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OpEdNews Op Eds    H2'ed 10/7/13

Bank Failures are "Inconceivable" under the Latest Neoclassical Fantasy

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When the CEO causes a bank to become an accounting control fraud he creates three "sure things" if he follows the "recipe."

  1. Grow extremely quickly by
  2. Making bad loans at premium yield
  3. While employing extreme leverage, and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)

The three sure things are that the bank will report record (albeit fictional) profits, the CEO will promptly be made wealthy by modern executive compensation, and the bank will suffer catastrophic losses.  Note that the fraud recipe works by massively overstating asset values.  "Capital" is simply an accounting residual (Assets -- Liabilities = Capital).  This means that accounting control frauds inflate reported capital and simultaneously reduce actual capital when they inflate asset values by making bad loans.  If a material number of bankers mimic the recipe the fraud recipe also becomes the ideal means of hyper-inflating financial bubbles.  This further inflates reported (fictional) asset and capital values and increases real losses.

The losses at accounting control frauds can easily run to 50% of total liabilities even without a bubble.  A bank's overwhelming liabilities, of course, represent deposits.  The speaker was not suggesting that depositors' accounts should be converted to equity.  Contingent capital would be wiped out several times over by the losses that occur in the typical bank that is looted through accounting control fraud before the bank finally admitted its massive losses had rendered it deeply insolvent and belatedly invoked the debt conversion trigger.  The debt holders who purchased the convertible debt would certainly sue and argue that those purchases were fraudulently induced.

What is most appalling about the latest theoclassical fantasy is not simply that it will not work.  The terrifying problems are the ones we have witnessed but theoclassical economists have ignored.  First, complacency in regulation is a disaster-in-waiting.  Regulators that do not believe that banks can fail will fail as regulators.  Second, the theoclassical goal is to cripple banking regulation under the claim that banks will no longer fail.  This maximizes the three "de's" -- deregulation, desupervision, and de facto decriminalization that as George Akerlof and Paul Romer aptly concluded in 1993 are "bound to produce looting" ("Looting: The Economic Underworld of Bankruptcy for Profit").  Third, by implicitly claiming that control fraud is impossible under a contingent capital system the theoclassical economists ensure that the regulators will not spot such frauds and will treat the CEO as if he were Caesar's wife.  Once the regulators defer to the CEO's purported expertise and unquestionable devotion to the shareholders' interests the regulators are set up to fail to spot a control fraud.  The regulators will be taught by their anti-regulatory leaders that the banks' reported asset values, income, and capital are real.

Tyler Cowen: Require Shareholders to Bear Increased Liability for the Bank's Debt

Cowen proposed removing limited liability for bank shareholders in the context of his ode to the systemically dangerous institutions (SDIs), who Cowen asserts are so efficient and safe that they represent national treasures.  I have expressed my contrary view in many columns.  Cowen expressly claims that limiting bank shareholders' limited liability would be ideal because it would justify removing most regulation.

"If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 -- or more -- of losses as insolvency approaches? In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks.

This proposal would shrink the financial sector, while avoiding excess regulatory micromanagement of bank activities.  But it could still be combined with other regulations, like limits on leverage, if deemed appropriate or necessary."

The last sentence demonstrates the degree of Cowen's disdain for financial regulation -- he's not even sure banks should have capital requirements.

Cowen's idea has a historical precedent.  Bank shareholders in the U.S. were once personally liable for the bank's debts to the extent of twice the purchase price of their shares.  Limited liability has, of course, been the norm here and abroad for a very long time.  Neoclassical economists have generally claimed that it is one of the primary reasons for U.S. economic success.  Neoclassical economists have long claimed that shareholders are a poor source of private market discipline and that it would be wasteful and harmful to try to turn them into hybrid investors -- part-equity and part-debt holder.  It is a testament to Cowen's slavish service to the SDIs that he would violate so many neoclassical nostrums he normally holds dear to endorse a system under which our pension funds and insurers (which are some of the largest holders of bank stock) suffered much larger losses rather than the FDIC.

Again, Cowen has ignored the failures of the banks' general creditors and subdebt holders to exert effective private market discipline.  Relative to the shareholders, the banks' subdebt holders should be vastly more competent in providing effective private market discipline because of their much exposure to loss and expertise.  As I have explained, the subdebt holders have consistently failed to provide effective private market discipline.

Similarly, relative to general creditors, the bank shareholders bearing limited, limited liability (capped at $1.50 per dollar of their stock purchase price) under Cowen's plan have far poorer incentives and ability to provide effective market discipline.  Banks are permitted to have very low capital requirements, so their debts are far greater than their shareholders' investments.  The banks' general creditors are primarily insured depositors who have greatly reduced incentives to exert private market discipline.  The SDIs' other major general creditors can include large corporations and financial institutions that purchase the SDIs' commercial paper or provide credit facilities to the large banks.  Under neoclassical theory these non-depositor creditors should have had the correct incentives and the expertise to exert effective private market discipline.

Again, history has shown that private market discipline is an oxymoron when it comes to control frauds.  Lenders, including the purportedly most sophisticated firms, typically eagerly fund the growth of banks that are accounting control frauds because the banks are certain to report record profits if they follow the fraud recipe.  That is why accounting control frauds are able to grow so large and have such great reported leverage.  Because accounting control frauds cause such large losses to the lender and overstate asset and capital values the true leverage of such frauds is dramatically greater than the reported leverage.  Creditors are the principal victim of accounting control frauds.  Cowen's proposal to rely on hybrid-shareholder discipline would fail even worse than relying on purportedly sophisticated creditors to provide private market discipline.  Shareholders are also eager to buy stock in banks that report they are earning record profits "blessed" by a Top Tier audit firm.  The senior officers leading accounting control frauds are expert and exceptionally successful in suborning audit partners of Top Tier firms to provide clean audit opinions to firms that report record profits and minimal losses while actually losing vast amounts of money and being deeply insolvent.

The speaker and Cowen's proposals are criminogenic because they do not understand that broader financial regulation, e.g., a sound underwriting mandate, is essential to limit accounting control fraud.  The speaker and Cowen purport to believe that incentives are the key, but they fail to deal with the four most criminogenic incentives: modern executive and professional compensation, crony capitalism in the form of the SDIs, the three "de's," and the virtual elimination of financial partnerships with joint and several liability.  It is the interaction of these four changes that is driving our recurrent, intensifying financial crises.

If the speaker and Cowen were serious about creating the proper governance incentives for many firms that are related to finance they would be calling for a reform we know works well.  The reform would be to go back to requiring that financial firms be owned in partnership form with joint and several liability.  This was the norm for hundreds of years.  That form of ownership, which classical economists praised, produces superior incentives to limit control fraud, moral hazard, adverse selection, and the creation of Gresham's dynamics.  It also leads the partners to adopt compensation systems that reward long-term perspectives and minimize insider fraud.

The Financial Crisis Inquiry Commission (FCIC) report on the causes of the mortgage fraud crisis contains an extensive discussion of these points.

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
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