How the US Congress is Sowing the Seeds of the Next Crisis

I wrote recently about the Bank of England sowing the seeds of their next banking crisis by deciding to reduce bank examinations. 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."

These comments share several characteristics. First, they demonstrate that many people in positions of power have not only learned the necessary lessons from the on-going crisis — they have learned the worst possible lessons. Second, the comments reprise disastrous approaches that allowed the crisis to occur. Third, the comments represent the continuing triumph of ideology over facts. Fourth, the comments rely on false dichotomies that are the enemy of reasoning and good policy.

1. The U.S. and much of Europe have suffered a crisis of great proportions after they adopted deregulation, de-supervision, and the de facto decriminalization of financial firms. For the U.S., this is our third major financial crisis in 20 years brought on by those triple "de’s." The incoming chairs’ response to these crises is increased deregulation and de-supervision (and no mention of prosecuting the control frauds driving the crises). What would it take to discredit policies that produce recurrent, intensifying crises?

2. The bipartisan "Reinventing Government" movement of the 1990s (championed by then Texas Governor Bush and Vice President Gore) led the senior leaders of the banking regulatory agencies to order their staff to refer to the industry as their "clients" or "customers." It became a major agency priority to make those clients happy with the regulators.

That policy became even more destructive during the Bush administration, which chose regulatory leaders based on the intensity of their opposition to vigorous supervision. SEC Chairman Pitt’s first major speech was before a group of accountants. He expressed his regret that the SEC had not always been a "kinder and gentler" place for accountants and blamed his agency for not showing accountants more love.

The Office of Thrift Supervision’s (OTS) head, "Chainsaw" Gilleran, posed with the three major banking lobbyists and the number two guy at the FDIC (who was Gilleran’s successor) over a pile of federal regulations. Everyone held pruning shears, except Gilleran, who demonstrated the indiscriminate nature of his hate for regulation by holding a chainsaw.

It is no surprise that among insured depositories the largest accounting control frauds were regulated by the OTS (where "regulated by" translated into "not regulated by"). The OTS went so far in its efforts to "serve the banks" that it encouraged or knowingly permitted several insolvent banks to file false financial statements relying on backdated entries.

The federal banking regulatory agencies "serve[d] the banks" by pre-empting state efforts to regulate abusive, predatory, and fraudulent lending. The federal banking regulatory agencies even tried to pre-empt State Attorney General lawsuits against the leading mortgage frauds.

Similarly, the SEC "serve[d] the [investment] banks" by creating the Consolidated Supervised Entities (CSE) program for the purpose of protecting them from serious regulation by the European Union. The CSE program was a sham. The SEC staff assigned to examine the largest investment banks in the U.S. were not examiners and did not examine the investment banks. No one believed they could because the staffing level was farcical.

Banks do not need regulators to "serve" them? There is no appropriate function in which we serve banks. There are many destructive ways in which anti-regulators would serve the interest of fraudulent banks.

3. Representative Paul’s claims epitomize the triumph of ideology over fact: "The market is a great regulator, and we’ve lost understanding and confidence that the market is probably a much stricter regulator." No, the "market" is not a "great regulator" and the on-going crisis is only the latest example of that point. Efficient, non-fraudulent markets would be a very good thing. Inefficient, markets with fraudulent participants can be a catastrophically bad thing.

The "market" also does not deal effectively with externalities (and they can be lethal) and with market power. The neoclassical claim that cartels cannot persist and that potential entry solves prevents all serious ills proved false in the real world. Here, however, I will discuss only why control fraud turns "markets" perverse. Accounting control frauds are guaranteed to report high profits in the early years. This is why Akerlof & Romer (1993) agreed with white-collar criminologists that such frauds were a "sure thing." I’ve explained why the four-part recipe for optimizing fictional accounting income maximizes executive bonuses — and real losses. In the interest of brevity I will merely mention four ways in which accounting control frauds make markets, and "private market discipline" perverse.

1. The fictional profits fool creditors and shareholders — they are eager to lend to and invest in firms reporting record profits. Rather than discipline accounting control frauds, creditors and shareholders fund their massive growth.
2. The fictional profits and the large bonuses they drive create a "Gresham’s" dynamic in which bad ethics tends to drive good ethics out of the marketplace. The CFO that fails to emulate the fraud recipe will report far lower profits in the near term and will fear losing his job. More junior executives whose compensation is based on the firm’s reported income have perverse incentives to engage in accounting fraud to ensure that the firm "hits the number" and have reduced incentives to blow the whistle on frauds.
3. Lenders engaged in accounting control fraud create "echo" epidemics of fraud. They use their powers to hire and fire and create compensation systems to create perverse incentives in other fields: among their employees, "independent" professionals, and agents (e.g., loan brokers).
4. When several large lenders follow similar fraud strategies they can hyper-inflate financial bubbles.

Anti-consumer control frauds can also turn markets perverse by creating Gresham’s dynamics. Chinese infant formula provides a good example. Dishonest firms drove honest firms from the market — maiming hundreds of thousands of infants’ health.

In the case of nonprime loans, for example, both principals (the borrower and the lender) typically lost utility as a result of the loan — reverse Pareto optimality. The unfaithful and fraudulent agents, however, won big.

Even when private market discipline did finally kick in it did not perform as advertised. Instead of differentiating between good and poor credit risks and honest v. fraudulent actors it simply shut down hundreds of markets.

Rep. Paul’s comparative statement — implying that the markets were tougher regulators than the regulators — fails on two bases. One, as pathetic as the anti-regulators were, they were commonly better than the market, e.g., warning about concentrations in commercial real estate well before the crash. Two, claiming that regulation is a failure because the ideological foes of regulation controlled the agencies and so completely de-supervised the financial sector so completely that they created a self-fulfilling prophecy of regulatory failure is an act of chutzpah.

4. Rep. Paul’s other remark, however, illustrates the false dichotomies that underlie the ideological assault on regulation. He notes that we "need law and order." He thinks that proves we don’t need regulation, but it proves the opposite. The banking regulators are the "cops on the beat." We have nearly a million police and guards that deal almost exclusively with blue collar criminals. Control fraud creates a Gresham’s dynamic because it means that cheaters prosper.

As regulators, we do "serve the [honest] banks" by taking away the ability of the cheaters to prosper — when we regulate effectively. The OCC and the OTS did zero criminal referrals during the current crisis. We did thousands as regulators during the S&L debacle. We prioritized the most severe frauds (the large control frauds) and made the support of criminal prosecutions a top agency priority. The result was over 1000 priority felony convictions of S&L elites. Without the regulators’ expertise the FBI cannot possibly stop an "epidemic" of mortgage (FBI House testimony, September 2004). In the on-going crisis, the Department of Justice, denied regulatory support and relying instead on the Mortgage Bankers Association – the trade association of the "perps" — has secured zero convictions of any senior officers of the large lenders specializing in nonprime lending/securitization.

Effective regulations and regulators are not the enemy of private markets or private market discipline, but rather one of the essential requirements for efficient, honest markets in a modern economy.

This article first appeared at the weekly column at the Huffington Post.

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist and was a senior financial regulator. He is the author of The Best Way to Rob a Bank is to Own One.