The economic underworld of bankruptcy for profit
Professor William Black, an expert on banking and economics from the US, testified in 2015 before the Joint Committee of Inquiry into the Banking Crisis in Ireland. In his testimony, he pointed out that the financial crisis of 2008 and 2009 is certain to repeat because none of of the criminal bankers that bankrupted the country had been sent to jail - unlike the "Savings and Loans" crisis nearly two decades earlier in the US, which resulted in more than 1,000 convictions. One of the indicators that tell us banks are making "liar loans" is the speed at which lending is growing. If Prof Black is right, modern banking will sink us all. It is predicated on a business model of bankruptcy for profit. This is a long read, but well worth it for the deep insight Professor Black provides into the crisis and the criminal mentality of the bankers who were bailed out by taxpayers. Part 2 on this article will be posted later.Chairman
The committee is in public session. In session 1 we have a discussion with Professor William Black on banking policy, systems and practices. I welcome Professor William Black to the seventh public hearing of the Joint Committee of Inquiry into the Banking Crisis. Later this morning we will hear from European Commissioner, Mr. Mario Nava.
At our first session we will hear from Professor William Black, University of Missouri-Kansas City school of law, on the subject of banking policy, systems and practices. I welcome Professor Black to the meeting and to Ireland. I am aware he is a regular visitor and I hope his stay is pleasant. Professor Black is an associate professor of economics and law at the University of Missouri-Kansas City. Previously he was executive director of the Institute of Fraud Prevention. He has taught previously at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin and at Santa Clara University. He was litigation director of the Federal Home Loan Bank board, general counsel of the Federal Home Loan Bank of San Francisco and senior deputy chief counsel, Office of Thrift Supervision, and recently helped the Work Bank develop anti-corruption initiatives and served as an expert for the Office of Federal Housing Enterprise Oversight in its enforcement against US financial institution Fannie Mae’s former management. Professor Black is also author of the book .
Professor William Black
I thank the Chairman and members of the committee. My statement will be forward-looking as to what one can do to prevent a future crisis. There are a number of restrictions as to what one is able to do currently in terms of the existing crisis so my focus will be on the future. My message is one of hope, in large part, that we can succeed at this. We cannot succeed in stopping all bank failures and we cannot even succeed in preventing all future crises but we can prevent many of them and we can dramatically reduce the severity and length of the crises as well. That is because the great bulk of the worst crises and the great bulk of the worst individual bank failures will follow a characteristic pattern that can be identified well before a crisis stage and can be the subject of successful regulatory intervention.
I am coming to the committee with four hats today, as we would say in US parlance. My primary appointment is in economics. I have a joint appointment in law. I am a recovering litigator but I also have a doctorate in criminality. My specialty is in elite white collar criminals, particularly in the financial area and I think I will be the only successful regulator the committee is like to have appearing before it. We not only write about regulation, as members will see from other parts of the statement we are cited as the exemplars of how to make regulations succeed by public administration scholars. We were the only people to come out of a crisis with our reputation enhanced, which is difficult to find in the current crisis. We made many mistakes and the committee can take advantage of what we did wrong and what we eventually figured out worked well. The first thing that needs to be done is to identify where the future institutions which will cause massive losses will be found, and how they can be identified when they are still reporting record profits so action can be taken while they are still doing so.
The committee has asked me to speak about principles-based regulation, which can mean many different things. The gloss put upon it throughout Europe and the United States was one which ensured it would fail against precisely the kinds of schemes I will talk about. This is not necessarily inherent in principles-based regulation. It is such a vague phrase it can mean different things to different people. Throughout Europe and the United States it came to have the same gloss, which was, basically, BFFs, which means best friends forever and is a cliché for American teenagers. This was the idea the banker could be the BFF and we could all have a Kumbaya moment and strum folk songs together, and if we were just nice to the bankers who were oppressed by regulation and removed this terrible hand of government they would work with us and we would all sit around the campfire and it would go very well. This has no basis in human history, or anything we know about human beings, but it was mighty convenient if you were a non-regulator because you did not have to do much of anything, and the world would be better because you did not do much of anything.
Here is the recipe which leads to something distinctive. It is the recipe that the institutions follow which produces the worst losses, is most likely to cause hyperinflated bubbles, is most likely to cause catastrophic individual losses, and is most likely to cause future crises. I am speaking about the past throughout the world, but my focus is going forward in Ireland with regard to policies the committee might consider recommending. The recipe has four ingredients: grow like crazy; make terrible quality loans – not kind of bad but absolutely terrible and obvious on their face loans; while employing extreme leverage, which means a whole lot of debt compared to equity; and while setting aside no meaningful loss reserves for the inevitable catastrophic losses which will follow.
If these four ingredients are followed it is mathematically guaranteed – and let me emphasise it is not hypothetical but mathematically guaranteed given how the accounting works – there will be three sure things. The bank will report, almost immediately, record profits. Under modern executive compensation the senior leadership will promptly be made wealthy but many other people in the food chain will also be made wealthy because the same perverse incentive structures are used to ensure they make those really crappy loans I talked about. The third sure thing is that down the road there will be catastrophic losses.
Thinking about it from the flipside, if you tried to devise a strategy that would cause catastrophic losses it would be with these four ingredients. Using them, you will cause huge losses and you will have no loss reserves. You are particularly vulnerable outside the United States in terms of the accounting rules, as you follow the international accounting rules, which also purport to be principles-based. The principle they purport to follow is an anti-fraud principle that is concerned with what we call the trade cookie jar reserves. These are loss reserves that can be established in good times and taken out in a bad quarter to allow officers to meet their targets and maximise their bonuses. This was the principle that the rule was designed to prevent, but it is being interpreted in a way which creates the perfect crime. It is being interpreted as saying loss reserves cannot be established currently for future losses, even in institutions which follow the recipe where it is absolutely guaranteed that because of their terrible underwriting they will have catastrophic losses.
Right now the anti-fraud principle is being interpreted as the most pro-fraud principle we can possibly imagine. As we speak today, six and a half years after the crisis hit, we still have the same international accounting rule. There have been all kinds of efforts to change it, but none of them has come to fruition. This is an area that could be addressed through regulatory policy. We could have regulatory accounting principles that require appropriate loss reserves. If we did that we would block the recipe I have been talking about and that would be a very good thing. It makes perfect sense that if you are doing things that are very risky you should establish loss reserves today. Otherwise you will create fictional income and you will get everything we have done. As I said, in a poker sense, this creates a tell. The tell is that in order to follow the strategy there has to be pathetic underwriting. What you will find when you look at all of the crises in the past and in other places is precisely this destruction of underwriting.
Underwriting is a process that a bank goes through to ensure it is likely to be repaid, and that if it does loan it will do so at an appropriate interest rate that reflects the risk. The committee can see that this was not done all through the world. I will talk about other places because of pending issues in Ireland and the Constitution. This is precisely what we did in the United States in the savings and loans crisis. We saw terrible underwriting, very low reported losses and record reported income, and we said this is too good to be true and it is. We all teach our children about things that are too good to be true, but we do not, in fact, follow this policy in reality in financial regulation. If we had, there would be none of these current crises, but we did in the past, which allowed us in the savings and loans crisis to identify when institutions were reporting record earnings, and literally reporting they were the most profitable savings and loans in America, and when they did so we targeted them for closure. In fact, we took the list of the allegedly most profitable and made it a priority to investigate each of the institutions in the top list.
To do this you have to understand the accounting and the econometrics. Econometrics is a fancy word for economic statistics. Here is the key: if a regulator examines with a standard econometric analysis, and benefits cost analyses using this kind of econometric test are mandated throughout Ireland, they will give the worst possible result if an institution is following the recipe. Any characteristic or practice such as ultra-concentration in commercial lending to 25 families during the run up when the bubble is still inflating will show the highest positive correlation with reported profits. It has to do so. If we do standard econometric analysis we will say we should encourage everybody in Ireland, England and the United States to loan to only 25 people who should put virtually all of their money in commercial lending. That mathematically has to follow, so you have to not rely on those kinds of test. You have to understand that if you do not underwrite, as we have known for centuries, it will produce adverse selection. This selection means you get the worst possible borrowers, and the expected value – in order words, what will normally happen – is that you will lose money. It is like gambling against the house in Las Vegas. Statistically, you are going to lose money in these circumstances.
I will leave you with the most important thing, which is a phrase that you probably have not even heard to date – Gresham’s dynamic, which is the opposite of that hypothetical Kumbaya dynamic – “All will be well.” There is this guy named Swift who identified it in 1726 and put it in , but it has also been dealt with by Nobel laureates in economics. It says “What happens if cheaters gain a competitive advantage in the markets?” Then bad ethics will drive good ethics out of the marketplace. This will happen in the professions as well. All of those supposed controls – credit rating agencies, outside auditors, what we call appraisers but you may call valuers – can be hired and fired by the senior management of the banks. That is why, worldwide, in this crisis you see them deliberately going to top-tier audit firms and always getting insane financial statements blessed with clean opinions – because that reputation is valuable and easily manipulated by creating a Gresham’s dynamic. You can block that Gresham’s dynamic. You can block these crises. We intervened to stop 300 of these frauds that were expanding at over 50% a year in terms of growth, typically while they were still reporting high profits. We adopted a rule restricting growth which attacks the Achilles heel – the need to grow very rapidly. We deliberately intervened to pop the real estate bubble – particularly commercial real estate – in Dallas-Fort Worth. We intervened to stop loans that were in those days simply called low-documentation loans but now in the American parlance are called liar loans. This was in 1990 and 1991. We drove them completely out of the savings and loan industry and prevented a crisis.
Our current crisis is sometimes called the sub-prime crisis, but it is far more of a liar loans crisis in the United States, and even in the United Kingdom. We successfully prosecuted more than a thousand elite people from the banking industry with felony convictions. Even with the best criminal defence lawyers in the world, there was a 90% conviction rate. So you can succeed. We would be very happy to help. If it would be useful, in terms of training, I will provide a week of free training on how we did whatever we did for your regulators or prosecutors, or anything you find helpful, without charge.
Chairman
I thank Professor Black for his opening statement. The order of questioners this morning is as follows: Deputy Joe Higgins will have 15 minutes and Deputy John Paul Phelan will have 15 minutes, and from then there will be six-minute rotations for the following: Deputy Eoghan Murphy, Senator Marc MacSharry, Deputy Kieran O’Donnell, Senator Sean Barrett, Senator Michael D’Arcy, Senator Susan O’Keeffe, Deputy Pearse Doherty and Deputy Michael McGrath.
Before I bring in Deputy Higgins, I wish to comment. I thank Professor Black for his opening address. He described in detail the problems associated with rapid growth in banks’ balance sheets. Can he give us some specific indications on how regulators could apply rules to limit the growth rate? Is he suggesting that regulators should stop a growth rate that is excessive by his reckoning?
Professor William Black
Yes. You are probably particularly aware of what I am going to say. This is a federal agency that had three presidential appointees, so you get the best you can. You have to reach agreements. The best we could get was a restriction on 25% growth annually. The rule of thumb in banking for many decades has been that if you grow more than 25% a year you will likely fail, so this is a very weak limit. But here is the good news. It was still a cutback from growth of over 50% a year, which proved fatal to all 300 of these institutions. When I say “fatal”, remember – they are dead but they are reporting that they have record profits. So you are not causing the failure, but you force recognition of the failure. In essence, these are Ponzi schemes. Ponzi schemes must grow extremely rapidly to appear to succeed for a while.
Chairman
Later today, in our second session, we will discuss the regulations set out in Basel I, II and III and the credit directives and so forth which are post-crisis measures established at the European level, particularly in regard to the eurozone. Does the professor think those measures are robust enough to protect us against a future crisis, going with his own metric of what he considers the sure things that would create a crisis into the future?
Professor William Black
Basel II was a very substantial contributor to the crisis, particularly in Europe. In the United States, because of heroic resistance by the Federal Deposit Insurance Corporation against the Federal Reserve economists, who are very much in favour of Basel II, we established a minimum leverage ratio. Therefore, leverage is roughly on average twice in Europe what it is in the United States in terms of the crisis. Leverage will magnify either gains or losses. If the FDIC had not done that, US losses would have been roughly twice as large. In fact, that is an understatement, because losses do not grow linearly but tend to grow exponentially in these circumstances. Yes, Basel II was a disaster, because it facilitated the recipe that I have just gone through – grow like crazy. It allowed massive growth. With extreme leverage, it allowed extreme leverage.
Is Basel III better? Yes, but Basel III is horrifically complicated. It would be vastly better to go back to much simpler rules. The position I am taking is, frankly, the majority position among people who are involved in regulation and economics.
Joe Higgins
I thank Professor Black for coming across the wide Atlantic to assist us with the banking inquiry. I had intended to ask him to give a short résumé of his experiences that have led him to be an expert on bad practices in the banks but he gave some of it in his introduction, which was quite interesting.
He referred to the prosecutions and the investigation into savings and loans. I remember it was a huge scandal in the United States back in 1990. It was a high profile case and was national news in the United States. With that success and what was shown, why was that not brought into legislation regulation? Why, 17 years later in the United States and internationally, were the same bad practices allowed to create mayhem?
Professor William Black
That is a superb question, not just a good question.
At the moment of our greatest success in 1993 – there is this period that basically ended in 1993 – a new Government came in. It brought with it, as its primary domestic priority involving government, the re-invention of government which is, essentially, principles-based regulation. They absolutely adored the lessons of the savings and loans crisis. I personally witnessed the following. We were instructed that we were to refer to the banks as our “customers”. I said, “Surely you mean the people of the United States of America?”. They said, “No, the banks.” I left government at this point, as you would imagine. I do not say it was a conspiracy, but it was a deliberate choice to move to a very different strategy without looking at the successes of the response to the savings and loan debacle. In order to produce over 1,000 felony convictions, we created a criminal referral process that provided the key information from the regulators. I remind the committee that we have vastly more expertise in the industry on accounting issues, etc., than the FBI white-collar folks. We made over 30,000 criminal referrals. That criminal referral process was eliminated. In the current crisis, there were no criminal referrals in the United States, as far as anyone can tell.
Joe Higgins
Professor Black said something that might worry some people out there following on from that. He said a few minutes ago, if I understood him correctly, that nothing has “come to fruition” in effective regulation in the six and a half years since the most recent crisis started. Why does he think that is the case?
Professor William Black
When I used that language, I was actually testifying explicitly about the accounting rule on loss reserves. It is true that in general, financial regulation has not been transformed. We are still vulnerable to precisely the things I have laid out. That is because we have not focused on the Gresham’s dynamic and we have not focused on the concept that is referred to in the economics literature as “looting”. The key document in this regard was written by Professor George Akerlof, who is a Nobel laureate in economics, and Professor Paul Romer in 1993. The article in question, Looting: The Economic Underworld of Bankruptcy for Profit, lays out precisely the strategy I have discussed. They chose to conclude that article with a paragraph emphasising that because economists had no concept of looting, they were unable to aid “the regulators in the field who understood what was happening from the beginning” and suggesting that “now we know better”. In other words, if we learn the lessons of this crisis, we need not experience this again. That very concept is forgotten. If the committee checks all the articles and all the testimony it is given, I bet it will find I am the only person who has cited Professor Akerlof, who is a Nobel laureate in economics in the heart of this specialty.
Joe Higgins
Could it be a factor in the United States or even in Europe that the financial markets and the massively powerful financial institutions have exerted pressure through lobbying, etc., to try to slow down or halt the type of radical regulation about which Professor Black speaks?
Professor William Black
By the way, “radical” in this context simply means regulation that proved incredibly effective for 50 years.
Joe Higgins
Yes.
Professor William Black
It was adopted on a bipartisan basis by conservatives, liberals and moderates. It is interesting that what was absolutely centrist in banking for half a century has now become “radical”. The race to the bottom is another key example of a Gresham’s dynamic (where bad money drives out good money). The regulatory race to the bottom was a real thing. If the members of the committee look at their counterparts in the United Kingdom – the parliamentary inquiries there – they will see it was absolutely explicit in the regulatory statute of the UK Financial Services Authority at that time that there was a need to win the competition. The aim was to keep the city of London as a top centre by deliberately weakening regulation.
Joe Higgins
Okay.
Professor William Black
Of course Wall Street always pointed to the city of London to say it needed to weaken or get rid of the Glass-Steagall law in the United States. It thought financial derivatives should not be regulated because that would result in all such activity being moved to the city of London.
Joe Higgins
Yes.
Professor William Black
Everybody loses during this race. The city of London won the race to the bottom. It is the absolute worst in the world. Wall Street is a close second in terms of the worst in the world.
Joe Higgins
We will put this question to the Commission representative who will be here later. We will ask whether there was such a race to the bottom in Europe. We await a response in regard to that. I would like to ask Professor Black briefly about the recipe he has laid out for bank failure, the drive for very rapid growth and the types of loans, etc. He said that one of the sure things is that this leads to immediate and vast profits.
Professor William Black
Reported profits.
Joe Higgins
Reporting profits.
Professor William Black
Fictional.
Joe Higgins
Could he explain very briefly to our people how that is possible? How do they make such profits in such a short time?
Professor William Black
They do not, but they report enormous profits. If I make a very bad loan at 9% and my funding cost is 4%, the difference, which is known as the spread in finance, is 5% or 500 basis points. If I make much worse loans, I will report a much bigger spread. That is not real profit, obviously, because I am taking vastly more risk.
Joe Higgins
Yes.
Professor William Black
In fact, I am taking so much risk that on every loan I make, I lose money in real economic terms. I should have an established loss reserve, perhaps of 600 basis points, which would make it clear that I was losing money every time I made one of these loans. The international accounting rules essentially provide for the establishment of a loss reserve of zero.
Joe Higgins
Okay.
Professor William Black
To put it simply, the riskier or crazier the loan I make, the more fictional profits I will report, the bigger the losses and the bigger the compensation.
Joe Higgins
How does that work for the person taking the loan, who is paying higher interest rates?
Professor William Black
They are sometimes paying that rate, but frequently of course they are not paying that rate. The saying in the trade is “a rolling loan gathers no loss”. To roll a loan is to refinance it. As long as the bubble is expanding, I can simply play this game by refinancing or giving what is due. It is really easy in commercial real estate. Someone who has €60 million in projects already funded is given another €100 million for a new project and told to use the cashflow to keep himself or herself alive.
Joe Higgins
Okay. I would like to ask Professor Black a question about Ireland. According to the Nyberg report, lending by the six banks covered by the bank guarantee of 2008 increased “from a stock of €120bn in 2000 to almost €400bn by 2007″. The report points out that “the three years ending in 2006 marked the highest sub-period of sustained growth, with loan assets more than doubling overall, growing at a compound rate of almost 28% per annum”. Would that kind of practice fit in with the bad practice or type of practice outlined by Professor Black at the beginning?
Professor William Black
It is the first ingredient in the recipe, obviously. It is also a question of concentration of risk. We also looked at concentration of risk. This is a sure tell that something is absolutely imprudent. The really good news is that there is no need to predict whether there is going to be a bubble or a crisis. Really bad underwriting is unambiguously bad for the world. When it is stopped, that makes everybody better off, except for the bad people, by blocking a Gresham’s dynamic and allowing the honest bankers to succeed in the marketplace.
Joe Higgins
I will move on. As part of a discussion on the Nyberg report, Professor Black said that the Irish economic environment before 2007 was not benign and that it was the largest bubble proportional to GDP of any developed nation. He further said that what happened in the banks was exceptionally profitable to the senior officers leading the banks.
Professor William Black
Yes.
Joe Higgins
Professor Black is probably familiar with Professor David Harvey. I do not have time to quote from his book, , but he referred to senior hedge fund managers getting bonuses of as much as $1 billion a year as a result of their activities in the financial markets. One can understand how that extreme level, as many people would regard it, of compensation could lead to recklessness but in the Irish case where we would not have figures of that dimension, would Professor Black say that the same type of incentive would prevail, with perhaps smaller levels of compensation?
Professor William Black
You do not need $1 billion to incentivise disastrous behaviour. Seriously, in the lower ranks, the bonuses would often be in the $500 range. It must be remembered that we are talking about people who are pretty close to minimum wage. If we look at the United Kingdom and the payment protection insurance, PPI, abuses, this is often incentivising people who are pretty much the working poor, and that can be done with just a few hundred dollars. By the way, they do not always do it just with money. In some places, if someone did not sell enough, they literally put a cabbage on their desk. It is the insult in the UK context of being considered a cabbage head.
Chairman
This is the Deputy’s last question for the moment.
Joe Higgins
Mr. Nyberg ascribed most of the problems to bad judgment rather than bad faith. Without going into specific cases, at which point does Professor Black think our people should judge the activities of the bankers as failed banks crossing the line from bad judgment to bad faith?
This is my last question. In view of the type of excesses we have seen and that Professor Black has devoted his life to countering, and what was found in the United States to be criminality etc., rather than having these huge financial resources swilling around the world in private hands, what would be his view of a publicly owned banking system subject to democratic ownership, control and accountability?
Professor William Black
In terms of the last one, postal savings banks have been very successful throughout large parts of the world, not just in Europe. Japan had them for a very long time. There is a concept in economics of Nero banks, and that fits well into that category.
As to the Deputy’s other question, one of the critical things this recipe does is allow us to differentiate between behaviour that is “reckless” or “optimistic” and behaviour which is deliberate. We get deliberate behaviour when we deliberately create adverse selection. We must remember that underwriting looks like a cost centre but it is really the primary profit centre of an honestly-run bank. I have not mentioned this, as a banker sitting on credit committees and such, that you make money by doing good underwriting. When you deliberately do bad underwriting and when you push out the people – this is in the Nyberg report – who object and who try to have good underwriting, that is deliberate behaviour. It allows you to distinguish. I have an entire article in the literature on criminology about how to distinguish between criminal behaviour and not; the Deputy can read that article. That is what allowed us to cut through these defences. We must remember these are the best criminal defence lawyers in the world. They are people in elite positions who could hire the best defence and get those convictions with a 90% conviction rate. It is possible to distinguish which of these things is really happening. There is literature available, and there is an experience.
Joe Higgins
I thank Professor Black.
Chairman
Before I call Deputy Phelan, will Professor Black tell us the role external auditors have to play in what he has been discussing with Deputy Higgins? There is an agency that comes in and examines the bank’s balance sheet in terms of risk concentrations and everything else. Surely it has some responsibility or is in a position to make a judgment on it.
Professor William Black
This is in the context where there has just been a very large settlement against a credit rating agency, in the United States context, Standard & Poor’s. That is another example of the Gresham’s dynamic. There is explicit stuff in our equivalent. I was the deputy staff director of this equivalent in the United States that looked at the US crisis in the Savings & Loan debacle. The Chairman will see in that that it explicitly states there was a Gresham’s dynamic among top-tier audit firms. In that context they were the big eight; we are down now to the big four.
Chairman
What does that mean in layman’s language?
Professor William Black
That means I hire the audit partner. The senior banker hires the audit partner. We have a dog and pony show in which they pitch for the business. This is how one becomes a “biggie” in a top-tier audit firm. One brings in a whale of a client, as the phrase goes, and signals in the course of that, and we could have a complete video tape and it would not matter, that one is the right kind of auditor. That is who gets hired, and that is why we will find throughout Europe and throughout the United States preposterous financial statements that got clean audit opinions from top-tier auditors. They deliberately go to top-tier auditors because that reputation enhances both looting and the fraud. Places that are massively insolvent with terrible underwriting invariably get clean opinions from top-tier auditors.
Chairman
I thank Professor Black for that because we will be speaking to Mr. Nava later this morning and I understand that under the Basel III framework auditing companies can still concentrate 80% of their business within one company, so we will certainly be dealing with that. I thank Professor Black for that answer. I call Deputy John Paul Phelan.
John Paul Phelan
I welcome Professor Black. To continue the point the Chairman just asked him about auditors, he said in his opening statement that we are still operating under the same accountancy rules today as we were six or seven years ago. Will he outline for the committee the changes to those rules with regard to external auditors that could be made?
Professor William Black
The straightforward answer is to not allow the bankers to pick the auditors. There should instead be a panel of qualified auditors that are assigned to them, and we should track the performance of those auditors. It would be like relegation. If someone had a record of screwing up, they get yanked from the panel, assuming what they did was not criminal. If it was criminal, they are driven out of business, but if it was just inept, they get relegated. They do smaller accounts and prove over the five years that they can do it right, and then get back up to the “bigs”.
John Paul Phelan
Who should operate the relegation?
Professor William Black
The United States Government, or the Irish Government in this context.
John Paul Phelan
I refer to the answer Professor Black gave earlier to the first question asked by the Chairman about the growth rate in banks’ balance sheets. Professor Black spoke about the 25% cap in the United States. Wearing two of his four caps that he mentioned at the start in terms of economics and regulator, what does he believe is the optimal sustainable growth rate for a bank?
Professor William Black
There is no such thing. It depends on the growth of the economy. The more sensible answer is to look at the real growth of the economy and the relevant sectors being loaned to. If you are greatly out of line with that and if you did so by lending cheap relative to risk, then you are a disaster waiting to happen. Actually, you are a disaster that has happened that needs a solution immediately.
John Paul Phelan
Professor Black has written extensively, and it was touched on earlier, about this perverse compensation and employment incentives within banks. Does Professor Black have a view as to how the remuneration systems within financial institutions should be run differently from the way they have been?
Professor William Black
Yes, it should be run consistent with all the literature on how it should be done. All the literature from people of all ideological persuasions says it should be ultra long term so you get in off a living wage and then in the US context you can send one’s kid to university. Ours are expensive. However, beyond that, the big kill comes not two years, but ten years down the line. You show sustained performance that is real for at least a decade. That is what all the literature, again by Nobel laureates, on this subject says. We simply do not run executive compensation in accordance with what we purport. We purport that we align the interests with the shareholders but we distinctly do the opposite. That is at the high end. At the lower end, never ever set banker compensation for, say, loan officers based on volume. We have known for centuries that this will produce a disaster. There is no upside to that. It should always be weighted with quality and people’s bonuses should be deferred to establish that they were making quality loans, not simply volume loans.
In particular, the PPI is an unbelievable disgrace. This was a product, again according to the testimony in the parliamentary inquiry in the UK, that had an 80% mark up. They talk about unsuitable and while some people could never recover under the policy, it was unsuitable for everyone. It was a pure, rip-off product and they created incentive structures that ensured that it was not just money, but it was also about the humiliation of people who refused to do the wrong thing. That should never be allowed at all. The dollar amount does not matter.
John Paul Phelan
With regard to financial reporting by banks and other financial institutions, does Professor Black believe they should be treated the same as other businesses in providing quarterly stock market reports and results or can a case be made to treat them differently?
Professor William Black
It is true that there is a generic problem with executive compensation that is not limited to banking. I have literature that I have written about how things should be cleaned up more directly but banking is the worst of the worst and it is the one that has been shown to have the most intensive fault. In the US context, for example, we are back where we were before the crisis with 40% of total corporate profits in finance. Finance is simply supposed to be an intermediary, a middleman, and the efficiency condition for a middleman is clear – lean and mean. Instead it has become a parasite that is the leading enemy in the US context of Main Street. The Brits would call it High Street; I do not know whether there is a phrase in Ireland for this. It is bad for regular people and small businesses now. Banking, therefore, needs to be fundamentally changed to make it an engine of what it claims to be – economic growth and strength.
John Paul Phelan
Does Professor Black feel six or seven years on from the major difficulties financial institutions got into that current regulation is fit for purpose?
Professor William Black
No, it is clearly not fit for purpose. That does not mean there have not been improvements in some areas but you can see that they are still talking in very much similar terms, for example, cost-benefit analyses and econometric studies. If such studies are followed, you guarantee that you will do things that most facilitate the looting recipe I outlined. That would be an absolute disaster. You will still see that they do not understand the concept. I guess I am the first person that even used the phrase, “Gresham’s dynamic” here. That dynamic is used. The testimony at the parliamentary inquiry in the UK highlighted that dynamic and the US has consistently sued institutions such as Standard & Poor’s where the allegation after investigation is they engaged in fraud as part of a Gresham’s dynamic. We have done that not just to those ratings agencies, but we have strong proof that this happened in the appraisal context. The then New York attorney general, now governor, Andrew Cuomo, found this in investigations. We found it in the top tier audit firm the Chairman asked me about. This is a pervasive problem and there is no Basel-type action to break this dynamic.
John Paul Phelan
Professor Black gave a number of interviews to Irish media outlets at the end of 2010. In one newspaper interview, he said the Lehman Brothers crisis had saved Ireland from an existential threat. What did he mean by that? Did international factors have an impact on what happened in Ireland?
Professor William Black
Yes. Back in the time machine, as the Deputy will recall, when the crisis originally broke out, in Europe the meme was that it is all the stupid Americans. Europe was clean and it was all about those idiot Americans and sub-prime lending and so on. That has changed a fair bit. My point was that Lehman Brothers precipitated the crisis stage but it would have been far worse if the crisis had continued to build for another two years. In the Irish context, the worst banks had losses well in excess of GDP. They were simply becoming big banks, vastly bigger than the economy. If that bubble expansion had gone on for another two years, think what the losses would have been. For example, in the Icelandic context when Lehman Brothers precipitated the failure, the bank had ten times the GDP of Iceland and it was growing at more than 50% a year. With compounding, when something grows at 50% a year, it doubles in size approximately every nine months. If the expansion had gone on for another two years, it would been more than 40 times the GDP of Iceland. The losses per person in Iceland would have been hundreds of thousands of euro. Everybody there has an EU passport and, therefore, pensioners would have been the only folks left.
John Paul Phelan
At the end of 2010, in a Irish television interview, Professor Black said, “Nobody has responded to the crisis as stupidly as the Irish Government have responded”. Will he elaborate on what he meant at the time?
Professor William Black
It was, in soccer parlance, the most destructive own goal in history. The Government as everyone knows guaranteed. This is the consequence in large part of truly terrible anti-regulation. If the regulators tell the Government, there is no problem here, there are no losses and it is a temporary liquidity problem but if it does not act within the next 12 ours, the entire system will melt down, what is it likely to do? If those are the facts as presented to you, it becomes very likely that you will do a guarantee. Giving an unlimited guarantee with no reliable facts turned a banking crisis into a fiscal crisis – not just any fiscal crisis, but clearly one that would crush Ireland. On top of that, Ireland guaranteed not just unsecured claims, it guaranteed subordinated debt. Subordinated debt is subordinated so that it will constitute capital, so that it will be at loss. The entire theory of why, under Basel II, it was tier-2 capital is because it would be lost. Those concerned made a deal, a contract deal. The deal was that if this bank cannot pay because it is insolvent, we get wiped out entirely, so in recompense we get a much higher interest rate. They got their interest rate. They are supposed to die and are supposed to be concerned with risk capital, and they got bailed out. I never understood this. Even with all the bad information they got from the regulators, and obviously from the banks because the banks had to file statements – all of those statements for the covered banks were hopelessly false – and even if you relied on that falsity and on the regulators, who were disasters, you would never, ever bail out the subordinated debt holders. They did not bail out every subordinated debt holder but bailed out the great bulk of them. To my knowledge, nobody else does that. That is why I said “the worst in history”.
Part 2 of this series can be read here.