Bill Black: Why our Fundamental Approach to Banking Regulation is Inherently Unsound

This is an outstanding essay on the fundamentals of why our banking  
system is broken.

regards,
-Lance

--------------------------

Bill Black: Why our Fundamental Approach to Banking Regulation is  
Inherently Unsound
By Bill Black, Associate Professor of Economics and Law at the  
University of Missouri-Kansas City and a former senior financial  
regulator. Cross posted with Benzinga

Our current approach to banking regulation exposes us to recurrent,  
intensifying financial crises. The good news is that because we  
reached an all time low in Basel II, Basel III almost has to be an  
improvement. The bad news is that Basel III has not reexamined the  
fundamental assumptions underlying the Basel process. As a result,  
Basel III will be a variant on the common ineffective theme of banking  
regulation designed by economists and the industry.

The Basel process is built upon three flawed assumptions.

1.	Capital requirements are the ideal form of banking regulation.
2.	Capital requirements can be set without establishing sound  
accounting.
3.	Accounting control fraud is not a serious concern.

Capital requirements are the ideal form of banking regulation under  
conventional economic wisdom. The attraction of capital requirements  
to neoclassical economists is elegance. Their theory is that while  
private market discipline ensures that normal corporations are  
inherently safe, private market discipline poses an inherent dilemma  
for banks. A bank run is a form of form of private market discipline.

Banks have very short-term liabilities and longer-term assets. This  
exposes them to interest rate risk and liquidity risk. A run is the  
ultimate liquidity nightmare for a bank. The conventional economic  
wisdom is that runs are not a desirable form of market discipline.  
Economists tend to use the word “panic” when they describe runs.  
Economists fear that depositors are likely to be financially  
unsophisticated and to start runs on banks on the basis of false  
rumors that the banks are unsound.
Deposit insurance is designed to prevent depositors from engaging in  
private market discipline. The insurance limit is often set at a  
sufficiently high amount that the overwhelming bulk of depositors’  
accounts are fully insured – minimizing private market discipline.  
Central banks often provide a “lender of last resort” facility to  
allow the central bank to trump any run. Many nations with advanced  
economies are so opposed to runs that they provide both deposit  
insurance and a lender of last resort facility through the central bank.

The conventional economic wisdom is that deposit insurance renders  
private market discipline ineffective because banks’ principal  
creditors are fully insured depositors. It is expensive for creditors  
to undertake the monitoring and analyses required to impose effective  
private market discipline, so fully insured depositors should not  
discipline banks. The conventional economic wisdom has a further  
prediction: the absence of private market discipline will increase the  
risk of moral hazard. The conventional theory gets quite fuzzy at this  
point about how moral hazard works, a point I return to below, but it  
predicts that moral hazard can lead banks to take excessive risks. The  
conventional economic wisdom further predicts that imposing adequate  
capital requirements will successfully constrain moral hazard. As long  
as the shareholders’ have material capital at risk of loss should the  
bank fail they will not cause the bank to take excessive risks. The  
shareholders’ incentives will be aligned with that of the public and  
the banks’ creditors as long as the bank meets its capital  
requirement. The conventional wisdom, therefore, requires that the  
regulators force the bank to be promptly recapitalized or closed if it  
fails to meets its minimum capital requirement.

The above analysis begins to explain why the conventional economic  
wisdom is that capital regulation is the optimal form of bank  
regulation. The key is the alignment of shareholder’s interests with  
the public interest, but capital also provides a buffer against loss  
to the insurance fund and the taxpayers. When the incentives are right  
there is little or no need for additional regulation. Any rules that  
constrained bank decision-making (when the incentives were correct)  
would constitute the regulators substituting their business judgments  
for those of the banks’ officers. The conventional economic wisdom  
asserts that private sector business judgments are vastly superior to  
regulatory decision (Easterbrook & Fischel 1991). It follows that the  
conventional economic wisdom was that the banking regulators that  
regulated the least produced the best banking results. Increased  
regulation did not simply increase cost; it increased the risk of  
banking failures and crises. Less banking regulation allowed financial  
intermediaries to be more efficient and increased economic growth.

The conventional economic wisdom also claimed that small levels of  
reported capital were sufficient to create the desired incentives  
among shareholders. In a bubble, bank loan losses are normally greatly  
reduced. Economists began to argue that the lower the banks’ capital  
requirement the greater the amount of productive loans that would be  
made and the faster the economy would grow. Basel II substantially  
reduced capital requirements.

The fundamental disconnect with making capital requirements the pillar  
of banking regulation is that “capital”, “net worth”, and “equity” are  
accounting concepts. They have no meaning outside of accounting.  
Worse, they are all residual accounting concepts. Accountants do not,  
and cannot, count a modern bank’s “capital.” They determine assets and  
subtract liabilities to determine capital. The implication of that is  
that the accuracy of reported “capital” depends on the accuracy of the  
valuation of every asset and liability. That means that capital is not  
only an accounting concept, but the accounting concept most subject to  
error. For a large bank, there are literally tens of thousands of ways  
to use accounting to distort reported capital by enormous amounts.  
Beyond the obvious – understate liabilities and overstate asset values  
– banks are the perfect vehicles to self-fund “capital.”

Accountants do purport to count “capital” when there is a purchase of  
newly issued stock or a capital contribution. Savings and loans and  
the Big Three Icelandic banks self-funded the purchase of newly issued  
stock by insiders, cronies, and shills. Anglo-Irish Bank self-funded  
the purchase of shares from a distressed shareholder to prevent the  
sale of a large block of shares in the market.

Banks can self-fund purported “capital contributions.” The person  
controlling the bank, for example, can purport to contribute $10  
million in capital to the bank by contributing real estate  
(improperly) valued at $25 million to the bank and receiving $15 in  
cash from the bank. If the real estate actually has a market value of  
$10 million he will make a profit of $5 million. The bank will suffer  
a real loss of $5 million but will falsely report that its capital has  
increased by $10 million. Its capital will be overstated by $15 million.

Banks also self-fund reported “income,” which can flow through to  
capital. I discuss this in more detail below, but the overall result  
that needs to be understood is that self-funding can be used to report  
guaranteed, record income and capital.

All of this means that accurate accounting is essential for banking  
regulation premised on capital requirements to succeed. The Basel  
process relies primarily on capital regulation, but ignores the  
accounting games that allow banks to create their reported capital.  
Bank examination and supervision, globally, puts only minimal emphasis  
on accounting in the era leading up to the crisis.

The failure of Basel and the regulators to make accurate bank  
accounting their central priority would be dangerous even if  
accounting control fraud did not exist. In the world of modern finance  
where accounting is the “weapon of choice” for control frauds, the  
failure to take accounting seriously was catastrophic. The four-part  
recipe that bank control frauds use to produce guaranteed, record  
fictional short-term income turns regulatory regimes based on capital  
regulation profoundly perverse.

1.	Grow extremely rapidly
2.	By making loans to the uncreditworthy at premium yields
3.	While employing extreme leverage
4.	While providing only trivial loss reserves (ALLL)

Akerlof & Romer (1993) emphasize that accounting fraud is a “sure  
thing.” If a bank can produce guaranteed, record income then it can  
appear to be healthy. Regulators are taught to worry about banks  
showing losses – not record gains. A bank reporting record income can  
pay its controlling officers huge compensation and still have plenty  
of fictional net income to flow through to fictional capital.  
Regulators are taught to believe that firms reporting adequate capital  
have the correct incentives and have a buffer that will protect the  
FDIC against losses.

The fictional increase in income and capital makes it easy for the  
bank to meet the first ingredient – extremely rapid growth. It also  
makes the regulators feel comfortable about the bank employing extreme  
leverage. The fourth ingredient is an essential ingredient of  
accounting control fraud. The first three ingredients maximize real  
losses. The expected value to the bank, for example, of making liar’s  
loans is sharply negative. That means that the loss reserves (ALLL)  
that the bank should establish under GAAP should exceed the net income  
from the loan (i.e., the loss reserves should be large enough that the  
lender recognizes a loss on the liar’s loans when they are  
originated). That would have meant ALLL provisions in the 20% range  
for liar’s loans. Instead, ALLL fell each year in the peak of liar’s  
loan originations to roughly one percent.

Basel III is premised on the assumption that raising capital  
requirements will greatly reduce the risk of future failures and  
crises. One can understand the logic. Basel II reduced capital  
requirements and failed banks followed extreme leverage. Special  
investment vehicles (SIVs) employed exceptional leverage and many SIVs  
failed. The regulators are correct that leverage matters – it is the  
third ingredient in the lenders’ accounting fraud recipe. What the  
regulators have not taken into account is a series of means of gaming  
reported capital that render capital requirements malleable. Instead  
of correcting these accounting abuses they have stood by, or in the  
case of Ben Bernanke encouraged, the destruction of the remaining  
integrity of accounting standards. Bernanke encouraged the Chamber of  
Commerce and the banking lobbyists to use their political allies to  
extort the Financial Accounting Standards Board (FASB) to junk the  
rules requiring banks to recognize their losses. This massively  
overstates asset valuations, which massively overstates reported  
capital – evading the requirements of the Prompt Corrective Action  
law. It also overstates income, allowing bank officers to enrich  
themselves through bonuses they had not earned. Having just gimmicked  
the accounting rules to achieve their goals of covering up the scale  
of the crisis (and claiming to have “resolved” the crisis for a  
pittance), it is bizarre that the banking regulatory agencies treat  
capital requirements as if they had meaning independent of accounting.  
A sound system of banking regulation cannot be based on capital  
regulation as it is conceived in the Basel process.






naked capitalism 1/24/11 9:53 PM Yves Smith Banking industry Credit  
markets Guest Post Legal Regulations and regulators Risk and risk  
management The dismal science Comments

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