Market Overview

The Wall Street Journal's Incredible Claim that Banks Can't "Game" Asset Values

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The Wall Street Journal has published a disingenuous editorial that claims that it is we should not worry about anti-regulatory leaders who produce a self-fulfilling prophecy of regulatory failure because they are chosen on the basis of their ideological opposition to effective regulation.  The WSJ’s position is that George Stigler supposedly proved that “regulatory capture” is “inevitab[le]” and that any need for financial regulation and supervision can be supplied by “simple laws that can’t be gamed” such as a 15% capital requirement.

“Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can’t be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital—an equity-to-asset ratio of perhaps 15%. It means bringing back bankruptcy for giant firms instead of resolution at the discretion of political appointees. And it means considering economist Charles Calomiris’s plan to automatically convert a portion of a bank’s debt into equity if the bank’s market value falls below a healthy level.”

No person did more to try to make financial regulation ineffective than did George Stigler, though Peter Wallison, Alan Greenspan, and Charles Calomiris were all in the running for that title.  No media organ tries so hard to destroy effective financial regulation as the WSJ.  Calomiris also ran his bank into the ground and was denounced by his brother as incompetent, so the suggestion that we take advice from him is a fine example of unintentional self-parody. 

In my next installment I will refute the claim that regulatory capture is inevitable.  I can personally attest that the WSJ’s claim is false.  Indeed, the WSJ editorial staff praised my work and that of Federal Home Loan Bank Board Chairman Gray as regulators because we took not only the most powerful members of the industry but also their even more powerful political allies.

In this first installment I refute the claim that there are “simple laws that can’t be gamed” such as a 15% capital requirement.  That claim is startling for a group that purports to have financial expertise.  Bank “capital” is not a sack of money.  It is simply an accounting residual (Assets – Liabilities = Capital).  That means it is constantly, massively “gamed” by banks.  They overstate assets and understate liabilities and the result is that they overstate capital.  Indeed, the essence of accounting control fraud epidemics that cause our recurrent, intensifying financial crises is the massive overstatement of asset values. 

Banks can also game “capital” and “equity” directly.  They finance faux purchasers of newly-issued equity with sweetheart loans – as was done during the Savings and Loan debacle, the Icelandic banking crisis, and the Irish banking crisis.  Bank owners also make “capital contributions” of massively overvalued assets that have no easily verifiable market value. 

Indeed, the complacency of believing that capital requirements cannot be “gamed” would compound the danger when they were gamed.  “It’s not the things you don’t know that cause disaster; it’s the things you do know – but aren’t true.”  The WSJ “knows” that capital requirements “can’t be gamed” – but what it “knows” is a lie.

The WSJ, alternatively, suggests that banks be made subject to the normal bankruptcy laws so that they can be subjected to involuntary bankruptcy petitions by creditors and so that regulators could no longer place a bank into receivership, which is often essential to an assisted acquisition by the FDIC.  The FDIC is almost always the largest creditor of a failed bank, and the WSJ’s suggested “simple law” would make the FDIC subject to the automatic stay, which would play havoc with its funding levels during a financial crisis.  Think hard for five minutes about the effects these “simple laws” would have had during the global financial crisis.  It is an excellent means of pouring gasoline on a financial crisis.

Then there is Calomiris’ “simple law” that would convert bank debt to equity as it suffered losses.  Conservative economists keep promising that “private market discipline” will remove the need for bank examiners and supervisors.  Prior to the crisis they claimed that requiring banks to sell subordinated debt would provide superb private market discipline.  However, they have never been able to demonstrate any bank where its issuance of subordinated debt prevented it from engaging in accounting control fraud. 

Calomiris’ “simple law” would prompt bank crises rather than prevent them.  Subordinated debt holders (except in Ireland where the government was insane) are already wiped out in the event of a banking failure, yet they provide no effective private market discipline against accounting control frauds.  Creditors of accounting control frauds already suffer staggering losses when the bank fails (absent a bailout or assisted acquisition) that differ only marginally from equity holders.  The creditors provide no effective private market discipline against accounting control frauds. 

Calmoris presumably does not propose to apply his conversion to banks’ primary creditors – depositors, for doing so would encourage runs.  One presumes that he would apply the rule to large institutional creditors, primarily other banks and financial institutions such as the money market mutual funds that held significant amounts of Lehman commercial paper.  If banks, money market mutual funds, and large corporations faced equity risks when they purchased hybrid debt/equity under the “simple” Calomiris plan there are three certain consequences.  First, it was (far smaller) losses by a money market mutual fund on Lehman’s straight debt (commercial paper) that prompted the largest run in history and turned Lehman’s failure into a global nightmare.  Calomiris’ plan would have produced dramatically lager losses. 

For my readers who have a basic familiarity with bankruptcy law consider the interaction of the WSJ’s proposed “simple law” applying the bankruptcy laws to FDIC-insured banks and Calomiris’ “simple law.”  The bankruptcy treatment of equity holders is substantially more hostile than creditors.   

The “preference recovery” provisions of the bankruptcy code would also have important implications for Calomiris’ “simple law.”  If the preference recovery provisions of bankruptcy law did not apply to Calomiris’ plan then creditors of any troubled bank would have powerful incentives to pull their lines of credit immediately lest they suffer very large losses as converted equity holders.  Similarly, they would have intense incentives to find arguments for declaring a default and accelerating the repayment of the bank’s debt prior to time that the bank hit the “simple” trigger that would convert their debt to equity.  Instead of stabilizing troubled banks this feature of Calomiris’ plan would prompt creditors to stage de facto runs on the bank.

If, instead, the bankruptcy preference recovery provisions did apply to Calomiris’ plan the choice of the trigger would be even less “simple” than the WSJ asserts.  If the trigger is set at a point well before bankruptcy the bank’s creditors who successfully rushed to accelerate the repayment of the bank’s debts to them would likely not run afoul of the preference rules.  The effect, again, would be destabilizing.  If the debt-to-equity conversion trigger were set at a point shortly before the bank became bankrupt then the creditors would typically be locked in to being converted to equity should the bank get into trouble.  That would greatly reduce the attractiveness of bank debt and cause large purchasers of such debt to charge a substantially greater risk premium, reducing bank profitability.       

The most destructive aspect of Calomiris’ simple plan, however, is that the first time a bank’s creditors have their debts converted to equity during a period of financial stress there will be a sharp and immediate reduction in the willingness of other creditors to purchase such convertible bank debt, an immediate spike in the risk premium for such debt, and a global effort – particularly by financial institutions – to get out of any positions in bank convertible debt.  This reaction will not constitute individualized “private market discipline” but a generic “flight to quality” that can trigger a global crisis.

“Simple laws” that do not remove the factors that produce the perverse incentives that make finance so criminogenic for epidemics of accounting control fraud cannot work because they do not address the fundamental problems.  Simple laws premised on these anti-regulatory ideologies are excellent means of making the financial system even more criminogenic and friable.

<i> <p> Bill Black is the author of <a href="http://www.amazon.com/Best-Way-Rob-Bank-Own/dp/0292706383">The Best Way to Rob a Bank is to Own One</a> and an associate professor of economics and law at the University of Missouri-Kansas City and the Distinguished Scholar in Residence for Financial Regulation at the University of Minnesota's School of Law. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.</i> </p>

 

 

<p> <i> Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his <a href="http://papers.ssrn.com/sol3/cf_dez/AbsByAuth.cfm?per_id=658251">Social Science Research Network author page</a> and at the blog <a href="http://neweconomicperspectives.blogspot.com/">New Economic Perspectives</a>.</i>

 

Follow him on Twitter:   @WilliamKBlack

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

 

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