Testimony of Joshua Rosner before the Subcommittee on TARP, Financial Servicerand Bailouts of Public and Private Programs.“Has Dodd-Frank Ended Too Big to Fail?” – 2154 Rayburn House Office Building

March 30, 2011Almost three years have passed since the United States financial system shook, began toseize up, and threatened to bring the global economy crashing down. The seismic eventfollowed a long period of neglect in bank supervision led by lobbyist-influencedlegislators, “a chicken in every pot” administrations, and neutered bank examiners.While the current cultural mythology suggests the underlying causes of the crisis wereunobservable and unforeseeable, the reality is quite different. Structural changes in themortgage finance system and the risks they posed were visible as early as 2001.

Even aslate as 2007 warnings of the misapplications of ratings in securitized assets

such ascollateralized debt obligations and the risks these errors posed to investors, to markets,and to the greater economy

were either unseen or ignored by regulators who believedfinancial innovation meant that risk was “less concentrated in the banking system”

and“made the economy less vulnerable to shocks that start in the financial system.”Borrowers, these regulators argued, had “a greater variety of credit sources and (hadbecome) less vulnerable to the disruption of any one credit channel.”

In the wake of the crisis, and before either the Congressional Oversight Panel or theFinancial Crisis Inquiry Commission delivered their final reports

on the causes of thecrisis, Congress passed the Dodd-Frank Act. The act claimed to end the era of “too-big-to-fail” institutions and sought to address the fundamental structural weaknesses and

Joshua Rosner, “Housing in the New Millennium: A Home Without Equity Is Just a Rental with Debt

”

(paperpresented at the midyear meeting of the American Real Estate and Urban Economics Association National Associationof Home Builders, Washington, DC, May 28–29, 2002). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456

Rosner and J. R. Mason, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securitiesand Collateralized Debt Obligation Market Disruptions

”

(2007).http://www.hudson.org/index.cfm?fuseaction=hudson_upcoming_events&id=393

Rosner, and Mason, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation MarketDisruptions?

”

(2007),http://www.hudson.org/files/publications/Mason_RosnerFeb15Event.pdf

Timothy Geithner, “Liquidity Risk and the Global Economy” (May 15, 2007),http://www.ny.frb.org/newsevents/speeches/2007/gei070515.html(see: “The dramatic changes we’ve seen in thestructure of financial markets over the past decade and more seem likely to have reduced this vulnerability. The largerglobal financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation infinancial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the bankingsystem, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread morebroadly across a greater diversity of institutions.”)

Donald L. Kohn, “Financial stability and policy issues” (May 16, 2007),http://www.federalreserve.gov/newsevents/speech/kohn20070516a.htm(see: “There are good reasons to think thatthese developments have made the financial system more resilient to shocks originating in the real economy and havemade the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of creditsources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to peoplewho are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years.”)

“Congressional Oversight Panel Reports,” accessed March 28, 2011,http://cop.senate.gov/reports/, and “FinancialCrisis Inquiry Commission Report,” accessed March 28, 2011,http://www.fcic.gov/report.

conflicts within the financial system. To falsely declare an end to Too Big to Fail withoutactually accomplishing that end is more damaging to the credibility of U.S. markets thana failure to act at all. The historic understanding that our markets were the most free tofair competition, most well regulated and transparent, has been the underlying basis of our ability to attract foreign capital. It is this view that, in turn, had supported our marketsas the deepest, broadest, and most liquid.In fact, Dodd-Frank reinforces the market perception that a small and elite group of largefirms are different from the rest. While the act sought to reduce the risks that too-big-to-fail (TBTF) institutions pose to the financial system and the broader global economy, it isunclear whether any such meaningful reduction has actually occurred.

Moreover,although not fully implemented, Dodd-Frank has not reduced the number of systemicallyrisky firms or placed meaningful new limits on their size, interconnectedness, orleverage. In fact, since the crisis began the largest financial firms have become evenlarger. In 1995 the assets controlled by JPMorgan Chase, Bank of America, Citigroup,Wells Fargo, Goldman Sachs, and Morgan Stanley represented 17 percent of GDP; as of January 2011 these firms controlled assets equal to 64 percent of our nation’s GDP.Today, the five largest banks, which controlled slightly more than 10 percent of depositsin the early 1990s, control over 45 percent.During the panic of 2008, regulators approved mergers of massive firms that left thebanking system far more concentrated. Rather than protecting society from theunderlying problems inherent in a system comprised of a small number of highlycorrelated, leveraged and concentrated firms who, by size and undue economicadvantage, have the ability to hold taxpayers hostage to their failings, today ourlegislators and the Obama White House appear complacent and uninterested in reviewingactions taken in crisis or considering whether those actions have enhanced or reducedlonger-term stability.It is of course understandable to want to “move on” from the crisis. But if we continue onour current path – and, allow the debts of certain companies to be viewed as impliedsovereign obligations, the artificial economic advantages these firms receive willaccelerate the demise of small and vibrant community banks, which successfullydiversified the nation’s risks during the crisis. Moreover, if we again find ourselves incrisis, there is a strong likelihood that, like Ireland, creditors will demand the U.S.government explicitly accept these banks’ obligations as sovereign obligations, leavingtaxpayers rather than creditors to once again shoulder the costs, as they have been forcedto do with Fannie Mae and Freddie Mac.In the years before the crisis, regulators and legislators confidently espoused now-disproven notions that the orderly resolution of Long Term Capital Management, thegiant hedge fund, demonstrated that no firm should be considered “too big to fail.” As aresult, regulators were believed to have armed themselves with new analytical tools and

Neil Irwin, “Paulson to Urge New Fed Powers,”

Washington Post

, June 19, 2008, accessed March 28, 2011,http://www.washingtonpost.com/wp-dyn/content/article/2008/06/18/AR2008061803225.html(see: "We must limit theperception that some institutions are either too big to fail or too interconnected to fail. . . . If we are to do that credibly,we must address the reality that some are.")

systems so that no financial firm would ever take risks that would imperil the institution.This absurdity of thought permeated even the most global bank policy initiative, theintended move from a Basel Capital Accord to a Basel II Capital Accord. Where Baselrequired banks to reserve for “expected losses,” Basel II supported the premise thatrational actors reserve for expected losses and should only be required to reserve for“unexpected losses.”Among the paradoxes in Dodd-Frank is this one: Key elements of the Act that seek toreduce risks to the system – branding institutions as “systemically important”, increasingtheir exposure to risk assets, and implementation of a subjective, and untested resolutionregime – actually increase risk to the system and even accelerate the moment of our nextcrisis. Furthermore, the broad discretion Dodd-Frank confers to regulators, combinedwith the fact that regulators so miserably failed us in the most recent crisis as well as thehistory of legislative and regulatory capture by the industry

, only serves to increaseuncertainty and promise a future relationship between the government and financialsystem that is not only corporatist, but promotes cronyism.IDENTIFYING “SYSTEMIC”—DANGEROUS TO DODodd-Frank requires that the Financial Stability Oversight Council identify and designatecertain financial firms as “systemically important”. These firms automatically include allbank entities with over $50 billion in assets and such other firms that the FSOCdetermines to be systemically significant. Once branded as “systemically important, thesefirms will be subject to “enhanced supervision” by the Federal Reserve and, in case of failure, could be subject to a special resolution regime under Title II of Dodd-Frank.“Systemically important,” firms will also be required to submit a resolution plan thatprovides regulators with a road map to their resolution under a Chapter 11 bankruptcyprocess. This is particularly ironic, given that they are being asked to craft their ownresolution using a regime that has been determined to be ineffective for them and towhich they will not be subject unless, on the “eve of bankruptcy,” the Treasury Secretary,Federal Reserve, and FDIC fail to agree to place them in a Title II receivership regime.

Italso demonstrates that the Title II Orderly Liquidation Authority is wholly unnecessary,since regulators will only allow those firms that have an adequate plan for resolutionunder Chapter 11 bankruptcy to maintain its existing risk profile.Far more troubling, though, is that this part of Dodd-Frank implicitly expands thetaxpayer safety net for large institutions and does so explicitly for systemically importantfinancial market utilities, “the implicit support or guarantee provided by government tocreditors of banks that (are) seen as ‘too important to fail.’” In fact, like the government-

Gretchen Morgenson and Rosner,

Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led toEconomic Armageddon

(Times Books, May 2011), 352

Davis Polk, “Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Enacted into Law onJuly 21, 2010,” accessed March 28, 2011 (see: “Subject to the exceptions described below for broker-dealers orinsurance companies, a financial company will be designated as a covered financial company, and the FDIC will beappointed as its receiver, if at any time, including on the eve of bankruptcy, the Treasury Secretary makes the followingdeterminations, upon the recommendation of 2/3 of the Federal Reserve Board and 2/3 of the FDIC Board, and inconsultation with the President.”)