The Dangerous Myth that Financial Regulation is Unrelated to Financial Crime

By William K. Black
(Cross-posted from Benzinga.com)

The inspiration for this article was an op ed in the Wall Street Journal by Wendy Long, the Republican/Conservative Party of New York’s candidate for the U.S. Senate.  Long’s thesis is:

“Since the financial crisis began in 2008, four proposals for financial-industry reform have emerged. Only one will work, and it’s not the one imposed by the 2010 Dodd-Frank law. Let’s review the options.

1. Break up the banks.

****

[I]f U.S. banks are split up, foreign competitors will take advantage.

2. Separate investment and commercial banking.

****

[T]he financial crisis showed that separating commercial and investment banking increases risk. The real culprits, Bear Stearns and Lehman Brothers, were stand-alone investment banks, as was Merrill Lynch. The crisis showed that runs on investment banks are more likely than bank runs. Diversification of liabilities and FDIC-insured deposit funding are not the problem but rather a source of strength.

3. Aggressively regulate the financial sector.

****

It is harder to understand why the two senators from New York would want to be a party to the Empire State’s downfall as the world’s financial capital, which is the direction Dodd-Frank is taking us. They apparently feel politically safe enough to indulge their big-government fantasies at the expense of tens of thousands of New Yorkers. They fear nothing from constituents whose financial sector jobs will disappear if Dodd-Frank goes forward.

4. Enforce free and fair markets by catching bad guys.

It’s clear that a lot has gone wrong with the financial industry. Most of it, however, could have been avoided by enforcing existing laws. If you asked New York Police Commissioner Ray Kelly how to fight a crime wave, he wouldn’t say, “take officers off the beat to write regulations on 1,000 pages of a new criminal law.”

Similarly, the way to stop financial fraud and cheating is to catch the fraudsters, not to put regulators behind desks writing new regulations. `

Let’s look at recent headlines: the collapse of MF Global that eluded the crusading Commodity Futures Trading Commission, money laundering by HSBC, the false reporting of the Libor benchmark interest rate. All of this—like the lax underwriting standards for mortgages before the crisis—stems from basic violations of law and proper dealing. Some of these incidents were even brought to the attention of regulators, including, in the case of Libor, Treasury Secretary Tim Geithner.

New York needs representatives in Washington who will resist the chest-beaters trying to appear tough on the financial industry. The Empire State should send a message that the role of government is to set clear, simple rules and catch bad guys to keep markets fair, free and flourishing.”

Long is an attorney.  She has never been a regulator or banker.  She successfully ran for the nomination on the basis that she was the most conservative Republican/Conservative Party candidate in the race (which is a large statement in the Tea Party era).

We are in the midst of our third financial crisis in 25 years driven by epidemics of accounting control fraud.  These epidemics occur when we create intensely perverse incentives that produce a criminogenic environment.  Top economists, regulators, and criminologists have long recognized that deregulation and desupervision can produce criminogenic environments.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

Long proves that Akerlof and Romer were overly optimistic in believing that the anti-regulatory ideologues would learn from experience and insist on vigorous financial regulation.

I believe that each position she advances about regulation and prosecution is dangerously false.  First, she has no positive theory of financial regulation.  Indeed, under her logic financial regulation should not exist.  She does not identify any regulation she supports.  She does not identify what role financial regulation should serve under her views beyond this statement, which is so vague that it is empty.

“The Empire State should send a message that the role of government is to set clear, simple rules and catch bad guys to keep markets fair, free and flourishing.”

Long provides no guidance to the “clear, simple rules” she supports.  Instead, she embraces the single most destructive version of anti-regulatory logic that drives our recurrent, intensifying financial crises – Wall Street must “win” the race to the bottom with the City of London.  To insure that Wall Street can win, U.S. regulators must win the “competition in laxity” with their U.K. counterparts.

Long defines the U.S. as engaging in “overregulation,” by which she means greater regulation than City of London banks experience.  That operational definition of regulation demonstrates that she sees financial regulation as having no value, for the “logic” of a race to the bottom is that all nations will be forced to deregulate and desupervise finance.  Some of the rules may remain in place, but they will not be enforced.

Long’s anti-regulatory logic should cause us (and her) to ask a series of questions.  If financial regulation has no value, then the race to the bottom is a distraction – we should immediately eliminate financial regulation regardless of what the City of London does.  Conversely, if financial regulation were valuable to society it would be vital to break the perverse dynamic of the race to the bottom. If the U.S. adopted the “clear, simple rules” that Long favors (whatever those rules are) and the UK adopts “clear, simple rules” that are much weaker in restraining banks what does Long want us to do in response to the UK’s race to the bottom?

Long fails to ask why bank CEOs prefer the weakest possible rules given the catastrophic harm that weaker rules have caused banks.  Indeed, bankers, as opposed to banks, never appear in Long’s assertions about bank decision-making.  In Long’s discussion, bankers only appear as potential victims of the bank CEOs’ decisions to move banks from Wall Street to the City of London, though that is not the phraseology she employs.  She ignores the CEO’s decisive role in deciding to move the bank to the City of London.  She treats it as an inevitable that the banks will move to wherever regulation is the weakest.  The inevitability causes the bank CEOs’ discretionary decision and its moral dimensions to disappear.  She fails to understand that fraudulent bank CEOs represent the greatest threat to banks and that effective rules and regulators are the only means of protecting banks from their controlling officers.  We have experienced three massive financial crises driven by accounting control fraud in the last quarter-century without the anti-regulators understanding even the most basic aspects of how such frauds occur.

Honest Wall Street CEOs would not choose to move the bank to the jurisdiction with the weakest regulation.  A concrete example may help.  Assume that the U.S. adopts a “clear, simple rule” that bans “liar’s” loans and the UK responds by permitting them.  If the U.S. bank CEOs decide to move “their” banks to the City of London in response to the U.K.’s “winning” the race to the bottom in this circumstance the most logical inference is that the CEOs are frauds who wish to use endemically fraudulent liar’s loans to loot “their” bank.

Honest banks are among the primary victims of fraudulent banks.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  George Akerlof (1970).

Because Long has no theory of when financial regulation is valuable and no understanding of its value she displays incoherent logic and supports self-destructive policies.  She knows that elite banking frauds drove a catastrophic crisis that did enormous damage to the world and she knows that elite bank fraud remains a grave threat.  She also knows that the most destructive frauds arose in the least regulated financial sectors – she singles out the investment banks (Bear, Lehman, and Merrill), the recently revealed (but long practiced) City of London scandals, and MF Global (where the principal regulator was CME – an industry self-regulatory body – functioning in that role because anti-regulatory politicians have denied the CFTC the budgetary resources it would need to hire the staff it needs to examine the firms it is supposed to regulate).  Her examples show the terrible cost of not requiring vigorous financial regulation, but she is blind to all of this.

The people who killed Wall Street jobs are the CEOs of Bear, Lehman, and Merrill and the anti-regulatory politicians and regulators who created the criminogenic environment that led to the epidemic of accounting control fraud that drove the crisis.  The U.S. “won” the regulatory race to the bottom in the context of investment banks through a competitive tactic that should be infamous but is largely unknown.  In 2002, the EU told the big five investment banks in the U.S. that they would have to be subject to “consolidated” supervision by 2004 if they wished to continue to do business in Europe.  The big five lobbied the SEC decided to create a voluntary regulatory system so that they could escape EU supervision.  The SEC’s Consolidated Supervised Entity (CSE) program was designed to be a farce – and functioned as intended.  It greatly reduced the big five’s capital requirements to match what Basel II did for the largest commercial banks (FCIC report, p. 150).  The regulatory race to the bottom was conducted at a breakneck pace.  The CSE program assigned two-to-three SEC monitors to each of the investment banks – massive, complex financial institutions that would have required vastly greater numbers of supervisors if the goal were to actually supervise the big five.  Even the superficial supervisory effort made by the SEC revealed severe problems, particularly at Bear, but no meaningful corrections were required.  The CSE was always a Potemkin program.

Contrary to Long’s claims, during the run up to the crisis the big five grew massively primarily by moving away from investment banking and becoming highly diversified financial institutions (FCIC report, pp. 150-151).  Recall her fictionalized version of the facts:

“[T]he financial crisis showed that separating commercial and investment banking increases risk. The real culprits, Bear Stearns and Lehman Brothers, were stand-alone investment banks, as was Merrill Lynch.”

Investment banks greatly diversified their assets and liabilities in a manner contrary to traditional stand-alone investment banks in the run up to the crisis, and the results were disastrous.  Her argument makes no historical sense.  Glass-Steagall, which separated commercial and investment banking in response to severe problems in the Great Depression, had a fifty year track record of success.  There were major investment bank failures (Drexel (junk bond frauds), Kidder (check kiting), and Sollie (fraud in government securities issuances)) due to control frauds, but no investment bank failures due to a lack of diversification.

Long proposes to recreate the criminogenic environment that drove the ongoing financial crisis.  She wants copious federal guarantees (explicit and implicit) for the systemically dangerous institutions (SDIs), no change in executive and professional compensation, unlimited asset investment authority, and renewed deregulation and desupervision driven to extremes by her embrace of the regulatory competition in laxity.

It is particularly disturbing that an avowed movement conservative calls for the continuation of the SDIs on the basis of the claim that “if U.S. banks are split up, foreign competitors will take advantage.”  The definition of the SDIs is that when (not if) the next one fails it is likely to cause a global systemic crisis.  The U.S. SDIs receive an explicit federal subsidy in the form of deposit insurance but a far larger implicit subsidy because they are treated as “too big to fail” (TBTF) given the systemic risk they pose.  In essence, they hold the health of the global financial system hostage.  TBTF is a misleading phrase.  It does not mean the bank will not fail or cannot be placed in receivership.  It means that the FDIC will pay the SDI’s general creditors in full (rather than paying them pro rata from the failed bank’s typically grossly inadequate assets).  The fear is that the SDIs are so large and interconnected that if there general creditors suffer losses it could cause a cascade series of failures that would cause a global crisis.  The U.S. cannot credibly promise not to bail out the SDIs’ general creditors, so the rhetoric of the Obama administration and Governor Romney promising to end TBTF is empty.

It is insane policy to continue the existence of the SDIs.  The SDIs will cause recurrent catastrophes.  There is a second problem with allowing the SDIs to continue to exist that should be nearly equally frightening for any real conservative.  Before they fail, the SDIs destroy the possibility of free and efficient markets and real democracy.  The authors of Guaranteed to Fail, conservative neo-classical economists, write largely to criticize Fannie and Freddie, but they emphasize that Fannie and Freddie were dangerous because they were SDIs, not because they were government sponsored enterprises (GSEs).  The authors stress six points.  First, because the SDIs’ general creditors are protected from loss the SDIs can borrow much more cheaply than their competitors.  This gives them a crushing advantage over other competitors.  Indeed, the authors stated that the advantage of the largest SDIs over even other SDIs were so great that it was equivalent “to bringing a gun to a knife fight.”  Non SDIs simply are not credible competitors because of the federal subsidy.

Second, the SDIs’ competitive advantages do not come from any business efficiencies.  The opposite is true.  The SDIs are too big to be efficient.

Third, the SDIs’ competitive advantage makes “free markets” impossible.  The authors emphasize that there was nothing free about the mortgage markets.

Fourth, the SDIs have immense political power because of their size, wealth, and connections.  Their survival depends on the continuation of their explicit and implicit federal subsidies so they have compelling incentives to control the political process by being the largest contributor to both parties.

Fifth, SDIs have perverse incentives to take excessive risk and engage in control fraud due.  Their subsidies and the substantial immunity from accountability that their complexity and political and economic power provides make them exceptionally likely to act abusively and unethically.  The accounting fraud recipe that creates a “sure thing” for SDIs’ CEOs calls for the financial institution to make or purchase massive amounts of bad loans.  The fraud recipe explains why SDIs with exceptionally large federal subsidies nonetheless became massively insolvent.  Remember that no one made any SDI – and that includes Fannie and Freddie – make or purchase fraudulent liar’s loans.  They did so because it maximized the bank officers’ wealth.  The fraud recipe and perverse incentives make it far more likely that the SDIs will frequently become deeply insolvent and cause systemic crises.

Sixth, the SDIs lobby for the continuation of their subsidies and economic and political dominance by raising the specter of an international competition in regulatory laxity.  The SDIs argue that if other nations create SDIs the U.S. must do so as well.  The proponents of SDIs try to convert the first and third points that I have just explained about the impossibility of competing against the SDIs into an argument that says we must “win” the competition in subsidies and make our SDIs the biggest in the world.  But if we engage in this competition we destroy our markets and our democracy and ensure that the world will suffer global financial crises that will make the Great Recession.  The nations that “win” the competition to subsidize the SDIs will be the epicenters of future crises.  It is vital that the U.S. not go down this path, but that is the path Long urges:  “if U.S. banks are split up, foreign competitors will take advantage.”

Long’s support for federal subsidies to Wall Street is not limited to her plea to continue the SDIs’ implicit subsidy.  She also wants to extend the explicit federal subsidy of deposit insurance to institutions and activities that real conservatives generally oppose.  She argues that investment banks should receive federal deposit insurance.

“The crisis showed that runs on investment banks are more likely than bank runs. Diversification of liabilities and FDIC-insured deposit funding are not the problem but rather a source of strength.”

A purported extreme conservative who says that federal guarantees “are not the problem but rather a source of strength” is a poser.  Consider how broadly her argument would apply.  A huge range of enterprises are subject to “runs.”  We saw that investment banks, insurance companies, money market mutual funds, hedge funds, investment funds, market makers, law firms, and governments without sovereign currencies were all subject to devastating runs.  We could reduce runs greatly in each of these enterprises if we provided federal deposit insurance, but that does not mean we should do so.  Until I read Long’s op ed I believed that conservatives firmly believed that such federal subsidies should not be extended to these entities.  For Long, Wall Street’s interests sweep the field when they come in conflict with the national interest or conservative principles.  If we extend federal guarantees to entities because they are subject to runs we will move from an affair with crony capitalism to permanent prostitution.

Similarly, Long wants the FDIC guarantee and subsidy to cover everything a bank with unlimited powers invests in or borrows.  This is another bizarre position for a conservative.  There are good reasons to provide deposit insurance to relatively less sophisticated commercial bank depositors.  There are no good public policy arguments in favor of subsidizing bank investments in direct investments, e.g., owning a hotel or speculative proprietary positions in financial derivatives.  It would be crazy to provide federal deposit insurance to special purpose vehicles that deliberately engaged in extreme leverage to make bets on interest rate movements.   Each of these subsidies would create immense risk to the government by creating intense, perverse incentives for the banks’ CEOs.  It would also fatally distort markets if my federally subsidized hotel got to compete with your no-subsidized hotel.  Long loves federal guarantees to Wall Street.  She is enthusiastic about the government subsidizing the banks’ hotels against other hotels and she hates the Volcker rule.  She is afraid that if other nations subsidize their banks to purchase hotels (or derivatives) U.S. banks will be uncompetitive and “tens of thousands of New Yorkers[’]” “financial sector jobs” will be lost.  If she believes that argument, however, she must also believe that if U.S. banks receive federal subsidies for owning hotels they will make other U.S. hotel owners uncompetitive.  Why would an extreme conservative support such a perversion of the “free market?”

Long does not understand that effective financial regulation and regulators are essential to her preferred policy, the policy she asserts is the “[o]nly one [that] will work.”  Her description of that policy is:  “Enforce free and fair markets by catching bad guys.”  She seems not to have noticed that neither the Bush nor the Obama administration has been “catching [the] bad guys” whose frauds drove the crisis.  As I have explained at length in many articles, the prosecutors cannot successfully prosecute epidemics of elite financial frauds without the aid of vigorous regulators who make assisting such prosecutions a top agency priority.

Even more importantly, only vigorous regulators and effective rules can prevent or contain a developing epidemic of accounting control fraud and prevent future financial crises.  The entire financial crisis in the U.S. could have been prevented if the Federal Reserve had used its unique statutory authority under the Hoe Ownership and Equity Protection Act of 1994 (HOEPA) to ban liar’s loans – an action urged on it by prominent Republican officials, a Federal Reserve Governor, and a vast array of housing advocates (including ACORN)!  Chairmen Greenspan and Bernanke refused to ban these loans, which they knew were massive, growing at extraordinary rates, and endemically fraudulent, for purely ideological reasons.  They were rabid anti-regulators.  Long derides the concepts that rule changes are necessary even though the Clinton and Bush administrations had repealed an entire series of vital rules and substituted deliberately unenforceable “guidance.”  The only significant rule that the banking agencies adopted to combat the accounting control frauds occurred when the Federal Reserve finally succumbed to Congressional pressure and used their HOEPA authority to ban liar’s loans in a rule adopted on July 14, 2008.  Even then, Bernanke delayed the rule’s effective date for 15 months lest it inconvenience any fraudulent lender.

Restoring the pre-1993 underwriting rules would impose no cost on honest lenders and would greatly reduce fraud and make it much easier to prove fraud when it occurred.  The rule we adopted in 1984 restricting S&L growth rates doomed the accounting control frauds that we were not able to close because we had no funds. The rule targeted an accounting control fraud’s Achilles’ heel – the need to grow rapidly or collapse.  The lack of a rule requiring Fannie, Freddie, the investment banks, and mortgage bankers to file criminal referrals was a major barrier to prosecuting.

The regulatory “black holes” exploited by fraudulent mortgage bankers created a superb criminogenic environment.  The GAAP and international accounting rules of credit default swaps (CDS) and international accounting rules for allowances for loan and lease losses (ALLL) are open invitations for accounting control fraud.

The broader point is that without superb criminal referrals by the financial regulators and the “detailing” of dozens of bank examiners to the FBI it is impossible for the FBI to investigate effectively an epidemic of elite accounting control fraud.  By 2006, there were over two million fraudulent liar’s loans being made annually.  Long does not understand that the financial regulators are the “cops on the beat.”  The NYC police department does not deal with elite financial crimes.  The FBI white-collar crime staff is so tiny (fewer than two agents per U.S. industry) that it cannot walk a beat.  The FBI only come and investigates in response to effective criminal referrals.  Banks will virtually never make a criminal referral against their CEOs.  One cannot combat such a fraud epidemic by having the FBI investigate the criminal referrals that the FDIC-insured banks make against individual borrowers.   

The anti-regulators controlling the banking agencies under Clinton and Bush killed the criminal referral process.  Obama has failed to reestablish it.  Long does not understand the meaning of her own example about Geithner’s response to learning of the Libor frauds.  Geithner and the Federal Reserve Bank of New York (FRBNY) did not use the word “fraud” in their communications with the Bank of England or their sister regulators.  The FRBNY did not make a criminal referral or even alert the FBI and the Justice Department to the Libor frauds.  Obama’s recently created “working group” on secondary mortgage market fraud does not even include representatives from the banking regulators.  Chris Swecker, the senior FBI official who made the famous twin warnings in 2004 (there was an “epidemic” of mortgage fraud that would cause a financial “crisis” if it were not contained) informed the FCIC that no banking regulator ever contacted him in response to his warnings.  Long’s anti-regulatory dogma would recreate the criminogenic environment and spark new fraud epidemics and lead to the three “de’s” (deregulation, desupervision, and de facto decriminalization).  One cannot credibly call for jailing the crooks while pushing anti-regulatory creeds that produce fraud epidemics and make it certain that the elite crooks will not even be investigated, much less jailed.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @williamkblack