The Myriad Mendacious Myths of “Market Regulation” of Finance

By William K. Black
June 7, 2016     Bloomington, MN

Representative Jeb Hensarling, Chair of the House Financial Services Committee has announced that he will introduce a Republican plan to repeal key provisions of the Dodd-Frank Act and replace them with “market-based” regulation.  I have explained in a prior column how theoclassical economists, for over 40 years, have created repeated criminogenic environments in finance due to their unholy ideological war against effective financial regulation.  The dominant policy view among economists and senior anti-regulatory policy advisers of every administration since President Carter embraced the myth that economists had invented means by which the “markets” will effectively “regulate” finance.

The reality is, first, that what they falsely call “market” “forces” are what creates the perverse incentives that cause our recurrent, intensifying crises.  Second, their “market” regulation makes those incentives even more perverse.  Third, the theoclassical myths and anti-regulatory policies generate regulatory complacency based on the myth that the problem of those perverse incentives has been vanquished by “incentive compatible” regulation.

It is ironic that economists’ proudest boast is that have unique insights and predictive abilities because of their understanding of the incentive of self-interest.  They brag that they have been taught to “think like economists” and understand that self-interested behavior is ubiquitous.  As we have all observed, they are actually so supremely bad at understanding how perverse the incentives they worship are in the real world that their predictive record is abysmal – and getting worse.

The most famous (to nerds) policies arising from this myth are requiring banks to issue subordinated debt – and allowing them to treat this debt as “equity.”  Theoclassical theory predicted that the purchasers of bank subordinated debt were the ideal source of “market discipline.”  The purchasers of bank sub debt are lenders to the banks who contractually agree (in return for a higher nominal interest rate) that if the bank is liquidated through bankruptcy or a receivership the lender will not be repaid until after all secured and general creditors are paid in full.  As a practical matter, this means that sub debt holders are almost certain to be wiped out if the bank is liquidated.  That fact is supposed to ensure that the sub debt holders will have the proper financial incentives to be zealous in preventing any actions by management that could endanger the bank’s health.  Bank sub debt is also sold in minimum denominations of $10,000, is typically purchased by lenders in blocks of over $1 million (often tens of millions of dollars), and is typically purchased by lenders that would be considered highly financially sophisticated.  Together, this means that theoclassical economists predicted that sub debt holders would combine the proper financial incentives to provide the ideal “private market discipline” because subordination of their loans to the banks meant that they were exposed to very large risk of loss and because they had enough money at risk (“skin in the game”) that it was worthwhile for them to spend the money necessary to conduct effective “due diligence” and determine the bank’s true financial condition.  The sub debt holders’ characteristic high financial sophistication meant that high ability to conduct effective due diligence was married to the proper incentives.

But there is a more subtle advantage that is supposed to be unique to “private market discipline” – it is not subject to the due process and equal protection clauses of federal and state constitutions.  Potential sub debt holders do not need to have any basis for refusing to buy a bank’s debt.  Once they have bought the debt they do not need to have any basis for refusing to renew the sub debt.  They can insist on any “debt covenants” they wish before purchasing or renewing their sub debt.  They can exercise those debt covenants without any procedural requirements that slow down regulatory actions.

There was only one problem with sub debt – it never worked as predicted by the theoclassical economists.  There was never, anywhere in the world, an effective case of private market discipline by bank sub debt holders.  As George Akerlof and Paul Romer noted in their 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit,” sub debt was typically “covenant lite” rather than stringent.  The theoclassical theory predicted that sub debt should have particularly stringent covenants and that they would be enforced zealously.

The universal failure of their sub debt predictions, of course, did not cause theoclasscial economists to admit error.  Instead, they developed “incentive compatible” “risk-based” Basel II capital standards.  These standards were preposterous and failed even more spectacularly than sub debt.

The newest theoclassical variant on “market” regulation is Hensarling’s Republican plan.  This variant relies on the myth that “capital” is a thing of great value sitting in a bank’s vaults that can easily be measured and that all we have to do is require higher capital requirements and banks will not fail or at least will fail at no or minimal cost to the public.  To believe this myth one need only be ignorant of accounting, finance, and regulation.

First, capital is merely an accounting residual.  Assets – Liabilities = Capital.  This means that if assets are overstated or liabilities are understated (or both) capital will be overstated.  Second, the way “accounting control fraud” works is to massively overstate asset values.  As Akerlof and Romer explained:

We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussions of the crisis in the savings and loan industry. If net worth is inflated … incentives for looting will be created.

Yes, the point was “obvious” 23 years ago before a Nobel Laureate in Economics (Akerlof) put it in print in a famous article.  By the end of 1993, we, the S&L regulators, had been putting the point to practical use for a decade as the core of our crackdown on the fraudsters.  Indeed, we prioritized the S&Ls reporting the highest profits for investigation and closure.  Akerlof and Romer’s article is one of the first things any Representative should read upon being named to the House Financial Services Committee.  The Chair should be among the last people in the world to propose relying on capital to create effective private market discipline.  But my readers know that Hensarling has never and will never read the relevant economics and criminology literature.

Third, it is epidemics of accounting control fraud that have driven our three modern financial crises – the savings and loan debacle, the Enron-era frauds, and the most recent financial crisis.  Hensarling’s plan assumes that the banks’ reported capital is real rather than the product of fraud.

Similarly, “income” is merely an accounting residual.  If the bank overstates revenue or understates expenses and losses, its income can be massively inflated.  Charles Keating’s Lincoln Savings, for example, reported that it was the most profitable S&L in America when it was actually the suffering the worst losses of any S&L.  Jamie Diamond, JPMorgan’s CEO, made this point in his March 30, 2012 letter to shareholders.

Low-quality revenue is easy to produce, particularly in financial services.  Poorly underwritten loans represent [fictional] income today and losses tomorrow.

Hensarling however, is peddling not only the myth of “market” regulation but also the myth that capital regulation and accounting can be made “simple.”

The Republicans’ better approach will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements.

If he believes his words quoted above, then Hensarling has demonstrated to the world that he does not understand even the most basic aspects of banking.  Let me be clear.  Higher capital requirements are a good idea.  The claim that such capital levels would be “too expensive” is bad economics.  The idea that there should be a strong minimum capital requirement as a percentage of total liabilities rather than a more complex risk-weighted standard is also a good idea.  The idea that a high capital requirement creates effective “market” regulation and obviates the need for vigorous real examination and regulation is a dangerous myth that would create the future criminogenic environments that would ensure future massive crises.

6 responses to “The Myriad Mendacious Myths of “Market Regulation” of Finance

  1. What about new values? Isn’t this a key factor in allowing the acceptability of a criminogenic environment? Doesn’t Theoclassical economics at the very least enable amoral behaviour? However values and pro social behaviour are core to humans and our success over millennia. How can they be resurrected in finance society? I think that is the core challenge. Without values there is only loophole exploitation and regulatory escalation followed by calls for removing red tape so the cycle starts again. What do you think!

  2. Andrew Anderson

    and replace them with “market-based” regulation. Bill Black

    Depository institutions are a government-privileged cartel. Until we all can have inherently risk-free accounts at our respective central banks and other explicit and implicit privileges for the banks abolished then what market are we talking about since it doesn’t include the citizens, at least not the non-rich ones? A market among what is essentially a government-privileged usury cartel?

  3. Andrew Anderson

    The idea that a high capital requirement creates effective “market” regulation and obviates the need for vigorous real examination and regulation is a dangerous myth that would create the future criminogenic environments that would ensure future massive crises. Bill Black

    So how about we make the liabilities the banks create (“loans create deposits”) real ones instead of the largely virtual ones they are today?

    Let’s assume for the sake of argument that physical fiat no longer exists. Then guess what? In that case fiat would only exist in the form of account balances at the central bank (aka “reserves” in the case of banks). But individual citizens, businesses, State and local governments, etc. MAY NOT have accounts at the central bank so how could they possibly redeem bank liabilities which are for fiat and not for goods and services? They couldn’t. Those liabilities would be entirely only virtual liabilities wrt the general population, not real ones.

    But physical fiat still exists and muddles the argument a bit since in theory individual citizens, businesses, State and local governments, etc. could redeem bank liabilities for inconvenient, unsafe physical fiat (aka “cash”). So for the present one may only say that bank liabilities wrt the public are LARGELY only virtual liabilities.

    So I ask you Mr. Black, how can we have honest accounting with largely only virtual liabilities wrt to the public? Or does honest accounting only matter between banks and others with accounts at the central bank and with the central bank itself?

    • Andrew Anderson

      Correction, last sentence should be:

      Or does honest accounting only matter between banks, the monetary sovereign and the central bank itself? Since only they (and perhaps a few other institutions) may have accounts at the central bank?

    • Andrew Anderson

      Of course if we followed equal protection under the law and allowed every citizen to deal conveniently and risk-free with their nation’s fiat via accounts for all at their respective central banks then naturally the question would arise: “Then why do we need government-provided deposit insurance?” and then the whole scheme whereby the poor, the least so-called creditworthy, are forced to lend (a deposit is legally a loan) to the banks for the benefit of the rich, the most so-called creditworthy, would start to unravel.

      I admit, it is a brilliant* scheme to produce wealth and advance technology but what good will those be if the systematic oppression of the poor leads to WWIII as it did with the Great Depression and WWII?

      * This is, of course, questionable since purchasing power creation schemes, both endogenous and exogenous, that DO NOT oppress the poor are possible.

  4. It might be taboo, but otherwise helpful to consider that “Jeb” as an individual didn’t come up with any “plan.” I say taboo because suggesting an elected official like Hensarling is otherwise working for people who view elections as a rigged formality is unwelcome on most blogs.

    Go with your instincts, the people who put a boot in your face, took your house, took your money, took your health are guarded by the media. No such thing ever really happened like that.

    Jeb already has Bloomberg, the WSJ purveying an easy reading understanding of what’s “sure to be a debate come next year”. This country is hopeless, there’s no voting to get out of this situation, emigrate if possible. They’ll burn through another generation to support their war machine.