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The Rosner Amendment, or the last line of defense in a financial reform bill

By Mike Konczal
So part of the financial reform package is allowing regulators to wind down large financial firms in a way similar to the way they wind down commercial banks. One question is, "When do you wind these firms down?" Is it when all hope is lost and everyone is running for the door? No, ideally it should be before that, when the firm still has some value.

People have different opinions on what kind of trigger should be used for resolution authority: amount of assets, how risky the debt structure ("tenor") is to bank runs, credit default swap ratings on certain types of debt, etc. But who gets to decide where that line is? Should it be Congress, or should it be the regulators? For commercial banks, Congress wrote it into a 1991 law ("tangible equity in an amount -- (i) not less than 2 percent of total assets"). Some say that this works well, because it ties the regulators' hands and stops regulatory discretion and procrastination. Others say that having it in law is too binding on regulators, and many failing banks skip to a failed state too quickly.

Economics of Contempt asks me whether I think Congress should write the line for a failed systemically risky bank into the bill, and argues that that is a bad approach. I tend to agree. I'll have more on this here soon, but I view the risks as a combination of size of liabilities and cross-section of liabilities (how much of the debt is short-term). Regulators should have discretion on this.

But. But I don't trust them. I want some level of democratic accountability here without trying to pretend that the law will be smart enough to handle all kinds of problems. So what can we do?
I'm going to propose something I'll call the Rosner Amendment, since Josh Rosner wrote it down after I discussed my worry for real accountability in a "regulators make all the calls" bill. Rosner wrote the securitization chapter for our Make Markets Be Markets conference, and this is what he suggested to any financial reform bill (my bold):

I propose an amendment that requires legislatively required action be taken against any “too big to fail” institution which becomes undercapitalized, requires any governmental or government agency guarantees of its obligations or governmentally supported purchase of its assets outside of the normal course of activities, receives funds from the Federal Reserve’s window with terms of more than 60 days or draws against any industry funds raised for funding the risks of these institutions. Specifically, the Directors, Officers and senior management of any institution that draws on the industry funds or receives any relief should immediately lose his/her pay and future benefits and, as soon as safely feasible, replaced by regulators. As importantly, directors, officers and all senior managers of such troubled TBTF should be explicitly prohibited from becoming employed as Director, officer, senior manager or consultant at any regulated financial institution or an affiliated holding company or operating subsidiary for a period of five years.

The first part is basically saying, "Hey, here are all the bailout conditions." And after clear bailout conditions, here are clear rules for what happens if you are bailed out -- the managers need to not work in the financial industry for five years.

If you are someone who is not part of the top 1 percent, this makes perfect sense. If you are a school bus driver who drives his school bus into a volcano, guess what -- you can't be a school bus driver anymore. If you are a lawyer who goes insane during a court case and attacks the
judge, guess what -- you are now disbarred. And if you run a systemically important financial company into the ground putting taxpayers on the hook, guess what -- you can't run a systemically important financial company for five years.

Trust me, the managers of any of those failed community banks that the FDIC scoops up every Friday will have a lot of trouble getting another banking license. Why should the biggest 30 firms have any less trouble?

This will immediately take care of a huge amount of agency problems within large firms. Managers will have good incentives to distinguish between skill and risk in terms of traders' profits if their own jobs are on the line. Firms where embedded managers don't want to take the risks of being systemically risky will immediately start de-risking. It kills a lot of birds with a single stone.

And I'd sleep better at night, knowing that there was some sort of simple rule that demands accountability both from the regulators and from the financial sector. How about you?

Mike Konczal is a fellow with the Roosevelt Institute and the author of the Rortybomb blog.

By Washington Post editor  |  April 1, 2010; 12:00 PM ET
Categories:  Financial Crisis , Financial Regulation  
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Love the idea, but I'm worried about how one would define "undercapitalized" or "guarantees of its obligations." Seems like an opening for gaming unless you strictly define those terms.

Conceptually though, it's very smart to put management on the hot seat. This most recent crisis as really exposed the agency problem in finance. I'd even add in stronger limits on rehiring failed TBTF managers to put a multi-year buffer between the private employment of any regulator with a TBTF firm and vice versa.

Posted by: etdean1 | April 1, 2010 12:49 PM | Report abuse

The incentive that this amendment creates for senior management is to avoid taking bailout money, whether or not that's the right decision for the company. If they take the bailout money, they'll definitely lose their job, but if they run up bigger and bigger gambles with the firm's money, there's a chance they might keep their job.

In other words, if the firm is teetering with $50 billion in debt, there's no upside for management to take bailout money and give up their jobs, and every incentive for them to run the debt up to $500 billion in a gamble to turn things around.

If being mildly reckless and being wildly reckless carry the same downside, more people are going to be wildly reckless.

Posted by: tomtildrum | April 1, 2010 1:21 PM | Report abuse

Fantastic idea; great 99% of the population analogy (although I hope that bus wasn't filled with kids). What would keep those directors and managers doing their job after triggering the bailout conditions if they knew they were to be sacked? I think there may be a need for some sort of post hoc powers allowing legislators to define theretofore undefined bailout triggers and apply them retroactively, i.e. sack managers even if they find loophole.

Posted by: rglvr | April 1, 2010 1:22 PM | Report abuse

While I agree that the cronyism - that all but ensures the guys that cause the messes always land on their feet - is an issue that needs to be addressed, I think that the bigger issue is figuring out when to "pull the trigger" and classify a large organization as failed. The consensus is that there is no good/reliable/fair way to legislate and/or regulate this. There's always going to be too much money and too much political pressure involved when the industry in ascension (bubble) again. Increasing the punishment for failure just makes it more likely that issues will be glossed over and pockets will be lined to keep the casino running.

What we may be able to do is create incentives (or remove exisitng disincentives) to make a large, financially unstable organizations more attractive to market players who would profit from breaking them up. So maybe the answer isn't so much that the executives wouldn't be able to work in the industry for a period, but that the shareholdlers wouldn't make a profit for 5 years once an organization is bailed out.

Posted by: lkslongboarder | April 1, 2010 1:38 PM | Report abuse

It's an interesting idea, but I had the same immediate reaction as TomTildrum. This eliminates some of the agency problems, but it creates a new huge moral hazard. I feel like this idea is in large part, just as Krugman described, depending on Greek vs Roman regulators.

Posted by: Quant | April 1, 2010 1:38 PM | Report abuse

While this is a fine idea, it fails to solve the problem of TBTF banks. What happens when another bubble comes along and the whole system goes out of whack again. When Lehman's went down, the bankers themselves stopped trusting each other and created a bank run. That's when everyone began to figure out how badly they were over exposed. The only solution became bailing out the banks as the entire credit market worldwide froze.

So, the real question is how do we prevent another bailout, because one will surely happen given the increased size of the mega-banks? I tend to agree with Simon Johnson and Ms Warren that these banks must be reduced in size so they no longer represent such systemic risk. I know the argument on the other side - the one Jamie Diamond has been arguing - but I don't buy it.

There's an old colloquialism that says: an ounce of prevention is worth a pound of cure. In the case of the mega-banks, that saying is both apt and true.

Posted by: valkayec | April 1, 2010 1:45 PM | Report abuse

@ TomTildrum, Quant

Making it all the more important that there's a fixed ceiling on leverage.

Posted by: etdean1 | April 1, 2010 1:58 PM | Report abuse

I agree with Tom Tildrum and others. The Rosner Amendment, by itself, is great. Couple that with a fixed ceiling on leverage and you eliminate virtually all of the TBTF problems.

I'd suggest too, that FinReg also look at mortgage loan originations. The legislation should flat out eliminate teaser rates and zero-down mortgages. With investor/speculators who accumulate houses for resale the legislation should require 20% down. These two features would both reduce foreclosures they would lessen fear for those buying the mortgage-backed bonds.

Come to think of it, we need to have some serious oversight of the ratings agencies. They bear a lot of blame for the recent crash, but have largely escaped blame.

Posted by: rkarraker | April 1, 2010 3:00 PM | Report abuse

I am Josh Rosner. This was not intended to SOLVE the problem it was meant to take the terrible reg reform bill and add one discreet amendment to make it significantly LESS bad.

It is not instead of leverage ratios, not instead of real capital requirements (real equity not the bull type of contingent capital).

I would add that the goal is to cause the boards and management at these firms to choose either to "release economic value" to shareholders by shrinking their leverage and reducing their interconnectedness OR, BEFORE they are at risk of a macro event that can turn them upside down, increase their spending on risk control environments so that they are certain they are not at risk of the triggering event. The point is proper incentives. If investors understood that the company could not be saved if it crashed (the changes to 13.3 in the bill and resolution authority ensure that) and management understood their risks the cost of capital to these institutions would price more effectively.

Let them decide which approach (shrink or increase risk controls and capital) is the economically more sensible one for their investors. Right now the low cost capital that comes with an implied government guarantee, or "too big to fail" assumption, is the economically sensible choice and the choice of which we must raise the cost.

Posted by: joshrosner | April 1, 2010 4:09 PM | Report abuse

I like it.

Posted by: zosima | April 2, 2010 2:22 AM | Report abuse

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