Time for a Moratorium on Prosecution of Banks

Roy C. Smith

As large investment banks begin reporting yet another quarter of lackluster earnings, leading them into their sixth year of failing to earn the cost of their equity capital, it is time to recognize that the industry is in severe distress and contributing much less than it should be to economic recovery.

Since 2008, large US and European banks have been designated the principal villains responsible for the financial crisis. Accordingly they have been hit with regulatory changes that have crippled their business models, and subjected to litigation by US federal and state attorneys general for mortgage and securities fraud, foreclosure abuse, market rigging of Libor, foreign exchange rates and metals prices, tax evasion, and circumventing money-laundering rules and sanctions.

Witness Citigroup’s announcement on July 7 of a $7 billion settlement to end all US government investigations of the banks’ pre-crisis involvement in mortgage-backed securities. A $3.8 billion provision slashed second-quarter profits to $181 million from $4.2 billion in the same period last year.

Bank of America is in endgame negotiations with the US Justice Department to settle similar charges and several other banks are expected to do the same, yet all the major banks are still under investigation in connection with other allegations.

It is clear that bad things did happen during a financial bubble that burst with a huge effect on the real economy. Regulatory changes and some prosecutions were necessary to restore stability to the financial system and to enforce tax and money-laundering laws, but the judicial pursuit of banks, rather than responsible individuals, has been taken to lengths that defeat the government’s other aim of restoring economic growth.

Most of the large investment banks replaced their chief, and other, executives, most of whom lost heavily as bank shares tumbled. But evidence of criminal (or civil) misconduct at the highest level of management was invariably difficult to find, though it was certainly sought. They may have failed as managers, but managers are not legally liable for mistakes.

Lacking sufficient evidence to convict senior executives, who would fight back in court, prosecutors pursued the banks’ corporate entities instead, which they know would prefer to settle than fight. Generally corporations are not sued unless there is evidence that management has corrupted the organization or failed to prevent such corruption.

The settlements have amounted to approximately $120 billion at the last count. The shareholders of the banks have paid the cost by subtracting it from capital they are required to increase as part of the most comprehensive and restrictive financial regulatory reforms since the 1930s.

As a result, the banks have become cautious, risk-averse and dull while they wait for the next shoe to fall. Share prices have slumped and much of the banks’ high-priced talent has quit to join boutiques, hedge funds or private equity groups.

Pyrrhic victories

So the high-profile litigation “victories” continuously announced by the US Attorney General, Eric Holder, and several of his state equivalents are substantially pyrrhic. They have won some battles but risk losing the more important war against economic stagnation and deflation.

True, the political gains have been satisfying – much of the public is convinced that bank bashing is a good thing. The settlements have contributed to government debt reduction (especially in New York State) and have enhanced the credibility of US efforts to enforce laws preventing tax evasion, money laundering and sanctions avoidance.

Citigroup’s chief executive, Michael Corbat, expressed his hope that the settlement last week would help the bank “to move forward and to focus on the future, not the past”. The Justice Department should follow the same advice.

At a time when economic growth in the US and the EU is dangerously below what it needs to be, government regulation and litigation have driven many of the largest providers of risk finance to the sidelines.

We need the banks to help economic recovery, and we need economic recovery badly.

It is time for governments to declare the war against the big banks to be over and won. It is time to remove the overhanging uncertainty of future settlements, capital shortfalls and permitted global activities to let the banks recover and adjust to their new environment.

Especially we need the Obama administration to declare a moratorium on the prosecutions of banks (but not of individuals) because these have entered the realm of diminishing returns, and because, under Dodd-Frank, regulators have accumulated sufficient powers to be able to monitor and control individual bank riskiness and governance effectively.

To make such a moratorium politically possible, the regulators could require enhanced governance conditions that might include the need for bank non-executive directors to acknowledge personal responsibility for the management of systemic risk (which they are largely required to do anyway) and to report concerns to regulators. The Federal Reserve did something similar during the banking crisis of the 1980s. Bank directors at the time took the acknowledgements seriously as an extension of their fiduciary duties.

Governments should also extend a moratorium on any further regulations that restrict banking operations or impose additional compliance burdens until they have a better understanding of the costs and benefits of the hundreds of new regulations already mandated by Dodd-Frank, Basel III and the European Central Bank.

Even better would be a quiet promise to put forth a corrective amendment to Dodd-Frank to eliminate extraneous, redundant and unworkable regulations as these are identified.

Regulators in the US and Europe need also to consider the deglobalization effects of their recent actions, and try to reverse the trend. Globalization adds to competition, liquidity and innovation, which are needed for recovery. It also adds to the complexity of systemic risk management, but the net effect is positive.

Systemic risk in finance is a consequence of a healthy system that exceeds its limits. Governments have rules to control these limits, but also use litigation to punish institutions they believe allowed rule violation to occur.

They know the banks will settle, so these are easy victories they have grown accustomed to enjoying.

They come, however, at a cost to a “systemic economic risk,” that of prolonging a painful period of slow to no growth in the global economy over a period now approaching a decade.

That is too big a war to lose for pyrrhic victories. We need the moratorium now.

From eFinancial News, July 21, 2014