Too Big to Regulate: Systemically Dangerous Institutions – the U.S., Iceland, and Ireland


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by William K. Black, Benzinga

This column was prompted by Thomas Hoenig’s December 1, 2010 op ed in the New York Times (“Too Big to Succeed”) warning that we must end banks that are “too big to fail.”

Mr. Hoenig is the President of the Federal Reserve Bank of Kansas City, and I am a professor of economics and law at the University of Missouri-Kansas City, so the reader may suspect that my profound agreement with much of his reasoning is the product of rooting for the home team. I have held the same views on this issue, however, for decades (and I only moved here four years ago).

I will focus on the profound, negative consequences that the “systemically dangerous institutions” (SDIs) pose for effective financial regulation using the examples of the U.S., Ireland, and Iceland (so this is in part a follow-up on our recent discussions in Kilkenny, Ireland at the Kilkenomics Festival). I call these banks SDIs because “systemically important” is a dishonest euphemism. The administration claims that the failure of any U.S. SDI is likely to cause a systemic, global financial crisis. That means that they are dangerous.

The SDIs led the charge against effective financial regulation and supervision. They produced the repeal of the Glass-Steagall Act and the passage of the Commodities Modernization Act of 2000 (which placed credit default swaps into a regulatory black hole).

At the international level, the SDI led the travesty that was Basel II. The anti-regulators that administered the Basel II process decided to invite the SDIs into the standard-setting process – with predictable results. At the same time that the SDIs were massively increasing their risks, the Basel II standards substantially reduced their capital requirements, placed increased reliance on credit rating agencies, and encouraged banks to create models to value their own assets. The result was an enormous growth of SDI leverage, grotesquely inflated credit ratings for financial derivatives created and sold by the SDIs that were backed by pools of “liar’s” loans (toxic waste became “AAA”), and ludicrously inflated asset values at the SDIs. Bank leverage was even more extreme in Europe than in the U.S.

The SDIs had so much power here that they induced a bipartisan House coalition to work with the Chamber of Commerce and Fed Chairman Bernanke to extort the Financial Accounting Standards Board (FASB) to gimmick the accounting rules to hide the banks’ real losses. The European SDIs had similar success in perverting international accounting standards. We have given hidden subsidies (via preferential loans by the Fed) measured in the trillions of dollars primarily to the SDIs, but also to large corporations, hedge funds, and even exceptionally wealthy individuals whose failures would cause severe losses to the SDIs. The claim that TARP solved the banking problem for $35 billion is dishonest. It ignores the hundreds of billions of dollars in hidden losses on the banks’ and the Fed’s books.

The banks’ failure to provide even remotely adequate general loss reserves (ALLL) is one of the great scandals of the crisis. GAAP was very weak (in practice) on ALLL, but international accounting standards were even worse. Nevertheless, no effective reforms have occurred or are scheduled to occur. The SDIs are all in favor of “cookie jar” reserves, but they oppose any obligation to place – and maintain – adequate loss reserves.

Rather than fixing our comprehensively broken system, the Dodd-Frank Act does not address effectively the fundamental factors that cause our recurrent, intensifying crises. Executive compensation creates perverse incentives and has gotten worse (it is even more heavily based on short-term (fictional) reported bank income than a decade ago). SDIs have grown even larger. Professional compensation (which “control frauds” manipulate to suborn the appraisers, auditors, and rating agencies that “bless” massively inflated asset values) is virtually unchanged. Accounting, the “weapon of choice” among financial control frauds, is substantially worse than before the crisis. No elite manager controlling the large, fraudulent nonprime lenders or related financial derivatives that caused what the FBI aptly termed the “epidemic” of mortgage fraud has been prosecuted. The SDIs have blocked fixing the things that are broken.

Even the discredited rationale for the continued existence of the SDIs is reappearing – the international “competition in regulatory laxity.” Because Germany allows its “universal” banks to be self-destructive and inefficient SDIs, we should allow our banks to become self-destructive and inefficient SDIs. The German SDIs funded the most destructive loans in Eastern Europe and the EU nations in crisis – Portugal, Ireland, Greece, and Spain. The Fed secretly intervened twice to cause American taxpayers to bail out the German SDIs. First, the Fed ordered that AIG pay Goldman Sachs and the foreign SDIs 100 cents on the dollar on their credit default swaps (and then ordered AIG not to tell the public and Congress about the decision). Second, the Fed secretly bailed out several foreign SDIs, including the largest German SDI, through huge loans based on more than dubious collateral.

Basel III’s (modest) increases in capital are being phased-in over a decade because the German SDIs are so weak (a euphemism for insolvent). The German government indicated that it would block increased international capital standards unless its banks were given many years to comply. The last thing the U.S. should do is to allow American SDIs to compound the global risk posed by non-American SDIs.

Ireland and Iceland demonstrate that when SDIs become large enough they inevitably dominate their regulators, the general economy, and their governments. The regulators will never have the resources or the national will to place the SDIs in pass-through receiverships prior to catastrophe.

SDIs also cannot be examined effectively. They are so large that an annual full scope examination – which is essential for an SDI – would take over a year to complete with the regulatory resources that might realistically be made available. The alternative – placing an examination force permanently in the headquarters – has always failed because the examiners “marry the natives.” The SDIs are too big to regulate.



Other articles by Bill Black:
The Bank of England Sows The Seeds Of The Next UK Crisis
The Irish Crisis and the Latest Silver Bullet Solutions
The Celtic Chimera

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.