Why we need regulatory cops on the beat – and why they make bankers cringe

(cross-posted with Benzinga.com)

One of the paradoxes of effective financial regulation is that the best way to help bankers and banks is to virtually never think in terms of helping banks and bankers. Financial regulators’ primary task is to detect, put out of business, and deter accounting control frauds. Those are the frauds that cause catastrophic individual failures, hyper-inflate financial bubbles, and produce our recurrent, intensifying financial crises. Accounting control frauds also produce “echo” epidemics in other professions (e.g., auditors, appraisers, and credit rating agencies) and industries, e.g., loan brokers. Fraud begets fraud and it can make fraud endemic in entire lines of business such as liar’s loans. The senior officers of investment and commercial banks spread these frauds through an industry and to other industries and professions by deliberately creating “Gresham’s” dynamics. In this context, the dynamic refers to situations in which bad ethics drives good ethics out of the market. George Akerlof first used this variant of the Gresham’s dynamic in his famous article on markets for “lemons” that led to the award of the Nobel Prize in Economics. Akerlof explained that if firms that defrauded their customers gained a competitive advantage over their honest rivals private market discipline became perverse and drove honest firms into bankruptcy.

The CEOs that lead accounting control frauds create intensely criminogenic environments by shaping perverse incentives that maximize such Gresham’s dynamics among their own officers – by basing executive compensation largely on short-term reported (fictional) income. They create perverse incentives among loan officers, “independent” professionals, and other firms (e.g., loan brokers) by hiring, firing, promoting, praising, and making wealthy those that will create and “bless” their fraudulent accounting practices. The art is to suborn – not defeat – “controls” by perverting them into allies.

The senior officers that control fraudulent banks are exceptionally successful in using these Gresham’s dynamics to produce fraud epidemics and massively overstated asset values and earnings. They routinely get clean accounting opinions for financial statements that do not comply with GAAP and are deliberately contrary to reality. They routinely get grossly inflated appraisal values. They routinely got “AAA” ratings for toxic waste that was not even single “C.” They routinely got “liar’s” loan applications and appraisals that their employees and agents falsified to make them appear to have far lower loan-to-value (LTV) and debt-to-income ratios. The result was loans with a premium yield that looked (to the credulous) as if they were not exceptionally risky. The lenders could sell these fraudulent liar’s loans at a premium or keep them in portfolio and claim high (fictional) earnings. Liar’s loans, of course, produce severe adverse selection and negative expected value (losses). The fictional reported income in the near-term, however, is a “sure thing” for accounting control frauds because they do not create remotely adequate allowances for loan and lease losses (ALLL).

These unique abilities, and dangers, posed by banks that are accounting control fraud mean that regulators are the only ones that can break a Gresham’s dynamic prior to catastrophe. Regulators’ unique advantage is that they are not paid, hired, or fired by bank CEOs. This logic also explains an important exception – if banks can create a “competition” in laxity among regulators (as they did with the Office of Thrift Supervision during the recent crisis) they can crate perverse incentives that can drive laxity. The worst bank CEOs often seek to create this competition in regulatory laxity by threatening to move internationally to the weakest regulator. They also seek to create regulatory black holes that serve as safe havens for control fraud.

When financial regulators are not captured by the industry and do not seek to serve the industry, then they can serve as regulatory cops on the beat. Their function is to break the Gresham’s dynamic by making it far less likely that cheaters will prosper through fraud. Regulators are in a better position to exercise real independence than any private sector “control.” This means that vigorous financial regulators who make fighting control fraud their top priority are honest bankers’ best friends and the control frauds’ worst nightmare.

As with Adam Smith’s paradox (which works well for the local village baker and fails utterly for global banker) financial regulators can be successful only when they do not act out of any desire to help banks, but rather to serve as the regulatory cop that is passionate about enforcing the law against even the most powerful banks when they engage in intentional misconduct. By taking the profit out of fraud, successful financial regulators help honest bankers and greatly reduce the scope, length, and damage of financial crises.

All of this explains why the “reinventing government” movement (a bipartisan project of then Texas Governor Bush and Vice President Gore) was a disaster for financial regulation. We were instructed to refer to banks and bankers as our “clients.” This is the worst possible mindset for effective financial regulation. Unfortunately, key politicians are determined to recreate this disastrous mindset.

Spencer Bachus (R. Ala.), the incoming Chair of the House Financial Services Committee, told the Birmingham News: “In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks.”

Ron Paul (R. Tex.), asked to comment on Bachus’ statement, said: “I don’t think we need regulators. We need law and order. We need people to fulfill their contracts. The market is a great regulator, and we’ve lost understanding and confidence that the market is probably a much stricter regulator.”

The latest manifestation of this mindset was in response to Professor Elizabeth Warren’s recent congressional testimony. Dana Milbank’s March 16, 2011 column reported:

“You kept saying ‘cop on the beat, cop on the beat,’ ” complained Rep. Shelley Moore Capito (R-W.Va.), who chaired the day’s hearing.

Basically, the members of the panel didn’t want the new [Consumer Financial Protection Bureau] CFPB to have anything that would displease bankers.

Rep. Blaine Luetkemeyer (R-Mo.) said the agency was “the last thing that our lenders need.” Rep. Robert Dold (R-Ill.) ridiculed the “theoretical consumer protection” the agency would provide. Rep. Sean Duffy (R-Wis.) complained that, in Warren’s agency, “consumer protection could trump safety and soundness.” 

Apparently, these politicians learned nothing useful from the crisis. The first thing honest bankers need is an end to fraudulent mortgage lending. Ending fraudulent mortgage lending does not “trump safety and soundness” – it is essential to attain and maintain safety and soundness. Liar’s loans destroyed trillions of dollars in wealth and caused many lenders to fail. They created inverse Pareto optimality – both parties were made worse off by the typical liar’s loan. The agents were the winners. Akerlof & Romer explained this dynamic in the title of their 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The looting causes the bank to fail (unless it is bailed out) but the senior officers walk away wealthy. Fraud is almost always a negative sum transaction – the losses exceed the gains. Accounting control fraud produced exceptional net losses at banks because the recipe for creating short-term fictional reported income also maximizes real losses.

A vigorous regulatory cop on the beat, and Elizabeth Warren is the exemplar, is exactly what honest banks and bankers need. But even honest bankers are typically Pavlovian about financial regulation. They have been taught for decades by theoclassical economists and anti-regulatory ideologues that regulation is evil. Regulators also ask embarrassing questions and criticize senior managers. So, it is the rare honest bank CEO who will publicly support vigilant regulation. If you have a psychological need to be liked by the bankers or if you think of them as your “clients” or “customers” you are unsuited to be a financial regulator because you are incapable of functioning as a cop on the beat.

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