Too big to fail (jail)

17/01/2013 | FxM – Hugo Vázquez

Every culture since ancient times has established rules that ensure the wellbeing of the collective group so it can survive, even if this group is only ruling class (Homer’s The Odyssey uses the metaphor of the Siren’s Song to refer to the means to control the internal impulses that carry us to ruin), recognising the tendency of the human being to put the long-term benefits of the group ahead of immediate, individual benefits. All religions hit on this theme in their writings and most, modern-day constitutions declare in a preamble the pursuit of the common good.

With the changes in banking institutions and their conversion into financial institutions, there is now a limited level of responsibility for the owners of the banks (if the bank went bankrupt, so did they) which is distributed and shared with society in general, via government support and bank bailouts.

Following the economic crisis in 1929, the U.S. government passed the Glass-Steagall Act to limit the size and, subsequently, the negative effects that a bank failure can have on the entire economy. However, the excess confidence that was derived from a long economic bonanza in the highest economically developed countries along with the pressure exerted by financial and banking groups led to a reduction in the restrictions on (legal) interaction between these two groups. This created some financial institutions with more economic power than some sovereign governments which has given way to these groups now being known as too big (to allow them) to fail because of the inherent, systematic risk.

The financial rules that have come out of Basel have not made financial institutions more solid and more solvent but, instead of simplifying the regulations to make them easier to apply, they have gone in the opposite direction.

It seems closing the door on the non-ethical behaviour of some of the personnel in financial institutions and, as a result, in the institutions themselves that search for any loophole in the laws they can find is a complex and on-going task.

During 2012 billions of dollars worth of fines were imposed on large financial institutions that partook in not only non-ethical behaviour but also criminal acts such as laundering money for drug cartels or terrorist organizations, manipulating the interest rate index Libor or the case of taking advantage of asymmetric information in the sale of financial products that were not apt to be sold to small investors through small retail banks (in Spain, for example).

It’s a bit adventurous to suppose that the personnel of those financial institutions actually consider the pros and cons of that behaviour before embarking on these operations and that they think that it’s worth taking the risk of being caught knowing that the fine will be less than the earnings that are obtained from activities that are on the limit or go over what is licit. It’s probably safer to think that there has been a lack of internal control or that you have to be stricter and uninvolved with the company to avoid cases like the sale of preferential stock to small-time savers or the tremendous losses incurred at JPMorgan in the “London Whale” case.

The size and influence of the financial institutions that have become entwined in these scandals has led to the New York Times to say: “Imposing criminal charges could put one of the largest banks in the world at risk and destabilise the world’s financial system again”. The same newspaper cited Simon Johnson (MIT professor and former member of the IMF) as saying that it has gone from “too big to fail to too big to jail”; even though Simon was at that time referring to the mortgage fraud that was taking place in the U.S. Even Rolling Stone magazine said that: “…the war on drugs is a joke…” when referring to the out-of-court settlement for HSBC when they were caught laundering money for drug cartels.

Banking regulation can look to avoid another financial crisis by increasing the guaranteed minimum deposit funds but it should also take into account the arguments in favour of making the financial institutions totally responsible for their destiny, making it clear there won’t be bailouts in case of bankruptcy, having the managing directors wait to see the results of their projects before being able to enjoy their perks or projected profits and establishing that any behaviour that violates the law will be punished without considering the systemic size or risk.

Maybe it’s better to not only avoid the “too big to fail” but also the “too big to jail”.

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