U.S. G-SIBs, smaller and midsized U.S. banks have maintained their average Tier 1 leverage capital ratios at approximately the same levels between 2016 and 2024, and their average Tier 1 leverage capital ratios have consistently exceeded 10% for banks with assets under $100 billion and 9.5% for banks with assets between $100 billion and $750 billion.[17]  The large disparities between the relatively low leverage capital ratios of U.S. G-SIBs and the significantly higher leverage capital ratios of smaller and midsized U.S. banks provide strong evidence that G-SIBs continue to receive unwarranted “too big to fail” subsidies and funding advantages.  Canadian, European, and UK G-SIBs have maintained even lower leverage capital ratios, as their average SLRs have been approximately 5% between 2018 and 2024.[18]

14. U.S bank regulators recently issued a proposal that would reduce minimum SLR requirements for U.S. G-SIBs to a range of 3.5% to 4.25%.  Big banks have long sought to weaken SLR requirements because they impose limits on (i) the ability of banks to expand their risk exposures through off-balance-sheet securitizations and derivatives, which are not captured by other capital rules,[19] and (ii) the ability of banks to assume greater risk exposures from trading in Treasury securities, which receive a zero risk weight (and a zero capital charge) under risk-based capital rules.[20]  If adopted, the proposal to reduce SLR requirements would potentially permit U.S. G-SIBs to reduce their equity capital levels by hundreds of billions of dollars, severely undermining their resilience against future economic and financial shocks.[21]  U.S. regulators should promptly withdraw that deeply misguided proposal, and international bank regulators should not adopt it. 

15. A 2012 study by Andrew Haldane and Vasileios Madouros reviewed the performance of about 100 large, complex global banks (each with assets of more than $100 billion) during the global financial crisis.  That group of global banks included 37 banks that failed and required government-assisted resolutions.  Haldane’s and Madouros’ study concluded that higher leverage capital ratios were a significantly better indicator of the ability of global banks to survive the crisis, compared to higher risk-based capital ratios.  Haldane and Madouros also found that none of the global banks failed with a reported leverage capital ratio higher than 8%, while five banks failed with reported leverage capital ratios between 6% and 8%, and eight other banks failed with reported leverage capital ratios between 4% and 6%.  Their study suggests that virtually all of today’s G-SIBs are operating with dangerously low leverage capital ratios.  At the end of 2024, all 29 G-SIBs had SLR ratios below 8%, and 20 of them (including all 11 UK and European banks) had SLR ratios below 6%.[22]  As discussed in ¶ 14, the current proposal by U.S. regulators to reduce minimum SLR ratios for U.S. G-SIBs would make that situation even worse.

16. Haldane and Madouros argued that a strong leverage capital ratio would be more effective than Basel’s overly complex risk-weighted capital standards in assuring the solvency and resiliency of G-SIBs and other large, complex banks that engage in nontraditional activities.[23]  In addition to strong leverage capital requirements, bank regulators should apply a broad set of prudential tools that include demanding stress tests, asset concentration and diversification standards, and careful assessments of the viability and resilience of business models for large, complex banks. 

17. The failures of Credit Suisse and Silicon Valley Bank (SVB) in March 2023 demonstrated that Basel III’s minimum capital and liquidity requirements are not sufficient to prevent sudden failures of large banks with high-risk business models, especially those that rely heavily on uninsured deposits and other “runnable” liabilities and invest heavily in volatile, high-risk assets.  The failures of Credit Suisse and SVB (like the downfall of Continental Illinois Bank in 1984 after an accelerated run by its uninsured depositors) showed that bank liquidity can disappear virtually overnight in banks that have high percentages of uninsured deposits and other volatile short-term liabilities, as well as weak and eroding capital levels, concentrations in speculative and hard-to-value assets, and growing doubts about the viability of their business models.[24]

18. On March 12, 2023, following the failures of SVB and Signature Bank (another U.S. regional bank), the Federal Reserve Board (Fed) established the Bank Term Funding Program (BTFP) to assist other troubled banks.  The BTFP provided loans to banks with terms up to one year, secured by pledges of Treasury securities and federal agency mortgage-backed securities.  The BTFP allowed banks to borrow 100% of the face (par) value of their pledged securities, thereby requiring the Fed to bear the risk of loss from declines in the market values of the government securities pledged for BTFP loans.[25]  The Fed’s potential risk exposures under the BTFP were indicated by the fact that U.S. banks had accumulated $620 billion of unrealized losses on their holdings of longer-dated government securities at the end of 2022, due to the Fed’s sharp increases in interest rates during that year.[26]  More than a quarter of  U.S. banks received BTFP loans from the Fed, and banks that did so generally had “higher shares of uninsured deposits, greater amounts of unrealized losses on their securities, and . . . larger deposit outflows.”  The amount of outstanding BTFP loans peaked at $165 billion in early 2024.  BTFP loans provided a significant subsidy to U.S. banks by ensuring that they could meet demands for depositor withdrawals without suffering losses from liquidating depreciated securities held in their portfolios.[27]  Surprisingly, the federal regulators’ annual stress test for the largest U.S. banks in 2022 – a test that was not applied to SVB and Signature – did not include an assumption that interest rates would rise significantly, even though the Fed began raising short-term interest rates in early 2022 and continued to do so until July 2023.[28]

3. Community banks play a vital role in the U.S. economy by providing credit to consumers, farmers, and small businesses, and by supporting the civic life of rural communities, small towns, and smaller cities.  Community banks continue to follow a traditional, relationship-based business model, serving as reliable intermediaries between depositors and borrowers.

19. There are currently around 4,000 community banks in the U.S., accounting for about 90% of all U.S. banks.  Community banks generally have assets of less than $10 billion and primarily serve consumers, farmers, and small and medium-sized enterprises (SMEs).  Since 2000, the number of U.S. community banks has fallen by more than half, and the percentage of total U.S. banking assets held by community banks has declined from 28% to less than 12%.  At the end of 2024, community banks held $2.8 trillion of assets, representing 11.6% of the $24 trillion of total assets held by all U.S. banks.[29]  In contrast to the steadily shrinking asset share of community banks, the five largest U.S. banks controlled almost 50% of U.S. banking assets in 2021, nearly double their 28% share in 2000.[30]

20. Only 77 new, FDIC-insured banks have been chartered in the U.S. since the global financial crisis ended in 2009.[31]  The scarcity of new bank charters since 2009 stands in sharp contrast to the period between 1990 and 2008, when 2,000 new banks were chartered.  Capital requirements ranging from $15 million to $30 million for chartering a new bank have created a major obstacle to the ability of entrepreneurs to open new banks, particularly in smaller communities.  Regulators have also required proposed business plans for new banks to demonstrate a very high probability of success.  The scrutiny by regulators of applications for new bank charters has often seemed more stringent than their examination and supervision of existing banks.  Supporters of community banks have urged regulators to promote the formation of new banks by adopting more flexible, phased-in capital requirements and more realistic reviews of business plans.  In addition, federal and state governments could encourage new bank formation by providing tax credits to owners of new banks located in underserved communities and rural areas.[32]

21. Despite holding less than 12% of U.S. banking assets, community banks originate 70% of all agricultural loans, 36% of all small business loans, and 30% of all commercial real estate loans.  Community banks are widely recognized as the most engaged and reliable lenders to farmers and SMEs through the business cycle. Community banks follow a customized, relationship-based approach, which builds long-term relationships with their customers and develops a detailed understanding of their customers’ businesses, in contrast to the “cookie cutter” financial metrics and uniform lending terms applied by most large banks to small businesses.  Unlike community banks, large banks extend many of their small business loans through credit card loans, which have standardized terms and typically charge much higher interest rates than community banks’ relationship loans.  Community banks are leading supporters of civic and charitable organizations in the communities they serve.  Community banks are the only banking presence in about one-quarter of all U.S. counties.  Studies have shown that SMEs and local communities suffer severe economic and social harms if their community banks fail or are acquired by larger, out-of-town banks with very different business models.[33] 

22. A 2024 FDIC survey found that small U.S. banks “are more likely than large banks to use a wide variety of soft information, especially loan officer assessments, when evaluating loan applications” by SMEs.  “Nine in ten small banks, but only four in ten large banks, have loan decision-makers meet with applicants” before making SME loan decisions.  Small banks are “more flexible in meeting credit needs and better able to engage with small businesses on a case-by-case basis,” and small banks are also more likely to lend to start-up businesses.[34]  In contrast to small banks, large banks rely primarily on “hard information,” such as quantitative financial metrics and credit bureau ratings, in making their SME loan decisions.  “[L]arge banks are much more likely than small banks to use some form of automated underwriting,” and “large banks indicate their top product to small businesses by volume is credit cards, while hardly any small banks report the same.”[35]  Both small and large U.S. banks typically make loans to small businesses that are located within a reasonably close geographic proximity (40 miles or less) to one of their branches.[36]

23. Large banks have significantly reduced their lending to small businesses since 2008, while community banks have remained deeply committed to providing credit to SMEs.  Large banks cut back sharply on their loans to SMEs during the global financial crisis of 2007-09, and they did not return to their previous levels of small business lending after the crisis.  Decisions by large banks to reduce their involvement in small business lending were based on their lack of a comparative advantage in that market, as well as their desire to increase their involvement in investment banking and other capital markets activities.[37]  The largest U.S. banks have substantially reduced the share of their balance sheets devoted to all types of lending since 2016, and they have increased their focus on capital markets activities.[38] 

24. During the second quarter of 2025, the six largest U.S. banks produced total investment banking and capital markets revenues of nearly $44 billion, representing 30% of their total operating revenues of $145 billion.  The same six banks currently account for 32% of global wholesale banking revenues and 44% of global investment banking and capital markets revenues.[39]  As the foregoing data indicate, the largest U.S. banks have increasingly focused their attention on investment banking and capital markets activities, and they have shifted their balance sheets away from traditional loans and toward investments in securities.[40]

25. Finance companies and fintech lenders have filled some of the gaps left by the reductions in small business lending by large banks.[41]  Despite the greater presence of nonbank lenders, a 2023 Fed survey showed that small banks approved higher percentages of small business loan applications and received higher ratings for satisfaction among small business borrowers, compared to large banks, finance companies, and online (fintech) lenders.[42]

26. Strong leverage capital requirements are highly effective in supporting the viability of community banks and other traditional banks that do not engage in capital markets activities and primarily serve consumers, farmers, and SMEs (whose credit obligations are less challenging for bank supervisors to evaluate).  U.S. federal bank regulators have established an opt-in program that allows qualifying community banks with traditional business models to avoid compliance with Basel III’s standardized risk-based capital rules if those banks maintain a Tier 1 leverage capital ratio higher than 9%.[43]  More than 1,600 community banks (about 40% of all U.S. community banks) opted in to the community bank leverage ratio program by 2023.[44] 

27. Establishing a strong leverage capital ratio for traditional banks in the UK and other foreign nations could potentially reduce their compliance burdens significantly, if regulators in those countries decide (as U.S. regulators have done) to exempt traditional banks that satisfy that leverage ratio from complying with Basel III’s standardized risk-based capital rules.  Traditional banks that apply for such an opt-in program should be required to demonstrate that their management and business operations are consistent with sound banking policies.

4. During the past four decades, large, complex banks (“universal banks”) have developed extensive and hazardous connections with nonbank financial intermediaries (“shadow banks”), whose functions mimic the traditional roles of commercial banks.  Universal banks and shadow banks have created a “toxic symbiosis,” which has promoted the rapid expansion of all types of debt obligations, including rising exposures to risky and illiquid private credit obligations.

28. G-SIBs are universal banks that engage in a wide range of nonbank financial activities closely linked to the capital markets.  G-SIBs own “internal” shadow banks, such as broker-dealer subsidiaries and in-house hedge funds and private credit funds. The “internal” shadow banks owned by G-SIBs are involved in prime brokerage activities, off-balance-sheet securitizations, underwriting and trading in government and corporate securities, and dealing in financial and credit derivatives.  G-SIBs also deal extensively with “external shadow banks,” such as independently-owned broker-dealers, hedge funds, private credit funds, and private equity funds.  I have argued that today’s global financial markets are driven by a “toxic symbiosis” between universal banks and both ”internal” and “external” shadow banks.[45]

29. “Shadow banks” are nonbank financial institutions that mimic the functions of traditional banks, as they offer deposit-like funding through short-term financial instruments – including money market funds (MMFs), short-term commercial paper, and repurchase agreements (repos) – and provide short-term and longer-term credit.  The short-term financial instruments offered by shadow banks function as deposit substitutes (“shadow deposits”) because they are payable at par (100% of face value) on demand or within a short period of time.  Shadow banks include both “internal” nonbank financial intermediaries owned by universal banks and “external” nonbank financial intermediaries that are owned and operated independently but maintain close business relationships with universal banks.[46]

30. Universal banks (including their “internal” shadow banks) and “external” shadow banks have expanded rapidly between since the global financial crisis of 2007-09.  In 2023, global banks held $189 trillion of assets, while “external” shadow banks held $70 trillion of assets.[47]  The assets held by global banks increased by more than 50% between 2009 and 2023, while the assets held by “external” shadow banks more than doubled during the same period.[48]  Global banks and “external” shadow banks together held more than half of the estimated $486 trillion of global financial assets in 2023.[49]  Nonbank financial institutions that are not generally considered to be “shadow banks” include insurance companies, pension funds, and equity investment funds, as those entities do not issue short-term financial claims that function as deposit substitutes.  Global insurance companies and pension funds held about $80 trillion of financial assets in 2023, while global equity investment funds (including open-end funds, equity real estate investment trusts, and closed-end funds) held about $40 trillion of financial assets.[50]

31. Securities broker-dealers and MMFs provide large volumes of short-term funding to banks, hedge funds, and other nonbank financial institutions through repos and purchases of short-term commercial paper.  Conversely, broker-dealers rely heavily on repos, short-term securities lending agreements, and other short-term credit furnished by MMFs and banks.  Troubled MMFs have frequently relied on bailouts provided by their bank and nonbank sponsors.[51] 

32. Assets managed by global MMFs increased from $5.5 trillion in 2008 to $10.6 trillion in 2024.[52]  Combined total volumes of repos and short-term commercial paper in global markets were probably close to $20 trillion in 2024.[53]  Thus, there were probably about $30 trillion of global “shadow deposits” in 2024, compared to $120 trillion of global bank deposits.[54] 

33. Bank-controlled and independent broker-dealers act as prime brokers for hedge funds and other trading firms, and their prime brokerage services include providing derivatives, margin loans, repos, and short-term securities lending arrangements.  Nine of the ten largest prime brokers in 2022 were either U.S. or European universal banks.  Assets managed by hedge funds have expanded rapidly since the global financial crisis, rising from $2 trillion in 2010 to $11.1 trillion in 2024.  Many hedge funds pursue highly-leveraged investment strategies that rely on both traditional (loan-based) and synthetic (derivatives-based) credit provided by G-SIBs and other prime brokers.[55] 

34. Hedge funds have become leading investors in the U.S. Treasury market and the UK gilt market by making massive, highly-leveraged “relative value” (cash-futures) basis trades that expose hedge funds to large losses during large price moves or serious disruptions in those markets.  Prime brokers finance the speculative trades of hedge funds by providing repos, margin loans, and derivatives.  When the Covid-19 pandemic caused widespread government shutdowns and triggered a financial panic in March 2020, the unwillingness or inability of prime brokers to refinance their repo and margin loans for hedge funds helped to produce a generalized breakdown in the U.S. Treasury market.[56]  That breakdown caused a systemic crisis in U.S. financial markets, which led to comprehensive government bailouts (¶¶ 50-53). 

35. In May 2025, the net short positions of hedge funds in the U.S. Treasury market reached $1.1 trillion, more than twice their level prior to the onset of the pandemic financial crisis.[57]  Financial regulators in the U.S. and UK have expressed growing concerns about the very large and volatile positions occupied by hedge funds in the U.S. Treasury and UK gilt markets.[58] 

36. Private equity (PE) firms represent an increasingly important category of shadow banks, as their total assets under management increased from $1.5 trillion to $10.8 trillion between 2008 and 2024.  The three biggest PE firms—Blackstone, Apollo, and KKR— control almost a third of those assets.  Since 2008, Blackstone, Apollo, and KKR have transformed themselves into large financial conglomerates by establishing broker-dealer subsidiaries, acquiring controlling interests in life insurance companies, and managing hedge funds.  Today’s leading private equity firms compete directly with universal banks and strongly resemble the “Big Five” securities broker-dealers that were major rivals of universal banks prior to the global financial crisis.[59]  All five of those securities broker-dealers failed, were bailed out, or made emergency conversions into bank holding companies to avoid collapsing during the global financial crisis (¶¶ 10-11).[60]

37. PE firms arranged almost $5 trillion of global corporate transactions between 2020 and 2022, and they controlled a quarter of the market for global corporate mergers and acquisitions at the end of that period.  To finance such transactions, PE firms and global universal banks have underwritten three types of risky corporate obligations: leveraged loans, high-yield (junk) bonds, and private credit (direct loans from nonbanks to business firms).  In 2023, the combined total amount of outstanding leveraged corporate loans, junk bonds, and private credit facilities was about $4.6 trillion, with private credit obligations accounting for $1.6 trillion of that amount and junk bonds and leveraged loans about equally dividing the remaining $3 trillion.[61]  Hedge funds have recently sought to expand their involvement in the private credit market.[62]  The rapid expansion of private equity and private credit obligations have raised a wide range of financial stability concerns, including the opacity of private credit obligations, their lack of reliable valuations, their rising credit risks and liquidity risks, and the increasing interconnections between PE firms that arrange private credit facilities and hedge funds, large banks, and life insurers.[63]

38. As indicated by the foregoing discussion, universal banks are crucial supporters as well as active competitors of PE firms and other “external” shadow banks.  The total amount of credit commitments extended by U.S. banks to nonbank financial institutions increased by over 50% between 2018 and 2024 and reached $2.3 trillion at the end of that period.[64]  U.S. G-SIBs held $700 billion of those credit commitments, equal to 14% of their total loan portfolios.[65]  Large banks have strong incentives to provide such financing, due to the lucrative fees they receive from PE firms, hedge funds, and other shadow banks.  For example, PE firms paid banks an estimated $20 billion of investment banking fees in 2024 (down from a peak of $33 billion of fees in 2021), while hedge funds paid banks an estimated $36 billion of prime brokerage fees in 2024 (an increase of 50% from 2020).[66] 

39. While arrangers of private credit facilities compete with bank lenders, private credit arrangers also cooperate with banks in the broader market for financing highly leveraged corporate transactions – a market that includes leveraged loans and junk bonds.  I have previously argued that the close connections between universal banks, PE firms, hedge funds, and other “external” shadow banks have created a “toxic symbiosis,” which encourages banks to finance nonbank lenders and support dangerously high levels of risky private-sector debts.  Those private-sector debts in the aggregate pose serious threats to the stability of our banking system and financial markets.[67]  As John Plender recently pointed out, “much of the growth [in private credit] reflects the regulatory constraints” imposed on banks by the prudential reforms implemented after the global financial crisis of 2007-09.  Those constraints have encouraged “regulatory arbitrage, with banks providing the majority of non-banks’ funding needs.  Private credit in turn finances burgeoning buyouts.”  Similarly, a recent staff study published by the Federal Reserve Bank of Boston found that “the growth of private credit has been funded largely by bank loans and that banks have become a key source of liquidity, in the form of credit lines, for [private credit] lenders.”  The study also warned:

“[Private credit] lenders’ reliance on banks for liquidity could pose systemic liquidity risk to the banking sector if a sufficient number of [private credit] lenders . . . draw down on their bank credit lines simultaneously in response to adverse aggregate shocks.  However, because bank loans to PC funds are typically secured and among those funds’ most senior liabilities, banks would suffer losses only in severely adverse economic conditions, such as a deep and protracted recession.  But losses could also occur in a less adverse scenario if the default correlation among the loans in [private credit] portfolios turned out to be higher than anticipated—that is, if a larger-than-expected number of [private credit] borrowers defaulted at the same time.  Such tail risk may be underappreciated.”[68]

40. The potential dangers of toxic relationships between universal banks and “external” shadow banks were illustrated by the catastrophic failure of Archegos Capital, a so-called “family office” that operated as a high-risk hedge fund.  Global banks received large trading fees from Archegos and built up huge financial exposures to Archegos through margin loans and leveraged equity derivatives.  The sudden downfall of Archegos inflicted more than $10 billion of losses on Credit Suisse and several other large universal banks.  The devastating impact of Archegos’ failure contributed to the collapse of Credit Suisse in 2023, requiring a government-assisted takeover by UBS.[69]  Archegos’ disastrous high-risk trading strategies and the dangerous exposures of universal banks to Archegos resembled the 1998 collapse of Long-Term Capital Management (LTCM).  LTCM was a large hedge fund with close connections and large exposures to more than a dozen major financial institutions.  LTCM’s threatened failure caused the Fed to arrange an emergency rescue funded by most of the threatened institutions.[70]  Family offices currently hold about $6 trillion in assets, and many of them are either former hedge funds that have closed their doors to outside investors or are consciously structured and managed like hedge funds (as was true in the case of Archegos).[71] 

5. Private equity funds face severe challenges and are imposing growing risks on bank lenders and captive life insurers.  Private equity funds and private credit funds are currently seeking to sell risky and illiquid investments to retail investors as well as pension funds and mutual funds that serve those investors.

41. The PE industry currently faces very significant challenges.  PE firms are attempting to sell more than 30,000 portfolio companies, valued at over $3 trillion.  Higher inflation, rising interest rates, and growing concerns about the reliability of PE firms’ valuations have significantly reduced the ability of PE firms to sell their portfolio companies through initial public offerings (IPOs) or leveraged buyouts.  The inability to sell portfolio companies has forced PE firms to limit their payouts to investors to half of their long-term average.[72]  To finance more distributions to investors, PE firms have borrowed large sums from banks, insurance companies, and other nonbank lenders, and PE firms have sold stakes in portfolio companies to other PE firms or to their own “continuation funds.”[73]  Critics have alleged that PE firms are using “financial engineering” to implement a dangerous strategy of “pray and delay” until market conditions for IPOs and buyouts improve.  During the year ended June 30, 2025, the PE industry’s fundraising declined to its lowest level in seven years, as “[h]igher interest rates and a slowdown in dealmaking have left firms unable to sell trillions of dollars in ageing investments, causing growing frustration from investors, many of whom are now refusing to back funds.”[74] 

42. As indicated above in ¶ 37, universal banks and PE firms have arranged about $4.6 trillion of outstanding credit obligations for highly leveraged transactions through private credit, junk bonds, and leveraged loans.  U.S. G-SIBs hold approximately $250 billion of credit exposures to highly leveraged transactions arranged by PE firms and private credit funds.[75]  Private equity firms have created a “sprawling web of debt” that is “fiendishly complex” and includes “multiple layers of leverage, in which banks have become increasingly intertwined.”[76]  In April 2024, the Bank of England’s executive director for financial stability strategy and risk, Nathanaël Benjamin, observed that highly-leveraged transactions by private equity firms raised “natural questions about the risks of these financing arrangements, and the growth in kinds and quantity of leverage, or ‘leverage on leverage’, throughout the ecosystem.”[77]

43. PE firms have acquired controlling interests in many life insurance companies.  In 2024, PE firms owned U.S. life insurers holding about $1 trillion of assets, representing about 10% of the total assets of the U.S. life insurance industry (up from only 2% in 2013).  Captive insurers owned by PE firms have purchased large volumes of private credit obligations, leveraged loans, and junk bonds, including those issued by portfolio companies that are owned by their PE parent firms.  PE firms have aggressively used securitized vehicles and offshore reinsurance companies to reduce the capital requirements of their captive insurers.  A recent Fed staff study determined that

“Since the 2007-09 financial crisis, the share of life insurers’ general account assets exposed to below-investment-grade ('risky') corporate debt has roughly doubled. . . . Partnerships between life insurers and asset managers have created complex and arguably opaque structures to increase investment returns. . . . Life insurers’ exposure to below-investment-grade firm debt has boomed and now exceeds the industry's exposure to subprime residential mortgage-backed securities in late 2007.  At the same time, the industry's level of wholesale funding is near its 2007 level, shortly after which life insurers experienced runs on their nontraditional funding structures.”[78]

44. In an era of “higher for longer” interest rates and significantly reduced opportunities for selling portfolio companies through IPOs and buyouts, many PE-controlled portfolio companies are struggling to repay or refinance their debts. More than 200 PE-owned firms filed for bankruptcy in the U.S. in 2023 and 2024, accounting for one-sixth of all U.S. corporate bankruptcies in those two years.[79]  In July 2025, 76% of the 240 U.S. companies with bonds rated by Moody’s as most likely to default (“highly speculative”) were portfolio companies owned by PE firms.[80]  Regulators and analysts have warned that banks and PE-controlled life insurers face growing potential losses from the leveraged loans, private credit obligations, junk bonds, and other risky credits they have extended to PE firms and their portfolio companies.[81]

45. The PE industry has experienced three severe downturns during the past 35 years.  Each of those downturns resulted in very high levels of defaults on junk bonds and leveraged loans as well as very high rates of bankruptcies among PE-owned portfolio companies.  Those three downturns occurred during (i) a sharp recession in 1990-91, which was associated with a severe crisis affecting banks and savings and loans and the collapse of the corporate leveraged buyout (LBO) boom of the 1980s, (ii) a significant recession in 2001-02, which followed the bursting of the dotcom-telecom bubble and included the scandalous bankruptcies of Enron and WorldCom, and (iii) the Great Recession, which was caused by the global financial crisis of 2007-09.[82]  During the first episode, Drexel Burnham, the top underwriter of junk bonds and the foremost promoter of corporate LBOs, failed along with several large savings and loans and two major insurance companies that had invested heavily in Drexel’s junk bonds.[83]  During the second episode, a $52 billion insurance holding company (Conseco) collapsed after making highly-leveraged acquisitions of several insurance companies and a large subprime lender.[84]  As indicated above in ¶ 11, the third episode (the global financial crisis) led to the bailouts or failures of dozens of large global banks as well as AIG, the world’s largest insurance company.  The global financial crisis erupted after a toxic credit boom, including a wave of LBOs that produced a huge volume of junk bonds and leveraged corporate loans.  Citigroup CEO Chuck Prince’s now-infamous statement in July 2007 that “[w]e’re still dancing” referred to Citigroup’s decision to continue underwriting leveraged loans with very risky terms for speculative LBOs.[85]  In addition to the three foregoing episodes, PE firms and their portfolio companies would have suffered enormous losses in 2020 if the Fed and the U.S. Treasury had not intervened to rescue the corporate bond market (including “fallen angel” bonds issued by PE-owned portfolio companies) during the Covid-19 pandemic (¶ 53).

46. PE firms and private credit funds, along with providers of crypto-assets, have lobbied regulators in the U.S. and UK for permission to sell risky private equity funds, private credit funds, and crypto-assets to retail investors as well as investment funds and pension funds that manage the personal and retirement savings of retail investors.  On August 7, 2025, President Trump issued an executive order directing federal agencies to adopt measures that would allow the purchase of “[a]lternative assets, such as private equity, real estate, and digital assets,” by 401(k) plans and other defined-contribution plans for employees.[86]  The aggressive efforts of PE firms and private credit funds to sell their funds to unsophisticated investors and their retirement plans are motivated by the lack of demand for those funds among institutional investors, who have become disillusioned with the high fees and very disappointing returns of PE funds and private credit funds since 2021.[87]  Experts have warned that PE funds and private credit funds are high-cost and high-risk investments that are not suitable for unsophisticated investors and would be likely to impose significant losses on those investors while undermining the liquidity and security of their personal and retirement savings.[88]

6. The inadequate reforms adopted by G20 nations after the global financial crisis of 2007-09 have allowed the “toxic symbiosis” between universal banks and shadow banks to continue and become much stronger.  The unhealthy partnerships between universal banks and shadow banks have produced uncontrolled growth in public-sector and private-sector debts.  Developed nations have arranged a series of massive bailouts and an ever-expanding array of financial backstops to prevent the collapse of national and global financial markets that are dangerously over-leveraged.  Those bailouts and backstops have created an asymmetric risk curve, which encourages universal banks, shadow banks, and investors to take excessive risks with the expectation that governments and central banks will maintain a “floor” under financial markets and prevent serious financial disruptions.

47. In 2009, G20 nations agreed on reforms that were ostensibly designed to solve the problems revealed by the global financial crisis (GFC) of 2007-09.  However, those reforms did not address the root causes of the crisis because they did not change the structures or business models of the universal banks and shadow banks that caused the crisis.  Post-GFC reforms did not break up universal banks or require any significant shrinkage in the size and scope of shadow banks.[89] 

48. Consequently, post-crisis reforms left in place a dangerously unstable financial system and perpetuated what my 2020 book called a “global doom loop.”  The global doom loop creates a perverse and toxic cycle in which (1) governments and central banks provide “too-big-to-fail” guarantees to universal banks and large shadow banks and frequently intervene to maintain the stability of financial markets; (2) universal banks and large shadow banks finance rapidly rising levels of public-sector and private-sector debts, with support from “easy money” policies of central banks; and (3) investors and creditors take outsized risks because they expect that governments and central banks will continue to take all necessary measures to stabilize financial markets and prevent failures of universal banks and large shadow banks.[90]  

49. The global doom loop creates an asymmetric risk curve, which undermines market discipline and increases moral hazard, because it encourages universal banks, shadow banks, and investors to believe that “they can make highly-leveraged bets on risky assets because governments and central banks will always intervene to create a floor under financial markets if the threat of a serious disruption appears.”[91]  The global doom loop also creates “a hazardous web of mutual dependence among governments, central banks, universal banks, shadow banks, and financial markets.  In view of that dependence, our financial markets are not truly markets.  Instead, they are a form of crony capitalism, which is supported and subsidized by explicit and implicit government guarantees.”[92]

50. G7 nations and other developed countries have repeatedly supported large universal banks and shadow banks since the global financial crisis, as shown most vividly in the comprehensive rescue programs they established in response to the financial crisis caused by the Covid-19 pandemic.  During the pandemic crisis, governments and central banks provided crucial support for universal banks and shadow banks by stabilizing short-term wholesale credit markets, backstopping corporate and municipal bond markets, and authorizing $16 trillion of fiscal stimulus programs that supported households and business firms.  As a practical matter, governments and central banks avoided the need to bail out universal banks and shadow banks by rescuing their customers.[93]  Additionally, in 2023, the U.S. and Switzerland provided extensive support to their banking systems following the collapse of three large U.S. regional banks and the failure of Credit Suisse (¶¶ 18, 40).[94]

51. During the early stages of the pandemic financial crisis in 2020, the Fed and the Treasury provided blanket guarantees to stabilize wholesale markets for short-term financial claims (MMFs, commercial paper, and repos), as they had previously done in 2008.  Even before the pandemic crisis began, the Fed intervened to stabilize the repo market in September 2019 by providing repo loans to borrowers that could not obtain such loans from broker-dealers or other private-sector lenders, and the Fed continued to support the repo market through the pandemic crisis.  In July 2021, the Fed confirmed its open-ended support for wholesale financial markets by establishing two standing repo facilities, which provide repo loans collateralized by government securities to U.S. and foreign banks and foreign central banks.”[95]  The Bank of England recently established a similar standing repo facility for qualifying borrowers that cannot obtain repo loans from broker-dealers or other private-sector lenders.[96]

52. In response to the blanket guarantees provided by governments and central banks in 2008 and 2020, the global repo market expanded from $6 trillion in 2008 to $15 trillion in 2022, and it is probably substantially larger today.[97]  The exact size of the global repo market is not known because a substantial portion of that market consists of bilateral repos that are arranged by broker-dealers and are not centrally cleared.  A recent Fed staff report estimated that the total U.S. repo market grew to almost $12 trillion in 2024, and 38% of those repos were non-centrally-cleared bilateral repos.[98]  As indicated above (¶¶ 28-34), repos provide a leading source of short-term funding for both “internal” and “external” shadow banks.  The standing repo facilities of the Fed and the Bank of England ensure repo funding for qualifying borrowers that cannot obtain repo loans from private-sector lenders.  Both the Fed and the Bank of England have revised their monetary policy frameworks to use repo loans, reverse repo loans, and the payment of interest on reserves as primary tools for setting short-term interest rates.[99] 

53. Federal agencies provided unprecedented backing to private equity firms and their portfolio companies during the pandemic crisis.  The four largest private equity firms—Apollo, Blackstone, Carlyle, and KKR—reported large losses during March and April 2020, and their stock prices plummeted.  Credit ratings agencies downgraded almost $1 trillion of corporate debts in early 2020, and $150 billion of those debts became “fallen angels” after they were downgraded to noninvestment grade (junk) status.  The Fed and the Treasury intervened in March to stabilize wholesale financial markets and markets for investment-grade corporate bonds, but markets for leveraged loans and junk bonds remained virtually frozen.  The ratio of U.S. nonfinancial corporate debts to U.S. gross domestic product (GDP) had reached a record high in early 2020, and many heavily indebted companies could not pay or refinance their debts.  More than half of the publicly-rated U.S. companies that defaulted on their debts during the first half of 2020 were owned by PE firms.  PE firms aggressively lobbied the federal government to provide emergency assistance to their endangered portfolio companies.  On April 9, 2020, the Fed expanded its programs for buying corporate bonds and bond exchange-traded funds to include “fallen angel” bonds and leveraged loans that had been downgraded to junk status after the outbreak of the pandemic.  Many observers viewed the Fed’s actions as a de facto bailout of the private equity industry.[100]

54. The comprehensive rescue programs provided by governments and central banks to universal banks, shadow banks, wholesale funding markets and corporate bond markets have encouraged a vast and dangerous expansion of global private-sector and public-sector debts since 2007.  Worldwide private-sector and public-sector debts increased from $167 trillion in 2007 to $323 trillion in 2024.  The ratio of total worldwide debts to global GDP rose from 275% in 2007 to 326% in 2024.[101]  Global government debts grew from $40 trillion in 2008 to $95 trillion in 2024, equal to 97% of global GDP.[102]

7. The enormous costs of rescuing universal banks, shadow banks, and financial markets during the financial crises of 2007-09 and 2020-21 have imposed huge fiscal burdens on governments and have left central banks with bloated balance sheets.  It is highly doubtful whether governments and central banks could respond to a future financial crisis with a comparable set of bailouts without triggering severe and destabilizing sovereign debt crises.

55. Due in substantial part to the huge costs of responding to the financial crises of 2007-09 and 2020-21, the U.S. federal government’s total debt more than quadrupled from $8.9 trillion to $36.2 trillion between December 2007 and December 2024,[103] and the federal government’s total debt as a percentage of U.S. GDP nearly doubled from 63% to 122%.[104]  During the same period, and for similar reasons, the UK’s gross government debt more than quadrupled from ₤640 billion to ₤2.8 trillion,[105] and the ratio of total UK government debt to UK GDP more than doubled from 43% to 101%.[106]

56. In view of the massive government debt burdens assumed by the U.S. and the UK since 2007, many analysts have questioned whether the U.S. and the UK could respond successfully to a future financial crisis by arranging large bailouts without precipitating severe and destabilizing sovereign debt crises.  Those concerns have gained additional salience based on the sharp downturn that occurred in the U.S. Treasury market in early April 2025, the significant crisis that occurred in the UK gilt market in October 2022, and a short-lived disruption that took place in the UK gilt market in early July 2025.  Among G7 countries, all except Germany currently confront very significant sovereign debt problems, as the other six – Canada, France, Italy, Japan, the UK, and the U.S. – are carrying government debt burdens “equal to more than 100 percent of their GDP.  Most of [that] group borrowed heavily during the global financial crisis and again during the COVID-19 pandemic.”[107]

57. The Fed and other leading central banks followed aggressive quantitative easing (QE) policies and purchased massive quantities of long-term government securities to mitigate the economic and financial consequences of the crises of 2007-09 and 2020-21.  The Fed’s purchases of Treasury bonds and federal agency mortgage-backed securities caused its balance sheet to balloon from less than $870 billion in July 2007 to more than $8.9 trillion in June 2022.  Since June 2022, the Fed has followed a quantitative tightening (QT) policy by selling government securities and not reinvesting the proceeds of maturing government securities.  The Fed’s QT policy reduced the Fed’s balance sheet to $6.6 trillion in July 2025.[108]  The Bank of England pursued similar QE and QT policies, causing its balance sheet to expand greatly from ₤80 billion in July 2007 to ₤1.12 trillion in January 2022, before declining to ₤760 billion in July 2025.[109] 

58. The Bank of Japan and the European Central Bank (ECB) also pursued aggressive QE policies in response to the crises of 2007-09 and 2020-21 and subsequently implemented QT policies.  The combined balance sheets of the Fed, Bank of England, Bank of Japan, and ECB recorded massive growth between 2007 and 2021, expanding from $4 trillion to $25 trillion.[110]  The subsequent QT policies of the four central banks have caused their combined balance sheets to decline to about $20 trillion in July 2025.[111]

59. Notwithstanding their recent QT efforts, the balance sheets of the four leading central banks remain far above their levels at the outbreak of the global financial crisis in August 2007.  During the past several months, investors and financial industry trade groups have urged the Fed and the Bank of England to stop shrinking their balance sheets because of concerns about (i) maintaining “ample” reserves for banks and abundant liquidity for participants in global financial markets, and (ii) avoiding additional pressures on government bond prices and yields that would likely be caused by continued sales of government securities by the two central banks.[112]  It should be remembered that the Fed and other leading central banks responded to similar entreaties and market pressures by abandoning their previous QT efforts in 2019.[113] 

60. A recent study by four prominent economists warned that “Fed balance-sheet expansion [QE] followed by contraction [QT] can create a large and persistent mismatch” between liquidity demands and liquidity supply.  They found that QE policies encourage banks to increase their extensions of credit significantly, and the resulting credit expansion creates a greater degree of “liquidity dependence” on the Fed by both banks and nonbanks.  They cautioned that, if the Fed decides to abandon its current QT efforts due to higher demands for liquidity and also decides to make additional QE purchases, those purchases would likely encourage a further expansion of bank credit and intensify “liquidity dependence” on the Fed, as events since 2018 have shown.[114]

61. Based on the foregoing considerations, the Fed and other leading central banks are not likely to reduce their balance sheets to size levels that are anywhere close to their pre-crisis levels in July 2007.  The continued maintenance of very large central bank balance sheets has raised significant questions about the capacity of central banks to respond effectively to a future systemic financial crisis.[115]

62. In the context of huge government debt burdens, the bloated balance sheets of leading central banks raise additional troubling questions, including (i) whether the independence of central banks has been seriously compromised by intense pressures to “monetize” the enormous fiscal deficits accrued by governments since 2007 in response to systemic financial crises; (ii) whether central banks, acting in concert with other government agencies, have undermined market discipline and encouraged excessive risk-taking by providing comprehensive support to all sectors of the financial markets during the financial crises of 2007-09 and 2020-21; and (iii) whether central banks are currently subsidizing large banks and shadow banks, and imposing unwarranted losses on taxpayers, by holding large QE portfolios of depreciated government securities while paying market rates of interest on reserves and repos held by banks and nonbank financial institutions.  The House of Lords Economic Affairs Committee addressed the first two of the foregoing questions with great insight in a July 2021 report, which I summarized in my article on the pandemic financial crisis.  I strongly agree with the Economic Affairs Committee’s conclusions that prolonged, large-scale QE policies have had significant adverse effects on the public interest (i) by eroding public confidence in the ability of central banks to adopt and maintain monetary policies (including policies designed to combat inflation) without being unduly influenced by the fiscal policy decisions of political authorities; and (ii) by encouraging financial institutions and investors to take excessive risks with the expectation that central banks will always intervene (in concert with other government agencies) to prevent serious disruptions in financial markets.[116] 

63. The third question identified in the preceding paragraph has been a topic of extensive discussion and debate on both sides of the Atlantic.[117]  In 2013, members of Congress discussed the Fed’s potential exposure to significant losses from its QE purchases of low-yielding, longer-term Treasury bonds and agency mortgage-backed securities.  However, Congress did not pressure the Fed to change its QE policy.  As that 2013 discussion indicated, the Fed clearly recognized that its QE purchases of low-yielding, longer-term government securities imposed significant interest rate risks on the Fed.[118]  Despite that recognition, the Fed massively expanded its commitment to QE policies in 2020 and 2021, thereby exposing the Fed to even greater losses when it subsequently raised interest rates to combat inflation in 2022 and 2023.[119]  The Fed further increased its interest rate risks and costs by paying interest on bank reserves beginning in 2008, and by greatly increasing its reliance on reverse repos as a key monetary policy tool in 2021.[120]  Between 2022 and May 2025, the Fed incurred $230 billion of operating losses, due to depreciation of the market value of its QE portfolio and payment of more than $600 billion of interest to banks and other financial institutions holding reserves and repos.[121]  Instead of disclosing its rapidly increasing operating losses “in a forthright manner, the Fed adopted nonstandard accounting practices” to disguise those losses by classifying them “as a ‘deferred asset’ so that its reported retained earnings remain unchanged despite its massive losses.”[122]  Losses to UK taxpayers from the Bank of England’s QE policies appear to be proportionately even worse than the losses to U.S. taxpayers from the Fed’s QE policies.  As a UK journalist pointed out, those “significant losses to taxpayers” indicate that “the balance of the cost-benefit analysis [for QE policies] is worse than we used to think.”[123]  The long-term benefits and costs of prolonged, large-scale QE policies should receive a comprehensive evaluation, and this written evidence does not attempt to conduct such an assessment.  However, the significant losses accrued by leading central banks since 2022 and their inability to return their balance sheets to levels anywhere close to their volumes in 2007 provide substantial reasons to question the wisdom and net benefits of the QE policies followed by leading central banks since 2007.  For reforms that could potentially resolve the continuing monetary policy problems created by the current structure of financial markets and current central bank policies, see ¶¶ H.1, I.1 and I.2 below.

64. In September 2020, Neel Kashkari, President of the Federal Reserve Bank of Minneapolis (who held a senior position in the U.S. Treasury Department during the 2007-09 crisis), made the following observation, which provides a useful frame of reference for this Committee’s review of current conditions in global financial markets: “[W]hat kind of absurd financial system do we have that requires the central bank to bail it out every decade? . . . Is betting on successful future bailouts a sensible risk for [investors]?  I would argue the answer is a resounding no.”[124]  In a 2024 article, I offered a similar reflection based on my study of financial crises between 2007 and 2023:

Despite post-GFC reforms, the world remains trapped in a recurring cycle of unsustainable booms—financed by universal banks and shadow banks—followed by destructive busts that governments and central banks must try to contain through costly rescue programs.  In view of the enormous debt burdens that are currently borne by the private and public sectors of the U.S. and many other countries, it is highly questionable whether those countries could successfully finance another series of massive bailouts and fiscal stimulus programs comparable to those of 2007-09 and 2020-21. . . . [We must] stop universal banks and shadow banks from continuing to finance speculative booms that threaten the stability and health of our financial system, economy, and society.[125]

8. Global financial regulators should adopt reforms to address the unacceptable dangers created by universal banks and shadow banks.  Those reforms should include:

1. Prohibiting nonbank financial institutions from offering “shadow deposits,” which enable them to compete with traditional banks by issuing short-term, deposit-like financial claims that are highly vulnerable to investor runs.  Only regulated banks protected by deposit insurance should be allowed to issue deposit-like claims.  I have previously proposed that only regulated banks with deposit insurance should be permitted to issue short-term financial claims that function as deposit substitutes because (i) they are payable at par value (100% of face value) and (ii) their issuers promise to repay those claims either on demand or within a specified period of 90 days or less (the maximum term for “cash equivalent” financial instruments under generally accepted accounting principles).  Under my proposal, only regulated banks with deposit insurance could issue traditional deposits, money market funds, short-term commercial paper, repos, stablecoins, and similar deposit substitutes.  Adopting my proposal would greatly improve the stability of the banking system and financial markets, and it would force shadow banks to shrink drastically by funding their operations with either equity securities or longer-term debt securities.[126]

2. Requiring large, complex banks to hold significantly higher levels of common equity capital based on strong leverage capital ratios, and to undergo rigorous stress tests that ensure their resilience and the viability of their business models.  I have discussed the crucial importance of strong capital requirements, rigorous stress tests, and business model assessments in ¶¶ 6-17.

3. Encouraging the formation of new banks by reducing application burdens and providing tax credits for owners who start new banks in underserved communities.  I have discussed this proposal in ¶ 20.

4. Reducing compliance burdens for traditional community-oriented banks by exempting them from Basel III’s standardized risk-based capital requirements if they maintain strong leverage capital ratios above 9% and demonstrate that their management and business operations are consistent with sound banking practices.  I have discussed this proposal in ¶¶ 26-27.

5. Implementing the Financial Stability Board’s recommendations to monitor and reduce leverage among broker-dealers, hedge funds, and private equity funds through (a) effective reporting and disclosure requirements, (b) mandates for central clearing of systemically important trading markets, including those for government securities, repos, and derivatives, (c) strong capital requirements for clearing members and robust margin requirements for customers of clearing facilities, and (d) margin requirements, position limits, and concentration limits for non-centrally-cleared financial instruments held by nonbank financial institutions.[127]  I have explained the increasing risks posed by government securities markets, wholesale markets for short-term funding, broker-dealers, hedge funds, and private equity funds in ¶¶ 28-54.

6. Adopting stronger reporting obligations, capital requirements, standards for asset quality and diversification, and robust supervisory procedures for life insurance companies and reinsurance companies that are affiliated with private equity firms.  I have discussed the increasing risks posed by captive insurers and reinsurers controlled by private equity firms in ¶¶ 36-37 and 41-43.

7. Establishing stronger disclosure and reporting requirements, stress tests, and rigorous supervisory standards, including asset concentration limits and diversification standards, for large private equity firms, hedge funds, and other systemically important asset managers.  I have discussed the growing risks of private equity firms and hedge funds in ¶¶ 28-54.

8. Prohibiting (or establishing very strong presumptions against) offerings of private equity funds and private credit funds to retail investors or to investment funds and pension funds that serve those investors. I have explained why private equity funds and private credit funds are not suitable investments for retail investors, or for investment funds and pension funds that serve those investors, in ¶¶ 41-46.

9. In addition to the foregoing reforms, policymakers should adopt a plan to restructure financial institutions and financial markets by separating banks from securities broker-dealers and other firms engaged in capital markets activities.  The proposed separation would be similar to the separation between commercial and investment banking established by the U.S. Glass-Steagall Act of 1933 until it was repealed in 1999.

1. Under the proposed separation, regulated banks would issue all deposit-like claims, provide payment services, and provide loans to consumers and business firms.  Banks would not be allowed to underwrite or trade in securities except for government bonds.  Nonbanks (including those engaged in capital markets activities) would not be allowed to issue deposit-like claims and would be required to fund their operations with equity stock and longer-term debt (Reform H.1).  Nonbanks would not be protected by deposit insurance and would not have access to the central bank as lender of last resort or other elements of the safety net for banks.[128]

2. The proposed separation would create a more stable banking system and greatly improve the effectiveness of central bank monetary policies by ensuring that all deposits and deposit-like claims are issued by regulated banks.  Central banks would regain the ability to regulate short-term interest rates effectively by imposing reserve requirements on regulated banks.  Those reserve requirements should not require the payment of interest because they would not be subject to evasion through the creation of deposit substitutes (“shadow deposits”).  Banks and nonbanks would not be allowed to establish alternative short-term funding operations by issuing “shadow deposits” either through “internal” shadow banks controlled by large bank holding companies or through “external” shadow banks controlled by nonbank financial institutions.[129]   

3. Removing the capital markets operations of larger banks would give them strong incentives to serve all segments of business and society – including consumers and SMEs that lack access to funding from the capital markets – instead of focusing their efforts on multinational corporations, wealthy investors, and speculators in the capital markets.  Community-oriented banks would be likely to attract more deposits and provide more loans as universal banks are broken up and nonbanks are barred from issuing deposit-like claims.

4. Securities firms and other nonbanks would be subject to much more effective market discipline because they could not raise money by issuing deposit-like claims and would be required to fund their operations with equity stock and longer-term debt.  Securities markets would once again become true markets – not crony capital markets – because they would no longer be bailed out to protect large universal banks and shadow banks.  Governments and central banks would no longer be held hostage to the interests of giant financial conglomerates.  Banks, securities firms, insurance companies, and asset managers would all return to their proper roles as servants – not masters – of commerce, industry, and society.

2 September 2025

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