Six reasons we may have another bank crisis

Rampant financial crime and poor regulation can only mean another blowup, and guess who will be holding the bag?

Topics: AlterNet, Goldman Sachs, U.S. Treasury, U.S. Economy, Great Recession,

This article originally appeared on AlterNet.

Surprise, surprise! Last week, the Justice Department announced it wasn’t going to prosecute Goldman Sachs or its employees for its shady activities during the mortgage crisis. The same day, Goldman disclosed in a regulatory filing that the Securities and Exchange Commission (SEC) had dropped an investigation into a troubled $1.3 billion residential mortgage-backed securities deal launched in 2006.

AlterNet

Time is running out for prosecutors to file cases against big banks for activities that triggered the 2007-2009 financial crisis, since statutes of limitations set deadlines for launching prosecutions for fraud and other financial crimes. If prosecutors don’t start lawsuits before these deadlines expire, the big banks will, once again, have got off scot-free.

Failure to pursue banks, culpable management and employees for their complicity in causing the financial crisis is one of six bad policies that ensure we’re likely to see another bust-up of a big U.S. bank — sooner rather than later.

Who’s going to pay the price for such a failure?  We will, of course. Uncle Sam’s policy of allowing banks to get too big to fail means we’ll all be left holding the bag when that collapse occurs — and another banking bailout is necessary.

1. Too big to fail

Thirty years of financial deregulation have seen unprecedented concentration of the financial sector. Before, financial firms were limited both in where they could do business and the types of business they could do. This prevented a big banking blowup in the U.S. for more than 50 years.

Banks used to be limited to owning branches within individual states.  When a bank got into trouble—and some did — losses stayed confined. Regulators such as the Federal Deposit Insurance Corporation (FDIC) could clean up the mess and preserve depositors’ assets, without unduly burdening taxpayers. But after changes culminating in the Riegle-Neal Interstate Banking and Branching Efficiency Act in 1994, those restrictions vanished.

So some banks got steadily bigger, while the overall number shrank.  From 1990 to 2011, the number of commercial banks halved, from about 12,000 to 6,000, according to the St. Louis Federal Reserve Bank.

Once upon a time, the 1933 Glass-Steagall Act limited banks to either commercial or investment banking functions. Brokerage activities were restricted, and the operations of insurance firms constrained. Problems in one area of financial activity didn’t spread to another. Bankers could not speculate with small depositors’ money. Banks competed with each other, which led to better lending terms. And they didn’t get too big, so when they screwed up, they paid the price. They failed.

In the 1980s, financial institutions claimed that Glass-Steagall and other restrictions prevented U.S. banks from competing head-to-head with foreign banks. They lobbied hard and regulators began to allow the restrictions slowly to erode.

Financiers like Sanford Weill, the head of the Traveler’s Group, couldn’t wait for U.S. laws to change. In 1998, he masterminded the takeover of Citicorp, a merger which combined commercial banking, investment banking, and insurance functions in one firm in a way that was technically illegal. But the merged company got a grace period—during which Weill deployed formidable lobbying muscle to dismantle Glass-Steagall. It worked. In 1999, Congress passed the Financial Services Modernization Act of 1999 and finally buried Glass-Steagall.

Last month, Weill gave an astounding interview to CNBC in which he admitted that “What we should probably do, is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not gonna risk the taxpayer dollars, that’s not gonna be too big to fail.”

That’s a bit like Jesus Christ returning to announce that introducing Christianity was all a big mistake. The reaction from the financial mafia has been appropriately apoplectic.

The net effect of all these rule changes – like the one that enriched Sandy Weill – was that banks became too big to fail. Fear that their failure has led regulators to go soft on the big banks, and to do anything to keep them alive.

2. See no evil, hear no evil

While the financial system was consolidating, another threat was looming: the “shadow banking system“ was being created. Another New Deal reform, the Investment Company Act of 1940, imposed heavy restrictions on investment companies, which were intended to protect investors from excessive risks, fraud and scams.

But regulators decided that sophisticated investors, including the wealthy, pension funds and charities, had enough financial savvy to be allowed to invest in shadow banks that were either lightly regulated, or not at all. Such alternative investment vehicles, including hedge funds and private equity funds, were exempt from investment restrictions.

In the last two decades, there’s been an explosive growth in shadow banks. The size of this unregulated system has increased fivefold and today is larger than the regulated financial system.

The rationale? Sophisticated investors, it’s claimed, can look after themselves, and therefore the largely unregulated funds that cater to them don’t pose any risks to the rest of us. But that’s not proven to be the case. And, surprise, surprise, when such firms fail, guess who pays the price? We do.

3. Calling in the cavalry, but giving them the wrong directions

Once the U.S. decided to deregulate the financial sector, and banks got bigger, it was inevitable that the government would be called in for a rescue. Most of us were aware that in 2008, the government stepped in to bail out big banks that were destabilized by Lehman Brothers’ collapse and by the bad derivatives bets entered into by AIG Financial Products. The world financial system was at the brink, we were told, and the Troubled Asset Relief Program (TARP) was necessary to save the system.

But a decade before this bailout, U.S. financial regulators were involved in a rescue of a shadow bank, which helped set the stage for TARP.  In 1998, the Long-Term Capital Management (LTCM) hedge fund got into trouble by placing heavily-leveraged derivatives bets during the Asian financial crisis. Hedge funds are allowed to operate with scant regulatory supervision on the rationale that they cater only to sophisticated investors who could bear the risk.

The Federal Reserve changed its mind when it realized that LTCM’s failure was a threat to the global economy. So the Fed corralled major banks in a room, and told them to fix the problem. They dismembered LTCM and took its underperforming assets onto their books.

The Fed’s role in this rescue sent the wrong message: that the government would be there to fix problems, and that banks and shadow banks alike didn’t have to work too hard to manage risk and to protect themselves from contagion.

Sometimes you want government intervention to quell a banking panic, and to shore up or reboot a failed banking system. Banks need to be seized, or at minimum assessed by a neutral observer, and their balance sheets cleaned up. Investors, too, must pay a price for making foolish investment choices. Typically, existing shareholders are wiped out, while bondholders see their promises of guaranteed debt payments converted to more speculative shares of stock.

We used to know how to do this. The Depression-era Reconstruction Finance Corporation seized failing banks, cleaned up their balance sheets, and later transferred these institutions back to private ownership. The Resolution Trust Corporation followed similar policies in cleaning up the savings and loan crisis of the 1980s and early 1990s. More recently, the Swedish government nationalized failing banks in the 1990s. Managers were penalized, and shareholders and sometimes bondholders took losses.

But the U.S. forgot all these sound policies in the 2008 TARP. The government provided cash to stabilize shaky financial institutions, guarantees to bondholders, and tax breaks. It also purchased some risky assets. But it didn’t get much in exchange. Regulators didn’t demand that banks open their books and clean up their balance sheets. The big banks continued as going concerns.

Bank managers paid no price and mostly kept their jobs. They paid themselves bonuses rather than using capital to shore up their banks. Bottom line: Managers, shareholders, and bondholders didn’t fully pay for their folly.

The government further erred by nudging sound banks to take over failing ones. This policy led to further consolidation of the banking system, making surviving banks even bigger! Finally, the government failed to take action to address the problems that let big financial institutions get into trouble in the first place.

4. Creating financial weapons of mass destruction

The need to bail out AIG Financial Products in 2008 arose from huge losses in unregulated derivatives trading. We should have seen that coming, because derivatives had caused LTCM to fail back in 1998. In fact, plenty of people saw that derivatives were problematic. Warren Buffett called them “financial weapons of destruction” back in 2003.

So, why wasn’t anything done to defuse these weapons?

Well, in 1998, one very prescient regulator, Brooksley Born, chairman of the Commodity Futures Trading Commission, tried, and failed, to initiate a unilateral disarmament policy.

Derivatives aren’t necessarily dangerous. Farmers have long used futures contracts to hedge—or lock in—prices for their crops. As long as they’re traded fairly on open exchanges, they’re a valuable tool for minimizing risk. Congress recognized this when in 1974 it created the Commodity Futures Trading Commission (CFTC) to regulate futures and options markets, which at that time, largely concerned agricultural commodities.

As derivatives became more popular, transactions were restricted to two parties, trading only with each other. These over-the-counter derivatives (OTC) transactions, weren’t regulated. Born had spotted this weakness in the regulatory framework before the 1998 LTCM collapse and had accordingly attempted to write rules to plug this regulatory gap.

But folks like Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and his successor, Lawrence Summers, and SEC chairman Arthur Levitt, ganged up on Born to preserve the status quo. They saw derivatives users as sophisticated financial players who should not be regulated.

Congress first passed a temporary provision forbidding any change in regulating derivatives. Born resigned in 1999. Congress then passed the Commodity Futures Modernization Act of 2000, which specifically excluded OTC derivatives from regulation. This same state of play remained in 2008 when these weapons of mass destruction nearly destroyed the world financial system.

In the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Congress has taken some steps to increase regulation of OTC derivatives, and to push for more trading on organized exchanges. But these provisions have been riddled with exceptions, and delayed in their implementation.

So these weapons remain armed—and dangerous.

5. Companies consolidate, while regulation remains fragmented

Which brings us to another key question: What’s happened to the regulators while financial companies continue to get bigger and bigger? Answer, not enough.

Regulation continues to be very fragmented, with many different agencies responsible for bits and pieces of banking regulation. The Commodity Futures Trading Corporation, the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corporation, the Federal Reserve, the National Credit Union Association, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the Treasury Department– each regulates some significant aspect of bank activities.

There’s no one single, buck-stops-here banking regulator. Instead, the newly created Financial Stability Oversight Council, comprised of representatives drawn from each agency named above, is supposed to coordinate and oversee all policies.

Believe it or not, each state is also part of the regulatory mix. Insurance regulation remains primarily a state affair, and states are also heavily involved in banking regulation.

Does this seem sensible? Just as a teenager may play one parent off of another until one of them says “All right! You can go to the prom,” the lack of a streamlined regulatory system means banks play regulatory arbitrage. Recently we saw this dynamic unfold—unsuccessfully in this case— as Standard Chartered Bank used its press cronies to pressure Benjamin Lawsky, New York’s Superintendent of Financial Services, to go easy on the bank for laundering money for Iranian clients and cooperate with other regulators — the Fed, Justice and Treasury— that favored a softer stance. Lawsky threatened to cancel the bank’s license to operate in New York—a death sentence for any international bank. When he didn’t back down, the bank agreed to a $340 million settlement. Lawsky’s firm stance improves the prospects for the pending federal probes.

There’s another major problem with our current regulation. Agency missions often confuse priorities. Some agencies are supposed to worry about a bank’s survival at the expense of other concerns, such as looking out for the bank’s customers or worrying about broader public goals such as stopping money laundering.

The consequence? The regulator often sides with the bank and colludes in concealing facts and circumstances that should be more widely known.

The latest financial crisis should have been a giant wakeup call. The Obama administration had the chance to reform bank regulation to confront 21st-century challenges. Instead, it caved to bank lobbying, and in Dodd-Frank cemented a confused mix of regulatory imperatives. Even the meager promises are not kept, since further rule-making procedures must occur before key provisions can be implemented. Many of these have slipped their deadlines, and as a result of continued bank pressure, reforms remain pending or have been watered-down.

6. Perps get off scot-free

And so we come back to where we started—the decision not to go after Goldman Sachs. Normally, the Justice Department doesn’t  comment on its pending investigations. But for Goldman, the rules are different. Justice issued an unusual statement saying the firm wouldn’t be criminally charged, as prosecutors didn’t believe they could meet the burden of proof necessary to win a trial. Earlier last week, Goldman disclosed that the SEC wouldn’t be pursuing criminal charges against the firm, despite having issued Goldman a “Wells notice” of its investigation. Dropping an investigation after issuing such a notice is not altogether unprecedented– but is also rare.

Things weren’t always this way. During the savings and loan crisis of the late 1980s, banks were allowed to fail, prosecutions were undertaken, and executives and employees were jailed. Even after the popping of the dot-com stock bubble in 2000, prosecutors chased after cheating companies and their executives. Officers of Adelphia, Enron, WorldCom, to name a few, ended up doing significant jail time.

The current failure to prosecute means that banks will continue to pursue risky policies. Bankers continue to get paid based on results, and there’s so much to gain from a successful risky bet, and so little to lose from a bet gone bad, particularly if the taxpayer is there to pick up the tab.

In America, if you misuse food stamps, and you get caught, there’s a good chance you’ll lose your benefits, and you might even go to jail.  If you rip off the Medicare system, commit tax fraud or perpetrate identity theft, federal prosecutors will throw the book at you. But if you’re part of a multi-billion dollar enterprise that misleads investors and lies to Congress, you’re like the trophy fish that’s caught and released.  You’re off the hook.

Alexander Arapoglou, professor of finance at the University of North Carolina’s Kenan-Flagler Business School, has been a derivatives trader and head of risk management worldwide for various global financial institutions.

Jerri-Lynn Scofield has worked as a securities lawyer and a derivatives trader.

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