Too-Big-to-Regulate, Prosecute or Exist

Some good things are happening in addressing our financial crisis. Beginning April 13, the Senate Permanent Subcommittee on Investigations held a series of four hearings on the role of high-risk home loans, bank regulators, credit-rating agencies and investment banks. Earlier in the month, the SEC charged Goldman Sachs with fraud. This week, right now, Senate Democrats and Republicans are sparring over sweeping financial reform legislation.

All this is important, even historic. In the narrative of our Great Recession, this is a “Pecora moment.” It is the moment to act. Unfortunately the action the Administration is taking is simply not enough. The banks will remain too big to exist.

Ferdinand Pecora was the chief counsel of the Senate Committee on Banking and Currency that investigated the causes of the Wall Street crash of 1929. His tenacious questioning of Wall Street's most influential bankers exposed the corruption and fraud that was pervasive on Wall Street in the 1920s.

Pecora's work made possible the regulatory regime that stabilized Wall Street from 1937 to 1980. His work is given major credit for the Glass-Steagall Banking Act separating commercial and investment banking, the Securities Act of 1933 penalizing fraud and false information and the Securities Exchange Act of 1934, which set up the SEC to regulate the stock exchanges. Pecora is the guy we want to emulate now.

Pecora is our man because, beginning in 1980, financial innovation and de-regulation made that system obsolete. These changes created what one Goldman Sachs official in the hearings this past Tuesday admitted was “a target-rich environment for fraud.”

The financial innovation was made possible by advances in information technology, worldwide markets and the sheer size of the firms and the money involved. That technology, and deregulation of course, permitted Wall Street to create new convoluted instruments, new off-the-books entities and new opaque forms of debt, especially derivatives.

Banks became super-sized. The notional value of derivatives went into the hundreds of trillions of dollars. The profits of the financial sector went from 20 to 40 percent of the national total. Most of this was outside existing regulations and the SEC, allowing and even encouraging that “environment for fraud.” The bankers, their lobbyists, the regulators and politicians colluded to keep things that way.

In the 1930s, the legislation followed by a year or more the hearings and investigations of the Pecora Commission. This time the House of Representatives has already passed a bill and the Senate expects to act within the next several weeks.

These financial reform bills are designed to avoid another near collapse. They provide the structure and money for phasing out large, bankrupt firms. They offer an institutional structure to detect threats to the system. They set up a consumer protection agency and an exchange where most derivatives would be traded. All of this is very nice standard stuff but it does not get to the point.

The banks had to be bailed out and the system rescued because the failure of any of the half-dozen largest banks would have brought down the global financial system. The fact is that Citibank, J.P. Morgan Chase, Bank of America and Wells Fargo hold $7.4 trillion in assets and that is 50 percent of our GDP. This danger to our system will still be there but that is not the only danger.

When a bank becomes too-big-to-fail, it also becomes too-big-to-regulate and too-big-to-prosecute. It becomes above the law. This was true in the old regulatory system and it will be true in the new one. The unwillingness to regulate is now legendary. The unwillingness to prosecute is newer.

The classic case of too-big-to-prosecute occurred recently in Jefferson County, Alabama. A sewer treatment plant, estimated to cost $250 million, ended up costing $3 billion. Some of this is because the county commissioners colluded illegally with the contractors. The commissioners also colluded with and were duped by the banks. The real culprit is J.P. Morgan Chase who foisted off on the unsophisticated commissioners the biggest swap deal in J.P. Morgan's history. The county is now way beyond bankruptcy.

The point being, the commissioners and contractors have been convicted and are doing jail time. Nobody at J.P. Morgan, or Goldman Sachs, who were peripherally involved, has been prosecuted or is likely to be. It would be too expensive for local or federal prosecutors.

The proposal presently before the Senate is not enough. It does nothing to limit the size of financial Leviathans. It contains a loophole on the regulation of derivatives. It does nothing to stiffen the spine of regulators and legislators.

America will not have a stable, sustainable, financial system until we shatter the banks like Standard Oil and we find some way to make the bankers pay with jail time and the failure of their institution. The bankers must be awarded the old-fashioned capitalist opportunity to fail.