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.

Print Friendly, PDF & Email


  1. Tao Jonesing

    I, for one, greatly appreciate public figures like Bill Black, whose voice has only grown stronger and more certain in the face of the vast dereliction of duty of our federal law enforcement when it comes to financial crime. It takes a substantial amount of courage and convinction to do what they’re doing.

    At times, however, I don’t feel they go far enough. The root problem is leveraged financial speculation, which should be criminalized and expose corporate shareholders to unlimited personal liability. Financial speculation leveraged through fractional reserve lending serves has no social purpose and is always the cause of economic depressions. Such speculation should be subject to the same property forfeiture laws as drug crimes, and the criminal penalties should be as harsh as those imposed on the most hardened criminals.

    At least that’s the kind of “regulation” I’d like to see. People who gamble with other people’s money should be locked away for a very long time.

    1. readerOfTeaLeaves

      You articulate it better than I can.
      Just to underscore your point about the remarkable contribution of Prof Wm Black, I read this here:

      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.

      while in a different browser window, I see at FT that Madrid is making noises about raising capital requirements. The reported yesterday that Clegg was making noises about breaking up the banks (judging from the comments section, the online readers doubt they’ll ever see real action). Meanwhile, there is spotty news that the FCIC is going to recommend US government prosecute financial crimes – we’ll see whether that comes to pass.

      The lack of public conversation on the topic of ‘control fraud’ is striking.
      If the economy is ever to recover, it’s increasingly clear that this underlying problem needs to be addressed.

      1. john

        In 1976 with Buckley vs Valeo, by judicial fiat the Supreme Court transformed America’s constitutionally protected free speech into a “market place of ideas”. While you can continue to say what you please in The United States, only those ideas backed by money can achieve a voice in the political “market place of ideas”. The Court made bribery legal when it is a political bribe as distinct from the other sorts of graft we continue to frown on.

        Until some communicative structure can be invented and tailored to communicate with the broad electorate the systematic decriminalization of political graft and anti-social behavior that the “great moderation” and “era of deregulation” embody, any ideas that actually might work to the benefit of society will be drowned out by the broadcast din of well funded accusations of “communism”.

        While in our broadcast media we live in a state where any statement of sympathy for another human expressed outside a church is called “communism”, I’ve been to a number of Tea Party events where it has been clear that the majority in the room do not share this sentiment even while the speakers appeal to simple moral heuristics to build a solidarity with medicaid and social security beneficiaries while extolling “virtues” that would impoverish these same people, their audiences. There is no coherent moral counterargument because there is no money to pay for the organization.

  2. Nathanael

    The principle of bank regulation should be to regulate what is truly measurable, to minimize control frauds.

    This means regulating at the lowest level possible: reserve requirements, interest rates charged and offered, fees, salaries, cash flows.

    1. Benedict@Large

      An admirable goal, but unrealistic without a greater willingness to criminally prosecute high-level fraud.

  3. jake chase

    President Andrew Jackson said that if the people understood banking there would be a revolution tomorrow morning. Instead of revolution we experienced one hundred eighty years of rent extraction covered up by Ponzi finance. In today’s world every bank is insolvent and every regulatory scheme is a fig leaf. The only question is who gets the money gushing from the Fed and how long it will be worth anything at all. The saddest truth is that the entrenched powers will keep up appearances for as long as possible by grinding those at the bottom.

  4. F. Beard

    Nice article by Mr. Black. I have bookmarked it.

    I assert that our current banking system is government backed counterfeiting. So how can ANY accounting changes fix the problem; the system is fundamentally corrupt.

    Gee wiz folks, the model was invented in 1694 and we still can’t make it work 317 years later?!

    There is at least one way to implement money without debt (hence no usury), fractional reserves, or PMs: common stock.

    Common stock as money shares wealth at the same time it consolidates it for economies of scale.

  5. profoundlogic

    Thank you Mr. Black!

    Few have taken up the cause where the cause is needed. You explain the accounting trickery with ease. I find it amazing that our government continues on this reckless pursuit of “fudging the numbers” to appease the general populous and maintain a sense of control. For those who’ve bothered to do a little research, it’s pretty obvious there is no economic recovery, quite the contrary. What we have is a systematic effort to sweep some of the biggest crimes in human history under the rug so we can get on with the business of raping and pillaging average Americans. At least I will be better prepared for the next collapse. With the level of fraud in the system and subsequent efforts to hide it, we are only insuring a catastrophic failure. I fear the next pop is going to be rather large indeed.

  6. liberal

    I think the argument about measuring capital here is similar to the (economist? and) blogger Steve Waldmann’s, though the one here (emphasizing the residual nature, and the incentive to game) a little easier to understand. (Admittedly I haven’t read the Waldmann post in quite a while.)

    1. Cedric Regula

      It really is simple.

      Capital = theoretical asset valuation – theoretical liabilty valuation

      Capitalist = Bullshit In – Bullshit Out

      1. skippy

        Can I have a go.

        Capital = theoretical asset valuation – theoretical liability valuation.


        Capital = selective ramrod asset valuation – nothing to see here liability valuation.

        Skippy…sorry mate, still having first coffee of the day.

  7. Independent Accountant

    Bravo! I have said things like this for over 20 years. Now comes a dirty “secret” of the CPA “Profession”: the TBTF banks are UNAUDITABLE! Where are the: SEC, PCAOB, AICPA, Big 87654, OTS and OCC on this? Nowhere to be seen.

  8. F. Beard

    A fundamental flaw is to equate money with capital. True capital is things like human talent, industrial processes, factories, land, resources, etc. And what is money? In our current system it is a de facto government backed monopoly medium of exchange lent to us at interest.

    If we should remove the explicit and implicit government backing for the money monopoly, such as the capital gains tax on potential private money alternatives, the income tax where income is measured in FRNs and any government backing of fractional reserve lending such as the Fed and FDIC then we can expect a much better correlation between money and capital than we have today. We could also expect the boom-bust cycle to disappear or at least to be local in its scope.

  9. india

    Of Note:

    House Bill 1506 posted on this site a few days ago was killed in committee last night. The only action now will be a letter sent to the Governor for his consideration of the proposed legislation.

    Del. Robert Marshall of The Virginia House of Delegates wrote a Bill that would have not only provided protection for the citizens of Virginia but would have served as a clarion call to other states to employ his efforts as a template for their own legislation. It had the support of several other delegates and a major proportion of County Clerks of the Court.

    Yves posted the presentation by Pennell that succinctly and effectively illustrated the chicanery employed by MERS and its subscribers. Yves also posted the excerpt of damning testimony by the MERS rep. in his appearance before the Va. Legislative committee. This is a major loss for everyone involved in the effort to prevent further fraud in the mortgage and securities industry.

  10. mezcal

    Another good piece by Professor Black.

    It’s quite easy to verify the truth of his premise by examining the “FDIC Friday” results where we see 20, 30, 40 percent losses week after week.

    Here’s just the most recent example from CR:

    If the accounting wasn’t perverted, and PCA was followed, then there should be zero losses to the taxpayer when these failed banks are resolved.
    That is clearly not what’s been happening.

  11. Uh uh

    Hang on, what are the new liquidity rules in Basel III? Chopped liver? And the leverage ratio? And the trading book review?

    And do you think that the Basel committee etc aren’t heavily involved in accounting standards and controls? If you think bank supervisors’ concerns begin and end at capital you are misinformed.

    It is a bit rich to blame Basel II for the US banks’ malfeasance, since the US wasn’t and still isn’t on Basel II.

      1. skippy

        Will Banks be the temples stormed like history’s past, for sacrificing too many of it believers, to maintain its fiat required trajectory.

        Skippy…more souls to the combustion chamber, the universes friction requires it! The Bankster Ship must achieve escape velocity, frictionless vacuum is where we belong, the heavens await[!] for if not, we will be on someones plate!

    1. Deus-DJ

      Sorry pal, none of the ratios you mentioned have any impact on the capital ratios that Dr. Black legimately criticized, ie they don’t change the argument.

      It was the idea of Basel II, which already had taken it’s role in Europe and was about to become active in the USA until the crisis hit, which Black criticized as the low point.

      1. Uh uh

        Dr Black criticizes Basel’s focus on capital, I mention that actually there are other elements to Basel’s rules, and you say this doesn’t change the argument? Yeah right. The trading book and counter party credit risk changes DO change the capital ratios because the risks weights will be very different.

        And he was complaining about the new Basel III or else why write the article?

        The idea that the Basel committee ignores accounting is just wrong, too. There is a woman from the Bank of France who is always in the trade papers on that issue. She is on the committee. Dr Black’s article sets up a straw man.

Comments are closed.