Josh Rosner of Graham Fisher testifies before a subcommittee of the House Financial Services committee today on why Dodd Frank has not ended too big to fail, but also has managed to entrench the megafirms’ advantaged position.
Rosner provided Congressional testimony on this same topic in 2011, and deemed Dodd Frank’s plans for winding down systemically important firms to be unworkable. Rosner has good company here; the BIS and the international bank lobbying group the IIF reached the same conclusion.
Rosner stresses that he’s not advocating the repeal of Dodd Frank but describing what is flawed so it can be remedied or replaced, and that he sees the sort of fixes embodied in the bills approved in the House to weaken derivatives regulations as a step in the wrong direction.
Rosner focuses on Articles I and II of Dodd Frank and describes how their plans to deal with resolving large firms has only made matters worse. It’s key to understand that these two sections are somewhat at odds with each other. Dodd Frank peculiarly provides for two ways to wind up systemically important firms. Title I says they should prepare for bankruptcy. They need to clean up how they are organized and make sure activities fit or can be mapped into legal entities and prepare living wills, which are plans for how they would wind themselves up. But confusingly, banks can also be “resolved” which is more like “rescued with a little pain inflicted on investors” under Title II. Title II provides for a second way to deal with stressed financial firms, which includes having the government provide what amounts to debtor-in-possession financing while the bank is restructured. This, sports fans, is what is otherwise known as a bailout.
In his previous testimony, Rosner criticized how having two ways to resolve a firm would create uncertainty in times of stress:
It is especially problematic that Dodd-Frank allows for ambiguity when defining institutional failure. The manner in which one is allowed to fail determines and defines its “going concern” value when alive. Every firm must be able to fail under the same regime—a different resolution regime for a select group of firms will create incentives for creditors of those firms to treat them differently in life than the “less important” firms. It was this ambiguity that created the incentives for Lehman to make itself less able to fail and thus less easily resolved.
Put it another way: you wouldn’t need Title II resolutions, described in the bill as the Orderly Liquidation Authority, if the authorities believed they could put them down using the bankruptcy code.
And, not surprisingly, the banks haven’t been fully cooperative in drawing up those living wills. And why should they? Follow the incentives. In a bankruptcy, top management is out and a trustee is in charge. By contrast, in a Title II resolution, the odds are good they’d survive. As Rosner writes:
While a true liquidation would result in the replacement of management, in the FDIC’s proposed regime, key management of failed operating subsidiaries would be able to continue to manage the newly recapitalized firm. Although the FDIC claims they would replace personnel there is no requirement to do so. Their decisions will be arbitrary and driven by both the perceptions of regulators and market realities. The risk remains that, even in instances in which it is clear that management should be replaced there may be a lack of a deep bench of available industry management. This was the reality during the past crisis. Artificial enrichment of personnel responsible for corporate failure is only one of the major problems with Title II.
So not surprisingly, the latest reports, filed a month ago, showed that the banks were going through the form of preparing living wills and far from having viable plans. From the Wall Street Journal:
U.S. regulators are demanding extensive new information from banks detailing how the government could dismantle their operations in the event of a crisis, saying information provided so far presents “obstacles” to an orderly resolution….
Banks are being asked to provide specific discussions of each of the five “obstacles” identified by regulators in the living wills, as well as a discussion of what steps they plan to take to mitigate the problems.
Now in fairness, the banks have a point. We’ve said the the OLA is unworkable, and so are bankruptcies, because resolution is a national process but these firms are international, with many trading books passed from time zone to time zone over a 24 hour day. Another major impediment are derivatives. Internationally recognized expert Satyajit Das has written about how “largely untested legal arrangements failed to work as intended” in the Lehman bankruptcy. He has also discussed at some length about “standardized” derivatives documentation isn’t as standard as you’d think, how many contain options as to how and when they are closed out (which will inevitably be exploited whenever possible) and how their valuation is often contested. This implies that reducing TBTF firm OTC derivative exposures and revisiting how they are wound down in bankruptcy and resolutions are essential to making a resolution a real possibility, but no one seems willing to cut that Gordian knot.
Rosner draws out the implications of the OLA:
The FDIC recognized that a “liquidation” authority would be deleterious to financial markets in a moment of crisis. Restructuring a firm, not liquidating a firm, is the proven way to preserve an institution’s value….Bankruptcy has and should continue to be the preferred means to restructure the assets of failed firms. Instead, OLA is effectively a cram down that requires a huge amount of debtor-in-possession (DIP) financing from the Treasury.
This financing is a taxpayer-funded and anti-competitive subsidy. It supports the continuation of a banking system in which “All animals are equal but some animals are more equal than others”. This is perhaps the easiest way to understand that these companies are far too large; the system simply can’t fund them in bankruptcy..
Simply stated, Title II creates further subsidies for a handful of firms that will be costly to taxpayers and bestow further advantages to systemically important financial institutions (SIFIs) relative to non-SIFI firms…. The OLF will be cheap and will provide great benefit – only the non-systemically holding company creditors will take losses, and the company will emerge from OLA much as it entered, to do it all again. We can’t allow this to happen – OLA rewards companies for becoming “systemically important” and overly influential, it hurts smaller companies, and stifles innovation. The government created it and the government can and should take it away
I urge you to read Rosner’s testimony in full. It’s short, well written, and makes some important technical issues accessible to laypeople. And it makes the key point deadly clear: Dodd Frank didn’t address too big to fail adequately, but measures that water it down only make a bad situation worse.