How the Current Refusal to Deal Harshly with Failing Banks and Their Executives Will Create an Even Bigger Crisis

Your humble blogger has been saying that the new bank rescue scheme, which is a covert backstop of nearly all uninsured deposits, is a disastrous extension of government support to institutions that are welfare queens save for executive and manager pay levels. And the Fed may make banks’ “Heads I win, tails you lose” bet even bigger by announcing that all deposits will be guaranteed.

We’ve argued since the crisis that banking is the most heavily government subsidized industry, far outstripping the military-surveillance complex in the support it gets from the great unwashed public. Yet every time banks predictably drive themselves off the cliff, they get even more goodies, with virtually nada in the way of new restrictions or punishment of miscreants. The US is keen to perp walk Donald Trump, but not bank executives.1

Aside from the long-overdue need to prosecute more bankers and also swiftly remove bank top managers who demonstrate that they are bad at banking, the US needs to regulate banks like utilities. They need to be kept stupid and allowed to make safe and boring profits. So no one talented will want to work for them? Outside of IT, where big banks’ systems are held together with duct tape and baling wire, banking does not require “talent” (which today usually amounts to rule-breaking or at least soft corruption), but people who perform reliably and competently. Our financial system is dangerously outsized. One way to put that in reverse is to set out to reduce pay levels across the industry.2

Georgetown Law professor and former Special Counsel to the Congressional committee which supervised the TARP Adam Levitin weighs in on where this even greater permissiveness towards banks is set to take us. Levitin starts by pointing out that the authorities simply will not shut down or otherwise hog-tie sick banks:3

The response to the current crisis only confirms that regulators will not shut down troubled banks: the Fed’s new Bank Term Funding Program is a zombie-bank life-support program. The new Fed facility allows banks to borrow against their Treasuries and agencies at par, not at market value. That’s a way of extending support to banks that have failed at Banking 101 and mismanaged their interest rate risk. What that should tell everyone is that the game plan for dealing with this crisis is basically the same as in 2008: extend and pretend. Specifically, banks will be given all sort of support to enable them to avoid immediate loss recognition (as many would be in prompt corrective action territory if their securities portfolios were marked to market) and to claw their way back to solvency through retained earnings. In 2008, the extend and pretend was about bank’s loan portfolios. Now we’re just repeated the song in the key of securities.

The idea that regulators simply will not order abandon ship until the bow is below water is reinforced by the history of regulatory (inaction) on all sorts of other legal violations by banks, be it for AML or consumer protection. Exhibit A here is Wells Fargo, a repeat recidivist, still having a charter. If regulators will not take away the charter of a bank that engages in repeated and egregious violations of law, when will they ever do so?

Levitin contends that the problem is that regulators are afraid of intervening early because doing so makes them look bad. Sadly, I think the root problem is even worse.

Bank regulators think it’s good for banks to be profitable because retained earnings are the big source of additional capital for banks. That means they are too willing allow financial firms to engage in “innovation,” particularly the sort that looks like it generates earnings now and the greater risks are hidden or can be ‘splained away. As Taleb warns, tails are fat so in lots of cases those risk bombs blow up. More generally, this pro-“innovation’ stance fits with the pervasive US regulatory stance that everything not specifically prohibited is permitted, while for banking, the regime needs to be that anything not specifically permitted is prohibited. But that’s another change we are unlikely to see.

A second problem is the US does not seem to have the capability to resolve any really large bank, particularly one with capital market operations. And there is a pragmatic problem: those banks have large trading books. It’s not clear how they could be wound down (the last time I can recall anything like that happening was with LTCM ad they were big enough to be dangerous but not part of the central plumbing).

Consider the last really big bank resolution: Continental Illinois, then the fourth largest bank, in 1984. Continental Illinois was in receivership till 1991.4 I suspect that result has led the FDIC to be extremely resolution averse (despite Shiela Bair, to her credit, wanting to pull the plug on Citigroup during the crisis, but she was checked by Geithner and Bernanke, who withheld information about huge areas of Citi’s operations, making it impossible for her to make an informed decision).

Mind you, that does not mean there are no answers to this problem, but they entail regulators doing what they don’t like to do, at least in the US: acting like they are in charge. For instance, punishments of banks that defy or ignore regulator warnings about serious problems could be subjected to removal of key executives and board members. That means regulators would need to be able to find replacements quickly. In theory that is not hard: the world is awash in senior bankers who lost out in political fights and would love to be personally vindicated by being called into a rescue operation. The tricky part is having a vetting process that is fast, robust, and can be defended as not cronyistic.

Another approach is to limit top bankers salaries and bennies to a comfortable but not egregious level (you would need rough bank size and regional cost of living adjustment) and have bonuses put in a rolling five year deferred account. If a bank fails, is put in resolution, or liquidates voluntarily, the bonuses are wiped out first, before any haircutting of shareholder equity. That structure would not only reduce bank risk-taking but would also give executives incentives to try to sell or break up a sick bank before it got to be a goner.

Levitin then explains how, as we’ve already warned, that we’re in store for even more subsidized risk-taking and incompetence with no brakes on the process:

What we’ve seen in 2008 and now in the Panic of 2023 is that regulators will disregard deposit insurance caps whenever they get twitchy about the possibility of contagion in the banking system…

Uncapping deposit insurance is basically a way of saying that banks will not be allowed to fail. Because if deposits are all guarantied, banks should not face runs and liquidity problems and any solvency issues can be massaged through extend and pretend. That’s a really troubling outcome. If we continue to have private ownership of banks (and no one is suggesting otherwise), then we’re in a situation in which there’s privatization of gains and socialization of losses: heads-I-win, tails-you-lose.

I can tell you how that movie ends: S&L Hell. Banks will be incentivized to engage in every riskier behavior. And given that regulators will be unwilling to toe the line, we’re going to be right back in the S&L situation of the 1980s: zombie banks being allowed to invest in race horses, shopping mall developments, etc. because of higher yields to offset their past losses. To be sure, the FDIC will start charging more in premiums, but that won’t fix the situation—they’ll always be below market pricing (and will be a regressive cross-subsidy). At some point this system becomes untenable, and then there’s going to be a MUCH worse crisis…

But don’t count on Congress addressing the problem: doing so would curtail credit. Congress is always incentivized to prefer easy money policy, and lax bank regulation is one way to implement easy money. The reason Congress is incentivized to prefer easy money policy is that there’s a concentrated interest that cares about it—would-be borrowers (like home mortgage borrowers and small businesses)—while those who pay for it—non-borrowers who do not want to be subsidizing this system—are a diffuse interest group who aren’t likely to see the connection between weak bank regulation and the costs they bear with higher deposit insurance premiums that get passed through to them in the form of lower APYs and higher bank fees. The former group donates and votes on this issue. The latter group does not.

All this leaves me somewhat despairing. Insuring all deposits would be workable … if regulators would actually rein in banks. (Desirability is another matter…) But the combination of cravenly prudential regulation and functionally uncapped deposit insurance is really toxic. Perhaps I should just go and buy some bank stock (especially now that it’s discounted) because after a couple of years of retained earnings to get back to solvency, the real winners will be bank equity holders, who will get all the upside and bear none of the downside.

We actually foresaw this all in ECONNED (Chapter 10) but I will spare you the lengthy quotes. The US is going to keep going on an inertial bad path. The result will be more and more misallocation of capital, more funds going to leveraged speculation and shiny investment objects like SPACs, unicorns, and apps, as opposed to real economy activities that will improve infrastructure, productivity, and quality of life.

Continued misrule by finance will also assure the US falls behind China even faster than we would otherwise. But of course we’ll blame China for competing unfairly rather than doing the hard work of getting our house in order.


1 Wells Fargo’s Carrie Tolstedt, its enthusiastic massive customer fraud implementer in chief, just entered a deal where she pleaded guilty to one count of obstructing a bank examination and could be sentenced for up to sixteen month. Sentencing is scheduled for April. Critics pointed out that Tolstedt did not act alone, and had plenty of co-conspirators, particularly in former chairman and CEO John Stumpf as well as other C-suite members. I did not find any evidence that she has been handcuffed.

2 In his seminal article, The Quiet Coup, Simon Johnson described how pay levels for bankers in 1980 were on a par with the average across sectors. Both compensation levels and total industry employment rose after then as financialization took hold.

3 Levitin is a long-standing ally and wants his posts read and hence is fine with my extensive hoisting of his very fine copy.

3 However, sometimes there are unexpected benefits to having a big bank on public life support. From a 2018 post:

A story we think can’t be told often enough: In the 1987 crash, the Chicago MERC almost failed; it was saved only with a three minute margin by Continental Illinois CEO Tom Theobald being in the office early and overriding an internal (and procedurally correct) order to not fund a $400 million loan against a failed customer order. John Phelan, head of the NYSE, said if the MERC hadn’t opened, the NYSE would not have opened, and if it has closed, he was not sure it would have been able to reopen.

And would Theobald have made that call if he had been running a privately owned bank? Continental Illinois was still under FDIC resolution. It took over seven years for the Feds to get out of the Continental Illinois business.

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  1. none

    It also sticks in my mind that at least in SVB’s case, an awful lot of the bailout money was to reimburse crypto speculators. What are we supposed to learn from this?

    1. Tony Wright

      Answer: It is who you know, and can effectively lobby or bribe, not what you do. Sadly.

    2. JP

      Can you site a reputable source. Surely crypto was not bailed. Were there crypto deposits? No just dollars. How can you learn something real if you don’t have the facts? Are not all savings/investments speculative to some degree?

    3. Tim

      What is the mechanism for that happening? If speculators go broke and can’t pay the loans, they won’t, and the government funds are not directly making those loans whole on behalf of the speculators, they are making depositors whole.

  2. Bjarne

    It doesn’t seem this can continue forever. Currency collapse? Some level of hyper-inflation? How much longer can the Fed pump up the system without a collapse? I know its going to be difficult to replace the dollar as reserve currency but it is slowly happening and as the demand for the dollar overseas continues to wain, is it feasible for the Fed to keep buying US treasuries forever? A lot happens on the margins in finance. If int’l demand for dollars drops 5-10% or more what effect will that have on our economy? If I’m missing something in my general vague understanding of this stuff I apologize. Just trying to understand.

    1. flora

      The Fed is only pumping up the big financial part of the system, Wall St and the banks, while starving other parts of the system like Main Street and small businesses. It’s a transfer of wealth upward. That can go on for a very long time.

  3. Lexx

    So, carrots for the executives but on five-year-long poles that get a little shorter every year? I like it. As long as there are no consequences to them and all they have to think about is quarter to quarter (like the Cisco salesforce or Homer Simpson – ‘Can I have some money now?!!) – the risk taking will continue. Change the reward structure, change the ‘talent’ pool attracted to that job.

    1. Eclair

      ” …. change the ‘talent’ pool attracted to that job.’

      As my husband the engineer keeps pointing out to me, China graduates roughly 600,000 engineers annually, Russia about 450,000 and the US about 250,000. Of course, the term ‘engineering’ covers a wide range of types, from mechanical to software. But they are linked by a commonality, a facility with math. In the US, so many math facile people are attracted to finance because that’s where the money has been; figuring out models for dodgy and ever-more complex financial instruments.

  4. griffen

    We are a nation of laws, not men. John Adams

    Yeah, historical statements such as the above, no longer supported in today’s America and our modern economic times. I was not yet out of high school, but recall reading how after the S&L Crisis that many executives served actual time in jail. The early 2000s with the Enron and Worldcom debacles, chief among others, also saw those executives serve time in jail; Ken Lay did not serve time, excepting only for an untimely demise. Imagine that young kids, bad guys not getting bailed out after their bad decision and nefarious deeds were brought to light.

    Heads they will win, tails you must lose. These crisis events can be broadly preventable it seems, but based on recent antics from Yellen, etc… by a few examples I am simply not encouraged.

    1. NotTimothyGeithner

      The Georgetown professor/former special counsel misses that 2008 and the aftermath happened. Yellen’s famed congressional appearance is likely the result of a white house not going to bat for treasury and the fed but wanting a bailout. Biden is the president. Obama let everyone off the hook and celebrated them. If congressional action is needed, the White House and Congress will be under siege, leading them to be frozen. Biden hasn’t done what he needed to do to break from Obama.

      There won’t be bad policies but no policies.

      1. flora

        Biden will never go against the big banks. Never. His senatorial nickname used to be ‘the senator from [some big bank]’. Then there’s the bankruptcy reform bill he pushed through congress. Student debt, anyone?

      2. Yves Smith Post author

        This is a smear and totally out of line. Levitin was most assuredly part of the post bailout process and also a big critic of later chain of title abuses.

  5. Ignacio

    Very good post with excellent explanations. One gets the feeling the world (or at least this part of the world) is being divided in a privileged sector given the excuse of “systemic risks” and the rest of mortals which will undoubtedly pay a price for those privileges. Interest rate risk is only for borrowers as well as loan default risk. I think this post sets pretty clear that the systemic risks are indeed much higher precisely because those privileges exist. It creates a double society with a few able to take all risks knowing they will be rescued, and with all incentives to do so, while the rest remain, one way or the other, the bag holders paying for all the misdeeds. Confidence in this system will erode and at some point might collapse. Don’t tell me this is not “systemic risk”.

  6. John

    Now let’s see. Fifteen years ago we had a crash prompted by massive mortgage fraud. Money was thrown at it. Not one fraudster was even slapped on the wrist. Now we have a couple of banks being closed for risky business. Money is thrown at it. Has there been even a tsk, tsk directed at the bank executives. The banking and finances geniuses take note. Next crisis in finance: five years? seven? ten?

  7. Stephen

    I agree with this. A former colleague who was an ex senior banker always used to say that banks only really need four key executives: a commercial guy to manage the products / customers; an operations guy to run the back office; a finance / risk guy to keep score in an honest way and a CEO to oversee things and manage the trade offs. Always said he never understood why they all want to employ so many highly paid people, other than they have the money to do so.

    His thinking was close to the utility model. A consideration is that it needs to be properly implemented. Many utilities these days seem to have convinced themselves and regulators that they are something else and have many of the same vices that banks do.

    Agree too that there there is always a lobby for easy money. Of course, ultimately I am not sure it helps new borrowers. Easy money inflates the asset prices that new purchasers face. The true beneficiaries are people who have existing assets that they have realised capital gains on and which they either own outright or have financed through earlier borrowing. This assumes, of course, the reality that most borrowing in financialized economies is to pay for existing assets such as land, property and shares rather than to fund new capital formation.

  8. KLG

    S&L hell was bad. My S&L disappeared into Wachovia, which later also disappeared. But IIRC the Justice Department of George H.W. Bush’s administration put a few thousand of the banksters in prison where they belonged. What a concept!

  9. Lex

    Finance capitalism. Capitalism, by definition, concentrates economic power – and hence political power – in the hands of a few. They will use that power to their own benefit. It can’t be fixed because it’s not broken. The next step is to openly fulfill Dimitrov’s definition, “Fascism is the political manifestation of finance capitalism.” For the nomenklatura of finance capitalism, open fascism will be far preferable to any loss of wealth or power. The PMC will tag along like the good Germans they are.

    *Other types of capitalism may be a workable economic system, but finance capitalism will always go this way.

  10. The Rev Kev

    Nothing is going to change unless there are consequences for all these risky sorts of behaviours. And by that I mean charters for some banks yanked and bank executives headed off to jail. But as a class, these bank executives have rigged the system so that none of them go to the slammer and politicians have gone along with it so long as they receive political donations from these bankers. If a bank executive knew that through these dodgy, illegal acts that it might see him sharing a prison cell with a 6′ 6”, 240-pound guy named Casper who spends his day working out with weights, then I will guarantee you that it might make him debate if it is worth the risk.

  11. spud

    the nafta types that gutted the new deal and made this mess, have a plan, gut whats left of the social safety net, and get the lazy ass seniors back to work, and of course why waste time with school, get them kids into the work force to educate them early on obedience.

    that will be a twofer, get rid of the teachers unions, they can be productive also/sarc

  12. eg

    This will go on until the US finanz biz no longer gets the best regulation and supervision their money can buy — America is run by and for them.

  13. Carolinian

    Sounds like we will have to solve politics before we can solve the banks and have to solve the press before we can solve politics. Then there’s the medical complex, the military complex, real estate–seemingly no end to it. My theory is that the country is suffering from a kind of affluenza where people who grow up rich and privileged never learn how to take no for an answer. In other words it’s not white privilege but privilege in general here in a country that prospered after others had wrecked themselves in war.

    So Trump is no solution although he is willing to say true things if it will serve him, because for Trump as for his opponents it’s all about him. But at least he does say true things. So many others are lying their heads off.

    Thanks for the above. Some of us starting reading NC after the 2008 bank crisis.

  14. mikkel

    Serious question: if the government backstops everything why should banks even have deposits at all? Why shouldn’t everything just sit with the government with the bulk of profits flowing to the public.

    I think the best utility models have been shown to be where the government maintains ownership of the infrastructure and then service providers bid on access. That balances the natural monopoly and market forces of providing good service/innovation as long as there is some light anti-collusion regulation enforced.

    Banking could be the same. Deposits sit with the central bank and loan providers bid to get access to liquidity, which they secure by putting up a chunk of their own cash as a performance bond. They then get a cut of profits, and if they make losses it first is taken from their performance bond. Ideally this performance has a five year payout like Yves advocates. If you eat through your whole bond you’re cut off and the execs are prohibited from managing again unless they reestablish credentials, similar to being disbarred.

    Is there any reason why this wouldn’t work? It seems it’d solve many issues and lead to more general prosperity while avoiding political control of loan management.

    1. flora

      “Deposits sit with the central bank…”

      Would that be the same central bank that wants to introduce Central Bank Digital Currency (CBDC) ? Asking for a friend.

      If the central bank and the Fed can’t or won’t effectively manage and regulate banks now, why would I trust them to manage my small deposits?

      Shorter: the govt should not backstop everything. If people want to sail close to the wind with uninsured bank deposits that’s their business. That’s their risk. (It’s not the little guys doing that.)

      1. flora

        Shorter: even greater concentration in banking to solve the current problem of already overly-concentrated banking is the wrong way to go, imo. It would in effect nationalize the banks.

        How about more state banks like the Bank of North Dakota. Or Post Office banking.

        1. mikkel

          Agree with public bank too. I live in NZ and use Kiwibank which has lots of post office locations. Astounded why kiwis pick anything else since all the profits go to the treasury.

          They are too conservative for basic business banking though and don’t get involved in securitization which does have a useful economic function when it’s not abused. I do think proper investment banks are critical to a strong economy.

      2. mikkel

        Well money is a fiction anyway, it’s not like the central bank can lose your deposit. The only question is how to structure who gets to move it around, and what happens when things go wrong. In the end the little guy is always downhill.

    2. Revelo

      Yes, what you said would work. Deposits are government created fiat money so obviously place to store them is with the government. We akso might as well merge Fed and Treasury to get rid of this fiction that they aren’t just one entity.

      As for your lending side idea, would have been unfeasible in the 19th century because of technology limitations, but it’s quite feasible now. Computer enabled asset backed securities of all types eliminate maturity mismatch and loan concentration (lack of diversification) problems that historically were problems for banks. As long as bank equity is in first loss position, and deferred loan officer compensation in rolling trust is first loss before remainder of bank equity, banking crises would almost completely disappear.

      We could also change tax laws to strongly favor equity over debt (no mortgage deduction, no tax exempt municipal bonds, collect top tax rate on bond interest before paid out so no incentive by tax free entities to hold bonds rather than stocks, etc) to further stabilize the system. And then impose a tiny tax on all trades to discourage high speed trading of all sorts. And maybe a steep land tax too to rein in the bloated real estate sector.

      None of the above will happen unless there is disaster on the scale of Germany post WW2. Argentina is a lesson of how countries can slowly get worse and worse and never reform because no really big crisis that allows cleaning out all the economic rent seekers. And that’s where the USA and UK are both heading (especially UK): Argentina-style inflation, economic stagnation and political chaos that gets worse and worse as the decades pass.

      1. mikkel

        Good point on the asset monitoring, forgot to mention that part but had realized that was critical too. And get some actual mathematicians to do it who properly understand how to sample from the non-closed form solutions that large tails create.

        Of course this won’t happen in anything like our current reality but I think imagining how to build a new future post collapse is a worthwhile activity for more ways than one and change can happen extraordinarily quickly once collapse does occur as history has shown.

  15. John

    I am understanding more and more Michael Hudson’s take that there is no way to reform finance capitalism.
    I think there is one way that I have not heard him mention: catastrophic war. Create enough damage on the ground and people will get back to making things with no time for paper fantasies. That is if enough people survive.
    Bio overshoot, which is humanity’s war on planetary life will have the same effect eventually.

    1. JP

      Planet of the apes? You say you want a revolution. Whenever it all gets torn down it is inevitably replaced by a strong man making rules to ensure his continued control. Grab a spear and join up.

  16. James McFadden

    “the US needs to regulate banks like utilities.”
    I think one should add one minor caveat — “utilities that don’t have stockholders with guaranteed profit”
    The banking utilities’ profits should be used to reduce taxes, not enrich investors.
    We need a public banking system.

  17. melvin keeney

    This is also a sneaky way to consolidate the banking industry. Scared people saw only the big banks were saved. They are withdrawing a lot of money from small banks and putting those funds in big ones. My guess is the FED will allow the smaller ones to fail.

  18. flora

    Great post. Thank you.

    One small quibble: nationally chartered (not state chartered) big banks and small community banks are regulated in a way that shows great forbearance to big bank problems but fine-tooth severe examination of small banks. Since at least the 1990’s, the Fed has been trying to get nationally chartered small banks to sell out to larger banks, consolidating the banking world into fewer and larger banks.
    That’s one source of the problem, imo.

    (Rather like the way the USDA treats big ags needs vs small family farm needs.)

  19. McWatt

    Getting a new huge price increase from suppliers next week, along with price the discounts disappearing for the volume I’m doing. Now I pay the same when I buy a 100 as the guy that buys 1. No one wants to talk to me. The reps don’t care cause their territories are so large they can afford to loose business.

    New American business model; “Talk to the hand!”, but only by computer, where there is no place for “comments”. All suppliers are doing exactly the same thing. Can’t move to a new one cause they are all playing from the same playbook.

    Hang man, hang man, slack your noose!!!

  20. Karl

    I (think) I would be less concerned about the FDIC insuring all deposits regardless of size if, at the same time, these account holders were paying for the additional insurance they are getting, and the insurance premiums were commensurate with the risks taken by the bank.

    Paying more insurance fees for more risk would remove the incentive of banks to take too much risk, knowing they’d have to pass higher insurance costs onto depositors. This would introduce more market discipline into the banking system, which doesn’t seem to exist much today.

    To paraphrase Milton Friedman, “there is no such thing as free insurance.” The banking system should be self-insuring over the long term, rather than relying on the Fed.

    Here’s an alternative proposal: If the Fed is the ultimate backstop for the FDIC, what do we need the FDIC for? Maybe we should just get rid of insurance premiums altogether. Hopefully that regressive charge would be passed on to the smaller depositors. Certainly they can use the money!

    1. Yves Smith Post author

      Levitin addressed that too. The higher insurance costs will be borne by the small accounts, not the big ones. It will be regressive.

  21. Tim

    But what will all of the top end talent do with themselves if they can’t strip mine the American public?

  22. Mikerw0

    I know I am late in commenting on this, but I hope Yves, in particular, sees this. There is a regulatory model that works, insurance. The regulators have actual teeth, led by NY State. The industry kind of hates it and every time they come up with a scheme to get things loosened up it gets fought back. As a result there are relatively few issues and they get mopped up quickly. The examples, of course are Baldwin United (Merril made everyone whole), Skandia and Canseco (in the case of Skandia execs went to jail), General American (rapid demutualization and purchase by Metlife), or companies that fail due to natural catastrophes.

    Granted there aren’t the same counterparty risks as in banking, but there are cross reinsurance relationships, and there are state guarantee funds.

    Either way, its just a bette model.

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