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Hair of the Dog that Bit Us: Capital Requirements Provide Ethical Cover for Abuse of the Safety Net

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By Edward Kane, Professor of Finance at Boston College and founding member of the hadow Financial Regulatory Committee

“We are a moving company not a storage company”
…Apocryphal Bear Stearns executive

Regulators define a financial institution’s capital as the difference between the value of its asset and liability positions. The idea that capital requirements can serve as a stabilization tool is based on the presumption that, other things equal, the strength of an institution’s hold on economic solvency can be proxied by the size of its capital position.

This way of crunching the numbers shown on a firm’s balance sheet seems simple and reliable, but it is neither. It is not simple because accounting principles offer numerous variations in how to decide which positions and cash flows are and are not recorded (so-called itemization principles), when items may or may not be booked (realization principles), and how items that are actually booked may or may not be valued (valuation principles). Accounting capital is not a reliable proxy for a firm’s survivability because, as a financial institution slides toward and then into insolvency, its managers are incentivized to manipulate the ways they apply these principles to hide the extent of their weakness and to shift losses and loss exposures surreptitiously onto the government’s safety net.

These incentives are reinforced by the reluctance of government lawyers to pursue managers of key financial firms in open court and by the ethically questionable notion that managers owe fiduciary duties of loyalty, competence, and care to their stockholders, but only covenanted duties to taxpayers and government supervisors. By covenanted duties, I mean those established by explicit legislative and regulatory requirements.

In policymaking, framing is crucial. Bear Stearns failed because the volume of dicey deals it was processing expanded its pipeline and put it into the storage business in a big way. Framing a nation’s safety net as an insurance scheme rather than a source of implicit equity provides similarly misleading cover for managers of difficult-to-fail financial firms to pick the pockets of other citizens.

Casting taxpayers as insurers makes it seem both wise and lawful to put the onus on professional regulators to understand the risks and to develop and enforce covenants intended to stop protected parties from gaming the safety net. Cousy (2012) notes that, while traditional insurance law imposed a duty on the insured party to disclose relevant information on its circumstances, modern insurance law increasingly focuses on protecting the policyholder rather than the insurer. The sanction of termination and forfeiture is now often limited to “serious cases where some high degree of intention and culpability is involved” (p. 131).

Conceiving of taxpayers as disadvantaged equity investors in protected firms suggests that they should have a legal standing similar to that of explicit shareholders. One way to do this is to reimagine taxpayers’ stake in protected firms as a kind of trust fund. Such a perspective implies that managers owe taxpayers fiduciary duties, including those of disclosure and nonexpropriation of their funds. If these duties were expressly written into corporate and even criminal law and taxpayers’ stake measured and managed by a dedicated board of nonregulator trustees with long-lived appointments, it would be easier for regulators and the courts to punish managers for dishonest accounting schemes and nontransparent forms of risk-taking that pilfer value from the safety net. As long as the fear of timely and effective individual punishments remains low, the temptation to circumvent or evade regulatory restraints will be extremely strong.

The root problem is twofold: (1) the existence of government safety nets gives protected firms an incentive to conceal leverage and aggressively manage their risk-weighted assets as a way of shifting tail risk to taxpayers and (2) regulators have insufficient vision and incentives to stop them. Asking firms to hold more capital than they want lowers the return on equity their current portfolio can achieve. This means that installing tougher capital requirements has the predictable side effect of simultaneously increasing a firm’s appetite for risk, so as to increase the rate or return on its assets enough to establish a more satisfying equilibrium. As Basel III becomes operational, aggressive institutions can and will game the system. Aided by the best financial, legal, and political minds that money can buy, they will ramp up their risk-management skills and expand their risk-taking over time in clever and low-cost ways that, in the current ethical and informational environments, overweening regulators will find hard to observe, let alone to discipline. When it comes to controlling regulation-induced risk-taking, regulators are outcoached, outgunned, and always playing from behind.

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Cousy, Herman, 2012. “About Sanctions and the Hybrid Nature of Modern Insurance Contract Law,” Erasmus Law Review, 5 (no. 2), 123-131.

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12 comments

  1. nanute

    You’re not arguing for lower capital requirements are you? What is the alternative? The regulatory process has broken down, and the legal system does not seem interested in holding fraud, abuse and violations of fiduciary trust accountable. Financial settlements are the new normal, and bit players might go to jail. There are no modern day Michael Milken or Ivan Boskey’s. Why is that?

    1. from Mexico

      I think the subtext of the post is that if you have inadequate, incompetent or corrupt regulation, that increased capital requirements will achieve nothing.

      Or in other words, all the talk about capital requirements is a bunny trail. The real problem is inadequate, incompentent or corrupt regulation.

      1. nonclassical

        …appears two major efforts have exacerbated problem;

        1) unlimited political influence, guaranteed by “Citizen’s United” decision formulating the fantasy that $$$$ is $peech, rather than PROPERTY…

        2) lack of anti-trust legal application leads to “too big to fail” bravado…

        result-FEDs, ethical politicos, whistle-blowers who warned long prior to 2007,
        all calling for breaking up “too big to fail” banks who CAUSED entire debacle..

    2. Nathanael

      The point is that capital requirements are meaningless.

      You need a form of regulation which works. This includes:
      (1) Outright prohibitions on certain types of activity (such as Glass-Steagal contained);
      (2) Government auditing requirements — so that the banks have to open their internal records up to government auditors, no trade secrets allowed, and the government can publish what it finds out;
      (3) Actual cash holding requirements (bills & coins). Unlike capital requirements, these are not subject to accounting manipulation.

      There are probably some other such “workable regulations”. The point is that capital requirements are not a workable regulation, because the definition of capital is at the mercy of the bank executives and their paid accountants.

  2. avg John

    In layman terms, the financial statements are a gigantic fraud, but not to worry, because we own the regulators and the external auditors, and if all else fails, the little people have our back(whether they like it or not). Wow, this makes me mad.

  3. leonard

    Hahaha.. “Taxpayers”. Oh the euphemisms that the intelligentsia use to fool the masses.

    Confucius said that a wise man calls things by their proper names. People do not “pay their taxes” because they support the state, or because they think it is right or just or good; people (who are honest with themselves and others) pay their taxes because they know that if they don’t, a man in a costume will come with a weapon to their house and take them away and lock them in a cage, and if they don’t want to go with the costumed thug to the cage, they will be murdered.

    “taxpayers”, hah. Try victims of theft. You people get so bent out of shape by the behavior of the crony banksters who engage in grand-scale theft in broad daylight (possible only via the violence of the state), but you turn a blind eye to those who threaten you and steal from you on a daily basis. Spare some outrage for the fact that you are free-range livestock, milked for your entire lives and allowed only the freedoms that the farmer deigns to grant you, and perhaps you’ll have a bit more credibility. Until then, keep trying to add up the angels dancing on the head of a pin, and wondering why things continue to get worse.

  4. Michael Jones

    Can we please reinstitute Glass-Steagall? It might not prevent these accounting tricks, but it would at least buffer the effect on the commons.

    1. Nathanael

      Exactly. Glass-Steagal said that banks which had insured deposits — and their subsidiaries, and their parent companies — were *outright prohibited* from engaging in a large number of activities. In fact, they were only allowed to engage in a short, restricted list of actitivies.

      The idea here is that there is much less scope for accounting fraud and gambling in a short, restricted list of activities.

      This seems to be correct.

  5. Susan the other

    In the EU they now have taxation without representation. If those sovereign governments with their so-called “sovereign debt” and their national central banks could print their own currency, they could grow their way out of their mess. The fact is they have no sovereignty. So the taxes they pay, the tribute, to the EU, are another form of taxation without representation. And, voila! That is exactly what we have. We, the descendants of the Boston Tea Party, are being taxed black and blue without representation. We do this by extortion – by agreeing to be the bailout of last resort – because if we don’t, everything we have striven for will be lost. Just where is our representation in all this mess? The mess starts with the investment banksters gaming the system because they know taxpayers will bail them out even tho’ taxpayers have no say whatsoever in how the banksters “invest” or do anything else for that matter. And taxpayers do not enjoy any of the profits of the investment banksters. Where is the justice in all this?

  6. JEHR

    The last line should read: the regulators are captured, monied and care not a wit about the citizenry.

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