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Higher Bank Capital Requirements are Necessary but not Sufficient

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Similarly, after Summers withdrew his name from consideration, Edward Luce wrote to defend Summers' regulatory vigor, arguing that Summers, by 2009, supported "much stricter" bank capital requirements.

Luce explains Summers' theory of regulation.

  "Mr Summers' real bias is his tendency to dismiss smaller regulations as self-defeating. He prefers big and simple to complex and gameable."

The problem I have is with Summers' assumption that "capital" is not "gameable."  Capital is simply an accounting residual: Assets -- Liabilities = Capital.  If a CEO leading an accounting control fraud can "game" assets (by overstating them) and/or understate liabilities, then the CEO will "game" (overstate) capital (and income) -- massively.  Banks, and corporations like Enron, that are massively insolvent and unprofitable can through accounting fraud report for many years that they have record profits and "excess" capital.  The famous 1993 article by George Akerlof and Paul Romer -- "Looting: The Economic Underworld of Bankruptcy for Profit" confirmed the accuracy of what competent regulators and white-collar criminologists had been saying for years.  Accounting fraud was a "sure thing" that mathematically guaranteed the ability to report record (albeit fictional) profits for years, which made the controlling officers immediately wealthy through modern executive compensation.  The firm might fail, but the controlling officers could walk away wealthy.

Summers and many of his supporters still don't understand the most basic aspects of accounting control fraud.  Accounting control fraud epidemics have driven our three modern financial crises (the S&L debacle, the Enron-era frauds, and the ongoing mortgage fraud crisis).  We cannot afford the continuing unwillingness of neoclassical economists to read the work of a Nobel laureate in economics (Akerlof 2001) because of their primitive tribal taboo and ideological dogmas against taking elite fraud seriously.  There would have been a fourth modern crisis had not the S&L regulators driven liar's loans out of the housing industry (on the grounds that they were inherently fraudulent) in 1990-1991 and the S&L debacle would have been massively more expensive had the S&L regulators listened to the economists' claim that fraud by the officers controlling banks was a "distraction."  Note that we did increase S&L capital requirements, but we never made what would have been the catastrophic mistake of believing that accounting fraud could not be used to "game" the higher capital requirements that we imposed.  Our most effective rule restricted growth -- it killed the remaining accounting control frauds even when Congress prevented us from gaining additional funds to close the remaining frauds.

Now that we can at least hope that the administration will cease attacking one of its most successful appointees, Janet Yellen, it is my hope that we can have a serious discussion about what it takes to be an effective financial regulator.  We know how to do it.  We showed how to do it in even more hostile circumstances in which the Reagan administration was virulently opposed to our actions "reregulating" the S&L industry.  Indeed, they called us "reregulators" because they considered that term to be the most repugnant, the most redolent of incomprehension, term in their lexicon with which they could insult us.

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Summers and his supporters and Yellen and her supporters should talk with us at length and take advantage of what we learned, including the mistakes we made.  Restoring effective regulation, supervision, and prosecutions of elite bankers is one of the most important tasks our Nation faces.  The arrogance of the last three administrations in the regulatory context is staggering.  Never have officials boasted so much about their purported "genius" while promoting policies that proved so destructive -- and then cashed in and gotten rich through ties with the CEOs that grew wealthy by directing the control frauds that caused the mortgage fraud crisis.

My view is that if a "genius" economist cannot maintain the batting average of a journeyman batter (.250) they not only are not a genius, they are the guy that gets cut from the minor league team because they cannot hit a curve.  The last three administrations and the Washington, D.C. (non) "think tanks" have been filled with economists with (predictive) batting averages of around .125 and weak gloves and errant arms -- all of them supposedly brilliant.  There were hundreds of Office of Thrift Supervision examiners whose opinions repeatedly proved vastly superior to the economists' predictions during the S&L debacle.  Akerlof and Romer concluded their 1993 article with these sentences in order to emphasize this message to their peers.

"The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the [deregulation] of the 1980s were 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" (Akerlof and Romer 1993: 60).

Larry and Janet:  please listen to the regulators in the field.  Please end Ben Bernanke's practice of placing economists in charge of Fed supervision.  The Fed's economists are a major source of the Fed's problems.  They are not the solution.  If they are transformed they can be part of the solution, but the solution needs to come from the people in the field.  That is particularly true with regard to detecting systemic risks.  End of the glaring conflict of interest in having your examiners and supervisors be employees of the regional Fed banks which are owned by the banks they are supposed to examine and supervise.

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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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