Bank Failures are "Inconceivable" Under the Latest Neoclassical Fantasy

Only theoclassical economics constantly recycles variants of its worst ideas that have proven disastrous when they have influenced policy. Other fields advance because they embrace the scientific method. Theoclassical economists repeat their worst errors because they embrace anti-governmental dogmas that blind them to the inherent weaknesses of the corporate form and limited liability. This represents a dramatic regression in understanding from over 200 years ago when classical scholars like Adam Smith were warning that corporations were inherently criminogenic and likely to produce what we now label “control frauds.”

I have just experienced two related examples of this regression in understanding by economists of the inherent risks of corporations and control fraud in the context of financial corporations. Both of the economists admit that corporate governance is flawed but implicitly assume control fraud out of existence and explicitly assume that the problems with governance are not inherent and can be remedied by moderate tweaks. As I will show, the tweaks are actually radical, but so badly designed that they would be even more criminogenic than the highly criminogenic status quo. The first proposal, “contingent capital” was presented by a more junior scholar who will remain nameless. The second proposal, limiting limited liability for bank shareholders, was suggested by Tyler Cowen. I ran across Cowen’s proposal to limit bank shareholders’ limited liability while researching my response to his newest claim that our largest financial corporations represent the leading wave of our future as a “hyper-meritocracy.”

http://neweconomicperspectives.org/2013/10/hyper-meritocracy-oxymoron-led-criminal-morons.html

Contingent Capital: and The Princess Bride

A speaker whose talk I attended stated as a fact that it would be “inconceivable” for any bank to fail if banks adopted “contingent capital.” Under “contingent capital” the bank would sell debt instruments that would convert to equity under a specified “trigger.” The trigger would be the bank’s reported capital falling below some threshold that the speaker did not identify. The theoclassical theory is, as always, the creation of “private market discipline” to prevent bank failures. The most catastrophic bank failures (the ones that drove the global financial crisis) are “accounting control frauds.” The speaker’s theory ignored fraud (the word never appeared). His thesis was that because the debt holders who would be converted into stockholders and the existing shareholders would suffer severe losses if the conversion were to occur, the stockholders and the convertible debt holders would have powerful incentives to prevent the bank’s capital from ever falling to the level that the trigger would force the conversion. The speaker assumed that the problem with banking is moral hazard and implicitly assumed that moral hazard leads only to excessive risk-taking rather than the “sure thing” of control fraud. He further assumed that the CEO controlled the bank and that the shareholders lacked the proper incentives to discipline the CEO’s excessive risk-taking. Contingent capital would purportedly address both problems by increasing the amount of bank capital and putting shareholders at a greater risk of loss such that they would have improved incentives to exercise effective discipline over the CEO and prevent excessive risk-taking.

The presentation I attended did not note that we had tried a variant of this strategy, which theoclassical economists assured us would produce superb private discipline, in the last three crises through the use of subordinated debt (“subdebt”). Subdebt means that the purchaser agrees to a lower bankruptcy priority in return for a higher yield. In the event the bank is placed in receivership the subdebt holders receive no payments unless there are sufficient funds to pay all the secured and unsecured general creditors’ claims in full. Typically, this would mean that the subdebt holders would be wiped out if there is a receivership. In the S&L crisis, we routinely wiped out the subdebt holders in our receiverships. Neoclassical economists claimed that subdebt holders provided the ideal source of private market discipline for three reasons. First, because they were so likely to be wiped out if the bank failed they had powerful incentives to exert superb discipline. Second, because the typical sub debt holder bought a substantial amount of debt that incentive was amplified. Third, only “sophisticated” (actually, wealthy) investors can purchase subdebt they should also have superior skills in disciplining the bank CEO and preventing him from looting the bank.

Theoclassical economists have long favored capital remedies that can be implemented by private parties over vigorous financial regulation. Their explicit premise is that their capital remedy will eliminate “agency” problems (e.g., excessive risk-taking by the CEO) and therefore means that there should be no, or virtually no, regulatory restrictions.

Theoclassical economists were so successful in pushing subdebt as the ideal source of vigorous and competent private market discipline that they convinced their regulators to allow banks to count subdebt toward meeting the bank’s capital requirement. Encouraging banks to issue high cost debt is an expensive policy that should require strong benefits that outweigh the costs. (Sorry, I’ve engaged in a fantasy. Neoclassical economists demand benefit-cost studies only for acts of regulation, not anti-regulation.)

The problem is that subdebt failed, universally, in providing effective private market discipline at banks. It failed during the S&L debacle, the bank frauds that aided Enron’s frauds, and the current mortgage fraud crisis. Subdebt simply helped fund the growth and frauds of accounting control frauds in each of the modern U.S. crises and the ongoing global crisis.

Contingent capital is, conceptually, weaker than subdebt as a source of private market discipline. Like subdebt; it will be expensive for the bank to sell because it will be far riskier than regular debt and will require a significantly greater yield. To count toward capital, subdebt must be relatively long-term debt. The convertible debt could be much shorter term, which would create perverse incentives on the part of the owners of the convertible debt to cover up a failing bank’s losses to avoid triggering the conversion prior to the debt maturing and being repaid in full prior to the bank’s failure.

Bank stockholders have even lower priority than subdebt holders in the event of a receivership. Theoclassical theory already asserts that shareholders should have the right incentives to exert private market discipline. The reality is that bank stockholders have also consistently failed to exert effective private market discipline in the modern crises.

The speaker stated that it was “inconceivable” that a bank could fail if it had contingent capital. Indeed, he stated that it was inconceivable that any bank would ever hit the trigger that would cause its debt to convert to equity. I, of course, quoted The Princess Bride.

“Vizzini: HE DIDN'T FALL? INCONCEIVABLE.

Inigo Montoya: You keep using that word. I do not think it means what you think it means.”

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

Grow extremely quickly by
Making bad loans at premium yield
While employing extreme leverage, and
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.”

http://www.nytimes.com/2012/02/12/business/making-shareholders-liable-for-big-banks-economic-view.html?_r=2&partner=rss&emc=rss

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.

“[F]or almost half a century after the Great Depression, pay inside the financial industry and out was roughly equal. Beginning in 1980, they diverged. By 2007, financial sector compensation was more than 80% greater than in other businesses—a considerably larger gap than before the Great Depression.

Until 1970, the New York Stock Exchange, a private self-regulatory organization, required members to operate as partnerships. Peter J. Solomon, a former Lehman Brothers partner, testified before the FCIC that this profoundly affected the investment bank’s culture. Before the change, he and the other partners had sat in a single room at headquarters, not to socialize but to ‘overhear, interact, and monitor’ each other. They were all on the hook together. ‘Since they were personally liable as partners, they took risk very seriously,’ Solomon said. Brian Leach, formerly an executive at Morgan Stanley, described to FCIC staff Morgan Stanley’s compensation practices before it issued stock and became a public corporation: ‘When I first started at Morgan Stanley, it was a private company. When you’re a private company, you don’t get paid until you retire. I mean, you get a good, you know, year-to-year compensation.’ But the big payout was ‘when you retire.’

When the investment banks went public in the 1980s and 1990s, the close relationship between bankers’ decisions and their compensation broke down. They were now trading with shareholders’ money. Talented traders and managers once tethered to their firms were now free agents who could play companies against each other for more money. To keep them from leaving, firms began providing aggressive incentives, often tied to the price of their shares and often with accelerated payouts. To keep up, commercial banks did the same. Some included “clawback” provisions that would require the return of compensation under narrow circumstances, but those proved too limited to restrain the behavior of traders and managers.

Studies have found that the real value of executive pay, adjusted for inflation, grew only 0.8% a year during the 30 years after World War II, lagging companies’ increasing size. But the rate picked up during the 1970s and rose faster each decade, reaching 10% a year from 1995 to 1999. Much of the change reflected higher earnings in the financial sector, where by 2005 executives’ pay averaged $3.4 million annually, the highest of any industry. Though base salaries differed relatively little across sectors, banking and finance paid much higher bonuses and awarded more stock. And brokers and dealers did by far the best, averaging more than $7 million in compensation.

Merrill paid out … 141% [of its revenues in compensation] in 2007—a year it suffered dramatic losses.

As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received $3.2 million in 1986 as CEO of Salomon Brothers. Stanley O’Neal’s package was worth more than $91 million in 2006, the last full year he was CEO of Merrill Lynch. In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received $68.5 million; Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million, respectively. That year Wall Street paid workers in New York roughly $33 billion in year-end bonuses alone. Total compensation for the major U.S. banks and securities firms was estimated at $137 billion.

Stock options became a popular form of compensation…. These pay structures had the unintended consequence of creating incentives to increase both risk and leverage, which could lead to larger jumps in a company’s stock price.

As these options motivated financial firms to take more risk and use more leverage, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these developments, would fail to rein in the increasing risks.

The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission,

‘I think if you look at the results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are going to leave my place and go someplace else.’’ Managing risk ‘became less of an important function in a broad base of companies, I would guess’” (FCIC 2011: 61-64).

While the FCIC discussion of these changes is extensive and useful it is incomplete. First, similar changes virtually eliminating partnerships with joint and several liability occurred in many fields related to finance such as law firms, auditing firms, and credit rating agencies. In each case the result proved disastrous for integrity.

Second, FCIC was inaccurate in asserting that increased risk was an “unintended consequence” of modern executive compensation. One of the express goals of modern executive compensation was to induce CEOs to cause the firm to make significantly riskier investments.

Third, the discussion ignores the role of modern executive and professional compensation in creating perverse incentives to engage in accounting control fraud and to create Gresham’s dynamics to suborn professionals that would aid and abet the fraud. Modern executive compensation also provides the means by which the controlling officers loot in a manner that minimizes the risk of prosecution.

The central problem with the financial CEOs that lead the epidemics of control fraud that drive our crises is not that they cause immense inequality but that they destroy wealth and cause intense inequality and increased poverty – devastating American families and effectively eliminating any realistic opportunity for millions to marry. The other central problem is that they have subverted our politics and created a system of crony capitalism that is the leading threat to our economy and our democracy.

Theoclassical economists are not taking the lead urging the return to private sector ownership structures that classical economists realized provided inherently superior governance. There are three excellent reasons why theoclassical economists refuse to recommend ownership structures they know are vastly superior. The CEOs of our largest financial firms love the current system. Theoclassical economists faithfully serve the interests of these CEOs, not the firms or shareholders.

Theoclassical economists know that it was the CEOs that caused these disastrous changes. It was not the evil government. The CEOs destroyed a system that was vastly superior because it minimized accounting control fraud, optimized long-term investment perspectives, and rewarded the most productive partners who displayed the greatest integrity and skill in mentoring and monitoring their partners. The accounting control fraud recipe causes such firms to become weapons of mass financial destruction and rewards the least competent and moral officers. By producing multiple Gresham’s dynamics the control frauds turn market forces so perverse that they drive good ethics out of the marketplace and the professions. Theoclassical economists refuse to admit that Adam Smith was correct that the inherent problem is the perverse incentives and power of CEOs in a corporate ownership structure.

Because the CEOs who lead the largest financial control frauds have used executive compensation to create a Gresham’s dynamic among a broad range of financial executives there is no private sector means for honest financial firms to recreate partnerships with joint and several liability that would defer the vast bulk of the officers’ compensation for decades. Only governmental action requiring a return to partnerships with joint and several liability and highly deferred compensation can break the destructive Gresham’s dynamic that makes it impossible for the private sector to return to vastly superior ownership and compensation structures. This situation is, of course, anathema to theoclassical economists who detest the government and are CEO cultists.

We are suffering from recurrent, intensifying financial crises because we have simultaneously weakened essential public and private sector restraints against control fraud. Theoclassical economists refuse to return to the proven means that combined effective private and public sector regulatory and prosecutorial restraints on CEOs and produced financial and economic systems that were anti-criminogenic, rewarded long-term investment perspectives that produced superior growth with far fewer crises, and were far more egalitarian and meritocratic.

Bill Black is the author of <a href="http://www.amazon.com/Best-Way-Rob-Bank-Own/dp/0292706383">The Best Way to Rob a Bank is to Own One</a> 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.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his <a href="http://papers.ssrn.com/sol3/cf_dez/AbsByAuth.cfm?per_id=658251">Social Science Research Network author page</a> and at the blog <a href="http://neweconomicperspectives.blogspot.com/">New Economic Perspectives</a>.

Follow him on Twitter: @WilliamKBlack

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