Interview with Bill Black

Travis Strawn recently interviewed Bill Black for Seven Pillars Institute.

William (Bill) Black is a lawyer, academic, author, and a former bank regulator. He developed the concept of ‘control fraud‘, in which a business or national executive uses the entity she controls as a ‘weapon’ to commit fraud. Black was a central figure in exposing Congressional corruption during the Savings and Loan Crisis. Black is the author of, among others, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. He is a columnist for the Huffington Post and writes on financial and political fraud and (legal and illegal) corruption. Black is currently an Associate Professor of Economics and Law at the University of Missouri-Kansas City in the Department of Economics and the School of Law. He was the Executive Director of the Institute for Fraud Prevention from 2005-2007 and previously taught at the LBJ School of Public Affairs at the University of Texas, and at Santa Clara University.

TRAVIS STRAWN:  In your opinion, have the problems with the financial industry that led to the economic crisis been resolved?

WILLIAM BLACK: No

TS: Why do you think that is so?

WB: Because I think the fundamental causes were not addressed.

TS: And the causes being?

WB: The fundamental causes as I see it are: we have created intensely criminogenic environments, and we have done this through a combination of the three D’s: deregulation, de-supervision, and de-facto decriminalization.   And we have created the criminogenic environments through modern executive compensation.

TS: What do you think remains to be done on those issues?

WB: Well in some sense everything, because not very much was done on any of those things.   Take the de-facto decriminalization. There still are no prosecutions of any of the elite criminals that drove the crisis. In terms of de-supervision, in general the people that screwed up as regulators were promoted, as opposed to being replaced by vigorous supervisors.  In terms of reregulation there’s been some, obviously the Dodd-Frank bill, but it doesn’t address the key factors producing the criminogenic environment, so I don’t think it will solve the problem. Indeed we continue to be strong supporters overall of the race to the bottom theory of regulation, typically with the city of London in finance, in which we have to “win a competition in laxity”. That’s the dynamic that produces an aggressions dynamic in which bad regulation drives good regulation out of the marketplace. That ends up being very criminogenic and of course we have one candidate [Mitt Romney] saying he is going to repeal all of Dodd-Frank if he is elected.

TS: What do you think of the Dodd-Frank financial reform bill as a means to regulate the financial industry in general and about the Volker rule against proprietary trading in particular?

WB: Well, I have gone through my overall view of Dodd-Franks so I will concentrate here on the Volker rule. I have written some things recently on the Volker rule that will give you more of my views in the context of the current JP Morgan losses. I think the Volker rule is a very good rule. If you look under liberal, conservative or libertarian principles, there is no reason why the systemically dangerous institutions (these are the institutions treated as too big to fail), should receive both an explicit federal subsidy through deposit insurance and a much larger implicit subsidy from the treatment of too big to fail.  This treatment allows them, in the words of the very conservative authors of “Guaranteed To Fail” (Guaranteed To Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White) to bring a gun to a knife fight.   There was nothing free about the markets because of the role of these implicit federal subsidies.   Financial derivatives are overwhelmingly traded by a very few banks, all of them systemically dangerous institutions, so all of them received these double subsidies. I can’t think of any public policy reason, on liberal, conservative, or libertarian grounds that would say we should be subsidizing those kinds of gambles. Gamble is the best term of course, because regulators still haven’t solved the agency problem with regard to derivatives. The agency problem probably explains why there is no more Merrill Lynch as an independent entity. What people forget about this crisis is that the biggest entities were also the entities that not only created the most of what we call the “green slime”  (toxic financial derivative instruments) but actually ate their own cooking to a far greater extent than people understand. This, I argue, is primarily because of agency problems where corporate officers have perverse incentives to create fictional income by having bad loans.

Jamie Dimon recently got this one correct at least in the loan context, but it applies to many derivatives as well. If you don’t underwrite these derivatives, they produce tremendous short-term fictional income and longer-term real losses. That is the fundamental agency problem because the officers are still paid overwhelmingly on the basis of short-term results so it’s a sure thing mathematically that if you buy these really bad assets it will report a record income in the short-term and that record reported income will lead to extraordinary bonuses. You can walk away wealthy – this is the meaning of the title of Akerloff and Romer’s famous article in 1993 “Looting: The Economic Underworld Of Bankruptcy For Profits[i].” The firm crashes but the officers walk away wealthy having looted the place – alas Merrill Lynch for example.

TS: And this is, you think, like control fraud?

WB: This is control fraud. Systemically dangerous institutions together with subsidies completely distort competition. You make markets dramatically inefficient and you encourage the officers to engage in gambling. The gambling is going to cause destruction ultimately, of many financial institutions.

That’s the good news.   My view is that control frauds can do something far worse.  They can hyper inflate bubbles which cause really bad financial crises, recessions or depressions.

TS: And you are saying instead of gambling on it, it is a sure thing because they have the insurance backing, the taxpayer backing?

WB: No the implicit subsidy means that you can borrow more cheaply. Too big to fail really means, operationally, the institution doesn’t fail but when it does fail, we bail out general creditors and even sometimes subordinated debt and even sometimes equity.  But mostly we bail out general creditors. That means since general creditors are implicitly protected against loss by the federal government, such institutions can borrow more cheaply.  And that gives them a competitive advantage. As I said earlier, that competitive advantage distorts competition and is the written equivalent of bringing a gun to a knife fight. All the wonderful stuff about efficient markets and such dies at that point.

The second point is that the bail outs produce what neoclassical economists fixate on, which is moral hazard. There is gambling of course, when traders take excessive risk. If they win really big they will do very well but if they do poorly they may cause $50billion in losses. But they walk away from the losses and maybe pay a hundred thousand dollars. The risk is asymmetric. Conventional economists focus on this asymmetric risk and call it gambling. I am saying, “well no”, because that’s an inferior option typically. Why gamble when you have a sure thing? Economists like Akerloff and Romer write about fraud being the sure thing. Virtually nobody cites Akerloff and Romer’s paper ignoring the possibility of fraud. Conventional economists focus entirely on gambling and that doesn’t comport with the facts. Gambling assumes massively irrational behavior on the part of the officers. If you are  willing to believe traders would be willing to gamble and destroy the entire firm then why should you not be willing to believe traders will choose to commit fraud, a sure bet to winning big, especially if they can get away with it. The fact traders can get away with fraud is what has really changed in the modern era– that’s the de-facto decriminalization of fraud.

TS: Because of Dodd-Frank and the higher capital requirements of Basel lll, the banks seem to be adjusting to a new business model.  Do you see the financial sector shrinking in terms of their cumulative earnings as a percentage of national GDP, perhaps back to the early 1980’s level? 

WB: No, it would be very good if they shrank the efficiency conditions for a middle-man. Investment banking is a middle-man enterprise after all. Finance is supposed to be lean and mean and not to have enormous profits. It is simply supposed to serve the real economy. In fact the financial sector has become parasitical in the real economy. It takes vastly too much wealth.

Higher capital requirements are in general a good thing. But you can’t count on them because, you know, capital is simply an accounting residual and what we’ve been saying is people can easily distort the asset valuations.  In other words accounting fraud is the weapon of choice in the financial sphere so we always urge, from a regulatory, criminology and economic standpoint, that you should not rely primarily on reported capital asset protection because it is so easy to manipulate.  That said, the parade of horribles Jamie Dimon raises, such as not being able to raise capital, and the subsequent disappearance of banking, are ridiculous.

TS: Is it too late to put the genie back in the bottle in regards to the financial industry?  Will finance return to its original function of being the means to channel money from investors to companies?

WB: Left to its own devices no, it will not return to its original and appropriate function.  It will remain really to some degree, crony capitalism and that is going to be very bad for the world.

Can we put the genie back in the bottle?  Yes, but it will take the Supreme Court to strike down Citizens United to have any realistic chance.

TS: What do you think is the relationship between ethics and regulation?

WB: Well, regulation when it’s done right is putting regulatory cops on the beat.  Regulators’ primary function is to prevent an aggressions dynamic, in which bad ethics by people in the business produces competitive advantage. This advantage drives good ethics out of the market place. We should be focused very much on ethical behavior and indeed one of the interesting things is conservatives, in general, love the broken windows theory.  In fact if they know anything about criminology, probably the only thing they know is the broken windows theory. This theory says that long before you deal with really serious crimes it is essential that the ethos of the overall community cracks down on relatively minor unethical acts that tend to weaken community.  To be consistent, conservatives need to apply the same logic to white-collar crime. The broken window theory works a lot better in white collar crimes than in the blue-collar context because we do away with having just minimum levels of ethics. Instead we are going to aim for a high ethical plane. Instead of a competition in laxity, we want to introduce a competition in integrity.  That would be a very different approach.

TS: Did business and financial education contribute to the economic crisis?

WB: Yes, business and financial education contributed to the economic crisis. Michael Jensen, who has of course turned against his Frankenstein creation of compensation for executives in modern finance, says that executive compensation has produced a profoundly unethical system. Jensen cites survey evidence which shows it is common for CFOs to be willing to take actions that are unethical and uneconomic. Jensen says this is what people are learning in business school  — how to employ unethical techniques. So in my more upset moments I refer to business school, the modern business school, as a fraud factory.

TS: U.S. stock markets are experiencing particularly low volumes of trading.  Is this an indication of the lack of trust Main Street has for Wall Street and will this situation of declining trust get even worse?

WB: Yes, there has been a reduction in the number of Americans willing to participate in the stock market. This goes back at least to Enron and WorldCom days. During the tech boom more Americans invested directly. Obviously they had investments through their pensions but it became much more common for regular middle-class Americans to have their own individualized stock portfolios. It is because of these recurrent crises that people quite rationally do not trust the markets very much.  And indeed this is perhaps part of the reason why you have economist after economist talking about the mystery, the alleged mystery, of the equity premium which is supposedly too high.

TS: Do you think there is a political-financial-media nexus that strongly supports the current status quo in finance?

WB: Yes. I have been dealing with business media for 27 to 28 years. Business media was never strong during that 28 year period and it has weakened considerably. It is very common for them to recycle press releases from the industry. Prestigious papers like the New York Times, basically want access to the top folks in finance. The price of access is self-censorship. Thus, business media can be a little critical but it cannot really fundamentally question the system.

TS: Do you think there is a big difference from 27 [28] years ago to now?

WB: Not huge, but business media was not strong 28 years ago and has fallen from a low point.

TS: What is your opinion about the Occupy Wall Street movement and will it last?

WB: My opinion is the movement has been very helpful because empirically, the number of media references to inequality went up dramatically. A number of us and certainly I believe, that rapidly increasing inequality is one of the major problems in America and in a number of other nations. If the Occupy Wall Street movement did nothing else but highlight inequality, that would be a really good accomplishment.   It is a really interesting movement in that it really doesn’t have leaders and it doesn’t really have an agenda. There is an enormous question of what will become of it. If Occupy Wall Street continues to exist it won’t be the same entity because it will have to develop some degree of leadership and greater programmatic issues.  However, it has already been a useful movement. It may spawn other alternatives approaches as well.

TS: Do you think there will be more criminal prosecutions for those connected with causing the economic crisis?

WB: I think they have to indict someone before the election but I think that indictment will be token.

TS: Do you have any idea who you think they would actually indict?

WB: I think they’ll indict one of the entities selling loans to Wall Street, possibly to Fannie and Freddie. They will do so under the aegis of this new working group that’s looking at securitization. They will look at false reps and warranties that were made and perhaps indict one or two of those entities. My guess is that the entities indicted will not be the big guys. They won’t indict Citicorp for example, despite the testimony given to the Financial Crisis Inquiry Commission about Citicorp’s false reps and warranties on hundreds of billions in sales.

TS: How do we get finance workers to behave and think more ethically?

WB: Right now we incentivize finance workers to do the wrong things.  There is a famous quotation from Frank Raines, who the Business Roundtable in a wonderful case of irony, made its spokesperson to the media in response to the Enron [and] WorldCom series of scandals. BusinessWeek asked him, “Hey, Frank why do we have all these frauds?”  He says that “it’s the money” and he summarizes, and this will be an almost exact quotation, “if you wave enough cash in front of people even good people will do bad things.”  So right now we systematically incentivize and reinforce the worst conduct by the officers and directors, from the most senior level through many of the most junior levels. You can’t create an intense incentive system that encourages people to do the wrong thing and then have somebody preaching, you know, come in and say [laughs] “you should do the right thing, you should do the right thing.”

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The Institute wishes to thank Mr. William Black for his insights and graciousness.