The New Book on Regulation I Just Decided to Write: Blame it on Monaco

April 30th, 2014
in Op Ed

by William K. Black, New Economic Perspectives

This is the third article in a series of columns devoted to financial regulation prompted by the comments of a Swiss academic at the XIIth Annual CIFA Forum in Monaco. (See first here and second here.)

Having spent 20 years as a non-academic professional, I still find it odd the directions in which a single speaker or writer can start an academic on a convoluted path of research that spans multiple disciplines and eras and produces a series of “light bulb” analytical moments. And that prompts a digression into a symptom of the problem illuminated by that series of moments that has led me to decide to write a book on regulation.

Follow up:

A Digression on Brooks, Greed, Curiosity, Academics, and Regulators

In David Brooks’ April 11, 2014 column, Brooks tells us that Michael Lewis’ most recent book about high frequency trading (HFT) abuses is “really a morality tale.”

It’s nominally a book about finance, but it’s really a morality tale. The core question Lewis forces us to ask is: Why did some people do the right thing while most of their peers did not?”

Brooks claims that the reason only a few people in finance act morally is that so many of them are focused exclusively on making money that only a few of them are curious.

The answer, I think, is that most people on Wall Street are primarily motivated to make money, but a few people are primarily motivated by an intense desire to figure stuff out.

Brooks explains why curiosity is a wonderful thing.

Most of us have at one time or another felt ourselves in the grip of the explanatory drive. You’re confronted by some puzzle, confusion or mystery. Your inability to come up with an answer gnaws at you. You’re up at night, turning the problem over in your mind. Then, suddenly: clarity. The pieces click into place. There’s a jolt of pure satisfaction.”

The “profit motive” (which Brooks will soon call “greed”) is an insuperable barrier to curiosity and “knowledge.” Only a tiny group of people with the “intrinsic desire” for knowledge can triumph over their immoral peers.

Knowledge is the deeper understanding of how things work. It’s obtained only by long and inefficient study. It’s gained by those who set aside the profit motive and instead possess an intrinsic desire just to know.

The heroes of Lewis’s book have this intrinsic desire.”

Brooks then claims that this rare passion (“love”) for knowledge that motivates this literal handful of financiers also inoculates them from immorality and predisposes them to be driven to “fairness.”

If everybody is just chasing material self-interest, the invisible hand won’t lead to well-functioning markets. It will just lead to arrangements in which market insiders take advantage of everybody else. Capitalism requires the full range of motivation, including the intrinsic drive for knowledge and fairness.

Second, you can’t tame the desire for money with sermons. You can only counteract greed with some superior love, like the love of knowledge.”

Yes, Brooks has recirculated the concept that a handful of “philosopher kings” are all that stands between us and moral ruin (plus endemic financial fraud and recurrent crises). Regulators, of course, are not eligible to be part of this elect.

“[I]f market-rigging is defeated, it won’t be by government regulators. It will be through a market innovation in which a good exchange replaces bad exchanges, designed by those who fundamentally understood the old system.”

As I have warned repeatedly, anyone who uses military metaphors that assert that fraud can be “defeated” in any field for eternity is sure to be peddling snake oil. But my question is why Brooks thinks he can get away with simply asserting as if it were a fact that regulators are incapable of curiosity and never have a “jolt of pure satisfaction?” Why does he think academics aren’t even worthy of his back-of-the-hand dismissal of regulators? Why does he think elite white-collar financial frauds aren’t curious and don’t get a “jolt of satisfaction” when they figure out how to suborn an employee and turn the “market innovation” that “defeated” “market-rigging” into an optimal means of “market rigging” that thrives on the philosopher kings’ complacency.

We Know Why the CEOs Leading Control Frauds Fear Regulators and Prosecutors

There’s no mystery why Charles Keating ordered his thug to make his “Highest Priority” the effort to “GET BLACK … KILL HIM DEAD” (all caps in original). He viewed us as the regulatory cops on the beat that could stop his fraud schemes, recover any remaining proceeds, and imprison him. There’s also no question but that Keating viewed us as having vastly too much curiosity, dedication, and competence and too little greed for his liking. Theoclassical economists have mounted an unholy war to discredit and intimidate regulation and regulators – and to replace them with anti-regulators – for over a century, as Nomi Klein documents in All The Presidents’ Bankers.

In the recent crisis, Clinton and Bush appointed anti-regulators who created a self-fulfilling prophecy of “regulatory failure.” It would be absurd to infer from such a planned failure that regulation must fail. If you had let me appoint Charles Keating to run any corporation in the world the result would have been a catastrophic failure – that does not mean that private ownership must fail. Clinton and Bush ran financial regulation by appointing the equivalents of Vidkun Quisling as our anti-regulatory leaders.

The mystery is why progressives, moderates, and conservatives have given up on regulation and regulators. Classical economists – and Ayn Rand, von Mises, and von Hayek – agreed that the government should prohibit and prosecute fraud. The consequences for honest business people of failing to prevent widespread fraud are often disastrous because it can create a “Gresham’s” dynamic in which bad ethics drives good ethics from the markets and professions. Our paramount job as financial regulators is to seek to detect and sanction elite control frauds so that we prevent such a Gresham’s dynamic by preventing cheaters from gaining a competitive advantage. George Akerlof explained the dynamic in his classic 1970 article on markets for “lemons” (often an example of an anti-purchaser control fraud).

“[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” (Akerlof 1970).

Non-economists have observed the Gresham’s dynamic long before Akerlof’s article.

The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage” (Swift, J., Gulliver’s Travels).

In future columns in this series I will provide examples of frauds becoming ubiquitous. Recall that I demonstrated in the first piece in this series that SEC investigators found that the CEOs and/or CFOs were involved in over 90% of the securities fraud cases in which the SEC took and enforcement action. Competent regulatory “cops on the beat” who root out control frauds are not simply helpful to honest businesses – they are essential to their ability to survive and prosper.

The widespread view that regulation is hopeless because regulators are sure to fail to stand up to the banks or hopelessly late to understand changes in banks is false. George Akerlof and Paul Romer researched that claim in the course of preparing their 1993 article entitled “Looting: The Economic Underworld of Bankruptcy for Profit.” They concluded:

The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations 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 & Romer 1993: 60).

With the advantage of hindsight from the scale of the current crisis we can finally begin to appreciate the many trillions of dollars saved because of the periods of effective financial regulation, supervision, enforcement, and criminal prosecutions that contained the S&L debacle. Effective S&L reregulation began Bank Board Chairman Edwin Gray during the Reagan administration (much to its horror) in late 1983. That was one year after the bipartisan passage of the Garn-St Germain Act of 1982 that triggered the state vs. federal regulatory “race to the bottom” that made the industry so criminogenic. The first act of effective reregulation in the current crisis began to become enforceable in 2009 – 16 years after the Clinton/Gore administration’s anti-regulatory assault under the guise of “Reinventing Government” began in 1983. The S&L debacle cost under $150 billion. The current crisis in America caused over $11 trillion in losses in household wealth, over $20 trillion in lost production, and over 10 million jobs. Effective financial regulation costs very little and its benefits are extraordinary.

Successful regulation is not limited to efforts to prevent, identify, and sanction financial frauds. Many forms of control fraud or non-fraudulent business practices maim and kill. Safety and anti-pollution regulation anti-smoking campaigns have saved the lives of hundreds of thousands of people.

The Folly of Defeatism

The claim that the political and financial power of Wall Street guarantees regulatory failure is only superficially appealing. Take the proposition into an even more asymmetrical power context. I am sure there were some “realists” in the leadership of the North Vietnamese government who claimed that it was a fool’s errand to fight the Americans in South Vietnam. The U.S. was so much more powerful militarily and so much richer that it could simply bribe enough North Vietnamese leaders to assure victory. The U.S. had bounties for Viet Cong and NVA troops willing to switch their loyalties and an active, accomplished assassination program against leaders who refused to support the U.S. The NVA, nevertheless, fought tenaciously and the U.S. abandoned the fight.

We would consider it preposterous, if the U.S. were contemplating defending itself from attack by Saudi Arabia’s army, to assume that we would fail because the Saudis were so wealthy that they could successfully bribe the U.S. military officers responsible for the conducting the defense. We expect – and we receive – the loyalty of our armed servicemen and women of all ranks to the Nation. The one famous exception to that rule in our senior officer corps, Benedict Arnold, remains a name of shame well over 200 years after his treason. Every American student is taught about Arnold’s treason. No one is taught in school how Danny Wall, Lee Henkel, Dick Pratt, Darrel Dochow, James (“Chainsaw”) Gilleran, and John Reich were chosen as senior OTS leaders because of their willingness to betray the Nation’s interests. We need walls of shame and praise and we need to bring high expectations and accountability to our regulatory leaders.

It is time that we expect – and demand – the loyalty of our regulators to the Nation. There is a military code and ethos of loyalty and discipline. Traitors exist, but they are rare and they are despised because they have betrayed the Nation, the Service, and their peers. Regulators and prosecutors that betray the Nation to aid the banksters need to face the same opprobrium, but mostly we need to create a culture of professionalism and integrity that will help resist even the efforts of the worst anti-regulatory leaders.

Again, the key is not to give in to defeatism. By providing that kind of professional resistance to anti-regulatory leaders who lacked integrity and courage we prompted the resignation in disgrace of the head of our agency (M. Danny Wall) and a Presidential recess appointee to the Federal Home Loan Bank Board (Lee Henkel) and the reassignment of the national head of supervision (Darrel Dochow) that was effectively a dramatic demotion. The Bank Board’s successor agency, the Office of Thrift Supervision (OTS) later issued a formal enforcement order that “removed and prohibited” Henkel from federally-insured financial institutions. Conversely, Dochow was brought back to power by the anti-regulators appointed by President Bush to run the OTS – who were made aware of Dochow’s cowardice in the face of Charles Keating. (I am not arguing that Dochow should have treated Keating as the “enemy,” but Dochow should have protected the Nation from Keating rather than surrendering to his demands to be able to violate the law with impunity.)

The seductive aspect of the problem we need to turn around is the view that the anti-regulators of Clinton and Bush have been pushing for two decades – that the bankers are our friends (“customers”) and the job of regulators is to work in “partnership” with our banking “customers.” The banks and bankers are not our “enemy” and we are not at “war.” No one, even fraudulent bankers, is our “enemy” when we are regulators. The banks and bankers, however, are not our “customers” when we are financial regulators. Our allegiance must be to the Nation.

The “Jolt” in Monaco about Regulation and Regulators

In Monaco last week I was treated to a display of heartfelt rage by Dr. Hans Geiger, a Swiss academic who sits on the European Shadow Financial Services Committee (EU Shadow). This article is the third in a series of article prompted by my research that was sparked by trying to understand the root of Geiger’s rage. Geiger was disgusted by anyone who worked for the government – they were all “bureaucrats” to him – because all democratically-elected governments are illegitimate thugs acting as “big brother.” His ire was particularly directed to efforts to regulate and prosecute tax frauds aided by Swiss banks. Geiger despises taxes because they allow the government to exist. He does not view U.S. citizens who engage in actions that constitute tax fraud under U.S. law with the aid of a Swiss bank to be committing a crime from the Swiss perspective. Geiger was most distressed by the potential requirement that Swiss banks file criminal referrals against customers engaged in tax fraud. In an article, he has also proposed ending any governmental requirements that banks not aid money laundering, terrorist financing, and financial dealings with internationally sanctioned nations and entities. His cri de coeur elicited considerable support from the audience.

Geiger’s plea led me into days of research about what has become of financial regulatory theory among economists and finance scholars and lawyers. I am appalled by the current state of thinking. I think it is wrong substantively and that it fails even the most basic test of internal logical consistency. Worse, it has become a major force reinforcing the problem of anti-regulatory leaders who create a self-fulfilling prophecy of regulatory failure. I have yet to find a leader of the assault on financial regulation and regulators who was ever a successful regulator. Indeed, there are only a handful of academic or regulatory defenders of effective financial regulation.

My Personal and Familial Responsibility for Geiger’s Pain

Geiger also forced me to confront my personal and familial culpability for his cry of pain. It gradually dawned on me that I came from an entire family of “bureaucrats” – moochers who had worked, or do work, for the government (aka “big brother” as Geiger repeatedly snarled). I am a “bureaucrat” as were my dad, my brothers, my dad’s brothers, my wife and her brother, her dad, and her cousins, our sister-in-law, our sons, and our daughter-in-law

I am a government employee. Indeed, I am a serial offender. I had summer jobs with the Postal Service as a substitute letter carrier and NASA at the Goddard Space Flight Center (which is based in Greenbelt, Maryland) – the original test bed of FDR and Tugwell’s plan for “greenbelt cities.” I was a Justice Department Attorney, the Litigation Director of the Federal Home Loan Bank Board, the Deputy Director of FSLIC, the Senior Vice President and General Counsel of the Federal Home Loan Bank of San Francisco, and the Deputy Staff Director of the National Commission on Financial Institution Reform, Recovery and Enforcement. I have been a government employee as a professor at the University of Texas at Austin (the LBJ School of Public Affairs) and the University of Missouri-Kansas City. All by myself I must have made Geiger’s “bureaucrat” counter go off the scale.

I’m married to a fellow-recidivist. June (Carbone) was a law professor at George Mason University, UMKC, and now at the University of Minnesota. She also worked for the Department of Justice.

My Dad, my dad’s brothers, my brothers, and a flock of June’s cousins (who are a generation older than she is) were all government employees – “bureaucrats” almost literally working for “big brother.” More precisely, they were working for “Uncle Sam” as soldiers, sailors, and airmen of the Army Air Corps. One of these moochers was awarded the Bronze Star for gallantry as commander of a Sherman tank that destroyed over a dozen pillboxes. The Sherman was also known as the “Ronson” because its gas tank had a nasty habit of exploding when the tank was hit (and it had neither the thickness or sloping of armor to prevent the penetration of high velocity and shaped charge German tank and anti-tank weapons).

Another was a navigator on a bomber in the European theater of operations. He beat the odds and survived his 20 mission tour. One of the places he bombed was the ball bearing plants at Schweinfurt, the city where one of my brothers was based years later. His unit’s base was easily within 155mm artillery range from the not-so-democratic German non-republic (DDR). His unit’s function, as with our troops in Berlin was euphemistically referred to as acting as a “tripwire.”: In plain English, their function was to ensure that enough Americans would die in the first assault of Warsaw Pact forces that it would be politically impossible for the U.S. not to honor its NATO commitment to defend the Federal Republic of Germany (BRD). Our daughter-in-law was in the Army at the same base. It was their great hope that if war came there would be time to evacuate their children from base housing to America before the shooting began.

My uncles, my other brother, and many of June’s male cousins served in a wide range of theaters. My Dad was on his way to prepare to invade Japan when the war ended.

Our eldest son worked for Treasury doing anti-money laundering and sanctioning folks like the Burmese Junta. He was based for weeks in our consulate in Guadalajara doing anti-money laundering. Your “security” consisted of having a very heavy car assigned to you when you drove. 5.56mm rounds would generally fail to penetrate, but an RPG or even a light machine gun would seriously mess up your day. If the cartels snatch you your corpse is generally found hung from an overpass after two-days of torture. Your head is usually dumped with a group of other heads to maximize the terror.

Our youngest son works for a state educational facility for the blind. He generally works as an aide helping to teach life skills to kids who are both blind and deaf. It isn’t like Helen Keller. It is rare for such children to be able to read braille. The children often act out physically in ways that endanger them, their classmates, and the aides. The pay is poor. June’s brother worked as a VA psychologists with those scarred emotionally by the trauma of their service. If there is a God I trust she will recognize similar caring souls.

Our daughter-in-law is a newly minted lawyer who worked as a prosecutor. Like me (but more directly because she was actually prosecuting the cases), she worked, as Geiger would phrase it, to remove the liberty of people. Some people who commit serious crimes should suffer a loss of liberty and they should certainly be kept from committing those crimes repeatedly.

So, from Geiger’s perspective my family and I represent the “bureaucratic” minions of “big brother” coming to deprive the rich and powerful of their natural right to commit crimes with impunity. I confess that I do not feel even slightly guilty about the service my family and I have provided to the United States of America. I will also tell you that I have never heard any of the family members I have described, including the Bronze Star recipient, ever make the slightest boast about that service or make the most minimal claim to heroism. I don’t know if they represented “the greatest generation” in U.S. history but they represented the greatest generation I had the great fortune to know and love.

I also make no claim that our family is anything other than a typical American family. I tell our story because it is so common and normal. I realize that other families suffered vastly greater losses to loved ones due to their service. We have been lucky so far. None of the family members I mentioned were killed or seriously wounded in their service.

I also confess that I am tired to the bone of hearing Ronald Reagan’s thoroughly dishonest “joke” that the scariest words in the English language are “I’m from the government, and I’m here to help you.” Every day firefighters go into burning and smoke-filled houses to rescue strangers, police officers respond to calls for help that may turn into murderous assaults on them, social security workers efficiently walk you through what you need to get care for your mother with advanced Alzheimer’s, teachers strive to help your kids learn, and financial regulators (if they do not have anti-regulators as leaders) try to protect all of us from massive frauds. The real joke is the phraseI’m from Goldman Sachs, and I’m here to make you rich.”

Everyone I mentioned in my family has also worked in the private sector. We like honest business people. We want them to be free of a Gresham’s dynamic that can cause them to fail and the immoral to gain a competitive advantage. It is not acceptable that the people most likely to denounce the fictional assault on elite frauds as akin to “big brothers” feel free to denounce government workers for the “sin” of upholding the rule of law against elite frauds.

The Paradox of Desirable Reforms Freighted with Disastrous Ideological Baggage

The dominant financial anti-regulatory paradigm has become that set by George Kaufman, a fierce foe of effective financial regulation and regulators. Kaufman is most known for his proposal to mandate that financial regulators take “prompt corrective action” (PCA) against a bank as its reported capital falls. PCA is a desirable concept that I have long supported, but it comes with implicit anti-regulatory dogma that has encouraged the anti-regulatory policies that made banking so criminogenic and cause our recurrent, intensifying financial crises. PCA also has an Achilles’ “heel” – accounting control fraud – the very problem that it’s ideological baggage helps to create. It is the rare economist who can surmount the field’s primitive tribal taboo against taking “fraud” seriously. My rule of thumb is that if they do not discuss Akerlof and Romer’s 1993 article on “looting” in the main text, ignore entirely the criminology literature, and fail to interview Ed Gray, Jim Cirona (recently deceased), Mike Patriarca, Chris Seefer, or me about fraud and regulation then the researchers are not making a serious, professional effort to understand what causes banking regulation to succeed or fail.

I show in subsequent articles in this series that PCA’s ideological freight also breeds deadly complacency. The various Shadows’ blind faith in their PCA plans caused them to claim that PCA had made expensive banking failures a thing of the past. When the largest banks instead suffer unprecedented, catastrophic losses due to epidemics of accounting control fraud their CEOs led, the theoclassical economists go into denial and suggest tweaks in PCA that ignore the gaping hole in their policy nostrums through which the fraud epidemics that produce our recurrent, intensifying financial crises surge.

Anat Admati and Martin Hellwig have proposed a plan in their book (The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It) that is similar to Kaufman’s plan. They would greatly increase bank capital requirements in order to encourage the bank and its regulators to promptly correct any defects before the bank deteriorates to the point that it would require public funds to resolve its problems. The Brown-Vitter (BV) bill purports to be based on their proposals and Admati and Hellwig support it. BV actively makes bank examiners more vulnerable to attack, particularly by large, fraudulent banks. It too breeds complacency and carries ideological freight that would make banking even more criminogenic. It has the same Achilles’ heel as PCA to the epidemics of accounting control fraud that its anti-regulatory policies would encourage and the same unwillingness to take fraud seriously even after it blew up the global economy.

  • Should bank capital requirements be greatly increased? “Yes,” not “yes, but….”
  • Are the conventional finance arguments against increasing bank capital bogus? “Yes,” not “yes, but….”

Indeed, I will argue in a future article that Admati and Hellwig greatly understate the case for increased capital requirements because they base their argument primarily on the Modigliani-Miller Theorem, when their analysis demonstrates that it is false. Very highly leveraged banks pose severe negative externalities.

The problem is the criminogenic anti-regulatory freight that comes with BV. Some of it is express, but much of it is unacknowledged because it is implicit. None of the freight is logically necessary or even desirable to the sound bases for calling for greatly increased bank capital requirements, but Admati and Hellwig have neither shed nor debunked the ideological freight that has so badly derailed PCA’s excellent core ideas – raise bank capital requirements dramatically and place failing banks in receivership earlier. I remain hopeful; however, that if we have an opportunity to discuss the policy issues we will be able to reach agreement. Defeatism is not in my nature. Their central insight is sound. The ideological freight is not simply unnecessary to that insight but hostile to it. As I explained last year, Brown-Vitter piles even more dangerous dogmas on top of this destructive ideological freight.

Brown and Vitter have never contacted me in response to my article pointing out the problems with their bill. I do not believe that they have amended the bill to the address the problems.









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