Guest Post: William K. Black’s Proposal for “Systemically Dangerous Institutions”

By George Washington of Washington’s Blog.

William K. Black, Associate Professor of Economics and Law at the University of Missouri – Kansas City, and the former head S&L regulator, has written the following fantastic new proposal concerning the giant, insolvent banks. Posted/reprinted with Professor Black’s permission.

William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City

September 10, 2009

The Obama administration is continuing the Bush administration policy of refusing to comply with the Prompt Corrective Action (PCA) law. Both administrations twisted a deeply flawed doctrine – “too big to fail” – into a policy enshrining crony capitalism.

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing. That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.” “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy). In this crisis, however, regulators have twisted the term into immunity. Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital. This policy is indefensible. It is also unlawful. It violates the Prompt Corrective Action law. If it is continued it will cause future crises and recurrent scandals.

On October 16, 2006, Chairman Bernanke delivered a speech explaining why regulators must not allow banks with inadequate capital to remain open.

Capital regulation is the cornerstone of bank regulators’ efforts to maintain a safe and sound banking system, a critical element of overall financial stability. For example, supervisory policies regarding prompt corrective action are linked to a bank’s leverage and risk-based capital ratios. Moreover, a strong capital base significantly reduces the moral hazard risks associated with the extension of the federal safety net.

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

We need to comply with the Prompt Corrective Action law. Any institution that the administration deems “too big to fail” should be placed on a public list of “systemically dangerous institutions” (SDIs). SDIs should be subject to regulatory and tax incentives to shrink to a size where they are no longer too big to fail, manage, and regulate. No single financial entity should be permitted to become, or remain, so large that it poses a systemic risk.

SDIs should:

1. Not be permitted to acquire other firms

2. Not be permitted to grow

3. Be subject to a premium federal corporate income tax rate that increases with asset size

4. Be subject to comprehensive federal and state regulation, including:

a. Annual, full-scope examinations by their primary federal regulator

b. Annual examination by the systemic risk regulator

c. Annual tax audits by the IRS

d. An annual forensic (anti-fraud) audit by a firm chosen by their primary federal regulator

e. An annual audit by a firm chosen by their primary federal regulator

f. SEC review of every securities filing

5. A prohibition on any stock buy-backs

6. Limits on dividends

7. A requirement to follow “best practices” on executive compensation as specified by their primary federal regulator

8. A prohibition against growth and a requirement for phased shrinkage

9. A ban (which becomes effective in 18 months) on having an equity interest in any affiliate that is headquartered in or doing business in any tax haven (designated by the IRS) or engaging in any transaction with an entity located in any tax haven

10. A ban on lobbying any governmental entity

11. Consolidation of all affiliates, including SIVs, so that the SDI could not evade leverage or capital requirements

12. Leverage limits

13. Increased capital requirements

14. A ban on the purchase, sale, or guarantee of any new OTC financial derivative

15. A ban on all new speculative investments

16. A ban on so-called “dynamic hedging”

17. A requirement to file criminal referrals meeting the standards set by the FBI

18. A requirement to establish “hot lines” encouraging whistleblowing

19. The appointment of public interest directors on the BPSR’s board of directors

20. The appointment by the primary federal regulator of an ombudsman as a senior officer of the SDI with the mission to function like an Inspector General

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        1. DownSouth


          Thanks for the links. I very much enjoyed the articles.

          Mexicans are blessed with this wonderful ability to sum up popular wisdom in short, common-sense phrases. Dichos, or sayings, they call them. There’s one that has emerged from the Mexican ghettos of Los Angeles that I believe pretty much says it all. “Their constituency is money” it goes, referring to the modern-day politician.

          And so it most certainly is. And I agree with your conclusion that nothing will change without violence. As Gandhi eventually was forced to conclude: “In my humble opinion the ordinary methods of agitation by way of petitions, deputations, and the like is no longer a remedy for moving to repentance a government so hopelessly indifferent to the welfare of its charge.”

          But care must be taken when we use that word “violence,” lest we end up like the tea party and healthcare town hall meeting protesters.

          “There is a school of French historians that uses the word deparage to describe the fateful moment when the Great Revolution of 1789…skidded from the enlightened universalism of the Declaration of the Rights of Man and Citizen into the rule of the Committee of Public Safety and the Terror,” Richard Bernstein writes in Dictatorship of Virtue. Is it fair to say that that same fateful moment was reached in the American polity when the advocates of “Black Power”—James Meredith, Floyd McKissick and Stokely Carmichael—branded Martin Luther King and other seminal figures of the Civil Rights movement as “old guard,” as “Uncle Toms” and vowed to “bring this country to its knees”? As true as it may be that the tea partiers didn’t initiate the American deparage, that nevertheless hasn’t precluded them from jumping on the slide into mayhem.

          Being internally torn as I now am, I feel I now confront the same predicament Martin Luther King did, plagued by “the paradoxes of a Christian leader trying to be righteous in an unrighteous world,” as James M. Washington put it. Here’s what King had to say about his situation, writing from the Birmingham City Jail:

          I started thinking about the fact that I stand in the middle of two opposing forces in the Negro community. One is the force of complacency made up of Negroes who, as a result of long years of oppression, have been so completely drained of self-respect and a sense of “somebodiness” that they have adjusted to segregation, and of a few Negroes in the middle class who, because of a degree of academic and economic security, and because at points they profit by segregation, have unconsciously become insensitive to the problems of the masses. The other force is one of bitterness and hatred, and comes perilously close to advocating violence. It is expressed in the various black nationalist groups that are springing up over the nation, the largest and best known being Elijah Muhammad’s Muslim movement. This movement is nourished by the contemporary frustration over the continued existence of racial discrimination. It is made up of people who have lost faith in America, who have absolutely repudiated Christianity, and who have concluded that the white man is an incurable “devil.” I have tried to stand between these two forces, saying that we need not follow the “do-nothingism” of the complacent or the hatred and despair of the black nationalist.

          1. Lavrenti Beria

            “And I agree with your conclusion that nothing will change without violence.”

            Well, that wasn’t exactly what I’d said, DownSouth. I made no mention whatsoever of violence. What I said was that (1) the franchise is useless and (2) that no change would be possible short of massive public demonstrations and/or the general strike. One needn’t presuppose violence in such a scenario. As a matter of fact, what I’d had in mind were the Solidarity demonstrations in Poland in the 1980s that peacefully brought about a restoration of democracy to that country. But the demonstrations there were enormous, the strike totally effective. Another example might be the demonstrations in Ukraine just a few years back. About a million people peacefully demonstrated for two weeks straight without let-up with very positive results. I see such a methodology as the only one remaining to the people of the United States. We’ve had our democracy hijacked and we won’t get it back through parliamentary means, so corrupt is the clique that runs things.

          2. DownSouth


            I fully understand your position. You say that there “will be no changing this reality short of massive public demonstrations and/or economy stopping strikes.” And undoubtedly both Gandhi and MLK would agree with you that those demonstrations and strikes can be conducted and justified under the rubric of “non-violence.” But there is some subtlety inherent in this argument, and I think it’s necessary to thoroughly think through that subtlety so that one is not caught off-guard when confronted with it.

            There’s been quite a bit of talk recently about a Debtors’ Revolt, including this post here on NC:

            Such an action definitely falls within the bounds of “non-violence.” “Non-violence is essentially non-co-opertion,” Reinhold Niebuhr tells us. “It expresses itself in the refusal to participate in the ordinary processes of society.”

            But, as several of those who commented on that thread were quick to point out, such an action would end up hurting innocent people, just as those “economy stopping strikes” you speak of would hurt innocent people. “Non-violent conflict and coercion may also result in the destruction of life or property and they usually do,” Niebuhr writes. “A strike may destroy the property values inherent in the industrial process which it brings to a halt, and it may imperil the life of a whole community which depends upon some vital service with which the strike interferes.” “Nor can it be maintained that it isolates the guilty from the innocent more successfully than violent coercion,” he adds. “The cotton spinners of Lancashire are impoverished by Gandhi’s boycott of English cotton, though they can hardly be regarded as the authors of British imperialism.”

            So if “non-violence” coerces and destroys and hurts innocent people just as violence does, is it any more justifiable than violence? Can it be justified?

            Both Niebuhr and Hannah Arendt answer in the affirmative. I won’t go into Niebuhr’s rather entailed moral defense of non-violence, other than to say that destruction is the intent of violence, whereas with non-violence destruction is an inevitable consequence. There is no place in non-violence for the embittered Madame Lafarge’s demand that the innocents’ heads roll.

            But the practical advantages of non-violence over violence are ample:

            Both the temper and method of non-violence yield another very important advantage in social conflict. They rob the opponent of the moral conceit by which he identifies his interests with the peace and order of society. This is the most important of all imponderables in a social struggle. It is the one which gives an entrenched and dominant group the clearest and the least justified advantage over those who are attacking the status quo. The latter are placed in the category of enemies of public order, of criminals and inciters to violence and the neutral community is invariably arrayed against them. The temper and the method of non-violence destroys the plausibility of this moral conceit of the entrenched interests. If the non-violent campaign actually threatens and imperils existing arrangements the charge of treason and violence will be made against it none-the-less. But it will not confuse the neutral elements in a community so easily…
            Non-violent coercion and resistance, in short, is a type of coercion which offers the largest opportunities for a harmonious relationship with the moral and rational factors in social life.

            Arendt doesn’t buy into MLK’s or Gandhi’s notion either that non-violence is without violence. There are just too many logical fallacies in it. In Crises of the Republic Arendt has a whole chapter “On Violence” where she delves into the use of violence (non-violence) to provoke a violent reaction and thus expose the covert and hidden coercive factor in society:

            Not many authors of rank glorified violence for violence’s sake; but these few—Sorel, Pareto, Fanon—were motivated by a much deeper hatred of bourgeois society and were led to a much more radical break with its moral standards than the conventional Left, which was chiefly inspired by compassion and a burning desire for justice. To tear the mask of hypocrisy from the face of the enemy, to unmask him and the devious machinations and manipulations that permit him to rule without using violent means, that is, to provoke action even at the risk of annihilation so that the truth may come out—these are still among the strongest motives in today’s violence on the campuses and in the streets. And this violence again is not irrational. Since men live in a world of appearances and, in their dealing with it, depend on manifestation, hypocrisy’s conceits—as distinguished from expedient ruses, followed by disclosure in due time—cannot be met by so-called reasonable behavior. Words can be relied on only if one is sure that their function is to reveal and not to conceal. It is the semblance of rationality, much more than the interests behind it, that provokes rage. To use reason when reason is used as a trap is not “rational;” just as to use a gun in self-defense is not “irrational.” This violent reaction against hypocrisy, however justifiable in its own terms, loses its raison d’etre when it tries to develop a strategy of its own with specific goals; it becomes “irrational” the moment it is “rationalized,” that is, the moment the re-action in the course of a contest turns into an action…

  1. Hugh

    The audits alone if done according to mark to market rules would kill them. A forensic audit would show fraud from top to bottom. Can you see why the banks would do everything they could to stop this?

  2. Skippy

    Is not the Shakespearian argument of Shylock

    The washing of hands by cleaver side stepping of responsibility.

    Firstly Deuteronomy 23:19 Thou shalt not lend upon interest to thy brother; interest of money, interest of victuals, interest of any thing that is lent upon interest.

    Then, Psalm 15:5 He does not put out his money at interest, Nor does he take a bribe against the innocent. He who does these things will never be shaken.

    Followed by, Leviticus 25:35 ‘Now in case a countryman of yours becomes poor and his means with regard to you falter, then you are to sustain him, like a stranger or a sojourner, that he may live with you.

    Funny how devout people sidestep their own law which is the law above all others by using the not my brother argument.

    Skippy…chew on that teabagers/fuax news obey your own laws and then talk.

    PS. for those with out the time to devour volumed tombs see link to: The Ascent of Money

  3. Francois T

    I love his proposal #10 too.
    Yet, we have yet to see ONE (just a freaking one) journalist on TV interviewing Obama and hammer him on this topic.

    But apparently, we only see that at the BBC or France Inter (Envoyé Spécial show).

    In the US, any informed person cannot listen to the news from the mainstream media (including NPR) without exposing themselves to explosive bouts of high blood pressure.

    Which means that Lavrenti is absolutely right: we’ll need to take it to the streets in huge numbers to instill the Fear of God in this American native criminal class called Congress.

    But for that to happen, the second leg of this Great Recession will have to be terrifying, with lots of collateral damage.

  4. Siggy

    Professor Black is very much on point. The failure of the Fed, the Treasury and the Justice Department to enforce the law is criminal in its own right. We, the electorate need to demand that our elected officials cause the laws to be enforced and executed.

    What we will probably be presented with will be more legislation the effect of which will be to obfuscate the frauds that underlie our distress.

  5. Gator

    Professor Black nailed it.

    We also need mandatory minimum jail terms for financial fraud. We need prompt and vigorous prosecution of such fraud. Politicians who sell influence need to be prosecuted for treason because their actions impair America’s sovereignty and security.

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