Why Big Banks Are Above the Law

By JAMES RICKARDS

July 30, 2012
Two developments in the banking industry with roots in the 1980s have now converged to give immunity to bankers for their criminal acts including mortgage fraud, accounting fraud, and LIBOR rate-rigging.

The first has to do with the consequences of a financial institution being charged with a crime. In the 1980s, Drexel Burnham was one of the largest and most powerful banks on Wall Street and the home of junk bond king Michael Milken and his hostile takeover empire. Drexel worked side-by-side with corporate raiders, hedge fund managers, and bond buyers to shake established company managers to the core and show that no one was safe from a debt-financed takeover backed by Milken. Behind this machine was a web of securities fraud and insider trading that was under investigation by the U.S. government. Beginning in 1986, Drexel suffered a series of individual and firm indictments and civil enforcement actions including some aimed at Milken himself. In December 1988, Drexel pleaded no contest to six felony charges and paid one of the largest fines in corporate history.

Then a curious thing happened. Over the course of a single day in February 1990, Drexel's short-term secured financing in the repo market evaporated. Drexel collapsed suddenly not because of a government indictment, but due to a run on the bank. The criminal cases against Drexel and Milken had caused a loss of confidence by the rest of Wall Street. Drexel was unable to leave its past behind and the firm succumbed to a criminal legacy.

The following year the king of Treasury securities dealers, Salomon Brothers, found itself involved in a criminal plot to rig the Treasury note market. Again, a run on the bank commenced and Salomon's balance sheet collapsed by two thirds in a matter of weeks. This time the outcome was different. The Treasury and Federal Reserve decided that two major bankruptcies in two years might be more than the system could bear. Warren Buffett was recruited as a white knight to refinance Salomon and a new management team including a former Treasury general counsel was brought in to put a clean face on the company. Salomon was spared. The lesson of Drexel and Salomon was that when banks face criminal prosecution, they also risk collapse.

The second development was the rise of the "too big to fail" doctrine. Many observers believe too big to fail is a product of the 2008 panic and TARP bailout, but the policy is much older. In 1984, Continental Illinois, the seventh largest bank in the United States, suffered a run on the bank. Contrary to established regulatory practice of bank closure or purchase by another bank, the regulators provided open bank assistance. In defending this action, the comptroller of the Currency explicitly stated that it was the policy of the United States not to let any of the 11 largest banks in the country fail. By 2011, that list had expanded to 29 firms including Citibank, J.P. Morgan, and Bank of America.

Now consider how these two developments work when applied together. The government knows that banks that are prosecuted may fail. They also know that some banks are too big to fail. It follows that some banks are too big to prosecute. They are above the law. Too big to fail means too big to jail.

Consider further that bankers know this. They know they are above the law and act accordingly. Normally, the prospect of being rousted out of bed at 5:00 a.m. and led away in handcuffs by FBI special agents in the full glare of television news lights is enough of a deterrent to keep even the greediest bankers in bounds. Yet, knowing they are immune from prosecution increases the temptation to engage in various kinds of fraud. When this green light for fraud is combined with heads-I-win, tails-you-lose gambling financed by federal deposit insurance, it's no wonder banks are engaged in institutionalized serial criminality not seen since the heyday of the Mafia in the 1950s.

Government has tried to finesse this dilemma using deferred prosecution agreements. These are basically deals where the government announces criminal charges but agrees not to go forward with the prosecution provided the bank pays fines, changes management, and keeps its nose clean for a year or more. If new crimes are committed in that time period, the deferred criminal charges spring back to life. It's a way to highlight alleged crimes without actually causing a run on the bank.

Expect to see such deferred prosecution agreements in the LIBOR scam cases. Also expect some individual arrests, perhaps soon, but only when the public has been carefully prepared and it has been made clear that these are "rouge" individuals and not the bank itself being charged with a crime.

At least that's some accountability. Yet, the larger problem remains. Unless banks are allowed to fail, whether it be for mismanagement or crimes, the feeling of being above the law will remain. The government reinforces that arrogance by its failure to prosecute. In the end, those who don't enforce the law are just as much to blame for bank crimes as the pinstriped perpetrators.


http://www.usnews.com/opinion/blogs/economic-intelligence/2012/07/30/why-big-banks-are-above-the-law