William K. Black’s Proposal for “Systemically Dangerous Institutions”

William K. Black, Associate Professor of Economics and Law at the University of Missouri – Kansas City, and the former head S&L regulator, has written the following fantastic new proposal concerning the giant, insolvent banks. Posted/reprinted with Professor Black’s permission.

William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City


September 10, 2009

The Obama administration is continuing the Bush administration policy of refusing to comply with the Prompt Corrective Action (PCA) law. Both administrations twisted a deeply flawed doctrine – “too big to fail” – into a policy enshrining crony capitalism.

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing. That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.” “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy). In this crisis, however, regulators have twisted the term into immunity. Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital. This policy is indefensible. It is also unlawful. It violates the Prompt Corrective Action law. If it is continued it will cause future crises and recurrent scandals.

On October 16, 2006, Chairman Bernanke delivered a speech explaining why regulators must not allow banks with inadequate capital to remain open.

Capital regulation is the cornerstone of bank regulators’ efforts to maintain a safe and sound banking system, a critical element of overall financial stability. For example, supervisory policies regarding prompt corrective action are linked to a bank’s leverage and risk-based capital ratios. Moreover, a strong capital base significantly reduces the moral hazard risks associated with the extension of the federal safety net.

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

We need to comply with the Prompt Corrective Action law. Any institution that the administration deems “too big to fail” should be placed on a public list of “systemically dangerous institutions” (SDIs). SDIs should be subject to regulatory and tax incentives to shrink to a size where they are no longer too big to fail, manage, and regulate. No single financial entity should be permitted to become, or remain, so large that it poses a systemic risk.

SDIs should:

1. Not be permitted to acquire other firms

2. Not be permitted to grow

3. Be subject to a premium federal corporate income tax rate that increases with asset size

4. Be subject to comprehensive federal and state regulation, including:

a. Annual, full-scope examinations by their primary federal regulator

b. Annual examination by the systemic risk regulator

c. Annual tax audits by the IRS

d. An annual forensic (anti-fraud) audit by a firm chosen by their primary federal regulator

e. An annual audit by a firm chosen by their primary federal regulator

f. SEC review of every securities filing

5. A prohibition on any stock buy-backs

6. Limits on dividends

7. A requirement to follow “best practices” on executive compensation as specified by their primary federal regulator

8. A prohibition against growth and a requirement for phased shrinkage

9. A ban (which becomes effective in 18 months) on having an equity interest in any affiliate that is headquartered in or doing business in any tax haven (designated by the IRS) or engaging in any transaction with an entity located in any tax haven

10. A ban on lobbying any governmental entity

11. Consolidation of all affiliates, including SIVs, so that the SDI could not evade leverage or capital requirements

12. Leverage limits

13. Increased capital requirements

14. A ban on the purchase, sale, or guarantee of any new OTC financial derivative

15. A ban on all new speculative investments

16. A ban on so-called “dynamic hedging”

17. A requirement to file criminal referrals meeting the standards set by the FBI

18. A requirement to establish “hot lines” encouraging whistleblowing

19. The appointment of public interest directors on the BPSR’s board of directors

20. The appointment by the primary federal regulator of an ombudsman as a senior officer of the SDI with the mission to function like an Inspector General

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  • The world has been stripped naked, turned on its head -that has been planted deep in the mud, -and the world then has been left there exposed with its arms and legs flailing in a state almost too impossible to comprehend or describe. Too big to Fail?The FDIC's -Shiela Bair- is reported to be maneuvering to "borrow" (and pay interest upon) money -from the SDI banks -to fund FDIC shortfalls in the depositor insurance fund.These loans will be made of money made out of thin air -and then will be considered -newly created cash equivalents- on the balance sheets of these SDI banks, increasing their capital reserves by sheer sleight of hand arranged by the banking examiners from the FDIC.That's one way for these banks to loan more money, is apparently part of the perverse and convoluted idea.So, the banks would simply create this money as they "loaned" it to the FDIC, for which the FDIC would pay interest back to these banks, ostensibly, so the banks would not have to pay higher insurance premiums -to insure their FDIC insured-depositor-accounts, which these same banks profess to be unable to afford.The SDI banks are lobbying for this new device, claiming they cannot afford to pay the higher insurance premiums to the FDIC that are required in order to continue insuring the accounts of their FDIC-insured depositors.The logic and reasoning here is incredible and astonishing -even for this well-heeled philosopher -used to dealing with the fallacy of every man's logic.These SDI banks are tacitly conceding their own insolvency to the FDIC -when they admit they cannot afford to pay the necessary higher FDIC insurance premiums -that are required to shore up the insurance fund that insures their FDIC-insured depositor accounts.For contrast to our current state of affairs -I am reading "Money and Banking" the 1957 revision of a classic in banking and finance tutorials -written by Charles L. Prather, Ph.D., Pd.D. – a Professor of Banking and Finance from the University of Texas. I have the Sixth Edition.I often read with my mouth agape.Something I just read today, is that banks are prohibited from making loans to bank examiners.This proscription was no doubt instilled and inscribed in banking ethics for a strong, reactive reason.

  • All great ideas that will never be implemented willingly. The money party is to deeply enmeshed in DC to let anything like this happen till after the rats have finished leaving the ship.

  • "Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded."Excellent! Let's start calling them by their more accurate description. Too big to fail is a Systemically Dangerous Institution or SDI.Let's also stop the call for more regulatory power without stopping to ask why the regulation we already had didn't work. As in the case of national security, when the CIA, FBI, NSA, ETC., failed to stop a terror attack, we created the DHS (now building a $3.5B headquarters). Washington's solution is always another layer instead of demanding effectiveness and accountability from what already exists.